CUO Continental Materials Corp

PART I — FINANCIAL INFORMATION

See notes to condensed consolidated financial statements.

CONTINENTAL MATERIALS CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF INCOME AND RETAINED EARNINGS

FOR THE THREE MONTHS ENDED OCTOBER 1, 2016 AND OCTOBER 3, 2015

(Unaudited)

(000’s omitted except per-share amounts)

See notes to condensed consolidated financial statements

CONTINENTAL MATERIALS CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF INCOME AND RETAINED EARNINGS

FOR THE NINE MONTHS ENDED OCTOBER 1, 2016 AND OCTOBER 3, 2015

(Unaudited)

(000’s omitted except per-share amounts)

See notes to condensed consolidated financial statements

CONTINENTAL MATERIALS CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

FOR THE NINE MONTHS ENDED OCTOBER 1, 2016 AND OCTOBER 3, 2015

(Unaudited)

(000’s omitted)

See notes to condensed consolidated financial statements

CONTINENTAL MATERIALS CORPORATION

SECURITIES AND EXCHANGE COMMISSION FORM 10-Q

The following methods were used to estimate the fair value of all other financial instruments recognized in the accompanying balance sheet:

Cash and Cash Equivalents: The carrying amount approximates fair value and was valued as Level 1.

Revolving Bank Loan Payable: Fair value is estimated based on the borrowing rates currently available to the Company for bank loans with similar terms and maturities and determined through the use of a discounted cash flow model. The carrying amount of the Revolving Bank Loan Payable represents a reasonable estimate of the corresponding fair value as the Company’s debt is held at variable interest rates and was valued as Level 2.

There were no transfers between fair value measurement levels of any financial instruments in the current quarter.

4.    The Company implemented ASU No. 2015-17, Income Taxes (Topic 740): Balance Sheet Classification of Deferred Taxes, which changes how deferred taxes are classified on organizations’ balance sheets.  The change has been applied for all periods presented.  The effect of implementation is to report a consolidated non-current net asset of $3,329,000 and $3,149,000 in the condensed consolidated balance sheets as of October 1, 2016 and January 2, 2016, respectively.

There are no other significant prospective accounting pronouncements that are expected to have a material effect on the Company’s consolidated financial statements.

5.    Operating results for the first nine months of 2016 are not necessarily indicative of performance for the entire year due to the seasonality of most of the Company’s products. Historically, sales of the Evaporative Cooling segment are higher in the first and second quarters, sales of the Concrete, Aggregates and Construction Supplies (CACS) segment are higher in the second and third quarters and sales of the Heating and Cooling segment are higher in the third and fourth quarters. Sales of the Door segment are generally more evenly spread throughout the year.

6.    There is no difference in the calculation of basic and diluted earnings per share (EPS) for the three-month or nine-month periods ended October 1, 2016 and October 3, 2015 as the Company does not have any dilutive instruments.

7.    The Company operates primarily in two industry groups, Heating, Ventilation and Air Conditioning (HVAC) and Construction Products. The Company has identified two reportable segments within each of the industry groups: the Heating and Cooling segment and the Evaporative Cooling segment in the HVAC industry group and the CACS segment and the Door segment in the Construction Products industry group.

The Heating and Cooling segment primarily produces and sells gas-fired wall furnaces, console heaters and fan coils from the Company’s wholly-owned subsidiary, Williams Furnace Co. (WFC) of Colton, California. The Evaporative Cooling segment primarily produces and sells evaporative coolers from the Company’s wholly-owned subsidiary, Phoenix Manufacturing, Inc. (PMI) of Phoenix, Arizona. Sales of these two segments are nationwide, but are concentrated in the southwestern United States. Concrete, aggregates and construction supplies are offered from numerous locations along the Southern Front Range of Colorado operated by the Company’s wholly-owned subsidiaries Castle Concrete Company and Transit Mix Concrete Co., of Colorado Springs and Transit Mix of Pueblo, Inc. of Pueblo, Colorado (the three companies collectively are referred to as TMC). The Door segment sells hollow metal and wood doors, door frames and related hardware, lavatory fixtures and electronic access and security systems from the Company’s wholly-owned subsidiary, McKinney Door and Hardware, Inc. (MDHI), which operates out of facilities in Pueblo and Colorado Springs, Colorado. Sales of these two segments are highly concentrated in the Southern Front Range of Colorado although door sales are also made throughout the United States.

In addition to the above reporting segments, an “Unallocated Corporate” classification is used to report the unallocated expenses of the corporate office which provides treasury, insurance and tax services as well as strategic business planning and general management services. Expenses related to the corporate information technology group are allocated to all locations, including the corporate office.

The Company evaluates the performance of its segments and allocates resources to them based on a number of criteria including operating income, return on investment and other strategic objectives. Operating income is determined by deducting operating expenses from all revenues. In computing operating income, none of the following has been added or deducted: unallocated corporate expenses, interest, other income or loss or income taxes.

The following table presents information about reported segments for the nine-month and three-month periods ended October 1, 2016 and October 3, 2015 along with the items necessary to reconcile the segment information to the totals reported in the financial statements (amounts in thousands):

There are no differences in the basis of segmentation or in the basis of measurement of segment profit or loss from the last annual report.

8.    On September 15, 2016 a Partial Summary Judgment was issued regarding the Company’s previously disclosed litigation, Continental Materials Corporation v. Valco, Inc., Civil Action No. 2014-cv-2510, filed in the United States District Court for the District of Colorado. The suit regards a sand and gravel lease between the Company and Valco, Inc. (“Valco”) that calls for the payment of royalties over the life of the lease on an agreed 50,000,000 tons of sand and gravel reserves. In the suit the Company sought, among other things, to reform the sand and gravel lease in regard to the agreed amount of sand and gravel reserves and to recover approximately $1,282,000 of royalty overpayments included in other long-term assets. The Partial Summary Judgment resolved many of the Company’s claims in Valco’s favor, but the Company’s claim for the return of royalty overpayments made during the statutorily allowed period is still pending. The Company has concluded that recovery of the overpayments in excess of approximately $650,000 is not likely due to the statute of limitations and has therefore recorded a $632,000 write-down to the long-term asset during the third quarter of 2016. The Company and its legal counsel believe there are

grounds to appeal the Partial Summary Judgment regarding this and the other claims of the suit as the court improperly resolved factual issues that should have been decided by a jury. The Company and its legal counsel believe there is a likelihood that some, or all, of the issues resolved by the Partial Summary Judgment may be reversed on appeal and remanded for trial by jury although there can be no assurance that an appeal will result in reversal. The Company paid royalties on approximately 17,700,000 tons, including the overpayments, of the 50,000,000 tons of sand and gravel reserves through the end of the third quarter of 2014. The impact of these proceedings could have a material effect although the Company does not believe that there is a reasonable basis for estimating the financial impact, if any, of the final outcome of these proceedings and accordingly no accrual or reserve has been recorded in compliance with accounting principles generally accepted in the United States of America. In addition, on September 30, 2016 Valco filed a motion seeking to add three new counterclaims alleging damages in excess of $5,900,000. The Company has vigorously opposed the motion which has not yet been ruled upon.

9.    Identifiable amortizable intangible assets as of October 1, 2016 include a restrictive land covenant and customer relationships. At October 1, 2016, these assets were collectively carried at  zero, net of $720,000 accumulated amortization. The pre-tax amortization expense for intangible assets during the quarter ended October 1, 2016 was zero compared to $11,000 for the quarter ended October 3, 2015 and $21,000 and $34,000 for the nine months ended October 1, 2016 and October 3, 2015, respectively.

Based upon the intangible assets recorded on the balance sheet at October 1, 2016, amortization expense after the third quarter of 2016 will be zero.

10.    The Company issued a total of 12,000 shares to the eight eligible board members effective April 6, 2016 as full payment for their 2016 retainer fee. The Company issued a total of 12,000 shares to the eight eligible board members effective January 15, 2015 as full payment for their 2015 retainer fee. All shares were issued under the 2010 Non-Employee Directors Stock Plan.

11.  The Company entered into an Amended and Restated Credit Agreement (the “Credit Agreement”) effective November 18, 2011. The Company entered into the Fifth Amendment to Credit Agreement effective March 20, 2015 and the Sixth Amendment to Credit Agreement effective August 10, 2015. Effective March 24, 2016 the Company entered into the Seventh Amendment to Credit Agreement. The Company had previously entered into four separate amendments to the Credit Agreement. Cumulatively, the amendments were entered into by the Company to, among other things, (i) modify certain of the financial covenants, (ii) increase the Revolving Commitment to $20,000,000, (iii) terminate the Term Loan Commitment upon the repayment in full of the outstanding principal balance (and accrued interest thereon) of the Term Loan, (iv) modify the Borrowing Base calculation to provide for borrowing availability in respect of new Capital Expenditures, (v) decrease the interest rates on the Revolving Loans and (vi) extend the maturity date to May 1, 2018. Borrowings under the Credit Agreement are secured by the Company’s accounts receivable, inventories, machinery, equipment, vehicles, certain real estate and the common stock of all of the Company’s subsidiaries. Borrowings under the Credit Agreement bear interest based on a London Interbank Offered Rate (LIBOR) or prime rate based option.

The Credit Agreement either limits or requires prior approval by the lender of additional borrowings, acquisition of stock of other companies, purchase of treasury shares and payment of cash dividends. Payment of accrued interest is due monthly or at the end of the applicable LIBOR period.

The Credit Agreement as amended provides for the following:

Definitions under the Credit Agreement as amended are as follows:

Outstanding funded revolving debt was $1,000,000 as of October 1, 2016 compared to $6,200,000 as of January 2, 2016. The highest balance outstanding during the first nine months of 2016 and 2015 was $7,500,000 and $6,800,000, respectively. Average outstanding funded debt was $4,548,000 and $4,901,000 for the first nine months of 2016 and 2015, respectively. At October 1, 2016, the Company had outstanding letters of credit totaling $5,415,000. At all times since the inception of the Credit Agreement, the Company has had sufficient qualifying and eligible assets such that the available borrowing capacity exceeded the cash needs of the Company and this situation is expected to continue for the foreseeable future.

The Company believes that its existing cash balance, anticipated cash flow from operations and borrowings available under the Credit Agreement will be sufficient to cover expected cash needs, including planned capital expenditures, for the next twelve months except for the expenditures related to a royalty agreement and the acquisition of the necessary equipment needed to begin mining an aggregates property near Colorado Springs

should Transit Mix succeed in obtaining the required mining permits from the State of Colorado and El Paso County. As of October 1, 2016 the Company has invested and capitalized approximately $2,400,000 of deferred development expenditures related to this aggregates property. The Company expects to arrange for term or mortgage financing to fund the acquisition of the necessary equipment needed to begin mining the property should the permits be granted. The Company expects to be in compliance with all debt covenants, as amended, throughout the facility’s remaining term.

12.  The Company is involved in litigation matters related to its business, principally product liability matters related to the gas-fired heating products and fan coil products in the Heating and Cooling segment. In the Company’s opinion, none of these proceedings, when concluded, will have a material adverse effect on the Company’s consolidated results of operations, cash flows or financial condition as the Company has established adequate accruals for matters that are probable and estimable. The Company does not accrue estimated future legal costs related to the defense of theses matters but rather expenses legal costs as incurred. Additionally, see Note 8 for discussion of litigation regarding the Pueblo sand and gravel lease.

primarily due to a planned build-up in anticipation of fourth quarter furnace sales as well as the delay in the receipt of orders from a large customer.

During the nine months ended October 1, 2016, investing activities used $3,312,000 of cash compared to $1,159,000 of cash used in the prior year’s period. Capital expenditures during the first nine months of 2016 were $3,617,000 compared to $1,379,000 during the first nine months of 2016. Capital spending in the CACS segment was the primary reason for these increases as the segment added new mixer trucks and continued to develop the aggregate property that is under option. Additionally, 2016 includes $305,000 of cash proceeds from the sale of equipment compared to $220,000 in the first nine months of 2015.

Financing activities during the first nine months of 2016 used $5,200,000 as available cash was used to pay down the revolving bank loan. During the first nine months of 2015 financing activities provided $900,000 as bank borrowings were used to partially finance the increase in working capital. See also the discussion of the Revolving Credit and Term Loan Agreement below.

Revolving Credit and Term Loan Agreement

As discussed in Note 11 to the condensed consolidated financial statements contained in this Quarterly Report, the Company maintains a Credit Agreement, which, as amended, provides for a Revolving Commitment of $20,000,000. Borrowings under the Credit Agreement are secured by the Company’s accounts receivable, inventories, machinery, equipment, vehicles, certain real estate and the common stock of all of the Company’s subsidiaries. Borrowings under the Revolving Commitment are limited to (a) 80% of eligible accounts receivable, (b) the lesser of 50% of eligible inventories and $8,500,000 plus (c) 80% of new Capital Expenditures not to exceed $5,500,000 in the aggregate with respect to each of Fiscal Year 2016 and 2017. Borrowings under the Credit Agreement bear interest based on a LIBOR or prime rate based option.

The Credit Agreement either limits or requires prior approval by the lender of additional borrowings, acquisition of stock of other companies, purchase of treasury shares and payment of cash dividends. Payment of accrued interest is due monthly or at the end of the applicable LIBOR period. The Credit Agreement has a maturity date of May 1, 2018.

The Company’s outstanding borrowings against the revolving credit facility were $1,000,000 at October 1, 2016. At all times since the inception of the Credit Agreement, the Company has had sufficient qualifying and eligible assets such that the entire revolving credit facility was available to the Company. This situation is expected to continue for the foreseeable future.

As of October 1, 2016 the Company was in compliance with all covenants in the Credit Agreement and expects to be in compliance with all loan covenants for the remaining term of the Credit Agreement. The Company believes that its existing cash balance, anticipated cash flow from operations and borrowings available under the Credit Agreement will be sufficient to cover expected cash needs, including planned capital expenditures, for the next twelve months except for the expenditures related to a royalty agreement and the acquisition of the necessary equipment needed to begin mining an aggregates property near Colorado Springs should Transit Mix succeed in obtaining the required mining permits from the State of Colorado and El Paso County. The Company expects to arrange for term or mortgage financing to fund the acquisition of the necessary equipment needed to begin mining the property should the permits be granted. The Company expects to be in compliance with all debt covenants, as amended, throughout the facility’s remaining term.

Results of Operations - Comparison of Quarter Ended October 1, 2016 to the Quarter Ended October 3, 2015

(In the ensuing discussions of the results of operations the Company defines the term gross profit as the amount determined by deducting cost of sales before depreciation, depletion and amortization from sales. The gross profit ratio is gross profit divided by sales.)

Consolidated sales in the third quarter of 2016 were $37,647,000, an increase of $1,482,000 or 4.1% compared to the third quarter of 2015. The CACS segment accounted for a majority of the increase reporting sales $1,397,000 higher than the third quarter of 2015. Smaller increases in third quarter sales in the Door and Heating and Cooling segments were partially offset by a slight decline in third quarter sales in the Evaporative Cooler segment.

The consolidated gross profit ratio in the third quarter of 2016 was 21.4% compared to 19.1% in the same period of 2015. The gross profit ratio improvement was realized in the CACS, Door and Evaporative Coolings segments which reported increases of 3.3%, 5.3% and 3.6%, respectively. The Heating and Cooling segment reported a slight decline, 1.2%, in gross profit margin. 

Consolidated selling and administrative expenses were $63,000 higher than the comparable prior year quarter.

However, as a percentage of consolidated sales, selling and administrative expenses decreased between quarters at 14.7% and 15.1% for 2016 and 2015, respectively.

As discussed in Note 8 above, the current quarter includes a $632,000 write-down related to an overpayment of prepaid royalties claim which was previously included within other long-term assets.

Consolidated depreciation and amortization charges declined $33,000 between the third quarter of 2016 and the third quarter of 2015.

The consolidated operating income in the third quarter of 2016 was $1,361,000 compared to $965,000 in the third quarter of the prior year. The majority of the improvement was seen in the CACS segment which reported a current quarter operating income of $1,010,000 compared to $686,000 in the third quarter of 2015. The Door and Evaporative Cooler segments also reported improved operating income up $269,000 and $105,000, respectively. The Heating and Cooling segment reported a decline of $284,000 in operating income between the third quarter of 2016 and the same period in 2015.

Interest income for the third quarter 2016 is $285,000 compared to $9,000 for the third quarter of 2015. The current year quarter includes $252,000 of preferred interest income recorded with the redemption of a preferred investment previously classified in other assets as of January 2, 2016. Interest expense includes interest on outstanding funded debt, finance charges on outstanding letters of credit, the fee on the unused revolving credit line and other recurring fees charged by the lending bank. Interest expense in the third quarter of 2016 was $83,000 compared to $111,000 in the third quarter of 2015. The decline from the prior year quarter is attributable to improved earnings, lower average borrowings and inclusion of $17,000 capitalized interest associated with expenditures related to a royalty agreement discussed in Note 11 above. The weighted average interest rate on outstanding funded debt in the third quarter of 2016, including the fee on the unused line of credit and other recurring bank charges but excluding finance charges on letters of credit, was approximately 6.5% compared to 4.7% in the third quarter of 2015. Average outstanding funded debt in the third quarter of 2016 was $2,779,000 compared to $4,940,000 in the third quarter of 2015. At the end of the third quarter of 2016 the outstanding funded debt was $1,000,000 compared to $6,700,000 at the end of the third quarter of 2015.

The Company’s effective income tax rate reflects federal and state statutory income tax rates adjusted for non-deductible expenses, tax credits and other tax items. The estimated effective income tax rate in the third quarter of 2016 was 34.0% compared to 38.0% for the third quarter of 2015.

The Company operates four businesses in two industry groups. The businesses are generally seasonal, weather sensitive and subject to cyclical factors. The following addresses various aspects of operating performance focusing on the reportable segments within each of the two industry groups.

Construction Products

The table below presents a summary of operating information for the two reportable segments within the Construction Products industry group for the quarters ended October 1, 2016 and October 3, 2015 (dollar amounts in thousands):

Concrete, Aggregates and Construction Supplies Segment

The product offerings of the CACS segment consist of ready mix concrete, aggregates and construction supplies. Ready mix concrete and aggregates are produced at multiple locations in or near Colorado Springs and Pueblo, Colorado. Construction supplies encompass numerous products purchased from third party suppliers and sold to the construction trades, particularly concrete sub-contractors. During the three months ended October 1, 2016, concrete, aggregates and construction supplies accounted for approximately 77%, 17% and 6% of the sales of the CACS segment, respectively, including aggregates consumed internally in the production of concrete. In the third quarter of 2015, the sales mix between concrete, aggregates and construction supplies was 72%, 20% and 8%, respectively. Sales including aggregates consumed internally increased $1,553,000 (8.8%) between the third quarter of 2016 and the comparable prior year quarter. Sales to third parties increased by $1,397,000 (8.3%) between the same periods. The gross profit reported by the CACS segment improved to 17.0% in the third quarter of 2016 from 13.7% in the third quarter of the prior year. The enhanced performance of the segment is attributable to sustained improvement in the construction market in the Colorado Springs area, an improving Pueblo market and increased pricing in both markets.

Excluding a flow fill project during 2015, ready mix concrete sales increased 17.4% in the third quarter of 2016 versus the third quarter of 2015. Concrete volume, on the same basis, was 9.4% higher in the third quarter of 2016 compared to the prior year quarter while average concrete prices for the third quarter of 2016 increased by approximately 7.3% over the comparable 2015 quarter. Even though concrete prices have increased, the market remains sharply competitive especially on large construction projects. Material cost per yard remained fairly consistent, increasing less than 1%, in the third quarter of 2016 compared to the prior year third quarter. Cement is the highest cost raw material used in the production of ready mix concrete. Cement costs per yard increased by 5.5% in the third quarter of the current year compared to the same quarter of 2015. Higher cement costs, including delivery, were partially offset by lower fly ash and other admixture costs. Batching cash costs per yard increased by 6.2% while delivery cash costs per yard decreased by 2.3%. Batching costs increased primarily due to higher labor costs associated with additional personnel and overtime required for several more technical jobs. Delivery costs

declined largely due to reduced repairs and maintenance costs as well as lower diesel fuel costs which more than offset an increase in contract trucking expense. The gross profit ratio from concrete increased to 20.1% for the third quarter 2016 from 14.6% in the third quarter of 2015.

The CACS segment also produces and sells sand, crushed limestone and gravel (collectively “aggregates”) from deposits in and around Colorado Springs. Sales volume (tons) of construction aggregates, including those used internally in the production of ready mix concrete, decreased 10.3% in the third quarter of 2016 compared to the comparable 2015 quarter. Average selling prices, excluding freight, increased 13.1% due to the higher ratio of concrete sand to fill sand sales. Although the sand operation reported an improved gross profit for the third quarter of 2016 compared to the same period in 2015, mining challenges at two of the quarries and carrying costs related to the closed Pueblo quarry contributed to the $215,000 loss reported by the aggregates operations in the third quarter of 2016 compared to a $30,000 profit for the third quarter of 2015.

Sales of construction supplies decreased by $367,000 (24.9%) in the third quarter of 2016 compared to the prior year quarter. The gross profit declined to 12.4% from 15.1% in 2015. Higher labor costs, both production and delivery, combined with the decrease in sales volume to account for the decline in gross profit.

Depreciation and amortization charges decreased by $14,000 in the third quarter of 2016 compared to the third quarter of 2015.

Selling and administrative expenses were $232,000 lower in the third quarter of 2016 compared to the same period in 2015. Increased compensation related expenses were more than offset by reduced legal fees. Litigation fees related to the Pueblo aggregate lease were $138,000 during the third quarter of 2016 compared to $453,000 incurred during the comparable period of 2015. As a percentage of sales selling and administrative expenses were 6.7% in 2016 compared to 8.6% in 2015. 

In addition, the third quarter of 2016 includes a write-down of $632,000 related to prepaid royalties discussed in Note 8 and $252,000 of preferred interest income received with the redemption of a preferred investment discussed in Results of Operations.

The prices of two commodities, cement and diesel fuel, can have a significant effect on the results of operations of this segment. Management negotiates cement prices with producers who have production facilities in or near the concrete markets that the Company serves. Management may negotiate separate cement prices for large construction projects depending on the demand for and availability of cement from the local producers. The Company buys diesel fuel from local distributors and occasionally enters into a short term arrangement with a distributor whereby the price of diesel fuel is fixed for a period of up to six months. In the past year the Company has not hedged diesel fuel prices. Increases in the cost of these two commodities have a direct effect on the results of operations depending upon whether competitive conditions prevailing in the marketplace enable the company to adjust its selling prices to recover such increases.

Door Segment

The Door segment sells hollow metal doors, door frames and related hardware, wood doors, lavatory fixtures and electronic access and security systems. Nearly all of the Door segments sales are for commercial and institutional buildings such as schools and healthcare facilities. Approximately 65% to 70% of the sales of the Door segment are related to jobs obtained through a competitive bidding process. Bid prices may be higher or lower than bid prices on similar jobs in the prior year. The Door segment does not track unit sales of the various products through its accounting or management reporting systems. Management focuses on the level of the sales backlog, the trend in sales and the gross profit rate in managing the business.

Door sales in the third quarter of 2016 were $196,000 (4.6%) more than in the third quarter of the previous year. Bidding prices remain competitive. The gross profit ratio in the third quarter of 2016 was 27.7%, up from 22.4% in the comparable quarter of 2015. The improvement in the gross profit ratio is principally due to better pricing on some of the bid jobs shipped during the third quarter of 2016.

Sales and administrative expenses were $11,000 higher in the third quarter of 2016 compared to the third quarter of 2015. As a percentage of sales, these expenses decreased to 14.9% from 15.3% in the third quarters of 2016 and 2015, respectively.

The Door segment sales backlog at the end of the third quarter of 2016 was $5,572,000 compared to $4,373,000 a year ago.

HVAC Products

The table below presents a summary of operating information for the two reportable segments within the HVAC products industry group for the quarters ended October 1, 2016 and October 3, 2015 (dollar amounts in thousands):