DORM Dorman Products Inc

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE TWENTY-SIX WEEKS ENDED JUNE 29, 2019 AND JUNE 30, 2018

(UNAUDITED)

As used herein, unless the context otherwise requires, “Dorman”, the “Company”, “we”, “us”, or “our” refers to Dorman Products, Inc. and its subsidiaries. Our ticker symbol on the NASDAQ Global Select Market is “DORM.”

The accompanying unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles in the U.S. for interim financial information and in accordance with the rules and regulations of the U.S. Securities and Exchange Commission (“SEC”). However, they do not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of only normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the twenty-six weeks ended June 29, 2019 are not necessarily indicative of the results that may be expected for the fiscal year ending December 28, 2019. We may experience significant fluctuations from quarter to quarter in our results of operations due to the timing of orders placed by our customers. The introduction of new products and product lines to customers may cause significant fluctuations from quarter to quarter. These financial statements should be read in conjunction with the consolidated financial statements and footnotes thereto included in our Annual Report on Form 10-K for the fiscal year ended December 29, 2018.

Certain prior year amounts have been reclassified to conform with current year presentation.

Revision of Prior Period Financial Statements

During the quarter ended June 29, 2019, we identified and corrected an immaterial error that affected previously issued consolidated financial statements. This error related to the application of Financial Accounting Standards Board (“FASB”) Accounting Standards Update (“ASU”) No. 2014-09, Revenue from Contracts with Customers, related to the balance sheet classification of accrued customer rebates and returns that are recognized in connection with sales of our products. We adopted this ASU on December 31, 2017, the beginning of our 2018 fiscal year. We previously recorded accrued customer rebates and returns that were expected to be issued as credits to our customers as a valuation account which offset accounts receivable. Accrued customer rebates and returns are now recorded as a current liability.  

Previously issued comparative financial statements, which were revised during the quarter ended June 29, 2019 to correct the error noted above, are presented as “As Revised” in the tables presented in the following footnotes.

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Additionally, as a result of the adoption of ASU No. 2014-09 , the Company should have disclosed the initial impact to the balance sheet reclassification for accrued customer rebates and returns from accounts receivable, net to accrued customer rebates and returns. The cumulative effect of the changes to the consolidated balance sheet from the adoption was as follows:

The effect of the above corrections on the consolidated statement of cash flows for the fiscal year ended December 29, 2018 is as follows:

The correction of this error did not impact our Consolidated Statements of Operations or our Consolidated Statements of Shareholder’s Equity in any period presented.

On August 31, 2018, we acquired 100% of the outstanding stock of Flight Systems Automotive Group LLC (“Flight Systems” or “Flight”), a privately-held manufacturer and remanufacturer of complex automotive electronics and diesel fuel system components, based in Lewisberry, Pennsylvania. The purchase price was $27.5 million. We believe complex electronics and diesel fuel system components represent important growth opportunities for us and Flight’s product portfolio delivers valuable alternatives to aftermarket professionals.

The transaction was accounted for as a business combination under the acquisition method of accounting. Accordingly, the assets acquired and liabilities assumed were recorded at fair value, with the remaining purchase price recorded as goodwill.

In connection with this acquisition, we preliminary recorded $5.5 million in goodwill, $5.3 million of identified intangibles, and $16.7 million of other net assets, primarily $2.0 million of accounts receivable, $9.1 million of inventory, $4.4 million of fixed assets, and $1.2 million of net other assets and liabilities. The estimated fair value of the Flight assets acquired and liabilities assumed are provisional as of June 29, 2019 and are based on information that is currently available to the Company. Additional information about conditions that existed as of the date of acquisition are being gathered to finalize these provisional measurements, particularly with respect to net working capital, intangible assets, deferred income taxes and tax liabilities. Accordingly, the measurement of Flight’s assets acquired and liabilities assumed may change significantly upon finalization of the Company’s valuations and completion of the purchase price allocation, both of which are expected to occur no later than one year from the acquisition date.

The valuation of the intangible assets acquired and related amortization periods are as follows:

The preliminary fair values of the Customer relationships and Tradenames were estimated using a discounted present value income approach.  

The goodwill recognized is attributable primarily to strategic and synergistic opportunities related to existing automotive aftermarket businesses, the assembled workforce of Flight and other factors. The goodwill is expected to be deductible for tax purposes.

The financial results of the acquisition have been included in the Consolidated Financial Statements since the date of acquisition.  

On October 26, 2017, we acquired 100% of the outstanding stock of MAS Automotive Distribution Inc. (“MAS”), a privately-held manufacturer of premium chassis and control arms based in Montreal, Canada. The purchase price was $67.2 million net of $3.3 million of cash acquired and including contingent consideration and other purchase price adjustment. The fair value of the contingent cash consideration was estimated by using an option pricing model framework, which represents our own assumptions and data, and is based on our best available information. As of June 29, 2019, we had $8.1 million recorded as a long-term liability which represents the fair value of the estimated payment which will become due if certain sales thresholds are achieved through December 2020. Accretion expense was $0.2 million in each of the twenty-six weeks ended June 29, 2019 and June 30, 2018, which was included in selling, general and administrative expenses in the Consolidated Statements of Operations.

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We have entered into several customer sponsored programs administered by unrelated financial institutions that permit us to sell certain accounts receivable at discounted rates to the financial institutions. Transactions under these agreements were accounted for as sales of accounts receivable and were removed from our Consolidated Balance Sheet at the time of the sales transactions. Pursuant to these agreements, we sold $355.1 million and $282.1 million of accounts receivable during the twenty-six weeks ended June 29, 2019 and June 30, 2018, respectively. If receivables had not been sold over the previous twelve months, $438.3 million and $378.5 million of additional accounts receivable would have been outstanding at June 29, 2019 and December 29, 2018, respectively, based on standard payment terms. Selling, general and administrative expenses for the twenty-six weeks ended June 29, 2019 and June 30, 2018 included $9.3 million and $6.7 million, respectively, in financing costs associated with these accounts receivable sales programs.

Inventories include the cost of material, freight, direct labor and overhead utilized in the processing of our products and are stated at the lower of cost or net realizable value. Inventories were as follows:

As discussed in Note 15, we adopted ASU No. 2016-02, Leases , on December 30, 2018, the beginning of our fiscal 2019, using the modified retrospective approach. We determine whether an arrangement is a lease at inception. This determination generally depends on whether the arrangement conveys the right to control the use of an identified fixed asset explicitly or implicitly for a period of time in exchange for consideration. Control of an underlying asset is conveyed if we obtain the rights to direct the use of and to obtain substantially all of the economic benefit from the use of the underlying asset. Some of our leases included both lease and non-lease components which are accounted for as a single lease component as we have elected the practical expedient. Some of our operating lease agreements include variable lease costs, primarily taxes, insurance, common area maintenance or increases in rental costs related to inflation. Substantially all of our equipment leases and some of our real estate leases have terms of less than one year and as such are accounted for as short-term leases as we have elected the practical expedient.

Operating leases are included in the right-of-use lease assets, other current liabilities and long-term lease liabilities on the Consolidated Balance Sheet. Right-of-use assets and lease liabilities are recognized at each lease’s commencement date based on the preset values of its lease payments over its respective lease term. When a borrowing rate is not explicitly available for a lease, our incremental borrowing rate is used based on information available at the lease’s commencement date to determine the present value of its lease payments. Operating lease payments are recognized on a straight-line basis over the lease term. We had no financing leases as of June 29, 2019.

We have operating leases for distribution centers, sales offices and certain warehouse and office equipment. Our leases have remaining lease terms of 1 to 12 years, many of which include one or more renewal options. We consider these renewal options in determining the lease term used to establish our right-of-use assets and lease liabilities when it is determined that it is reasonably certain that the renewal option will be exercised.

As of June 29, 2019, there was no material variable lease costs or sublease income. Cash paid for operating leases was $2.5 million in the twenty-six weeks ended June 29, 2019. The following table summarizes the lease expense for the thirteen and twenty-six weeks ended June 29, 2019:

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Supplemental balance sheet information related to our operating leases is as follows:

The following table summarizes the maturities of our lease liabilities for all operating leases as of June 29, 2019:

For the year ended December 29, 2018, minimum rental payments under operating leases were recognized on a straight-line basis over the term of the lease including any periods of free rent. Rent expense for operating leases, including payments for short-term equipment and storage rentals, was $6.9 million in fiscal 2018. Minimum future rental payments required under operating leases in effect as of December 29, 2018 were as follows:

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Amortization expense was $1.3 million and $1.1 million for the twenty-six weeks ended June 29, 2019 and June 30, 2018, respectively .

We regularly assess our adherence to customs laws and regulations as part of our trade compliance program. In connection with our assessment process, we discovered that we previously reported incorrect importation codes to the United States Customs & Border Protection (“CBP”) on certain products that we imported into the United States. As a result, we elected to initiate an internal review and commence a voluntary prior disclosure process with CBP. We informed CBP, as part of the prior disclosure, that we had previously incorrectly classified certain products which we believe would result in both underpayments and overpayments of duties to CBP, that we were continuing to investigate the historical misclassifications, and that at that time we were not able to fully determine the nature and scope of all prior misclassifications. Since discovering the misclassifications, we have taken corrective actions with respect to the ongoing classification of our products and payment of duties on products being imported into the United States.

Since we have made a prior disclosure to CBP, we believe our liability to CBP will be limited to the unpaid duties, after deducting the overpayment of duties, and interest on such net unpaid duties for the last five years, which is the applicable statute of limitations. In July 2019, we engaged a customs advisory firm to assist us in completing the prior disclosure, including determining the nature and scope of the historical misclassifications and the amount of duties and interest payable to CBP. We expect to complete our prior disclosure to CBP and pay any unpaid duties and interest in late 2019 or early 2020. Based on currently known information, it is probable that we will be liable to CBP for unpaid duties and interest, but we are unable to reasonably estimate the loss, or range of loss, that may result due to the complexity of the calculations required to complete the prior disclosure and the volume of importation records subject to analysis over the five-year period. The resolution of this prior disclosure could be material to our cash flows in a future period and to our results of operations for any period, but is not expected to be material to our financial position.

We are a party to or otherwise involved in legal proceedings that arise in the ordinary course of business, such as various claims and legal actions involving contracts, competitive practices, intellectual property infringement, product liability claims and other matters arising out of the conduct of our business. In the opinion of management, none of the actions, individually or in the aggregate, taking into account relevant insurance coverage, would likely have a material financial impact on the Company and we believe the range of reasonably possible losses from current matters, taking into account relevant insurance coverage, is immaterial.

The FASB issued ASU No. 2014-09, Revenue from Contracts with Customers , in May 2014 regarding the accounting for and disclosure of revenue. Specifically, the update outlined a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers, which is common to both U.S. GAAP and International Financial Reporting Standards.  

Our primary source of revenue is from contracts with and purchase orders from customers. Revenue is recognized from product sales when goods are shipped, title and risk of loss and control have been transferred to the customer, and collection is reasonably assured. We estimate the transaction price at the inception of a contract or upon fulfilling a purchase order, including any variable consideration, and will update the estimate for changes in circumstances. We utilize the most likely amount method consistently to estimate the effect of uncertainty on the amount of variable consideration to which we would be entitled. The most likely amount method considers the single most likely amount from a range of possible consideration amounts. This method is utilized for all of our variable consideration.  

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We record estimates for cash discounts, product returns, promotional rebates, core return deposits and other discounts in the period the related p roduct revenue is recognized (“c ustomer rebates and r eturns ”). The provision for c ustomer rebates and r eturns is recorded as a reduction of gross sales . Beginning with our Form 10-Q for the period ended June 29, 2019, our obligation associated with c ustomer rebates and r eturns is classified as a current liability on our consolidated balance sheets (“accrued c ustomer rebate s and r eturns”). We have revised prior period balances to conform with this presentation. Please refer to Note 1. Actual c ustomer rebates and r eturns have not differed materially from estimated amounts for each period presented. Amounts billed to customers for shipping and handling are included in net sales. Costs associated with shipping and handling are included in cost of goods sold. We have concluded that our estimates of variable consideration are not constrained according to the definition of the new standard.   

All of our revenue was recognized under the point of time approach in accordance with the revenue standard during the twenty-six weeks ended June 29, 2019 and June 30, 2018, respectively. Also, we do not have significant financing arrangements with our customers, as our credit terms are all less than one year. Lastly, we do not receive noncash consideration (such as materials or equipment) from our customers to facilitate the fulfillment of our contracts.  

Five-step model

We apply the FASB’s guidance on revenue recognition, which requires us to recognize the amount of revenue and consideration which we expect to receive in exchange for goods or services transferred to our customers. To do this, we apply the five-step model prescribed by the FASB, which requires us to: (i) identify the contract with a customer; (ii) identify the performance obligations in the contract; (iii) determine the transaction price; (iv) allocate the transaction price to the performance obligations in the contract; and (v) recognize revenue when, or as, we satisfy a performance obligation.

Contract Assets and Liabilities  

We recognize a receivable or contract asset when we perform a service or transfer a good in advance of receiving consideration.  

- A receivable is recorded when our right to consideration is unconditional and only the passage of time is required before payment of that consideration is due.

- A contract asset is recorded when our right to consideration in exchange for goods or services that we have transferred to a customer is conditional on something other than the passage of time. We did not have any contract assets recorded as of June 29, 2019 or December 29, 2018.

We recognize a contract liability when we receive consideration, or if we have the unconditional right to receive consideration, in advance of satisfying the performance obligation. A contract liability is our obligation to transfer goods or services to a customer for which we have received consideration, or an amount of consideration is due from the customer. We did not have any contract liabilities recorded as of June 29, 2019 or December 29, 2018.

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9. Stock-Based Compensation

On May 16, 2018, our shareholders approved our 2018 Stock Option and Stock Incentive Plan (the “2018 Plan” or the “Plan”), which supersedes our 2008 Stock Option and Stock Incentive Plan. Under the terms of the Plan, our Board of Directors may grant up to 1,200,000 shares of common stock in the form of shares of restricted stock, restricted stock units, stock appreciation rights, stock options, or combinations thereof, to officers, directors, employees, consultants and advisors. Grants under the Plan must be made within ten years of the date the Plan was approved. Stock options are exercisable upon the terms set forth in each grant agreement, but in no event more than ten years from the date of grant. Restricted stock and restricted stock units vest in accordance with the terms set forth in each applicable award agreement. At June 29, 2019, 1,046,264 shares were available for grant under the 2018 Plan.

Restricted Stock

We may grant restricted stock to officers, directors, employees, consultants and advisors. Vesting of restricted stock is conditional based on continued employment or service for a specified period and, in certain circumstances, the attainment of performance goals. We retain the unvested restricted stock, and any dividends paid thereon, until the vesting conditions have been met. For time-based restricted stock awards, compensation cost related to the stock is recognized on a straight-line basis over the vesting period and is calculated using the closing price per share of our common stock on the grant date. For performance-based restricted stock awards tied to growth in adjusted pre-tax income, compensation cost related to the stock is recognized over the performance period and is calculated using the closing price per share of our common stock on the grant date and an estimate of the probable outcome of the performance conditions. In 2019, we introduced performance-based shares that vest based on our total shareholder return ranking relative to the S&P Midcap 400 Growth Index over a three-year performance period. For performance-based restricted stock awards tied to total shareholder return, compensation cost related to the stock is recognized on a straight-line basis over the performance period and is calculated using the simulated fair value per share of our common stock based on the application of a Monte Carlo simulation model. Compensation cost related to restricted stock was $1.5 million and $1.6 million for the twenty-six weeks ended June 29, 2019 and June 30, 2018, respectively, and is classified as selling, general and administrative expense in the Consolidated Statements of Operations.

The following table summarizes our restricted stock activity for the twenty-six weeks ended June 29, 2019:

As of June 29, 2019, there was $7.2 million of unrecognized compensation cost related to unvested restricted stock, which is expected to be recognized over a weighted-average period of approximately 2.8 years.

Cash flows resulting from tax deductions in excess of the tax effect of compensation cost recognized in the financial statements are classified as operating cash flows. The excess tax benefit generated from restricted stock which vested was $0.2 million and $0.1 million in the twenty-six weeks ended June 29, 2019 and June 30, 2018, respectively, and was credited to income tax expense.

Stock Options

We may grant stock options to officers, directors, employees, consultants and advisors. We expense the grant-date fair value of stock options. Compensation cost is recognized on a straight-line basis over the vesting period for which related services are performed. The compensation cost charged against income was $0.3 million for each of the twenty-six weeks ended June 29, 2019 and June 30, 2018. The compensation costs were classified as selling, general and administrative expense in the Consolidated Statements of Operations. No cost was capitalized during the twenty-six weeks ended June 29, 2019 and June 30, 2018.

We use the Black-Scholes option valuation model to estimate the fair value of stock options granted. Expected volatility and expected dividend yield are based on the actual historical experience of our common stock. The expected life represents the period of time that options granted are expected to be outstanding and was calculated using historical option exercise data. The risk-free rate was based on a U.S. Treasury security with terms equal to the expected time of exercise as of the grant date. During the twenty-six weeks ended June 29, 2019 and June 30, 2018 we granted 36,235 and 61,514 stock options, respectively.

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The following table summarizes our stock option activity for the twenty-six weeks ended June 29, 2019 :

   There were 34,301 options exercised during the twenty-six weeks ended June 29, 2019. There were no options exercised in the twenty-six weeks ended June 30, 2018. As of June 29, 2019, there was $1.9 million of unrecognized compensation cost related to non-vested stock options, which is expected to be recognized over a weighted-average period of 3.0 years.

Cash generated from stock option exercises was less than $0.1 million in the twenty-six weeks ended June 29, 2019. There was no cash received from stock option exercises in the twenty-six weeks ended June 30, 2018.

There was no excess tax benefit generated from stock options exercised in the twenty-six weeks ended June 29, 2019 or June 30, 2018.

Employee Stock Purchase Plan

In May 2017, our shareholders’ approved the Dorman Products, Inc. Employee Stock Purchase Plan (the “ESPP”), which made available 1,000,000 shares of our common stock for sale to eligible employees. There were 13,669 and 7,382 shares purchased under this plan in the twenty-six weeks ended June 29, 2019 and June 30, 2018, respectively. During the twenty-six weeks ended June 29, 2019 and June 30, 2018, compensation cost under the ESPP was $0.2 million and $0.1 million, respectively.

Basic earnings per share is calculated by dividing our net income by the weighted average number of common shares outstanding during the period, excluding nonvested restricted stock which is considered to be contingently issuable. To calculate diluted earnings per share, common share equivalents are added to the weighted average number of common shares outstanding. Common share equivalents are calculated using the treasury stock method and are computed based on outstanding stock-based awards. Stock-based awards of 54,000 shares and 71,000 shares were excluded from the calculation of diluted earnings per share as of June 29, 2019 and June 30, 2018, respectively, as their effect would have been anti-dilutive.

The following table sets forth the computation of basic earnings per share and diluted earnings per share:

We periodically repurchase, at the then current market price, and cancel common stock issued to the Dorman Products, Inc. 401(k) Retirement Plan and Trust (the “401(k) Plan”). Shares are generally purchased from the 401(k) Plan when participants sell units as permitted by the 401(k) Plan or elect to leave the 401(k) Plan upon retirement, termination or other reasons. For the twenty-six weeks ended June 29, 2019, we repurchased and cancelled 17,710 shares of common stock for $1.6 million at an average price of $88.82 per share. During the fifty-two weeks ended December 29, 2018, we repurchased and cancelled 26,280 shares of common stock for $2.0 million at an average price of $74.79 per share.

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Our Board of Directors authorized a share repurchase program of up to $400 million through December 31, 2020. Under this program, share repurchases may be made from time to time depending on market conditions, share price, share availability and other factors at our discretion. The share repurchase program does not obligate us to acquire any specific number of shares. For the twenty-six weeks ended June 29, 2019, we repurchased and cancelled 272,564 shares of common stock for $22.8 million at an average price of $83.53 per share under this program. For the fifty-two weeks ended December 29, 2018, we repurchased and cancelled 622,223 shares of common stock for $43.4 million at an average price of $69.73 per share under this program.

We have a non-cancelable operating lease for our primary operating facility with a partnership in which Steven L. Berman, our Executive Chairman, and his family members, are partners. Based upon the terms of the lease, payments will be $1.6 million in fiscal 2019 and were $1.6 million in fiscal 2018. This lease will expire on December 31, 2022. The right-of-use asset and total lease liabilities related to this lease were both $5.3 million as of June 29, 2019. In the opinion of our Audit Committee, the terms and rates of this lease are no less favorable than those which could have been obtained from an unaffiliated party when the lease was renewed during November 2016.

Additionally, we had a non-cancelable operating lease for our Canadian operating facility from a corporation of which an employee, who is also the former owner of an acquired entity, and his family members are owners. Based upon the terms of the lease, payments were $0.2 million in fiscal 2019 and were $0.5 million in fiscal 2018. This lease expired on April 30, 2019.

We are a partner in a joint venture with one of our suppliers and own minority interests in two other suppliers. Each of these investments is accounted for according to the equity method.

At June 29, 2019, we had $2.5 million of net unrecognized tax benefits, $2.2 million of which would affect our effective tax rate if recognized. We recognize interest and penalties related to uncertain tax positions in income tax expense. As of June 29, 2019 we had approximately $0.3 million of accrued interest and penalties related to uncertain tax positions.

We file income tax returns in the United States, Canada, China, India, and Mexico. All years before 2015 are closed for United States federal tax purposes. Tax years before 2014 are closed for the states in which we file. Tax years before 2016 are closed for tax purposes in Canada. Tax years before 2015 are closed for tax purposes in China. All tax years remain open for Mexico.

14. Fair Value Disclosures

The carrying value of financial instruments such as cash, accounts receivable, accounts payable, and other current assets and liabilities approximate their fair value based on the short-term nature of these instruments.

On December 30, 2018, the beginning of our 2019 fiscal year, we adopted ASU No. 2016-02, Leases , which replaces existing lease guidance. The ASU is intended to provide enhanced transparency and comparability by requiring lessees to record right-of-use assets and corresponding lease liabilities on the balance sheet. The new guidance will continue to classify leases as either finance or operating, with classification affecting the pattern of expense recognition in the statement of operations. Additionally, in August 2018, the FASB issued ASU 2018-11,  Targeted Improvements to ASC 842 , which includes an option to not restate comparative periods in transition and elect to use the effective date of ASC 842 as the date of initial application of transition. We adopted the standard using the modified retrospective approach and adoption resulted in right-of-use assets of $36.3 million and lease liabilities of $37.9 million as of December 30, 2018. Deferred rent and lease incentive liabilities associated with historical operating leases totaling $1.6 million were reclassified to the operating lease right-of-use assets as required by ASC 842. The transition did not have a material impact on our results of operations or Statement of Cash Flows. See Note 5 for additional information on leases.

In January 2017, the FASB issued ASU 2017-04, Simplifying the Test for Goodwill Impairment , which eliminates the need to perform a hypothetical purchase price allocation to measure goodwill impairment. ASU 2017-04 is effective for annual periods beginning after December 15, 2019, including interim periods within those fiscal years. Early adoption is permitted, including adoption in an interim period. We are evaluating the new guidance, however, we do not believe the new guidance will have a material impact on our consolidated financial statements and related disclosures.

In June 2018, the FASB issued ASU 2018-07, Improvements to Nonemployee Share-Based Payment Accounting , which expands the scope of the current employee share-based payment guidance to include share-based payments issued to nonemployees to substantially align the accounting for share-based payments for nonemployees with those made to employees including, the fair value measurement, measurement date and classification of certain awards. The new guidance is effective for fiscal years beginning after December 15, 2018, with early application permitted. We adopted this ASU effective December 30, 2018, the beginning of our 2019 fiscal year. Adoption of this ASU did not have a material impact on our consolidated financial statements.

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