TAYD Taylor Devices Inc

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

Cautionary Statement

The Private Securities Litigation Reform Act of 1995 provides a "safe harbor" for forward-looking statements. Information in this Item 2, "Management's Discussion and Analysis of Financial Condition and Results of Operations," and elsewhere in this 10-Q and its Exhibits that does not consist of historical facts, are "forward-looking statements." Statements accompanied or qualified by, or containing, words such as "may," "will," "should," "believes," "expects," "intends," "plans," "projects," "estimates," "predicts," "potential," "outlook," "forecast," "anticipates," "presume," and "assume" constitute forward-looking statements and, as such, are not a guarantee of future performance. The statements involve factors, risks and uncertainties, the impact or occurrence of which can cause actual results to differ materially from the expected results described in such statements. Risks and uncertainties can include, among others, reductions in capital budgets by our customers and potential customers; changing product demand and industry capacity; increased competition and pricing pressures; advances in technology that can reduce the demand for the Company's products; the kind, frequency and intensity of natural disasters that affect demand for the Company’s products; and other factors, many or all of which are beyond the Company's control. Consequently, investors should not place undue reliance on forward-looking statements as predictive of future results. The Company disclaims any obligation to release publicly any updates or revisions to the forward-looking statements herein to reflect any change in the Company's expectations with regard thereto, or any changes in events, conditions or circumstances on which any such statement is based.

Sales under certain fixed-price contracts, requiring substantial performance over several periods prior to commencement of deliveries, are accounted for under the percentage-of-completion method of accounting whereby revenues are recognized based on estimates of completion prepared on a ratio of cost to total estimated cost basis. Costs include all material and direct and indirect charges related to specific contracts.

Adjustments to cost estimates are made periodically and any losses expected to be incurred on contracts in progress are charged to operations in the period such losses are determined. However, any profits expected on contracts in progress are recognized over the life of the contract.

For financial statement presentation purposes, the Company nets progress billings against the total costs incurred on uncompleted contracts. The asset, "costs and estimated earnings in excess of billings," represents revenues recognized in excess of amounts billed. The liability, "billings in excess of costs and estimated earnings," represents billings in excess of revenues recognized.

For the nine months ended February 28, 2018 (All figures discussed are for the nine months ended February 28, 2018 as compared to the nine months ended February 28, 2017).

The Company's consolidated results of operations showed a 7% decrease in net revenues and a decrease in net income of 78%. Revenues recorded in the current period for long-term construction projects (“Project(s)”) were 16% less than the level recorded in the prior year. We had 46 Projects in process during the current period compared with 48 during the same period last year. Revenues recorded in the current period for other-than long-term construction projects (non-projects) were 12% more than the level recorded in the prior year. Total sales within the U.S. decreased 13% from the same period last year. Total sales to Asia increased 40% from the same period of the prior year. Sales decreases recorded over the same period last year to customers involved in construction of buildings and bridges (19%), were offset somewhat by increases in sales to industrial customers (31%) and to customers in aerospace / defense (8%). The significant reduction in sales to construction customers was the result of several factors including 1.) scheduling delays at customer construction sites, 2.) delays in receiving custom components from vendors, 3.) quality issues from a subcontractor, and 4.) testing bottlenecks caused by delays in getting a new test machine operating. These issues are resolved and management is optimistic that the sales volume will continue to improve. Please refer to the charts, below, which show the breakdown of sales. The gross profit as a percentage of net revenue of 24% in the current period is lower than the 30% recorded in the same period of the prior year. The reduction in gross profit as a percentage of revenue is primarily due to 1.) a lower total volume of product sales in the current period to cover non-variable manufacturing costs, and 2.) several projects in the current period that were very competitively bid.

Sales of the Company’s products are made to three general groups of customers: industrial, construction and aerospace / defense. A breakdown of sales to the three general groups of customers is as follows:

At February 28, 2017, the Company had 119 open sales orders in our backlog with a total sales value of $19.5 million. At February 28, 2018, the Company has 37% more open sales orders in our backlog (163 orders), and the total sales value is $18.8 million.

The Company's backlog, revenues, commission expense, gross margins, gross profits, and net income fluctuate from period to period. The changes in the current period, compared to the prior period, are not necessarily representative of future results.

Net revenue by geographic region, as a percentage of total net revenue for the nine month periods ended February 28, 2018 and 2017 is as follows:

Selling, general and administrative expenses increased by 1% from the prior year. Outside commission expense decreased by 6% from last year's level due to lower levels of commissionable sales. Other selling, general and administrative expenses increased 3% from last year to this.

The above factors resulted in operating income of $582,000 for the nine months ended February 28, 2018, 72% less than the $2,104,000 in the same period of the prior year.

Net income for the current period of $330,000 includes a $164,000 write down of deferred tax assets to reflect a lower future federal income tax rate under the recently enacted Tax Cuts and Jobs Act. The non-cash write down of the deferred tax asset increased the provision for income taxes by an equal amount. This resulted in a substantially higher effective income tax rate of 45% for the period as compared to 31% in the prior year. The lower federal income tax rate became effective in January 2018. The Company is expected to benefit from this lower rate for the remainder of the current fiscal year and in future years.

For the three months ended February 28, 2018 (All figures discussed are for the three months ended February 28, 2018 as compared to the three months ended February 28, 2017).

The Company's consolidated results of operations showed a 16% increase in net revenues and a decrease in net income of 107%. Revenues recorded in the current period for long-term construction projects (“Project(s)”) were 3% less than the level recorded in the prior year. We had 37 Projects in process during the current period compared with 30 during the same period last year. Revenues recorded in the current period for other-than long-term construction projects (non-projects) were 65% more than the level recorded in the prior year. Total sales within the U.S. increased 1% from the same period last year. Total sales to Asia increased 212% from the same period of the prior year. Sales increases were recorded over the same period last year to customers involved in construction of buildings and bridges (12%), to industrial customers (32%) and to customers in aerospace / defense (19%). Please refer to the charts, below, which show the breakdown of sales. The gross profit as a percentage of net revenue of 22% in the current period is lower than the 29% recorded in the same period of the prior year. The reduction in gross profit as a percentage of revenue is primarily due to several projects in the current period that were very competitively bid.

Sales of the Company’s products are made to three general groups of customers: industrial, construction and aerospace / defense. A breakdown of sales to the three general groups of customers is as follows:

Net revenue by geographic region, as a percentage of total net revenue for the three month periods ended February 28, 2018 and 2017 is as follows:

Selling, general and administrative expenses increased by 12% from the prior year. Outside commission expense increased by 43% from last year's level due to higher levels of commissionable sales combined with higher commission rates on some orders. Other selling, general and administrative expenses are slightly higher from last year to this.

The above factors resulted in operating income of $137,000 for the three months ended February 28, 2018, significantly less than the $466,000 in the same period of the prior year.

Net loss for the current period of $23,000 includes a $164,000 write down of deferred tax assets to reflect a lower future federal income tax rate under the recently enacted Tax Cuts and Jobs Act. The non-cash write down of the deferred tax asset increased the provision for income taxes by an equal amount. This resulted in a substantially higher effective income tax rate of 116% for the period as compared to 30% in the prior year. The lower federal income tax rate became effective in January 2018. The Company is expected to benefit from this lower rate for the remainder of the current fiscal year and in future years.

Stock Options

The Company has a stock option plan which provides for the granting of nonqualified or incentive stock options to officers, key employees and non-employee directors. Options granted under the plan are exercisable over a ten year term. Options not exercised at the end of the term expire.

The Company expenses stock options using the fair value recognition provisions of the FASB ASC. The Company recognized $56,000 and $79,000 of compensation cost for the nine month periods ended February 28, 2018 and 2017.

The fair value of each stock option grant has been determined using the Black-Scholes model. The model considers assumptions related to exercise price, expected volatility, risk-free interest rate, and the weighted average expected term of the stock option grants. Expected volatility assumptions used in the model were based on volatility of the Company's stock price for the thirty month period ending on the date of grant. The risk-free interest rate is derived from the U.S. treasury yield. The Company used a weighted average expected term.

The following assumptions were used in the Black-Scholes model to estimate the fair market value of the Company's stock option grants:

The ultimate value of the options will depend on the future price of the Company's common stock, which cannot be forecast with reasonable accuracy.

A summary of changes in the stock options outstanding during the nine month period ended February 28, 2018 is presented below:

Capital Resources, Line of Credit and Long-Term Debt

The Company's primary liquidity is dependent upon the working capital needs. These are mainly inventory, accounts receivable, costs and estimated earnings in excess of billings, accounts payable, accrued commissions, and billings in excess of costs and estimated earnings. The Company's primary source of liquidity has been operations.

Capital expenditures for the nine months ended February 28, 2018 were $750,000 compared to $1,622,000 in the same period of the prior year. As of February 28, 2018, the Company has commitments for capital expenditures totaling $95,000 during the next twelve months. These costs are primarily related to acquisition of new equipment used to test the function of products prior to shipment to customers.

The Company believes it is carrying adequate insurance coverage on its facilities and their contents.

Effective August 30, 2017, the Company replaced its bank credit facility with a $10,000,000 bank demand line of credit, with interest payable at the Company's option of 30, 60 or 90 day LIBOR rate plus 2.25%. There is no balance outstanding as of February 28, 2018 or as of May 31, 2017. The line is unsecured and includes a negative pledge of substantially all of the Company’s property. This line of credit is subject to the usual terms and conditions applied by the bank, is subject to renewal annually, and is not subject to an express requirement on the bank’s part to lend.

NOTE: Inventory turnover is annualized for the nine month period ended February 28, 2018.

Inventory, at $11,450,000 as of February 28, 2018, is $39,000 less than the prior year-end level of $11,489,000. Approximately 88% of the current inventory is work in process, 6% is finished goods, and 6% is raw materials.

Maintenance and other inventory represent stock that is estimated to have a product life cycle in excess of twelve months. This stock represents certain items the Company is required to maintain for service of products sold and items that are generally subject to spontaneous ordering. This inventory is particularly sensitive to technological obsolescence in the near term due to its use in industries characterized by the continuous introduction of new product lines, rapid technological advances and product obsolescence. Management of the Company has recorded an allowance for potential inventory obsolescence. The provision for potential inventory obsolescence was $60,000 and $135,000 for the nine month periods ended February 28, 2018 and 2017. The Company continues to rework slow-moving inventory, where applicable, to convert it to product to be used on customer orders.

The Company combines the totals of accounts receivable, the current asset, CIEB, and the current liability, BIEC, to determine how much cash the Company will eventually realize from revenue recorded to date. As the accounts receivable figure rises in relation to the other two figures, the Company can anticipate increased cash receipts within the ensuing 30-60 days.

Accounts receivable of $5,342,000 as of February 28, 2018 includes approximately $824,000 of amounts retained by customers on Projects. It is expected that amounts retained by customers under contracts will be released in the normal course of the business in accordance with the related contracts. Accounts receivable also includes $110,000 of an allowance for doubtful accounts (“Allowance”). The accounts receivable balance as of May 31, 2017 of $2,546,000 included an Allowance of $110,000.

The number of an average day's sales outstanding in accounts receivable (“DSO”) increased from 36 days at May 31, 2017 to 73 at February 28, 2018. The DSO is a function of 1.) the level of sales for an average day (for example, total sales for the past three months divided by 90 days) and 2.) the level of accounts receivable at the balance sheet date. The level of sales for an average day in the third quarter of the current fiscal year is only slightly more than in the fourth quarter of the prior year. The level of accounts receivable at the end of the current fiscal quarter is slightly more than double the level at the end of the prior year. The significant increase in the level of accounts receivable caused the DSO to increase from last year end to this quarter-end. The primary reason for the increase in the level of accounts receivable from last year end to this quarter-end was significantly higher billings for Projects in February ($3.1 million) compared to last May ($0.5 million). The Company expects to collect the net accounts receivable balance, including the retainage, during the next twelve months.

As noted above, CIEB represents revenues recognized in excess of amounts billed. Whenever possible, the Company negotiates a provision in sales contracts to allow the Company to bill, and collect from the customer, payments in advance of shipments. Unfortunately, such provisions are often not possible. The $8,047,000 balance in this account at February 28, 2018 is 17% more than the prior year-end balance. This increase is the result of normal flow of the projects through production with billings to the customers as permitted in the related contracts. The Company expects to bill the entire amount during the next twelve months. 23% of the CIEB balance as of the end of the last fiscal quarter, November 30, 2017, was billed to those customers in the current fiscal quarter ended February 28, 2018. The remainder will be billed as the Projects progress, in accordance with the terms specified in the various contracts.

The balances in this account are comprised of the following components:

As noted above, BIEC represents billings to customers in excess of revenues recognized. The $1,999,000 balance in this account at February 28, 2018 is up 54% from the $1,296,000 balance at the end of the prior year.

The balance in this account fluctuates in the same manner and for the same reasons as the account “costs and estimated earnings in excess of billings”, discussed above. Final delivery of product under these contracts is expected to occur during the next twelve months.

The balances in this account are comprised of the following components:

Summary of factors affecting the balances in CIEB and BIEC:

The Company's backlog of sales orders at February 28, 2018 is $18.8 million, slightly less than the $20.6 million at the end of the prior year. $9.2 million of the current backlog is on Projects already in progress.

Other Balance Sheet Items

Accounts payable, at $1,460,000 as of February 28, 2018, is 10% more than the prior year-end. Commission expense on applicable sales orders is recognized at the time revenue is recognized. The commission is paid following receipt of payment from the customers. Accrued commissions as of February 28, 2018 are $1,106,000, up 31% from the $847,000 accrued at the prior year-end. This large increase is due to the increases in the accounts receivable and CIEB, discussed above. Other current liabilities increased slightly from the prior year-end, to $842,000. The Company expects the current accrued amounts to be paid during the next twelve months.

Management believes the Company's cash flows from operations and borrowing capacity under the bank line of credit are sufficient to fund ongoing operations and capital improvements for the next twelve months.