Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Forward-Looking Statements
The following discussion and analysis should be read in conjunction with the condensed consolidated financial statements and notes thereto included in Part I, Item 1 of this Quarterly Report on Form 10-Q (this “report”) and the audited consolidated financial statements and related notes thereto included in Part II, Item 8, “Financial Statements and Supplementary Data,” as well as Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” of our Annual Report on Form 10-K for the fiscal year ended November 30, 2019. Some of the statements in this report may be forward-looking statements that reflect our current view on future events, future business, industry and other conditions, our future performance, and our plans and expectations for future operations and actions. In some cases you can identify forward-looking statements by the use of words such as “may,” “should,” “anticipate,” “believe,” “expect,” “plan,” “future,” “intend,” “could,” “estimate,” “predict,” “hope,” “potential,” “continue,” or the negative of these terms or other similar expressions. Many of these forward-looking statements are located in this report under Part I, Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” but they may appear in other sections as well. Forward-looking statements in this report generally relate to: (i) our warranty costs and order backlog; (ii) our beliefs regarding the sufficiency of working capital and cash flows; (iii) our expectation that we will continue to be able to renew or obtain financing on reasonable terms when necessary; (iv) the impact of recently issued accounting pronouncements; (v) our intentions and beliefs relating to our costs, business strategies, and future performance; (vi) our expected financial results; and (vii) our expectations concerning our primary capital and cash flow needs; and (viii) our expectations regarding the impact of COVID-19 on our business condition and results of operations.
You should read this report thoroughly with the understanding that our actual results may differ materially from those set forth in the forward-looking statements for many reasons, including events beyond our control and assumptions that prove to be inaccurate or unfounded. We cannot provide any assurance with respect to our future performance or results. Our actual results or actions could and likely will differ materially from those anticipated in the forward-looking statements for many reasons, including but not limited to: (i) the impact of changing credit markets on our ability to continue to obtain financing on reasonable terms; (ii) our ability to repay current debt, continue to meet debt obligations and comply with financial covenants; (iii) the effect of general economic conditions, including consumer and governmental spending, on the demand for our products and the cost of our supplies and materials; (iv) the ongoing COVID-19 pandemic; (v) fluctuations in seasonal demand and our production cycle; and (vi) other factors described from time to time in our Securities and Exchange Commission filings. We do not intend to update the forward-looking statements contained in this report other than as required by law. We caution you not to put undue reliance on any forward-looking statements, which speak only as of the date of this report. You should read this report and the documents that we reference in this report and have filed as exhibits completely and with the understanding that our actual future results may be materially different from what we currently expect. We qualify all of our forward-looking statements by these cautionary statements.
Critical Accounting Policies
Our critical accounting policies involving the more significant judgments and assumptions used in the preparation of our financial statements as of August 31, 2020 remain unchanged from November 30, 2019, other than the adoption of the new lease accounting standard in ASC 842, as discussed in Note 2, “Summary of Significant Accounting Policies” included in Part I, Item I, “Financial Statements” of this report. Disclosure of these critical accounting policies is incorporated by reference from Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of our Annual Report on Form 10-K for the fiscal year ended November 30, 2019.
Results of Operations
Net Sales and Cost of Sales
Our consolidated corporate sales for the three- and nine-month periods ended August 31, 2020 were $6,465,000 and $16,937,000, respectively, compared to $5,504,000 and $15,375,000 during the same respective periods in fiscal 2019, a $961,000, or a 17.5%, increase for the three months and a $1,562,000, or 10.2%, increase for the nine months. The three-month increase in sales is due to increased sales from our agricultural products and modular building segments while our tools segment showed a decrease in sales for this period. All three segments showed increased sales for the nine months ended August 31, 2020. Consolidated gross margin for the three-month period ended August 31, 2020 was 14.3% compared to 18.3% for the same period in fiscal 2019. Consolidated gross margin for the nine-month period ended August 31, 2020 was 17.1% compared to 16.7% for the same period in fiscal 2019. The decreased margin for the three months ended August 31, 2020 was due to lower gross margin in the modular buildings and tools segments, as discussed below. The increased margin for the nine months ended August 31, 2020 is due primarily to operational improvements in the agricultural products segment.
Our third quarter sales in the agricultural products segment were $3,671,000 compared to $3,194,000 during the same period of fiscal 2019, an increase of $477,000, or 14.9%. Our year-to-date agricultural product sales were $9,695,000 compared to $9,441,000 during the same period in fiscal 2019, an increase of $254,000, or 2.7%. At the end of our first quarter of fiscal 2020, our sales were up 13.1% in the agricultural products segment from the prior year. We were on track for a strong year and then the COVID-19 pandemic hit, which decreased our sales 15.6% in the second quarter of fiscal 2020 compared to the second quarter of fiscal 2019. Our third quarter provided another strong sales showing with an increase of 14.9% over the third quarter of fiscal 2019. We attribute the increased sales success to gained market share for our dump box product line and improved design of our manure spreader line. The addition of key employees to our sales and marketing team over the past year has also contributed to our recent sales success. Gross margin for our agricultural products segment for the three-month period ended August 31, 2020 was 21.5% compared to 15.7% for the same period in fiscal 2019. Gross margin for our agricultural products segment for the nine-month period ended August 31, 2020 was 21.3% compared to 15.7% for the same period in fiscal 2019. Our increased gross margin in fiscal 2020 reflects continuous improvement initiatives enacted in fiscal 2019 that have increased our workforce efficiency. Another contributing factor was our ability to increase our standard gross profit margin by 5% through price increases, strategic product offerings and product eliminations.
Our third quarter sales in the modular buildings segment were $2,319,000 compared to $1,802,000 for the same period in fiscal 2019, an increase of $517,000, or 28.7%. Our year-to-date sales in our modular buildings segment were $5,575,000 compared to $4,382,000 for the same period in fiscal 2019, an increase of $1,193,000, or 27.2%. The increase for the quarter and the year is largely due to progress on a sizeable research laboratory contract. Gross margin for the three- and nine-month periods ended August 31, 2020 was 2.4% and 8.6%, respectively, compared to 20.0% and 14.7% for the same respective periods in fiscal 2019. The decreased gross margin was in part expected due to a lower initial profit margin on the sizeable research laboratory job but has also been amplified with unexpected costs to finish the project on site.
Our tools segment had sales of $475,000 and $1,667,000 during the three- and nine-month periods ended August 31, 2020, respectively, compared to $508,000 and $1,552,000 for the same respective periods in fiscal 2019, a 6.5% decrease and a 7.4% increase, respectively. The decrease for the quarter is due a slowdown of our oil and gas industry and pipe tool business related to the COVID-19 pandemic. We have not seen signs of recovery yet in these industries. The increase year to date is due to the addition of a large volume OEM customer that was added to our product offering in the third quarter of fiscal 2019. This customer has offered us stability to counteract the unpredictability of oil and gas industry demands. Gross margin was 17.1% and 21.1% for the three- and nine-month periods ended August 31, 2020, respectively, compared to 28.0% and 28.4% for the same respective periods in fiscal 2019. Our decreased gross margin is due to the addition of labor and overhead as we continue to fully integrate our OEM customer’s product line into our manufacturing facility.
Expenses
Our third quarter consolidated selling expenses were $370,000 compared to $379,000 for the same period in fiscal 2019. Our year-to-date selling expenses were $1,227,000 in fiscal 2020 compared to $1,119,000 for the same period in fiscal 2019. The agriculture products segment showed an increase in selling expenses due to the addition of a territory development manager and an inside sales representative and increased commissions as sales increased in our represented territories. We did show a decrease in selling expenses in our tools segment as we paid no commissions on our OEM agreement and a decrease in our modular buildings segment as we had less travel and trade show attendance due to COVID-19. Selling expenses as a percentage of sales were 5.7% and 7.3% for the three- and nine-month periods ended August 31, 2020, respectively, compared to 6.9% and 7.3% for the same respective periods in fiscal 2019.
Consolidated engineering expenses were $129,000 and $361,000 for the three- and nine-month periods ended August 31, 2020, respectively, compared to $116,000 and $380,000 for the same respective periods in fiscal 2019. The decrease in engineering expenses for the nine months ended August 31, 2020 was due to lower research and development costs from our agricultural products segment as we shifted our engineering department focus to improve internal processes and reduce costs of our products. We also shifted an engineer to a welding position in the first quarter of fiscal 2019 to lower our indirect labor costs and fill a needed production position. Engineering expenses as a percentage of sales were 2.0% and 2.1% for the three- and nine-month periods ended August 31, 2020, respectively, compared to 2.1% and 2.5% for the same respective periods in fiscal 2019.
Consolidated administrative expenses for the three- and nine-month periods ended August 31, 2020 were $939,000 and $3,216,000, respectively, compared to $815,000 and $2,466,000 for the same respective periods in fiscal 2019. The mostly non-recurring increase in administrative expense is due to approximately $133,000 of recruitment expense for management recruitment, dual management salaries of approximately $68,000 as we transitioned our Chief Executive Officer and director of materials positions, approximately $54,000 for the implementation of our OEM customer’s product line in the tools segment, and additional expense of $280,000 that includes stock granted to new management staff, payout of employment agreements and bonus accruals for incentives offered by the Compensation Committee of the Board for fiscal 2020 targets. We also had $197,000 of pandemic-related expense related to employment rewards for keeping our operations running safely during the COVID-19 pandemic. Administrative expenses as a percentage of sales were 14.5% and 19.0% for the three- and nine-month periods ended August 31, 2020, respectively, compared to 14.8% and 16.0% for the same respective periods in fiscal 2019.
Net Loss
Consolidated net loss was $(424,000) for the three-month period ended August 31, 2020 compared to net loss of $(289,000) for the same period in fiscal 2019. Our consolidated net loss for the nine months ended August 31, 2020 was $(1,663,000) compared to $(1,251,000). Despite the increased net loss for the three and nine months we did show substantial operational improvement. Our sales were up for the three and nine months ended August 31, 2020 in all three of our segments. Our gross profit as a percentage of sales was up 5.8% and 5.6% for the three and nine months ended August 31, 2020, respectively, in our largest segment, agricultural products. We were heavy on administrative expenses related to finding and training new management staff, implementing an OEM product line and properly rewarding our employees for their continued service during the pandemic as our segments operate as essential businesses. Without these additional non-recurring administrative expenses, we would have shown significant bottom line improvement for the nine months ended August 31, 2020 compared to the same period of fiscal 2019.
CEO Transition
As previously announced, David King took over for Carrie Gunnerson as Chief Executive Officer in the third fiscal quarter of 2020. Carrie Gunnerson’s final day was July 21, 2020. Mr. King previously served as Executive Vice President since March 30, 2020. Mr. King brings 25 years of agriculture industry experience in operations, marketing and business development. We look forward to Mr. King bringing Art’s Way new strategic business opportunities and providing a revitalized brand image.
Order Backlog
The consolidated order backlog net of discounts as of October 6, 2020 was $3,539,000 compared to $7,561,000 as of October 6, 2019. The agricultural products segment order backlog was $1,081,000 as of October 6, 2020 compared to $1,174,000 in fiscal 2019. The slight decrease in backlog from the agricultural products segment is due to our early order program kicking off later in 2020 than in 2019. The backlog for the modular buildings segment was $2,129,000 as of October 6, 2020, compared to $6,174,000 in fiscal 2019. The decrease is due to progress made on a large construction contract that is not part of our typical year. Excluding this project from backlog, our backlog is down $369,000 compared to fiscal 2019. The backlog for the tools segment was $328,000 as of October 6, 2020 compared to $213,000 in fiscal 2019. The increase in backlog for our tools segment is due largely to an increase in order volume from a new OEM customer. Our order backlog is not necessarily indicative of future revenue to be generated from such orders due to the possibility of order cancellations and dealer discount arrangements we may enter into from time to time.
Impact of COVID-19
While the COVID-19 pandemic had very little impact on our results of operations for the first quarter of fiscal 2020, it did impact our results of operations for the second and third quarters of fiscal 2020 and we believe that it may continue to do so for the foreseeable future. From March 23, 2020 until May 18, 2020 the majority of our office staff in all three segments worked remotely with the exception of key operations support. At the height of the initial outbreak our workforce was down approximately 17% due to self-quarantine. By the end of May 2020 our entire workforce had returned and operations have continued as normal with additional safety precautions in place.
In our agricultural products segment, we did not experience any order cancellations, however, calls for new whole goods slowed significantly in the second quarter and many dealers held off on the shipping or pickup of their completed units. While the third quarter concluded with a 14.9% increase in sales compared to the third quarter of fiscal 2019, resulting in a year-to-date increase of 2.7%, we are currently 10% shy of our projected sales for fiscal 2020. As farmers continue to evaluate the impact of the pandemic on their operations, including future purchases of our equipment, we may yet see an impact on order volume as fiscal 2020 continues.
Our modular buildings segment started the year with a more diverse backlog than we had a year ago; however, we have had some setbacks on site work as subcontractors have been forced to quarantine after testing positive for COVID-19. Our workers have been hesitant to travel during the pandemic and, as a result, we had a large amount of buildings that were complete and ready to be placed on site as of the beginning of the third quarter. However, during the third quarter, we were successful in keeping our site work moving forward. At the start of the fourth quarter our order backlog was lower than expected, due to COVID-19, but we have recently seen an increase in order activity.
In our tools segment, oil prices dropped significantly at the start of the pandemic, which caused our sales to drop significantly in the second quarter of fiscal 2020. The diversification of our business with our new OEM customer helped us get through the oil and gas industry lows during that time, however, since oil and gas prices have not yet reached their pre-pandemic levels, we have not seen our sales levels from these customers return.
At this time, while we are short of our pre-pandemic expectations, we believe the worst of the economic hardship has passed for us. We have built and improved our business over the last few years to help us better weather any economic storms that come our way.
Liquidity and Capital Resources
Our primary source of funds for the nine months ended August 31, 2020 was cash generated by financing activities, which includes the receipt of a Paycheck Protection Program loan and three Economic Injury Disaster Loans. We expect that all or a significant portion of the Paycheck Protection Program loan will be forgiven. Our contracts in progress also provided a significant amount of cash for the first nine months of fiscal 2020, but we do expect these contracts to consume cash in Q4 of fiscal 2020 as we bring them to completion. Our operating activities cash flowed quite well despite the net loss for the year, only consuming $362,000 of cash during the first nine months of fiscal 2020. The most significant use of operating cash was related to the increase of inventory in our modular buildings and tools segments. We also consumed a significant amount of cash investing in property, plant, and equipment to improve our business operations and used cash to reduce the balance of our operating line of credit. We expect our primary capital needs for the remainder of fiscal 2020 to relate to operating costs, primarily production costs and contract fulfilment, and the retirement of debt.
We have a $5,000,000 revolving line of credit with Bank Midwest that, as of August 31, 2020, had an outstanding principal balance of $1,767,530. The line of credit is scheduled to mature on March 30, 2021.
We believe our current financing arrangements will provide sufficient cash to finance operations and pay debt when due during the next twelve months. We expect to continue to be able to procure financing upon reasonable terms and have had discussions with Bank Midwest about obtaining additional financing should the ongoing COVID-19 pandemic further impact our ability to operate.
Off Balance Sheet Arrangements
None.