Item 2: Management’s Discussion and Analysis of Financial Condition and Results of Operations
This report contains forward-looking statements. These statements relate to future events or the Company’s future financial performance. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “except,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “potential” or “continue,” the negative of such terms or other comparable terminology. These statements are only predictions. Actual events or results may differ materially.
Although the Company believes that the expectations reflected in the forward-looking statements are reasonable, the Company cannot guarantee future results, levels of activity, performance or achievements. Moreover, neither the Company, nor any other person, assumes responsibility for the accuracy and completeness of the forward-looking statements. The Company is under no obligation to update any of the forward-looking statements after the filing of this Quarterly Report on Form 10-Q to conform such statements to actual results or to changes in its expectations.
The following discussion should be read in conjunction with the Company’s unaudited condensed consolidated financial statements and the related notes and other financial information appearing elsewhere in this Form 10-Q. Readers are also urged to carefully review and consider the various disclosures made by the Company which attempt to advise interested parties of the factors which affect the Company’s business, including without limitation the disclosures made under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” under the caption “Risk Factors,” and the audited consolidated financial statements and related notes included in the Company’s Annual Report filed on Form 10-K for the year ended October 31, 2019 and other reports and filings made with the Securities and Exchange Commission.
Critical Accounting Policies
Our unaudited condensed consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). The preparation of these consolidated financial statements requires us to make significant estimates and judgments that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosure of contingent assets and liabilities. We evaluate our estimates, including those related to bad debts, inventory reserves, earn-out liabilities, and contingencies on an ongoing basis. We base our estimates on historical experience and on various other assumptions that are believed to be appropriate under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
Inventories
Inventories are stated at the lower of cost or net realizable value, with cost determined using the weighted average cost method of accounting. Certain items in inventory may be considered obsolete or excess and, as such, we periodically review our inventories for excess and slow moving items and make provisions as necessary to properly reflect inventory value. Because inventories have, during the past few years, represented up to one-fourth of our total assets, any reduction in the value of our inventories would require us to take write-offs that would affect our net worth and future earnings.
Allowance for Doubtful Accounts
We record an allowance for doubtful accounts based upon our assessment of various factors. We consider historical experience, the age of the accounts receivable balance, credit quality of our customers, current economic conditions and other factors that may affect a customer’s ability to pay.
Long-Lived Assets Including Goodwill
We assess property, plant and equipment and intangible assets, which are considered definite-lived assets, for impairment. Definite-lived assets are reviewed when there is evidence that events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. We measure recoverability of these assets by comparing the carrying amounts to the future undiscounted cash flows the assets are expected to generate. If property and equipment and intangible assets are considered to be impaired, the impairment to be recognized equals the amount by which the carrying value of the asset exceeds its fair market value.
We amortize our intangible assets with definite useful lives over their estimated useful lives and review these assets for impairment.
We test our goodwill and trademarks and indefinite-lived assets for impairment at least annually or more frequently if events or changes in circumstances indicate these assets may be impaired. These events or circumstances require significant judgment and could include a significant change in the business climate, legal factors, operating performance indicators, competition and sale or disposition of all or a portion of a division. This analysis requires significant judgments, including estimation of future cash flows, which is dependent on internal forecasts, estimation of the long-term rate of growth for our business, estimation of the useful life over which cash flows will occur, and determination of our weighted average cost of capital.
Warranty Reserve
We recognize an accrued warranty liability for the estimated claims to remedy potential deficiencies of quality or performance of our products in the Schroff Technologies International, Inc. (“Schrofftech”) division within the Custom Cabling and Manufacturing Assembly segment. The product warranties extend over various periods, depending upon the product subject to the warranty. We record a provision for estimated future warranty claims based upon the historical relationship of warranty claims to sales, any specifically identified warranty issues and current trends and knowledge. We base our estimates in part on historical experience and on assumptions that are believed to be reasonable under the circumstances and revise our estimates, as appropriate, when events or changes in circumstances indicate that revisions may be necessary. Although these estimates are based on management’s knowledge of and experience with past and current events and on management’s assumptions about future events, it is reasonably possible that they may ultimately differ materially from actual results, including in the case of a significant product failure.
Earn-out Liability
The purchase agreement for the acquisition of Schrofftech provides for an earn-out payment of up to $2,400,000, which amount is earned through October 31, 2021. The initial earn-out liability was valued at its fair value using an option pricing based approach with a risk-neutral framework using Black Scholes due to the option-like nature of the earn-out payout structure. The earn-out was and will continue to be revalued quarterly using a present value approach, and any resulting increase or decrease will be recorded into selling and general expenses. Any changes in the amount of the actual results and forecasted scenarios could impact the fair value. Significant judgment is employed in determining the appropriateness of the assumptions used in calculating the fair value of the earn-out as of the acquisition date. Accordingly, significant variances between actual and forecasted results or changes in the assumptions can materially impact the amount of contingent consideration expense we record in future periods.
Income Taxes
We record a tax provision for the anticipated tax consequences of the reported results of operations. Income taxes are accounted for under the asset and liability method, under which deferred tax assets and liabilities are recognized for the expected future tax consequences of temporary differences between the financial reporting and tax bases of assets and liabilities, and for operating losses and tax credit carryforwards. Deferred tax assets and liabilities are measured using the currently enacted tax rates as of the date of the financial statements that apply to taxable income in effect for the years in which those tax assets are expected to be realized or settled. We record a valuation allowance to reduce deferred tax assets to the amount that is believed more likely than not to be realized.
The calculation of the tax provision involves significant judgment in estimating the impact of uncertainties in the application of GAAP and complex tax laws. Resolution of these uncertainties in a manner inconsistent with management’s expectations could have a material impact on our financial condition and operating results.
Stock-based Compensation
We use the Black-Scholes model to value the stock option grants. This valuation is affected by our stock price as well as assumptions regarding a number of inputs which involve significant judgments and estimates. These inputs include the expected term of employee stock options, the expected volatility of the stock price, the risk-free interest rate and expected dividends.
Overview
RF Industries, Ltd. (together with subsidiaries, the “Company,” we,” “us,” or “our”) is a national manufacturer and marketer of interconnect products and systems, including coaxial and specialty cables and connectors, fiber optic cables and connectors, and electrical and electronic specialty cables and components. Through our manufacturing and production facilities, we provide a wide selection of interconnect products and solutions primarily to telecommunications carriers and equipment manufacturers, wireless and network infrastructure carriers and manufacturers and to various original equipment manufacturers (OEMs) in several market segments. Since the acquisition of Schrofftech in November 2019, we also manufacture and sell energy-efficient cooling systems and integrated small cell solutions and related components.
We operate through two reporting segments: (i) the RF Connector and Cable Assembly (“RF Connector”) segment, and (ii) the Custom Cabling Manufacturing and Assembly (“Custom Cabling”) segment. The RF Connector segment primarily designs, manufactures, markets and distributes a broad range of connector and cable products, including coaxial connectors and cable assemblies that are integrated with coaxial connectors, used in telecommunications and information technology OEM markets and other end markets. The Custom Cabling segment designs, manufactures, markets and distributes custom copper and fiber cable assemblies, complex hybrid fiber optic and power solution cables, electromechanical wiring harnesses, wiring harnesses for a broad range of applications in a diverse set of end markets, energy-efficient cooling systems for wireless base stations and remote equipment shelters and custom designed, pole-ready 5G small cell integrated enclosures. The two segments were determined based on the aggregation of operating divisions that have similar economic characteristics and are similar in the majority of the following areas: (1) the nature of the product and services; (2) the nature of the production process; (3) the type or class of customer for their products and services; (4) the methods used to distribute their products or services; and (5) if applicable, the nature of the regulatory environment.
For the nine months ended July 31, 2020, most of our revenues were generated from the Custom Cabling segment from the sale of fiber optics cable, copper cabling, custom patch cord assemblies, and wiring harnesses, which collectively accounted for 67% of the Company’s total sales. Revenues from the RF Connector segment were generated from the sales of RF connector products and cable assemblies and accounted for 33% of total sales for the nine months ended July 31, 2020.
In March 2020, the World Health Organization (the “WHO”) declared coronavirus (“COVID-19”) a pandemic emergency. The COVID-19 pandemic has negatively impacted regional and global economies, disrupted global supply chains, and created significant volatility and disruption of financial markets. The global impact of the outbreak has been rapidly evolving and certain jurisdictions, including those where we have operations, have also reacted by instituting quarantines, restrictions on travel, “shelter in place” rules, social distancing protocols and restrictions on types of business that may continue to operate. While we have been deemed an “essential” business, and therefore have been permitted to continue our operations, the impact of the COVID-19 pandemic has affected both our operations and those of our customers. Our operations have been negatively affected by partial shutdowns of our facilities (particularly in the Northeast), by changes that we had to make on our operating methods and procedures, and by our reduced workforce as many of our employees stayed at home. Many of our customers and vendors have likewise had temporary closures of their facilities and have otherwise been impacted by changes in their industries. As a result, overall demand for our products has been reduced, and certain costs have increased. We have taken measures to protect the health and safety of our employees, and we continue to work with our customers and vendors to minimize potential disruptions in addressing the challenges posed by this global pandemic.
The extent of the impact of the COVID-19 pandemic on our operational and financial performance will depend on future developments, including the duration and spread of the pandemic and related actions taken by domestic and international jurisdictions to prevent disease spread, all of which are uncertain and cannot be predicted. The outbreak impacted our performance for the three and nine months ended July 31, 2020. We currently expect the decline caused by the economic slowdown to persist through the remainder of 2020. The operations of our Cables Unlimited, Inc. subsidiary in Long Island, New York, was particularly affected as many employees stayed at home and as local customers shut down or otherwise delayed, deferred or cancelled orders for our products. Because of the impact that COVID-19 has on our Northeastern operations, in May 2020 we applied for and received loans under the Paycheck Protection Program (“PPP”) of the CARES Act totaling approximately $2.8 million (“PPP Loans”). The funds from the PPP Loans were used to retain employees, maintain payroll and benefits, and make lease and utility payments. Without the PPP Loans, we would have made material reductions in our workforce (particularly at Cables Unlimited). We anticipate that most of the PPP Loans will be eligible for forgiveness in accordance with the provisions of the CARES Act. To the extent not forgiven, the PPP Loans have a two-year term, a fixed interest rate of 1%, and principal and interest payments are deferred for six months.
We considered the impact of the COVID-19 related economic slowdown on our evaluation of goodwill impairment indicators as of July 31, 2020. Although no goodwill impairment indicators were identified, it is possible that impairments could emerge as the impact of the crisis becomes clearer, and those impairment losses could be material.
Liquidity and Capital Resources
Historically, we have been able to fund our liquidity and other capital requirements from funds we generated from operations. While we still believe that our existing current assets, the amount of cash we anticipate will be generated from on-going operations, and funds we received from the PPP Loans collectively will be sufficient to fund our anticipated liquidity and capital resource needs for at least twelve months from the date of this filing, there is some uncertainty because of the unknown future impact of COVID-19 pandemic on our business. Nevertheless, we believe that our existing assets and the cash we expect to generate from operations, including from our current backlog of unfulfilled orders, will be sufficient to fund our liquidity needs during the next twelve months from the date of this filing based on the following:
As of July 31, 2020, we had a total of $15.6 million of cash and cash equivalents compared to a total of $12.5 million of cash and cash equivalents as of October 31, 2019. As of July 31, 2020, we had working capital of $25.2 million and a current ratio of approximately 5.2:1. Despite a decrease in sales as a result of the COVID-19 pandemic, our cash and cash equivalents increased from October 31, 2019 due to the receipt of the PPP Loans, and the timing of collections of outstanding accounts receivables, resulting in a decrease in the accounts receivable balance by $7.2 million, from $12.2 million as of October 31, 2019 to $5.0 million as of July 31, 2020. As of July 31, 2020, we had $31.2 million in current assets and $4.8 million in current liabilities.
As of July 31, 2020, we had $5.7 million of backlog, compared to $6.1 million as of October 31, 2019. Since purchase orders are submitted from customers based on the timing of their requirements, our ability to predict orders in future periods or trends in future periods is limited. Furthermore, purchase orders may be subject to cancellation from customers, although we have not historically experienced material cancellations of purchase orders.
We generated cash of $3.1 million during the nine months ended July 31, 2020 due largely to the receipt of the PPP Loans ($2.8 million) and the collection of accounts receivables ($7.4 million) that were outstanding as of October 31, 2019. The cash received from the PPP Loans and collected from our accounts receivables, and the increase in cash from non-cash credits from depreciation and amortization ($0.8 million) and from stock-based compensation expense ($0.4 million), was partially offset by the net cash used in the purchase of Schrofftech ($3.9 million), net loss of $0.2 million, and a decrease in accounts payable ($1.3 million) and accrued expenses ($1.6 million) primarily due to the payout of prior year bonuses. In addition, during the nine months ended July 31, 2020, we received $0.4 million from the exercise of stock options and paid out $0.4 million in dividends. The current year dividends were declared before the full impact of the COVID-19 pandemic was realized.
We do not anticipate needing material additional capital equipment in the next twelve months. In the past, we have financed some of our equipment and furnishings requirements through capital leases. No additional capital equipment purchases have been currently identified that would require significant additional leasing or capital expenditures during the next twelve months.
In November 2019, we entered into an agreement for a revolving line of credit (“LOC”) in the amount of $5.0 million. Amounts outstanding under the LOC shall bear interest at a rate of 2.0% plus LIBOR Daily Floating Rate (“base interest rate”), with interest payable on the first day of each month. Borrowings under the LOC are secured by a security interest in certain assets of the Company. The LOC contains certain loan covenants. Failure to maintain the loan covenants may constitute an event of default, which could result in all outstanding amounts of principal and interest becoming immediately due and payable. All outstanding principal and interest is due and payable on December 1, 2021. As of July 31, 2020, we were in compliance with all loan covenants. Additionally, as of the date of this report, we have not used the LOC and accordingly, the entire amount of the LOC is currently available.
From time to time, we may undertake acquisitions of other companies or product lines in order to diversify our product and solutions offerings and customer base. Conversely, we may undertake the disposition of a division or product line due to changes in our business strategy or market conditions. Acquisitions may require the outlay of cash, which may reduce our liquidity and capital resources while dispositions may increase our cash position, liquidity and capital resources. On November 4, 2019, we purchased the business of Schroff Technologies International, Inc., a Rhode Island-based manufacturer and marketer of intelligent thermal control systems used by telecommunications companies across the U.S. and Canada, and shrouds for small cell integration and installation. At the closing, in consideration for Schrofftech, we paid the sellers $4 million in cash, and, if certain financial targets are met by Schrofftech over a two-year period, agreed to pay an additional cash earn-out payment of up to $2.4 million.
Results of Operations
Three Months Ended July 31, 2020 vs. Three Months Ended July 31, 2019
Net sales were $9.5 million, a decrease of 39%, or $6.0 million, for the three months ended July 31, 2020 (the “fiscal 2020 quarter”) compared to the three months ended July 31, 2019 (the “fiscal 2019 quarter”). Net sales for the fiscal 2020 quarter at the Custom Cabling segment decreased by $6.1 million, or 51%, to $5.9 million, compared to $12.0 million in the fiscal 2019 quarter. The decrease was primarily in our project-based business due to COVID-19 where we saw project delays with distributed antenna systems (DAS) and small cell as there were difficulties gaining site zoning approvals, lack of building and site access and the availability of work crews. In addition, we continued to see a general slowdown in the wireless macro and tower site business which further impacted our sales. This decrease was partially offset by additional sales contributed by the newly acquired Schrofftech subsidiary as we did not own Schrofftech in the fiscal 2019 quarter. Net sales for the fiscal 2020 quarter at the RF Connector segment increased by $0.1 million, or 4%, to $3.6 million as compared to $3.5 million in the fiscal 2019 quarter.
Gross profit for the fiscal 2020 quarter decreased by $1.5 million to $2.7 million due to the decrease in net sales, while gross margins increased to 28.6% of sales from 27.5% of sales in the fiscal 2019 quarter. The increase in gross margins was primarily due to the product mix at the Custom Cabling segment.
Engineering expenses remained fairly consistent between the fiscal 2020 quarter and the fiscal 2019 quarter at $0.4 million. Engineering expenses represent costs incurred relating to the ongoing research and development of new products.
Selling and general expenses decreased by $0.1 million to $2.5 million (26% of sales) compared to $2.6 million (17% of sales) in the third quarter last year primarily due to the decrease in valuation of Schrofftech’s earn-out liability. The decrease was partially offset by (i) the addition of the selling and general expenses of the newly acquired Schrofftech subsidiary, and (ii) the severance obligation payable upon an officer’s termination, which included a severance cash payout of $93,500 and the non-cash expense resulting from the accelerated vesting of the officer’s unvested options totaling approximately $58,000. Additionally, total selling and general expenses in the current quarter included $0.2 million of amortization expense, an increase of $0.1 million over last year as a result of the acquisition of Schrofftech, and $0.2 million in stock-based compensation expense.
For the fiscal 2020 quarter, pretax (loss) income for the Custom Cabling segment and the RF Connector segment was $(1.0) million and $0.8 million, respectively, as compared to $1.1 million and $0.2 million for the comparable third quarter last year. The pretax loss at the Custom Cabling segment in the fiscal 2020 quarter was primarily due to the lower sales in the project-based business resulting from the slowdown in carrier spending.
The provision or benefit for income taxes was 63% and 21% of (loss) income before income taxes for the fiscal 2020 quarter and the fiscal 2019 quarter, respectively. The change in the effective tax rate from the fiscal 2019 quarter to fiscal 2020 quarter was primarily driven by the disproportionate impact of various permanent book-tax differences with respect to our forecasted book income or loss in each period.
For the fiscal 2020 quarter, net loss was $0.1 million and fully diluted loss per share was $0.01 per share as compared to a net income of $1.0 million and fully diluted earnings per share of $0.11 per share for the fiscal 2019 quarter. For the fiscal 2020 quarter, the diluted weighted average shares outstanding was 9,714,700 as compared to 9,872,899 for the fiscal 2019 quarter.
Nine Months Ended July 31, 2020 vs. Nine Months Ended July 31, 2019
Net sales were $32.3 million, a decrease of 19%, or $7.4 million, for the nine months ended July 31, 2020 (the “fiscal 2020 nine-month period”) compared to the nine months ended July 31, 2019 (the “fiscal 2019 nine-month period”). The decrease in net sales is attributable to a decrease in net sales at the Custom Cabling segment, which decreased by $7.9 million, or 27%, to $21.8 million compared to $29.7 million in the fiscal 2019 nine-month period. The decrease was primarily in our project-based business which resulted from the slowdown in carrier spending. This decrease was partially offset by additional sales from the newly acquired Schrofftech and C Enterprises subsidiaries. Net sales for the fiscal 2020 nine-month period at the RF Connector segment increased by $0.5 million, or 5%, to $10.6 million compared to $10.1 million in the fiscal 2019 nine-month period.
Gross profit for the fiscal 2020 nine-month period decreased by $2.9 million to $8.6 million, and gross margins decreased to 26.5% of sales from 28.9% of sales in the fiscal 2019 nine-month period. The decrease in gross profit and gross margins was primarily due to lower sales in the project-based business that resulted in lower coverage of fixed production costs, product mix at the Custom Cabling segment, and increased sales at the C Enterprises subsidiary, whose gross margins are lower than the blended margins of our other divisions.
Engineering expenses increased $0.6 million to $1.6 million for the fiscal 2020 nine-month period compared to $1.0 million in the fiscal 2019 nine-month period primarily due to the absorption of the engineering costs of the newly acquired Schrofftech (which we did not own in fiscal 2019) and a full nine months of engineering costs at C Enterprises (whose expenses were only included in 2019 following the acquisition of this subsidiary on March 15, 2019). Engineering expenses represent costs incurred relating to the ongoing research and development of new products.
Selling and general expenses increased $0.4 million to $7.4 million (23% of sales) compared to $7.0 million (18% of sales) in the nine-month period last year largely due to the additional selling and general expenses of the recently acquired Schrofftech and C Enterprises subsidiaries. Additionally, total selling and general expenses in the current nine-month period included (i) $0.5 million of amortization expense, an increase of $0.3 million over last year as a result of the acquisition of Schrofftech, (ii) $0.4 million in stock-based compensation expense, an increase of $0.1 million over last year due in part to option grants to new hires and the expense related to accelerated vesting of options under a departing officer’s severance agreement totaling approximately $58,000, and (iii) the severance obligation payable upon this officer’s termination of $93,500. These costs were partially offset with a $0.7 million valuation decrease in the Schrofftech earn-out liability.
For the fiscal 2020 nine-month period, pretax (loss) income for the Custom Cabling segment and the RF Connector segment was $(2.2) million and $1.8 million, respectively, as compared to $2.7 million and $0.7 million for the comparable nine-month period last year. The pretax loss at the Custom Cabling segment in the nine-month period of fiscal 2020 was primarily due to the decrease in project-based businesses resulting from the slowdown in carrier spending.
The provision or benefit for income taxes was 38% and 22% of (loss) income before income taxes for the nine months ended July 31, 2020 and 2019, respectively. The change in the effective tax rate from the fiscal 2019 nine-month period to the fiscal 2020 nine-month period was primarily driven by the disproportionate impact of various permanent book-tax differences with respect to our forecasted book income or loss in each period.
For the fiscal 2020 nine-month period, net loss was $0.2 million and fully diluted loss per share was $0.02 per share as compared to a net income of $2.7 million and fully diluted earnings per share of $0.28 per share for the fiscal 2019 nine-month period. For the fiscal 2020 nine-month period, the diluted weighted average shares outstanding was 9,661,054 as compared to 9,849,889 for the fiscal 2019 nine-month period.