SMTX SMTC Corporation

SMTC Corporation (the “Company,” “we,” “our,” or “SMTC”) is a provider of end-to-end electronics manufacturing services (“EMS”), including product design and engineering services, printed circuit board assembly (“PCBA”), production, enclosure, cable assembly, precision metal fabrication, systems integration and comprehensive testing services, configuration to order (“CTO”), build to order (“BTO”) and direct order fulfillment (“DOF”). SMTC has more than 50 manufacturing and assembly lines at strategically located facilities in the United States, Canada and Mexico that provide local support and manufacturing capabilities to our global customers. SMTC’s services extend over the entire electronic product life cycle from new product development and new product introduction (“NPI”) through to growth, maturity and end of life phases.

Our business operations have generally performed during the first quarter of 2020 as expected. However, the fast-developing coronavirus disease 2019 (“COVID-19”) pandemic presents significant uncertainty for the remainder of the year. During our first quarter, our business has not been significantly impacted by the COVID-19 pandemic and demand from our customers did not change materially. The COVID-19 pandemic could impact our customers and may result in unpredictable reductions or increases in demand across the industry sectors we service. We do anticipate COVID-19-related disruptions, including potential materials constraints for inventory sourced from certain regions, increased shipping costs and lead-times. As at March 29, 2020, the funds available to borrow under our PNC Facility (as described and defined below) after deducting the current borrowing base conditions was $31,185 (December 29, 2019 - $21,644).

         
             We are actively monitoring the global COVID-19 pandemic and continuously communicating with our employees and union representatives, in addition to government and state representatives where our manufacturing facilities reside. We have initiated measures designed to protect our employees and we continue to adapt in order to maintain operations while providing a safe environment. We have experienced increased workplace absenteeism as illness, potential COVID-19 exposure or personal commitments that restrict the ability of some employees to come to work. The Company has modified shift schedules and hired temporary labor to help address this situation and meet our customers’ product shipping schedules. We anticipate incurring higher direct labor charges in the second quarter of 2020 as a result of this. Decisions on further measures or the continuation of these measures will depend on the impact of the COVID-19 pandemic on our operations and the requirements of each jurisdiction in which we operate.

During the fourth quarter of 2019 we ceased manufacturing in China and began to relocate the equipment used at our Chinese manufacturing facility to our other North American sites. During the first quarter of 2020 the Company completed final shipments for customers serviced at our Chinese manufacturing facility and completed the relocation of the equipment to our other North American sites. Customer concerns about uncertainties relating to the prolonged impact of tariffs and macro-economic factors caused a number of our customers to begin to re-evaluate demand for some of their products and reconsider where they outsource their manufacturing. Revenues attributable to production from SMTC’s manufacturing operations in China declined in 2019 as compared to 2018, but more significant declines were anticipated in 2020 which would have resulted in negative operating margins from our China site. This ultimately resulted in the decision to close the manufacturing facility.

The accompanying unaudited interim consolidated financial statements of the Company have been prepared in accordance with the accounting principles and methods of application disclosed in the audited consolidated financial statements within the Company’s Form 10-K for the fiscal period ended December 29, 2019, (“Form 10-K”) filed with the Securities and Exchange Commission (the “SEC”) on March 13, 2020. The accompanying unaudited interim consolidated financial statements include adjustments of a normal, recurring nature that are, in the opinion of management, necessary for a fair statement of the consolidated financial statements under generally accepted accounting principles in the United States (“U.S. GAAP”). These unaudited interim consolidated financial statements should be read in conjunction with the Company’s audited consolidated financial statements contained in the Company’s Form 10-K. The consolidated balance sheet at December 29, 2019 was derived from the audited annual consolidated financial statements, but does not contain all of the footnote disclosures from the annual consolidated financial statements.

Unless otherwise specified or the context requires otherwise, all statements in these notes to the interim consolidated financial statements regarding financial figures are expressed in thousands of U.S. dollars.

In August 2018, the FASB published ASU 2018-13: Fair Value Measurement (Topic 820): Disclosure Framework – Changes to the Disclosure Requirements for Fair Value Measurement. The amendment includes the removal, modification and addition of disclosure requirements under Topic 820. The amendments in this ASU are effective for all entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. The impact of the adoption of the standard expands the disclosure of certain assets and liabilities recorded at fair value.

In March 2020, the FASB published ASU 2020-04: Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting. The amendments in this update are elective and provide optional guidance for a limited period of time to ease the potential burden in accounting for (or recognizing the effects of) reference rate reform on financial reporting. The amendments in this Update are effective for all entities as of March 12, 2020, through December 31, 2022. An entity may elect to apply the amendments for contract modifications by Topic or Industry Subtopic as of any date from the beginning of an interim period that includes or is subsequent to March 12, 2020, or prospectively from a date within an interim period that includes or is subsequent to March 12, 2020, up to the date that the financial statements are available to be issued. Once elected for a Topic or an Industry Subtopic, the amendments in this Update must be applied prospectively for all eligible contract modifications for that Topic or Industry Subtopic. The impact of the adoption of the standard is not material to the Company, as alternative reference rates are available under the agreements governing the financial instruments.

Recent Accounting Pronouncements Not Yet Adopted

In May 2016, the FASB published ASU 2016-13: Financial Instruments – Credit losses (Topic 326): Measurement of Credit Losses on Financial Instruments. The main objective of Topic 326 is to provide financial statement users with more decision-useful information about the expected credit losses on financial instruments and other commitments to extend credit held by a reporting entity at each reporting date. To achieve this objective, the amendments in this update replace the incurred loss impairment methodology in current U.S. GAAP with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to inform credit loss estimates. In April 2019, the FASB published ASU 2019-04 Codification Improvements to Topic 326, Financial Instruments – Credit Losses, which made certain amendments and corrections to the original codification. In May 2019, the FASB published ASU 2019-05 Financial Instruments – Credit losses (Topic 326) which made transitional relief available, specifically allowing the option to elect a fair value option for financial instruments measured at amortized cost. In November 2019, the FASB published ASU 2019-11 Codification Improvements to Topic 326, Financial Instruments – Credit losses, which made certain amendments and corrections to the original codification. In November 2019, the FASB published ASU 2019-10 Financial Instruments – Credit losses (Topic 326), which made certain amendments to the effective dates of the new standard. The amendment is effective for the Company for years beginning after December 15, 2022 including interim periods with those years. The Company is currently evaluating the impact of this accounting standard, but it is expected that the new standard may result in additional credit losses being recorded.

In January 2017, the FASB published ASU 2017-04: Intangibles – Goodwill and Other (Topic 350): Topic 350 seeks to simplify goodwill impairment testing requirements for public entities. Under the amendments in this update, an entity should perform its annual, or interim, goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount. An entity should recognize an impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value; however, the loss recognized should not exceed the total amount of goodwill allocated to that reporting unit. Additionally, an entity should consider income tax effects from any tax deductible goodwill on the carrying amount of the reporting unit when measuring the goodwill impairment loss, if applicable. The FASB also eliminated the requirements for any reporting unit with a zero or negative carrying amount to perform a qualitative assessment and, if it fails that qualitative test, to perform Step 2 of the goodwill impairment test. Therefore, the same impairment assessment applies to all reporting units. An entity is required to disclose the amount of goodwill allocated to each reporting unit with a zero or negative carrying amount of net assets. The amendments in this ASU are effective for all entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2022. The Company is currently evaluating the impact of this accounting standard. However, it is expected that this may reduce the complexity of evaluating goodwill for impairment.

In December 2019, the FASB published ASU 2019-12: Income Taxes (Topic 740): Simplifying the Accounting for income taxes. The purpose of this codification is to simplify the accounting for income taxes, which addresses a number of topics including but not limited to the removal of certain exceptions currently included in the standard related to intraperiod allocation when there are losses, in addition to calculation of income taxes when current year-to-date losses exceed anticipated loss for the year. The amendment also simplifies accounting for certain franchise taxes and disclosure of the effect of enacted change in tax laws or rates. Topic 740 is effective for public entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2020. The impact of the adoption of the standard has not yet been determined and is being evaluated.

The following consolidated financial statement details are presented as of the period ended for the consolidated balance sheets and for the periods ended for each of the consolidated statements of operations and comprehensive income.

The allowance for doubtful accounts pertains primarily to one customer previously serviced out of Dongguan China. This was provisioned and included with the restructuring charges for the closure of the facility in 2019. Refer to note 10 for further details. To date, there has been no impact of the COVID-19 pandemic on the allowance for doubtful accounts.

Unbilled contract assets

The provision for obsolescence primarily pertains to customers previously serviced out of the Dongguan facility. These have been provisioned and included with the restructuring charges for the closure of the facility in 2019. Refer to note 10 for further details.

Property, plant and equipment – net:

Intangible assets:

These intangible assets arose from the acquisition of MC Assembly Holdings Inc. (“MC Assembly”) in November 2018 and were allocated to the following operating segments:

Amortization expense of $1,518 is recorded in cost of sales in the consolidated statement of income and comprehensive income for the three months ended March 29, 2020, and $1,844 for the three months ended March 31, 2019. Amortization expense for the next five years and thereafter is as follows:

Goodwill:

The carrying value of goodwill as at March 29, 2020 was $18,165 (December 29, 2019 – $18,165). This goodwill arose from the acquisition of MC Assembly in November 2018 and was allocated to the following operating segments that are expected to benefit from the synergies of this business combination and has not changed since the acquisition:

The carrying value of goodwill is assessed annually at year-end and at each reporting period for impairment triggers to determine whether there exists any indicators of impairment. The assessment is done at the operating segment level as the group of components (production facilities) within each operating segment all have similar economic characteristics. Our business operations have performed during the first quarter of 2020 as expected. While the COVID-19 pandemic creates significant uncertainty, in the near term, the Company did not identify any triggering events as at March 29, 2020.

Accrued liabilities: 

(a) Revolving credit and long-term debt facilities 

The Company borrows money under an Amended and Restated Revolving Credit and Security Agreement with PNC Bank, National Association (“PNC”) which governs the Company’s revolving credit facility (“PNC Facility”). The PNC Facility has a term ending on November 8, 2023. Advances made under the PNC Facility bear interest at the U.S. base rate plus a grid ranging from 0.50% to 1.00% or 1, 2 or 3-month fully-absorbed PNC LIBOR plus a grid ranging from 1.50% to 2.00%. The base commercial lending rate should approximate U.S. prime rate.  

The Company also borrows money under a Financing Agreement (the “Financing Agreement”), by and among the Company and certain of its subsidiaries, the lenders party to the Financing Agreement from time to time (collectively, the “Lenders”), and TCW Asset Management Company, LLC, as collateral agent for the Lenders (“TCW”). The Financing Agreement governs a term loan A facility (the “Term A Loan Facility” and together with the PNC Facility, the “Credit Facilities” and previously governed a term loan B facility (the “Term Loan B Facility”) until it was paid in full on July 3, 2019. The Term Loan A Facility matures on November 8, 2023 (the “Maturity Date”). The Term Loan A Facility bears interest LIBOR plus an applicable margin of 8.75% through June 30, 2020, and borrowings under the Financing Agreement will thereafter bear interest at LIBOR plus an applicable margin ranging from 7.25% to 8.75%. Payments made under the Term Loan A Facility at any time prior to the Maturity Date (other than scheduled amortization payments and mandatory prepayments) are subject to an applicable premium equal to the amount of such payment multiplied by (i) 3.00% in the event that such payment occurs before November 8, 2019, (ii) 2.00% in the event that such payment occurs after November 8, 2019 and on or before November 8, 2020, and (iii) 1.00% in the event that such payment occurs after November 8, 2020 and on or before November 8, 2021. No such applicable premium is payable for any payment of loans made under the Term Loan A Facility occurring after November 8, 2021.

As at March 29, 2020, the funds available to borrow under the PNC Facility after deducting the current borrowing base conditions were $31,185 (December 29, 2019 - $21,644). The maximum amount of funds that could be available under the PNC Facility is $65,000. However, availability under the PNC Facility is subject to certain conditions, including borrowing base conditions based on eligible inventory and accounts receivable, and certain conditions as determined by PNC. The Company is required to use a “lock-box” arrangement for the PNC Facility, whereby remittances from customers are swept daily to reduce the borrowings under this facility.

At March 29, 2020, $33,340 (December 29, 2019 - $34,701) was outstanding under the PNC Facility and is classified as a current liability based on the requirement to hold a “lock-box” under the terms of the PNC Facility.

At March 29, 2020, $38,438 (December 29, 2019 - $38,750) was outstanding under the TCW Term Loan A Facility. The TCW Facilities are reported on the consolidated balance sheet net of deferred financing fees of $2,140 (December 29, 2019 - $2,286) and a discount on debt of $1,371 (December 29, 2019 - $1,464) related to the outstanding warrants described below.

The Credit Facilities are joint and several obligations of the Company and its subsidiaries that are borrowers under the Credit Facilities and are jointly and severally guaranteed by other subsidiaries of the Company. Repayment under the PNC Facility and Term A Loan Facility are collateralized by the assets of the Company and each of its subsidiaries.

(b) Covenants

The Credit Facilities contain certain financial and non-financial covenants, including restrictions on dividend payments. The financial covenants require the Company to maintain a fixed charge coverage ratio and a total leverage ratio quarterly during the term of the Credit Facilities.

The Company was in compliance with the covenants included in the Credit Facilities as at March 29, 2020.  The Company’s continued financial covenant compliance will depend on key variables, including the Company’s cash flow from earnings before interest, income taxes and depreciation as well as debt levels.  For context, assuming no change to debt balances, a reduction of approximately 19% and 25% of earnings before interest, income taxes, depreciation and amortization over the next six month period, could jeopardize covenant compliance at the end of our second and third quarters 2020, respectively, which test our ratios against twelve-month trailing results.  The Company attempts to address risks of covenant compliance by taking measures to reduce its inventory, revolving credit facility and term debt balances as necessary.

Market conditions, including the implications of the COVID-19 pandemic, may negatively impact our ability to secure and source alternative methods of financing. We do not currently foresee a material impact in the short term based on our working capital needs, however if a number of our customers reduce or temporarily cease payments to us, this would present a risk and negatively impact our cash flow and ability to meet our working capital obligations to operate our business, which could require us to secure alternative methods of financing.

The Company continues to monitor operations and results closely and manage debt levels relative to our operational results to ensure compliance with its lenders covenants.

(c) Warrant liability

On November 8, 2018, 504,735 warrants were issued to TCW in connection with the Financing Agreement and are outstanding as at March 29, 2020. As a result of the anti-dilution provisions contained in the warrants that were triggered in connection with the Rights Offering and the Registered Direct Offering in June 2019, the warrants were exercisable to purchase an additional 7,214 shares of common stock (or a total of 511,949) at March 29, 2020. These warrants are exercisable on a cashless basis, or for an exercise price of $0.01. The Company initially recorded the value of the warrants as a warrant liability with a corresponding discount on the long-term debt in the amount of $1,898. The fair value has been assessed at $2.37 per unit or $1,213 as at March 29, 2020 ($3.38 per unit or $1,730 – December 29, 2019). The fair value of the warrant obligation is presented as a warrant liability on the consolidated balance sheet with changes to the fair value recorded each reporting period as either a gain or a loss in the consolidated statement of operations and comprehensive income. 

Common shares

Issued and outstanding:

The issued and outstanding number of common shares included in shareholders’ equity consisted of the following:

 Stock Options

For more detailed information regarding the Company’s stock option arrangements, see Note 7 of the consolidated financial statements within the Company’s Form 10-K for the fiscal period ended December 29, 2019. During the three month period ended March 29, 2020, there were no stock options granted, exercised or forfeited. A summary of stock option activity for the three month period ended March 29, 2020 is as follows:

During the three month periods ended March 29, 2020 and March 31, 2019, the Company recorded stock-based compensation expense related to stock options and a corresponding increase in additional paid-in capital of $57 and $22, respectively.

Certain stock options outstanding have market conditions such that the awards are vested and exercisable only if the Company’s stock exceeds specified targets during the vesting period. If the market conditions are not met, the stock options will not vest and will expire.

Restricted Stock Units and Restricted Stock Awards

For more detailed information regarding the Company’s Restricted Stock Units (“RSU”) and Restricted Stock Awards (“RSA”) arrangements, see Note 7 of the consolidated financial statements within the Company’s Form 10-K for the fiscal period ended December 29, 2019. During the three months period ended March 29, 2020, 28,000 RSUs were granted. A summary of the RSU activity for the three month period ended March 29, 2020 is as follows:

Certain RSUs outstanding have a market condition such that the awards are vested and issuable only if the market price of the Company’s stock meets or exceeds a specified target during the vesting period. If the market condition is not met, the RSUs will not vest and will be forfeited.

Stock based compensation recognized during the three month period ended March 29, 2020, and March 31, 2019, related to the restricted stock units was $105 and $66, respectively.  

During the three month period ended March 29, 2020 and March 31, 2019, the Company recorded current income tax expense $275 and $279, respectively, in connection with U.S. state taxes and taxes on profits in certain foreign jurisdictions, and deferred income tax expense of $15 and recovery of $8, respectively, in connection with temporary differences related to the Mexican operations.   

 In assessing the realization of deferred tax assets, management considers whether it is more likely than not that some portion or all of its deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income. Management considers the scheduled reversal of deferred tax liabilities, change of control limitations, projected future taxable income and tax planning strategies in making this assessment. Guidance under ASC 740, Income Taxes, (“ASC 740”) states that forming a conclusion that a valuation allowance is not needed is difficult when there is negative evidence, such as cumulative losses in recent years in the jurisdictions to which the deferred tax assets relate. The U.S., Canadian and Asian jurisdictions continue to have a full valuation allowance recorded against the deferred tax assets.

On March 27, 2020, the U.S. federal government enacted The Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”), which provides for certain tax relief with favorable implications for the Company. Most significantly, these provisions include a temporary relaxation of limitations on annual interest expense under Internal Revenue Code Section 163(j), and accelerated refund of certain federal tax credits. For the three months ended March 29, 2020, the current income tax benefit of these provisions is estimated to be $56, reflected in current tax expense.

The following table details the weighted average number of common shares outstanding for the purposes of computing basic and diluted earnings per common share for the following periods:

General description

During the three months ended March 29, 2020, the Company operated and managed by geographic region in the United States, Mexico and China, which are our operating and reportable segments. During the three months ended March 29, 2020, the Company completed final shipments for customers serviced in our Chinese manufacturing facility and began relocating the equipment to our other North American sites. We utilize each reportable segment’s contribution (revenue minus operating expenses, excluding unrealized foreign exchange gain (loss) on unsettled forward foreign exchange contracts, corporate allocations and restructuring expenses) to monitor reportable segment performance. Contribution by country is utilized by the chief operating decision-maker (defined as the Chief Executive Officer) as the indicator of reportable segment performance, as it reflects costs which our operating segment management are directly responsible for. Intersegment adjustments reflect intersegment sales that are generally recorded at prices that approximate arm’s-length transactions.

 In assessing the performance of the reportable segments, management attributes site revenue to the reportable segment that ships the product to the customer, irrespective of the product’s destination. Information about the reportable segments is as follows: 

Additions to property, plant and equipment

The following table contains additions, including those acquired through capital leases, to property, plant and equipment for the three months ended:

Property, plant and equipment (a)

 Other long term segment assets (b)

Total segment assets (a)

Geographic revenue

The following table contains geographic revenue based on our customer invoicing location, for the three months ended March 29, 2020 and March 31, 2019.

Significant customers and concentration of credit risk

Sales of the Company’s products are concentrated in certain cases among specific customers in the same industry. The Company is subject to concentrations of credit risk in trade receivables. The Company considers concentrations of credit risk in establishing the allowance for doubtful accounts and believes the recorded allowances are adequate.

The Company expects to continue to depend upon a relatively small number of customers for a significant percentage of its revenue. In addition to having a limited number of customers, the Company manufactures a limited number of products for each customer. If the Company loses any of its larger customers or any product line manufactured for one of its larger customers, it could experience a significant reduction in revenue. Also, the insolvency of one or more of its larger customers or the inability of one or more of its larger customers to pay for its orders could decrease revenue. As many costs and operating expenses are relatively fixed, a reduction in net revenue can decrease profit margins and adversely affect the business, financial condition and results of operations.

During the three months ended March 29, 2020, one customer exceeded 10% of total revenue, comprising of 12.6% of total revenue across all geographic segments. During the three months ended March 31, 2019, one customers exceeded 10% of total revenue, comprising of 13.1% of total revenue across all geographic segments.

As of March 29, 2020, no customers represented more than 10% of the trade accounts receivable. At December 29, 2019, one customer comprised 10% of the Company’s trade accounts receivable. No other customers individually represented more than 10% of total revenue or trade accounts receivable.

During the three months ended March 29, 2020, the Company entered into forward foreign exchange contracts to reduce its exposure to foreign exchange currency rate fluctuations related to forecasted Mexican peso expenditures. These contracts were effective as hedges from an economic perspective, but do not meet the requirements for hedge accounting under ASC Topic 815 “Derivatives and Hedging”. Accordingly, changes in the fair value of these contracts were recognized into net income in the consolidated statement of operations and comprehensive income. The Company had no outstanding forward foreign exchange contracts in the first quarter of 2019.

The following table presents a summary of the outstanding foreign currency forward contracts as at March 29, 2020:

The unrealized loss recognized in earnings as a result of revaluing the instruments to fair value on March 29, 2020 was $512 (March 31, 2019– $Nil) which was included in cost of sales in the interim consolidated statement of operations and comprehensive income. Fair value is determined using the market approach with valuation based on market observables (Level 2 quantitative inputs in the hierarchy set forth under ASC 820 “Fair Value Measurements”).

The average contract and mark-to-market rates for outstanding forward foreign exchange contracts were as follows;

The derivative liability was $512 (March 31, 2019 –Nil) which reflected the fair market value of the unsettled forward foreign exchange contracts. There were no derivative assets as at March 29, 2020 or March 31, 2019.

Dongguan facility closure

In September 2019, the Company announced it plans to close its Dongguan manufacturing facility in China, concurrent with the expiration of the facility lease in December 2019, which was extended to February 2020. The closure was formally approved by the Board of Directors in September 2019. The closure of the Dongguan facility resulted in a reduced labor force by approximately 137 employees. The employee group was notified of the closure in the last week of September 2019. The closure of the Dongguan facility and majority of the cash outflows associated with the $2,037 included within the restructuring liability was for severance and other exit costs which was substantially completed by the end of the first quarter of 2020. Remaining activities include a small number of support staff performing administrative duties, professional services to be rendered with respect to the closure activities, taxes and duties to be settled in addition to severance payments. Substantially all of the costs are anticipated to be spent by the third quarter of 2020. Manufacturing by the Company of certain products previously manufactured at the Dongguan facility has been transferred to the Company’s other manufacturing facilities. A restructuring charge of $5,000 was recorded in the twelve months ended December 29, 2019 relating to the announced planned closure.

During the three months ended March 29, 2020, restructuring recoveries were recorded of $221 primarily related to shipments and cash payments received on previously provisioned Dongguan inventory.

Purchase obligations not recorded on the balance sheet as at March 29, 2020 consist of open non-cancellable purchase orders (PO) for raw materials for $34,696 which are expected to be paid within 12 months of the PO issue date. Purchase obligations not recorded on the balance sheet as at December 29, 2019, consisted of open non-cancellable purchase orders for raw materials for $27,959 to be paid within 12 months of the PO issue date.