ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The statements contained in this Quarterly Report that are not historical facts are frequently forward-looking statements that describe anticipated results for Span-America Medical Systems, Inc. (the “Company,” “Span-America” or “we”). These statements are estimates or forecasts about Span-America and its markets based on our beliefs, assumptions and expectations. These forward-looking statements therefore involve numerous risks and uncertainties. We wish to caution the reader that these forward-looking statements, such as, but not limited to, our expectations for future sales or future expenses, are only predictions. These forward-looking statements may be generally identified by the use of forward-looking words and phrases, such as “will,” “intends,” “would,” “estimates,” “continues,” “may,” “believes,” “anticipates,” “should,” “optimistic” and “expects,” and are based on the Company’s current expectations or beliefs concerning future events that involve risks and uncertainties. Actual events or results may differ materially as a result of risks and uncertainties in our business. Such risks include, but are not limited to, the “Risk Factors” described in “Item 1A. Risk Factors” in our Annual Report on Form 10-K for the fiscal year ended October 1, 2016, other risks referenced from time to time in our Securities and Exchange Commission (“SEC”) filings, or other unanticipated risks. We disclaim any obligation to update any forward-looking statement, whether as a result of new information, future events or otherwise.
RESULTS OF OPERATIONS
Overview
Medical segment sales increased 10% to $12.5 million in the first quarter of fiscal 2017 compared with $11.4 million in the first quarter of fiscal 2016 due primarily to higher sales volumes of therapeutic support surfaces and medical beds during the quarter. In the custom products segment, sales in the first quarter of fiscal 2017 decreased 73% to $2.7 million compared with the same quarter last year as expected because of lower sales of consumer bedding products resulting primarily from a $6.1 million seasonal promotion that took place in the first quarter of fiscal 2016 and was not repeated in the first quarter of fiscal 2017. As a result, total sales for the first quarter of fiscal 2017 decreased by 29% to $15.2 million compared with $21.5 million in the first quarter of last fiscal year due to lower sales volume of consumer bedding products within our custom products segment.
Net income for the first quarter of fiscal 2017 decreased by 16% to $963,000, or $0.35 per diluted share, compared with $1.1 million, or $0.42 per diluted share, in the first quarter of last fiscal year. The decrease in first quarter earnings was primarily driven by lower sales volume of consumer bedding products, higher administrative expenses and lower foreign currency exchange gains in the first quarter of fiscal 2017 compared with the same quarter last year.
Medical Sales – First Quarter
Fiscal 2017
Total medical sales increased 10% in the first quarter of fiscal 2017 to $12.5 million compared with $11.4 million in the same quarter last year. The $1.1 million increase resulted from higher sales volumes of therapeutic support surfaces and medical beds compared with the first quarter of fiscal 2016. Our sales of medical beds and in-room furnishing products increased by 14% to $3.1 million in the first quarter of fiscal 2017 compared with $2.7 million in the same quarter last year primarily as the result of higher demand for medical beds from our traditional long-term care customer base as well as higher sales in the government and export markets, which we believe reflects the ordinary ebb and flow of customer demand for our medical beds.
Among our pressure management product lines, sales in the first quarter of fiscal 2017 were up by 8% to $9.4 million compared with $8.7 million in the first quarter of last fiscal year. Sales of therapeutic support surfaces, our largest medical product line, were up by 12% to $6.9 million compared with $6.1 million in the first quarter last fiscal year. The increase in support surface sales was the result of several orders from large-corporate customers in addition to the normal fluctuations of customer demand. Sales of our other pressure management product lines as a group decreased by 1% during the first quarter of fiscal 2017 to $2.5 million compared with $2.6 million during the first quarter of fiscal 2016 due to lower sales of overlays, seating and Selan® product lines, offset partially by higher sales of patient positioners and Risk Manager® products.
Custom Products Sales – First Quarter
Fiscal 2017
Our custom products segment consists of two product lines: consumer bedding products and specialty industrial products. Total sales in the custom products segment decreased by 73% to $2.7 million in the first quarter of fiscal 2017 compared with $10.1 million in the first quarter last fiscal year. The sales decrease came entirely from our consumer bedding products, where sales decreased 82% to $1.7 million compared with $9.2 million in the same quarter last fiscal year. There were two events that caused the large decrease in consumer sales. First, as we reported last year, we participated in a seasonal promotion of consumer products in the first quarter of fiscal 2016, which added approximately $6.1 million in sales in the first quarter of fiscal 2016 but was not repeated in the first quarter of fiscal 2017. Second, also as previously reported, we lost business with Sinomax in May of 2016 following their decision to in-source the manufacturing of products they previously purchased from Span-America. Consumer bedding sales represent the larger portion of our custom products segment.
The sales to Sinomax and the seasonal promotion were for resale to a single large retail customer in fiscal 2016. Excluding these sales-for-resale to this single retail customer in the first quarter of fiscal 2016, consumer sales would have increased 63% to $1.7 million in the first quarter of fiscal 2017 compared with $1.0 million in the first quarter of fiscal 2016 due to the addition of new customers in the last half of fiscal year 2016.
The other part of the custom products segment is made up of our industrial product lines. Industrial sales were up 16% in the first quarter of fiscal 2017 to $1.0 million compared with $901,000 in the first quarter of fiscal 2016. Most of the first-quarter growth in industrial sales came from customers in the packaging market.
Gross Profit
Our gross profit level increased by 2% to $5.6 million in the first quarter of fiscal 2017 compared with $5.5 million in the first quarter last fiscal year. Our gross margin percentage increased to 36.6% in the first quarter this fiscal year compared with 25.6% in the same quarter last year. The increases in gross profit level and margin were the result of a large shift in sales mix toward the higher-margin medical segment, as medical sales increased during the quarter while custom products sales decreased. Medical sales made up 82% of total sales in the first quarter of fiscal 2017 compared with only 53% in the first quarter of fiscal 2016. Our medical segment has historically had higher gross margins than our custom products segment.
Selling, Research & Development and Administrative Expenses
Selling and marketing expenses rose by 4% during the first quarter of fiscal 2017 to $2.6 million compared with $2.5 million in the first quarter of fiscal 2016, generally reflecting the growth in medical sales volume during the first quarter of fiscal 2017.
Compared with the first quarter of fiscal 2016, R&D expenses decreased by 13% in the first quarter of fiscal 2017 to $256,000 due to normal quarter-to-quarter fluctuations in our product development costs in the medical segment.
Administrative expenses increased by 16% to $1.3 million during the first quarter of fiscal 2017 primarily because of higher professional fees and an increase in business development efforts compared with the same quarter last fiscal year. We hired a vice president of business development in the first quarter of fiscal 2017. As a result we expect to have ongoing expenses related to these new business development efforts.
Operating Income
Operating income for the first quarter of fiscal 2017 decreased by 11% to $1.4 million compared with $1.6 million in the same period last fiscal year due primarily to the decrease in consumer sales and the increase in administrative expenses.
Non-Operating Income and Expenses
Net non-operating income in the first quarter of fiscal 2017 decreased by 69% to $34,000 compared with $108,000 in the first quarter last fiscal year. The decrease was primarily the result of lower foreign currency exchange gains from the operations of our Canadian subsidiary. The Canadian-U.S. dollar exchange rate was relatively stable during the first quarter of fiscal 2017. During this same quarter a year ago, the Canadian dollar weakened against the U.S. dollar, which created foreign exchange gains in the first quarter last year that were not repeated in the first quarter this year.
Net Income and Dividends
Net income for the first quarter of fiscal 2017 decreased by 16% to $963,000, or $0.35 per diluted share, compared with $1.1 million, or $0.42 per diluted share, in the first quarter last fiscal year due primarily to lower consumer sales volume, and to a lesser extent, higher administrative expenses and lower foreign currency exchange gains from our operations in Canada.
During the first quarter of fiscal 2017, we paid dividends of $441,000, or 46% of net income, which consisted of one regular quarterly dividend of $0.16 per share. During the same period last fiscal year, we paid dividends of $436,000, or 38% of net income, which also consisted of one regular quarterly dividend of $0.16 per share.
Outlook
We expect medical sales to continue to show solid growth during the remainder of fiscal 2017. We believe higher demand for therapeutic support surfaces and medical beds, particularly from our Canadian customers and our export business, will be a major driver of medical sales in fiscal 2017. In the custom products segment, we expect consumer sales volume to be down in the second quarter of fiscal 2017 compared with the second quarter of fiscal 2016, although the decrease should be much smaller than we experienced in the first quarter of fiscal 2017 comparison. For the second half of fiscal 2017, we expect our consumer sales comparisons to improve compared with the first half of fiscal 2017.
We believe our earnings for the remainder of fiscal 2017 will benefit from continued strength in medical sales combined with lower administrative expenses. We expect our quarter-over-quarter earnings comparisons to be more favorable, beginning in the second quarter of fiscal 2017, since we will have no further comparisons during fiscal 2017 with a single quarter in fiscal 2016 that included a large seasonal promotion of consumer products.
LIQUIDITY AND CAPITAL RESOURCES
Cash provided by operations during the first quarter of fiscal 2017 increased to $1.3 million compared with $23,000 in the first quarter of fiscal 2016. Our cash flow from operations in the first quarter last year was much lower than usual because of an increase in working capital requirements for the seasonal promotion of consumer products that took place in the year-ago quarter. Since we did not repeat the seasonal promotion in the first quarter of this fiscal year, our cash flow of $1.3 million represented a more normalized quarterly level for the business based on our earnings performance. Our primary uses of cash during the first quarter of fiscal 2017 were dividend payments of $441,000 and equipment purchases of $248,000.
Working capital increased by 2% to $14.9 million at the end of the first quarter of fiscal 2017 compared with $14.6 million at fiscal year-end 2016. Likewise, the current ratio at the end of the first quarter of fiscal 2017 increased to 3.8 from 3.4 at fiscal year-end 2016. The increases in working capital and the current ratio were the result of an increase in cash combined with decreases in accounts payable and accrued liabilities during the first quarter of fiscal 2017.
Accounts receivable, net of allowances, decreased by $780,000, or 10%, to $7.3 million at the end of the first quarter of fiscal 2017 compared with $8.1 million at the end of fiscal 2016. The decrease was related to normal monthly fluctuations in accounts receivable. Our average collection time for trade accounts receivable during the first quarter of fiscal 2017 was 42.2 days compared with 40.9 days for the full fiscal year 2016. The increase in collection time was caused primarily by the shift in sales mix toward the medical segment. Our collection time in the medical segment is generally longer than in the custom products segment. All of our accounts receivable are unsecured; however, certain receivables of Span-Canada are insured under the terms of an insurance policy.
Inventory decreased by $266,000, or 4%, to $7.2 million at the end of the first quarter of fiscal 2017 compared with $7.4 million at fiscal year-end 2016. Inventory turns, calculated using annualized cost of sales and average inventory balances, were 5.3 times for the first quarter of fiscal 2017 compared with 5.6 times for the full year of fiscal 2016.
From the end of our 2016 fiscal year to the end of the first quarter of fiscal 2017:
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Prepaid expenses increased by 11% from $879,000 to $976,000 due to the payment of insurance premiums for our property and casualty insurance for fiscal year 2017;
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Net property and equipment increased by $54,000, or 1%, to $4.2 million primarily as the net result of equipment purchases of $248,000, depreciation expense of $180,000 and foreign currency translation adjustments;
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Net intangibles decreased by $98,000, or 5%, to $1.9 million primarily as a result of amortization expenses of $73,000 and foreign currency translation adjustments that resulted from the U.S.-Canadian currency conversion;
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Other assets increased by 4% to $3.0 million primarily as a result of increases in deposits on raw material purchases and cash value of life insurance;
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Accounts payable decreased 17% from $2.4 million to $2.0 million due to normal monthly fluctuations in accounts payable.
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Accrued and sundry liabilities decreased by $269,000, or 8%, to $3.3 million due primarily to payments for incentive compensation and customer rebates during the first quarter of fiscal 2017.
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At December 31, 2016, we had no outstanding balance under our revolving credit facility. The maximum principal amount we can borrow at any one time under our revolving credit agreement is $5.0 million with a maturity date of April 30, 2018. The credit facility is unsecured and accrues interest at a variable rate equal to 30-day LIBOR plus a margin ranging from 85 to 165 basis points, depending on our leverage ratio (as defined in the credit agreement). The interest rate, including the margin of 85 basis points, was 1.2795% in January 2016, the last time we had borrowings outstanding. Interest-only payments are required monthly. We have pledged to grant the lending bank a security interest in our accounts, instruments and chattel paper upon its request in the event of a default as defined in the credit agreement. Our obligations under the credit agreement are guaranteed by our subsidiary, Span-Canada.
The credit facility includes financial covenants relating to tangible net worth and leverage ratios, and restricts mergers and acquisitions, asset sales, indebtedness, liens and capital expenditures. Violation of loan covenants could result in acceleration of the term of the agreement. We believe that we were in compliance with all loan covenants in the credit facility as of December 31, 2016.
The Company’s founder and former chief executive officer, Donald C. Spann, passed away on January 6, 2017. We had retirement and resignation agreements with Mr. Spann in place since 1993 when he retired from the Company. These agreements provided for payments of $113,561 per year to Mr. Spann and his former wife. Mr. Spann’s former wife survives him, so in accordance with these agreements, we will continue to make the retirement payments to Ms. Spann for the remainder of her life. To help fund our payment obligations under the retirement arrangement, the Company owns and is the beneficiary of three life insurance policies on Mr. Spann that were put in place from 1981 through 1993. These policies had a total death benefit of approximately $3.3 million and a total cash value of approximately $2.6 million as of December 31, 2016. The cash value of these policies has been recorded in “Other assets” on our balance sheet. As of December 31, 2016, we had a liability balance of approximately $380,000, which represents the present value of the expected future retirement payments to be made to Ms. Spann. This liability is recorded in “Accrued and sundry liabilities” and “Deferred compensation” on the Company’s balance sheet.
As a result of Mr. Spann’s death, we expect to receive the life insurance proceeds of approximately $3.3 million in cash. We will remove from our balance sheet the associated cash value of the life insurance policies of approximately $2.6 million. The difference between the total life insurance proceeds and the total cash values of the policies is approximately $700,000, which will be recorded as non-operating income in the second quarter of fiscal 2017. The resulting effect on our financial statements from these transactions will be as follows:
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“Cash and cash equivalents” on the balance sheet will increase by approximately $3.3 million.
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“Other assets” on the balance sheet will decrease by approximately $2.6 million, which is the cash value of the life insurance policies prior to Mr. Spann’s death.
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“Non-operating income” on the income statement will increase by approximately $700,000.
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For more information, see Notes 2, 7 and 11 in the Notes to Consolidated Financial Statements and “Critical Accounting Policies – Present Value of Deferred Compensation” in Management’s Discussion and Analysis of Financial Condition and Results of Operations in our annual report on Form 10-K for the fiscal year ended October 1, 2016.
We believe that funds on hand, funds generated from operations, funds available under our revolving credit facility and funds expected to be received from life insurance proceeds are adequate to finance our operations and expected capital requirements during fiscal 2017 and for the foreseeable future.
OFF-BALANCE SHEET ARRANGEMENTS
We have no off-balance sheet arrangements.
IMPACT OF INFLATION AND COST OF RAW MATERIALS
Inflation was low in the United States and Canada during the first quarter of our fiscal year 2017 and was consequently a minor factor in our operations for the quarter. If the rate of inflation were to accelerate, the largest effect on the Company would likely be increases in cost of goods sold, primarily in the cost of raw materials, which is our single largest cost category. If unemployment rates remain low and the economy continues to grow, we could also experience wage inflation, which would increase our payroll costs. We would attempt to mitigate any such higher costs, but we can give no assurance that higher costs could be fully offset by sales price increases, expense reductions or other operational changes. See Item 3 “Quantitative and Qualitative Disclosures about Market Risk” below for more information on the cost of our raw materials.
FOREIGN CURRENCY EXCHANGE
Span-Canada, operating under the name “M.C. Healthcare Products,” uses the Canadian dollar as its functional currency. However, all transactions originally denominated in Canadian dollars are converted to U.S. dollars for financial reporting purposes. We are subject to exchange rate fluctuations, which vary based on volume and currency market conditions. These exchange rate fluctuations will cause foreign exchange gains and losses, which could be material to our results of operations depending on currency market conditions and the timing and levels of our business activities in the U.S and Canada. For the first quarter of fiscal year 2017, our realized foreign currency exchange gain was $35,000 compared with a gain of $117,000 in the first quarter of fiscal 2016. The decrease in foreign currency gain was caused by a more moderate strengthening of the U.S. dollar versus the Canadian dollar during the first quarter of fiscal 2017 compared with the trend that occurred during the first quarter of fiscal year 2016.
Exchange rate fluctuations may also impact the competitive price position of our products manufactured in the U.S. and sold in Canada, which is our primary market outside the U.S. The appreciation of the U.S. dollar relative to the Canadian dollar makes our U.S.-origin products more expensive in Canadian dollar terms compared to similar products manufactured in Canada.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are exposed to financial market risk in four areas: commodity price risk, cash value of life insurance, our credit facility and foreign currency exchange. Commodity price risk could affect our operations primarily through our purchase of raw materials used in our manufacturing processes. The cost of polyurethane foam, our primary raw material, is indirectly influenced by oil prices. However, other market factors also affect foam prices, including the available supply of component chemicals, demand for related products from domestic and international manufacturers, competition among domestic suppliers, our purchase volumes and regulatory requirements. Consequently, it is difficult for us to accurately predict the impact that future inflation and other factors might have on the cost of polyurethane foam, our largest-volume raw material. If the cost of polyurethane foam increased significantly, and if we were unable to offset the cost increase through sales price increases or other expense reductions, our earnings could be materially negatively affected.
The significant reduction in oil prices in 2014 followed by more recent modest increases have to date had no material impact on our cost of polyurethane foam or other raw materials. In addition, we do not have any indication yet as to whether or how the recent oil price increases will impact our raw material costs.
As of December 31, 2016, our other assets included $2.8 million in cash value of life insurance, which is subject to market risk related to equity pricing and interest rate changes. The cash value is generated from life insurance policies that are being used primarily as the funding vehicle for a retirement program for Span-America’s founder and former chief executive officer and his ex-wife. The cash value is invested in a combination of fixed income life insurance contracts and a portfolio of mutual funds managed by an insurance company. The fixed income contracts are similar to fixed income bond funds and are therefore subject to interest rate and company risk. The mutual fund portfolios invest in common stocks and bonds in accordance with their individual investment objectives. These portfolios are exposed to stock market, company and interest rate risks similar to comparable mutual funds. We believe that substantial fluctuations in equity markets and interest rates and the resulting changes in cash value of life insurance would not have a material adverse effect on our financial position. During the first quarter of fiscal 2017, the cash value of life insurance increased by 3%, creating after-tax income of approximately $72,000. As disclosed above, Span-America’s founder and former chief executive officer, Donald C. Spann, passed away on January 6, 2017. As a result, we expect to receive an approximately $3.3 million cash death benefit from the related life insurance policies. Once the insurance proceeds are received, we expect our market risk related to the cash value of life insurance to cease to be material from and after the second quarter of fiscal 2017.
Our credit facility accrues interest at a variable rate equal to 30-day LIBOR plus a margin ranging from 85 to 165 basis points depending on our then-applicable leverage ratio (as defined in the credit agreement). Interest is payable monthly. The interest rate, including the margin of 85 basis points, was 1.2795% in January 2016, the last time we incurred interest. A material increase in interest rates could have a negative impact on our financial condition and earnings to the extent that we had significant outstanding borrowings under the facility. The degree of impact would vary depending on the level of the borrowings. We had no outstanding balance under our credit facility as of December 31, 2016. Assuming a constant level of debt of $1.0 million for an entire fiscal year, a 100 basis point increase in the interest rate on the outstanding loan balance would increase our interest expense by $10,000 per year.
As a result of the M.C. Healthcare asset acquisition, we own assets in Canada and manufacture and sell products in Canada in addition to the U.S. We are therefore subject to realized and unrealized gains or losses on foreign currency translation activities related to our operations. Foreign exchange gains or losses have not had a material effect on our results of operations since the M.C. Healthcare acquisition. We do not currently hedge our foreign exchange risks because our foreign exchange transactions occur infrequently and in relatively small amounts since our revenues and costs are incurred in both U.S. and Canadian dollars. Our foreign exchange risk could increase if the exchange rates between the U.S. and Canadian dollars became more volatile.
Most of our Span-Canada operating costs and liabilities are denominated in Canadian dollars. Span-Canada sales are denominated in the currency of the country in which they occur. Accordingly, material changes in the Canadian-U.S. dollar exchange rate may significantly impact our revenues and costs and the value of our assets and liabilities. The magnitude and direction of this impact primarily depends on our production and sales volume, the proportion of our production and sales that occur in Canada, the proportion of our financial liabilities denominated in Canadian dollars and the magnitude, direction and duration of changes in the Canadian-U.S. dollar exchange rate. Increases in the value of the Canadian dollar versus the U.S. dollar reduce our earnings, which are reported in U.S. dollar terms. Assets and liabilities are translated into U.S. dollars at the quarter-end exchange rate. Revenues and expenses are translated at weighted average exchange rates. Based on our levels of assets and liabilities in Canada as of December 31, 2016, for every 1% increase or decrease in the value of a Canadian dollar compared to a U.S. dollar, our total assets would have increased or decreased, respectively, by approximately $108,000, and our total liabilities would have increased or decreased, respectively, by approximately $10,000 for a net change of approximately $98,000. For the first quarter of fiscal year 2017, our net realized foreign currency exchange gain was $35,000 compared with a net realized foreign currency exchange gain of $117,000 in the first quarter of fiscal 2016. The decrease in foreign currency gain was caused by a more moderate strengthening of the U.S. dollar versus the Canadian dollar during the first quarter of fiscal 2017 compared with the trend that occurred during the first quarter of fiscal year 2016.