ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Forward-looking Statements
Some of the statements contained in this Report are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (“Exchange Act”). Management and representatives of UFP Technologies, Inc. (the “Company”) also may from time to time make forward-looking statements. These statements are subject to known and unknown risks, uncertainties, and other factors, which may cause our or our industry’s actual results, performance, or achievements to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements. Forward-looking statements include, but are not limited to, statements about the Company’s prospects; statements about the potential further impact the novel coronavirus ("COVID-19") pandemic may have on the Company’s business, financial condition and results of operations, including with respect to the different markets in which the Company participates, the demand for its products, the well-being and availability of the Company’s employees, the continuing operation of the Company’s locations, delayed payments by the Company’s customers and the potential for reduced or canceled orders, the Company’s efforts to address the pandemic, including regarding the safety of its employees, the maintenance of its facilities and the sufficiency of the Company’s supply chain, inventory, liquidity and capital resources, including increased costs in connection with such efforts, the impact of the pandemic on the businesses of the Company’s suppliers and customers, and the overall impact the pandemic may have on the Company’s financial results in 2021; statements about the Company’s acquisition strategies and opportunities and the Company’s growth potential and strategies for growth; expectations regarding customer demand; expectations regarding the Company’s liquidity and capital resources, including the sufficiency of its cash reserves and the availability of borrowing capacity to fund operations and/or potential future acquisitions; anticipated revenues and the timing of such revenues; expectations regarding the potential impact of the proposed phase out of LIBOR by the end of 2021; expectations about shifting the Company’s book of business to higher-margin, longer-run opportunities; anticipated trends and potential advantages in the different markets in which the Company competes, including the medical, aerospace and defense, automotive, consumer, electronics, and industrial markets, and the Company’s plans to expand in certain of its markets; statements regarding anticipated advantages the Company expects to realize from its investments and capital expenditures; statements regarding anticipated advantages to improvements and alterations at the Company’s existing plants; expectations regarding the Company’s manufacturing capacity, operating efficiencies, and new production equipment; statements about new product offerings and program launches; statements about the Company’s participation and growth in multiple markets; statements about the Company’s business opportunities; and any indication that the Company may be able to sustain or increase its sales, earnings or earnings per share, or its sales, earnings or earnings per share growth rates.
Investors are cautioned that such forward-looking statements involve risks and uncertainties that could adversely affect the Company’s business and prospects, and otherwise cause actual results to differ materially from those anticipated by such forward-looking statements, or otherwise, including without limitation: the severity and duration of the COVID-19 pandemic and its impact on the markets in which the Company participates, including its impact on the Company’s customers, suppliers and employees, as well as the U.S. and worldwide economies; the timing, scope and effect of further governmental, regulatory, fiscal, monetary and public health responses to the COVID-19 pandemic; risks and uncertainties associated with the COVID-19 pandemic and its impact on the Company’s business, financial condition and results of operations, risks associated with the identification of suitable acquisition candidates and the successful, efficient execution of acquisition transactions, the integration of any such acquisition candidates, the value of those acquisitions to our customers and shareholders, and the financing of such acquisitions; risks related to our indebtedness and compliance with covenants contained in our financing arrangements, and whether any available financing may be sufficient to address our needs; risks related to the proposed phase out of LIBOR by the end of 2021; risks associated with efforts to shift the Company’s book of business to higher-margin, longer-run opportunities; risks associated with the Company’s entry into and growth in certain markets; risks and uncertainties associated with seeking and implementing manufacturing efficiencies and implementing new production equipment; risks and uncertainties associated with growth of the Company’s business and increases to sales, earnings and earnings per share; and risks associated with new product and program launches. Accordingly, actual results may differ materially.
In some cases, you can identify forward-looking statements by terms such as “may,” “will,” “should,” “could,” “would,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “projects,” “predicts,” “potential,” and similar expressions intended to identify forward-looking statements. Our actual results could be different from the results described in or anticipated by our forward-looking statements due to the inherent uncertainty of estimates, forecasts, and projections, and may be materially better or worse than anticipated. Given these uncertainties, you should not place undue reliance on these forward-looking statements. Forward-looking statements represent our current beliefs, estimates and assumptions and are only as of the date of this Report. We expressly disclaim any duty to provide updates to forward-looking statements, and the estimates and assumptions associated with them, after the date of this Report, in order to reflect changes in circumstances or expectations, or the occurrence of unanticipated events, except to the extent required by applicable securities laws. All of the forward-looking statements are qualified in their entirety by reference to the factors discussed above and under “Risk Factors” set forth in Part I Item 1A of our Annual Report on Form 10-K for the fiscal year ended December 31, 2020, as well as the risks and uncertainties discussed elsewhere in this Report. We qualify all of our forward-looking statements by these cautionary statements. We caution you that these risks are not exhaustive. We operate in a continually changing business environment and new risks emerge from time to time.
Unless the context requires otherwise, the terms “we”, “us”, “our”, or “the Company” refer to UFP Technologies, Inc. and its consolidated subsidiaries.
Overview
UFP Technologies, Inc. (the “Company”) is an innovative designer and custom manufacturer of components, subassemblies, products and packaging primarily for the medical market. Utilizing highly specialized foams, films and plastics, the Company converts raw materials through laminating, molding, radio frequency welding and fabricating techniques. The Company is diversified by also providing highly engineered solutions to customers in the aerospace & defense, automotive, consumer, electronics and industrial markets. The Company consists of a single operating and reportable segment.
The Company’s current strategy includes further organic growth and growth through strategic acquisitions.
As further summarized below, the COVID-19 pandemic has had, and we believe it will continue to have, negative effects on our business and financial results. Despite the continuing impact of the COVID-19 pandemic, conditions related to the pandemic generally appear to be improving and sales for the Company for the six-month period ended June 30, 2021 increased 9.2% to $99.3 million from $90.9 million in the same period of 2020. Gross margins for the six-month period ended June 30, 2021 increased to 26.2% from 25.0% in the same period last year. Operating income and net income increased 42.6% and 43.0%, respectively.
Recent Developments
IMPACT OF COVID-19 ON OUR BUSINESS
Through much of 2020, COVID-19 spread across the country to areas in which our products are designed, manufactured, distributed or sold. The spread of COVID-19 and the response to it negatively impacted operating conditions for our business in 2020. Although we expect COVID-19 will continue to have negative impacts on our operating results in future periods, the magnitude and duration of the continuing impact is uncertain.
To stall the spread of COVID-19 during calendar year 2020, authorities in states in which we do business implemented numerous measures, including social distancing guidelines, travel bans and restrictions, quarantines, curfews, stay-at-home orders, and business shutdowns. Since then, most federal, state and local mandates or executive orders have been lifted. Our top priorities continue to be ensuring the health and safety of our workforce and serving our various constituencies with as little disruption as possible, so we continue to follow practical safety procedures and continue to monitor that status of the COVID-19 pandemic, vaccination rates and mutations COVID-19.
Our operations continue to expose us to risks associated with the COVID-19 pandemic. The COVID-19 pandemic has impacted the cost of manufacturing our goods, including higher labor costs, maintenance costs and manufacturing inefficiencies due to employee absenteeism and significantly enhanced cleaning and sterilization. There are continuing delays in scheduling elective medical procedures and exams, there is still a significant reduction in physician office visits from pre-pandemic levels, and hospitals continue to postpone or delay capital purchases. Although the conditions related to the COVID-19 pandemic generally appear to be improving, due to the speed with which the COVID-19 situation continues to evolve, its global nature, the range of governmental and community responses thereto and our business line and geographic diversity, the further impact of COVID-19 on our business and operations remains highly uncertain and could adversely and materially affect our business, financial condition and results of operations, as well as those of our customers.
To ensure the health and safety of our employees, since March 2020 we have required or enabled certain employees to work from home or remotely where practicable, and expanded IT and communication support to enhance their productivity; adjusted work spaces and shifted schedules to facilitate social distancing and sterilization for those who continue to work in our facilities; enhanced cleaning and disinfecting procedures at our facilities; required face coverings in accordance with local mandates and procured and distributed personal protective equipment; implemented health checks and visitor protocols and restricted travel.
The full extent to which the COVID-19 pandemic impacts our business and operations, is unknown and will depend on the severity, location and duration of the effects and spread of COVID-19, the effectiveness of the vaccine programs and the other actions undertaken by national, regional and local governments and health officials to contain the virus or treat its effects (including the ultimate efficacy of vaccine programs on new variants of the virus), and how quickly and to what extent economic conditions improve and normal business and operating conditions resume. As certain restrictions are lifted in various geographical locations throughout the U.S., we will continue to monitor and respond to the impacts that the COVID-19 pandemic has on our business and operations. We have a strong liquidity position, solid balance sheet, and access to capital which we expect will enable us to effectively manage through the COVID-19 pandemic.
Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”)
The CARES Act was enacted on March 27, 2020 in the United States. The CARES Act and related notices include several significant provisions, including delaying certain payroll tax payments and estimated income tax payments that we expect to defer to future periods. Accordingly, the Company deferred social security payments of approximately $1.6 million through December 31, 2020. Fifty percent of this amount is required to be paid by December 31, 2021 and the remaining balance is required to be paid by December 31, 2022. We do not currently expect the CARES Act to have a material impact on our financial results, including on our annual estimated effective tax rate, or on our liquidity. We will continue to monitor and assess the impact the CARES Act may have on our business and financial results.
Results of Operations
Sales
Sales for the three-month period ended June 30, 2021 increased approximately 18.8% to $50.7 million from sales of $42.6 million for the same period in 2020 (first full period of the COVID-19 pandemic). The increase in sales is primarily due to increases in sales to customers in the Automotive, Consumer, and Aerospace & Defense markets of 146.0%, 88.2%, and 40.7% respectively. Sales to customers in the Medical market increased 3.3%.
Sales for the six-month period ended June 30, 2021 increased approximately 9.2% to $99.3 million from sales of $90.9 million for the same period in 2020. The increase in sales is primarily due to increases in sales to customers in the Automotive, Consumer, and Aerospace & Defense markets of 35.7%, 74.4%, and 50.1% respectively, partially offset by a decrease in sales to customers in the Medical market of 4.0% due to the deferral of elective medical procedures.
Gross Profit
Gross profit as a percentage of sales (“gross margin”) increased to 26.5% for the three-month period ended June 30, 2021, from 23.3% for the same period in 2020. As a percentage of sales, material and labor costs collectively increased 1.0%, while overhead decreased 4.1%. The increase in collective material and labor costs as a percentage of sales was primarily due to increases in raw material costs and an unfavorable change in mix. The decrease in overhead as a percentage of sales was primarily due to fixed overhead costs measured against increased sales, and the increased costs incurred in the second quarter of 2020 in response to COVID-19.
Gross profit as a percentage of sales (“gross margin”) increased to 26.2% for the six-month period ended June 30, 2021, from 25.0% for the same period in 2020. As a percentage of sales, material and labor costs collectively increased 0.8%, while overhead decreased 2.0%. The increase in collective material and labor costs as a percentage of sales was primarily due to increases in raw material costs and an unfavorable change in mix. The decrease in overhead as a percentage of sales was primarily due to fixed overhead costs measured against increased sales, and the increased costs incurred in the second quarter of 2020 in response to COVID-19.
Selling, General and Administrative Expenses
Selling, general, and administrative expenses (“SG&A”) increased approximately 8.4% to $7.2 million for the three-month period ended June 30, 2021, from $6.7 million for the same period in 2020, primarily due to increases in discretionary compensation and company-wide travel and entertainment during the second quarter of 2021. As a percentage of sales, SG&A decreased to 14.3% for the three-month period ended June 30, 2021, from 15.6% for the same three-month period in 2020. The decrease in SG&A as a percentage of sales for the three-month period ended June 30, 2021 was primarily due to increased sales.
SG&A increased slightly to $14.5 million for the six-month period ended June 30, 2021, from $14.4 million for the same period in 2020. As a percentage of sales, SG&A decreased to 14.6% for the three-month period ended June 30, 2021, from 15.9% for the same three-month period in 2020. The decrease in SG&A as a percentage of sales for the six-month period ended June 30, 2021 was primarily due to increased sales.
Interest Income and Expense
Net interest income was approximately $21 thousand for the three-month period ended June 30, 2021, compared to net interest expense of approximately $33 thousand for the same period in 2020. The increase in net interest income for the three-month period ended June 30, 2021 was primarily due to interest received from the federal government related to income tax refunds.
Net interest income was approximately $5 thousand for the six-month period ended June 30, 2021, compared to net interest expense of $49 thousand in the same period of 2020. The increase in net interest income for the six-month period ended June 30, 2021 was primarily due to interest received from the federal government related to income tax refunds.
Other (Income) Expense
Other expense was approximately $4 thousand and $35 thousand for the three-month periods ended June 30, 2021 and 2020, respectively, and other income was approximately $7 thousand compared to other expense of approximately $362 thousand for the six-month periods ended June 30, 2021 and 2020, respectively. The changes in other expense are primarily generated by changes in the fair value of the swap liability, which is driven by anticipated future interest rate changes, offset by net cash settlement amounts related to the swap.
Income Taxes
The Company recorded tax expense of approximately 24.2% and 20.8% of income before income tax expense, respectively, for each of the three-month periods ended June 30, 2021 and 2020. The increase in the effective tax rate for the current period as compared to the prior period was largely due to lower discrete income tax benefits from share-based compensation in the three months ended June 30, 2021 than in the comparable period.
The Company recorded tax expense of approximately 22.9% and 18.9% of income before income tax expense, respectively, for each of the six-month periods ended June 30, 2021 and 2020. The increase in the effective tax rate for the current period was largely due to lower discrete income tax benefits from share-based compensation in the six months ended June 30, 2021 than in the comparable period. The Company notes the potential for volatility in its effective tax rate, as any windfall or shortfall tax benefits related to its share-based compensation plans will be recorded directly into income tax expense.
Liquidity and Capital Resources
The Company generally funds its operating expenses, capital requirements, and growth plan through internally generated cash and bank credit facilities.
Cash Flows
Net cash provided by operations for the six-month period ended June 30, 2021 was approximately $9.9 million and was primarily a result of net income generated of approximately $8.9 million, depreciation and amortization of approximately $4.2 million, share-based compensation of approximately $1.1 million, an increase in deferred taxes of approximately $0.4 million, an increase in accounts payable of approximately $4.0 million due to the timing of vendor payments in the ordinary course of business, and an increase in accrued expenses of approximately $0.3 million. These cash inflows and adjustments to income were partially offset by an increase in accounts receivable of approximately $4.8 million due to higher sales in the last two months of the second quarter of 2021 as compared to the same period in the fourth quarter of 2020, an increase in inventory of approximately $2.5 million due to restocking to historical levels, an increase in prepaid expenses of approximately $0.4 million, an increase in refundable income taxes of approximately $0.9 million, an increase in other assets of approximately $0.2 million, and a decrease in other long-term liabilities of approximately $0.2 million.
Net cash used in investing activities during the six-month period ended June 30, 2021 was approximately $3.3 million and was primarily the result of additions of manufacturing machinery and equipment across the Company.
Net cash used in financing activities was approximately $0.6 million during the six-month period ended June 30, 2021, resulting primarily from payments of statutory withholding for stock options exercised and restricted stock units vested.
Outstanding and Available Debt
On February 1, 2018, the Company, as the borrower, entered into an unsecured $70 million Amended and Restated Credit Agreement (the “Amended and Restated Credit Agreement”) with certain of the Company’s subsidiaries (the “Subsidiary Guarantors”) and Bank of America, N.A., in its capacity as the initial lender, Administrative Agent, Swingline Lender and L/C Issuer, and certain other lenders from time to time party thereto. The Amended and Restated Credit Agreement amended and restated the Company’s prior credit agreement.
On December 31, 2020, the Company, as the borrower, and Bank of America, N.A., as administrative agent and sole lender, entered into a First Amendment (the “First Amendment”) to the Company’s Amended and Restated Credit Agreement, dated February 1, 2018 (as amended, the “Restated Credit Agreement”).
The First Amendment amended the Restated Credit Agreement by (i) extending the scheduled maturity date from February 1, 2023 to December 31, 2025, and (ii) creating procedures and guidelines for establishing a successor benchmark rate if LIBOR ceases to be available during the term of the revolving credit facility. The Restated Credit Agreement called for interest of LIBOR plus a margin that ranges from 1.0% to 1.5% or, at the discretion of the Company, the bank’s prime rate less a margin that ranges from 0.25% to zero. The First Amendment calls for interest of LIBOR plus a margin that ranges from 1.25% to 1.75% or, at the discretion of the Company, the bank’s prime rate plus a margin that ranges from zero to 0.25%. In both cases the applicable margin remains dependent upon Company performance. The First Amendment also added certain representations and covenants concerning compliance by the Company with legal requirements.
The credit facilities under the Restated Credit Agreement consist of a $20 million unsecured term loan to the Company and an unsecured revolving credit facility, under which the Company may borrow up to $50 million. The proceeds of the Restated Credit Agreement may be used for general corporate purposes, as well as permitted acquisitions. The Company’s obligations under the Restated Credit Agreement are guaranteed by the Subsidiary Guarantors.
Under the Restated Credit Agreement, the Company is subject to a minimum fixed-charge coverage financial covenant as well as a maximum total funded debt to EBITDA financial covenant. The Restated Credit Agreement contains other covenants customary for transactions of this type, including restrictions on certain payments, permitted indebtedness and permitted investments. As of June 30, 2021 and December 31, 2020 there were no amounts outstanding; the applicable interest rate was approximately 1.09%, and the Company was in compliance with all financial covenants under the Restated Credit Agreement. As of June 30, 2021 and December 31, 2020, there were $0.7 million in standby letters of credit outstanding, drawable as a financial guarantee on worker’s compensation insurance policies.
Derivative Financial Instruments
The Company used interest-rate-related derivative instruments to manage its exposure related to changes in interest rates on its variable-rate debt instruments. The Company does not enter into derivative instruments for any purpose other than cash flow hedging. Derivative financial instruments expose the Company to credit risk and market risk. Credit risk is the failure of the counterparty to perform under the terms of the derivative contract. When the fair value of a derivative contract is positive, the counterparty owes the Company, which creates credit risk for the Company. When the fair value of a derivative contract is negative, the Company owes the counterparty and, therefore, the Company is not exposed to the counterparty’s credit risk. The Company minimizes counterparty credit risk in derivative instruments by entering into transactions with carefully selected major financial institutions based upon their credit profile. Market risk is the adverse effect on the value of a derivative instrument that results from a change in interest rates. The Company assesses interest rate risk by identifying and monitoring changes in interest rate exposures that may adversely impact expected future cash flows and by evaluating hedging opportunities. The Company’s debt obligations expose the Company to variability in interest payments due to changes in interest rates. The Company believes that it is prudent to limit the variability of a portion of its interest payments. To meet this objective, in connection with the term loan under the Amended and Restated Credit Agreement, the Company entered into a $20 million, 5‑year interest rate swap agreement under which the Company receives three-month LIBOR plus the applicable margin and pays a 2.7% fixed rate plus the applicable margin. The swap agreement was established to modify the Company’s interest rate exposure by converting the interest on the term loan from a variable rate to a fixed rate to hedge against the possibility of rising interest rates during the term of the loan. As the Company repaid its term loan in full, the swap agreement no longer serves this purpose and may be canceled by the Company prior to its expiration date. The notional amount was approximately $10 million at June 30, 2021. The fair value of the swap as of June 30, 2021 and December 31, 2020 was approximately $(321) thousand and $(465) thousand, respectively, and is included in other liabilities on the condensed consolidated balance sheets. Changes in the fair value and net cash settlement amounts related to the swap are recorded in other expense on the condensed consolidated statements of income and resulted in income of $64 thousand and expense of $144 thousand, respectively, during the three- and six-month periods ended June 30, 2021. In the same periods in 2020, change in the fair value of the swap resulted in income of $8 thousand and expense of $292 thousand, respectively. As the Company has paid the remaining balance of the term loan in its entirety, there is no longer underlying debt to hedge against with the swap. The changes in the fair value of the swap will continue to be accounted for as a financial instrument until the sooner of the time that the Company elects to cancel it or until its maturity.
Future Liquidity
The Company requires cash to pay its operating expenses, purchase capital equipment, and to service its contractual obligations. The Company’s principal sources of funds are its operations and its amended and restated credit facility. The Company generated cash of approximately $9.9 million in operations during the six months ended June 30, 2021; however, the Company cannot guarantee that its operations will generate cash in future periods. The Company’s longer-term liquidity is contingent upon future operating performance and draws on the revolving credit facility are possible. Further, the continued economic uncertainty resulting from the COVID-19 pandemic could affect the Company’s long-term ability to access the public markets and obtain necessary capital in order to properly capitalize and continue operations.
Throughout fiscal 2021, the Company plans to continue to add capacity to enhance operating efficiencies in its manufacturing plants. The Company may consider additional acquisitions of companies, technologies, or products that are complementary to its business. The Company believes that its existing resources, including its revolving credit facility, together with cash expected to be generated from operations, will be sufficient to fund its cash flow requirements, including capital asset acquisitions, through the next twelve months.
The Company may also require additional capital in the future to fund capital expenditures, acquisitions or other investments. These capital requirements could be substantial. The Company anticipates that any future expansion of its business will be financed through existing resources, cash flow from operations, the Company's revolving credit facility, or other new financing. The Company cannot guarantee that it will be able to meet existing financial covenants or obtain other new financing on favorable terms, if at all. The Company's liquidity will be impacted to the extent additional stock repurchases are made under the Company's stock repurchase program.
Stock Repurchase Program
The Company accounts for treasury stock under the cost method, using the first-in, first-out flow assumption, and includes treasury stock as a component of stockholders’ equity. On June 16, 2015, the Company announced that its Board of Directors authorized the repurchase of up to $10.0 million of the Company’s outstanding common stock. Under the program, the Company is authorized to repurchase shares through Rule 10b5-1 plans, open market purchases, privately negotiated transactions, block purchases or otherwise in accordance with applicable federal securities laws, including Rule 10b-18 of the Securities Exchange Act of 1934. The stock repurchase program will end upon the earlier of the date on which the plan is terminated by the Board or when all authorized repurchases are completed. The timing and amount of stock repurchases, if any, will be determined based upon our evaluation of market conditions and other factors. The stock repurchase program may be suspended, modified or discontinued at any time, and the Company has no obligation to repurchase any amount of its common stock under the program. The Company did not repurchase any shares of its common stock under this program in the first six months of 2021. At June 30, 2021 approximately $9.4 million was available for future repurchases of the Company’s common stock under this authorization.
Commitments and Contractual Obligations
There have been no material changes outside the ordinary course of business to our contractual obligations and commitments, as disclosed in our Annual Report on Form 10-K for the year ended December 31, 2020.