Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
Forward Looking Statements
This quarterly report includes both historical and “forward-looking statements” within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended. We have based these forward-looking statements on our current expectations and projections about future results. Words such as “may,” “should,” “could,” “would,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “potential,” “continue,” or similar words are intended to identify forward-looking statements, although not all forward-looking statements contain these words. Although we believe that our opinions and expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements, and our actual results may differ substantially from the views and expectations set forth in this quarterly report on Form 10-Q. We disclaim any intent or obligation to update any forward-looking statements after the date of this quarterly report to conform such statements to actual results or to changes in our opinions or expectations.
Overview
We produce film products for novelty, packaging and container applications. These products include foil balloons, latex balloons and related products, films for packaging and custom product applications, and flexible containers for packaging and consumer storage applications. We produce all of our film products for packaging, container applications and most of our foil balloons at our plant in Lake Barrington, Illinois. We produce all of our latex balloons and latex products at our facility in Guadalajara, Mexico. Substantially all of our film products for packaging and custom product applications are sold to customers in the United States. We market and sell our novelty items and flexible containers for consumer use in the United States, Mexico, Latin America, and Europe. We also market and sell Candy Blossoms and party goods.
As of January 1, 2018, we adopted Accounting Standards Codification (ASC) Topic 606, Revenue from Contracts with Customers, using the modified retrospective method. The adoption of ASC 606 did not have a material impact on our consolidated financial position or results of operations, as our revenue arrangements generally consist of a single performance obligation to transfer promised goods at a fixed price.
Net sales include revenues from sales of products and shipping and handling charges, net of estimates for product returns. Revenue is measured at the amount of consideration the Company expects to receive in exchange for the transferred products. The Company recognizes revenue for shipping and handling charges at the time the goods are shipped to the customer, and the costs of outbound freight are included in cost of sales, as we have elected the practical expedient included in ASC 606. Revenue Recognition. Substantially all of the Company's revenues are derived from the sale of products. With respect to the sale of products, revenue from a transaction is recognized once it has (i) identified the contract(s) with a customer, (ii) identified the performance obligations in the contract, (iii) determined the transaction price, (iv) allocated the transaction price to the performance obligations in the contract, and (v) recognized revenue as the company satisfies a performance obligation. The Company generally recognizes revenue for the sale of products when the products have been shipped and invoiced. In some cases, product is provided on consignment to customers. In those cases, revenue is recognized when the customer reports a sale of the product.
We provide for product returns based on historical return rates. While we incur costs for sales commissions to our sales employees and outside agents, we recognize commission costs concurrent with the related revenue, as the amortization period is less than one year and we have elected the practical expedient included in ASC 606. We do not incur incremental costs to obtain contracts with our customers. Our product warranties are assurance-type warranties, which promise the customer that the products are as specified in the contract. Therefore, the product warranties are not a separate performance obligation and are accounted for as described herein. Sales taxes assessed by governmental authorities are accounted for on a net basis and are excluded from net sales.
As of January 1, 2019, we adopted ASC Topic 842, Leases (“ASC Topic 842”). Refer to Note 13 for additional information. Our primary leases relate to the facilities we use in Mexico. We also have ancillary leases for items ranging from forklifts to printers. The majority of our leases are classified as operating lease right-of-use (“ROU”) assets and related operating lease liabilities. Finance leases are included in property and equipment and related liabilities. ROU assets and lease liabilities are recognized based on the present value of future minimum lease payments over the expected lease term at the commencement date for leases that exceed 12 months. The expected lease term includes options to renew when it is reasonably certain that we will exercise such option.
Operating lease expense is recognized on a straight-line basis over the lease term and is included in the cost of sales or sales, general and administrative expense areas. Finance leases are amortized on a straight-line basis and included in similar areas of expense classification. Variable lease payments, non-lease component payments, and short-term rentals (leases less than 12 months in duration) are expensed as incurred.
Summary of Subsequent Events
As previously disclosed on a Current Report on Form 8-K of Yunhong CTI Ltd., on December 14, 2017, the Company entered into a Revolving Credit, Term Loan and Security Agreement (the “Loan Agreement”) with PNC Bank, National Association (“Lender”).
Prior to January 13, 2020, certain events of default under the Loan Agreement had occurred (the "Prior Defaults"). On January 13, 2020, a Limited Waiver, Consent, Amendment No. 5 and Forbearance Agreement (the “Forbearance Agreement”) between Lender and the Company became effective, pursuant to which Lender agreed to, among other things, forebear from exercising the rights and remedies in respect of the Prior Defaults afforded to Lender under the Loan Agreement for a period ending no later than December 31, 2020 (the “Forbearance Period”).
On June 15, 2020, the Lender provided the Company notice (the “Default Notice”) that (i) an additional Event of Default (as defined in the Loan Agreement) had occurred and is continuing as a result of the Company's failure to maintain a Fixed Charge Coverage Ratio (as defined in the Loan Agreement) of 0.75 to 1.00 for the three-month period ended March 31, 2020 (the "March FCCR Default"), (ii) as a result of the occurrence and continuance of the March FCCR Default, the Forbearance Period has ended, and (iii) as a result of the termination of the Forbearance Period, the Lender is entitled to exercise immediately all of its rights and remedies under the Loan Agreement including, without limitation, ceasing to make further advances to the Company and declaring all obligations to be immediately due and payable in accordance with the Loan Agreement.
The Lender has continued to make advances to the Company (“Discretionary Advances”), although it is not required to do so under the terms of the Loan Agreement due to the Events of Default. On July 17, 2020, the Lender provided the Company notice that multiple previously disclosed events, which each constitute an Event of Default, are continuing to occur. Additionally, the Lender required that the Company obtain a commitment for third-party equity funding in an amount not less than $3,000,000 by no later than July 31, 2020. Absent such commitment, the Lender advised that it may cease making discretionary advances to the Company. On July 22, 2020, the Company’s board of directors authorized the Company to seek such funding and, to ensure that the Company met the Lender’s equity funding commitment deadline. Mr. Yubao Li, the Company’s Chairman, committed that, in the event the Company does not obtain funding of at least $3,000,000, he would provide the necessary funding. In September 2020, the Company received $1.5 million from an unrelated third party as an advance on a proposed sale of Series B Convertible Preferred Stock (the terms of which are currently being negotiated and finalized). Additionally, in October 2020, the Company received a $1.5 million advance on a separate proposed equity financing for which the terms have not yet been finalized. The Lender has continued to make the Discretionary Advances throughout this period and has indicated that we have complied with their request.
Comparability
In July 2019, management and the Board engaged in a review of CTI Balloons and CTI Europe and determined that they are not accretive to the Company overall, add complexity to the Company’s structure and utilize resources. Therefore, as of July 19, 2019, the Board authorized management to divest these international subsidiaries. These actions were taken to focus our resources and efforts on our core business activities, particularly foil balloons and ancillary products based in North America. The Company determined that these entities met the held-for-sale and discontinued operations accounting criteria. Accordingly, the Company has reported the results of these International operations as discontinued operations in the Consolidated Statements of Comprehensive Income and presented the related assets and liabilities as held-for-sale in the Consolidated Balance Sheets. These changes have been applied for all periods presented. The Company divested its CTI Balloons (United Kingdom) subsidiary in the fourth quarter 2019 and is divesting its CTI Europe (Germany) subsidiary and Ziploc product line in 2020.
Results of Operations
Net Sales. For the three and nine month periods ended September 30, 2020, net sales were $5,981,000 and $18,794,000, compared to net sales of $6,365,000 and $24,259,000 for the same periods of 2019, respectively.
For the three month period ended September 30, 2020 and 2019, net sales by product category were as follows:
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Three Months Ended
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September 30, 2020
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September 30, 2019
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$
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% of
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$
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% of
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Product Category
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(000) Omitted
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Net Sales
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(000) Omitted
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Net Sales
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Foil Balloons
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4,516
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|
76
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%
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3,681
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62
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%
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Latex Balloons
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1,014
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17
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%
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2,059
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|
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34
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%
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Film Products
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78
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1
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%
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236
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4
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%
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Other
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374
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6
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%
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9
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0
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%
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Total
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5,981
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100
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%
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5,985
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|
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100
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%
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For the nine month period ended September 30, 2020 and 2019 net sales by product category were as follows:
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Nine Months Ended
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September 30, 2020
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September 30, 2019
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$
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% of
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$
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% of
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Product Category
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(000) Omitted
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Net Sales
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(000) Omitted
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Net Sales
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Foil Balloons
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12,380
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|
|
66
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%
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13,325
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|
|
56
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%
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Latex Balloons
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3,712
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20
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%
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5,640
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23
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%
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Film Products
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664
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4
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%
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1,475
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6
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%
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Other
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2,038
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11
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%
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3,571
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15
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%
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|
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Total
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18,794
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|
100
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%
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24,011
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|
|
|
100
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%
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Foil Balloons. Revenues from the sale of foil balloons increased during the three months period from $3,681,000 ending September 30, 2019 compared to $4,516,000 during the three month period of 2020. Revenues from the sale of foil balloons decreased during the nine month period from $13,325,000 ending September 30, 2019 compared to $12,380,000 during the nine month period of 2020 mainly due to decreased foil sales in our Mexican subsidiary.
Latex Balloons. Revenues from the sale of latex balloons were $1,014,000 and $3,712,000 during the three and nine month periods ended September 30, 2020, compared to $2,059,000 and $5,640,000 during the same periods of 2019. Latex balloons encountered a COVID-19 constraint, as production activities were severely limited by the Mexican government.
Films. Revenues from the sale of commercial films were $78,000 and $664,000 during the three and nine month periods ended September 30, 2020, compared to $236,000 and $1,475,000 during the same periods of 2019. Our main customer had restructured their program in the first quarter both related to COVID-19 disruption and also the integration of a merger partner.
Other Revenues. Revenues from the sale of other products were $374,000 and $2,038,000 during the three and nine month periods ended September 30, 2020, compared to $9,000 and $3,571,000 during the same periods of 2019. Revenues in 2019 include a discontinued line of organizing solutions that was fully deconsolidated in 2019. The revenues from the sale of other products during the first nine months of 2020 include (i) sales of a line of “Candy Blossoms” and similar products consisting of candy and small inflated balloons sold in small containers and (ii) the sale of accessories and supply items related to balloon products.
Sales to a limited number of customers continue to represent a large percentage of our net sales. The table below illustrates the impact on sales of our top three and ten customers for the nine month periods ended September 30, 2020 and 2019.
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Three Months Ended September 30,
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% of Sales
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2020
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2019
|
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|
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|
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Top 3 Customers
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77
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%
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|
|
43
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%
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|
|
|
|
|
|
|
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Top 10 Customers
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88
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%
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|
|
58
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%
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|
Nine Months Ended September 30,
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|
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% of Sales
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2020
|
|
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2019
|
|
|
|
|
|
|
|
|
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Top 3 Customers
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|
|
71
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%
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|
|
53
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%
|
|
|
|
|
|
|
|
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Top 10 Customers
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|
82
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%
|
|
|
71
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%
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During the nine month period ended September 30, 2020, there was one customer whose purchases represented more than 10% of the Company’s consolidated net sales. Sales to this customer for the nine month period ended September 30, 2020 was $9,412,000 or 50% of consolidated net sales. Sales to this customer for the nine months ended September 30, 2019 was $8,190,000, or 34% of consolidated net sales. As of September 30, 2020, the total amount owed to the Company by this customer was approximately $1,725,000, or 33% of the Company’s consolidated net accounts receivable. The amount owed at September 30, 2019 by this customer was approximately $831,000, or 16% of the Company’s consolidated net accounts receivable.
Cost of Sales. During the three and nine month periods ended September 30, 2020, the cost of sales was $5,720,000 and $16,442,000, compared to $6,285,000 and $20,926,000, respectively, for the same periods of 2019. The reduction in cost of sales was largely due to the termination of the vacuum sealing product line, reduced presence in the form of discontinued subsidiaries, and a temporary reduction in orders related to COVID-19.
General and Administrative. During the three and nine month periods ended September 30, 2020, general and administrative expenses were $1,067,000 and $3,254,000 as compared to $1,167,000 and $3,866,000 respectively, for the same periods in 2019. Decrease is due mainly to headcount reductions.
Selling, Advertising and Marketing. During the three and nine month periods ended September 30, 2020, selling, advertising and marketing expenses were $101,000 and $384,000 as compared to $148,000 and $714,000, respectively, for the same periods in 2019. Decrease is due mainly to headcount reductions.
Other Income (Expense). During the three and nine month periods ended September 30, 2020, the Company incurred interest expense of $255,000 and $1,033,000 as compared to interest expense of $465,000 and $1,493,000 during the same periods of 2019. During the three months ended September 30, 2020 the Company recorded $248,000 of other income for the Payroll Protection Program, PPP, anticipated grant related to payroll, utility and rent payments. During the nine months ended September 30, 2020 the Company recorded $1,048,000 of other income for the Payroll Protection Program, PPP, anticipated grant related to payroll, utility and rent payments.
For the three month and nine month periods ended September 30, 2020, the Company had a foreign currency transaction gain/(loss) of $15,000 and $(169,000) as compared to a gain/(loss) of $(26,000) and $(27,000) during the same periods of 2019.
Financial Condition, Liquidity and Capital Resources
Cash Flow Items.
Operating Activities. During the nine months ended September 30, 2020, net cash provided by operations was $995,000, compared to net cash provided by operations during the nine months ended September 30, 2019 of $4,172,000.
Significant changes in working capital items during the nine months ended September 30, 2020 included:
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●
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A decrease in accounts receivable of $2,916,000 compared to a decrease in accounts receivable of $2,776,000 in the same period of 2019.
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●
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A decrease in inventory of $2,315,000 compared to an increase in inventory of $1,435,000 in 2019.
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●
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An increase in trade payables of $852,000 compared to a decrease in trade payables of $1,893,000 in 2019.
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●
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A decrease in accrued liabilities of $331,000 compared to an increase in accrued liabilities of $167,000 in 2019.
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In September 2020, the Company received $1.5 million from an unrelated third party as an advance on a proposed sale of Series B Redeemable Convertible Preferred Stock. As of September 30, 2020, the Company was in the process of negotiating and finalizing the terms of the arrangement. As the agreement was not finalized as of September 30, 2020, the $1.5 million advance is classified as Advance from Investor within liabilities on the accompanying balance sheet.
Investing Activity. During the nine months ended September 30, 2020, cash used in investing activity was $140,000, compared to cash used in investing activity for the same period of 2019 in the amount of $144,000.
Financing Activities. During the nine months ended September 30, 2020, cash used in financing activities was $2,237,000 compared to cash used in financing activities for the same period of 2019 in the amount of $4,546,000. Financing activity consisted principally of changes in the balances of revolving and long-term debt. During 2020, the Company sold 542,660 shares of Series A Preferred to multiple investors for an aggregate purchase price of $5.4 million. The Company has also received an advance of $1.5 million in from an investor for a Series B stock purchase that was not finalized as of September, 30 2020.
Liquidity and Capital Resources.
At September 30, 2020, the Company had cash balances of none compared to cash balances of $115,000 for the same period of 2019.
As of September 30, 2020, the Company was not in compliance with its credit facility, operating under a forbearance agreement. For this reason, $1.4 million of long-term debt was reclassified as current debt as of September 30, 2020. Failure to ultimately regain compliance with the terms of our credit agreement, or enter into a suitable replacement financing vehicle, could negatively impact our ability to carry on our business up to and including our ability to continue as a going concern. Additionally, we have encountered difficulties with seasonal cash flow needs, including increased costs associated with recruiting and retaining workers in the Chicago area. The failure to either regain compliance with the terms of our credit facility or properly manage seasonal cash needs could put a strain on the Company, up to and including our ability to continue as a going concern. See Note 3 for additional discussion.
Seasonality
In the foil balloon product line, sales have historically been seasonal with approximately 40% occurring in the period from December through March of the succeeding year and 24% being generated in the period July through October in recent years.
Please see pages 25-28 of our Annual Report on Form 10-K for the year ended December 31, 2019 for a description of policies that are critical to our business operations and the understanding of our results of operations. The impact and any associated risks related to these policies on our business operations is discussed throughout Management’s Discussion and Analysis of Financial Condition and Results of Operations where such policies affect our reported and expected financial results. No material changes to such information have occurred during the three and nine months ended September 30, 2020.