Clearfield, Inc. - Quarter Report: 2019 December (Form 10-Q)

Note 1. Basis of Presentation

 

The accompanying (a) condensed balance sheet as of September 30, 2019, which has been derived from audited financial statements, and (b) unaudited interim condensed financial statements as of and for the three months ended December 31, 2019 have been prepared by the Company in accordance with accounting principles generally accepted in the United States of America for interim financial information, pursuant to the rules and regulations of the Securities and Exchange Commission. Pursuant to these rules and regulations, certain financial information and footnote disclosures normally included in the financial statements have been condensed or omitted. However, in the opinion of management, the financial statements include all adjustments, consisting of normal recurring accruals, necessary for a fair presentation of the financial position, results of operations and cash flows of the interim periods presented. Operating results for the interim periods presented are not necessarily indicative of results to be expected for the full year or for any other interim period, due to variability in customer purchasing patterns and seasonal, operating and other factors. These condensed financial statements should be read in conjunction with the financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended September 30, 2019.

 

In preparation of the Company’s financial statements, management is required to make estimates and assumptions that affect reported amounts of assets and liabilities and related revenues and expenses during the reporting periods. As future events and their effects cannot be determined with precision, actual results could differ significantly from these estimates.

 

Recently Adopted Accounting Pronouncements

 

Effective October 1, 2019 we adopted the Financial Accounting Standards Board (“FASB”) Accounting Standards Update (“ASU”) 2016-02, Leases, using the effective date method under the modified retrospective approach. The amended guidance requires lessees, at the commencement date, to recognize a lease liability, which is a lessee's obligation to make lease payments arising from a lease, measured on a discounted basis, and to record a right-of-use asset, which is an asset that represents the lessee’s right to use, or control the use of, a specified asset for the lease term. In July 2018, the FASB issued ASU 2018-11, Leases, Targeted Improvements, which gave companies the option of applying the new standard at the adoption date, rather than retrospectively to the earliest period presented in the financial statements. The Company elected the package of practical expedients permitted under the new standard, which among other things, allowed the Company to carry forward the historical lease classification. The Company also elected the practical expedient to not recognize a lease liability and ROU asset for short-term leases less than 12 months. We chose the option to apply the new standard at the adoption date, and therefore we are not required to restate the financial statements for prior periods, nor are we required to provide the disclosures required by the new standard for prior periods. Upon adoption, we recognized an approximate $2.4 million right-of-use asset, and an approximate $2.6 million lease liability. Our adoption of the new standard did not impact our cash flows or have a material impact on our results of operations. We have expanded our financial statement disclosures to comply with the requirements of the new standard.

Note 2. Net Income Per Share

 

Basic net income per common share (“EPS”) is computed by dividing net income by the weighted average number of common shares outstanding for the reporting period. Diluted EPS equals net income divided by the sum of the weighted average number of shares of common stock outstanding plus all additional common stock equivalents, such as stock options, when dilutive.

 

 

The following is a reconciliation of the numerator and denominator of the net income per common share computations for the three months ended December 31, 2019 and 2018:

 

Note 3. Cash, Cash Equivalents and Investments

 

The Company currently invests its excess cash in bank certificates of deposit (“CDs”) that are fully insured by the Federal Deposit Insurance Corporation (“FDIC”) and Unites States Treasury (“Treasuries”) securities with terms of not more than five years, as well as money market accounts. CDs and Treasuries with original maturities of more than three months are reported as held-to-maturity investments and are recorded at amortized cost, which approximates fair value due to the negligible risk of changes in value due to interest rates. The maturity dates of the Company’s investments as of December 31, 2019 and September 30, 2019 are as follows:

 

Note 4. Stock-Based Compensation

 

The Company recorded $240,586 of compensation expense related to current and past restricted stock grants, non-qualified stock options and the Company’s Employee Stock Purchase Plan (“ESPP”) for the three months ended December 31, 2019 of which $235,788 is included in selling, general and administrative expense, and $4,798 is included in cost of sales. The Company recorded $538,524 of compensation expense related to current and past restricted stock grants, non-qualified stock options and the Company’s Employee Stock Purchase Plan (“ESPP”) for the three months ended December 31, 2018 of which $507,284 is included in selling, general and administrative expense, and $31,240 is included in cost of sales. As of December 31, 2019, $2,650,700 of total unrecognized compensation expense related to non-vested restricted stock awards and stock options is expected to be recognized over a period of approximately 4.7 years.   

 

Stock Options

 

The Company uses the Black-Scholes option pricing model to determine the fair value of options granted. During the three months ended December 31, 2019, the Company granted employees non-qualified stock options to purchase an aggregate of 116,600 shares of common stock with a weighted average contractual term of 5.78 years, a weighted average 4.78 year vesting term, and an exercise price of $12.43. During the three months ended December 31, 2018, the Company granted employees non-qualified stock options to purchase an aggregate of 172,000 shares of common stock with a weighted average contractual term of four years, a three year vesting term, and a weighted average exercise price of $12.17. The weighted average fair value at the grant date for options issued during the three months ended December 31, 2019 was $4.93.

 

 

This fair value was estimated as of the grant date using the range of assumptions listed below:

 

 

The expected stock price volatility is based on the historical volatility of the Company’s stock for a period approximating the expected life. The expected life represents the period of time that options are expected to be outstanding after their grant date. The risk-free interest rate reflects the interest rate as of the grant date on zero-coupon U.S. governmental bonds having a remaining life similar to the expected option term.

 

Options are granted at fair market values determined on the date of grant and vesting normally occurs over a three to five-year period. Shares issued upon exercise of a stock option are issued from the Company’s authorized but unissued shares.

 

The following is a summary of stock option activity during the three months ended December 31, 2019:

 

 

The intrinsic value of an option is the amount by which the fair value of the underlying stock exceeds its exercise price. As of December 31, 2019, the weighted average remaining contractual term for all outstanding and exercisable stock options was 2.40 years and their aggregate intrinsic value was $362,123. During the three months ended December 31, 2019, the Company received proceeds of $2,580 from the exercise of stock options. During the three months ended December 31, 2018, the Company received proceeds of $17 from the exercise of stock options.

 

Restricted Stock

 

The Company’s 2007 Stock Compensation Plan permits its Compensation Committee to grant stock-based awards, including stock options and restricted stock, to key employees and non-employee directors. The Company has made restricted stock grants that vest over one to ten years.

 

There were no restricted stock awards granted during the three months ended December 31, 2019 or 2018. During the three months ended December 31, 2019, the Company granted 8,625 performance stock units which entitles the participant to receive the same number of shares of the Company’s common stock, upon achievement of a fiscal year 2020 performance goal. The shares issued to the participant in settlement of the performance stock unit, if any, will be restricted stock subject to forfeiture that will vest one year following the settlement date of the performance stock unit. The Company has determined the fair value per underlying share of the performance stock unit awards to be $11.86 as of the grant date. The Company believes it is probable that these performance stock unit awards will vest.

 

Restricted stock transactions during the three months ended December 31, 2019 are summarized as follows:

 

 

 

 

Employee Stock Purchase Plan

 

Clearfield, Inc.’s ESPP allows participating employees to purchase shares of the Company’s common stock at a discount through payroll deductions. The ESPP is available to all employees subject to certain eligibility requirements. Terms of the ESPP provide that participating employees may purchase the Company’s common stock on a voluntary after-tax basis. Employees may purchase the Company’s common stock at a price that is no less than the lower of 85% of the fair market value of one share of common stock at the beginning or end of each stock purchase period or phase. The ESPP is carried out in six month phases, with phases beginning on January 1 and July 1 of each calendar year. For the phases that ended on December 31, 2019 and December 31, 2018, employees purchased 15,107 and 17,312 shares at a price of $11.23 and $8.43 per share, respectively. After the employee purchase on December 31, 2019, 34,739 shares of common stock were available for future purchase under the ESPP.

Note 5. Revenue

 

Revenue Recognition

 

Net sales include products and shipping and handling charges. Revenue is measured as the amount of consideration we expect to receive in exchange for transferring products. All revenue is recognized when we satisfy our performance obligations under the contract. We recognize revenue by transferring the promised products to the customer, with substantially all revenue recognized at the point in time the customer obtains control of the products. We recognize revenue for shipping and handling charges at the time the products are delivered to or picked up by the customer. The majority of our contracts have a single performance obligation and are short term in nature. Sales taxes and value added taxes in foreign jurisdictions that are collected from customers and remitted to governmental authorities are accounted for on a net basis and therefore are excluded from net sales.

 

Disaggregation of Revenue

 

The Company allocates sales from external customers to geographic areas based on the location to which the product is transported. Sales outside the United States are principally to countries in the Caribbean, Canada, Central and South America.

 

Our revenues related to the following geographic areas were as follows for the three months ended:

 

 

Clearfield manufactures and sells a proprietary product line designed for the Broadband Service Provider marketplace. In addition, the Company provides Build-to-Print services for original equipment manufacturers requiring copper and fiber cable assemblies built to their specification.

 

 

The percentages of our sales by markets were as follows for the three months ended:

 

 

Broadband Service Providers are made up of Community Broadband, which includes local and regional telecom companies, utilities, municipalities and alternative carriers, also referred to as Tier 2 and 3 customers, National Carriers, which includes large national and global wireline and wireless providers also referred to as Tier 1’s, MSO’s, which include cable tv companies, and International customers.

 

Accounts Receivable

 

Credit is extended based on the evaluation of a customer’s financial condition and collateral is generally not required. Accounts that are outstanding longer than the contractual payment terms are considered past due. The Company writes off accounts receivable when they become uncollectible; payments subsequently received on such receivables are credited to the allowance for doubtful accounts. As of both December 31, 2019 and September 30, 2019, the balance in the allowance for doubtful accounts was $289,085.

 

See Note 7, “Major Customer Concentration” for further information regarding accounts receivable and net sales.

Note 6. Inventories

 

Inventories consist of the following as of:

 

 

Note 7. Major Customer Concentration

 

For the three months ended December 31, 2019, three customers comprised 18%, 13%, and 10%, respectively, or 41% in the aggregate of the Company’s net sales. All three of these customers were distributors. For the three months ended December 31, 2018, two customers comprised 18%, and 14%, respectively, or 32% in the aggregate of the Company’s net sales. These customers are both distributors. These major customers, like our other customers, purchase our products from time to time through purchase orders, and we do not have any agreements that obligate these major customers to purchase products in the future from us.

 

As of December 31, 2019, two customers accounted for 14%, and 11%, respectively, or 25% in the aggregate, of accounts receivable. Both of these customers are distributors. As of September 30, 2019, two customers accounted for 16%, and 12%, respectively, or 28% in the aggregate of accounts receivable. Both of these customers are distributors.

Note 8. Goodwill and Intangibles

 

The Company analyzes its goodwill for impairment annually or at an interim period when events occur or changes in circumstances indicate potential impairment. The result of the analysis performed as of September 30, 2019 did not indicate an impairment of goodwill. During the three months ended December 31, 2019, there were no triggering events that indicate potential impairment exists.

 

The Company capitalizes legal costs incurred to obtain patents. Once accepted by either the U.S. Patent Office or the equivalent office of a foreign country, these legal costs are amortized using the straight-line method over the remaining estimated lives, not exceeding 20 years. As of December 31, 2019, the Company has 21 patents granted and multiple pending applications both inside and outside the United States.

 

 

In addition, the Company has various finite lived intangible assets, most of which were acquired as a result of the acquisition of the active cabinet product line from Calix, Inc. (“Calix”) during fiscal year 2018. The Company analyzes its intangible assets for impairment annually or at interim periods when events occur or changes in circumstances indicate potential impairment. The result of the analysis performed as of September 30, 2019 did not indicate an impairment of our intangible assets. During the three months ended December 31, 2019, there were no triggering events that indicate potential impairment exists.

Note 9. Income Taxes

 

For the three months ended December 31, 2019, the Company recorded income tax expense of $123,000, reflecting an effective tax rate of 19.7%. For the three months ended December 31, 2018, the Company recorded an expense for income taxes of $296,000, reflecting an effective tax rate of 22.7%. Our first quarter of fiscal 2020 tax expense reflected a lower tax rate due to increased permanent differences related to research and development credits. The differences between the effective tax rate and the statutory tax rate were related to nondeductible meals and entertainment, nondeductible stock compensation, foreign derived intangibles deduction and research and development credits.

 

Deferred taxes recognize the impact of temporary differences between the amounts of the assets and liabilities recorded for financial statement purposes and these amounts measured in accordance with tax laws. The Company’s realization of deferred tax temporary differences is contingent upon future taxable earnings. The Company reviewed its deferred tax asset for expected utilization using a “more likely than not” criteria by assessing the available positive and negative factors surrounding its recoverability.

 

As of December 31, 2019 and September 30, 2019, the Company had a remaining valuation allowance of approximately $47,000 related to state net operating loss carry forwards the Company does not expect to utilize. Based on the Company’s analysis and review of long-term forecasts and all available evidence, the Company determined that there should be no further change in the valuation allowance for the three months ended December 31, 2019.

 

As of December 31, 2019, we do not have any unrecognized tax benefits. It is the Company’s practice to recognize interest and penalties accrued on any unrecognized tax benefits as a component of income tax expense. The Company does not expect any material changes in its unrecognized tax positions over the next 12 months.

Note 10. Leases

 

Clearfield leases a 71,000 square foot facility at 7050 Winnetka Avenue North, Brooklyn Park, Minnesota consisting of our corporate offices, manufacturing and warehouse space. The lease term is ten years and two months and commenced on January 1, 2015.  On June 30, 2019, the Company amended its lease to add 14,000 square feet to this facility, with the lease term for the additional space coterminous with the original lease. Upon proper notice and payment of a termination fee of approximately $249,000, the Company has a one-time option to terminate the lease effective as of the last day of the eighth year of the term after the Company commenced paying base rent. The renewal and termination options have not been included within the lease term because it is not reasonably certain that we will exercise either option.

 

We also have an indirect lease arrangement for a 46,000 square foot manufacturing facility in Tijuana, Mexico. The lease term is three years and commenced on August 1, 2017. This lease does not contain a written option to renew.

 

Right-of-use lease assets and lease liabilities are recognized as of the commencement date based on the present value of the remaining lease payments over the lease term which includes renewal periods we are reasonably certain to exercise. Our leases do not contain any material residual value guarantees or material restrictive covenants. As of December 31, 2019, we do not have material lease commitments that have not commenced.

 

For the three months ended December 31, 2019, operating lease expense included within cost of goods sold and selling, general and administrative expense was $185,628 and $56,366, respectively.

 

 

Maturities of lease liabilities were as follows as of December 31, 2019:

 

 

The weighted average term and weighted average discount rate for our leases as of December 31, 2019 were 4.94 years and 3.51%, respectively. For the three months ended December 31, 2019, the operating cash outflows from our leases was $167,840.

 

Rent expense for our operating leases the three months ended December 31, 2018 as accounted under ASC 840, included within cost of goods sold and selling, general and administrative expense was $168,828 and $53,538, respectively.

 

As previously disclosed in Note B of the Notes to the Financial Statements in our 2019 Annual Report on Form 10-K, prior to the adoption of ASU 2016-02, Leases (Topic 842), the future minimum payments required under lease agreements were as follows: