EASTERN CO - Quarter Report: 2020 October (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q 

(Mark One)

OR

Commission File Number 001-35383 

Securities registered pursuant to Section 12(b) of the Act:

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒     No ☐

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ☒     No ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ☐    No ☒

As of October 3, 2020 6,242,912 shares of the registrant’s common stock, no par value per share, were issued and outstanding.

The Eastern Company

Form 10-Q

FOR THE QUARTERLY PERIOD ENDED OCTOBER 3, 2020

TABLE OF CONTENTS

PART 1 – FINANCIAL INFORMATION

ITEM 1 – FINANCIAL STATEMENTS

THE EASTERN COMPANY AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)

See accompanying notes.

THE EASTERN COMPANY AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED)

See accompanying notes.

THE EASTERN COMPANY AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

 See accompanying notes.

See accompanying notes.

THE EASTERN COMPANY AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

See accompanying notes.

THE EASTERN COMPANY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

October 3, 2020

Note A – Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with the instructions to Form 10-Q and Rule 8-03 of Regulation S-X and do not include all of the information and footnotes required by generally accepted accounting principles in the United States (“GAAP”) for complete financial statements. Refer to the consolidated financial statements of The Eastern Company (together with its consolidated subsidiaries, the “Company,” “we,” “us” or our”) and the notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 28, 2019, filed with the Securities and Exchange Commission on March 5, 2020 (the “2019 Form 10-K”), for additional information.

The accompanying condensed consolidated financial statements are unaudited. However, in the opinion of management, all adjustments (consisting only of normal recurring accruals) necessary for a fair presentation of the results of operations for interim periods have been reflected therein. Operating results for interim periods are not necessarily indicative of the results that may be expected for the full year. All intercompany accounts and transactions are eliminated.

The condensed consolidated balance sheet as of December 28, 2019 has been derived from the audited consolidated balance sheet at that date.

The Company’s fiscal year is a 52-53-week fiscal year ending on the Saturday nearest to December 31. References to 2019 or the 2019 fiscal year mean the 52-week period ended on December 28, 2019 and references to 2020 or the 2020 fiscal year mean the 53-week period ending on January 2, 2021. In a 52-week fiscal year, each quarter is 13 weeks long. In a 53-week fiscal year, each of the first two fiscal quarters and the fourth quarter are 13 weeks long, and the third fiscal quarter is 14 weeks long. References to the third quarter of 2019, the third fiscal quarter of 2019 or the three months ended September 28, 2019 mean the period from June 30, 2019 to September 28, 2019. References to the third quarter of 2020, the third fiscal quarter of 2020 or the three months ended October 3, 2020 mean the 14-week period from June 28, 2020 to October 3, 2020. References to the nine months ended September 28, 2019 or the first nine months of fiscal 2019 mean the 39-week period from December 30, 2018 to September 28, 2019. References to the nine months ended October 3, 2020 or the first nine months of 2020 mean the 40-week period from December 29, 2019 to October 3, 2020.

Certain amounts in the 2019 financial statements have been reclassified to conform with the 2020 presentation with no impact or change to previously reported net income or shareholder’s equity.

Note B – Earnings Per Share

The denominators used to calculate earnings per share are as follow:

Note C – Inventories

Inventories consist of the following components:

Note D - Goodwill

The Company maintains 12 reporting units, seven of which comprise the goodwill balance. These seven units have an aggregate carrying amount of goodwill of approximately $77.8 million as of October 3, 2020.

The Company tests its reporting units for impairment annually in December, or more frequently if events or circumstances indicate it is more likely than not that the fair value of a reporting unit is less than its carrying amount. Such events and circumstances could include, among other things, increased competition or unexpected loss of market share, significant adverse changes in the markets in which the Company operates, or unexpected business disruptions. The Company tests reporting units for impairment by comparing the estimated fair value of each reporting unit with its carrying amount. If the carrying amount of a reporting unit exceeds its estimated fair value, the Company records an impairment loss based on the difference between fair value and carrying amount not to exceed the associated carrying amount of goodwill. Determining the fair value of a reporting unit involves the use of significant estimates and assumptions. The values assigned to the key assumptions represent management’s assessment of future trends in the relevant industry and have been based on historical data from both external and internal sources.

In the second quarter of 2020, management determined that it was more likely than not that the estimated fair value of Greenwald Industries was below its carrying amount. The factors that led to this determination included additional competition, industry movement away from legacy products and intense competition in new mobile payment apps. This fundamental shift in lower cost mobile payment systems away from the higher cost electronic smart card payment systems resulted in our belief that the carrying value of Greenwald exceeded its fair value. As a result, an independent valuation was conducted which estimated that the carrying value exceeded the fair value by approximately $4.0 million. Management recognized this impairment charge in the second quarter.

In the third quarter of 2020, management performed assessments to determine if there were any events, circumstances or indicators of impairment among the Company’s reporting units as a result of the operating conditions resulting from the COVID-19 pandemic. Management concluded that the Company has not experienced any specific indicators of impairment for goodwill among its reporting units that would require additional impairment tests. There were no goodwill impairments in the third quarter of 2020.

Note E – Leases

The Company presents right-of-use (ROU) assets and lease liabilities on the balance sheet for all leases with terms longer than 12 months, in accordance with the Financial Accounting Standards Board (“FASB”) Accounting Standards Update (“ASU”) 2016-02, Leases. The Company elected to account for non-lease components as part of the lease component to which they relate. Lease accounting involves significant judgements, including making estimates related to the lease term, lease payments, and discount rate.

The Company has operating leases for buildings, warehouse and office equipment. The Company determines whether an arrangement is, or contains, a lease at contract inception. An arrangement contains a lease if the Company has the right to direct the use of and obtain substantially all of the economic benefits of an identified asset. ROU assets and lease liabilities are recognized at lease commencement based on the present value of lease payments over the lease term. Leases with an initial term of 12 months or less are not recorded on the balance sheet; we recognize lease expense for these leases on a straight-line basis over the lease term. Most leases include one or more options to renew. The exercise of lease renewal options is at our sole discretion. The Company’s option to extend certain leases ranges from 2 – 131 months. All options to extend, when it is reasonably certain the option will be exercised, have been included in the calculation of the ROU asset and lease liability.

Currently, the Company has 36 operating leases and four finance leases with a lease liability of $11,248,144 as of October 3, 2020. The finance lease arrangements are immaterial. The basis, terms and conditions of the leases are determined by the individual agreements. The leases do not contain residual value guarantees, restrictions, or covenants that could cause the Company to incur additional financial obligations. We rent or sublease a part of one real estate property to a third party. There are no related party transactions. There are no leases that have not yet commenced that could create significant rights and obligations for the Company.

Total lease expense for each of the next five fiscal years is estimated to be as follows: remainder of 2020 - $824,251; 2021 - $3,011,067; 2022 - $2,067,173; 2023 - $1,699,249; 2024 - $1,223,651and $2,422,753thereafter. The weighted average remaining lease term is 6 years. The interest rate used was 5.0%.

Note F - Debt

On August 30, 2019, the Company entered into a credit agreement with Santander Bank, N.A., for itself, People’s United Bank, National Association and TD Bank, N.A. as lenders (the “Credit Agreement”), that included a $100 million term portion and a $20 million revolving commitment portion. Proceeds of the term loan were used to repay the Company’s remaining outstanding term loan (and to terminate its existing credit facility) with People’s United Bank, N.A. (approximately $19 million) and to acquire certain subsidiaries of Big 3 Holdings, LLC (collectively “Big 3 Precision”). The term portion of the loan requires quarterly principal payments of $1,250,000for an 18-month period beginning December 31, 2019. The repayment amount then increases to $1,875,000 per quarter beginning September 30, 2021 and continues through June 30, 2023. The repayment amount then increases to $2,500,000per quarter beginning September 30, 2023 and continues through June 30, 2024. The term loan is a 5-year loan with the remaining balance due on August 30, 2024. The revolving commitment portion has an annual commitment fee of 0.25% based on the unused portion of the revolver. The revolving commitment portion has a maturity date of August 30, 2024. As of October 3, 2020, the Company has not borrowed any funds on the revolving commitment portion of the facility. The term loan bears interest at a variable rate based on the LIBOR rate plus an applicable margin of 1.25% to 2.25%, depending on the Company’s senior net leverage ratio. Borrowings under the revolving portion bear interest at a variable rate based on, at the Company’s election, a base rate plus an applicable margin of 0.25% to 1.25% or the LIBOR rate plus an applicable margin of 1.25% to 2.25%, with such margins determined based on the Company’s senior net leverage ratio. The Company’s obligations under the Credit Agreement are secured by a lien on certain of Company’s and its subsidiaries’ assets pursuant to a Pledge and Security Agreement, dated August 30, 2019 with Santander Bank, N.A., as administrative agent.

The Company’s loan covenants under the Credit Agreement require the Company to maintain a senior net leverage ratio not to exceed 4.25 to 1. In addition, the Company is required to maintain a fixed charge coverage ratio to be not less than 1.25 to 1. The Company was in compliance with all of its covenants under the Credit Agreement at October 3, 2020 and through the date of filing this Form 10-Q.

On August 30, 2019, the Company entered into an interest rate swap contract with Santander Bank, N.A., with an original notational amount of $50,000,000, which was equal to 50% of the outstanding balance of the term loan on that date. The Company has a fixed interest rate of 1.44% on the swap contract and will pay the difference between the fixed rate and LIBOR when LIBOR is below 1.44% and will receive interest when the LIBOR rate exceeds 1.44%. On October 3, 2020, the interest rate for half ($47.5 million) of the term portion was 1.66%, using a one month LIBOR rate, and 2.94% on the remaining balance ($47.5 million) of the term loan based on a one month LIBOR rate.

The interest rates under the Credit Agreement and the interest rate swap contract are susceptible to changes to the method of determining LIBOR rates and to the potential phasing out of LIBOR after 2021. Information regarding the potential phasing out of LIBOR is provided below.

On July 27, 2017, the U.K. Financial Conduct Authority announced that it intends to stop persuading or compelling banks to submit LIBOR rates after 2021. In the United States, the Federal Reserve Board and the Federal Reserve Bank of New York, in conjunction with the Alternative Reference Rates Committee, identified the Secured Overnight Financing Rate (“SOFR”) as its preferred benchmark alternative to U.S. dollar LIBOR. SOFR represents a measure of the cost of borrowing cash overnight, collateralized by U.S. Treasury securities, and is calculated based on directly observable U.S. Treasury-backed repurchase transactions. In March 2020, in response to this transition, the FASB issued ASU 2020-04, Reference Rate Reform (Topic 848) – Facilitation of the Effects of Reference Rate Reform on Financing Reporting, which provides optional expedients and exceptions for applying U.S. GAAP to contracts, hedging relationships and other transactions that reference LIBOR or another reference rate expected to be discontinued by reference rate reform, and addresses operational issues likely to arise in modifying contracts to replace discontinued reference rates with new rates. ASU 2020-04 is effective as of March 12, 2020 through December 31, 2022. The Company is evaluating the potential impact of the replacement of LIBOR, which ultimately may or may not be SOFR, from both a risk management and financial reporting perspective, as well as the guidance under ASU 2020-04. At this time, it is not possible to predict whether any such changes to LIBOR will occur, whether SOFR will attain market traction as a LIBOR replacement, whether LIBOR will be phased out or any such alternative reference rates, other than SOFR, or other reforms to LIBOR will be enacted in the United Kingdom, the United States or elsewhere or the effect that any such changes, phase-out, SOFR or other alternative reference rates, or other reforms, if they occur, would have on the amount of interest paid on the Company’s LIBOR-based borrowings. Uncertainty as to the nature of such potential changes, phase-out, SOFR or other alternative reference rates, or other reforms may materially adversely affect interest rates paid by the Company on its borrowings. Reform of, or the replacement or phasing out of, LIBOR and proposed regulation of LIBOR and other “benchmarks”, including SOFR, may materially adversely affect the amount of interest paid on the Company’s LIBOR-based borrowings and could have a material adverse effect on the Company’s business, financial condition and results of operations.

The Eastern Company 2010 Executive Stock Incentive Plan (the “2010 Plan”), for officers, other key employees, and non-employee Directors expired in February 2020.  On February 19, 2020, the board of directors of the Company adopted the Eastern Company 2020 Stock Incentive Plan (the “2020 Plan”).   On April 29, 2020, at the Company’s 2020 Annual Meeting of Shareholders, the shareholders of the Company approved and adopted the 2020 Plan.  The 2020 Plan replaced the 2010 Plan.  The Company has no other existing plan pursuant to which equity awards may be granted.

Incentive stock options granted under the 2010 Plan and the 2020 Plan must have exercise prices that are not less than 100% of the fair market value of the Company’s common stock on the dates the stock options are granted.  Restricted stock awards may also be granted to participants under the 2010 Plan and the 2020 Plan with restrictions determined by the Compensation Committee of the Company’s Board of Directors.  Under the 2010 Plan and the 2020 Plan, non-qualified stock options granted to participants will have exercise prices determined by the Compensation Committee of the Company’s Board of Directors. During the first nine months of fiscal 2020 and 2019, no stock options or restricted stock were granted that were subject to the meeting of performance measurements.  For the first nine months of fiscal 2019, the Company used several assumptions which included an expected term of 3.5 to 4 years, volatility deviation of 28.88% to 32.33% and a risk free rate of 1.42% to 2.48%.  For the first nine months of fiscal 2020, the Company used several assumptions which included an expected term of 4.0 years, volatility deviation of 38.62% and a risk free rate of 0.26% for the purposes of measuring compensation under the Black Scholes Method. 

The 2010 Plan and the 2020 Plan also permit the issuance of Stock Appreciation Rights (“SARs”).  The SARs are in the form of an option with a cashless exercise price equal to the difference between the fair value of the Company’s common stock at the date of grant and the fair value as of the exercise date resulting in the issuance of the Company’s common stock.  During the first nine months of fiscal 2020, the Company issued 44,000 SARs under the 2020 Plan, and during the first nine months of fiscal 2019, 96,000 SARs were issued under the 2010 Plan.

Stock-based compensation expense in connection with SARs previously granted to employees was approximately $85,000 and $108,000 in the third quarter of 2020 and 2019 respectively and was approximately $279,000 and $281,000 in the first nine months of fiscal years 2020 and 2019 respectively. 

As of October 3, 2020, there were 818,864 shares of Company common stock reserved and available for future grant under the 2020 Plan.

The following tables set forth the outstanding SARs for the period specified:

The following tables set forth the outstanding stock grants for the period specified:

As of October 3, 2020, outstanding SARs and grants had an intrinsic value of $558,000.

Note H – Share Repurchase Program

On May 3, 2018, the Company announced that its Board of Directors had authorized a new program to repurchase up to 200,000 shares of the Company’s common stock. The Company’s share repurchase program does not obligate it to acquire the Company’s common stock at any specific cost per share. Under this program, shares may be repurchased in privately negotiated and/or open market transactions, including under plans complying with Rule 10b5-1 under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). The Company did not repurchase any shares under its share repurchase program during the third quarter of 2020.

Note I – Revenue Recognition

The Company’s revenues result from the sale of goods and services and reflect the consideration to which the Company expects to be entitled. The Company records revenues based on a five-step model in accordance with FASB Accounting Standards Codification (“ASC”) Topic 606, “Revenue from Contracts with Customers.” The Company has defined purchase orders as contracts in accordance with ASC Topic 606. For its customer contracts, the Company identifies its performance obligations, which are delivering goods or services, determines the transaction price, allocates the contract transaction price to the performance obligations (when applicable), and recognizes the revenue when (or as) the performance obligation is transferred to the customer. A good or service is transferred when the customer obtains control of that good or service. The Company’s revenues are recorded at a point in time from the sale of tangible products. Revenues are recognized when products are shipped.

Customer volume rebates, product returns, discount and allowance are variable consideration and are recorded as a reduction of revenue in the same period that the related sales are recorded. The Company has reviewed the overall sales transactions for variable consideration and has determined that these costs are not material.

Refer to Note L for revenues reported by segment. Refer to Note D for a discussion of goodwill impairment. The Company has no future performance obligations and does not capitalize costs to obtain or fulfill contracts.

Note J - Income Taxes

The Company files income tax returns in the U.S. federal jurisdiction, and in various states and foreign jurisdictions. With limited exceptions, the Company is no longer subject to U.S. federal, state and local income tax examinations by tax authorities for years before 2015 and is no longer subject to non-U.S. income tax examinations by foreign tax authorities for years prior to 2013.

In December 2019, the FASB issued ASU 2019-12, Simplifying the Accounting for Income Taxes. The changes implemented in ASU 2019-12 include removing exceptions to incremental intraperiod tax allocation of losses and gains from different financial statement components, exceptions to the method of recognizing income taxes on interim period losses and exceptions to deferred tax liability recognition related to foreign subsidiary investments. In addition, ASU 2019-12 requires that entities recognize franchise tax based on an incremental method, requires an entity to evaluate the accounting for step-ups in the tax basis of goodwill as inside or outside of a business combination, and removes the requirement to allocate the current and deferred tax provision among entities in standalone financial statement reporting. The ASU also now requires that an entity reflect enacted changes in tax laws in the annual effective rate, and other codification adjustments have been made to employee stock ownership plans. For public business entities, the amendments in ASU 2019-12 are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2020. Early adoption of ASU 2019-12 is permitted, including adoption in any interim period for public business entities for periods for which financial statements have not yet been issued. The Company will adopt ASU 2019-12 in 2021.

On March 27, 2020, the $2 trillion bipartisan Coronavirus Aid, Relief, and Economic Security Act (H.R. 748) (“the CARES Act” became law). The CARES Act includes a variety of economic and tax relief measures intended to stimulate the economy, including loans for small businesses, payroll tax credits/deferrals, and corporate income tax relief. We are analyzing the following components of the CARES Act to determine their effect on our income tax provision:

The Company will also continue to assess the effect of state level tax relief provisions as enacted, such as state net operating loss rule changes and conformity to the federal interest, depreciation and charitable contribution deduction changes.

The total amount of unrecognized tax benefits could increase or decrease within the next 12 months for a number of reasons, including the closure of federal, state and foreign tax years by expiration of the statute of limitations and the recognition and measurement considerations under FASB ASC Topic 740, “Income Taxes.” There have been no significant changes to the amount of unrecognized tax benefits during the three months ended October 3, 2020. The Company believes that it is reasonably possible that the total amount of unrecognized tax benefits will not increase or decrease significantly over the next twelve months.

Note K - Retirement Benefit Plans

The Company has non-contributory defined benefit pension plans covering most U.S. employees. Plan benefits are generally based upon age at retirement, years of service and, for the plan covering salaried employees, the level of compensation. The Company also sponsors unfunded non-qualified supplemental retirement plans that provide certain former officers with benefits in excess of limits imposed by federal tax law.

The Company also provides health care and life insurance for retired salaried employees in the United States who meet specific eligibility requirements.

Significant disclosures relating to these benefit plans for the first nine months of fiscal years 2020 and 2019 are as follows:

The Company’s funding policy with respect to its qualified plans is to contribute at least the minimum amount required by applicable laws and regulations. In fiscal year 2020, the Company expects to contribute $2,690,000 into its pension plans and $50,000 into its postretirement plan. As of October 3, 2020, the Company has made contributions of approximately $400,000into its pension plans, has contributed $10,000 to its postretirement plan and will make the remaining contributions as required during the remainder of fiscal the year. The Company delayed its required pensions payments, as permitted, under the CARES Act until the fourth quarter of 2020.

The Company has a contributory savings plan under Section 401(k) of the Internal Revenue Code (the “401(k) Plan”) covering substantially all U.S. non-union employees. The 401(k) Plan allows participants to make voluntary contributions from their annual compensation on a pre-tax basis, subject to limitations under the Internal Revenue Code. The 401(k) Plan provides for contributions by the Company at its discretion.

The Company made contributions to the plan as follows:

The non-discretionary contribution of $550,286 made in the nine months ended October 3, 2020 was accrued for and expensed in the prior fiscal year.

Note L – Segment Information

For the third quarter of 2020, financial information by segment is as follows:

Note M - Recent Accounting Pronouncements

Upcoming

In December 2019, FASB issued ASU 2019-12, Simplifying the Accounting for Income Tax. The changes implemented in ASU 2019-12 include removing exceptions to incremental intraperiod tax allocation of losses and gains from different financial statement components, exceptions to the method of recognizing income taxes on interim period losses and exceptions to deferred tax liability recognition related to foreign subsidiary investments. In addition, ASU 2019-12 requires that entities recognize franchise tax based on an incremental method, requires an entity to evaluate the accounting for step-ups in the tax basis of goodwill as inside or outside of a business combination, and removes the requirement to allocate the current and deferred tax provision among entities in standalone financial statement reporting. The ASU also now requires that an entity reflect enacted changes in tax laws in the annual effective rate, and other codification adjustments have been made to employee stock ownership plans. For public business entities, the amendments in ASU 2019-12 are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2020. Early adoption of ASU 2019-12 is permitted, including adoption in any interim period for public business entities for periods for which financial statements have not yet been issued. The Company will adopt ASU 2019-12 as of January 1, 2021. The adoption of this guidance is not expected to have a material impact on the consolidated financial statements of the Company.

The Company has implemented all new accounting pronouncements that are in effect and that could impact its consolidated financial statements and does not believe that there are any other new accounting pronouncements that have been issued, but are not yet effective, that might have a material impact on the consolidated financial statements of the Company.

Note N - Concentration of Risk

Credit Risk

Credit risk is the potential financial loss resulting from the failure of a customer or counterparty to settle its financial and contractual obligations to the Company, as and when they become due. The primary credit risk for the Company is its accounts receivable due from customers. The Company has established credit limits for customers and monitors their balances to mitigate the risk of loss. As of October 3, 2020, there was one significant concentration of credit risk with a customer, who has receivables representing 13% of our total accounts receivable. One single customer represented more than 10% of the Company’s net accounts receivable as of December 28, 2019. The maximum exposure to credit risk is primarily represented by the carrying amount of the Company’s accounts receivable.

Interest Rate Risk

The Company’s exposure to the risk of changes in market interest rates relates primarily to the Company’s debt, which bears interest at variable rates based on the LIBOR rate plus a margin spread of 1.25% to2.25%. The Company has an interest rate swap with a notional amount of $47,500,000 on October 3, 2020, to convert a portion the borrowing under the Credit Agreement from variable to fixed rates. The valuation of this swap is determined using the one month LIBOR rate index and mitigates the Company’s exposure to interest rate risk. Additionally, interest rates on the Company’s debt are susceptible to changes to the method that LIBOR rates are determined and to the potential phasing out of LIBOR after 2021. The potential phasing out of LIBOR is discussed in greater detail in Note F — Debt hereof and under the heading “The phase out of the London Interbank Offered Rate (LIBOR), or the replacement of LIBOR with a different reference rate, may adversely affect interest rates” in Part I, Item 1A of the 2019 Form 10-K.

Currency Exchange Rate Risk

The Company’s currency exposure is concentrated in the British pound, Canadian dollar, Mexican peso, New Taiwan dollar, Chinese RMB and the Hong Kong dollar. Because of the Company’s limited exposure to any single foreign market, any currency gains or losses have not been material and are not expected to be material in the future. As a result, the Company does not attempt to mitigate its foreign currency exposure through the acquisition of any speculative or leveraged financial instruments.

Note O – Business Acquisition

Effective August 10, 2020 the Company acquired certain assets of Hallink, RSB Inc. (“Hallink”) including accounts receivable, inventories, furniture, fixtures and equipment, intellectual property rights, assumption of certain liabilities and rights existing under all sales and purchase agreements. Hallink is a leader in innovative injection blow mold tooling and is a leading supplier of blow molds and change parts to the food, beverage, healthcare and chemical industry. Hallink specializes in the design, development and manufacture of 2-step stretch blow molds, and related components for the stretch blow molding industry offering integrated turnkey solutions to its customers worldwide.

Hallink is included in the Industrial Hardware segment of the Company from the date of the acquisition. The cost of the acquisition of Hallink was approximately $7,173,000.

The above acquisition was accounted for under ASU 2014-18, Business Combinations (Topic 805). The acquired business is included in the consolidated operating results of the Company from the effective date of the acquisition. The excess of the cost of Hallink over the fair market value of the net assets acquired of $2,302,000 has been recorded as goodwill.

In connection with the above acquisition, the Company recorded the following intangible assets:

There is no anticipated residual value relating to these intangible assets.

Neither the actual results nor the pro forma effects of the acquisition of Hallink are material to the Company’s financial statements.

Note P – Subsequent Events

The Company evaluated its October 3, 2020 unaudited condensed consolidated financial statements for subsequent events through the date the financial statements were issued, and has determined that it does not have any material subsequent events to disclose in these financial statements.

ITEM 2 – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion is intended to highlight significant changes in the financial position and results of operations of The Eastern Company (together with its consolidated subsidiaries, the “Company,” “we,” “us” or “our”) for the quarter ended October 3, 2020. The interim financial statements and this Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Consolidated Financial Statements and Notes thereto for the fiscal year ended December 28, 2019 and the related Management’s Discussion and Analysis of Financial Condition and Results of Operations, both of which are contained in the Company’s 2019 Form 10-K, which was filed with the SEC on March 5, 2020 (the “2019 Form 10-K”).

The Company’s fiscal year is a 52-53-week fiscal year ending on the Saturday nearest to December 31. References to 2019 or the 2019 fiscal year mean the 52-week period ended on December 28, 2019 and references to 2020 or the 2020 fiscal year mean the 53-week period ending on January 2, 2021. In a 52-week fiscal year, each quarter is 13 weeks long. In a 53-week fiscal year, each of the first two fiscal quarters and the fourth quarter are 13 weeks long, and the third fiscal quarter is 14 weeks long. References to the third quarter of 2019, the third fiscal quarter of 2019 or the three months ended September 28, 2019 mean the period from June 30, 2019 to September 28, 2019. References to the third quarter of fiscal 2020, the third fiscal quarter of 2020 or the three months ended October 3, 2020 mean the 14-week period from June 28, 2020 to October 3, 2020. References to the nine months ended September 28, 2019, or the first nine months of fiscal 2019 mean the 39-week period from December 30, 2018 to September 28, 2019. References to the nine months ended October 3, 2020, or the first nine months of fiscal 2020 mean the 40-week period from December 29, 2019 to October 3, 2020.

Safe Harbor for Forward-Looking Statements

Statements contained in this Quarterly Report on Form 10-Q that are not based on historical facts are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements may be identified by the use of forward-looking terminology such as “should,” “could,” “may,” “will,” “expect,” “believe,” “estimate,” “anticipate,” “intend,” “continue,” or similar terms or variations of those terms or the negative of those terms. There are many factors that affect the Company’s business and the results of its operations and that may cause the actual results of operations in future periods to differ materially from those currently expected or anticipated. These factors include, but are not limited to: effects of the COVID-19 pandemic and the measures being taken to limit the spread and resurgence of COVID-19, including supply chain disruptions, delays in delivery of our products to our customers, impact on demand for our products, reductions in production levels, increased costs, including costs of raw materials, the impact on global economic conditions, the availability, terms and cost of financing, including borrowings under the Credit Agreement, and risks associated with employees working remotely or operating with reduced workforce; the scope and duration of the COVID-pandemic, including the extent of any resurgences and how quickly and to what extent normal economic activity can resume; the timing of the development and distribution of effective vaccine or treatment of COVID-19; risks associated with doing business overseas, including fluctuations in exchange rates and the inability to repatriate foreign cash, the impact on cost structure and on economic conditions as a result of actual and threatened increases in trade tariffs and the impact of political, economic and social instability; restrictions on operating flexibility imposed by the agreement governing our credit facility; the inability to achieve the savings expected from global sourcing of materials; the impact of higher raw material and component costs, particularly steel, plastics, scrap iron, zinc, copper and electronic components; lower-cost competition; our ability to design, introduce and sell new products and related components; market acceptance of our products; the inability to attain expected benefits from acquisitions or the inability to effectively integrate such acquisitions and achieve expected synergies; domestic and international economic conditions, including the impact, length and degree of economic downturns on the customers and markets we serve and more specifically conditions in the automotive, construction, aerospace, energy, oil and gas, transportation, electronic, commercial laundry, mining and general industrial markets; costs and liabilities associated with environmental compliance; the impact of climate change or terrorist threats and the possible responses by the U.S. and foreign governments; failure to protect our intellectual property; cyberattacks; and materially adverse or unanticipated legal judgments, fines, penalties or settlements. Although the Company believes it has an appropriate business strategy and the resources necessary for its operations, future revenue and margin trends cannot be reliably predicted and the Company may alter its business strategies to address changing conditions. Also, the Company makes estimates and assumptions that may materially affect reported amounts and disclosures. These relate to valuation allowances for accounts receivable and excess and obsolete inventories, accruals for pensions and other postretirement benefits (including forecasted future cost increases and returns on plan assets), provisions for depreciation (estimating useful lives), uncertain tax positions, and, on occasion, accruals for contingent losses. The Company undertakes no obligation to update, alter, or otherwise revise any forward-looking statements, whether written or oral, that may be made from time to time, whether as a result of new information, future events, or otherwise, except as required by law.

Overview

COVID-19 Update

As of October 2020, there have been significant impacts to the Company’s operations due to the COVID-19 pandemic and actions that have been taken to slow the spread and resurgence of COVID-19, and we expect those impacts to continue for some time.

Across the Company, we have implemented a broad range of policies and procedures to ensure that employees at all of our locations remain healthy. We listened to and learned a great deal from our colleagues in China, who began feeling the impact of COVID-19 in late 2019, and took early-on decisive action across our North American operations, accordingly. Steps that we have taken to reduce COVID-19 risk to our employees include, among others: implementing social distancing measures, staggering staff and shifts, enabling work from home for as many employees as possible, and implementing an enhanced cleaning program across all sites. We are advising our employees on the importance of wearing facemasks to reduce the spread COVID-19. As government authorities implement restrictions on commercial operations, we continue to ensure compliance with these directives in order to maintain business continuity for our essential operations. We continue to seek and implement additional methods to further reduce COVID-19 risk to our employees.

The Company has operations in Shanghai and Dongguan China that were affected by COVID-19 in the first six months of the year. The virus led to a chain of events that interfered with our ability, and the ability of certain suppliers of ours, to conduct business. We source approximately 10% of our products and components from China. As a result of government mandated shutdowns at our facilities, and those of certain suppliers, in China, many of the products that we have ordered were delayed by approximately four to six weeks, which resulted in delays in our product shipments to our customers through May 2020. By mid-March 2020, COVID-19 spread across the United States, which precipitated the closure by government authorities of non-essential businesses. The majority of our businesses were deemed essential and accordingly remained open, but at reduced levels. Many of our customers operating in both automotive/transportation and non-automotive/transportation markets experienced varying degrees of shutdowns beginning in the last week of March, and, on a case-by-case basis, began to reopen at various dates beginning in May 4, 2020. We estimate the adverse financial impact of COVID-19 on our third quarter operating sales and profit to be an approximate $6.1 million and $1.1 million reduction net of tax, respectively. The broader economic fallout caused by COVID-19 may result in unfavorable operating earnings and cash flow generation in the months to follow.

Although we sustained delays and disruptions in our supply chain and operations in China, in the first quarter of 2020, the majority of our facilities returned to normal operation but at reduced levels during the second fiscal quarter of 2020 and through the third quarter of 2020. We do not anticipate further disruption in our operations unless resurgence of COVID-19 were to appear, which could cause further disruptions in our business and could adversely affect our financial condition, results of operations and cash flow. In addition, the broader economic fallout caused by COVID-19 may result in unfavorable operating earnings and cash flow generation in the months to follow, as a result of decreased consumer demand for our and our customers’ products. The future extent of the effect of COVID-19 on our operational and financial performance will depend in large part on developments, that cannot be predicted with confidence at this time. Future developments include the ultimate duration, scope and severity of the pandemic and any resurgences, actions that may continue to be taken to contain or mitigate the impact of the pandemic, such as the extent of restrictions on gatherings and travel, the impact on governmental programs and budgets, the development of treatments or vaccines, and the resumption of widespread economic activity. Although the inherent uncertainty of the unprecedented and rapidly evolving crisis makes it difficult to predict with any confidence the likely impact of COVID-19 on our future operations, COVID-19 could have a material adverse impact on our consolidated business, results of operations and financial condition. For a discussion of certain COVID-19-related risks, see Item 1A, Risk Factors, of Part II of this Form 10-Q.

General Overview

On August 7, 2020, the Company acquired certain assets of Hallink RSB Inc. (“Hallink”) including accounts receivable, inventories, furniture, fixtures and equipment, intellectual property rights, and assumed certain liabilities and rights existing under all sales and purchase agreements. The transaction price was $7.2 million and was internally financed. Hallink is a leading supplier of blow molds and change parts to the food, beverage, healthcare and chemical industry. Hallink specializes in the design, development and manufacture of 2-step stretch blow molds, and related components for the stretch blow molding industry offering integrated turnkey solutions to its customers worldwide.

During the third quarter of 2020 the Company announced a change in its organization resulting from the combination of our Illinois Lock Division and Eberhard Manufacturing Division. As a result of this organizational change, the Company evaluated its segment reporting. Based on this evaluation, the Company determined that organizational change did not impact our internal reporting and reportable segments for the third quarter of 2020, but will impact our internal reporting and reportable segments for the fourth quarter of 2020. For the third quarter of 2020, as reflected in prior periods, we had three reportable segments: Industrial Products Segment, Security Product Segment and Metal Product Segment. Beginning in the fourth quarter of 2020, we will report in two segments: Engineered Solutions Segment and Diversified Products Segment. The Engineered Solutions Segment will consist of our combined Illinois Lock and Eberhard Manufacturing Division; Big 3 Precision including Big 3 Products, Big 3 Mold, Associated Toolmakers Ltd, and the newly named Hallink Moulds, Inc.; Eastern Industrial Ltd.; Velvac Holdings and Dongguan Reeworld Security Products Ltd. The Diversified Products Segment will consist of Frazer and Jones Division; Greenwald Industries Division; Argo EMS and Sesamee Mexicana, S.A. de C.V.

Net sales in the third quarter of 2020 increased 8% to $65.8 million from $60.7 million, and net sales in the first nine months of 2020 decreased 2% to $180.0 million from $183.0 million, compared to the corresponding periods in 2019. Excluding Big 3 Precision, sales in the third quarter and first nine months of 2020 declined $5.0 million or 9%, to $51.0 million from sales of $56.0 million and $38.4 million or 22%, to $140.0 million from sales of $178.4 million from the corresponding periods in 2019, respectively. The sales decline is primarily due to the divestiture of a subsidiary, Canadian Commercial Vehicle, in the second quarter of 2020. Sales in 2019 included Canadian Commercial Vehicles Corporation of $2.7 million in the third quarter and $7.6 million in the first nine months of 2019 whereas in 2020 there were no sales in the third quarter of 2020 and $2.6 million in the first nine months of 2020. In addition, the decline in sales in the first nine months of 2020 can be attributed to the fact that many of our industrial and consumer goods customers closed their operations in the second quarter of 2020 as a result of the COVID-19 pandemic.

Net sales in the third quarter of 2020 increased in the Industrial Hardware segment by 20% to $47.1 million from $39.4 million in the third fiscal quarter of 2019 and increased by 11% to $128.2 million for the first nine months of 2020 from $115.3 million in the corresponding period of 2019. Excluding Big 3 Precision, sales in the third quarter of 2020 decreased 7% in the Industrial Hardware segment to $32.3 million from sales of $34.7 million in the third quarter of 2019, and sales in the first nine months of 2020 decreased 20% to $88.3 million from sales of $110.6 million in the first nine months of 2019. Lower sales in the third quarter of 2020 were due to the sale of Canadian Commercial Vehicles Corporation in the second quarter of 2020 and continued softness in the majority of the markets into which we sell. For the first nine months of 2020, sales decreases were attributable to (i) the sale of Canadian Commercial Vehicles Corporation in the second quarter of 2020, (ii) the temporary customer closures in April and May of 2020 and (iii) the continued softness in the majority of our markets we serve through the first nine months of 2020. These declines were partially offset by third quarter sales in military products which were up by 14%, off-highway products which were up by 18%, and truck and recreational vehicle mirror sales, which were up by 18% and 14%, respectively.

Net sales in the Security Products segment in the third quarter of 2020 were comparable to the sales in the third quarter of 2019. Increases in storage, distribution vehicular accessories and medical markets were more than offset by decreases in sales to our point of sales, network technology equipment and commercial laundry markets. Sales for the first nine months of 2020 were down 17% compared to the same periods of 2019. The impact of COVID-19 in the first half of the year can be attributed to lower demand across all of our markets as businesses we serve dramatically curtailed purchasing. In addition, sales for the first nine months of fiscal 2020 were down due to the loss of several supply contracts that generated sales in the first half of 2019 that did not reoccur in 2020.

Sales in the Metal Products segment decreased 37% in the third quarter and for the first nine months of 2020 compared to sales in the corresponding periods of 2019. Mining products decreased 40%, and sales of industrial casting products decreased 36% in both the third quarter and first nine months of 2020. Mining product sales in the third quarter and first nine months were impacted by a combination of growing renewable energy capacity and extremely low natural gas prices, which led utilities to cut back on coal usage in addition to COVID-19 which forced many mine closures and resulted in further loss of sales. Mines began to open up in the third quarter and sales of mining product improved by 24% from the second quarter of 2020. Sales of industrial castings in the first nine months were negatively impacted by the loss of a customer that had temporarily sourced products from us in 2019 due to a fire at its facility in 2018.

Net sales of existing products increased 3% in the third quarter and decreased 6% in the first nine months of 2020 compared to the corresponding periods in 2019. Price increases and new products increased net sales in the third quarter by 5% and 4% in the first nine months of 2020. New products included numerous mirror assemblies, compression latches, a handle and finger pull assembly, mount plate latch, canopy lock assembly, handle assembly and crossbar lock assembly and hospital bed frames for use in the field hospitals established due to COVID-19.

Cost of products sold increased $5.3 million, or 12%, in the third quarter of 2020. The primary reason for the increase in cost of products sold in the third quarter is due to an increase in sales from the Big 3 Precision acquisition in 2019. Excluding Big 3 Precision cost of products sold in the third quarter of 2020, decreased $2.4 million or 6% to $40.4 million from costs of products sold of $42.8 million in the third quarter of 2019. Material costs decreased $3.0 million in the third quarter as we reduced inventory and curtailed replenishing stock in order to improve our cash flow generation. For the first nine months of 2020 cost of products sold was comparable to the same periods in 2019. Excluding Big 3 Precision cost of products sold decreased $29.5 million or 21% to $110.7 million from cost of products sold of $140.2 in the first nine months of 2019 on lower sales volume and lower material costs. In addition, raw material costs have decreased year-over-year, hot-rolled steel decreased 3%, cold-rolled steel decreased 8%, nickel decreased 9%, scrap iron decreased 4% while copper and zinc increased 11% and 5% respectively. However raw material prices are starting to show signs of price increases in the third quarter of 2020. Also favorably impacting the third quarter and first nine months of 2020 were lower freight costs of $0.5 million, or a 27% decrease, and $1.9 million, or a 36% decrease, over the comparable periods in 2019, respectively. Lower production levels resulted in the under-absorption of operating costs in the amount of $1.4 million during the third quarter and $1.6 million in the first nine months of 2020 compared to the corresponding periods in 2019. Further, foreign currency exchange losses increased $0.6 million and $0.4 million for the third quarter and first nine months as compared to the same periods of 2019 respectively.

Finally, the Company paid tariff costs on China-sourced products of approximately $0.6 million in the third quarter of 2020 compared to $0.9 million incurred in the third quarter of 2019, and $2.4 million for the first nine months of 2020 compared to $1.5 million in the first nine months of 2019, all of which have been recovered through price increases.

Gross margin as a percent of sales was 22% in the third quarter and 23% in the first nine months of 2020 compared to 25% in the third quarter and 24% in the first nine months of 2019.

Product development expense in the third quarter of 2020 was comparable to that of the third quarter of 2019 at $0.9 million and decreased $2.6 million or 52% in the first nine months of 2020 compared to the corresponding periods of 2019. The reduction in this expense relates to the closure of the Velvac Road-iQ development operation in Bellingham, Washington, in the second quarter of 2019, to adopt a leaner approach to the development of new vision products.

Selling and administrative expense increased $1.2 million or 14% in the third quarter and increased $2.4 million or 10% in the first nine months of 2020 compared to the corresponding periods of 2019, primarily as a result of the inclusion of Big 3 Precision in the 2020 period. For the first nine months of 2020 the most significant factor contributing to the overall increase was payroll and payroll related expenses of $1.1 million and amortization expense related to the acquisition of Big 3 Precision in the amount of $1.7 million. Excluding Big 3 Precision, selling and administrative expenses in the third quarter of 2020 increased 5% to $7.0 million from selling and administrative expenses of $6.7 million in the third quarter of 2019, and selling and administrative expenses in the first nine months of 2020 decreased 10% to $21.1 million from selling and administrative expenses of $23.3 million in the first nine months of 2019. The most significant factor contributing to the increase in the third quarter of 2020 was the reclassification of acquisition related cost for the Big 3 acquisition in 2019. For the first nine months of 2020, the decrease in selling and administrative expenses was due to payroll and payroll related expenses of $1.6 million, and travel expenses of $0.5 million respectively, as compared to the same periods of 2019.

Restructuring costs of $0.3 million incurred in the first nine months of 2020 related to the divestiture of Canadian Commercial Vehicles Corporation in the second quarter of fiscal 2020, compared to restructuring costs of $2.7 million during for the first nine months of 2019, which were related to the discontinuance of our Road iQ development operations based in Bellingham, Washington and the relocation costs of our Composite Panels Technologies division in Salisbury, North Carolina to the Canadian Commercial Vehicles Corporation located in Kelowna, British Columbia.

Goodwill impairment loss of $4.0 million was incurred in the second quarter of 2020. The Company determined that it was more likely than not that the estimated fair value of one of its 12 reporting units (Greenwald Industries) was below its carrying amount. The factors that led to this determination included additional competition, industry movement away from legacy products and intense competition in new mobile payment apps. This fundamental shift in lower cost payment systems away from the higher cost electronic smart card payment systems resulted in the carrying value of Greenwald exceeding its fair value. As a result, an independent valuation was conducted which estimated that the carrying value exceeded the fair value by approximately $4.0 million. Management has recognized this non-cash impairment charge in the second fiscal quarter of 2020. There were no goodwill impairment charges in the third quarter of 2020.

Interest expense increased $0.3 million in the third quarter and $1.1 million for the first nine months of 2020 compared to the same periods in 2019 as a result of increased debt related to our acquisition of Big 3 Precision in August 2019.

Other income increased $0.2 million in the third and the first nine months of 2020 compared to the corresponding periods in 2019 due to a favorable return on our pension plan assets and a onetime sale-leaseback transaction gain in the first quarter of fiscal 2020.

Net income for the third quarter of fiscal 2020 was $3.0 million, or $0.48 per diluted share compared to income of $4.2 million, or $0.67 per diluted share, for the comparable period in 2019. In the first nine months of 2020 net income was $4.0 million, or $0.64 per diluted share, compared to $8.3 million, or $1.33 per diluted share, for the comparable period in 2019. During the second quarter of 2020, the Company had a significant non-recurring goodwill impairment loss of $4.0 million. There were no goodwill impairment charges in the third quarter of 2020.

A more detailed analysis of the Company’s results of operations and financial condition follows:

Results of Operations

The following table shows, for the periods indicated, selected line items from the condensed consolidated statements of operations as a percentage of net sales, by segment for the period indicated:

The following table shows the change in sales and operating profit by segment for the third quarter of fiscal 2020 compared to the third quarter of fiscal 2019 (dollars in thousands):

The following table displays selected line items from the condensed consolidated statements of operations as a percentage of net sales, by segment, for the periods indicated: