HG Holdings, Inc. - Quarter Report: 2017 April (Form 10-Q)

Three Months Ended April 1, 2017 Compared to Three Months Ended April 2, 2016

Net sales of $11.2 million for the three month period ended April 1, 2017, decreased $493,000, or 4.2%, compared to the 2016 three month period, primarily due to lower average selling prices and to a lesser extent, lower unit volume.  Lower average selling prices were the result of discounting to move older discontinued product, place floor sample discounts of new introductions which shipped later than expected due to sourcing issues and a successful President’s Day holiday promotion.  Lower unit volume was primarily a result of delays in shipping floor samples of new productions.  A majority of this new product should have already been on customers’ floors and generating resale activity.   

Gross profit for the first three months of 2017 decreased to $2.2 million, or 20.0% of net sales, from $2.5 million, or 21.7% of net sales, for the comparable three months of 2016.  The decrease in gross profit and gross margin was driven by higher discounting for the reasons mentioned above.  Partially offsetting the higher discounting was a decrease in product costs, as some of our newer, more marketable product began shipping in the period.     

Selling, general and administrative expenses decreased to $2.7 million, or 23.7% of net sales, for the three month period of 2017 from $3.3 million, or 28.3% of net sales, for the comparable three month period of 2016.  The decrease in spending is largely due to cost reduction actions taken at the beginning of the year to reduce our break-even level, lower stock compensation related expenses, lower legal and professional expenditures despite increased fees associated with an agreement with Hale Partnership and the strategic review process with Stephens Inc.  Lower bad debt expense also contributed to lower expenditures.  Partially offsetting these lower expenses were higher commission costs and not benefitting from the cash surrender value growth of corporate-owned life insurance policies that were liquidated in the first quarter of 2016.

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We incurred no interest expense for the three month period ended April1, 2017.  Interest expense in the prior year three month period was composed of interest on loans against cash surrender value of insurance policies used to fund our legacy deferred compensation plan.  The elimination of this expense was due to surrendering these policies and paying off loans against the cash surrender value in the first quarter of 2016. 

Our effective tax rate for the current year three month period is effectively 0% due to our net loss.  The effective tax rate for the prior year quarter was a negative 69.9%.  As indicated above, we surrendered our corporate-owned life insurance policies during the first quarter of 2016, which resulted in taxable income for the period.  The premiums paid and the growth in surrender value of these policies were excludable from taxable income over the life of these polices when held until death of the covered lives, but this growth, net of premiums paid, became taxable when we surrendered the policies.  The aggregate impact of the surrender of these policies in the first quarter of last year was the creation of $24.0 million in taxable income.  The income tax expense recognized was largely the result of federal alternative minimum tax which limits our ability to offset income generated during that period with net operating carry-forwards, and, to a lesser extent, the impact of the policy surrenders had on state income taxes.  The major reconciling items between our effective income tax rate and the federal statutory rate are the change in our valuation allowance and, in the prior year period, the cash surrender value on life insurance policies.

Three Months Ended April 1, 2017 Compared to Three Months Ended December 31, 2016

Gross profit as a percentage of net sales remained consistent at 20% for the three month period ended April 1, 2017 compared to the three month period ending December 31, 2016.  Gross profit percentage would have improved over fourth quarter 2016 if not for the higher discounts related to late backlog fulfillment carried over from production delays in the prior year.

            Selling, general and administrative expenses decreased to $2.7 million, or 23.7% of net sales, for the first three months of 2017 compared to $3.4 million, or 34.2% for the last three month period of 2016.  The decrease in expenses was mainly from cost reductions implemented in the first quarter of 2017, lower legal and professional fees, despite fees mentioned above, and lower stock compensation expense. 

            As a result, operating loss as a percentage of net sales for the first quarter was 3.7% compared to an operating loss of 14.1% for the fourth quarter of 2016.

During the fourth quarter of 2016, we received $1.1 million in funds under the CDSOA.

Financial Condition, Liquidity and Capital Resources

            Sources of liquidity include cash on hand, the revolving credit facility and cash generated from operations. While we believe that our business strategy will be successful, we cannot predict with certainty the ultimate impact on our revenues, operating costs and cash flow from operations.  We expect cash on hand to be adequate for ongoing operational and capital expenditures over the next twelve months.  At April 1, 2017, we had $3.6 million in cash and $663,000 in restricted cash.

Working capital, excluding cash and restricted cash, increased slightly to $18.9 million on April 1, 2017 from $18.8 million on December 31, 2016.  The increase was primarily the result of a decrease in accounts payable tied to lower in-transit inventory at the end of the period and an increase in accounts receivable due to higher shipments in the period compared to the fourth quarter of 2016.  Mostly offsetting these increases in working capital was a reduction in inventory as we increased our sales of discontinued product and began shipping newer introductions as we received the balance of product needed to complete these orders that were in backlog at year end.  

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No investing activities occurred in the first quarter of 2017. Cash generated from investing activities in the first quarter of 2016 was due to $28.1 million in proceeds from the surrender of corporate-owned life insurance policies. 

No financing activities occurred in the first quarter of 2017. Net cash used by financing activities in the first quarter of 2016 was $6.5 million.  During the first quarter of 2016, we used $5.5 million to pay off the remaining outstanding life insurance policy loans in conjunction with our decision to surrender corporate-owned life insurance policies and $1.0 million for the repurchase and retirement of 400,000 shares of our common stock. 

Continued Dumping and Subsidy Offset Act (“CDSOA”)

The CDSOA provides for distribution of monies collected by U.S. Customs and Border Protection (“Customs”) for imports covered by antidumping duty orders entering the United States through September 30, 2007 to eligible domestic producers that supported a successful antidumping petition (“Supporting Producers”) for wooden bedroom furniture imported from China. Antidumping duties for merchandise entering the U.S. after September 30, 2007 have remained with the U.S. Treasury.

In November 2016, Customs distributed $3.3 million in collected duties that were available for distribution in 2015 and 2016, respectively. Our portion of these distributions was $1.1 million, representing 33.5% of the balance available for distribution in 2016. As of October 1, 2016, Customs reported that approximately $1.4 million in cash deposits or other security paid at the time of import on subject entries remains in a clearing account, which potentially may become available for distribution under the CDSOA to eligible domestic manufacturers in connection with the case involving bedroom furniture imported from China. The final amounts available for distribution may be higher or lower than the preliminary amounts reported in the clearing account due to liquidations, reliquidations, protests, and other events affecting entries. Assuming that our percentage allocation in the future is the same as it was for the 2016 distribution (approximately 33.5% of the funds distributed) and that the $1.4 million in cash deposits ultimately is collected by the government, we could receive approximately $460,000 in CDSOA funds at some point in the future.

Due to the uncertainty of the administrative processes, we cannot provide assurances as to future amounts of additional CDSOA funds that ultimately will be received, if any, and we cannot predict when we may receive any additional CDSOA funds.   

New Accounting Pronouncements

In March 2017, the FASB issued ASU 2017-07, Compensation – Retirement Benefits (Topic 715): Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost (“ASU 2017-07). Currently, net benefit cost is reported as an employee cost within operating income (or capitalized into assets where appropriate).  The amendment requires the bifurcation of net benefit cost. The service cost component will be presented with the other employee compensation costs in operating income (or capitalized in assets). The other components will be reported separately outside of operations, and will not eligible for capitalization. The amendment is effective for public entities for annual reporting period beginning after December 15, 2017. Early adoption will be permitted as of the beginning of an annual reporting period for which financial statements have not been issued or made available for issuance. The guidance is required to be applied on a retrospective basis for the presentation of the service cost component and the other components of net benefit cost (including gains and losses on curtailments and settlements, and termination benefits paid through plans), and on a prospective basis for the capitalization of only the service cost component of net benefit cost.  Amounts capitalized into assets prior to the date of adoption should not be adjusted through a cumulative effect adjustment, but should continue to be recognized in the normal course, as for example, inventory is sold or fixed assets are depreciated. The Company has no service cost component in its net benefit cost.  The impact of adopting this amendment will be the movement of approximately $330,000 of net benefit cost from within operating income to a separate expense outside of operations.

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In June 2016, the FASB issued ASU 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”).  The amendments in ASU 2016-13 require the measurement of all expected credit losses for financial assets held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts.  In addition, ASU 2016-13 amends the accounting for credit losses on available-for-sale debt securities and purchased financial assets with credit deterioration.  The amendment is effective for public entities for annual reporting periods beginning after December 15, 2019, however early application is permitted for reporting periods beginning after December 15, 2018.  The Company does not anticipate ASU 2016-13 to have a material impact to the consolidated financial statements.

In February 2016, the FASB issued its final lease accounting standard, FASB Accounting Standard Codification ("ASC"), Leases (Topic 842) (“ASU 2016-02”), which requires lessees to recognize a right-of-use asset and a lease liability for virtually all of their leases (other than leases that meet the definition of a short-term lease).  The lease liability will be equal to the present value of lease payments and the right-of -use asset will be based on the lease liability, subject to adjustment such as for initial direct costs.  For income statement purposes, the new standard retains a dual model similar to ASC 840, requiring leases to be classified as either operating or finance.  For lessees, operating leases will result in straight-line expense (similar to current accounting by lessees for operating leases under ASC 840) while finance leases will result in a front-loaded expense pattern (similar to current accounting by lessees for capital leases under ASC 840).  Our leases as of December 31, 2016, principally relate to real estate leases for corporate office, showrooms and warehousing.  The new standard will be effective for the first quarter of our fiscal year ending December 31, 2019. Early adoption is permitted. We are evaluating the effect that ASU 2016-02 by reviewing all long-term leases and determining the potential impact it will have on our consolidated financial statements and related disclosures. The standard is to be applied under the modified retrospective method, with elective reliefs, which requires application of the new guidance for all periods presented.

In March 2016, the FASB issued ASU 2016-09, Improvements to Employee Share-Based Payment Accounting (“ASU 2016-09”).  The amendments in ASU 2016-09 simplify several aspects of the accounting for share-based payment transactions.  The new guidance requires that excess tax benefits (which represent the excess of actual tax benefits receive at the date of vesting or settlement over the benefits recognized over the vesting period or upon issuance of share-based payments) be recorded in the income statement as a reduction of income or income taxes when the awards vest or are settled.  The new guidance also requires excess tax benefits to be classified as an operating activity in the statement of cash flows rather than as a financing activity.   The adoption of these amendments in the first quarter of this year had no material impact on the Company’s financial statements.  The Company has elected to maintain its practice of estimating forfeitures when recognizing expense for share-based payment awards.

         In August 2016, FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230).  The guidance is intended to reduce diversity in practice in how certain cash receipts and cash payments are presented and classified in the statement of cash flows.  This standard will be effective for the first quarter of our fiscal year ending December 31, 2018.  Early adoption is permitted, provided all amendments are adopted in the same period.  In November 2016, FASB issued ASU 2016-18, Statement of Cash Flows (Topic 230): Restricted Cash.  We have reviewed the standard and determined that our statement of cash flows will include changes in restricted cash with related disclosures.  The guidance requires application using a retrospective transition method.  We do not anticipate ASU 2016-15 or ASU 2016-18 to have a material impact to our consolidated financial statements.

In July 2015, the FASB issued ASU 2015-11, Inventory (Topic 330): Simplifying the Measurement of Inventory (“ASU 2015-11”). The amendments in ASU 2015-11 require an entity to measure in scope inventory at the lower of cost and net realizable value. Net realizable value is the estimated selling prices in the ordinary course of business, less reasonable predictable costs of completion, disposal, and transportation. Subsequent measurement is unchanged for inventory measured using last-in, first-out (“LIFO”) or the retail inventory method. The amendments do not apply to LIFO or the retail inventory method. The amendments apply to all other inventory, which includes inventory that is measured using first-in, first-out (“FIFO”) or average cost.  The adoption of these amendments in the first quarter of this year had no material impact on the Company’s financial statements.

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         In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers (Topic 606).  This standard is intended to improve, and converge with international standards, the financial reporting requirements for revenue from contracts with customers.  The new standard will be effective for the first quarter of our fiscal year ending December 31, 2018.  Early adoption is permitted but we do not expect to early adopt this new accounting pronouncement.  In preparation for this new standard, we are identifying all forms of agreements with our customers and will begin to evaluate the provisions in such agreements in light of the five-step model specified by the new guidance.  The five-step model includes: 1) determination of whether a contract – an agreement between two or more parties that creates legally enforceable rights and obligations exists; 2) identification of the performance obligations in the contract; 3) determination of the transaction price; 4) allocation of the transaction price to the performance obligations in the contract; and 5) recognition of revenue when (or as) the performance obligation is satisfied.  We are also evaluating the impact of the new standard on certain common practices currently employed by us and others in our industry, such as co-operative advertising, pricing allowances and consumer coupons.  We are in the initial phases and have not yet determined the impact of the new standard on our financial statements or whether we will adopt on a full or modified retrospective basis in the first quarter of our fiscal year ending December 31, 2018.

Critical Accounting Policies

There have been no material changes to our critical accounting policies and estimates from the information provided in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, included in our 2016 Annual Report on Form 10-K.

Forward-Looking Statements

Certain statements made in this report are not based on historical facts, but are forward-looking statements.  These statements can be identified by the use of forward-looking terminology such as “believes,” “estimates,” “expects,” “may,” “will,” “should,” “could,” or “anticipates,” or the negative thereof or other variations thereon or comparable terminology, or by discussions of strategy.  These statements reflect our reasonable judgment with respect to future events and are subject to risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements.  Such risks and uncertainties include disruptions in foreign sourcing including those arising from supply or distribution disruptions or those arising from changes in political, economic and social conditions, as well as laws and regulations, in countries from which we source products, international trade policies of the United States and countries from which we source products, the inability to raise prices in response to inflation and increasing costs, lower sales due to worsening of current economic conditions, the cyclical nature of the furniture industry, business failures or loss of large customers, failure to anticipate or respond to changes in consumer tastes, fashions and perceived values in a timely manner, competition in the furniture industry, environmental, health, and safety  compliance costs, and failure or interruption of our information technology infrastructure.  Any forward-looking statement speaks only as of the date of this filing and we undertake no obligation to update or revise any forward-looking statements, whether as a result of new developments or otherwise.

ITEM 3.  Quantitative and Qualitative Disclosures about Market Risk

None of our foreign sales or purchases are denominated in foreign currency and we do not have any foreign currency hedging transactions.  While our foreign purchases are denominated in U.S. dollars, a relative decline in the value of the U.S. dollar could result in an increase in the cost of our products obtained from offshore sourcing and reduce our earnings or increase our losses, unless we are able to increase our prices for these items to reflect any such increased cost.

ITEM 4.  Controls and Procedures

(a)        Evaluation of disclosure controls and procedures.  Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of our disclosure controls and procedures, as such term is defined under Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended (the Exchange Act).  Based on this evaluation, our principal executive officer and our principal financial officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this quarterly report.

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(b)        Changes in internal controls over financial reporting.  There were no changes in our internal control over financial reporting that occurred during the first quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Part II. OTHER INFORMATION

ITEM 6. Exhibits

(1)           Filed herewith

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SIGNATURE

            Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has caused this report to be signed on its behalf by the undersigned thereunto duly authorized.