HUTTIG BUILDING PRODUCTS INC - Quarter Report: 2019 September (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

☑ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2019

or

☐ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from ______ to ______

Commission file number 1-14982

HUTTIG BUILDING PRODUCTS, INC.

(Exact name of registrant as specified in its charter)

(314) 216-2600

(Registrant’s telephone number, including area code)

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

*The rights currently transfer with the shares of Common Stock

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 the 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 Exchange Act).    Yes  ☐    No  ☑

The number of shares of Common Stock outstanding on September 30, 2019 was 26,538,181 shares.

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PART I FINANCIAL INFORMATION

ITEM 1 — FINANCIAL STATEMENTS

HUTTIG BUILDING PRODUCTS, INC. AND SUBSIDIARY

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited)

(in millions, except per share data)

See notes to condensed consolidated financial statements

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HUTTIG BUILDING PRODUCTS, INC. AND SUBSIDIARY

CONDENSED CONSOLIDATED BALANCE SHEETS

(unaudited)

(in millions)

See notes to condensed consolidated financial statements

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HUTTIG BUILDING PRODUCTS, INC. AND SUBSIDIARY

CONDENSED CONSOLIDATED BALANCE SHEETS

(unaudited)

(in millions, except share data)

See notes to condensed consolidated financial statements

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HUTTIG BUILDING PRODUCTS, INC. AND SUBSIDIARY

CONDENSED CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY

(unaudited)

(in millions)

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HUTTIG BUILDING PRODUCTS, INC. AND SUBSIDIARY

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

(in millions)

See notes to condensed consolidated financial statements

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HUTTIG BUILDING PRODUCTS, INC. AND SUBSIDIARY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

1. BASIS OF PRESENTATION

The unaudited interim condensed consolidated financial statements of Huttig Building Products, Inc. and its subsidiary (the “Company” or “Huttig”) were prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) and reflect all adjustments (including normal recurring accruals) which, in the opinion of management, are considered necessary for the fair presentation of the results for the periods presented. Financial statement preparation further requires management to make estimates and assumptions. Management bases these estimates and assumptions on historical results and known trends as well as management forecasts. Actual results could differ from these estimates and assumptions and these differences may be material. These statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2018.

The condensed consolidated results of operations and resulting cash flows for the interim periods presented are not necessarily indicative of the results that might be expected for the full year, or any other interim period. Due to the seasonal nature of Huttig’s business, operating profitability is usually lower in the Company’s first and fourth quarters than in the second and third quarters.

2. NEW ACCOUNTING STANDARDS

Adoption of New Accounting Standards

On January 1, 2018, the Company adopted Accounting Standards Update (“ASU”) 2014-09, “Revenue from Contracts with Customers (Topic 606)” and all related amendments.  The Company adopted the standard using the full retrospective method, which did not require a cumulative effect adjustment to retained earnings. As a result of this adoption, there was no material impact on revenue recognition practices, income from continuing operations after taxes, net income or earnings per share.  See Note 3 - “Revenue” for further discussion, including additional required qualitative and quantitative disclosures of revenue recognition policies. 

On October 1, 2018, the Company adopted ASU 2017-04, “Intangibles-Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment.” ASU 2017-04 eliminates the two-step process that required identification of potential impairment and a separate measure of the actual impairment. The annual assessment of goodwill impairment will now consist of a comparison of the fair value of a reporting unit with its carrying amount. Any impairment will now be determined by using the difference between the carrying amount and the fair value of the reporting unit, not to exceed the total goodwill allocated to that unit.

On January 1, 2019, the Company adopted ASU 2016-02, “Leases (Topic 842),” which requires lessees to recognize leases on-balance sheet and disclose key information about leasing arrangements.  The new standard establishes a right-of-use (“ROU”) model that requires a lessee to recognize a ROU asset and a lease liability on the balance sheet for all leases with a term longer than 12 months.  Leases will be classified as finance or operating, with classification affecting the pattern and classification of expense recognition in the income statement.  The Company adopted the standard on its effective date using the modified retrospective approach and a package of practical expedients permitted by the transition guidance of the new standard.  The practical expedients included an accounting policy election to forgo recognition of ROU asset and liability on leases with an intial term of 12 months or less, and to forgo separate recognition of lease and non-lease components for all leases.

On January 1, 2019, the Company adopted ASU 2018-07, “Improvements to Nonemployee Share-Based Payment Accounting.”  ASU 2018-07 more closely aligns the accounting for employee and nonemployee share-based payments.  There was no material impact to stock compensation, income from continuing operations after taxes, net income or earnings per share as a result of adoption.

The Company adopted the amendments to certain disclosure requirements in Securities Act of 1933, as amended, Release No. 33-10532, “Disclosure Update and Simplification” on November 5, 2018, the effective date of the release. Among the amendments is a requirement to present the changes in shareholders’ equity in the interim financial statements (either in a separate statement or footnote) in quarterly reports on Form 10-Q. See the Consolidated Statement of Shareholders’ Equity.

3. REVENUE

Revenue is measured as the amount of consideration the Company expects to receive in exchange for transferring goods.  The Company reports sales revenue, including direct sales, on a net basis, which includes gross revenue adjustments for estimated returns, cash payment discounts based on the satisfaction of outstanding receivables, and volume purchase rebates.  The Company’s customer payment terms are typical for its industry. These terms vary by customer, location, and products.

Regarding direct sales, the Company is the principal of these arrangements and is responsible for fulfilling the promise to provide specific goods to its customers, including product specifications, pricing and modifications prior to delivery.

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The following table disaggregates revenue by product classification (in millions):

4.  LEASES

The Company has operating and financing leases for corporate offices, distribution centers, vehicles, and certain equipment. These leases have remaining lease terms of less than 1 year to 12 years and many of the leases have renewal options.  Because the Company is not reasonably certain to exercise the renewal options, the options are not considered in determining the lease term, and associated potential option payments are excluded from lease payments and right-of-use calculations.  Leases with an initial term of 12 months or less are likewise excluded from right-of-use calculations.

In addition to fixed payments, many of the Company’s lease contracts contain variable payments. Vehicle lease variable payments typically include mileage, and real estate leases include variable charges for taxes and common area maintenance.  Variable lease payments and payments for leases with an initial term of 12 months or less are recognized in the period incurred.

The following lease assets and liabilities are included on the condensed consolidated balance sheet (in millions):

As of September 30, 2019, the weighted average remaining lease term for the Company’s operating leases was 5.6 years and for its financing leases was 3.6 years. These leases have weighted average discount rates of 5.8% and 5.2% for operating leases and financing leases, respectively. The rate implicit in the lease is used to discount leases when known. While the implicit rate is often known for finance leases, the Company is generally unable to calculate the implicit rate in operating leases because it does not have access to the lessor’s residual value estimates nor the amount of the lessor’s deferred initial direct costs.  When the implicit rate is not known, the Company uses the incremental borrowing rate for secured loans of similar term. The Company uses available data for unsecured loans to borrowers of similar credit to the Company and adjusts the rate to reflect the effect of providing collateral equivalent to the outstanding obligation balance.

The following cash flow items are included on the condensed consolidated statement of cash flows (in millions):

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Maturities of lease liabilities are as follows (in millions):

Disclosures Related to Periods Prior to Adoption of ASU 2016-02

Operating lease rent expense was $16.6 million and $14.8 million, and sublease income $0.5 million and $0.5 million, for the years ended December 31, 2018 and 2017, respectively.  Future minimum lease payments under non-cancelable rental and lease agreements with initial or remaining terms in excess of one year were as follows at December 31, 2018 (in millions):

Certain leases also include options to purchase the leased property. Assets recorded under capital leases as of December 31, 2018 and December 31, 2017 were $8.5 million and $6.6 million, respectively.  These assets are recorded net of accumulated amortization of $2.9 million and $2.3 million as of December 31, 2018 and December 31, 2017, respectively.

5. DEBT

Debt consisted of the following (in millions): 

Credit Facility — The Company has a $250.0 million asset-based senior secured revolving credit facility (the “credit facility”).  Borrowing availability under the credit facility is based on eligible accounts receivable, inventory and real estate. The real estate component of the borrowing base amortizes monthly over 12.5 years on a straight-line basis.  Borrowings under the credit facility are collateralized by substantially all of the Company’s assets, and the Company is subject to certain operating limitations applicable to a loan of this type, which, among other things, place limitations on indebtedness, liens, investments, mergers and acquisitions, dispositions of assets, cash dividends and transactions with affiliates.  The entire unpaid balance under the credit facility is due and payable on July 14, 2022.    

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At September 30, 2019, the Company had revolving credit borrowings of $147.8 million outstanding at a weighted average interest rate of 3.87% per annum, letters of credit outstanding totaling $3.3 million, primarily used as collateral for health and workers’ compensation insurance, and $43.6 million of excess committed borrowing availability.  The Company pays an unused commitment fee of 0.25% per annum. In addition, the Company had $1.4 million of other obligations maturing in 2023 at a borrowing rate of 6.11%. The Company also had $4.3 million of financing lease obligations at September 30, 2019.  See Note 4 – “Leases” for more information.  

The sole financial covenant in the credit facility is the minimum fixed charge coverage ratio (“FCCR”) of 1.00:1.00, which must be tested by the Company if the excess borrowing availability falls below an amount in the range of $17.5 million to $31.3 million, depending on the borrowing base. In the third quarter of 2019, the minimum FCCR was not required to be tested as excess borrowing availability was greater than the minimum threshold. However, if the Company’s availability would have fallen below that threshold, the Company would not have met the minimum FCCR. The FCCR must also be tested on a pro forma basis prior to consummation of certain significant business transactions outside the ordinary course of business, as defined in the agreement. 

6. CONTINGENCIES

The Company carries insurance policies on insurable risks with coverage and other terms that it believes to be appropriate. The Company has self-insured retention limits and has obtained fully insured layers of coverage above such self-insured retention limits. Accruals for self-insurance losses are made based on claims experience. Liabilities for existing and unreported claims are accrued when it is probable that future costs will be incurred and can be reasonably estimated.

Environmental and Legal Matters

The Company accrues expenses for contingencies when it is probable that an asset has been impaired or a liability has been incurred and management can reasonably estimate the expense. Contingencies for which the Company has made accruals include environmental and other legal matters. It is possible, however, that actual expenses could exceed the accruals by a material amount, which could have a material adverse effect on the Company’s future liquidity, financial condition, and operating results in the period in which any such additional expenses are incurred or recognized.

Environmental Matters

The Company was previously identified as a potentially responsible party in connection with contamination cleanup at a formerly owned property in Montana. On February 18, 2015, the Montana Department of Environmental Quality (the “DEQ”) issued an amendment to the unilateral administrative order of the DEQ outlining the final remediation of the property in its Record of Decision.  In September 2015, the remedial action work plan (“RAWP”) was approved.

The Company paid $0.3 million in the first nine months of 2019 implementing the RAWP.  The Company estimates the total remaining cost of implementing the RAWP to be $3.0 million at September 30, 2019 with $1.1 million in short-term other accrued liabilities and $1.9 million in other non-current liabilities. As of September 30, 2019, the Company believes the accrual represents a reasonable best estimate of the total remaining remediation costs, based on facts, circumstances, and information currently available.  However, there are currently unknown variables relating to the actual levels of contaminants and amounts of soil that will ultimately require treatment or removal. As part of the remediation process, additional soil and groundwater sampling, and bench and pilot testing is required to ensure the remediation will achieve the outcome required by the DEQ.  The ultimate final amount of remediation costs and expenditures are difficult to estimate with certainty and as a result, the amount of actual costs and expenses ultimately incurred by the Company with respect to this property could be lower than, or exceed the amount accrued as of September 30, 2019 by a material amount.  If actual costs are materially higher, the incremental expenses over the amount currently accrued could have a material adverse effect on the Company’s liquidity, financial condition and operating results.  

In addition, some of the Company’s current and former distribution centers are located in areas where environmental contamination may have occurred, and for which the Company, among others, could be held responsible. The Company currently believes that there are no material environmental liabilities at any of its distribution center locations.

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7. EARNINGS (LOSS) PER SHARE

The Company calculates its basic income (loss) per share by dividing net income (loss) allocated to common shares outstanding by the weighted average number of common shares outstanding. Unvested shares of restricted stock participate in dividends on the same basis as common shares. As a result, these share-based awards meet the definition of participating securities and the Company applies the two-class method to compute earnings per share. The two-class method is an earnings allocation formula that treats participating securities as having rights to earnings that would otherwise have been available to common stockholders. In periods in which the Company has net losses, the losses are not allocated to participating securities because the participating security holders are not obligated to share in such losses.

The following table presents the number of participating securities and earnings allocated to those securities (in millions).

The diluted earnings per share calculations include the effect of assumed exercise using the treasury stock method for unvested restricted stock units, except when the effect would be anti-dilutive.  The following table presents the number of common shares used in the calculation of net income (loss) per share from continuing operations (in millions):

8. INCOME TAXES

The Company assesses available positive and negative evidence to estimate whether sufficient future taxable income will be generated to permit use of existing deferred tax assets.  The cumulative loss incurred by the Company over the three-year period ended September 30, 2019 constitutes a significant piece of objective negative evidence.  Such objective negative evidence limits the ability to consider other subjective evidence, such as our projections for future profitability and growth.  Based on this evaluation, for the nine months ended September 30, 2019, the Company maintained a valuation allowance of $11.8 million to reduce net deferred tax assets as their realization did not meet the more-likely-than-not criterion.  The amount of deferred tax assets considered realizable, however, could be adjusted in the future if objective negative evidence in the form of cumulative losses is no longer present and additional weight is given to subjective evidence such as our projections for future profitability and growth.

The Company’s effective tax rate from continuing operations was an expense of 0% and benefit of 29% in the three-month periods ended September 30, 2019 and 2018, respectively, and expense of 1388% and benefit of 72% in the nine-month periods ended September 30, 2019 and 2018, respectively. The valuation allowance recorded in the nine months ended September 30, 2019 was the primary component of tax expense and the resulting effective tax rate.  The year-to-date tax rate for both 2019 and 2018 was also impacted by the vesting of restricted stock, which provided an income tax deduction in excess of the compensation deduction for GAAP purposes.

As of September 30, 2019, the Company had a $19.1 million valuation allowance to reserve net state and federal deferred tax assets.

9. STOCK-BASED COMPENSATION

The Company recognized $0.5 million and $0.6 million in non-cash, stock-based compensation expense for the third quarter of 2019 and 2018, respectively, and $1.6 million and $1.8 million in non-cash, stock-based compensation expense for the nine-month periods ended September 30, 2019 and 2018, respectively.  During the first nine months of 2019, the Company granted an aggregate of 510,684 shares of restricted stock at a weighted average value of $2.37 per share under its 2005 Executive Incentive Compensation Plan, as amended and restated. Most restricted shares vest in three equal installments on the first, second and third anniversaries of the grant date, or cliff vest in five years. During the first nine months of 2019, the Company granted an aggregate of 90,000 shares of restricted stock under its Non-Employee Directors’ Restricted Stock Plan, as amended, at an average fair market value of $2.30 per share. The directors’ restricted shares vest on the first anniversary of the grant date. Unearned compensation expense is amortized into expense on a straight-line basis over the requisite service period for the entire award. As of September 30, 2019 and 2018, the total compensation expense not yet recognized related to all outstanding restricted stock awards was $2.6 million and $3.8 million, respectively.

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

Cautionary Statement Relevant to Forward-Looking Information for the Purpose of “Safe Harbor” Provisions of the Private Securities Litigation Reform Act of 1995

This Quarterly Report on Form 10-Q contains “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995.  The words or phrases “will likely result,” “are expected to,” “will continue,” “is anticipated,” “believe,” “estimate,” “project” or similar expressions may identify forward-looking statements, although not all forward-looking statements contain such words.  Statements made in this Quarterly Report on Form 10-Q and our Annual Report on Form 10-K looking forward in time, including, but not limited to, statements regarding our current views with respect to financial performance, future growth in the housing market, distribution channels, sales, favorable supplier relationships, inventory levels, the ability to meet customer needs, enhanced competitive posture, strategic initiatives, absence of material financial impact from litigation or contingencies, including environmental proceedings, are included pursuant to the “safe harbor” provision of the Private Securities Litigation Reform Act of 1995.

These statements present management’s expectations, beliefs, plans and objectives regarding our future business and financial performance. We cannot guarantee that any forward-looking statements will be realized or achieved.  These forward-looking statements are based on current projections, estimates, assumptions and judgments, and involve known and unknown risks and uncertainties. We disclaim any obligation to publicly update or revise any of these forward-looking statements, whether as a result of new information, future events or otherwise.

There are a number of factors, some of which are beyond our control that could cause our actual results to differ materially from those expressed or implied in the forward-looking statements. These factors include, but are not limited to, the strength of construction, home improvement and remodeling markets and the recovery of the homebuilding industry to levels consistent with the historical annual average; the cyclical nature of our industry; the successful implementation of our growth initiatives; the effects of increased inventories to support our growth initiatives and the impact if levels become excessive; the uncertainties resulting from changes to United States and foreign laws, regulations and policies; the cost of environmental compliance, including actual expenses we may incur to resolve proceedings we are involved in arising out of the formerly owned facility in Montana; any limitations on our ability to utilize our deferred tax assets to reduce future taxable income and tax liabilities; our ability to comply with, and the restrictive effect of, the financial covenant applicable under our credit facility; the loss of a significant customer; deterioration of our customers’ creditworthiness or our inability to forecast such deteriorations; commodity prices; dumping duties; tariffs; risks associated with our private brands; termination of key supplier relationships; risks of international suppliers; competition with existing or new industry participants; goodwill impairment;  the seasonality of our operations; significant uninsured claims; federal and state transportation regulations; fuel cost increases; our failure to attract and retain key personnel; deterioration in our relationship with our unionized employees, including work stoppages or other disputes; funding requirements for multi-employer pension plans for our unionized employees; product liability claims and other legal proceedings; the integration of any business we acquire and the liabilities of such businesses; information technology system failure, network disruptions, cybersecurity attacks and breaches in data security; and those set forth under Part I, Item 1A – “Risk Factors” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2018. These factors may not constitute all factors that could cause actual results to differ from those discussed in any forward-looking statement. Accordingly, forward-looking statements should not be relied upon as a predictor of actual results.

Overview

We are a distributor of a broad array of building material products used principally in new residential construction, home improvement, and remodeling and repair projects.  We distribute our products through 27 distribution centers serving 41 states and sell primarily to building materials dealers, national buying groups, home centers and industrial users, including makers of manufactured homes.

The following table sets forth our sales by product classification as a percentage of total sales:

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Industry Conditions

New housing activity in 2019 continues to trend below the historical annual average of 1.4 million total housing starts from 1959 to 2018 based on statistics tracked by the United States Census Bureau. Total housing starts were approximately 1.2 million in 2018. Through September 30, 2019, based on the most recent data provided by the United States Census Bureau, total new housing starts were 1.3% below 2018 levels for the corresponding nine month period.  Single family starts were 1.8% below 2018 levels for the corresponding nine-month period.

Various factors have caused our results of operations to fluctuate from period to period. These factors include levels of residential construction, the mix of single family and multi-family starts as a percentage of total residential construction, home improvement and remodeling activity, weather, prices of commodity wood and steel products, dumping duties, tariffs, interest rates, competitive pressures, availability of credit and other local, regional and national economic conditions. Many of these factors are cyclical or seasonal in nature. We anticipate that further fluctuations in operating results from period to period will continue in the future. Our results in the first and fourth quarters of each year are generally adversely affected by winter weather patterns in the Midwest, Northeast and Northwest, which typically result in seasonal decreases in levels of construction activity in these areas. As much of our overhead and expenses remain relatively fixed throughout the year, our operating profits tend to be lower during the first and fourth quarters.

We believe we have the product offerings, distribution channels, personnel, systems infrastructure and financial and competitive resources necessary for continued operations. Our future revenues, costs and profitability, however, are all likely to be influenced by a number of risks and uncertainties.

Strategic Initiatives

Our strategy is to increase shareholder value through the growth and diversification of our business.  To accomplish this, we have developed strategic initiatives that require investments in our infrastructure, our people and technology platform.  Our goals are to accelerate our growth and diversify our business, which we believe will improve operating leverage over the intermediate term.

To accelerate our growth and diversification, we have made strategic capital and operating investments to execute our product line expansion and market segment penetration organic growth initiatives.  The national expansion of our Huttig-Grip product line, which is sourced both domestically and internationally, expands the breadth and geographic coverage of our private label specialty building product lines.  Through our investments in automated, high-capacity, pre-finish door lines and segment-focused sales resources, further penetration of the home improvement, repair and remodel market diversifies our business to be less dependent on new home construction, reinforces our position as the largest, value-add door fabricator to the professional residential construction market in the country, and accelerates our growth in higher value, and higher gross margin products.

In addition to the above initiatives, we continue to invest in our organization to attract the best talent to achieve our goal of creating a top-performing, disciplined organization with talented, engaged, and empowered people.  We also continue to invest in our technology platform to achieve improved operating efficiencies in the functional areas of the business while delivering advanced customer interface technology to make Huttig the clear supplier of choice for the products we sell.

Critical Accounting Policies

We prepare our condensed consolidated financial statements in accordance with U.S. generally accepted accounting principles, which requires management to make estimates and assumptions. Management bases these estimates and assumptions on historical results and known trends as well as management forecasts. Actual results could differ from these estimates and assumptions and these differences may be material. For a discussion of our significant accounting policies and estimates, see our Annual Report on Form 10-K for the year ended December 31, 2018 in Part II, Item 7 - “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Critical Accounting Policies.” During the nine months ended September 30, 2019, there were no material changes to the critical accounting policies and estimates discussed in our Annual Report on Form 10-K for the year ended December 31, 2018.

Results of Operations

Three Months Ended September 30, 2019 Compared to Three Months Ended September 30, 2018

Net sales were $215.7 million in the third quarter of 2019, which was $6.3 million, or 2.8%, lower than the third quarter of 2018.  The decrease in net sales was primarily attributed to a modest softening in certain market segments we serve as well as a competitive pricing environment, particularly among commodity products.  During the third quarter of 2019, we continued to experience carryover effect of the temporary disruption which impacted sales subsequent to our major enterprise system upgrade during the second quarter.

Millwork product sales decreased 5.0% in the third quarter of 2019 to $99.6 million, compared to $104.8 million in the third quarter of 2018, building products sales increased 3.6% in the third quarter of 2019 to $100.4 million, compared to $96.9 million in the third quarter of 2018, and wood product sales decreased 22.7% in the third quarter of 2019 to $15.7 million, compared to $20.3 million in the third quarter of 2018. Millwork was the product category most impacted by the temporary disruption from our system upgrade.  The proportionate increase in sales of building products was generally consistent with our strategic growth initiatives.  Wood product

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sales were negatively impacted by underlying market segment softening in certain parts of the country, a competitive market and by commodity pricing.

Gross margin was $44.7 million in the third quarter of 2019, compared to $44.6 million in the third quarter of 2018. As a percentage of sales, gross margin was 20.7% in the third quarter of 2019, compared to 20.1% in the third quarter of 2018. Gross margin improvement was generally related to product mix as well as a concerted effort to focus on higher margin opportunities.

Operating expenses increased $0.3 million to $41.4 million in the third quarter of 2019, compared to $41.1 million in the third quarter of 2018.  Personnel costs decreased $0.3 million as lower compensation and contract labor costs were partially offset by higher medical expenses. Non-personnel costs increased $0.6 million for the quarter primarily due to maintenance costs and depreciation, including software depreciation from our recent enterprise resource planning system upgrade. Other decreases in non-personnel expenses were offset by higher rent from our operating facilities, including expansion efforts. As a percentage of sales, operating expenses were 19.2% in the third quarter of 2019 compared to 18.5% in 2018.

Net interest expense was $1.7 million in the third quarter of 2019 and $1.8 million in the third quarter of 2018 as the impact of lower average borrowing was offset by higher interest rates.

Income tax expense was zero for the quarter ended September 30, 2019, as compared to $0.5 million for the quarter ended September 30, 2018.

As a result of the foregoing factors, we reported income from continuing operations of $1.6 million for the quarter ended September 30, 2019, compared to income from continuing operations of $1.2 million for the quarter ended September 30, 2018.

Nine Months Ended September 30, 2019 Compared to Nine Months Ended September 30, 2018

Net sales were $631.6 million in the first nine months of 2019, which was $11.8 million, or 1.8%, lower than the first nine months of 2018.  The decrease in net sales was primarily attributed to a modest softening in the markets we serve.  We also completed a major enterprise resource planning system upgrade in the second quarter of 2019 which caused some temporary disruption and impacted our sales.  The disruption impacted sales for portions of our second and third quarters.

Millwork product sales decreased 3.0% in the first nine months of 2019 to $294.3 million, compared to $303.5 million in the first nine months of 2018, building products sales increased 2.7% in the first nine months of 2019 to $289.7 million, compared to $281.9 million in the first nine months of 2018, and wood product sales decreased 17.9% in the first nine months of 2019 to $47.6 million, compared to $58.0 million in the first nine months of 2018. Millwork was the product category most impacted by the temporary disruption from our system upgrade.  The proportionate increase in sales of building products was generally consistent with our strategic growth initiatives.  Wood product sales were negatively impacted by underlying market segment softening in certain parts of the country, a competitive market and by commodity pricing.

Gross margin was $126.4 million in the first nine months of 2019, compared to $128.3 million in the first nine months of 2018. As a percentage of sales, gross margin was 20.0% in the first nine months of 2019, compared to 19.9% in the first nine months of 2018. The gross margin percentage reflects the favorable impact from our focus on higher margin sales opportunities, partially offset by the change in product mix consistent with the disproportionate increase in the building products category.

Operating expenses decreased $1.2 million to $122.0 million in the first nine months of 2019, compared to $123.2 million in the first nine months of 2018.  Personnel costs decreased $0.7 million as lower wages and variable compensation costs were offset by a significant increase in medical costs, which were $1.6 million higher than in 2018, driven by higher claims. Non-personnel costs decreased $0.5 million in the first nine months of 2019 primarily due to non-recurring litigation and settlement costs of approximately $3.3 million in 2018, which were largely offset by increases in facility costs, including increases from expansion efforts, depreciation and amortization, including costs from our recent software upgrade, and higher maintenance costs. As a percentage of sales, operating expenses were 19.3% in 2019 compared to 19.1% in 2018. Adjusted for non-recurring litigation and settlement costs, our operating expenses were 18.6% in 2018.

Net interest expense was $5.2 million in the first nine months of 2019 compared to $4.6 million in the first nine months of 2018.  The increase was primarily due to higher average interest rates in the first nine months of 2019 compared to the first nine months of 2018.

Income tax expense was $11.1 million for the first nine months of 2019, as compared to an income tax benefit of $0.4 million for the first nine months of 2018. We recorded a tax charge of $11.8 million in 2019 related to an increase in our deferred tax asset valuation allowance.  The increase was required as realization of the net deferred asset no longer meets the more-likely-than-not criterion under US GAAP.  Most of the Company’s net deferred tax asset is comprised of federal tax loss carryforwards which will begin expiring in 2030.  The deferred tax valuation allowance is assessed each reporting period and the amount of net deferred tax assets considered realizable could be adjusted in future periods based on the Company’s financial performance.  The net operating loss carryforwards remain available to offset future taxable income.

As a result of the foregoing factors, we reported a loss from continuing operations of $11.9 million for the nine months ended September 30, 2019, compared to income from continuing operations of $0.9 million for the nine months ended September 30, 2018.

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Liquidity and Capital Resources

We depend on our cash flows from operations and funds available under our revolving credit facility to finance seasonal working capital needs, capital expenditures, additional investments in our product lines, including Huttig-Grip, and any acquisitions that we may undertake. Typically, our working capital requirements are greatest in the second and third quarters, which reflect the seasonal nature of our business. The second and third quarters also tend to be our strongest operating quarters, largely due to more favorable weather throughout many of our markets compared to the first and fourth quarters. We typically generate cash from working capital reductions in the fourth quarter of the year and build working capital during the second quarter in preparation for our second and third quarters. We also maintain significant inventories to meet the rapid delivery requirements of our customers and to enable us to obtain favorable pricing, delivery and service terms with our suppliers.

Throughout 2018, our working capital was significantly impacted by investments in inventory related to the national expansion of our Huttig-Grip product line. Sourcing Huttig-Grip products internationally requires longer lead-times and higher inventory levels to ensure available supply, and generally requires shorter payment terms to suppliers, but it also provides an opportunity for higher margins. We closely monitor operating expenses and inventory levels during seasonally affected periods and, to the extent possible, manage variable operating costs to minimize seasonal effects on our profitability.

At September 30, 2019, we had $43.6 million of excess committed borrowing availability and $2.9 million cash.

Operations.  Cash used in operating activities was $10.5 million during the first nine months of 2019, compared to cash used in operating activities of $57.1 million during the first nine months of 2018. Accounts receivable increased by $19.5 million during the first nine months of 2019, compared to an increase of $29.5 million in the prior-year corresponding period. The increase in accounts receivable over the first nine months of the year was a result of the normal seasonality of our business. Our inventory levels increased $8.7 million during the first nine months of 2019 largely driven by the normal seasonal build for increased sales activity. Inventory increased $41.8 million in the comparative prior-year period driven by normal seasonal build and by expansion of our Huttig-Grip product line.  These working capital increases were offset by an increase in accounts payable of $16.9 million and $13.7 million in 2019 and 2018, respectively, primarily as a result of our inventory build for the respective periods. The accounts payable increase relative to the increase in inventories in 2018 was impacted in part by shorter payment terms to suppliers on internationally-sourced Huttig-Grip products.

Investing.  During the first nine months of 2019, net cash used in investing activities was $1.2 million compared to $5.9 million for the corresponding period in 2018 and was largely used for replacement equipment at various distribution centers.

Financing.  Cash provided by financing activities of $13.8 million during the first nine months of 2019 reflected net borrowings of $13.9 million offset by $0.1 million for the repurchase of shares to satisfy employee tax withholdings on stock-based awards.  Cash provided by financing activities of $64.2 million in the first nine months of 2018 reflected net borrowings of $64.6 million offset by $0.4 million for the repurchase of shares to satisfy employee tax withholdings on stock-based awards. Net borrowings in 2018 were impacted by our Huttig-Grip inventory increase.

We believe cash generated from operations and funds available under the credit facility will provide sufficient funds to meet our operating needs for at least the next twelve months. At September 30, 2019, the minimum fixed charge coverage ratio (“FCCR”) was not required to be tested, as excess borrowing availability was greater than the minimum threshold. However, if our availability had fallen below that threshold, we would not have met the minimum FCCR. If we are unable to maintain excess borrowing availability of more than the applicable amount in the range of $17.5 million to $31.3 million and we do not meet the minimum FCCR, the lenders would have the right to terminate the loan commitments and accelerate the repayment of the entire amount outstanding under the credit facility. The lenders could also foreclose on our assets that secure the credit facility. If the credit facility was terminated, we would be forced to seek alternative sources of financing, which may not be available on terms acceptable to us, or at all.

Goodwill Analysis

We review goodwill annually for impairment, or more frequently if Company or market conditions indicate reporting units may be at risk of impairment.  Our last annual review was performed as of December 31, 2018 when our market capitalization was $48.4 million, which was below the carrying value of equity. At December 31, 2018, no indicators of impairment were identified.  As of September 30, 2019, our market capitalization was $55.7 million, which was 7.9% above the carrying value of equity, although during the quarter ended September 30, 2019 our market capitalization fell briefly below carrying value of equity.  

As of September 30, 2019, we concluded that it is more likely than not the implied fair value of goodwill remains in excess of its carrying value of $9.5 million.  Changes in our assumptions or forecasts, a reduction of economic activity in the markets in which we operate, or an erosion of our market capitalization may result in impairments in future periods.    

Contingencies

We carry insurance policies on insurable risks with coverage and other terms that we believe to be appropriate. We generally have self-insured retention limits and have obtained fully insured layers of coverage above such self-insured retention limits. Accruals for self-insurance losses are made based on claims experience. Liabilities for existing and unreported claims are accrued for when it is probable that future costs will be incurred and can be reasonably estimated.

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See Note 6 – “Contingencies” of the Notes to the Condensed Consolidated Financial Statements (unaudited) in Part I, Item 1 for information on legal proceedings in which we are involved.

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ITEM 3 – QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

There have been no material changes in market risk from the information provided in Part II, Item 7A – “Quantitative and Qualitative Disclosures About Market Risk” in our Annual Report on Form 10-K for the year ended December 31, 2018.

ITEM 4 — CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures – The Company, under the supervision and with the participation of our Disclosure Committee and management, including our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e)) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Based upon that evaluation, our Chief Executive officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of September 30, 2019 in all material respects to (a) cause information required to be disclosed by us in reports that we file or submit under the U.S. Securities and Exchange Commission’s rules and forms and (b) cause such information to be accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.

Control systems must reflect resource constraints and be cost-effective, can be undercut by simple errors and misjudgments, and can be circumvented by individuals within an organization. Because of these and other inherent limitations in all control systems, no matter how well they are designed, our disclosure controls and procedures and internal controls can provide reasonable, but not absolute, protection from error and fraud.

Management’s Report on Internal Control Over Financial Reporting – The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f). Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control-Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. Management’s assessment included an evaluation of the design of the Company’s internal control over financial reporting and testing of the operational effectiveness of its internal control over financial reporting. Management reviewed the results of its assessment with the Audit Committee of our Board of Directors. Based on our evaluation under the framework in Internal Control-Integrated Framework (2013), our management concluded that our internal control over financial reporting was effective as of September 30, 2019.

Changes in Internal Control of Financial Reporting – In conjunction with the adoption of ASC Topic 842, effective January 1, 2019, we implemented a lease accounting system and related processes and internal controls over financial reporting. There were no other changes that occurred during the quarter ended September 30, 2019, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II — OTHER INFORMATION

ITEM 1 — LEGAL PROCEEDINGS 

See Note 6 – “Contingencies” of the Notes to the Condensed Consolidated Financial Statements (unaudited) in Part I, Item 1 for information on legal proceedings in which the Company is involved. See also Note 9 – “Commitments and Contingencies” in the notes to our consolidated financial statements under Part II, Item 8 in the Company’s Annual Report on Form 10-K for the year ended December 31, 2018.

ITEM 1A — RISK FACTORS

In addition to the other information set forth in this report, you should carefully consider the factors discussed in Part I, Item 1A – “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2018, which could materially affect our business, financial condition, and future results. These described risks are not the only risks that we face. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition, and operating results. There have been no material changes to the risk factors set forth in our Annual Report on Form 10-K for the year ended December 31, 2018.

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ITEM 6 — EXHIBITS

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SIGNATURES

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

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