HUTTIG BUILDING PRODUCTS INC - Quarter Report: 2020 September (Form 10-Q)

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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, 2020

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:

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 October 26, 2020 was 26,889,191 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, 2019.

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, which may differ materially due to, among other things, the factors described in Part I, Item 2 of this Quarterly Report on Form 10-Q 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, 2019, as supplemented by Form 8-K filed on April 27, 2020, Part II, Item 1A – “Risk Factors” of the Quarterly Report on Form 10-Q for the quarter ended March 31, 2020, and Part II, Item 1A – “Risk Factors” of this Quarterly Report. 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, 2020, the Company adopted ASU 2016-13, “Measurement of Credit Losses on Financial Instruments.” ASU 2016-13 requires a financial asset (or a group of financial assets) measured at amortized cost basis to be assessed for impairment under the current expected credit loss model rather than an incurred loss model. The measurement of expected credit losses is based on relevant information about past events, including historical experience, current conditions and reasonable and supportable forecasts that affect the collectability of the reported amount.  The primary financial asset of the Company within the scope of ASU 2016-13 is trade receivables.  The adoption of ASU 2016-13 did not materially impact the Company's consolidated financial statements.

Recent accounting pronouncements pending adoption and not discussed above are either not applicable or will not have, or are not expected to have, a material impact on our consolidated financial condition, results of operations, or cash flows.

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 vary by customer, location, and the products purchased but are typical for the Company’s industry.

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.  Direct sales as a percentage of net sales were 16.0% and 15.5% in the three-month periods ended September 30, 2020 and 2019, respectively, and 18.6% and 19.1% in the nine-month periods ended September 30, 2020 and 2019, respectively.

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

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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, 2020, the weighted average remaining lease term for the Company’s operating leases was 5.1 years and for its financing leases was 3.1 years. These leases have weighted average discount rates of 6.2% 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):

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

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5. GOODWILL

Goodwill is reviewed for impairment annually, or more frequently if certain indicators arise. The Company assesses each reporting period whether events and circumstances warrant a revision to the previously established useful lives.

During the first quarter of 2020, a decline in the market value of the Company’s public equity concurrent with the COVID-19 pandemic triggered an assessment of goodwill. The fair value of each reporting unit was determined using a market approach to consider factors such as market capitalization of the Company at March 31, 2020, observed ratios of enterprise value to earnings and the relative sales contribution of each reporting unit. If a reporting unit’s carrying value exceeded its estimated fair value, an impairment was recorded for the amount in excess. As a result of the interim goodwill impairment test, the Company recognized a goodwill impairment charge of $9.5 million.  The following table summarizes goodwill activity for the nine-month periods ended September 30, 2020 and 2019 (in millions):

6. ALLOWANCE FOR DOUBTFUL ACCOUNTS

The allowance for doubtful accounts consisted of the following (in millions):

7. 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

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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.    

At September 30, 2020, the Company had revolving credit borrowings of $96.8 million outstanding at a weighted average interest rate of 1.73% per annum, letters of credit outstanding totaling $3.2 million, primarily used as collateral for health and workers’ compensation insurance, and $69.0 million of excess committed borrowing availability.  The Company pays an unused commitment fee of 0.25% per annum. In addition, the Company had $1.1 million of other obligations maturing in 2023 at a borrowing rate of 6.11%. The Company also had $3.7 million of financing lease obligations at September 30, 2020.  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 committed borrowing availability falls below an amount in the range of $17.5 million to $31.3 million, depending on the borrowing base. 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. 

While the Company believes its cash on hand, borrowing capacity available under the credit facility, and cash flows from operations for the next twelve months will be sufficient to service its liquidity needs, it cannot predict whether future developments associated with the COVID-19 pandemic will materially adversely affect its liquidity position. See Note 13, “Impact of and Company Response to the COVID-19 Pandemic” for additional disclosure regarding the potential impact the current pandemic may have on the Company’s future liquidity and financial position.

8. OTHER ACCRUED LIABILITIES

The Company had other accrued liabilities consisting of the following (in millions):

9. 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 $0.1 million in the first nine months of 2020 implementing the RAWP.  The Company estimates the total remaining cost of implementing the RAWP to be $2.8 million at September 30, 2020, with $1.1 million in short-term other accrued liabilities and $1.7 million in other non-current liabilities. As of September 30, 2020, 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

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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, 2020 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.  

With consent of the DEQ, remediation efforts and expenditures have been temporarily suspended during the current pandemic based on health, safety, financial and other considerations.  The Company is working with the DEQ to schedule further remediation as the circumstances of the COVID-19 pandemic allow.  See Note 13, “Impact of and Company Response to the COVID-19 Pandemic.”

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.

10. 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.

Earnings allocated to participating securities were inconsequential for all periods presented. The following table presents the number of participating 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):

11. 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, 2020 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, as of September 30, 2020, the Company maintained a valuation allowance of $19.7 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 a benefit of 0% and 0% in the three-month periods ended September 30, 2020 and 2019, respectively, and expense of 0% and 1388% in the nine-month periods ended September 30, 2020 and 2019, respectively.

In response to COVID-19, President Donald Trump signed into law the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”) on March 27, 2020. The CARES Act provides numerous tax provisions and other stimulus measures, including temporary changes regarding the prior and future utilization of net operating losses, temporary changes to the prior and future limitations on interest deductions, temporary suspension of certain payment requirements for the employer portion of Social Security taxes, technical corrections from prior tax legislation for tax depreciation of certain qualified improvement property, alternative

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minimum tax credit refunds, and the creation of certain refundable employee retention credits. The Company anticipates it may benefit in the future from the temporary five-year net operating loss carryback provisions, the technical correction for qualified leasehold improvements, which changes 39-year property to 15-year property, eligibility for 100% tax bonus depreciation, and potentially other provisions within the CARES Act. Where certain tax provisions of the CARES Act are determined to be applicable following the completion of the Company’s assessment, these may result in tax credits, refunds and income tax or other benefits which would be recorded in the Consolidated Statements of Operations in the period in which the benefit is incurred.

12. STOCK-BASED COMPENSATION

The Company recognized $0.4 million and $0.5 million in non-cash, stock-based compensation expense for the third quarter of 2020 and 2019, respectively, and $1.0 million and $1.6 million in non-cash, stock-based compensation expense for the nine-month periods ended September 30, 2020 and 2019, respectively.  During the first nine months of 2020, the Company granted an aggregate of 390,325 shares of restricted stock at a weighted average value of $1.40 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 2020, 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 $1.44 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, 2020 and 2019, the total compensation expense not yet recognized related to all outstanding restricted stock awards was $1.2 million and $2.6 million, respectively.

13. IMPACT OF AND COMPANY RESPONSE TO COVID-19

In March 2020, the World Health Organization recognized the novel strain of coronavirus, COVID-19, as a pandemic.  The United States, various other countries and state and local jurisdictions have imposed, among other things, travel and business operation restrictions intended to limit the spread of the COVID-19 virus and have advised or required individuals to adhere to social distancing or limit or forego their time outside of their home.  This pandemic and the governmental response have resulted in significant and widespread economic disruptions to, and uncertainty in, the global and U.S. economies, including in the regions in which the Company operates.  In many jurisdictions, the Company and its customers were deemed “essential businesses” and continued to operate, reducing the impact of these restrictions on its operations and results for the three and nine months ended September 30, 2020.  However, the Company’s management cannot reliably predict the future impact of the pandemic and the governmental response to the pandemic on the Company’s operations and future results.

With the exception of closing two branches as a part of the Company’s restructuring efforts (as discussed in Note 14, “Branch Closures and Related Costs”), all of the Company’s branches remain open and capable of meeting customer needs. The Company has taken protective measures to guard the health and well-being of its employees and customers, including the implementation of social distancing requirements and remote work options where possible. The Company has observed certain of its customers reducing purchases and operations due to the impact of COVID-19 and governmental restrictions. The pandemic has also had an adverse impact to the supply chain, with some of the Company’s vendors putting the Company on allocation as a result of reduced inventory and labor shortages resulting in longer lead-times for the fulfillment of certain products. The Company adjusted its sales forecast accordingly and previously took proactive measures to protect its operating liquidity, including communicating with vendors and customers, seeking modification of payment and other terms of rental and procurement agreements and monitoring its accounts receivable. The Company has also reduced inventory levels to meet an anticipated decrease in demand and has implemented cost containment measures, including closing two of its branches, lay-offs, wage reductions, suspension of matching contributions to its qualified defined contribution plan, and eliminated non-essential spend. Wages were reinstated for a majority of employees in October 2020. However, our higher salaried employees and senior management team continue to have reduced compensation. Additionally, the compensation paid to our Board of Directors continues at a reduced level. The Company has also delayed or cancelled certain planned non-essential capital expenditures. The Company has utilized its diverse overseas network to source alternative suppliers of its proprietary products, while simultaneously rationalizing its purchase volume to better align with its current sales projections and to manage the supply chain. The Company has also been proactively communicating with its lenders regarding potential modification to the terms of its credit facility should it be deemed necessary. While the Company believes these actions have mitigated the impact of the pandemic on its operations, it cannot provide any assurance that these actions will be successful if the pandemic continues to have a longer-term impact on the economy. As of September 30, 2020, the Company does not have any material outstanding deferred obligations to suppliers as deferred amounts have been substantially repaid.

14. BRANCH CLOSURES AND RELATED COSTS

During the second quarter of 2020, the Company announced the planned closure of its Columbus, OH and Selkirk, NY branches to improve operating results and gain operational efficiency through leverage of workforce, logistics and working capital. The Company recorded a $1.5 million pre-tax charge in the second quarter, which consisted of $0.7 million for estimated impairment of inventory and inventory transfer costs, $0.2 million of facility exit costs, $0.1 million for employee retention and extension of benefits, and $0.5 million for other branch closure costs. The facility closures were substantially completed by September 30, 2020 and are expected to be fully completed in the fourth quarter of 2020.

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The following table summarizes the restructuring activity during the three months ended September 30, 2020 (in thousands):

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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 following: the impact of global health concerns, including the current COVID-19 pandemic, and governmental responses to such concerns, on our business, results of operations, liquidity and capital resources; the success of our growth initiatives; the strength of new construction, home improvement and remodeling markets and the recovery of the homebuilding industry to levels consistent with the historical annual average total housing starts from 1959 to 2019 of approximately 1.4 million starts based on statistics tracked by the U.S. Census Bureau (“Historical Average”); the cyclical nature of our industry; our ability to comply with, and the restrictive effect of, the financial covenant applicable under our credit facility; risks of international suppliers; the ability to source alternative suppliers in light of the COVID-19 pandemic; product liability claims and other legal proceedings; commodity prices and demand in light of the COVID-19 pandemic; stock market volatility; failure to meet exchange listing requirements; stockholder activist disruption; current or future litigation; information technology failures, network disruptions, cybersecurity attacks or breaches in data security; termination of key supplier relationships; our failure to attract and retain key personnel; goodwill impairment; deterioration of our customers’ creditworthiness or our inability to forecast such deteriorations particularly in light of the COVID-19 pandemic; the loss of a significant customer; the cost of environmental compliance, including actual expenses we may incur to resolve proceedings we are involved in arising out of a formerly owned facility in Montana; competition with existing or new industry participants; 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; significant uninsured claims; the integration of any business we acquire and the liabilities of such businesses; the seasonality of our operations; federal and state transportation regulations; fuel cost increases; any limitations on our ability to utilize our deferred tax assets to reduce future taxable income and tax liabilities; risks associated with our private brands; uncertainties resulting from changes to United States and foreign laws, regulations and policies; the potential impact of changes in tariff costs, including tariffs on imported steel and aluminum, and potential anti-dumping or countervailing duties; 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, 2019, as supplemented by Form 8-K filed on April 27, 2020, Part II, Item 1A – “Risk Factors” of the Quarterly Report on Form 10-Q for the quarter ended March 31, 2020, and Part II, Item 1A – “Risk Factors” of this Quarterly Report. 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 25 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.

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

Industry Conditions

New housing activity has recently recovered to a pace nearing the historical annual average of 1.4 million total housing starts from 1959 to 2019 based on statistics tracked by the United States Census Bureau. Total housing starts were approximately 1.3 million in 2019. Through September 30, 2020, based on the most recent data provided by the United States Census Bureau, total new housing starts were 1.0 million, which was 5.5% higher than 2019 levels for the corresponding nine-month period.

In March 2020, the World Health Organization recognized the novel strain of coronavirus, COVID-19, as a pandemic. The United States, various other countries and state and local jurisdictions have imposed, among other things, travel and business operation restrictions intended to limit the spread of the COVID-19 virus and are advising or requiring individuals to adhere to social distancing or limit or forego their time outside of their home. This pandemic and the governmental response have resulted in significant and widespread economic disruptions to, and uncertainty in, the global and U.S. economy, including in the regions in which we operate. In many jurisdictions, we and our customers were deemed “essential businesses” and continued to operate, reducing the impact of these restrictions on our operations and results for the three- and nine-month periods ended September 30, 2020. However, we cannot reliably predict the future impact of the pandemic and the governmental response to the pandemic on our operations and future results.

With the exception of closing two branches as a part of our restructuring efforts (as discussed in Note 14, “Branch Closures and Related Costs”), all of our branches remain open and capable of meeting customer needs. We have taken protective measures to guard the health and well-being of our employees and customers, including the implementation of social distancing requirements and remote work options where possible. We have observed certain of our customers reducing purchases and operations due to the impact of COVID-19 and governmental restrictions. The pandemic has also had an adverse impact to the supply chain, with some of our vendors putting us on allocation as a result of reduced inventory and labor shortages, resulting in longer lead-times for the fulfillment of certain products. We adjusted our sales forecast accordingly and previously took proactive measures to protect our operating liquidity, including communicating with vendors and customers, seeking modification of payment and other terms of rental and procurement agreements and monitoring its accounts receivable.  We have also reduced inventory levels to meet an anticipated decrease in demand and have implemented cost containment measures, including closing two of our branches, lay-offs, wage reductions, suspension of matching contributions to our qualified defined contribution plan, and eliminating non-essential spend. Wages were reinstated for a majority of employees in October 2020. However, our higher salaried employees and senior management team continue to have reduced compensation. Additionally, the compensation paid to our Board of Directors continues at a reduced level. We have also delayed or cancelled certain planned non-essential capital expenditures.  We have utilized our diverse overseas network to source alternative suppliers of our proprietary products, while simultaneously rationalizing our purchase volume to better align with our current sales projections and to manage the supply chain. We have also been proactively communicating with our lenders regarding potential modification to the terms of our credit facility should it be deemed necessary.  While we believe these actions have mitigated the impact of the pandemic on our operations, we cannot provide any assurance that these actions will be successful if the pandemic continues to have a longer-term impact on the economy. As of September 30, 2020, we do not have any material outstanding deferred obligations to suppliers as deferred amounts have been substantially repaid.

Early in the pandemic we also communicated with lenders regarding potential modification of terms under our credit facility. Modification has not been deemed necessary based on our financial performance. However, we continue to proactively communicate with our lending partners in the normal course of business. If in the future, we fail to meet our borrowing covenants and are unable to maintain excess borrowing availability of more than the applicable required amount, our lenders would have the right to terminate the loan commitments and accelerate the repayment of the entire amount outstanding under the credit facility. Our lenders also could foreclose on our assets securing our credit facility. In that event, we would be forced to seek alternative sources of financing. Our ability to restructure our debt or refinance may depend on the condition of the financial markets and the availability of credit during the COVID-19 pandemic, which may result in credit being unavailable on terms acceptable to us or at all.

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While we believe these actions have mitigated the impact of the pandemic on our operations, we cannot provide any assurance that these actions will be successful if the pandemic continues to have a longer-term impact on the economy. As of September 30, 2020, we do not have any material outstanding deferred obligations to suppliers as deferred amounts have been substantially repaid.

Various other 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, all of which may be amplified by the COVID-19 pandemic. If the pandemic were to worsen or negatively impact our industry due to its duration, we are prepared to selectively re-activate or extend actions previously taken as part of our readiness and response plan. These actions may include deferral or cancelation of planned capital spending, negotiation of terms with vendors and customers, lay-offs and wage reductions, continuing suspension of matching contributions to our qualified defined contribution plan, further rationalization of inventories and reduction of other fixed and variable costs. We have communicated with our lenders regarding potential modification to terms of our credit facility should it be deemed necessary.

Early and aggressive actions taken to mitigate the impact of the pandemic coupled with a subsequent level of market stability have resulted in our improved financial performance. Management believes that certain actions taken with regard to working capital management and efficiency, as well as cost reduction activities, can be sustainable and provide leverage if the economy continues to improve. However, there remains a significant amount of uncertainty related to the continued impact the pandemic may have on our operating results.

Strategic Initiatives

Our strategy is to increase shareholder value through focused, profitable 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 profitable growth and diversify our business, which we believe will improve operating leverage over the intermediate term.  We have continued to make progress on our strategic initiatives, although our ability to continue advancing these initiatives has been, and may continue to be, impaired by present and future impacts of the COVID-19 pandemic on our operations.

To accelerate profitable 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.  We evaluate our strategic initiatives on a regular basis as part of our overall strategic planning process.

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, 2019 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, 2020, 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, 2019.

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Results of Operations

Three Months Ended September 30, 2020 Compared to Three Months Ended September 30, 2019

Although as anticipated, the impact of the COVID-19 pandemic negatively affected our net sales, our COVID-19 readiness and response plan has driven an overall improvement in our operating results relative to our initial pandemic forecasts.  

Net sales were $212.7 million in the third quarter of 2020, which were $3.0 million, or 1.4%, lower than the third quarter of 2019.  The decline was attributable to a number of factors, including pandemic-induced changes to the operating environment resulting in supply chain disruption, labor shortages, which have increased lead times to our customers for value-add production sales, and the acceleration of planned restructuring activities, including the closure of two branches in the third quarter of 2020. We also commenced a broader product rationalization project in the third quarter designed to strengthen our focus on core and strategic products. This plan, while initially resulting in lower sales as we forgo replenishment or promotion of these items, is expected to ultimately generate higher gross margins and higher sales of focused product categories. While some of our largest markets were significantly impacted early in the pandemic, third quarter activity has recovered to levels approaching prior year sales after posting a 12.1% year-over-year decline in the second quarter of 2020. Demand has improved as construction activity has rebounded.  

Due primarily to supply chain disruption and labor shortages, which lengthened lead times to our customers, millwork sales decreased 8.8% to $90.8 million in the third quarter, compared to $99.6 million in the comparable prior year period. Building products sales increased 5.7% in the third quarter of 2020 to $106.1 million, compared to $100.4 million in the third quarter of 2019 as sales benefitted from consistent high levels of demand for certain product lines within the category, including certain strategic product lines. The sales growth in this category was mitigated by product rationalization activities related to our objective of focusing on higher-margin, non-commoditized products. Wood product sales increased 0.6% in the third quarter of 2020 to $15.8 million, compared to $15.7 million in the third quarter of 2019.

Gross margin was $42.7 million in the third quarter of 2020, compared to $44.7 million in the third quarter of 2019. As a percentage of sales, gross margin was 20.1% in the third quarter of 2020, compared to 20.7% in the third quarter of 2019. Gross margins were negatively impacted by product sales mix as higher margin, value add categories were affected by supply chain disruption and labor shortages, which extended our lead times. Gross margins were also pressured by sales from branch closures and product rationalization activities as we reduced inventories at less than normal margins. While substantially complete, restructuring activities will continue through the fourth quarter. These initiatives, taken together, are expected to improve our overall margin performance.

Operating expenses decreased $5.6 million to $35.8 million in the third quarter of 2020, compared to $41.4 million in the third quarter of 2019.  Personnel costs decreased $3.0 million, or 12.4%, as a result of expense reduction actions taken in response to the COVID-19 pandemic, workforce reductions, wage reductions, suspension of our matching contributions under our employee benefit plan and restructuring activities. These cost reductions were partially offset by higher incentive compensation driven by improved operating results. Non-personnel costs decreased $2.6 million, or 15.1%. Operationally, travel, materials handling and other discretionary spending was curtailed, due in part to the pandemic, and fuel costs were lower due to lower volume and pricing. Additionally, bad debt and insurance charges were lower than the third quarter of 2019. As a percentage of sales, operating expenses were 16.8% in the third quarter of 2020 compared to 19.2% in the third quarter of 2019.

Net interest expense was $0.8 million in the third quarter of 2020 compared to $1.7 million in the third quarter of 2019.  The lower expense in the third quarter of 2020 reflects both lower average debt outstanding and lower interest rates.

Income taxes were zero for the quarters ended both September 30, 2020 and 2019.  

As a result of the foregoing factors, we reported net income of $6.1 million for the quarter ended September 30, 2020, compared to net income of $1.6 million for the quarter ended September 30, 2019.  

Nine Months Ended September 30, 2020 Compared to Nine Months Ended September 30, 2019

Net sales were $607.7 million in the first nine months of 2020, which were $23.9 million, or 3.8%, lower than the first nine months of 2019. The decline was attributable to a number of factors, including pandemic-induced changes to the operating environment, resulting in supply chain disruption, labor shortages, which have increased lead times to our customers for value-add production sales, and the acceleration of planned restructuring activities, including the closure of two branches in the third quarter of 2020. We also commenced a broader product rationalization project in the third quarter designed to strengthen our focus on core and strategic products. This plan, while initially resulting in lower sales as we forgo replenishment or promotion of these items, is expected to ultimately generate higher gross margins and higher sales of focused product categories. While some of our largest markets were significantly impacted early in the pandemic, by the end of the third quarter, activity has recovered to levels approaching prior year sales. Demand has improved as construction activity has rebounded.

Due primarily to supply chain disruption and labor shortages, which lengthened lead times to our customers, millwork sales decreased 8.7% to $268.7 million in the first nine months of 2020, compared to $294.3 million in the comparable prior year period. Building products sales increased 2.2% in the first nine months of 2020 to $296.1 million, compared to $289.7 million in the first nine months of 2019 as sales benefitted from consistent high levels of demand for certain product lines within the category, including certain strategic product lines. The sales growth in this category was mitigated in the third quarter by product rationalization activities related

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to our objective of focusing on higher-margin, non-commoditized products. Wood product sales decreased 9.9% in the first nine months of 2020 to $42.9 million, compared to $47.6 million in the first nine months of 2019.  

Gross margin was $122.3 million in the first nine months of 2020, compared to $126.4 million in the first nine months of 2019. As a percentage of sales, gross margin was 20.1% in the first nine months of 2020, compared to 20.0% in the first nine months of 2019.  The gross margin percentage reflects the favorable impact from our focus on higher margin sales opportunities, partially offset by sales product mix as higher margin categories were affected by supply chain disruption and labor shortages, which extended our lead times. Gross margins were impacted in the third quarter by sales from branch closures and product rationalization activities as we reduced inventories at less than normal margins. While substantially complete, restructuring activities will continue through the fourth quarter. These initiatives, taken together, are expected to improve our overall margin performance.

Operating expenses, excluding a restructuring charge of $1.5 million and goodwill impairment charge of $9.5 million, decreased $12.5 million to $109.5 million in the first nine months of 2020, compared to $122.0 million in the first nine months of 2019.  Personnel costs decreased $8.9 million as a result of expense reduction actions taken in response to the COVID-19 pandemic, including workforce reductions, wage reductions, suspension of Company matching contributions under an employee benefit plan and reduced medical claims.  Non-personnel costs decreased $3.6 million. Operationally, travel, materials handling and other discretionary spending was curtailed, due in part to the pandemic, and fuel costs were lower due to lower volume and price. Additionally, bad debt charges were lower than the first nine months of 2019.  These reductions were partially offset by an increase in worker’s compensation charges and other insurance costs. As a percentage of sales, operating expenses, net of restructuring, were 18.0% in the first nine months of 2020 compared to 19.3% in the first nine months of 2019.

During the first quarter of 2020, a decline in the market value of the Company’s public equity concurrent with, and caused in part by, the COVID-19 pandemic triggered an assessment of goodwill. As a result of the interim goodwill impairment test, the Company recognized a goodwill impairment charge of $9.5 million.

During the third quarter of 2020, we substantially completed the closure of our Columbus, Ohio and Selkirk, New York branch locations as part of our restructuring efforts. We expect the full closure to be completed in the fourth quarter of 2020. During the second quarter of 2020, we recorded a restructuring charge of $1.5 million for closure-related expenses for personnel, facility, equipment and working capital related costs.

Net interest expense was $3.0 million in the first nine months of 2020 compared to $5.2 million in the first nine months of 2019. The lower expense in the first nine months of 2020 reflected both lower average borrowing and lower interest rates.

Income taxes were zero for the first nine months of 2020, as compared to income tax expense of $11.1 million for the first nine months of 2019. In the nine months ended September 30, 2019, we recorded a tax charge of $11.8 million for an increase in our deferred tax asset valuation allowance.  The increase was required as realization of the net deferred asset was determined to no longer meet the more-likely-than-not criterion under U.S. 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 net loss of $1.2 million and $11.9 million for the nine months ended September 30, 2020 and 2019, respectively.  Adjusted for the $9.5 million goodwill impairment charge and the $1.5 million restructuring charge in 2020, and adjusted for the $11.8 million tax charge in 2019, year-to-date net income was $9.8 million in 2020 compared to a net loss of $0.1 million a year ago.

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, and any acquisitions that we may undertake. To the extent that our sales decline or our customers are unable to meet their obligations, including as a result of the current COVID-19 pandemic and global economic instability, our cash flows would be negatively affected.

Typically, our working capital requirements are greatest in the second and third quarters, which reflects 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. As part of our COVID-19 readiness and response plan, we significantly reduced our inventory levels in the second quarter of 2020. Reductions were made in anticipation of reduced sales demand which improved as the second and third quarters progressed. As a result, in the second and third quarters, we were able to generate cash from operations and reduce our indebtedness.

At September 30, 2020, we had $69.0 million of excess committed borrowing availability and $0.8 million cash.  We have reduced our senior indebtedness year-over-year at September 30, 2020 by $51.9 million.  However, the current COVID-19 pandemic could

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have a negative impact on our excess committed borrowing availability if sales and working capital levels decline and outstanding debt increases. Our liquidity assumptions and our ability to meet our credit facility covenants are dependent on many additional factors, including the “Risk Factors” set forth in Part I, Item 1A of the Form 10-K for the year ended December 31, 2019 as supplemented by Form 8-K filed on April 27, 2020, Part II, Item 1A – “Risk Factors” of the Quarterly Report on Form 10-Q for the quarter ended March 31, 2020, and Part II, Item 1A – “Risk Factors” of this Quarterly Report.