OPTICAL CABLE CORP - Quarter Report: 2018 April (Form 10-Q)

See accompanying condensed notes to condensed consolidated financial statements.

See accompanying condensed notes to condensed consolidated financial statements.

See accompanying condensed notes to condensed consolidated financial statements.

See accompanying condensed notes to condensed consolidated financial statements.

OPTICAL CABLE CORPORATION

Condensed Notes to Condensed Consolidated Financial Statements

Six Months Ended April 30, 2018

(Unaudited)

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Forward-Looking Information

This Form 10-Q may contain certain forward-looking information within the meaning of the federal securities laws. The forward-looking information may include, among other information, (i) statements concerning our outlook for the future, (ii) statements of belief, anticipation or expectation, (iii) future plans, strategies or anticipated events, and (iv) similar information and statements concerning matters that are not historical facts. Such forward-looking information is subject to known and unknown variables, uncertainties, contingencies and risks that may cause actual events or results to differ materially from our expectations. Such known and unknown variables, uncertainties, contingencies and risks (collectively, “factors”) may also adversely affect Optical Cable Corporation and its subsidiaries (collectively, the “Company” or “OCC^®”), the Company’s future results of operations and future financial condition, and/or the future equity value of the Company. Factors that could cause or contribute to such differences from our expectations or that could adversely affect the Company include, but are not limited to: the level of sales to key customers, including distributors; timing of certain projects and purchases by key customers; the economic conditions affecting network service providers; corporate and/or government spending on information technology; actions by competitors; fluctuations in the price of raw materials (including optical fiber, copper, gold and other precious metals, plastics and other materials); fluctuations in transportation costs; our dependence on customized equipment for the manufacture of certain of our products in certain production facilities; our ability to protect our proprietary manufacturing technology; market conditions influencing prices or pricing in one or more of the markets in which we participate, including the impact of increased competition; our dependence on a limited number of suppliers; the loss of or conflict with one or more key suppliers or customers; an adverse outcome in litigation, claims and other actions, and potential litigation, claims and other actions against us; an adverse outcome in regulatory reviews and audits and potential regulatory reviews and audits; adverse changes in state tax laws and/or positions taken by state taxing authorities affecting us; technological changes and introductions of new competing products; changes in end-user preferences for competing technologies relative to our product offering; economic conditions that affect the telecommunications sector, the data communications sector, certain technology sectors and/or certain industry market sectors (for example, mining, oil & gas, military and wireless carrier industry market sectors); economic conditions that affect U.S. based manufacturers; economic conditions or changes in relative currency strengths (for example, the strengthening of the U.S. dollar relative to certain foreign currencies) that affect certain geographic markets, the relative costs of U.S. products exported, and/or the economy as a whole; changes in demand for our products from certain competitors for which we provide private label connectivity products; changes in the mix of products sold during any given period (due to, among other things, seasonality or strength or weaknesses in particular markets in which we participate) which may impact gross profits and gross profit margins or net sales; variations in orders and production volumes of hybrid cables (fiber and copper) with high copper content, which tend to have lower gross profit margins; significant variations in sales resulting from high volatility, timing of large sales orders, and high sales concentration among a limited number of customers in certain markets, particularly the wireless carrier market; terrorist attacks or acts of war, and any current or potential future military conflicts; changes in the level of military spending or other spending by the United States government, including, but not limited to reductions in government spending due to automatic budget cuts or sequestration; ability to recruit and retain key personnel; poor labor relations; the impact of cybersecurity risks and incidents, and the related actual or potential costs and consequences, in compliance with the federal securities laws; the impact of upcoming data privacy laws and the General Data Protection Regulation and the related actual or potential costs and consequences; the impact of changes in accounting policies and related costs of compliance, including changes by the Securities and Exchange Commission (“SEC”), the Public Company Accounting Oversight Board (“PCAOB”), the Financial Accounting Standards Board (“FASB”), and/or the International Accounting Standards Board (“IASB”); our ability to continue to successfully comply with, and the cost of compliance with, the provisions of Section 404 of the Sarbanes-Oxley Act of 2002 or any revisions to that act which apply to us; the impact of changes and potential changes in federal laws and regulations adversely affecting our business and/or which result in increases in our direct and indirect costs, including our direct and indirect costs of compliance with such laws and regulations; the impact of the Patient Protection and Affordable Care Act of 2010, the Health Care and Education Reconciliation Act of 2010, and any revisions to those acts that apply to us and the related legislation and regulation associated with those acts, which directly or indirectly result in increases to our costs; the impact of changes in state or federal tax laws and regulations increasing our costs and/or impacting the net return to investors owning our shares; any changes in the status of our compliance with financial debt covenants with our lender; our ability to maintain and/or secure debt financing and/or equity financing to adequately finance our ongoing operations; the impact of future consolidation among competitors and/or among customers adversely affecting our position with our customers and/or our market position; actions by customers adversely affecting us in reaction to the expansion of our product offering in any manner, including, but not limited to, by offering products that compete with our customers, and/or by entering into alliances with, making investments in or with, and/or acquiring parties that compete with and/or have conflicts with our customers; voluntary or involuntary delisting of the Company’s common stock from any exchange on which it is traded; the deregistration by the Company from SEC reporting requirements, as a result of the small number of holders of the Company’s common stock; a continued suspension of dividends declared to shareholders due to inadequate or alternative uses of cash on hand; adverse reactions by customers, vendors or other service providers to unsolicited proposals regarding the ownership or management of the Company; the additional costs of considering, responding to and possibly defending our position on unsolicited proposals regarding the ownership or management of the Company; impact of weather or natural disasters in the areas of the world in which we operate, market our products and/or acquire raw materials; an increase in the number of shares of the Company’s common stock issued and outstanding; further economic downturns generally and/or in one or more of the markets in which we operate; changes in market demand, exchange rates, productivity, market dynamics, market confidence, macroeconomic and/or other economic conditions in the areas of the world in which we operate and market our products; and our success in managing the risks involved in the foregoing.

We caution readers that the foregoing list of important factors is not exclusive. Furthermore, we incorporate by reference those factors included in current reports on Form 8-K, and/or in our other filings.

Dollar amounts presented in the following discussion have been rounded to the nearest hundred thousand, except in the case of amounts less than one million and except in the case of the table set forth in the “Results of Operations” section, the amounts in which both cases have been rounded to the nearest thousand.

Overview of Optical Cable Corporation

Optical Cable Corporation (or OCC^®) is a leading manufacturer of a broad range of fiber optic and copper data communication cabling and connectivity solutions primarily for the enterprise market and various harsh environment and specialty markets (the non-carrier markets), offering integrated suites of high quality products which operate as a system solution or seamlessly integrate with other providers’ offerings. Our product offerings include designs for uses ranging from enterprise network, datacenter, residential and campus installations to customized products for specialty applications and harsh environments, including military, industrial, mining, petrochemical and broadcast applications, and for the wireless carrier market. Our products include fiber optic and copper cabling, fiber optic and copper connectors, specialty fiber optic and copper connectors, fiber optic and copper patch cords, pre-terminated fiber optic and copper cable assemblies, racks, cabinets, datacom enclosures, patch panels, face plates, multi-media boxes, fiber optic reels and accessories and other cable and connectivity management accessories, and are designed to meet the most demanding needs of end-users, delivering a high degree of reliability and outstanding performance characteristics.

OCC^® is internationally recognized for pioneering the design and production of fiber optic cables for the most demanding military field applications, as well as of fiber optic cables suitable for both indoor and outdoor use, and creating a broad product offering built on the evolution of these fundamental technologies. OCC is also internationally recognized for pioneering the development of innovative copper connectivity technology and designs used to meet industry copper connectivity data communications standards.

Founded in 1983, Optical Cable Corporation is headquartered in Roanoke, Virginia with offices, manufacturing and warehouse facilities located in Roanoke, Virginia, near Asheville, North Carolina and near Dallas, Texas. We primarily manufacture our fiber optic cables at our Roanoke facility, which is ISO 9001:2015 registered and MIL-STD-790G certified, primarily manufacture our enterprise connectivity products at our Asheville facility, which is ISO 9001:2015 registered, and primarily manufacture our harsh environment and specialty connectivity products at our Dallas facility which is ISO 9001:2008 registered and MIL-STD-790G certified.

OCC designs, develops and manufactures fiber optic cables for a broad range of enterprise, harsh environment and specialty markets and applications. We refer to these products as our fiber optic cable offering. OCC designs, develops and manufactures fiber and copper connectivity products for the enterprise market, including a broad range of enterprise and residential applications. We refer to these products as our enterprise connectivity product offering. OCC designs, develops and manufactures a broad range of specialty fiber optic connectors and connectivity solutions principally for use in military, harsh environment and other specialty applications. We refer to these products as our harsh environment and specialty connectivity product offering.

We market and sell the products manufactured at our Dallas facility through our wholly owned subsidiary Applied Optical Systems, Inc. (“AOS”) under the names Optical Cable Corporation and OCC^® by the efforts of our integrated OCC sales team.

The OCC team seeks to provide top-tier communication solutions by bundling all of our fiber optic and copper data communication product offerings into systems that are best suited for individual data communication needs and application requirements of our customers and the end-users of our systems.

OCC’s wholly owned subsidiary Centric Solutions LLC (“Centric Solutions”) provides cabling and connectivity solutions for the datacenter market. Centric Solutions’ business is located at OCC’s facility near Dallas, Texas.

Optical Cable Corporation, OCC^®, Procyon^®, Procyon Blade^™, Superior Modular Products^™, SMP Data Communications^™, Applied Optical Systems^™, Centric Solutions^™ and associated logos are trademarks of Optical Cable Corporation.

Summary of Company Performance for Second Quarter of Fiscal Year 2018

Results of Operations

We sell our products internationally and domestically to our customers, which include major distributors, various regional and smaller distributors, original equipment manufacturers and value-added resellers. All of our sales to customers outside of the United States are denominated in U.S. dollars. We can experience fluctuations in the percentage of net sales to customers outside of the United States and in the United States from period to period based on the timing of large orders, coupled with the impact of increases and decreases in sales to customers in various regions of the world. Sales outside of the U.S. can also be impacted by fluctuations in the exchange rate of the U.S. dollar compared to other currencies.

Net sales consist of gross sales of products by the Company and its subsidiaries on a consolidated basis less discounts, refunds and returns. Revenue is recognized at the time of product shipment or delivery to the customer (including distributors) provided that the customer takes ownership and assumes risk of loss (based on shipping terms), collection of the relevant receivable is probable, persuasive evidence of an arrangement exists and the sales price is fixed or determinable. Our customers generally do not have the right of return unless a product is defective or damaged and is within the parameters of the product warranty in effect for the sale.

Cost of goods sold consists of the cost of materials, product warranty costs and compensation costs, and overhead and other costs related to our manufacturing operations. The largest percentage of costs included in cost of goods sold is attributable to costs of materials.

Our gross profit margin percentages are heavily dependent upon product mix on a quarterly basis and may vary based on changes in product mix. To the extent not negatively impacted by product mix, gross profit margins tend to be higher when we achieve higher net sales levels, as certain fixed manufacturing costs are spread over higher sales. Hybrid cables (fiber and copper) with higher copper content tend to have lower gross profit margins.

Selling, general and administrative expenses (“SG&A expenses”) consist of the compensation costs for sales and marketing personnel, shipping costs, trade show expenses, customer support expenses, travel expenses, advertising, bad debt expense, the compensation costs for administration and management personnel, legal, accounting, advisory and professional fees, costs incurred to settle litigation or claims and other actions against us, and other costs associated with our operations.

Royalty income (expense), net consists of royalty income earned on licenses associated with our patented products, net of royalty and related expenses.

Amortization of intangible assets consists of the amortization of the costs, including legal fees, associated with internally developed patents that have been granted. Amortization of intangible assets is calculated using the straight-line method over the estimated useful lives of the intangible assets.

Other income (expense), net consists of interest expense and other miscellaneous income and expense items not directly attributable to our operations.

The following table sets forth and highlights fluctuations in selected line items from our condensed consolidated statements of operations for the periods indicated:

Three Months Ended April 30, 2018 and 2017

Net Sales

Consolidated net sales for the second quarter of fiscal year 2018 increased 69.7% to $26.9 million, the highest quarterly net sales in the Company’s history, compared to net sales of $15.8 million for the same period last year. We experienced an increase in net sales in our specialty markets in the second quarter of fiscal year 2018 compared to the same period last year, particularly in our wireless carrier and military markets. This increase in the specialty markets was partially offset by a decrease in net sales in our enterprise markets.

Net sales to customers in the United States increased 88.0% in the second quarter of fiscal year 2018, compared to the same period last year. Net sales to customers outside of the United States decreased 4.3% compared to the same period last year.

During our second fiscal quarter of 2018, we experienced an increase in our sales order backlog/forward load—particularly for our fiber optic cable products. Generally, OCC’s consolidated sales order backlog/forward load varies throughout the year between approximately 3 to 4 weeks of net sales, or approximately $4 million to $5 million. As of April 30, 2018, our sales order backlog/forward load was $11.8 million, or approximately 7 to 8 weeks of net sales (on a trailing 12 month basis). By comparison, our sales order backlog/forward load was $14.8 million, or approximately 11 to 12 weeks of net sales (on a trailing 12 month basis) as of January 31, 2018 (the end of our first quarter of fiscal year 2018), and $19.0 million, or approximately 14 to 15 weeks of net sales (on a trailing 12 month basis) as of the end of February 2018.

OCC’s increase in net sales during the second quarter of fiscal year 2018 and backlog/forward load have been driven by significant orders from one customer with whom OCC has done business for a number of years.

As a result of our sales order backlog/forward load at the end of the second quarter of fiscal year 2018, at this time, we believe it is likely we will see a positive impact on net sales during the third quarter of fiscal year 2018, compared to the same period last year. However, we expect net sales during the third quarter to be less than net sales during the second quarter of fiscal year 2018.

Gross Profit

Our gross profit was $9.0 million in the second quarter of fiscal year 2018, an increase of 58.2% compared to gross profit of $5.7 million in the second quarter of fiscal year 2017. Gross profit margin, or gross profit as a percentage of net sales, was 33.3% in the second quarter of fiscal year 2018 compared to 35.7% in the second quarter of fiscal year 2017.

Our gross profit margin percentages are heavily dependent upon product mix on a quarterly basis. Gross profit margin in the second quarter of fiscal year 2018 was negatively impacted by a shift in product mix toward the sale of certain lower margin products in the second quarter of fiscal year 2018 compared to the second quarter of fiscal year 2017. However, the significant increase in net sales levels during the second quarter of fiscal year 2018 for our fiber optic cable products helped to offset the impact of the decrease in gross profit margin on gross profit, as certain fixed manufacturing costs were spread over higher sales.

Selling, General, and Administrative Expenses

SG&A expenses increased 25.5% to $7.4 million during the second quarter of fiscal year 2018, compared to $5.9 million for the same period last year. SG&A expenses as a percentage of net sales were 27.5% in the second quarter of fiscal year 2018, compared to 37.2% in the second quarter of fiscal year 2017.

The increase in SG&A expenses during the second quarter of fiscal year 2018 compared to the same period last year was primarily the result of increases in employee related costs totaling $1.4 million. Included in employee related costs are employee incentives and commissions which increased due to increased net sales and the improved financial results during the second quarter of fiscal year 2018.

Royalty Income (Expense), Net

We recognized royalty income, net of royalty and related expenses, totaling $12,000 during the second quarter of fiscal year 2018 compared to royalty expense, net of royalty income, totaling $39,000 during the second quarter of fiscal year 2017. The change when comparing the second quarter of fiscal year 2018 to the same period last year is due to the expiration of a patent in the fourth quarter of fiscal year 2017 that was previously licensed by OCC from a third party for product sold by OCC. We expect the trend of royalty income to offset royalty expense to continue in fiscal year 2018.

Amortization of Intangible Assets

We recognized $9,000 of amortization expense, associated with intangible assets, during the second quarter of fiscal year 2018, compared to $6,000 during the second quarter of fiscal year 2017.

Other Income (Expense), Net

We recognized other expense, net in the second quarter of fiscal year 2018 of $152,000 compared to other income, net of $49,000 in the second quarter of fiscal year 2017. Other expense, net for the second quarter of fiscal year 2018 was comprised primarily of interest expense together with other miscellaneous items which may fluctuate from period to period. Other income, net during the second quarter of fiscal year 2017 was comprised of the reversal of amounts previously accrued of approximately $171,000, resulting from the favorable settlement of certain legal matters, partially offset by interest expense and other miscellaneous items.

Income (loss) Before Income Taxes

We reported income before income taxes of $1.4 million for the second quarter of fiscal year 2018, compared to a loss before income taxes of $231,000 for the second quarter of fiscal year 2017. The change was primarily due to the increase in gross profit of $3.3 million, partially offset by the increase in SG&A expenses of $1.5 million, compared to the same period in 2017.

Income Tax Expense (Benefit)

Income tax expense totaled $16,000 in the second quarter of fiscal year 2018, compared to $8,000 for the same period in fiscal year 2017. Our effective tax rate for the second quarter of fiscal year 2018 was 1.1% compared to negative 3.4% for the second quarter of fiscal year 2017.

Fluctuations in our effective tax rates are primarily due to permanent differences in U.S. GAAP and tax accounting for various tax deductions and benefits, but can also be significantly different from the statutory tax rate when income or loss before taxes is at a level such that permanent differences in U.S. GAAP and tax accounting treatment have a disproportional impact on the projected effective tax rate.

During fiscal year 2015, we established a valuation allowance against all of our net deferred tax assets. As a result of establishing a full valuation allowance against our net deferred tax assets, if we generate sufficient taxable income in subsequent periods to realize a portion or all of our net deferred tax assets, our effective income tax rate could be unusually low due to the tax benefit attributable to the necessary decrease in our valuation allowance. Further, if we generate losses before taxes in subsequent periods, our effective income tax rate could also be unusually low as any increase in our net deferred tax asset from such a net operating loss for tax purposes would be offset by a corresponding increase to our valuation allowance against our net deferred tax assets.

If we generate sufficient income before taxes in subsequent periods such that U.S. GAAP would permit us to conclude that the removal of any valuation allowance against our net deferred tax asset is appropriate, then during the period in which such determination is made, we will recognize the non-cash benefit of such removal of the valuation allowance in income tax expense on our consolidated statement of operations, which will increase net income and will also increase the net deferred tax asset on our consolidated balance sheet. If we do not generate sufficient income before taxes in subsequent periods such that U.S. GAAP would permit us to conclude that the reduction or removal of any valuation allowance against our net deferred tax asset is appropriate, then no such non-cash benefit would be realized. There can be no assurance regarding any future realization of the benefit by us of all or part of our net deferred tax assets.

The Tax Cuts and Jobs Act (the “Tax Act”), enacted on December 22, 2017, lowers the statutory federal corporate income tax rate from 35% to 21%. The reduction of the statutory federal corporate tax rate to 21% became effective on January 1, 2018. Because our fiscal year 2018 commenced on November 1, 2017, the annual statutory federal corporate tax rate applicable to fiscal year 2018 is a blended rate of 23.2%. Beginning in our 2019 fiscal year, the annual statutory federal corporate tax rate will be 21%. As a result of the reduction in the federal corporate tax rate, we remeasured our net deferred tax assets and the corresponding valuation allowance in the period that includes the enactment date of the Tax Act, resulting in a reduction of $1.3 million in both our net deferred tax assets and the corresponding valuation allowance. The use of a blended rate may result in further adjustment to the remeasurement of the net deferred tax assets and the corresponding valuation allowance in the fourth quarter of fiscal year 2018, when the annual results are finalized and the annual change in gross temporary differences are determined. Because we decreased both our net deferred tax assets and our valuation allowance by the same amount, there was no impact on our results of operations from the remeasurement. Any future benefit we may realize from our net deferred tax assets is effectively reduced by $1.3 million, adjusted for any changes that may be recorded in the fourth quarter of fiscal year 2018, as a result of the remeasurement.

As of October 31, 2017, prior to the enactment of the Tax Act, our valuation allowance totaled $3.6 million, completely offsetting our net deferred tax assets.

Net Income (Loss)

Net income for the second quarter of fiscal year 2018 was $1.4 million compared to a net loss of $239,000 for the second quarter of fiscal year 2017. This change was primarily due to the increase in income before income taxes of $1.6 million.

Six Months Ended April 30, 2018 and 2017

Net Sales

Consolidated net sales for the first half of fiscal year 2018 increased 45.9% to $44.4 million compared to net sales of $30.5 million for the same period last year. We experienced an increase in net sales in our specialty markets in the first half of fiscal year 2018 compared to the same period last year, particularly in our wireless carrier and military markets, but this increase was partially offset by a decrease in net sales in our enterprise market. Net sales to customers in the United States increased 53.9% in the first half of fiscal year 2018 compared to the same period last year, and net sales to customers outside of the United States increased 12.9%.

OCC’s increase in net sales during the first half of fiscal year 2018 and backlog/forward load have been driven by significant orders from one customer with whom OCC has done business for a number of years.

Gross Profit

Our gross profit was $14.2 million in the first half of fiscal year 2018, an increase of 35.4% compared to gross profit of $10.5 million in the first half of fiscal year 2017. Gross profit margin, or gross profit as a percentage of net sales, was 31.9% in the first half of fiscal year 2018 compared to 34.4% in the first half of fiscal year 2017.

Our gross profit margin percentages are heavily dependent upon product mix on a quarterly basis. Gross profit margin in the first half of fiscal year 2018 was negatively impacted by a shift in product mix toward the sale of certain lower margin products in the first half of fiscal year 2018 compared to the first half of fiscal year 2017. However, the significant increase in net sales levels during the first half of fiscal year 2018 for our fiber optic cable products helped to offset the impact of the decrease in gross profit margin on gross profit, as certain fixed manufacturing costs were spread over higher sales.

Selling, General, and Administrative Expenses

SG&A expenses increased 16.8% to $13.0 million for the first half of fiscal year 2018 from $11.1 million for the same period last year. SG&A expenses as a percentage of net sales were 29.2% in the first half of fiscal year 2018 compared to 36.4% in the first half of fiscal year 2017.

The increase in SG&A expenses during the first half of fiscal year 2018 compared to the same period last year was primarily the result of increases in employee related costs totaling $1.8 million. Included in employee related costs are employee incentives and commissions which increased due to increased net sales and the improved financial results during the first half of fiscal year 2018.

Royalty Income (Expense), Net

We recognized royalty income, net of royalty and related expenses, totaling $17,000 during the first half of fiscal year 2018, compared to royalty expense, net of royalty income totaling $70,000 during the same period last year. The change when comparing the first half of fiscal year 2018 to the same period last year is due to the expiration of a patent in the fourth quarter of fiscal year 2017 that was previously licensed by OCC from a third party for product sold by OCC. We expect the trend of royalty income to offset royalty expense to continue in fiscal year 2018.

Amortization of Intangible Assets

We recognized $16,000 of amortization expense, associated with intangible assets, for the first half of fiscal year 2018, compared to amortization expense of $12,000 during the first half of fiscal year 2017.

Other Expense, Net

We recognized other expense, net in the first half of fiscal year 2018 of $271,000 compared to $168,000 in the first half of fiscal year 2017. Other expense, net in the first half of fiscal year 2018 was comprised of interest expense together with other miscellaneous items. Other expense, net in the first half of fiscal year 2017 was comprised of interest expense and other miscellaneous items, partially offset by income of approximately $171,000, resulting from the reversal of amounts previously accrued upon the favorable settlement of certain legal matters.

Income (Loss) Before Income Taxes

We reported income before income taxes of $957,000 for the first half of fiscal year 2018 compared to loss before income taxes of $868,000 for the first half of fiscal year 2017. This change was primarily due to the increase in gross profit of $3.7 million, partially offset by the increase in SG&A expenses of $1.9 million in the first half of fiscal year 2018, compared to the same period in 2017.

Income Tax Benefit

Income tax benefit totaled $24,000 in the first half of fiscal year 2018 compared to $13,000 for the same period in fiscal year 2017. Our effective tax rate for the first half of fiscal year 2018 was negative 2.5% compared to 1.5% for the first half of fiscal year 2017.

Fluctuations in our effective tax rates are primarily due to permanent differences in U.S. GAAP and tax accounting for various tax deductions and benefits, but can also be significantly different from the statutory tax rate when income or loss before taxes is at a level such that permanent differences in U.S. GAAP and tax accounting treatment have a disproportional impact on the projected effective tax rate.

During fiscal year 2015, we established a valuation allowance against all of our net deferred tax assets. As a result of establishing a full valuation allowance against our net deferred tax assets, if we generate sufficient taxable income in subsequent periods to realize a portion or all of our net deferred tax assets, our effective income tax rate could be unusually low due to the tax benefit attributable to the necessary decrease in our valuation allowance. Further, if we generate losses before taxes in subsequent periods, our effective income tax rate could also be unusually low, as any increase in our net deferred tax asset from such a net operating loss for tax purposes would be offset by a corresponding increase to our valuation allowance against our net deferred tax assets.

If we generate sufficient income before taxes in subsequent periods such that U.S. GAAP would permit us to conclude that the removal of any valuation allowance against our net deferred tax asset is appropriate, then during the period in which such determination is made, we will recognize the non-cash benefit of such removal of the valuation allowance in income tax expense on our consolidated statement of operations, which will increase net income and will also increase the net deferred tax asset on our consolidated balance sheet. If we do not generate sufficient income before taxes in subsequent periods such that U.S. GAAP would permit us to conclude that the reduction or removal of any valuation allowance against our net deferred tax asset is appropriate, then no such non-cash benefit would be realized. There can be no assurance regarding any future realization of the benefit by us of all or part of our net deferred tax assets.

The Tax Cuts and Jobs Act (the “Tax Act”), enacted on December 22, 2017, lowers the statutory federal corporate income tax rate from 35% to 21%. The reduction of the statutory federal corporate tax rate to 21% became effective on January 1, 2018. Because our fiscal year 2018 commenced on November 1, 2017, the annual statutory federal corporate tax rate applicable to fiscal year 2018 is a blended rate of 23.2%. Beginning in our 2019 fiscal year, the annual statutory federal corporate tax rate will be 21%. As a result of the reduction in the federal corporate tax rate, we remeasured our net deferred tax assets and the corresponding valuation allowance in the period that includes the enactment date of the Tax Act, resulting in a reduction of $1.3 million in both our net deferred tax assets and the corresponding valuation allowance. The use of a blended rate may result in further adjustment to the remeasurement of the net deferred tax assets and the corresponding valuation allowance in the fourth quarter of fiscal year 2018, when the annual results are finalized and the annual change in gross temporary differences are determined. Because we decreased both our net deferred tax assets and our valuation allowance by the same amount, there was no impact on our results of operations from the remeasurement. Any future benefit we may realize from our net deferred tax assets is effectively reduced by $1.3 million, adjusted for any changes that may be recorded in the fourth quarter of fiscal year 2018, as a result of the remeasurement.

As of October 31, 2017, prior to the enactment of the Tax Act, our valuation allowance totaled $3.6 million, completely offsetting our net deferred tax assets.

Net Income (Loss)

Net income for the first half of fiscal year 2017 was $981,000 compared to a net loss of $855,000 for the first half of fiscal year 2017. This change was due primarily to the increase in income before income taxes of $1.8 million in the first half of fiscal year 2018, compared to the same period in fiscal year 2017.

Financial Condition

Total assets increased $12.9 million, or 32.1%, to $53.0 million at April 30, 2018, from $40.1 million at October 31, 2017. This increase was primarily due to an $11.7 million increase in trade accounts receivable, net and a $2.0 million increase in inventories. The increase in trade accounts receivable, net largely resulted from the increase in net sales in the second quarter of fiscal year 2018 when compared to the fourth quarter of fiscal year 2017. At April 30, 2018, 61.2% of our trade accounts receivable is from one customer; however, we believe that credit risks as of April 30, 2018 have been adequately provided for in the condensed consolidated financial statements. Inventories increased as the result of the timing of certain raw material purchases and increases in work in process levels related to pending shipments.

Total liabilities increased $11.4 million, or 69.0%, to $27.8 million at April 30, 2018, from $16.4 million at October 31, 2017. The increase in total liabilities was primarily due to an increase in accounts payable and accrued expenses, including accrued compensation and payroll taxes, totaling $8.5 million, primarily resulting from purchases of raw materials in preparation for the manufacture and shipment of orders in the second and third quarters of fiscal year 2018 and the timing of certain vendor and payroll related payments. Also contributing to the increase in total liabilities was the increase in note payable to bank-noncurrent totaling $1.3 million and the increase in note payable to bank-current totaling $1.7 million due to borrowings on our new special project revolving credit note. Our additional borrowing needs during the first half of fiscal year 2018 are a result of significant orders placed by one customer requiring completion within a short timeframe.

Total shareholders’ equity at April 30, 2018 increased $1.5 million in the first half of fiscal year 2018. The increase resulted primarily from net income of $981,000 and share-based compensation, net of $538,000.

Liquidity and Capital Resources

Our primary capital needs during the first half of fiscal year 2018 have been to fund working capital requirements and to make principal payments on long-term debt. Our primary source of capital for these purposes has been existing cash, borrowings under our revolving credit facilities and cash provided by operations.

Our cash totaled $278,000 as of April 30, 2018, a decrease of $613,000, compared to $891,000 as of October 31, 2017. The decrease in cash for the six months ended April 30, 2018 primarily resulted from net cash used in operating activities of $3.0 million, partially offset by cash provided by financing activities of $2.7 million.

On April 30, 2018, we had working capital of $25.9 million compared to $22.9 million on October 31, 2017. The ratio of current assets to current liabilities as of April 30, 2018 was 2.8 to 1 compared to 6.5 to 1 as of October 31, 2017. The increase in working capital was primarily due to the $11.7 million increase in trade accounts receivable, net and the $2.0 million increase in inventories, partially offset by the $8.5 million increase in accounts payable and accrued expenses, including accrued compensation and payroll taxes and the $1.7 million increase in note payable to bank-current. The decrease in the current ratio was primarily due to the fact that current assets increased $13.2 million, or 48.8%, while current liabilities increased $10.2 million, or 242.7%.

As of April 30, 2018 and October 31, 2017, we had outstanding loan balances under our revolving credit facilities totaling $8.7 million and $5.7 million, respectively. As of April 30, 2018 and October 31, 2017, we had outstanding loan balances, excluding our revolving credit facility, totaling $6.5 million and $6.7 million, respectively.

Net Cash

Net cash used in operating activities was $3.0 million in the first half of fiscal year 2018, compared to $501,000 in the first half of fiscal year 2017. Net cash used in operating activities during the first half of fiscal year 2018 primarily resulted from an increase in the cash flow impact of increases in trade accounts receivable, net totaling $11.7 million and an increase in inventories totaling $2.0 million, partially offset by certain adjustments to reconcile net income of $981,000 to net cash used in operating activities including depreciation and amortization of $859,000 and share-based compensation expense of $703,000. Additionally, the cash flow impact of increases in accounts payable and accrued expenses, including accrued compensation and payroll taxes, of $8.2 million further contributed to offset net cash used in operating activities. We expect that operating activities will provide net cash during the second half of fiscal year 2018 as payments associated with the significant increase in net sales are received, but there can be no guarantees that operating activities will provide net cash in the second half of fiscal year 2018.

Net cash used in operating activities during the first half of fiscal year 2017 primarily resulted from an increase in inventories totaling $2.5 million and the cash flow impact of increases in trade accounts receivable, net totaling $599,000, partially offset by certain adjustments to reconcile a net loss of $855,000 to net cash used in operating activities including depreciation, amortization and accretion of $807,000 and share-based compensation expense of $431,000. Additionally, the cash flow impact of increases in accounts payable and accrued expenses of $1.8 million further contributed to offset net cash used in operating activities.

Net cash used in investing activities totaled $227,000 in the first half of fiscal year 2018, compared to $203,000 in the first half of fiscal year 2017. Net cash used in investing activities during the first half of fiscal years 2018 and 2017 resulted primarily from purchases of property and equipment and deposits for the purchase of property and equipment.

Net cash provided by financing activities totaled $2.7 million in the first half of fiscal year 2018, compared to net cash used in financing activities of $378,000 in the first half of fiscal year 2017. Net cash provided by financing activities in the first half of fiscal year 2018 resulted primarily from proceeds from notes payable to our bank under our lines of credit, net of repayments, totaling $3.0 million. Net cash used in financing activities in the first half of fiscal year 2017 resulted primarily from repayments, net of proceeds from a note payable to our bank under our line of credit totaling $100,000 and principal payments on long-term debt totaling $149,000.

We have a plan (the “Repurchase Plan”), approved by our Board of Directors on July 14, 2015, to purchase and retire up to 400,000 shares of our common stock, or approximately 6.0% of the shares then outstanding. When the Repurchase Plan was approved, we had anticipated that the purchases would be made over a 24- to 36-month period, but there was no definite time period for repurchase, or plan expiration. As of April 30, 2018, we had 398,400 shares remaining to purchase under this Repurchase Plan.

We have repurchased outstanding common stock outside of the Repurchase Plan through an odd lot repurchase offer. During the first half of fiscal year 2018, we repurchased and retired 19 shares for $47, outside of the Repurchase Plan.

Credit Facilities

We have credit facilities consisting of a real estate term loan, as amended and restated (the “Virginia Real Estate Loan”), a supplemental real estate term loan, as amended and restated (the “North Carolina Real Estate Loan”), a revolving credit note and a special project revolving credit note.

Both the Virginia Real Estate Loan and the North Carolina Real Estate Loan are with Pinnacle Bank (“Pinnacle”), have a fixed interest rate of 3.95% and are secured by a first priority lien on all of our personal property and assets, all money, goods, machinery, equipment, fixtures, inventory, accounts, chattel paper, letter of credit rights, deposit accounts, commercial tort claims, documents, instruments, investment property and general intangibles now owned or hereafter acquired by us and wherever located, as well as a first lien deed of trust on our real property.

Our Revolving Credit Note (“Revolver”) with Pinnacle provides the Company with a $7.0 million revolving line of credit (“Revolving Loan”) for our working capital needs. Under the Revolver, Pinnacle provides us with one or more revolving loans in a collective maximum principal amount of $7.0 million. We may borrow, repay, and reborrow at any time or from time to time while the Revolving Loan is in effect.

The applicable margin in the Revolving Credit Note has a floor on the interest rate for the Revolving Credit Note such that the rate will never be less than 2.50% per annum. The Revolving Loan accrues interest at LIBOR plus 2.50% (resulting in a 4.38% rate at April 30, 2018). The Revolving Loan is payable in monthly payments of interest only with principal and any outstanding interest due and payable at maturity.

On April 10, 2018, we entered into a Fourth Loan Modification Agreement with Pinnacle to modify the Credit Agreement dated April 26, 2016 entered into between the Company and Pinnacle and the term loans dated April 26, 2016.

The Fourth Loan Modification Agreement extends the maturity date of the Revolving Loan to September 30, 2019 and modifies two financial covenants for the Company. All other terms of the Revolving Loan remain unaltered and in effect.

Also on April 10, 2018, we entered into a Special Project Loan Agreement and Special Project Revolving Credit Note (“Special Project Revolver”) with Pinnacle which provides the Company with a $6.0 million revolving line of credit (the “Special Project Revolving Loan”) for the working capital needs related to the fulfillment and processing of certain orders. Under the Special Project Revolver, Pinnacle provides us with one or more revolving loans in a collective maximum principal amount of $6.0 million. We may borrow, repay, and reborrow at any time or from time to time while the Special Project Revolving Loan is in effect.

The Special Project Revolving Loan accrues interest at LIBOR plus 4.0% (resulting in a 5.94% rate at April 30, 2018). The Special Project Revolving Loan is payable in monthly payments of interest only with principal and any outstanding interest due and payable at maturity. Maturity for the Special Project Revolving Loan is October 1, 2018, unless extended.

The Revolving Loan and the Special Project Revolving Loan are secured by a perfected first lien security interest on all assets, including but not limited to, accounts, as-extracted collateral, chattel paper, commodity accounts, commodity contracts, deposit accounts, documents, equipment, fixtures, furniture, general intangibles, goods, instruments, inventory, investment property, letter of credit rights, payment intangibles, promissory notes, software and general tangible and intangible assets owned now or later acquired. The Revolving Loan and Special Project Revolving Loan are also cross-collateralized with our real property.

As of April 30, 2018, we had $7.0 million of outstanding borrowings on our Revolving Loan and no available credit, and $1.7 million of outstanding borrowings on our Special Project Revolving Loan and $4.3 million in available credit.

Capital Expenditures

We did not have any material commitments for capital expenditures as of April 30, 2018. During our 2018 fiscal year budgeting process, we included an estimate for capital expenditures of $2.0 million for the year. We anticipate these expenditures will be funded out of our working capital or borrowings, including under our credit facility. Capital expenditures are reviewed and approved based on a variety of factors including, but not limited to, current cash flow considerations, the expected return on investment, project priorities, impact on current or future product offerings, availability of personnel necessary to implement and begin using acquired equipment, and economic conditions in general. Historically, we have spent less than our budgeted capital expenditures in most fiscal years.

Corporate acquisitions and other strategic investments, if any, are considered outside of our annual capital expenditure budgeting process.

Future Cash Flow Considerations

We believe that our future cash flow from operations, our cash on hand and our existing credit facilities will be adequate to fund our operations for at least the next twelve months.

From time to time, we are involved in various claims, legal actions and regulatory reviews arising in the ordinary course of business. In the opinion of management, the ultimate disposition of these matters will not have a material adverse effect on our financial position, results of operations or liquidity.

Seasonality

We typically expect net sales to be relatively lower in the first half of each fiscal year and relatively higher in the second half of each fiscal year, which we believe may be partially due to the construction cycles, buying patterns and budgetary considerations of our customers. Our trend for the last three fiscal years has been that an average of approximately 48%, 47% and 49% of our net sales occurred during the first half of fiscal years 2017, 2016 and 2015, respectively, and an average of approximately 52%, 53% and 51% of our net sales occurred during the second half of fiscal years 2017, 2016 and 2015, respectively.

This trend may be substantially altered during any quarter or year by the timing of larger projects, timing of orders from larger customers, other economic factors impacting our industry or impacting the industries of our customers and end-users, and macroeconomic conditions. We believe we will not experience this typical seasonality pattern in fiscal year 2018 as a result of significant sales to one customer concentrated in the first half of the year. While we believe seasonality may be a factor that impacts our quarterly net sales results, we are not able to reliably predict net sales based on seasonality because these other factors can also substantially impact our net sales patterns during the year. We also believe net sales may not follow this trend in periods when overall economic conditions in the industry and/or in the world are atypical.

Critical Accounting Policies and Estimates

Our discussion and analysis of financial condition and results of operations is based on the condensed consolidated financial statements and accompanying condensed notes that have been prepared in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”) for interim financial information and the instructions to Form 10-Q and Regulation S-X. The preparation of these condensed consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the condensed consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Note 1 to the consolidated financial statements filed with our Annual Report on Form 10-K for fiscal year 2017 provides a summary of our significant accounting policies. Those significant accounting policies detailed in our fiscal year 2017 Form 10-K did not change during the period from November 1, 2017 through April 30, 2018.

New Accounting Standards

In May 2014, the FASB issued Accounting Standards Update 2014-09, Revenue from Contracts with Customers (“ASU 2014-09”). ASU 2014-09 is a comprehensive new revenue recognition model that expands disclosure requirements and requires an entity to recognize revenue when promised goods or services are transferred to a customer at an amount that reflects the consideration it expects to receive in exchange for those goods or services. In August 2015, the FASB issued Accounting Standards Update 2015-14, Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date (“ASU 2015-14”) which defers the effective date of the new revenue recognition standard by one year. Under ASU 2015-14, the new revenue recognition standard is effective for the Company beginning in fiscal year 2019. The FASB has also issued ASU 2016-08, ASU 2016-10, ASU 2016-11, ASU 2016-12, ASU 2016-20, and ASU 2017-14 all of which clarify certain implementation guidance within ASU 2014-09. We are currently evaluating the potential impact of the adoption of this guidance, but do not anticipate that the adoption will significantly change the timing or amount of revenue recognized. Therefore, we believe the adoption will be limited to expanded disclosures with no material impact on our results of operations, financial position and liquidity.

In February 2016, the FASB issued Accounting Standards Update 2016-02, Leases (“ASU 2016-02”). ASU 2016-02 requires the recognition of a separate lease liability representing the required lease payments over the lease term and a separate lease asset representing the right to use the underlying asset during the same lease term. Additionally, this ASU provides clarification regarding the identification of certain components of contracts that would represent a lease as well as requires additional disclosures to the notes of the financial statements. ASU 2016-02 is effective for fiscal years beginning after December 15, 2018, including interim periods within that reporting period with early adoption permitted. We are currently evaluating the provisions of ASU 2016-02 in order to determine the impact on our results of operations, financial position and liquidity and our related financial statement disclosures. We expect the adoption of ASU 2016-02 may result in an increase to our long-term assets and liabilities on our consolidated balance sheet depending on the resulting impact of any decision by us to renew, extend or replace our two existing real estate leases, as the current leases expire; however, we do not expect the adoption to have a material impact on our results of operations, financial position and liquidity and our related financial statement disclosures.

In August 2016, the FASB issued Accounting Standards Update 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments (“ASU 2016-15”). ASU 2016-15 provides guidance related to the classification of certain cash receipts and cash payments on the statement of cash flows. The pronouncement provides clarification guidance on eight specific cash flow presentation issues that have developed due to diversity in practice. ASU 2016-15 is effective for fiscal years beginning after December 15, 2017, including interim periods within that reporting period, with early adoption permitted. The adoption of ASU 2016-15 is not expected to have a material impact on our results of operations, financial position or liquidity or our related financial statement disclosures.

In October 2016, the FASB issued Accounting Standards Update 2016-16, Income Taxes (Topic 740): Intra-Entity Transfers of Assets Other Than Inventory (“ASU 2016-16”). ASU 2016-16 requires an entity to recognize the income tax consequences of an intra-entity transfer of an asset (with the exception of inventory) when the transfer occurs.  Under current GAAP, entities are prohibited from recognizing current and deferred income taxes for an intra-entity transfer until the asset is sold to a third party.  Examples of assets that would be affected by the new guidance are intellectual property and property, plant and equipment.  ASU 2016-16 is effective for fiscal years beginning after December 15, 2017, including interim periods within that reporting period, with early adoption permitted. The adoption of ASU 2016-16 is not expected to have a material impact on our results of operations, financial position or liquidity or our related financial statement disclosures.

There are no other new accounting standards issued, but not yet adopted by us, which are expected to be applicable to our financial position, operating results or financial statement disclosures.

Item 4. Controls and Procedures

The Company maintains disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) that are designed to be effective in providing reasonable assurance that information required to be disclosed in reports under the Exchange Act are recorded, processed and summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission (the “SEC”), and that such information is accumulated and communicated to management to allow for timely decisions regarding required disclosure.

Our management evaluated, with the participation of our Chief Executive Officer (principal executive officer) and Chief Financial Officer (principal financial officer), the effectiveness of the Company’s disclosure controls and procedures as of April 30, 2018. Based on this evaluation process, the Chief Executive Officer and Chief Financial Officer have concluded that the Company’s disclosure controls and procedures were effective as of April 30, 2018, and that there were no changes in the Company’s internal control over financial reporting that occurred during the last fiscal quarter ended April 30, 2018 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II.  OTHER INFORMATION

Item 6. Exhibits

The exhibits listed on the Exhibit Index are filed as part of, and incorporated by reference into, this report.

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.

Exhibit Index