TWIN DISC INC - Quarter Report: 2018 December (Form 10-Q)

 

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		December 28, 2018				June 30, 2018
ASSETS
Current assets:
Cash		$	18,542			$	15,171
Trade accounts receivable, net			47,890				45,422
Inventories			130,234				84,001
Prepaid expenses			7,314				8,423
Other			8,320				6,252
Total current assets			212,300				159,269
Property, plant and equipment, net			70,309				55,467
Goodwill, net			27,829				2,692
Intangible assets, net			22,362				1,906
Deferred income taxes			13,907				18,056
Other assets			4,123				3,850
Total assets		$	350,830			$	241,240
LIABILITIES AND EQUITY
Current liabilities:
Accounts payable		$	35,123			$	29,368
Accrued liabilities			42,266				32,976
Total current liabilities			77,389				62,344
Long-term debt			46,686				4,824
Lease obligations			16,467				6,527
Accrued retirement benefits			19,552				21,068
Deferred income taxes			7,053				1,203
Other long-term liabilities			1,839				1,658
Total liabilities			168,986				97,624
Commitments and contingencies (Note F)
Equity:
Twin Disc shareholders' equity:
Preferred shares authorized: 200,000; issued: none; no par value			-				-
Common shares authorized: 30,000,000; issued: 14,632,802 and 13,099,468, respectively; no par value			44,137				11,570
Retained earnings			192,734				178,896
Accumulated other comprehensive loss			(32,055	)			(23,792	)
			204,816				166,674
Less treasury stock, at cost (1,533,290 and 1,545,783 shares, respectively)			23,485				23,677
Total Twin Disc shareholders' equity			181,331				142,997
Noncontrolling interest			513				619
Total equity			181,844				143,616
Total liabilities and equity		$	350,830			$	241,240

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		For the Quarter Ended								For the Two Quarters Ended
		December 28, 2018				December 29, 2017				December 28, 2018				December 29, 2017
Net sales		$	78,107			$	56,546			$	152,796			$	101,611
Cost of goods sold			52,019				38,323				102,723				69,396
Gross profit			26,088				18,223				50,073				32,215
Marketing, engineering and administrative expenses			18,909				15,070				37,894				28,464
Restructuring expenses			434				831				607				2,049
Income from operations			6,745				2,322				11,572				1,702
Interest expense			417				83				1,134				147
Other expense (income), net			798				364				1,118				934
			1,215				447				2,252				1,081
Income before income taxes and noncontrolling interest			5,530				1,875				9,320				621
Income tax expense			1,451				5,925				2,338				1,267
Net income (loss)			4,079				(4,050	)			6,982				(646	)
Less: Net earnings attributable to noncontrolling interest, net of tax			(6	)			(63	)			(47	)			(76	)
Net income (loss) attributable to Twin Disc		$	4,073			$	(4,113	)		$	6,935			$	(722	)
Income (loss) per share data:
Basic income (loss) per share attributable to Twin Disc common shareholders		$	0.31			$	(0.36	)		$	0.56			$	(0.06	)
Diluted income (loss) per share attributable to Twin Disc common shareholders		$	0.31			$	(0.36	)		$	0.56			$	(0.06	)
Weighted average shares outstanding data:
Basic shares outstanding			12,909				11,297				12,233				11,278
Diluted shares outstanding			12,997				11,297				12,304				11,278
Comprehensive income (loss):
Net income (loss)		$	4,079			$	(4,050	)		$	6,982			$	(646	)
Benefit plan adjustments, net of income taxes of $146, $674, $292 and $952, respectively			478				1,734				949				2,208
Foreign currency translation adjustment			(1,786	)			488				(2,347	)			3,029
Comprehensive income (loss)			2,771				(1,828	)			5,584				4,591
Less: Comprehensive loss (income) attributable to noncontrolling interest			7				(62	)			(9	)			(69	)
Comprehensive income (loss) attributable to Twin Disc		$	2,778			$	(1,890	)		$	5,575			$	4,522

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		For the Two Quarters Ended
		December 28, 2018				December 29, 2017
Cash flows from operating activities:
Net income (loss)		$	6,982			$	(646	)
Adjustments to reconcile net income (loss) to net cash (used) provided by operating activities, net of acquired assets:
Depreciation and amortization			4,510				3,263
Amortization of inventory fair value step-up			2,173				-
Restructuring expenses			-				162
Provision for deferred income taxes			2,555				1,613
Stock compensation expense and other non-cash changes, net			1,506				1,064
Net change in operating assets and liabilities			(21,505	)			(1,644	)
Net cash (used) provided by operating activities			(3,779	)			3,812
Cash flows from investing activities:
Acquisition of Veth Propulsion, less cash acquired			(59,651	)			-
Acquisitions of fixed assets			(6,676	)			(3,013	)
Proceeds from sale of fixed assets			63				79
Other, net			(129	)			(129	)
Net cash used by investing activities			(66,393	)			(3,063	)
Cash flows from financing activities:
Proceeds from issuance of common stock, net			32,210				-
Borrowings under long-term debt agreement			35,000				-
Borrowings under revolving loan agreement			93,675				35,315
Proceeds from exercise of stock options			36				-
Repayments under revolving loan agreement			(62,326	)			(36,957	)
Repayments of long-term borrowings			(24,230	)			-
Dividends paid to noncontrolling interest			(115	)			(172	)
Payments of withholding taxes on stock compensation			(926	)			(400	)
Net cash provided (used) by financing activities			73,324				(2,214	)
Effect of exchange rate changes on cash			219				864
Net change in cash			3,371				(601	)
Cash:
Beginning of period			15,171				16,367
End of period		$	18,542			$	15,766

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A.	Basis of Presentation

 

The unaudited condensed consolidated financial statements have been prepared by Twin Disc, Incorporated (the “Company”) pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”) and, in the opinion of the Company, include all adjustments, consisting only of normal recurring items, necessary for a fair statement of results for each period. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such SEC rules and regulations. The Company believes that the disclosures made are adequate to make the information presented not misleading. It is suggested that these financial statements be read in conjunction with the consolidated financial statements and the notes thereto included in the Company’s Annual Report filed on Form 10-K for June 30, 2018. The year-end condensed balance sheet data was derived from audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States.

 

The unaudited condensed consolidated financial statements and information included in this Quarterly Report on Form 10-Q (“Form 10-Q”) includes the financial results of Veth Propulsion Holding BV (“Veth Propulsion”) for the period beginning July 2, 2018 through December 28, 2018. The financial results included in this Form 10-Q related to the acquisition method of accounting for the Veth Propulsion acquisition are subject to change as the acquisition method accounting is not yet finalized and dependent upon the finalization of management’s review of certain independent valuations and studies that are still in process. See Note B, “Acquisition of Veth Propulsion Holding BV” for further information about the acquisition and related transactions and the acquisition accounting.

 

Recently Adopted Accounting Standards

 

a.

In May 2014, the Financial Accounting Standards Board (“FASB”) issued updated guidance (ASU 2014-09) on revenue from contracts with customers. This revenue recognition guidance supersedes existing guidance, including industry-specific guidance. The core principle is that an entity should recognize revenue to depict the transfer of control over promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The guidance identifies steps to apply in achieving this principle. The Company adopted this guidance effective July 1, 2018, using the modified retrospective method and applied the cumulative effect to its retained earnings balance as of that date. Prior periods presented were not retrospectively adjusted for this change. The Company has applied the new revenue recognition standard only to contracts that were not completed as of July 1, 2018.

 

The Company determined that deferral of revenue is appropriate for certain agreements where the performance of services after product delivery is required. Such services primarily pertain to technical commissioning services by its distribution entities in its marine business, whereby the Company’s technicians calibrate the controls and transmission to ensure proper performance for the customer’s specific application. This service helps identify issues with the ship's design or performance that need to be remediated by the ship builder or other component suppliers prior to the ship being officially accepted into service by the ship buyer. The cumulative effect adjustment of adopting the new standard is not significant to the Company’s results of operations and financial condition.

 

b.

In February 2016, the FASB issued guidance (ASU 2016-02) which replaces the existing guidance for leases. The new standard establishes a right-of-use (“ROU”) model that requires a lessee to record a ROU asset and a lease liability on the balance sheet for all leases with terms longer than 12 months. The Company elected to early adopt the standard effective July 1, 2018, concurrent with the adoption of ASU 2014-09, Revenue from Contracts with Customers, using the modified retrospective approach at the beginning of the earliest comparative period presented in the financial statements, which required the Company to restate each prior reporting period presented.

 

For operating leases in which the Company is a lessee, the Company concluded that all existing operating leases under the old guidance continue to be classified as operating leases under the new guidance, and all existing capital leases under the old guidance are classified as finance leases under the new guidance. The Company excluded any lease contracts with terms of twelve months or less as of the adoption date. The Company has lease agreements with lease and non-lease components, which are generally accounted for as separate lease components. The Company accounts for short-term leases on a straight-line basis over the lease term.

 

 

The following table presents the effect of the adoption of ASU 2016-02 on the Company’s condensed consolidated balance sheet as of June 30, 2018:

 

 

The adoption of ASU 2014-09 and ASU 2016-02 did not have an impact on the Company’s condensed consolidated statement of operations and comprehensive income for the quarter and two quarters ended December 29, 2017, or condensed consolidated statement of cash flows for the two quarters ended December 29, 2017.

 

c.

In March 2017, the FASB issued guidance (ASU 2017-07) intended to improve the presentation of net periodic pension cost and net periodic postretirement cost. This guidance requires that an employer report the service cost component in the same line item as other compensation costs arising from services rendered by the pertinent employees during the period. The other components of net benefit cost are required to be presented in the statement of operations separately from the service cost component and outside the subtotal of income from operations. The Company adopted this guidance effective July 1, 2018 on a retrospective basis, which resulted in the reclassification of certain amounts from cost of goods sold and marketing, engineering and administrative expenses to other expense (income), net in the condensed consolidated statements of operations and comprehensive income. As a result, prior period amounts impacted have been revised accordingly.

 

The following table presents the effect of the adoption of ASU 2017-07 on the Company’s condensed consolidated statements of operations and comprehensive income for the quarter and two quarters ended December 29, 2017:

 

 

d.

In February 2018, the FASB issued guidance (ASU 2018-02) intended to eliminate the stranded tax effects resulting from the Tax Cuts and Jobs Act by allowing a reclassification from accumulated other comprehensive income to retained earnings. The Company elected to early adopt this guidance effective July 1, 2018 by making a reclassification of $6,903 from accumulated other comprehensive loss to retained earnings.

 

e.

In October 2016, the FASB issued updated guidance (ASU 2016-16) that changes the recognition of income tax consequences of an intra-entity transfer of an asset other than inventory. The Company adopted this guidance effective July 1, 2018. The adoption of this guidance did not have a material impact on the Company’s financial statements and disclosures.

 

f.

In August 2016, the FASB issued updated guidance (ASU 2016-15) that addresses eight specific cash flow issues with the objective of reducing the existing diversity in practice. The Company adopted this guidance effective July 1, 2018. The adoption of this guidance did not have a material impact on the Company’s financial statements and disclosures.

 

g.

In August 2018, the SEC issued Release No. 33-10532, Disclosure Update and Simplification. In addition to eliminating certain disclosure requirements, this release also amends the interim financial statement requirements to require provision of the information required by Regulation S-X Rule 3-04 for the current and comparative year-to-date periods, with subtotals for each interim period. Rule 3-04 requires a reconciliation of stockholders’ equity beginning and ending balances for each period for which a statement of comprehensive income is required to be filed. The Company adopted this guidance during the Company’s second quarter of fiscal year 2019. The adoption of this guidance did not have a material impact on the Company’s disclosures.

 

New Accounting Releases

 

In August 2018, the FASB issued updated guidance (ASU 2018-13) as part of the disclosure framework project, which focuses on improving the effectiveness of disclosures in the notes to the financial statements. The amendments in this update modify the disclosure requirements on fair value measurements in Topic 820, Fair Value Measurement. The amendments in this guidance are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019 (the Company’s fiscal 2021), with early adoption permitted. The Company is currently evaluating the potential impact of this guidance on the Company’s disclosures.

 

 

In August 2018, the FASB issued updated guidance (ASU 2018-14) intended to modify the disclosure requirements for employers that sponsor defined pension or postretirement plans. The amendments in this guidance are effective for fiscal years ending after December 15, 2020 (the Company’s fiscal 2021), with early adoption permitted. The Company is currently evaluating the potential impact of this guidance on the Company’s disclosures.

 

Special Note Regarding Smaller Reporting Company Status

 

In June 2018, the SEC issued Release 33-10513; 34-83550, Amendments to Smaller Reporting Company Definition, which changes the definition of a smaller reporting company in Rule 12b-2 of the Securities Exchange Act of 1934, as amended.  Under this release, the new thresholds for qualifying are (1) public float of less than $250 million or (2) annual revenue of less than $100 million and public float of less than $700 million (including no public float).  The rule change is effective on September 10, 2018, the Company’s first fiscal quarter of fiscal year 2019.  Under this release, the Company continues to qualify as a smaller reporting company based on its public float as of the last business day of its second fiscal quarter of fiscal year 2019. A smaller reporting company may choose to comply with scaled or non-scaled financial and non-financial disclosure requirements on an item-by-item basis. The Company has not scaled its disclosures of financial and non-financial information in this Quarterly Report. The Company may determine to provide scaled disclosures of financial or non-financial information in future quarterly reports, annual reports and/or proxy statements if it remains a smaller reporting company under SEC rules.

 

 

B.	Acquisition of Veth Propulsion Holding BV

 

On July 2, 2018, the Company completed the acquisition of 100% of the outstanding common stock of Veth Propulsion. Veth Propulsion is a global manufacturer of highly-engineered primary and auxiliary propulsions and propulsion machinery for maritime vessels, including rudder propellers, bow thrusters, generator sets and engine service and repair, based in the Netherlands. These products are complementary to and expand the Company’s current product offerings in the marine and propulsion markets. Prior to the acquisition, the Company was a distributor of Veth products in North America and Asia. This acquisition was pursuant to a Share Purchase Agreement (“Purchase Agreement”) entered into by Twin Disc NL Holding B.V., a wholly-owned subsidiary of the Company, with Het Komt Vast Goed B.V., the prior parent of Veth Propulsion, on June 13, 2018.  Veth Propulsion is reported as part of the Company's manufacturing segment.

 

Under the terms of the Purchase Agreement, the Company paid an aggregate of approximately $60,729 in cash at closing, which included a base payment plus adjustments for net cash and working capital. This amount is subject to a final determination of working capital adjustments and an earn-out. The maximum earn-out is approximately $3,800. The earn-out will be paid if the earnings before interest, tax, depreciation and amortization of Veth Propulsion in the period January 1, 2018 through December 31, 2018 exceeds the agreed upon threshold amount. The earn-out is payable in the form of Company stock or cash, and will be determined by April 2019.

 

The Company financed the payment of the cash consideration through borrowings of $60,729 under a new credit agreement entered into on June 29, 2018 with BMO Harris Bank N.A. (the “Credit Agreement”). The Credit Agreement is further discussed in Note L, Debt.

 

Consideration Transferred

 

The following table summarizes the consideration transferred at the acquisition date. This amount is subject to a final determination of a working capital adjustment and earn-out, which will be settled prior to the end of the measurement period ending July 1, 2019.

 

 

a)

In the statement of cash flows, the cash used in the acquisition of Veth Propulsion in the amount of $59,651 is net of the cash, including restricted cash, acquired in the transaction, of $1,078 (see below for fair value of assets acquired and liabilities assumed).

 

b)

This pertains to the fair value of the earn-out, which was estimated based on a probability-weighted approach.

 

 

Fair Value Estimate of Assets Acquired and Liabilities Assumed

 

The Company is continuing its review of the fair value estimate of assets acquired and liabilities assumed during the measurement period, which will conclude as soon as the necessary information regarding the facts and circumstances that existed as of the acquisition date is obtained, or otherwise not available. This measurement period will not exceed one year from the acquisition date. At the effective date of the acquisition, the assets acquired and liabilities assumed are required to be measured at fair value. The fair value estimates are pending completion of several elements, including the finalization of an independent appraisal and final review by the Company. Accordingly, until the fair values are final, there could be material adjustments to the Company’s consolidated financial statements, including changes to depreciation and amortization expense related to the valuation of property and equipment and intangible assets acquired and their respective useful lives, among other adjustments.

 

Upon the final determination of the fair value of assets acquired and liabilities assumed, the excess of the purchase price over such fair values is allocated to goodwill. The final determination of the purchase price, fair values and resulting goodwill may differ significantly from what is reflected in these consolidated financial statements.

 

The following summarizes the preliminary estimate of fair value of the assets acquired and liabilities assumed at the acquisition date.  Some of these amounts reflect updated values from those previously reported as of September 28, 2018, the Company's prior fiscal quarter, due to management's ongoing fair value assessment during the measurement period.

 

 

 

The following information provides further details about the estimated net step-up in fair value and/or the estimated fair value at the acquisition date for some key balance sheet items. 

 

(a) Included in cash is restricted cash in the amount of $685. This amount is restricted and not available for general business use in order to guarantee performance obligations by Veth Propulsion under certain customer contracts. A significant majority of these arrangements have expired as of December 28, 2018 and they are not expected to be renewed.

 

(b) Accounts receivable represents contractual amounts receivable from customers less an allowance for doubtful accounts. This amount approximates fair value.

 

(c) Inventories consist of:

 

 

 

As of the effective date of the acquisition, inventory is required to be measured at fair value. Raw materials are typically utilized in operations within one year of purchase and therefore book values approximate fair value. Projects work in progress are estimated to be approximately 70% complete, and the step-up to fair value less estimated costs to complete and sell resulted in a step-up value of approximately $4,402.

 

(d) The fair value of property, plant and equipment is estimated at $2,641. These assets primarily consist of manufacturing equipment, test equipment, vehicles, and office and plant fixtures. Their estimated useful lives range from 2 to 13 years.

 

(e) Intangible assets consist of:

 

 

 

The preliminary fair values were determined primarily using an income method, which utilizes financial forecasts of expected future cash flows. Some of the more significant assumptions used in the development of intangible asset values include: the amount and timing of projected future cash flows, the discount rate selected to measure the risks inherent in future cash flows, and the assessment of the asset’s life cycle and competitive trends impacting the asset, as well as other factors.

 

(f) This represents the net deferred tax liability associated with the fair value of assets acquired and liabilities assumed.

 

(g) The Company is not able to deduct any of the goodwill for tax purposes.

 

The fair values presented above are preliminary until the final purchase price consideration is determined and the Company completes its work with the use of a third party valuation firm. These values are subject to change. Any changes to the initial estimates of the fair value of assets and liabilities will impact residual goodwill and may affect future earnings.

 

As part of the acquisition, the Company entered into a fifteen-year lease with Het Komt Vast Goed B.V., the owner of the real property where Veth Propulsion’s operations are located. Under this lease, the Company pays an annual market-based rent of $1,249, with provisions for increasing rent based on the prevailing consumer price index.

 

Summary Financial Information

 

The following table presents financial information for Veth Propulsion that is included in the Company’s consolidated statement of operations for the quarter and two quarters ended December 28, 2018:

 

 

(a)	Gross profit includes the non-recurring charge for the step-up of inventories acquired of $1,002 and $2,173 for the quarter and two quarters ended December 28, 2018, respectively.

 

(b)   In addition to (a), operating income (loss) includes the depreciation of property, plant and equipment and amortization of intangible assets acquired of $647 and $1,268 for the quarter and two quarters ended December 28, 2018, respectively. Operating income (loss) also includes one-time transaction charges related to the acquisition of $256 and $460 for the quarter and two quarters ended December 28, 2018, respectively.

 

 

The following table presents unaudited supplemental pro forma information as if the acquisition of Veth Propulsion had occurred on July 1, 2017.

 

 

(a)	Gross profit includes the amortization of the step-up of inventories of $1,179 and $2,358 for the quarter and two quarters ended December 29, 2017, respectively.

 

(b)	In addition to (a), this includes the amortization of intangible assets acquired and interest expense on borrowings under the Credit Agreement net of other expenses, amounting to $1,136 and $2,271, before tax, for the quarter and two quarters ended December 29, 2017, respectively.

 

 

C.  Revenue Recognition

 

Revenue from contracts with customers is recognized using a five-step model consisting of the following: (1) identify the contract with a customer; (2) identify the performance obligations in the contract; (3) determine the transaction price; (4) allocate the transaction price to the performance obligations in the contract; and (5) recognize revenue when (or as) the Company satisfies a performance obligation. Performance obligations are satisfied when the Company transfers control of a good or service to a customer, which can occur over time or at a point in time. The amount of revenue recognized is based on the consideration to which the Company expects to be entitled in exchange for those goods or services, including the expected value of variable consideration. The customer’s ability and intent to pay the transaction price is assessed in determining whether a contract exists with the customer. If collectibility of substantially all of the consideration in a contract is not probable, consideration received is not recognized as revenue unless the consideration is nonrefundable and the Company no longer has an obligation to transfer additional goods or services to the customer or collectibility becomes probable.

 

The Company designs, manufactures and sells marine and heavy duty off highway power transmission equipment. Products offered include: marine transmissions, azimuth drives, surface drives, propellers and boat management systems as well as power-shift transmissions, hydraulic torque converters, power take-offs, industrial clutches and controls systems. The Company sells its products to customers primarily in the commercial, pleasure craft, and military marine markets as well as in the energy and natural resources, government and industrial markets. The Company's worldwide sales to both domestic and foreign customers are transacted through a direct sales force and a distributor network.

 

Identify contract with customer:

 

The Company gathered customer contracts and representative customer purchase orders of its various locations. The Company’s customers consist of distributors and direct end-users. With regard to distributors, the Company generally has written distribution agreements which describe the terms of the distribution arrangement, such as the product range, the sales territory, product pricing, sales support, payment and returns policy, etc. Customer contracts are generally in the form of acknowledged purchase orders. Services to be rendered, as part of the delivery of those products, are also generally specified. Such services include installation reviews and technical commissioning.

 

 

Performance obligations:

 

The Company’s performance obligation as it relates to the delivery of goods is straightforward; the recognition of revenue is generally driven by shipment date and the terms of sale. As it relates to the Company’s service obligations, the Company determined that installation reviews, shift development and technical commissioning are separate and distinct performance obligations.

 

Transaction price:

 

The Company considers the invoice price as the transaction price.

 

Allocation of transaction price:

 

The Company determined that the most relevant allocation method for its service obligations is to apply the expected cost plus appropriate margin. This is the Company’s current practice of billing for repairs, overhaul, and other product service related time incurred by its technicians.

 

Recognize revenue:

 

Revenue is recognized upon transfer of control of the products to the customer. For installation review, shift development, and technical commissioning services, revenue is recognized upon completion of the service.

 

Disaggregated revenue:

 

The following table presents details deemed most relevant to the users of the financial statements for the quarter and two quarters ended December 28, 2018.

 

Net sales by product group for the quarter ended December 28, 2018 is summarized as follows:

 

 

Net sales by product group for the two quarters ended December 28, 2018 is summarized as follows:

 

 

 

Contract assets/liabiliies:

 

There are no significant balances of contract assets or liabilities as of December 28, 2018.

 

 

 

D.	Inventories

 

The major classes of inventories were as follows:

 

 

 

E.

Warranty

 

The Company engages in extensive product quality programs and processes, including actively monitoring and evaluating the quality of its suppliers. However, its warranty obligation is affected by product failure rates, the number of units affected by the failure and the expense involved in satisfactorily addressing the situation. The warranty reserve is established based on our best estimate of the amounts necessary to settle future and existing claims on products sold as of the balance sheet date. When evaluating the adequacy of the reserve for warranty costs, management takes into consideration the term of the warranty coverage, historical claim rates and costs of repair, knowledge of the type and volume of new products and economic trends. While we believe the warranty reserve is adequate and that the judgment applied is appropriate, such amounts estimated to be due and payable in the future could differ materially from what actually transpires. The following is a listing of the activity in the warranty reserve for the quarter and two quarters ended December 28, 2018 and December 29, 2017:

 

 

The current portion of the warranty accrual ($3,309 and $2,032 as of December 28, 2018 and December 29, 2017, respectively) is reflected in accrued liabilities, while the long-term portion ($534 and $435 as of December 28, 2018 and December 29, 2017, respectively) is included in other long-term liabilities on the consolidated balance sheets.

 

 

F.	Contingencies

 

The Company is involved in litigation of which the ultimate outcome and liability to the Company, if any, is not presently determinable. Management believes that final disposition of such litigation will not have a material impact on the Company’s results of operations, financial position or cash flows.

 

 

G.	Business Segments

 

The Company and its subsidiaries are engaged in the manufacture and sale of marine and heavy-duty off-highway power transmission equipment. Principal products include marine transmissions, azimuth drives, surface drives, propellers and boat management systems, as well as power-shift transmissions, hydraulic torque converters, power take-offs, industrial clutches and controls systems. The Company sells to both domestic and foreign customers in a variety of market areas, principally pleasure craft, commercial and military marine markets, as well as in the energy and natural resources, government and industrial markets.

 

The Company has two reportable segments: manufacturing and distribution.  Its segment structure reflects the way management makes operating decisions and manages the growth and profitability of the business. It also corresponds with management’s approach of allocating resources and assessing the performance of its segments. The accounting practices of the segments are the same as those described in the summary of significant accounting policies. Transfers among segments are at established inter-company selling prices.  Management evaluates the performance of its segments based on net income.

 

 

Information about the Company’s segments is summarized as follows:

 

 

 

 

H.	Stock-Based Compensation

 

Performance Stock Awards (“PSA”)

 

During the first half of fiscal 2019 and 2018, the Company granted a target number of 42.3 and 54.9 PSAs, respectively, to various employees of the Company, including executive officers. The fiscal 2019 PSAs will vest if the Company achieves performance-based target objectives relating to average return on invested capital, average annual sales and average annual Earnings Per Share (“EPS”) (as defined in the PSA Grant Agreement), in the cumulative three fiscal year period ending June 30, 2021. These PSAs are subject to adjustment if the Company’s return on invested capital, net sales, and EPS for the period falls below or exceeds the specified target objective, and the maximum number of performance shares that can be awarded if the target objective is exceeded is 63.4. Based upon favorable actual results to date, the Company is currently accruing compensation expense for these PSAs.

 

The fiscal 2018 PSAs will vest if the Company achieves performance-based target objectives relating to average return on invested capital, average annual sales and average annual EPS (as defined in the PSA Grant Agreement), in the cumulative three fiscal year period ending June 30, 2020. These PSAs are subject to adjustment if the Company’s return on invested capital, net sales, and EPS for the period falls below or exceeds the specified target objective, and the maximum number of performance shares that can be awarded if the target objective is exceeded is 69.2. Based upon favorable actual results to date, the Company is currently accruing compensation expense for these PSAs.

 

There were 188.0 and 224.9 unvested PSAs outstanding at December 28, 2018 and December 29, 2017, respectively. The fair value of the PSAs (on the date of grant) is expensed over the performance period for the shares that are expected to ultimately vest. Compensation expense of $242 and $121 was recognized for the quarters ended December 28, 2018 and December 29, 2017, respectively, related to PSAs. Compensation expense of $788 and $136 was recognized for the two quarters ended December 28, 2018 and December 29, 2017, respectively, related to PSAs. The weighted average grant date fair value of the unvested awards at December 28, 2018 was $15.02. At December 28, 2018, the Company had $1,522 of unrecognized compensation expense related to the unvested shares that would vest if the specified target objective was achieved for the fiscal 2019, 2018 and 2017 awards. The total fair value of PSAs vested as of December 28, 2018 and September 29, 2017 was $0.

 

Restricted Stock Awards (“RS”)

 

The Company has unvested RS awards outstanding that will vest if certain service conditions are fulfilled. The fair value of the RS grants is recorded as compensation expense over the vesting period, which is generally 1 to 3 years. During the first half of fiscal 2019 and 2018, the Company granted 35.6 and 85.3 service based restricted shares, respectively, to employees and non-employee directors. There were 185.3 and 272.4 unvested shares outstanding at December 28, 2018 and December 29, 2017, respectively. A total of 2.8 shares of restricted stock were forfeited during the two quarters ended December 28, 2018. There were no shares of restricted stock forfeited during the two quarters ended December 29, 2017. Compensation expense of $266 and $464 was recognized for the quarters ended December 28, 2018 and December 29, 2017, respectively. Compensation expense of $516 and $927 was recognized for the two quarters ended December 28, 2018 and December 29, 2017, respectively. The total fair value of restricted stock grants vested as of December 28, 2018 and December 29, 2017 was $2,102 and $1,758, respectively. As of December 28, 2018, the Company had $1,217 of unrecognized compensation expense related to restricted stock which will be recognized over the next three years.

 

 

Restricted Stock Unit Awards (“RSU”)

 

Under the 2018 Long Term Incentive Plan, the Company has been authorized to issue RSUs. The RSUs entitle the employee to shares of common stock of the Company if the employee remains employed by the Company through a specified date, generally three years from the date of grant. During the first half of fiscal 2019, the Company granted 38.0 RSUs to various employees of the Company, including executive officers. The fair value of the RSUs (on the date of grant) is recorded as compensation expense over the vesting period. There were 38.0 unvested RSUs outstanding at December 28, 2018. Compensation expense of $82 was recognized for the quarter ended December 28, 2018. Compensation expense of $136 was recognized for the two quarters ended December 28, 2018. The weighted average grant date fair value of the unvested awards at December 28, 2018 was $25.77. As of December 28, 2018, the Company had $842 of unrecognized compensation expense related to restricted stock which will be recognized over the next three years.

 

 

I.	Pension and Other Postretirement Benefit Plans

 

The Company has non-contributory, qualified defined benefit plans covering substantially all domestic employees hired prior to October 1, 2003 and certain foreign employees. Additionally, the Company provides health care and life insurance benefits for certain domestic retirees. The components of the net periodic benefit cost for the defined benefit pension plans and the other postretirement benefit plan are as follows:

 

 

 

The Company expects to contribute approximately $2,382 to its pension plans in fiscal 2019. As of December 28, 2018, the amount of $1,429 in contributions has been made.

 

The Company has reclassified $478 (net of $146 in taxes) of benefit plan adjustments from accumulated other comprehensive loss during the quarter ended December 28, 2018, and $1,734 (net of $674 in taxes) during the quarter ended December 29, 2017. The Company has reclassified $949 (net of $292 in taxes) of benefit plan adjustments from accumulated other comprehensive loss during the two quarters ended December 28, 2018, and $2,208 (net of $952 in taxes) during the two quarters ended December 29, 2017. These reclassifications are included in the computation of net periodic benefit cost.

 

 

J.	Income Taxes

 

On December 22, 2017, the Tax Cuts and Jobs Act (the “Tax Act”) was signed into law in the United States. The Tax Act, among other provisions, introduced changes in the U.S corporate tax rate, business related exclusions, deductions, and credits, and has tax consequences for companies that operate internationally. Most of the changes introduced in the Tax Act were effective beginning on January 1, 2018; however, as the Company has a fiscal year end of June 30, the effective dates for the Company are various and different.

 

 

For the two quarters ended December 28, 2018 and December 29, 2017, the Company’s effective income tax rate was 25.1% and 204.0% respectively. In the prior year, increased and sustained profitability in a foreign jurisdiction resulted in the release of a $3,803 valuation allowance, which decreased the effective tax rate by 611.5%. In the prior year, the impact of the Tax Act was reflected resulting in an increase to tax expense of $4,526, which increased the effective tax rate by 727.9%. Foreign tax reform also reflected in the prior year increased tax expense and by $431 and resulted in an increase in the effective tax rate of 69.3%.

 

Within the calculation of the Company’s annual effective tax rate, the Company has used assumptions and estimates that may change as a result of future guidance, interpretation, and rule-making from the Internal Revenue Service, the SEC, and the FASB and/or various other taxing jurisdictions. Further, the Company anticipates that the state jurisdictions will continue to determine and announce their conformity to the Tax Act, which could have an impact on the annual effective tax rate.

 

The permanent reduction to the U.S. federal corporate income tax rate from 35% to 21% was effective January 1, 2018. The effective tax rate in the current quarter of fiscal 2019 reflects the reduction in the statutory federal income tax rate to 21%.

 

The deemed repatriation transition tax is a tax on previously untaxed accumulated and current earnings and profits of certain foreign subsidiaries. To determine the amount of the transition tax, the Company calculated the amount of post-1986 earnings and profits for all foreign subsidiaries as well as the amount of non-U.S. income taxes paid on such earnings. The Company calculated the amount of the transition tax and determined it to be zero based on overall net historical negative earnings and profits.

 

As no new material information nor material interpretational changes have developed, the Company’s previous calculation reflected in fiscal 2018 has not changed. With the enactment of the transition tax, any future dividends repatriated would benefit from the 100% Dividends Received Deduction. The company reaffirms its positon that the earnings of certain foreign subsidiaries remain permanently reinvested. An analysis was also completed to verify the future utilization of tax attributes and it was determined that full utilization would be realized and no valuation allowance was required. The Company has completed a provisional analysis of the global intangible low taxed income (“GILTI”) provisions and anticipates no impact to the financial statements due to the offset of the inclusion with the associated foreign tax credits. A provisional foreign-derived intangible income (“FDII”) calculation was completed and the benefit has been reflected in the quarterly provision. The Company has provisionally elected to treat GILTI as a period expense; however, the Company has not made a final accounting policy decision with respect to this item. A provisional analysis of the new base erosion anit-abuse tax (“BEAT”) rules has been completed and the Company does not meet the minimum thresholds at this time and is therefore not subject to this tax. These estimates may be impacted by actual future data, additional guidance or other unforeseen circumstances.

 

Under ASC Topic 740, Income Taxes, a company is generally required to recognize the effect of changes in tax laws in its financial statements in the period in which the legislation is enacted. U.S. income tax laws are deemed to be effective on the date the president signs tax legislation. The president signed the Tax Act on December 22, 2017. As such, the Company is required to recognize the related impacts to the financial statements in the quarter ended December 29, 2017. In acknowledgment of the substantial changes incorporated in the Tax Act, in conjunction with the timing of the enactment being just weeks before the majority of the provisions became effective, the SEC staff issued Staff Accounting Bulletin ("SAB") 118 to provide certain guidance in determining the accounting for income tax effects of the legislation in the accounting period of enactment as well as provide a measurement period (similar to that used when accounting for business combinations) within which to finalize and reflect such final effects associated with the Tax Act. Further, SAB 118 summarizes a three-step approach to be applied each reporting period within the overall measurement period: (1) amounts should be reflected in the period including the date of enactment for those items which are deemed to be complete (i.e. all information is available and appropriately analyzed to determine the applicable financial statement impact), (2) to the extent the effects of certain changes due to the Tax Act for which the accounting is not deemed complete but for which a reasonable estimate can be determined, such provisional amount(s) should be reflected in the period so determined and adjusted in subsequent periods as such effects are finalized and (3) to the extent a reasonable estimate cannot be determined for a specific effect of the tax law change associated with the Tax Act, no provisional amount should be recorded but rather, continue to apply ASC 740 based upon the tax law in effect prior to the enactment of the Tax Act. Such measurement period is deemed to end when all necessary information has been obtained, prepared and analyzed such that a final accounting determination can be concluded, but in no event should the period extend beyond one year. If a company does not have the necessary information available, prepared or analyzed for certain income tax effects of the Tax Act, SAB 118 allows a company to report provisional numbers and adjust those amounts during the measurement period not to extend beyond one year. For the two quarters ended December 28, 2018, the Company has recorded all known and estimable impacts of the Tax Act that are effective for fiscal year 2019. Future adjustments to the provisional numbers will be recorded as discrete adjustments to income tax expense in the period in which those adjustments become estimable and/or are finalized.

 

 

The Company maintains valuation allowances when it is more likely than not that all or a portion of a deferred tax asset will not be realized. Changes in valuation allowances from period to period are included in the tax provision in the period of change. In determining whether a valuation allowance is required, the Company takes into account such factors as prior earnings history, expected future earnings, carry-back and carry-forward periods, and tax strategies that could potentially enhance the likelihood of realization of a deferred tax asset. In addition, all other available positive and negative evidence is taken into consideration, including all new impacts of tax reform. The company has evaluated the realizability of the net deferred tax assets related to its operations and based on this evaluation management has concluded that no valuation allowances are required.

 

Accounting policies for interim reporting require the Company to adjust its effective tax rate each quarter to be consistent with the estimated annual effective tax rate. Under this effective tax rate methodology, the Company applies an estimated annual income tax rate to its year-to-date ordinary earnings to derive its income tax provision each quarter.

 

The Company has approximately $1,092 of unrecognized tax benefits, including related interest and penalties, as of December 28, 2018, which, if recognized, would favorably impact the effective tax rate. There was no significant change in the total unrecognized tax benefits due to the settlement of audits, the expiration of statutes of limitations or for other items during the two quarters ended December 28, 2018. It appears possible that the amount of unrecognized tax benefits could change in the next twelve months due to on-going audit activity.

 

Annually, the Company files income tax returns in various taxing jurisdictions inside and outside the United States. In general, the tax years that remain subject to examination are 2011 through 2018 for the major operations in Italy, Canada, Belgium, and Japan. The tax years open to examination in the U.S. are for years subsequent to fiscal 2015. The state of Wisconsin income tax audit remains ongoing for the fiscal years 2010 through 2013. It is reasonably possible that other audit cycles will be completed during fiscal 2019.

 

 

K.     Goodwill and Other Intangibles

 

Goodwill represents the excess of the consideration transferred net of the acquisition-date fair values of the identifiable assets acquired and the liabilities assumed.

 

The Company reviews goodwill for impairment on a reporting unit basis annually as of the end of the fiscal year, and whenever events or circumstances (“triggering events”) indicate that the carrying value of goodwill may not be recoverable. The Company monitors for interim triggering events on an ongoing basis. Such triggering events include unfavorable operating results and macroeconomic trends.

 

The fair value of reporting units is primarily driven by projected growth rates and operating results under the income approach using a discounted cash flow model, which applies an appropriate market-participant discount rate, and consideration of other market approach data from guideline public companies. If declining actual operating results or future operating results become indicative that the fair value of the Company’s reporting units has declined below their carrying values, an interim goodwill impairment test may need to be performed and may result in a non-cash goodwill impairment charge.

 

On July 2, 2018, as discussed in Note B, the Company acquired goodwill in the estimated amount of $25,679 and intangible assets in the estimated amount of $22,000 as part of the acquisition of Veth Propulsion Holding BV. These estimates are preliminary and are pending completion of several elements, including the final determination of the purchase price adjustment, finalization of an independent valuation of fair value of the assets acquired and liabilities assumed and final review by the Company’s management. The final determination of the purchase price, fair values and resulting goodwill may differ significantly from what is currently reflected.

 

 

As of December 28, 2018, changes in the carrying amount of goodwill is summarized as follows:

 

 

For the quarter ended December 28, 2018, the Company performed a review of potential triggering events, and concluded there were no triggering events that indicated that the fair value of its European Industrial reporting unit had not more likely than not declined to below its carrying value at December 28, 2018. The Company will perform its annual impairment test for this reporting unit as of June 30, 2019.

 

As of December 28, 2018, the following acquired intangible assets have definite useful lives and are subject to amortization:

 

 

Other intangibles consist of certain amortizable acquisition costs, proprietary technology, computer software, licensing agreements and certain customer relationships.

 

The weighted average remaining useful life of the intangible assets included in the table above is approximately 10 years.

 

Intangible amortization expense was $583 and $45 for the quarters ended December 28, 2018, and December 29, 2017, respectively. Intangible amortization expense was $1,249 and $89 for the two quarters ended December 28, 2018, and December 29, 2017, respectively. Estimated intangible amortization expense for the remainder of fiscal 2019 and each of the next five fiscal years is as follows:

 

 

The gross carrying amount of the Company’s intangible assets that have indefinite lives and are not subject to amortization as of December 28, 2018 and June 30, 2018 was $200 and $202, respectively. These assets are comprised of acquired trade names.

 

 

L.	Long-term Debt

 

On June 29, 2018, the Company entered into a new credit agreement (the “Credit Agreement”) with BMO Harris Bank N.A. (“BMO”) that provided for the assignment and assumption of the previously existing loans between the Company and Bank of Montreal (the “2016 Credit Agreement”) and subsequent amendments into a term loan (the “Term Loan”) and revolving credit loans (each a “Revolving Loan” and, collectively, the “Revolving Loans,” and, together with the Term Loan, the “Loans”). Pursuant to the Credit Agreement, BMO agreed to make the Term Loan to the Company in a principal amount not to exceed $35,000 and the Company may, from time to time prior to the maturity date, enter into Revolving Loans in amounts not to exceed, in the aggregate, $50,000 (the “Revolving Credit Commitment”). The Credit Agreement also allows the Company to obtain Letters of Credit from BMO, which if drawn upon by the beneficiary thereof and paid by BMO, would become Revolving Loans.

 

 

Borrowings under the Credit Agreement are secured by substantially all of the Company’s personal property, including accounts receivable, inventory, machinery and equipment, and intellectual property, and the personal property of Mill-Log Equipment Co., Inc. (“Mill-Log”), a wholly-owned domestic subsidiary of the Company. The Company has also pledged 100% of its equity interests in certain domestic subsidiaries and 65% of its equity interests in certain foreign subsidiaries. To effect these security interests, the Company and Mill-Log entered into various amendments and assignment agreements that consent to the assignment to BMO of certain agreements previously entered into between the Company and Mill-Log with Bank of Montreal in connection with the 2016 Credit Agreement. The Company also entered into a Collateral Assignment of Rights under Purchase Agreement for its acquisition of Veth Propulsion described in Note B.

 

On July 2, 2018, in connection with the acquisition of Veth Propulsion, as described in Note B, the Company drew a total of $60,729 of additional borrowings on the new credit facility, consisting of a $35,000 Term Loan payable and revolver borrowings of $25,729. 

 

On September 25, 2018, the Company used the proceeds of a stock offering (see Note M) of $32,310 to partially pay down the Term Loan and Revolving Loans.

 

Long-term debt at December 28, 2018 and June 30, 2018 consisted of the following:

 

 

During the two quarters ended December 28, 2018, the average interest rates paid on loans were as follows: 5.20% on the Term Loan, 2.25% on the euro revolver, and 4.45% on the USD revolver.

 

As of December 28, 2018, the Company’s borrowing capacity under the terms of the Credit Agreement was $50,000, and the Company had approximately $14,185 of available borrowings. In addition to the Credit Agreement, the Company has established unsecured lines of credit that are used from time to time to secure certain performance obligations by the Company.

 

The Company’s borrowings described above approximates fair value at December 28, 2018 and June 30, 2018. If measured at fair value in the financial statements, long-term debt (including the current portion) would be classified as Level 2 in the fair value hierarchy.

 

 

M.	Shareholders’ Equity

 

The Company completed the sale of 1,533.3 shares of its common stock through a registered offering which closed on September 25, 2018, at a price to the public of $22.50 per share. The net proceeds received by the Company and after underwriting expenses of $2,070 and offering expenses of $220, were $32,210 and were recorded as paid-in capital as of December 28, 2018. The proceeds were used to partially pay down the Term Loan and Revolving Loans (see Note L).

 

The Company, from time to time, makes open market purchases of its common stock under authorizations given to it by the Board of Directors, of which 315.0 shares as of December 28, 2018 remain authorized for purchase.  The Company did not make any open market purchases of its shares during the quarters ended December 28, 2018 and December 29, 2017.

 

 

The following is a reconciliation of the Company’s equity balances for the first two fiscal quarters of 2019 and 2018:

 

 

 

Reconciliations for the changes in accumulated other comprehensive income (loss), net of tax, by component for the quarters ended September 28, and December 28, 2018, and September 29, and December 29, 2017 are as follows:

 

 

 

 

Reconciliation for the changes in benefit plan adjustments, net of tax for the quarter and two quarters ended December 28, 2018 are as follows:

 

 

 

Reconciliation for the changes in benefit plan adjustments, net of tax for the quarter and two quarters ended December 29, 2017 is as follows:

 

 

(a)

These accumulated other comprehensive income components are included in the computation of net periodic pension cost (see Note I "Pension and Other Postretirement Benefit Plans" for further details).

 

 

N.	Restructuring of Operations

 

The Company has implemented various restructuring programs in response to unfavorable macroeconomic trends in certain of the Company’s markets since the fourth quarter of fiscal 2015. These programs primarily involved the reduction of workforce in several of the Company’s manufacturing locations, under a combination of voluntary and involuntary programs.

 

During the current year, the Company implemented continued actions to reduce personnel costs in its Belgian operations and reorganize for productivity in its European operations. These actions resulted in restructuring charges of $434 and $607 in the quarter and two quarters ended December 28, 2018, respectively. For the quarter and two quarters ended December 29, 2017, restructuring charges of $831 and $2,049, respectively, pertained to similar actions to reduce personnel costs in the Company’s Belgian operations, as well as costs associated with the India manufacturing operations exit.

 

 

Restructuring activities since June 2015 have resulted in the elimination of 175 full-time employees in the manufacturing segment. Accumulated costs to date under these programs within the manufacturing segment through December 28, 2018 were $9,880.

 

The following is a rollforward of restructuring activity:

 

 

 

O.	Earnings Per Share

 

The Company calculates basic earnings per share based upon the weighted average number of common shares outstanding during the period, while the calculation of diluted earnings per share includes the dilutive effect of potential common shares outstanding during the period.  The calculation of diluted earnings per share excludes all potential common shares if their inclusion would have an anti-dilutive effect.  Certain restricted stock award recipients have a non-forfeitable right to receive dividends declared by the Company, and are therefore included in computing earnings per share pursuant to the two-class method. 

 

The components of basic and diluted earnings per share were as follows:

 

 

 

The following potential common shares were excluded from diluted EPS for the quarter and two quarters ended December 28, 2018 because they were anti-dilutive: 134.4 related to the Company’s unvested PSAs, 185.3 related to the Company’s unvested RS awards, 33.6 and 16.6, respectively, related to the Company’s unvested RSUs, and 3.4 related to outstanding stock options.

 

The following potential common shares were excluded from diluted EPS for the quarter and two quarters ended December 29, 2017 as the Company reported a net loss: 224.9 related to the Company’s unvested PSAs, 272.4 related to the Company’s unvested RS awards, and 9.6 related to outstanding stock options.

 

 

 

P.	Lease Liabilities

 

The Company leases certain office and warehouse space, as well as production and office equipment.

 

The components of lease expense were as follows:

 

 

 

 

Other information related to leases was as follows:

 

 

Approximate future minimum rental commitments under non-cancellable lease as of December 28, 2018 were as follows:

 

 

The Company had $16,465 and $6,527 of operating lease right-of-use assets recorded in property, plant and equipment, net as of December 28, 2018 and June 30, 2018, respectively. The Company had $16,467 and $6,527 of operating lease liabilities recorded in lease obligations as of December 28, 2018 and June 30, 2018, respectively.