TWIN DISC INC - Quarter Report: 2020 September (Form 10-Q)

Part I.     FINANCIAL INFORMATION

Item 1.     Financial Statements

TWIN DISC, INCORPORATED

CONDENSED CONSOLIDATED BALANCE SHEETS

(IN THOUSANDS, EXCEPT SHARE AMOUNTS)

(UNAUDITED)

The notes to condensed consolidated financial statements are an integral part of these statements.

TWIN DISC, INCORPORATED

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)

(IN THOUSANDS, EXCEPT PER SHARE DATA)

(UNAUDITED)

The notes to condensed consolidated financial statements are an integral part of these statements.

TWIN DISC, INCORPORATED

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(IN THOUSANDS)

(UNAUDITED)

The notes to condensed consolidated financial statements are an integral part of these statements.

TWIN DISC, INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)

(UNAUDITED)

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 adjustments, consisting primarily 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, 2020. 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.

Recently Adopted Accounting Standards

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 Company adopted this guidance effective July 1, 2020. The adoption of this guidance did not have a material impact on the Company’s financial statements and disclosures.

In August 2018, the FASB issued updated guidance (ASU 2018-14) intended to modify the disclosure requirements for employers that sponsor defined benefit pension or postretirement plans. The Company adopted this guidance effective July 1, 2020. The adoption of this guidance did not have a material impact on the Company’s financial statements and disclosures.

New Accounting Releases

In June 2016, the FASB issued updated guidance (ASU 2016-13) and also issued subsequent amendments to the initial guidance under ASU 2018-19, ASU 2019-04, ASU 2019-05 and ASU 2019-10 (collectively Topic 326). Topic 326 requires the measurement and recognition of expected credit losses for financial assets held at amortized cost. This replaces the existing incurred loss model with an expected loss model and requires the use of forward-looking information to calculate credit loss estimates. The amendments in this guidance are effective for filers, excluding smaller reporting companies, for fiscal years beginning after December 15, 2019, and for smaller reporting companies for fiscal years beginning after December 15, 2022 (the Company’s fiscal 2024), with early adoption permitted for certain amendments. Topic 326 must be adopted by applying a cumulative effect adjustment to retained earnings. The Company is currently evaluating the potential impact of this guidance on the Company’s disclosures.

In December 2019, the FASB issued guidance (ASU 2019-12) intended to simplify the accounting for income taxes. The amendments in this guidance are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2020 (the Company’s fiscal 2022), with early adoption permitted. The Company is currently evaluating the potential impact of this guidance on the Company’s disclosures.

In March 2020, the FASB issued guidance (ASU 2020-04), intended to provide optional expedients and exceptions for applying generally accepted accounting principles to contracts, hedging relationships, and other transactions affected by the discontinuation of the London Interbank Offered Rate (“LIBOR”) or by another reference rate expected to be discontinued. The amendments in this guidance are effective beginning on March 12, 2020, and the Company may elect to apply the amendments prospectively through December 31, 2022. The Company is currently evaluating the potential impact of this guidance on the Company’s financial statements and disclosures.

Special Note Regarding Smaller Reporting Company Status

Under SEC Release 33-10513; 34-83550, Amendments to Smaller Reporting Company Definition, the Company qualifies as a smaller reporting company and accordingly, it has scaled some of its disclosures of financial and non-financial information in this quarterly report. The Company will continue to determine whether to provide additional 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.

The major classes of inventories were as follows:

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 quarters ended September 25, 2020 and September 27, 2019:

Included in expense in the quarters ended September 25, 2020 and September 27, 2019 is a non-recurring warranty charge in the amount of $188 and $3,889, respectively, to accrue for estimated costs to resolve a unique product performance issue at certain installations.

The current portion of the warranty accrual ($3,863 and $6,253 as of September 25, 2020 and September 27, 2019, respectively) is reflected in accrued liabilities, while the long-term portion ($819 and $854 as of September 25, 2020 and September 27, 2019, respectively) is included in other long-term liabilities on the consolidated balance sheets.

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.

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's worldwide sales to both domestic and foreign customers are transacted through a direct sales force and a distributor network.

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:

Disaggregated revenue:

The following table presents details deemed most relevant to the users of the financial statements for the quarters ended September 25, 2020 and September 27, 2019.

Net sales by product group for the quarter ended September 25, 2020 is summarized as follows:

Net sales by product group for the quarter ended September 27, 2019 is summarized as follows:

Performance Stock Awards (“PSA”)

During the first quarter of fiscal 2021 and 2020, the Company granted a target number of 265.3 and 71.7 PSAs, respectively, to various employees of the Company, including executive officers. The fiscal 2021 PSAs will vest if the Company achieves performance-based target objectives relating to average return on invested capital, average annual sales and average free cash flow (as defined in the PSA Grant Agreement), in the cumulative three fiscal year period ending June 30, 2023. These PSAs are subject to adjustment if the Company’s return on invested capital, net sales, and free cash flow 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 397.9. Based upon actual results to date, the Company is currently accruing compensation expense for these PSAs.

The fiscal 2020 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, 2022. 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 94.8. Based upon actual results to date, the Company is not currently accruing compensation expense for these PSAs.

There were 433.1 and 167.8 unvested PSAs outstanding at September 25, 2020 and September 27, 2019, 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 $87 and $72 was recognized for the quarters ended September 25, 2020 and September 27, 2019, respectively, related to PSAs. The weighted average grant date fair value of the unvested awards at September 25, 2020 was $9.26. At September 25, 2020, the Company had $3,923 of unrecognized compensation expense related to the unvested shares that would vest if the specified target objective was achieved for the fiscal 2021, 2020 and 2019 awards. The total fair value of PSAs vested as of September 25, 2020 and September 27, 2019 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 quarter of fiscal 2021 and 2020, the Company granted 151.6 and 86.4 service based restricted shares, respectively, to employees and non-employee directors. There were 332.8 and 178.8 unvested shares outstanding at September 25, 2020 and September 27, 2019, respectively. Compensation expense of $339 and $306 was recognized for the quarters ended September 25, 2020 and September 27, 2019, respectively. The total fair value of restricted stock grants vested as of September 25, 2020 and September 27, 2019 was $293 and $1,017, respectively. As of September 25, 2020, the Company had $1,842 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. 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 September 25, 2020 and at September 27, 2019. Compensation expense of $82 and $81 was recognized for the quarters ended September 25, 2020 and September 27, 2019, respectively. The weighted average grant date fair value of the unvested awards at September 25, 2020 was $25.77. As of September 25, 2020, the Company had $272 of unrecognized compensation expense related to restricted stock which will be recognized over the next two years.

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 $2,346 to its pension plans in fiscal 2021. As of September 25, 2020, the amount of $151 in contributions has been made.

The Company has reclassified $553 (net of $177 in taxes) of benefit plan adjustments from accumulated other comprehensive loss during the quarter ended September 25, 2020, and $557 (net of $169 in taxes) during the quarter ended September 27, 2019. These reclassifications are included in the computation of net periodic benefit cost.

For the quarters ended September 25, 2020 and September 27, 2019, the Company’s effective income tax rate was 19.1% and 20.5% respectively. The mix of income earned by jurisdiction net of the changes in the tax preference items recognized resulted in a minimal change in rate of 1.4%.

The spread of the COVID-19 outbreak (the global pandemic declared by the World Health Organization in March 2020) has caused significant volatility and uncertainty in U.S. and international markets. On March 27, 2020 the U.S. government enacted the Coronavirus Aid, Relief and Economic Security Act (the “CARES Act”). The CARES Act includes many measures to assist companies, including temporary changes to income and non-income-based tax laws, some of which were enacted under the Tax Cuts and Jobs Act in 2017. In addition, governments around the world continue to initiate various forms of assistance. The full impact of the COVID-19 outbreak continues to evolve as of the date of this report. As such it is uncertain as to the full magnitude that the COVID-19 outbreak will have on the Company’s financial condition, liquidity, and future results of operations.

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 $1,138 of unrecognized tax benefits, including related interest and penalties, as of September 25, 2020, 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 quarter ended September 25, 2020. 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 in foreign jurisdictions are 2013 through 2019. The tax year open to exam in the Netherlands is fiscal 2019. The tax years open to examination in the U.S. are for years subsequent to fiscal 2016. The state of Wisconsin income tax audit remains ongoing for the fiscal years 2011 through 2013. It is reasonably possible that other audit cycles will be completed during fiscal 2021.

I.     Intangible Assets

As of September 25, 2020, the following acquired intangible assets have definite useful lives and are subject to amortization:

Other intangibles consist mainly of computer software. Amortization is recorded on the basis of straight-line or accelerated, as appropriate, over the estimated useful lives of the assets.

The weighted average remaining useful life of the intangible assets included in the table above is approximately 8 years.

Intangible amortization expense was $835 and $1,129 for the quarters ended September 25, 2020, and September 27, 2019, respectively. Estimated intangible amortization expense for the remainder of fiscal 2021 and each of the next five fiscal years is as follows:

Long-term debt at September 25, 2020 and June 30, 2020 consisted of the following:

Credit Agreement Debt: The Company’s credit agreement debt represents borrowings made under the credit agreement, as amended, which it entered into with BMO Harris Bank N.A, on June 29, 2018 (“Credit Agreement”). As a result of the most recent amendment of July 22, 2020, the revolving loan facility has been amended from $50,000 to $45,000, and the term loan principal quarterly payments of $500 payable on September 30, 2020 and December 31, 2020 were deferred to fiscal 2026. Interest rate margins on the term loan also changed, from 3.375% to 3.875%.

As of September 25, 2020, current maturities include $1,500 of term loan payments due within a year.

Also as a result of the most recent amendment, the Company was given financial covenant relief for the quarters ended June 30, 2020 through June 30, 2021. During this period, in lieu of the Total Funded Debt to EBITDA ratio financial covenant, the Company is required to maintain a minimum cumulative EBITDA, as follows: (1) $1,000 for the fiscal quarter ended June 30, 2020 and the two fiscal quarters ending September 25, 2020; (2) $2,500 for the three fiscal quarters ending December 25, 2020; (3) $6,000 for the four fiscal quarters ending March 26, 2021; and (4) $10,000 for the four fiscal quarters ending June 30, 2021. As of September 25, 2020, the Company was in compliance with financial covenants.

The Credit Agreement, including its amendments, is more fully described in the Company’s Annual Report filed on Form 10-K for June 30, 2020, as well as in Item 2 of this quarterly report.

The PPP Loan: On April 17, 2020, the Company entered into a promissory note (the “PPP Note”) evidencing an unsecured loan in the amount of $8,200 made to the Company under the Paycheck Protection Program ("PPP"). The PPP is a liquidity facility program established by the U.S. government as part of the CARES Act in response to the negative economic impact of the COVID-19 outbreak. The PPP Loan to the Company is being administered by BMO. The PPP Loan has a two-year term and bears interest at a rate of 1.0% per annum. Monthly principal and interest payments are due starting on May 2021. PPP Loan recipients can be granted forgiveness for all or a portion of loans granted subject to certain conditions, based on the use of the loan proceeds for payment of payroll costs and any payments of mortgage interest, rent and utilities. The Company has started the process of applying for loan forgiveness.

In accounting for the terms of the PPP Loan, the Company is guided by ASC 470 Debt, and ASC 450-30 Gain Contingency. Accordingly, it recorded the proceeds of the PPP Loan of $8,200 as debt and it will derecognize the liability when the loan is paid off or it believes forgiveness is reasonably certain. The Company believes that the possibility of loan forgiveness is to be regarded as a contingent gain and therefore will not recognize the gain (and derecognize the loan) until all uncertainty is removed (i.e. all conditions for forgiveness are met).

As of September 25, 2020, current maturities include $2,200 of PPP principal payments due within a year.

The PPP Loan is more fully described in the Company’s Annual Report filed on Form 10-K for June 30, 2020, as well as in Item 2 of this quarterly report.

Other: Other long-term debt pertains mainly to a financing arrangement in Europe. These liabilities carry terms of three to five years and implied interest rates ranging from 7% to 25%. A total amount of $21 in principal was paid on these liabilities during the current fiscal year.

During the quarter ended September 25, 2020, the average interest rate was 4.03% on the Term Loan, and 4.25% on the Revolving Loans.

As of September 25, 2020, the Company’s borrowing capacity on the Revolving Loans under the terms of the Credit Agreement was $40,894, and the Company had approximately $24,111 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 approximate fair value at September 25, 2020 and June 30, 2020. 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.

The Company is party to an interest rate swap arrangement with Bank of Montreal, with an initial notional amount of $20,000 and a maturity date of March 4, 2026 to hedge the Term Loan. As of September 25, 2020, the notional amount was $17,500. This swap has been designated as a cash flow hedge under ASC 815, Derivatives and Hedging. This swap is included in the disclosures in Note O, Derivative Financial Instruments.

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 September 25, 2020 remain authorized for purchase.  The Company did not make any open market purchases of its shares during the quarters ended September 25, 2020 and September 27, 2019.

The following is a reconciliation of the Company’s equity balances for the first fiscal quarters of 2021 and 2020:

Reconciliations for the changes in accumulated other comprehensive income (loss), net of tax, by component for the quarters ended September 25, 2020, and September 27, 2019 are as follows:

Reconciliation for the changes in benefit plan adjustments, net of tax for the quarter ended September 25, 2020 are as follows:

Reconciliation for the changes in benefit plan adjustments, net of tax for the quarter ended September 27, 2019 is as follows:

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. In its European operations, the Company also implemented actions to reorganize for productivity.

These actions resulted in restructuring charges of $405 in the quarter ended September 25, 2020, and restructuring charges of $121 for the quarter ended September 27, 2019.

Restructuring activities since June 2015 have resulted in the elimination of 249 full-time employees in the manufacturing segment. Accumulated costs to date under these programs within the manufacturing segment through September 25, 2020 were $12,810.

The following is a roll-forward of restructuring activity:

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 ended September 25, 2020 as the Company reported a net loss: 433.1 related to the Company’s unvested PSAs, 332.8 related to the Company’s unvested RS awards, and 38.0 related to the Company’s unvested RSUs.

The following potential common shares were excluded from diluted EPS for the quarter ended September 27, 2019 as the Company reported a net loss: 167.8 related to the Company’s unvested PSAs, 178.8 related to the Company’s unvested RS awards, 38.0 related to the Company’s unvested RSUs, and 3.6 related to outstanding stock options.

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

The Company determines if an arrangement is a lease at contract inception. The lease term begins upon lease commencement, which is when the Company takes possession of the asset, and may include options to extend or terminate the lease when it is reasonably certain that such options will be exercised. As its lease agreements typically do not provide an implicit rate, the Company primarily uses an incremental borrowing rate based upon the information available at lease commencement. In determining the incremental borrowing rate, the Company considers its current borrowing rate, the term of the lease, and the economic environments where the lease activity is concentrated.

The components of lease expense were as follows:

Other information related to leases was as follows:

Approximate future minimum rental commitments under non-cancellable leases as of September 25, 2020 were as follows:

The following table provides a summary of leases recorded on the condensed consolidated balance sheet.

From time to time, the Company enters into derivative instruments to manage volatility arising from risks relating to interest rates and foreign exchange. The Company does not purchase, hold or sell derivative financial instruments for trading purposes. The Company’s practice is to terminate derivative transactions if the underlying asset or liability matures or is sold or terminated, or if it determines the underlying forecasted transaction is no longer probable of occurring.

The Company reports all derivative instruments on its consolidated balance sheets at fair value and establishes criteria for designation and effectiveness of transactions entered into for hedging purposes.

Interest Rate Swap Contracts

The Company has one outstanding interest rate swap contract as of September 25, 2020, with a notional amount of $17,500. It has been designated as a cash flow hedge in accordance with ASC 815, Derivatives and Hedging.

The primary purpose of the Company’s cash flow hedging activities is to manage the potential changes in value associated with interest payments on the Company’s LIBOR-based indebtedness. The Company records gains and losses on interest rate swap contracts qualifying as cash flow hedges in accumulated other comprehensive loss to the extent that these hedges are effective and until the Company recognizes the underlying transactions in net earnings, at which time these gains and losses are recognized in interest expense on its consolidated statements of operations and comprehensive (loss) income. Cash flows from derivative financial instruments are classified as cash flows from financing activities on the consolidated statements of cash flows. These contracts generally have original maturities of greater than 12 months.

Net unrealized after-tax losses related to cash flow hedging activities that were included in accumulated other comprehensive loss were $1,029 and $1,104 as of September 25, 2020 and June 30, 2020, respectively. The unrealized amounts in accumulated other comprehensive loss will fluctuate based on changes in the fair value of open contracts during each reporting period.

The Company estimates that $378 of net unrealized losses related to cash flow hedging activities included in accumulated other comprehensive loss will be reclassified into earnings within the next twelve months.

Foreign Currency Forward Contracts

The Company primarily enters into forward exchange contracts to reduce the earnings and cash flow impact of non-functional currency denominated receivables and payables. At September 25, 2020, one of the Company’s foreign subsidiaries had one outstanding forward exchange contract to purchase U.S. dollars in the notional value of $711 with a weighted average maturity of 6 days. The fair value of the Company’s contract was a loss of $13 at September 25, 2020. At June 30, 2020, the same foreign subsidiary had one outstanding forward exchange contract to purchase U.S. dollars in the notional value of $1,247 with a weighted average maturity of 7 days. The fair value of the Company’s contract was a loss of $9 at June 30, 2020.

Fair Value of Derivative Instruments

The fair value of derivative instruments included in the condensed consolidated balance sheets were as follows:

The impact of the Company’s derivative instruments on the consolidated statement of operations and comprehensive income (loss) for the quarters ended September 25, 2020 and September 27, 2019, respectively, was as follows:

Item 2.     Management Discussion and Analysis

In the financial review that follows, we discuss our results of operations, financial condition and certain other information. This discussion should be read in conjunction with our consolidated financial statements as of September 25, 2020, and related notes, as reported in Item 1 of this Quarterly Report.

Some of the statements in this Quarterly Report on Form 10-Q are “forward-looking statements” as defined in the Private Securities Litigation Reform Act of 1995. Forward-looking statements include the Company’s description of plans and objectives for future operations and assumptions behind those plans. The words “anticipates,” “believes,” “intends,” “estimates,” and “expects,” or similar anticipatory expressions, usually identify forward-looking statements. In addition, goals established by the Company should not be viewed as guarantees or promises of future performance. There can be no assurance the Company will be successful in achieving its goals.

In addition to the assumptions and information referred to specifically in the forward-looking statements, other factors, including but not limited to those factors discussed under Item 1A, Risk Factors, of the Company’s Annual Report filed on Form 10-K for June 30, 2020, as supplemented in this Quarterly Report, could cause actual results to be materially different from what is expressed or implied in any forward-looking statement.

Results of Operations

Comparison of the First Quarter of Fiscal 2021 with the First Quarter of Fiscal 2020

Net sales for the first quarter decreased 22.2%, or $13.1 million, to $46.1 million from $59.3 million in the same quarter a year ago. The Company experienced a broad-based softening in demand across the oil and gas, industrial and marine markets, due in large part to the continued impacts of the COVID-19 crisis on the Company’s global markets. Global demand for industrial products declined 22.5% from the prior year, while off-highway transmission demand fell by 23.7% and marine and propulsion fell by 25.2%. The North American region suffered the most significant sales decline ($7.5 million or 34.2%) due to continued weakness in the North American oil and gas market and a general decline across all markets. The North American region declined from 37% of total sales in the prior year first quarter to 31% in the fiscal 2021 first quarter. The European region saw a similar decline ($6.3 million and 29.3%), with similar weakness across the markets served. Sales into the Asia Pacific region increased slightly ($0.2 million or 1.6%), due to stable demand for oil and gas units in China and an improving marine market in Australia. Currency translation had a favorable impact on first quarter fiscal 2021 sales compared to the first quarter of the prior year totaling $1.5 million primarily due to the strengthening of the euro and Australian dollar against the U.S. dollar.

Sales at our manufacturing segment decreased 29.4%, or $16.1 million, versus the same quarter last year. The U.S. manufacturing operation experienced a 39.8%, or $12.6 million, decrease in sales versus the first fiscal quarter of 2020, with weakness across all product lines, including weaker demand for the Company’s oil and gas related products, industrial and marine products. The Company’s operation in the Netherlands was down $4.1 million (31.2%) compared to first fiscal quarter of 2020, with many boat construction projects being delayed due to the COVID-19 crisis. The Company’s Belgian operation saw a slight increase compared to the prior year (6.0% or $0.3 million), primarily currency exchange driven, with some market strength in Asia. The Company’s Italian manufacturing operations, also benefiting from some positive exchange impact, were up $0.4 million (8.1%) compared to the first quarter of 2020. The Company’s Swiss manufacturing operation, which supplies customized propellers for the global mega yacht and patrol boat markets, was essentially equal to the prior year first fiscal quarter.

Our distribution segment experienced a very minor increase (0.3%, or $0.1 million) in sales compared to the first quarter of fiscal 2020. The Company’s Asian distribution operations in Singapore, China and Japan were up 2.7% from the prior year on stable demand for the Company’s commercial marine, oil and gas, and patrol craft products in the region. The Company’s North America distribution operation saw a decline of 36.7% on overall weakness across the domestic markets served. The Company’s distribution operation in Australia, which provides boat accessories, propulsion and marine transmission systems for the pleasure craft market, saw strong growth (41.6% increase from the prior year first fiscal quarter), on improving pleasure craft marine market trends in the region. The Company’s European distribution operation saw an increase of $0.3 million (6.1%).    

Gross profit as a percentage of sales for the first quarter of fiscal 2021 increased to 22.3%, compared to 16.3% for the same period last year. This increase is largely due to a $3.9 million expense recorded in the prior year first quarter for an isolated product performance issue related to one of the Company’s oil and gas transmission models. The Company continued to experience an unfavorable product mix profile ($1.6 million) and reduced volume ($3.0 million). These negative impacts were partially offset by cost reduction activities ($0.9 million) and foreign COVID-19 relief programs ($0.4 million).

For the fiscal 2021 first quarter, marketing, engineering and administrative (“ME&A”) expenses, as a percentage of sales, were 28.2%, compared to 27.6% for the fiscal 2020 first quarter. ME&A expenses decreased $3.3 million (20.3%) versus the same period last fiscal year. The decrease in ME&A spending for the quarter was comprised of decreases to bonus expense ($0.4 million), domestic salaries and benefits ($1.5 million), marketing expenses ($0.3 million), corporate travel ($0.3 million) and general cost containment actions ($0.8 million).

The Company incurred $0.4 million in restructuring charges during the first quarter of fiscal 2021, primarily associated with ongoing cost reduction actions at its European operations and actions to adjust the cost structure at the Company’s domestic operation. The Company continues to focus on actively managing its cost structure and reducing fixed costs in light of the ongoing market challenges.

Interest expense increased to $0.6 million in the first quarter of fiscal 2021, compared to $0.4 million for the first quarter of the prior fiscal year. This increase reflects a higher average interest rate during the current year, partially offset by a lower average balance.

The unfavorable movement in other expense (income) compared to the prior year is primarily due to the impact of currency movements related to the euro and Australian dollar.

The fiscal 2021 first quarter tax rate of 19.1% is slightly lower than the prior year rate of 20.5%. The decrease in the fiscal 2021 rate is primarily a function of the mix of earnings and losses across the various jurisdictional tax rates.

Financial Condition, Liquidity and Capital Resources

Comparison between September 25, 2020 and June 30, 2020

As of September 25, 2020, the Company had net working capital of $103.2 million, which represents a decrease of $4.1 million, or 3.8%, from the net working capital of $107.3 million as of June 30, 2020.

Cash decreased $1.4 million to $9.3 million as of September 25, 2020, versus $10.7 million as of June 30, 2020. The majority of the cash as of September 25, 2020 is at the Company’s overseas operations in Europe ($4.0 million) and Asia-Pacific ($4.2 million).

Trade receivables of $31.8 million were up $1.1 million, or approximately 3.7%, when compared to last fiscal year-end. The impact of foreign currency translation was to increase accounts receivable by $0.7 million versus June 30, 2020. As a percent of sales, trade receivables finished at 69.0% in the first quarter of fiscal 2021 compared to 62.2% for the comparable period in fiscal 2020 and 51.7% for the fourth quarter of fiscal 2020.

Inventories decreased by $0.4 million, or 0.3%, versus June 30, 2020 to $120.2 million. The impact of foreign currency translation was to increase inventories by $1.8 million versus June 30, 2020. The remaining decrease was seen primarily at the Company’s North American operation, driven by improved purchasing discipline and the initial impacts of a renewed sales, inventory and operations planning (SIOP) process. On a consolidated basis, as of September 25, 2020, the Company’s backlog of orders to be shipped over the next six months approximates $69.4 million, compared to $66.6 million at June 30, 2020 and $96.7 million at September 27, 2019. As a percentage of six-month backlog, inventory has decreased from 181% at June 30, 2020 to 173% at September 25, 2020.

Net property, plant and equipment was up $5.0 million (6.9%) to $77.8 million versus $72.7 million at June 30, 2020. The primary reason for the increase is the recording of the right-of-use asset for the lease of the recently completed building in Lufkin, TX. In addition, the Company had capital spending ($1.4 million) and a favorable exchange impact, partially offset by depreciation ($1.9 million). The capital spending in the quarter reflects a continuation of the Company’s strategy to modernize machine tools and improve manufacturing efficiency through improved technology, including investment in the new facility in Lufkin, TX. In total, the Company expects to invest between $5 and $7 million in capital assets in fiscal 2021. The Company continues to review its capital plans based on overall market conditions and availability of capital, and may make changes to its capital plans accordingly. The Company’s capital program is focused on modernizing key core manufacturing, assembly and testing processes and improving efficiencies at its facilities around the world.

Accounts payable as of September 25, 2020 of $23.3 million was down $2.4 million, or 9.2%, from June 30, 2020. The impact of foreign currency translation was to increase accounts payable by $0.5 million versus June 30, 2020. The remaining decrease is primarily related to the reduced purchasing activities in light of reduced volume in the quarter and a focus on inventory reduction.

Total borrowings and long-term debt as of September 25, 2020 increased just $0.1 million to $42.7 million versus $42.6 million at June 30, 2020. During the first quarter, the Company incurred negative free cash flow (defined as operating cash flow less acquisitions of fixed assets) of $2.1 million and ended the quarter with total debt, net of cash, of $33.4 million, compared to $31.9 million at June 30, 2020, for a net change of $1.5 million.

Total equity increased $0.6 million, or 0.4%, to $140.6 million as of September 25, 2020. The net loss during the quarter decreased equity by $4.0 million, partially offset by a favorable foreign currency translation of $3.6 million. The net change in common stock and treasury stock resulting from the accounting for stock-based compensation increased equity by $0.3 million. The net remaining increase in equity of $0.7 million primarily represents the amortization of net actuarial loss and prior service cost on the Company’s defined benefit pension plans.

On June 29, 2018, the Company entered into the 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 $35.0 million 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, $50.0 million (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. Under the Credit Agreement, the Company may not pay cash dividends on its common stock in excess of $3.0 million in any fiscal year.

On March 4, 2019, the Company entered into a second amendment (the “Second Amendment”) to the Credit Agreement. The Second Amendment reduced the principal amount of the term loan commitment under the Credit Agreement from $35.0 million to $20.0 million. In connection with the Second Amendment, the Company issued an amended and restated term note in the amount of $20.0 million to the Bank, which amended the original $35.0 million note provided under the Credit Agreement.

Prior to entering into the Second Amendment, the outstanding principal amount of the term loan (the “Term Loan”) under the Credit Agreement was $10.8 million. On the date of the Second Amendment, the Bank made an additional advance on the Term Loan to the Company in the amount of $9.2 million. The Second Amendment also extended the maturity date of the Term Loan from January 2, 2020 to March 4, 2026, and added a requirement that the Company make principal installments of $0.5 million per quarter starting with the quarter ending June 30, 2019.

The Second Amendment also reduced the applicable margin for purposes of determining the interest rate applicable to the Term Loan. Previously, the applicable margin was 3.00%, which was added to the Monthly Reset LIBOR Rate or the Adjusted LIBOR, as applicable. Under the Second Amendment, the applicable margin was between 1.375% and 2.375%, depending on the Company’s total funded debt to EBITDA ratio.

The Second Amendment also adjusted certain financial covenants made by the Company under the Credit Agreement. Specifically, the Company covenanted (i) not to allow its total funded debt to EBITDA ratio to be greater than 3.00 to 1.00 (the cap had previously been 3.50 to 1.00 for quarters ending on or before September 30, 2019 and 3.25 to 1.00 for quarters ending on or about December 31, 2019 through September 30, 2020), and (ii) that its tangible net worth will not be less than $100.0 million plus 50% of net income for each fiscal year ending on and after June 30, 2019 for which net income is a positive number (the $100.0 million figure had previously been $70.0 million). 

On January 28, 2020, the Company entered into a third amendment (the “Third Amendment”) to the Credit Agreement. The Third Amendment restated the financial covenant provisions related to the maximum allowable ratio of total funded debt to EBITDA from 3.00 to 1.00 to 4.00 to 1.00 for the quarter ended December 27, 2019, 5.00 to 1.00 for the quarter ending March 27, 2020, 4.00 to 1.00 for the quarter ending June 30, 2020, 3.50 to 1.00 for the quarter ending September 25, 2020 and 3.00 to 1.00 for quarters ending on or after December 25, 2020. For purposes of determining EBITDA, the Third Amendment added back extraordinary expenses (not to exceed $3.9 million) related to the previously reported isolated product performance issue on one of the Company’s oil and gas transmission models at certain installations. Under the Third Amendment, the applicable margin for revolving loans, letters of credit, and term loans was between 1.25% and 3.375%, depending on the Company’s total funded debt to EBITDA ratio.

On July 22, 2020, the Company entered into a fifth amendment (the “Fifth Amendment”) to the Credit Agreement that amends the Credit Agreement dated as of June 29, 2018, as amended between the Company and BMO. The Fifth Amendment reduced BMO’s Revolving Credit Commitment from $50.0 million to $45.0 million. The Fifth Amendment also gives the Company the option to make interest-only payments on the Term Loan for quarterly payments occurring on September 30, 2020 and December 31, 2020, and limits the Company’s Capital Expenditures for the fiscal year ending June 30, 2021 to $10.0 million.

The Fifth Amendment provides the Company with relief from its Total Funded Debt to EBITDA ratio financial covenant under the Credit Agreement through (and including) the earlier of June 30, 2021 or a date selected by the Company. During the financial covenant relief period:

For purposes of the minimum EBITDA covenant and the Total Funded Debt to EBITDA ratio, the Fifth Amendment clarified that EBITDA shall exclude any gain that is realized on the forgiveness of the Small Business Administration Paycheck Protection Program loan that the Company previously received.

The Fifth Amendment also changed the definition of “LIBOR” (used in calculating interest on Eurodollar Loans), “Monthly Reset LIBOR Rate” (used in calculating interest on LIBOR Loans), and “LIBOR Quoted Rate” (used in the definition of “Base Rate,” which is used in calculating interest on Letters of Credit that are drawn upon and not timely reimbursed).

The Company also entered into a Deposit Account Control Agreement with the Bank, reflecting the Bank’s security interest in deposit accounts the Company maintains with the Bank. Under the Fifth Amendment, the Bank may not provide a notice of exclusive control of a deposit account (thereby obtaining exclusive control of the account) prior to the occurrence or existence of a Default or an Event of Default under the Credit Agreement or otherwise upon the occurrence or existence of an event or condition that would, but for the passage of time or the giving of notice, constitute a Default or an Event of Default under the Credit Agreement.

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. The Company has also pledged 100% of its equity interests in certain domestic subsidiaries and 65% of its equity interests in certain foreign subsidiaries. The Company also entered into a Collateral Assignment of Rights under Purchase Agreement for its acquisition of Veth Propulsion. To effect these security interests, the Company entered into various amendment and assignment agreements that consent to the assignment of certain agreements previously entered into between the Company and the Bank of Montreal in connection with the 2016 Credit Agreement. The Company also amended and assigned to BMO a Negative Pledge Agreement that it has previously entered into with Bank of Montreal, pursuant to which it agreed not to sell, lease or otherwise encumber real estate that it owns except as permitted by the Credit Agreement and the Negative Pledge Agreement.

Upon the occurrence of an Event of Default, BMO may take the following actions upon written notice to the Company: (1) terminate its remaining obligations under the Credit Agreement; (2) declare all amounts outstanding under the Credit Agreement to be immediately due and payable; and (3) demand the Company to immediately Cash Collateralize L/C Obligations in an amount equal to 105% of the aggregate L/C Obligations or a greater amount if BMO determines a greater amount is necessary. If such Event of Default is due to the Company’s bankruptcy, BMO may take the three actions listed above without notice to the Company.

On April 17, 2020, the Company entered into a promissory note (the “PPP Note”) evidencing an unsecured loan in the amount of $8.2 million (the “PPP Loan”) made to the Company under the Paycheck Protection Program (“PPP”). The PPP was established under the CARES Act and is a program under the U.S. Small Business Administration (the “SBA”). The PPP Loan to the Company is administered by BMO. The PPP Loan has a two-year term and bears interest at a rate of 1.0% per annum. Monthly principal and interest payments are due starting in May 2021.

Under the terms of the CARES Act, PPP loan recipients can be granted forgiveness for all or a portion of loans granted under the PPP. Such forgiveness will be determined, subject to limitations, based on the use of loan proceeds for payment of payroll costs and any payments of mortgage interest, rent, and utilities. However, no assurance is provided that the Company will obtain forgiveness for any portion of the PPP Loan.

In connection with the PPP Loan, the Company entered into a fourth amendment to the Credit Agreement (the “Fourth Amendment”) on April 17, 2020. The Fourth Amendment: (1) permits the Company to incur indebtedness in the form of the PPP Loan notwithstanding the Credit Agreement’s restrictions limiting the Company’s ability to incur indebtedness, and (2) provides that the PPP Loan (to the extent that the PPP Loan is forgiven) shall be disregarded for purposes of calculating financial covenants in the Credit Agreement. Any unforgiven portion of the PPP Loan and the interest thereon will not be disregarded for purposes of calculating the covenants.

The Company is closely tracking qualified expenses to ensure its compliance with the PPP requirements and to support its application for forgiveness.  As of September 25, 2020, the Company estimates that the amount of expenses qualifying for forgiveness it has incurred to date is approximately $8.2 million.  These expenses are included in cost of goods sold and marketing, engineering and administrative expenses in the accompanying statement of operations and comprehensive income (loss).  While the forgiveness of the loan is not taxable, the expenses that were used by the funds are not deductible for tax purposes. Although the rules are still fluid and subject to revisions, currently the Company expects that at the end of the measurement period, it would be able to provide support and qualify for loan forgiveness in the amount of approximately $7.0 million to $7.6 million.  If, and when, forgiveness of this amount is assured, the Company would record this as a gain on debt extinguishment in fiscal 2021. This is described further in Note J, Long-term Debt, of the notes to the consolidated financial statements.

There are no material off-balance-sheet arrangements, and the Company continues to have sufficient liquidity for near-term needs. The Company had approximately $24.1 million of available borrowings under the Credit Agreement as of September 25, 2020. The Company expects to continue to generate enough cash from operations, as well as have sufficient capacity under its credit facilities, to meet its operating and investing needs. As of September 25, 2020, the Company also had cash of $9.3 million, primarily at its overseas operations. These funds, with some restrictions and tax implications, are available for repatriation as deemed necessary by the Company. In fiscal 2021, the Company expects to contribute $2.3 million to its defined benefit pension plans, the minimum contribution required.

Net working capital decreased $4.1 million, or 3.8%, during the first quarter of fiscal 2021, and the current ratio fell slightly to 2.5 for September 25, 2020 from 2.6 at June 30, 2020. The decrease in net working capital was primarily driven by an increase in accrued expenses, partially offset by reduced accounts payable resulting from lower purchasing activity on reduced sales volume.

The Company expects capital expenditures to be approximately $5 million - $7 million in fiscal 2021. These anticipated expenditures reflect the Company’s plans to invest in modern equipment and facilities (including the new Lufkin, TX facility), its global sourcing program and new products.

Management believes that available cash, the BMO credit facility, and potential access to debt markets will be adequate to fund the Company’s capital requirements for the foreseeable future.

The Company has approximately $1.1 million of unrecognized tax benefits, including related interest and penalties, as of September 25, 2020, which, if recognized, would favorably impact the effective tax rate. See Note H, Income Taxes, of the Condensed Consolidated Financial Statements for disclosures surrounding uncertain income tax positions.

The Company maintains defined benefit pension plans for some of its operations in the United States and Europe. The Company has established the Benefits Committee (a non-Board management committee) to oversee the operations and administration of the defined benefit plans. The Company estimates that fiscal 2021 contributions to all defined benefit plans will total $2.3 million. As of September 25, 2020, $0.2 million in contributions have been made.

New Accounting Releases

See Note A, Basis of Presentation, to the condensed consolidated financial statements for a discussion of recently issued accounting standards.

Critical Accounting Policies

The preparation of this Quarterly Report requires management’s judgment to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the dates of the financial statements, and the reported amounts of revenues and expenses during the reporting period. There can be no assurance that actual results will not differ from those estimates.

The Company’s critical accounting policies are described in Item 7 of the Company’s Annual Report filed on Form 10-K for June 30, 2020. There have been no significant changes to those accounting policies subsequent to June 30, 2020.

Item 3.     Quantitative and Qualitative Disclosure About Market Risk

The Company is electing not to provide this disclosure due to its status as a Smaller Reporting Company.

Item 4.     Controls and Procedures

(a)     Evaluation of Disclosure Controls and Procedures

The Company’s management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, have evaluated the effectiveness of the Company’s disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (“the Exchange Act”) as of the end of the period covered by this report. Based on such evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, the Company’s disclosure controls and procedures are effective in recording, processing, summarizing, and reporting, on a timely basis, information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act, and that such information is accumulated and communicated to the Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely discussions regarding required disclosure.

(b)     Changes in Internal Control Over Financial Reporting

Management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f) and 15d-15(f). During the most recent fiscal quarter, no changes were made which have materially affected, or which are reasonably likely to materially affect, our internal control over financial reporting.

Part II.     OTHER INFORMATION

Item 1.     Legal Proceedings

The Company is a defendant in several product liability or related claims which are considered either adequately covered by appropriate liability insurance or involving amounts not deemed material to the business or financial condition of the Company.

Item 1A.     Risk Factors

There have been no material changes to the risk factors previously disclosed in response to Item 1A to Part I of our 2020 Annual Report on Form 10-K.

Item 2.     Unregistered Sales of Equity Securities and Use of Proceeds

There were no securities of the Company sold by the Company during the quarter ended September 25, 2020, which were not registered under the Securities Act of 1933, in reliance upon an exemption from registration provided by Section 4 (2) of the Act.

Not applicable.

Issuer Purchases of Equity Securities

The amounts shown in Column (a) above represent shares of common stock delivered to the Company as payment of withholding taxes due on the vesting of restricted stock and performance stock awards issued under the Twin Disc, Incorporated 2010 Long-Term Incentive Compensation Plan.

Under authorizations granted by the Board of Directors on February 1, 2008 and July 27, 2012, the Company was authorized to purchase 500,000 shares of its common stock.  This authorization has no expiration, and as of September 25, 2020, 315,000 may yet be purchased under these authorizations. The Company did not purchase any shares of its common stock pursuant to these authorizations during the quarter ended September 25, 2020.

The discussion of limitations upon the payment of dividends as a result of the Credit Agreement between the Company and BMO Harris Bank, N.A., as discussed in Part I, Item 2, "Management's Discussion and Analysis " under the heading "Financial Condition, Liquidity and Capital Resources," is incorporated herein by reference.

Item 3.     Defaults Upon Senior Securities

None.

Item 5.     Other Information

None.

Item 6.     Exhibits

SIGNATURE

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.