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SEV > SEC Filings for SEV > Form 10-K on 20-Dec-2011All Recent SEC Filings

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Form 10-K for SEVCON, INC.


20-Dec-2011

Annual Report


ITEM 7 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

FORWARD LOOKING STATEMENTS

Statements in this discussion and analysis about the Company's anticipated financial results and growth, as well as those about the development of its products and markets, are forward-looking statements that involve risks and uncertainties that could cause actual results to differ materially from those projected. These include the risks discussed in Item 1A to this Annual Report, entitled 'Risk Factors', and others discussed in this report.

CRITICAL ACCOUNTING ESTIMATES

The Company's significant accounting policies are summarized in Note 1 of its Consolidated Financial Statements in this Annual Report. While these significant accounting policies impact the Company's financial condition and results of operations, certain of these policies require management to use a significant degree of judgment and/or make estimates, consistent with generally accepted accounting principles, that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities as of the date of the financial statements and the reported amounts of income and expenses during the reporting periods. Since these are judgments and estimates, they are sensitive to changes in business and economic realities, and events may cause actual operating results to differ materially from the amounts derived from management's estimates and judgments.

The Company believes the following represent the most critical accounting judgments and estimates affecting its reported financial condition and results of operations:

Bad Debts

The Company estimates an allowance for doubtful accounts based on known factors related to the credit risk of each customer and management's judgment about the customer's business. Ten customers account for approximately 50% of the Company's sales. At September 30, 2011, the allowance for bad debts amounted to $49,000, which represented 1% of receivables.

Because of the Company's long term relationships with the majority of its customers, in most cases, the principal bad debt risk to the Company arises from the insolvency of a customer rather than its unwillingness to pay. In addition, in certain cases the Company maintains credit insurance covering up to 90% of the amount outstanding from specific customers. The Company also carries out some of its foreign trade, particularly in the Far East, using letters of credit.

The Company reviews all accounts receivable balances on a regular basis, concentrating on any balances that are more than 30 days overdue, or where there is an identified credit risk with a specific customer. A decision is taken on a customer-by-customer basis as to whether a bad debt reserve is considered necessary based on the specific facts and circumstances of each account. In general, the Company would reserve 100% of the receivable, net of any recoverable value added taxes or insurance coverages, for a customer that becomes insolvent or files for bankruptcy, and lesser amounts for less imminent defaults. The Company maintains a small bad debt reserve to cover the remaining balances based on historical default percentages.

If the financial condition of any of the Company's customers is worse than estimated or were to deteriorate, resulting in an impairment of its ability to make payments, the Company's results may be adversely affected and additional allowances may be required.

Inventories

Inventories are valued at the lower of cost or market. Inventory costs include materials and overhead, and are relieved from inventory on a first-in, first-out basis. The Company carries out a significant amount of customization of standard products and also designs and manufactures special products to meet the unique requirements of its customers. This results in a significant proportion of the Company's inventory being customer specific. The Company's reported financial condition includes a provision for estimated slow-moving and obsolete inventory that is based on a comparison of inventory levels with forecasted future demand. Such demand is estimated based on many factors, including management judgments, relating to each customer's business and to economic conditions. The Company reviews in detail all significant inventory items with holdings in excess of estimated normal requirements. It also considers the likely impact of changing technology. It makes an estimate of the provision for slow moving and obsolete stock on an item-by-item basis based on a combination of likely usage based on forecasted customer demand, potential sale or scrap value and possible alternative use. This provision represents the difference between original cost and market value at the end of the financial period. In cases where there is no estimated future use for the inventory item and there is no estimated scrap or resale value, a 100% provision is recorded. Where the Company estimates that only part of the total holding of an inventory item will not be used, or there is an estimated scrap, resale or alternate use value, then a proportionate provision is recorded. Once an item has been written down, it is not subsequently revalued upwards. The provision for slow moving and obsolete inventories at September 30, 2011 was $437,000, or 6% of the original cost of gross inventory. If actual future demand or market conditions are less favorable than those projected by management, or if product designs change more quickly than forecast, additional inventory write-downs may be required, which may have a material adverse impact on reported results.

Warranty Costs

The Company provides for the estimated cost of product warranties at the time revenue is recognized. While the Company engages in product quality programs and processes, the Company's warranty obligation is affected by product failure rates and repair or replacement costs incurred in correcting a product failure. Accordingly, the provision for warranty costs is based upon anticipated in-warranty failure rates and estimated costs of repair or replacement. Anticipating product failure rates involves making judgments about the likelihood of defects in materials, design and manufacturing errors, and other factors that are based in part on historical failure rates and trends, but also on management's expertise in engineering and manufacturing. Estimated repair and replacement costs are affected by varying component and labor costs. Should actual product failure rates and repair or replacement costs differ from estimates, revisions to the estimated warranty liability may be required and the Company's results may be materially adversely affected. In the event that the Company discovers a product defect that impacts the safety of its products, then a product recall may be necessary, which could involve the Company in substantial unanticipated expense significantly in excess of the reserve. There were no safety related product recalls during the past three years.

Goodwill Impairment

At September 30, 2011, the Company's balance sheet reflected $1,435,000 of goodwill relating to the controls business. The Company carries out an assessment annually or more frequently if events or circumstances change, to determine if its goodwill has been impaired. The assessment is based on three separate methods of valuing the controls business based on expected free cash flows, the market price of the Company's stock and an analysis of precedent transactions. These valuation methods require estimates of future revenues, profits, capital expenditures and working capital requirements which are based on evaluation of historical trends, current budgets, operating plans and industry data. Based on all of these valuation methods, management concluded in 2011 that the goodwill had not been impaired. If, in future periods, the Company's results of operations, cash flows or the market price of the Company's stock were to decrease significantly, then it may be necessary to record an impairment charge relating to goodwill of up to $1,435,000.

Pension Plan Assumptions

The Company makes a number of assumptions relating to its pension plans in order to measure the financial position of the plans and the net periodic benefit cost. The most significant assumptions relate to the discount rate, the expected long term return on plan assets and the rate of future compensation increase. If these assumptions prove to be incorrect then the Company may need to record, and may actually incur, additional expense or liabilities relating to the pension plans, which could have a material effect on the Company's financial position and results of operations. At September 30, 2011 there was a pension liability on the Company's balance sheet of $7,634,000. The Company's pension plans are significant relative to the size of the Company. At September 30, 2011, pension plan assets were $15,557,000, plan liabilities were $23,191,000, and the total assets of the Company were $22,947,000. In accordance with FASB guidance, changes in the funded status of the pension plans (plan assets less plan liabilities) are recorded in the Company's balance sheet and could have a material effect on the Company's financial position.

The funded status of the Company's defined benefit pension plans improved from a deficit of $8,203,000 at September 30, 2010 to a deficit of $7,634,000 at September 30, 2011. The reduction in the deficit of $569,000 was due to several factors. The most significant factor was a change in the inflation index used, from the Retail Prices Index to the Consumer Prices Index, to calculate the annual increase in accrued benefits for deferred pension plan members of the U.K. defined benefit plan. As a result of this change, the Company had a one-time decrease in the liability of $854,000, net of a tax benefit. This reduction in the estimated pension liability was partially offset by an actuarial loss of $405,000 arising from a reduction in the discount rate of the U.S. pension plan from 5.56% at September 30, 2010 to 4.55% at September 30, 2011.

- 5 -

The table below sets out the approximate impact on the funded status of the Company's pension plans at September 30, 2011 that the Company estimates would arise from the following respective changes in significant plan assumptions:

                                                Favorable
                                              (unfavorable)
                                                Impact on
                                              Funded Status
                                              (in thousands  Change in funded
Plan Assumption         Change in Assumption   of dollars)        status
Assumptions impacting
accumulated benefit
obligation:
Discount rate                  (0.1)%            $ (483)            6%
Inflation rate                  0.1%              (260)             3%
Salary increase                 0.5%              (503)             7%
Mortality rate                 1 Year             (605)             8%

Income Taxes

The Company's effective tax rate is dependent on many factors, including the impact of enacted tax laws in jurisdictions in which the Company operates, the amount of earnings by jurisdiction, varying tax rates in each jurisdiction and the Company's ability to utilize foreign tax credits related to foreign taxes paid on foreign earnings that will be remitted to the U.S.

The Company accounts for income taxes under the asset and liability approach, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequence of events that have been recognized in the Company's financial statements or income tax returns. Income taxes are recognized during the period in which the underlying transactions are recorded. Deferred taxes are provided for temporary differences between amounts of assets and liabilities as recorded for financial reporting purposes and such amounts as measured by tax laws. If the Company determines that a deferred tax asset arising from temporary differences is not likely to be utilized, the Company will establish a valuation allowance against that asset to record it at its expected realizable value. If the Company later determines, based on the weight of available evidence, that the deferred tax assets are more likely than not to be realized in the future, the allowance may be reversed in whole or in part. Management considers many factors when assessing the likelihood of future realization of the Company's deferred tax assets, including recent cumulative earnings experience by taxing jurisdiction, expectations of future taxable income, the carry-forward periods available for tax reporting purposes and other factors. The range of possible estimates relating to the valuation of the Company's deferred tax assets is very wide. Significant judgment is required in making these assessments and it is very difficult to predict when, if ever, management may conclude that any portion of the deferred tax assets is realizable. As of September 30, 2011, there is a partial valuation allowance against net deferred tax assets. If future experience is significantly different from that which was projected in making these assessments, there could be significant additional adjustments to the Company's deferred tax assets and income tax expense.

The Company recognizes uncertain tax positions when it is more likely than not that the tax position will be sustained upon examination by relevant taxing authorities, based on the technical merits of the position. Although the Company believes that its tax positions are appropriate, the final determination of tax audits and any related litigation could result in material changes in the underlying estimates.

- 6 -

A) Results of Operations

2011 compared to 2010

The following table compares the 2011 results, for both the controls and capacitor segments, with the prior year, showing separately the percentage variances due to currency exchange rate changes and volume.

                             (in thousands of dollars)                  Favorable (unfavorable) % change due to:
                                  2011                2010         Total                 Currency               Volume

Sales
Controls - to
external customers       $      30,039       $      24,434                 23                      2                    21
Capacitors- to
external customers               2,247               1,619                 39                      4                    35
Capacitors -
inter-segment                       26                  30                (15 )                    2                   (17 )
Capacitors - total               2,273               1,649                 38                      4                    34
Total sales to
external customers              32,286              26,053                 24                      2                    22
Gross Profit
Controls                        10,191               8,347                 22                     (2 )                  24
Capacitors                       1,108                 773                 43                      4                    39
Total                           11,299               9,120                 24                     (1 )                  25
Selling, research
and administrative
expenses, gain on
sale of fixed assets
and pension
curtailment gain
Controls                        (9,405 )            (8,215 )              (14 )                   (3 )                 (11 )
Capacitors                        (716 )              (697 )               (3 )                   (3 )                   -
Gain on sale of
fixed assets                       447                   -                100                      -                   100
Pension curtailment
gain                                 -                 507               (100 )                    -                  (100 )
Unallocated
corporate expense                 (555 )              (386 )              (44 )                    -                   (44 )
Total                           10,229               8,791                (16 )                   (3 )                 (13 )
Operating income
Controls                         1,233                 639                 93                    (56 )                 149
Capacitors                         392                  76                416                     21                   395
Unallocated
corporate expense                 (555 )              (386 )              (44 )                    -                   (44 )
Total                            1,070                 329                225                   (104 )                 329
Other income and
expense                           (101 )               177               (157 )                  (97 )                 (60 )
Income before income
taxes                              969                 506                 92                   (102 )                 194
Income taxes
(provision) benefit               (257 )               360               (171 )                   28                  (199 )
Net income               $         712       $         866                (17 )                  (47 )                  30

The Company's main customers in the controls segment manufacture electric vehicles for on-road, off-road and industrial applications, including automotive, construction, distribution, mining, airport ground support and utility applications. Following the significant economic turmoil of 2008 and 2009, which led to some of the Company's customers experiencing between 60% and 85% reduction in demand for new vehicles, there was a modest recovery in demand for the Company's products in 2010 and this has continued into 2011. The increase in sales in 2011 has also been the result of new product introduction which has led to customer gains in on-road vehicle applications.

In 2011, sales were $32,286,000, an increase of $6,233,000, or 24%, compared to 2010. In 2011, approximately 53% of the Company's sales were made outside the United States and were denominated in currencies other than the U.S. Dollar, principally the Euro and the British Pound; accordingly, those revenues are subject to fluctuation when translated into U.S. Dollars. In 2011, the average U.S. Dollar exchange rate was 3% higher compared to both the British Pound and the Euro, than in 2010. As a result, foreign currency sales denominated in British Pounds and Euros translated into more U.S. Dollars. The overall impact to 2011 was that reported sales increased by $541,000, or 2%, due to currency rate changes.

Excluding the currency impact, volumes shipped in the controls business segment were $5,128,000 or 21% higher than in 2010. Volumes shipped were higher in Europe and North America by 89% and 12% respectively, but were 36% lower in the Far East due largely to lower domestic demand in Japan and South Korea, compared to the same period last year. The decrease in demand in Japan was due to the impact of the earthquake in 2011 and in South Korea to the demise of a significant customer in the automotive sector. The increase in sales volume in Europe and North America is in part due to continued customer gains in a range of on-road and off-road EV applications. In addition, the Company's traditional markets of industrial applications for construction, distribution, mining, airport ground support and utility applications have seen healthy recovery from the significant reduction in customer demand experienced in the recession of 2009 with volumes shipped up 27% over last year.

In the capacitor business, reported sales to external customers increased by $628,000, or 39%, compared to 2010. Currency exchange rate changes increased sales by $64,000, or 4% and capacitor volumes shipped were $564,000, or 35%, higher than last year due principally to higher demand in the railway signaling market and the industrial sector.

- 7 -

Cost of sales was $20,987,000 compared to $16,933,000 in 2010, an increase of $4,054,000. As the gross profit percentage in 2011 of 34.5% was broadly the same as in 2010 when it was 35.0%, the increase in cost of sales was principally due to the 22% increase in volumes shipped in 2011 compared to the prior year.

Foreign currency fluctuations had a net unfavorable impact on gross profit of $98,000. This was due to the U.S. Dollar being marginally weaker in 2011 than in 2010 compared with the British Pound and the Euro, which had a favorable impact on sales of $541,000 but an unfavorable impact on cost of sales of $639,000. In the controls segment, gross profit of $10,191,000 or 34.0%, was $1,844,000 or 22% higher than last year which was due to the 21% increase in volumes shipped in 2011 compared to last year. In the capacitor segment gross profit of $1,108,000 was significantly higher than the 2010 gross profit of $773,000. The gross profit was 49% of sales in 2011 compared to 47% of sales in 2010. The increase in the capacitor business gross profit percentage was mainly due to an increase in the proportion of sales to higher margin industrial and railway signaling customers. The table below analyzes the year-to-year change in sales, cost of sales and gross profit.

                              (in thousands of dollars)
                     Sales        Cost of sales       Gross Profit

Actual 2010        $  26,053     $        16,933     $        9,120
Change in 2011
due to:
Foreign
currency
fluctuations             541                 (98 )              639
Increased
volume,
assuming 2010
gross profit
percentage             5,692               3,700              1,992
All other cost
of sales
changes, net               -                 452               (452 )

Actual 2011        $  32,286     $        20,987     $       11,299

Selling, research and administrative expenses, excluding a one-time gain of $447,000 on the sale of fixed assets in 2011 and a pension curtailment gain of $507,000 in 2010, increased by $1,378,000, or 15%, compared to 2010. Unfavorable foreign currency fluctuations increased reported operating expenses by $244,000, or 3%, due to the weaker U.S. Dollar in 2011 compared to both the British Pound and the Euro in the prior year. The increase in selling, research and administrative expenses was due largely to higher salary and fringe costs compared to the same period last year, due to the hiring of additional sales and marketing and engineering staff to support the current and future growth of the business and also the award of a general pay increase in the first quarter of 2011. The Company received U.K. government grants of $600,000 in the first two quarters of 2011 associated with research and development expense of $1,714,000 in the same period. The grants received were recorded as a reduction of research and development expense in the period. The Company also recorded in selling, research and administrative expenses in 2011, a one-time gain of $447,000 from the sale of fixed assets which included a gain of $451,000 on the sale of a surplus U.K. facility offset by a $4,000 write down of other fixed assets in the business.

An analysis of the year-to-year change in selling, research and administrative expenses, before gain on sale of fixed assets and pension curtailment gain, is set out below:

Selling, research and administrative expenses,
before gain on sale of fixed assets and pension               (in thousands of
curtailment gain                                                  dollars)

Reported expense in 2011                                     $            10,676
Reported expense in 2010                                                   9,298
Increase in expense                                                        1,378
Increase due to:
Effect of exchange rate changes                                              244
Higher research and sales and marketing expense,
net of currency effect                                                       331
Higher administrative expense, net of currency
effect                                                                       803
Total increase in selling, research and
administrative expenses, before gain on sale of
fixed assets in 2011 and pension curtailment gain
in 2010                                                      $             1,378

In 2010 the Company took the decision to freeze the defined benefit pension plan for U.S. employees effective September 30, 2010. This decreased the projected benefit obligation by $507,000 as of September 30, 2010 and as this eliminated all future service for the purposes of benefit accrual, this amendment was treated as a curtailment under Financial Accounting Standards Board ("FASB") authoritative guidance. Accordingly, the entire effect of the amendment was recognized as a gain in 2010 in the consolidated statement of operations.

There was operating income for the year of $1,070,000 compared to $329,000 in 2010, an improvement of $741,000. This was due to several factors including the significant increase in sales volumes shipped and the receipt of U.K. government grants, offset by higher operating expenses. The controls business reported operating income of $1,232,000 compared to $639,000 in 2010. Operating income in the capacitor business was $392,000 compared with $76,000 in 2010.

- 8 -

Other income and expense was an expense of $101,000 in 2011 compared to $177,000 of income in the previous year. The change year on year was largely due to a foreign currency exchange loss of $39,000 in 2011, compared to a foreign currency gain of $158,000 in 2010. Interest expense was $64,000, which was $15,000 higher than the prior year, due to higher borrowing in 2011. Interest income was $66,000 lower at $2,000 compared to $68,000 in 2010, due to lower average surplus cash balances during 2011 compared with 2010.

Income before income taxes in 2011 was $969,000 compared to income before income taxes of $506,000 in 2010, an improvement year on year of $463,000. Foreign currency fluctuations decreased pre-tax income by $514,000 in 2011; the pre-tax result, before the effect of the favorable currency fluctuations, was $977,000 higher than the prior year.

The Company recorded a provision for income tax of $257,000 or 26.5% of the pre-tax income for the year compared to an income tax benefit of $360,000 in 2010. The income tax provision of 26.5% of pre-tax income was lower than the statutory Federal income tax rate of 34% for several reasons. There was a net reversal of $177,000 of deferred tax valuation allowances in 2011 following a review of the Company's realizability of its deferred tax assets. In addition, the Company recorded $232,000 of additional research and development tax credits arising from the research activity in the Company's U.K. operations. The reduction in the effective tax rate associated with these items was partly offset by an increased tax charge of $373,000 arising from a reduction in the U.K. tax rate which resulted in a write down in the value of the Company's U.K. deferred tax assets. The income tax benefit of $360,000 in 2010 arose largely from $412,000 of research and development tax credits in the Company's U.K. operations and $150,000 arising from the partial reversal of a deferred tax valuation allowance in the U.S.

The Company recorded net income after income taxes of $712,000 compared to net income after income taxes of $866,000 last year, a decrease of $154,000. Basic and diluted income per share was $.22 and $.21, respectively, in 2011 compared to a basic and diluted income per share of $.26 in 2010.

B) Liquidity and Capital Resources

The Company's operating activities used $1,492,000 of cash during 2011 compared with cash generated from operating activities for 2010 of $938,000. Acquisitions of property, plant and equipment amounted to $635,000 compared to $848,000 in . . .

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