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WSCI > SEC Filings for WSCI > Form 10-K on 13-Nov-2012All Recent SEC Filings

Show all filings for WSI INDUSTRIES, INC.



Annual Report

Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations

Critical Accounting Policies and Estimates:

Management's Discussion and Analysis of Financial Condition and Results of Operations discuss our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities.

We base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances, the result of which forms the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Results may differ from these estimates due to actual outcomes being different from those on which we based our assumptions. The estimates and judgments utilized are reviewed by management on an ongoing basis and by the audit committee of our board of directors at the end of each quarter prior to the public release of our financial results. We made no significant changes to our critical accounting policies during fiscal 2012.

Application of Critical Accounting Policies:

Excess and Obsolete Inventory:
Inventories, which are composed of raw materials, work in process and finished goods, are valued at the lower of cost or market by comparing the cost of each item in inventory to its most recent sales price or sales order price. Inventory cost is adjusted down for any excess cost over net realizable value of inventory components.

In addition, the Company determines whether its inventory is obsolete by analyzing the sales history of its inventory, sales orders on hand and indications from the Company's customers as to the future of various parts or programs. If, in the Company's determination, the inventory value has become impaired, the Company adjusts the inventory value to the amount the Company estimates as the ultimate net realizable value for that inventory. Actual customer requirements in any future periods are inherently uncertain and thus may differ from our estimates. The Company performs its lower of cost or market testing, as well as its excess or obsolete inventory analyses, quarterly.

The Company has no specific timeline to dispose of its remaining obsolete inventory and intends to sell this obsolete inventory from time to time, as market conditions allow.

Goodwill Impairment:
The Company evaluates the valuation of its goodwill according to the provisions of Accounting Standards Codification ("ASC") 350 to determine if the current value of goodwill has been impaired. The Company believes that its stock price is not necessarily an indicator of the Company's value given its limited trading volume and its wide price fluctuations. The Company has also adopted Accounting Standard Update (ASU) No. 2011-08, Intangibles-Goodwill and Other (Topic 350). With ASU No. 2011-08, an entity is given the option to make a qualitative evaluation of goodwill impairment to determine whether it should calculate the fair value of its reporting unit. In the fiscal 2012 fourth quarter, the Company made its qualitative evaluation of its goodwill considering, among other things, the overall macroeconomic conditions, industry and market considerations, overall financial performance and other relevant company specific events. Based on this qualitative evaluation, the Company concluded that it was more likely than not that its goodwill was not impaired and that it wasn't required to calculate the fair value of its reporting unit. If the Company has changes in events or circumstances, including reductions in anticipated cash flows generated by its operations, goodwill could become impaired which would result in a charge to earnings.

Deferred Taxes:
The Company accounts for income taxes using the liability method. Deferred income taxes are provided for temporary differences between the financial reporting and tax bases of assets and liabilities. A deferred tax valuation allowance is set up should the realization of any deferred taxes become less likely than not to occur. The valuation allowance is analyzed periodically by the Company and may result in income tax expense being different than statutory rates. The Company has not established a valuation allowance as it believes it is more likely than not that it will fully realize the benefit of its tax assets. Currently, the Company's deferred tax assets have two major components which relate to the Company's net operating loss (NOL) and the Company's alternative minimum tax (AMT) tax credit carryforwards. The Company's AMT tax credit carryforward does not expire. The Company's NOL carryforward is approximately $2.4 million expiring in 2021 - 2030. The Company believes that given the extended time period for the NOL carryforward to expire as well as a return to a more normal growth rate experienced prior to the economic recession of fiscal 2009, that the Company is more likely than not to fully utilize its NOL carryforward before it expires. However, a significant loss of a customer or a change in the Company's business could affect the realization of the deferred tax assets. If a major program were discontinued, the Company would immediately assess the impact of the loss of the program on the realization of the deferred tax assets.

Revenue Recognition:
The Company considers its revenue recognition policy to fall under the guidance of FASB's conceptual framework for revenue recognition. The Company recognizes revenue only after: (a) The Company has received a purchase order identifying price and delivery terms or services to be rendered; (b) shipment has occurred, or in the case of services, after the service has been completed; (c) the Company's price is fixed as evidenced by the purchase order; and
(d) collectability is reasonably assured. The Company continually monitors its accounts receivable for any delinquent or slow paying accounts. The Company believes that based upon its past history with minimal bad debt write-offs, that all accounts are collectible upon shipment or delivery of services. Credit losses from customers have been minimal and within management's expectations. Based on management's evaluation of uncollected accounts receivable, bad debts are provided for on the allowance method. Accounts are considered delinquent if they are 120 days past due. If an uncollectible account should arise during the year, it would be written-off at the point it was determined to be uncollectible. The Company mitigates its credit risk by performing periodic credit checks and actively pursuing past due accounts. The Company refers to "net sales" in its consolidated statements of operations as the Company's sales are sometimes reduced by product returned by its customers.

Liquidity and Capital Resources:

The Company's net working capital at the end of fiscal 2012 was $6,417,000 as compared to $5,283,000 at the end of fiscal 2011. The increase occurred primarily from increases in accounts receivable and inventories partially offset by an increase in accounts payable and in the current maturities of long-term debt. The ratio of current assets to current liabilities decreased to 2.29 to 1.0 at August 26, 2012 from 2.54 to 1.0 at the end of the prior fiscal year as to the percentage increase in current assets was smaller than the percentage increase in current liabilities. The Company generated $2,188,000, $2,690,000 and $1,634,000 in cash from operations in fiscal 2012, 2011 and 2010, respectively.

In fiscal 2012 and 2011, additions to property, plant and equipment either by cash or financing were $3,696,000 and $1,743,000, respectively. These amounts included $3,114,000 and $1,280,000 of machinery acquired through financing in fiscal 2012 and 2011, respectively. In fiscal 2010, the Company had minimal additions to property, plant and equipment, capitalizing $61,000 during the year.

In the fiscal 2012 first quarter, the Company added two milling machines and a lathe to supplement and increase capacity in its energy business. In the Company's second quarter, another milling machine was added for increased capacity of a new program in the Company's recreational vehicle market. In the Company's third quarter, a lathe was purchased to add capacity in the energy business. In the fiscal 2012 fourth quarter, the Company implemented a robotic automation work cell for a new program and increased capacity in the recreational vehicle market. The work cell consisted of two milling machines and an automated robot. In its fiscal 2011 first quarter, the Company added two machining centers, one of which was purchased to supplement capacity in its energy business while the other machine was bought primarily for replacement purposes. In the Company's second and fourth quarters, the Company added two more machining centers for new programs in its energy business.

On February 1, 2012, the Company renewed its revolving line of credit agreement with its bank. Under the agreement, the Company can borrow up to $1 million. The agreement expires on February 1, 2013. No balances were owed at August 26, 2012 and August 28, 2011, and no advances were made on the credit line during either fiscal 2012 or 2011.

In August 2008, the Company entered into an agreement with its bank to finance a building addition to its existing manufacturing facility. The Company was able to draw upon the loan on a non-revolving basis through May 31, 2009 in an aggregate amount not to exceed $1.2 million. The loan required monthly payments of interest only at the bank's prime rate plus 0.50%. The loan matured on, and was paid in full on June 30, 2010.

The Company's total debt was $6,840,000 at August 26, 2012 which consisted of a mortgage on its building of $1,081,000 and capital lease obligations secured by production equipment of $5,759,000. Current maturities of long-term debt consist of $1,333,000 due on capital leases and $44,000 on its building related debt. During fiscal 2012, the Company made principal payments on its debt of $1.2 million. It is management's belief that the combination of its current cash balance, its internally generated funds, as well as its revolving line of credit will be sufficient to enable the Company to meet its financial requirements during fiscal 2013.

Results of Operations:

The Company experienced a sales increase of 30% in fiscal 2012 which came on top of a 33% increase in fiscal 2011. Net sales in fiscal 2012 were $32.5 million as compared to $25.0 million in fiscal 2011 and $18.8 million in fiscal 2010. The increase in the fiscal 2012 sales was driven by a 19% increase in recreational vehicle market sales and a 78% increase in sales from the energy market. The increases in the fiscal 2011 sales came primarily from a 39% increase in recreational vehicle sales and a 27% increase in energy sales.

The following is a reconciliation of sales by major market:

                         Fiscal 2012      Fiscal 2011      Fiscal 2010

Recreational vehicle    $  20,248,000     $ 16,969,000     $ 12,209,000
Aerospace and defense       1,641,000        1,886,000        1,633,000
Energy                     10,150,000        5,693,000        4,485,000
Biosciences & Other           417,000          415,000          499,000
                        $ $32,456,000     $ 24,963,000     $ 18,826,000

The increase in sales in the recreational vehicle market in both fiscal 2012 and fiscal 2011 resulted from the overall increase in demand from the Company's largest customer for the parts the Company supplies. The Company's sales also increased due to new programs that had been awarded and started in fiscal 2012.

Sales from the Company's aerospace and defense markets were down $245,000 or 13% from fiscal 2011. The decrease is primarily attributable to a lack of sales from a program and customer first announced in fiscal 2010. Sales from the Company's aerospace and defense markets were up 15% in fiscal 2011 due primarily to sales from that customer and program. The Company understands from its customer that sales will resume in fiscal 2013.

Sales in the Company's energy business were up 78% in fiscal 2012 over the prior year. The increase in sales came primarily from a customer engaged in the oil and gas shale fracturing ("fracking") business. Sales with this customer increased from $1.2 million in fiscal 2011 to $5.1 million in fiscal 2012. Fiscal 2012 sales to the Company's main customer in the oil field equipment industry were up 7% versus the prior year. Fiscal 2011 sales from the Company's energy business were up 27% with the gain primarily due to increased sales to the customer involved in shale fracking.

Sales to the Company's biosciences and other industries decreased from fiscal 2010 to fiscal 2011, and were flat from fiscal 2011 to fiscal 2012. However, the effect on overall Company sales is relatively small as sales from these markets only amount to approximately 1% - 3% of total sales.

The Company's gross margin remained steady at 17.8% in fiscal 2012 versus fiscal 2011. Fiscal 2011 gross margin had decreased as compared to fiscal 2010 gross margin of 19.9%. In both fiscal 2012 and fiscal 2011, the Company experienced start-up costs with programs involving its fracking customer. In fiscal 2012, the costs were related to new programs that had been added in the first two quarters of the fiscal year. In fiscal 2011, the costs were related to initial start-up expenses with the customer and were incurred primarily in the first two quarters of fiscal 2011.

The Company's margins can also vary dependent on whether the Company purchases its raw material or whether raw material is provided or consigned to them by its customer. Generally, the Company will experience a higher gross margin percentage of sales where material has been consigned or provided by the customer. Therefore, in any particular quarter or year, the Company's gross margin can vary dependent on the mix of parts sold and whether those parts had material that was purchased or had material that had been consigned to them.

No significant sales of obsolete items occurred in fiscal 2010 through 2012 and, correspondingly, no significant gross margin was recognized.

Selling and administrative expense in fiscal 2012 was approximately $3.2 million, an increase of $401,000 over the fiscal 2011 amount of approximately $2.8 million. The increase in fiscal 2012 was due primarily to increased payroll and benefit costs due to headcount additions as well as increased incentive compensation and profit sharing expense. In fiscal 2011, selling and administrative expense increased over 2010 by $335,000. The increase was due primarily to higher payroll and benefit costs as well as additional incentive compensation and profit sharing expense. The Company recorded non-cash stock option compensation expense of $198,000, $205,000 and $211,000 in fiscal 2012, 2011 and fiscal 2010, respectively. In addition, the Company incurred professional service expense in each of those three fiscal years in connection with its analysis of internal controls over financial reporting as required by the Sarbanes-Oxley Act.

Interest expense in fiscal 2012 amounted to $316,000 as compared to $289,000 in fiscal 2011. The higher expense is attributable to a higher average level of debt in fiscal 2012 as compared to fiscal 2011, with the higher level being primarily related to equipment additions made during fiscal 2012. However, the amount of interest expense was mitigated to a degree as the overall interest rate on debt was lower in fiscal 2012. Interest expense in fiscal 2011 amounted to $289,000 as compared to $359,000 in fiscal 2010. The lower expense is attributable to a lower average level of debt in fiscal 2011 as compared to fiscal 2010, with the lower level being primarily related to the $1.2 million loan for the Company's building addition that was paid off in the fiscal 2010 fourth quarter.

The Company recorded income taxes at an effective tax rate of 36% for fiscal 2012, 2011 and 2010, respectively. The Company had no valuation allowance on its deferred tax assets during 2012 and 2011.

Caution Regarding Forward-Looking Statements

Statements included in this Management's Discussion and Analysis of Financial Condition and Results of Operations, in the letter to shareholders, elsewhere in the Annual Report, in the Company's Form 10-K and in future filings by the Company with the Securities and Exchange Commission, in the Company's press releases and in oral statements made with the approval of an authorized executive officer which are not historical or current facts are "forward-looking statements." These statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. The Company wishes to caution readers not to place undue reliance on any such forward-looking statements, which speak only as of the date made and are not predictions of actual future results. Forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from historical earnings and those presently anticipated or projected. These risks and uncertainties are described above under Item 1A. Risk Factors.

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