Virco Manufacturing - 10-Q quarterly report FY2019 Q3

Note 3. New Accounting Pronouncements

In May 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers (Topic 606) (ASU 2014-09) and has modified the standard thereafter. The Company adopted ASU 2014-09 effective February 1, 2018 using the modified retrospective method to apply this guidance to all open contracts at the date of initial application.  The results of applying Topic 606 were insignificant and did not have a material impact on our consolidated financial condition, results of operations, cash flows, business process, controls or systems.

The Company manufactures, markets and distributes a wide variety of school and office furniture to wholesalers, distributors, educational institutions and governmental entities. Revenue is recorded for promised goods or services when control is transferred to customers in an amount that reflects the consideration to which the entity expects to be entitled to in exchange for those goods or services.

Sales are recorded net of discounts, sales incentives and rebates, sales taxes and estimated returns and allowances. The Company offers sales incentives and discounts through various regional and national programs to our customers. These programs include product rebates, product returns allowances and trade promotions. Variable consideration for these programs is estimated in the transaction price at contract inception based on current sales levels and historical experience using the expected value method, subject to constraint.

The Company generates revenue primarily by manufacturing and distributing products through resellers and direct-to-customers. Control transfers to both resellers and direct customers at a point in time when the delivery process is complete as determined by the corresponding shipping terms. Therefore, we do not consider them to be meaningfully different revenue streams given similarities in the nature of the products, performance obligation and distribution processes. Sales are predominately in the United States and to a similar class of customer. We do not manage or evaluate the business based on product line or any other discernable category.

For product produced by and sourced from third parties, management has determined that it is the principal in all cases, since it (i) bears primary responsibility for fulfilling the promise to the customer; (ii) bears inventory risk before and/or after the good or service is transferred to the customer; and (iii) has discretion in establishing the price for the sale of good or service to the customer.

Contract Assets and Liabilities

Payment terms are established on the Company’s pre-established credit requirements based upon an evaluation of customers’ credit quality. Most customers obtain payment terms between 1-30 days and an asset is recognized for the related accounts receivable.

Contract liabilities are recognized for contracts where payment has been received in advance of delivery. The contract liability balance can vary significantly depending on the timing of when an order is placed and when shipment or delivery occurs. As of October 31, 2018, other than accounts receivable, the Company had no material contract assets, contract liabilities or deferred contract costs recorded on its condensed consolidated balance sheet.

Practical Expedients & Optional Exemptions

Significant Financing Component - as we expect the period between when we transfer control of the promised good or service to a customer and when the customer pays for that good or service will be one year or less, the Company elected to apply the practical expedient for significant financing components.

Remaining Performance Obligations - due to the short-term duration of the Company’s contracts with customers and fulfillment of performance obligations, the Company has elected not to disclose the information regarding the remaining performance obligations as of the end of each reporting period or when the Company expects to recognize this revenue.

The following table presents breakdown of the Company’s inventories as of October 31, 2018, January 31, 2018 and October 31, 2017 (in thousands):

The Company recognizes deferred income taxes under the asset and liability method of accounting for income taxes in accordance with the provisions of ASC No. 740, Accounting for Income Taxes. Deferred income taxes are recognized for differences between the financial statement and tax basis of assets and liabilities at enacted statutory tax rates in effect for the years in which the differences are expected to reverse. The effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date. In assessing the realizability of deferred tax assets, the Company considers the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies in making this assessment. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income or reversal of deferred tax liabilities during the periods in which those temporary differences become deductible.  The Company maintains a partial valuation allowance against certain state deferred tax assets that the Company does not believe it is more-likely-than-not to realize.

The January 31, 2015 and subsequent years remain open for examination by the IRS and state tax authorities. The Company is not currently under any state examination. The Company is currently under IRS examination for its fiscal year ended January 31, 2016 Federal tax return.

The Company and its subsidiaries are defendants in various legal proceedings resulting from operations in the normal course of business. It is the opinion of management, in consultation with legal counsel, that the ultimate outcome of all such matters will not materially affect the Company’s financial position, results of operations or cash flows.

For the three months ended October 31, 2018, the Company earned pre-tax income of $4,035,000 on net sales of $76,809,000 compared to a pre-tax income of $4,228,000 on net sales of $68,794,000 in the prior year.

Net sales for the three months ended October 31, 2018 increased by $8,015,000 or 11.7%. This increase was primarily due to an increase in price combined with a small increase in volume. As discussed in the Company’s Form 10K, there are two significant funding sources that drive the Company’s sales; bond-funded business and business funded from the operating budgets of the schools. The Company experienced robust growth in orders during the first six months, which is more heavily influenced by bond-funded projects. Orders in the third quarter are typically more dependent on the operating budgets of the schools. Orders for the third quarter declined by approximately $6.5 million. Ending backlog at October 31, 2018 was $16.2 million compared to $16.9 million at the same date last year.

The third quarter results reflected continued seasonality of the Company’s business, with revenue moving from the second to the third quarters due to an increase in orders received in July that were delivered in the third quarter. Gross margin as a percentage of net sales decreased to 34.4% for the three months ended October 31, 2018 compared to 35.6% in the same period last year.  The deterioration of the margin in the third quarter is attributable to several components.  The Company raised selling prices at the beginning of this year.  The increase was targeted to cover cost increases incurred during 2017 and a moderate increase in 2018.  The Company did not raise prices adequately to compensate for all the cost increases subsequently incurred during the 2018 fiscal year.  The primary change in costs related to raw materials (steel, plastic, and imported components) and employee compensation.

Selling, general and administrative expenses for the three months ended October 31, 2018 increased by $1,967,000 compared to the same period last year but was leveraged to 28.3% of net sales compared to 28.8% of net sales in the same period last year. The increase in selling, general and administrative expenses was attributable to variable freight and selling expenses. Interest expense increased due to increased levels of borrowing and higher interest rates.

For the nine months ended October 31, 2018, the Company earned a pre-tax income of $6,594,000 on net sales of $174,180,000 compared to a pre-tax income of $8,545,000 on net sales of $164,665,000 in the same period last year. Net sales for the nine months ended October 31, 2018 increased by $9,515,000 compared to the same period last year. This increase was the result of growth in price. The Company began the year with a backlog of orders that was approximately $3.6 million greater than the prior year. Order rates for the first nine months increased by approximately 3.7% compared to the prior year.

Gross margin as a percentage of net sales declined to 35.2% for the nine months ended October 31, 2018 compared to 36.2% in the same period last year. There are three primary reasons for the decrease. First, for the first nine months, most of the increase in sales was from project type business, which included larger more complex orders. Bidding on these projects can be intense, and typically include a larger portion of products sourced from third-party manufacturing partners. Margins on product from third-party manufacturing partners typically have a lower margin than product manufactured by Virco. Second, was the relationship between the selling price increases to the cost increases incurred. The Company raised selling prices at the beginning of this year, but increased prices modestly in effort to increase sales volume. The Company did not raise prices adequately to compensate for all the cost increases subsequently incurred during the year. Third, production levels in our factories increased by approximately 1%, but increased compensation costs combined with more complex orders to fill, adversely impacted manufacturing efficiencies.

Selling, general and administrative expenses for the nine months ended October 31, 2018 increased by approximately $3,000,000 compared to the same period last year and remained relatively consistent at 30.3% of net sales compared to 30.2% of net sales in the same period last year. The increase in selling, general and administrative expenses was attributable to variable freight, variable selling and variable compensation expenses driven by the increased sales and by the increase in project related business. Interest expense increased due to increased levels of borrowing and higher rates.

Income tax expense for the third quarter and nine months ended October 31, 2018 is not comparable to the prior year, primarily due to the reduction in federal income tax rates for 2018 as a result of the Tax Cut and Jobs Act passed in December 2017.

As discussed in the Company's Form 10-K, approximately 50% of the Company's annual sales volume is shipped in June through August. The Company traditionally builds large quantities of inventory during the first and second quarters of each fiscal year in anticipation of seasonally high summer shipments. In addition, the Company finances a large balance of accounts receivable during the peak season.

For the first nine months, the Company increased inventory by approximately $613,000 at October 31, 2018 compared to January 31, 2018. This compares to an increase of $688,000 during the same period last year. Inventory at October 31, 2018 was $6,293,000 more than October 31, 2017 of the prior year. Approximately 50% of this increase is valuation and approximately 50% is quantity. Accounts receivable at October 31, 2018 compared to January 31, 2018 increased by $12,896,000 compared to $11,205,000 during the same period in the prior year. The increase in inventory and receivables was financed in part by vendor credit, which naturally increases with increased third quarter business activity, and through the Company's credit facility with PNC Bank.

Interest expense for the nine months ended October 31, 2018 is $618,000 higher than the same period last year due to increased borrowings and increased rates. Borrowing under the Company's revolving line of credit with PNC Bank at October 31, 2018 is greater than October 31, 2017 due to increased inventory and accounts receivable.

Capital spending for the nine months ended October 31, 2018 was $3,319,000 compared to $12,521,000 for the same period last year. The prior year capital expenditures included the purchase of a manufacturing facility in Conway, AR. The Company had previously occupied the building under a 10-year lease. Capital expenditures are being financed through the Company's credit facility with PNC Bank and operating cash flow.

The Company utilizes borrowings from the arrangement with PNC to fund seasonal working capital needs and certain capital expenditures.  Compared to prior year net cash provided by financing activities decreased to $2,444,000 from $9,237,000, primarily due to the large decrease in capital expenditures in the current year. 

The Company believes that cash flows from operations, together with the Company's unused borrowing capacity with PNC Bank will be sufficient to fund the Company's debt service requirements, capital expenditures, cash dividends, and working capital needs for the next twelve months.

The Company's critical accounting policies are outlined in its Annual Report on Form 10-K for the fiscal year ended January 31, 2018.  There have been no significant changes in the quarter ended October 31, 2018.

The Company is subject to interest rate risk related to its seasonal borrowings used to finance additional inventory and receivables. Rising interest rates may adversely affect the Company's results of operations and cash flows related to its variable-rate bank borrowings under its credit line with PNC. Accordingly, a 100-basis point upward fluctuation in PNC's base rate would have caused the Company to incur additional interest charges of approximately $85,000 and $261,000 for the three months and nine months ended October 31, 2018, respectively. The Company would have benefited from a similar interest savings if the base rate were to have fluctuated downward by a like amount.

The Company carried out an evaluation, under the supervision and with the participation of the Company's management, including its Principal Executive Officer along with its Principal Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) under the Securities Exchange Act of 1934 (“Exchange Act”) as of October 31, 2018. Based upon the foregoing, the Company's Principal Executive Officer along with the Company's Principal Financial Officer concluded that the Company's disclosure controls and procedures as of such date were effective to ensure that the information required to be disclosed in the Company’s Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to Company management, including its Principal Executive Officer and Principal Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, Company management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

There have been no changes in the Company's internal control over financial reporting during the fiscal quarter covered by this quarterly report on Form 10-Q that have materially affected, or are reasonably likely to materially affect, its internal control over financial reporting.