# COMPX INTERNATIONAL INC (CIX) FY 2022 MD&A

Verbatim Item 7 Management's Discussion and Analysis from COMPX INTERNATIONAL INC's 10-K for fiscal year 2022.

SEC filing source: https://www.sec.gov/Archives/edgar/data/1049606/000155837023002573/cik-20221231x10k.htm
Accession: 0001558370-23-002573
Filing date: 2023-03-01
Report date: 2022-12-31
Extracted structurally from real Item 7 body heading to real Item 7A/8 boundary.
Confidence: high

Company profile: /company/CIX/
All MD&A years: /company/CIX/mda/
Previous year: /company/CIX/mda/fy2021/ (FY 2021)
Next year: /company/CIX/mda/fy2023/ (FY 2023)

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

Business Overview

We are a leading manufacturer of engineered components utilized in a variety of applications and industries. Through our Security Products segment we manufacture mechanical and electrical cabinet locks and other locking mechanisms used in postal, recreational transportation, office and institutional furniture, cabinetry, tool storage and healthcare applications. We also manufacture wake enhancement systems, stainless steel exhaust systems, gauges, throttle controls, trim tabs and related hardware and accessories for the recreational marine and other industries through our Marine Components segment.

Operating Income Overview

We reported operating income of $25.4 million in 2022 compared to operating income of $20.5 million in 2021 and $11.8 million in 2020. The increase in operating income in 2022 over 2021 is primarily due to higher Marine Components sales and to a lesser extent higher Security Products sales. Our operating income was negatively impacted by the COVID-19 pandemic in 2020, primarily in the second and third quarters, which significantly impacts operating income comparisons for the comparative periods. Beginning in the third quarter of 2020 and continuing through 2021, our sales volumes generally improved at both our business segments and the increase in operating income in 2021 over 2020 primarily resulted from the higher sales volumes. See results of operations discussion below.

Our product offerings consist of a large number of products that have a wide variation in selling price and manufacturing cost, which results in certain practical limitations on our ability to quantify the impact of changes in individual product sales quantities and selling prices on our net sales, cost of sales and gross margin. In addition, small variations in period-to-period net sales, cost of sales and gross margin can result from changes in the relative mix of our products sold.

Results of Operations - 2022 Compared to 2021 and 2021 Compared to 2020

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[[/GREPCENT_TABLE]]

​

Net Sales. Net sales increased approximately $25.8 million in 2022 compared to 2021 due to higher Marine Component sales primarily to the towboat market and, to a lesser extent, higher Security Products sales across a variety of markets.

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Net sales increased approximately $26.3 million in 2021 compared to 2020 primarily due to higher sales at both of our segments, particularly in the second quarter of 2021, as many of our customers were temporarily closed or reduced production during the second quarter of 2020 due to government ordered closures or reduced demand resulting from the COVID-19 pandemic. Beginning in the third quarter of 2020 and continuing through 2021, Marine Components sales exceeded pre-pandemic levels.  Security Products sales generally improved since third quarter of 2020 but did not recover to pre-pandemic levels until the second quarter of 2021 when sales improved in markets that had been slower to recover from the COVID-19 pandemic, particularly sales to distributors and the office furniture market.

Cost of Sales and Gross Margin. Cost of sales increased in 2022 compared to 2021 primarily due to the effects of the higher sales, as well as increased production costs at both Security Products and Marine Components. Gross margin as a percentage of sales decreased over the same period primarily due to the decrease in the Security Products gross margin percentage.

Cost of sales increased in 2021 compared to 2020 primarily due to the effects of the higher sales, as well as increased production costs at both Security Products and Marine Components. Gross margin as a percentage of sales increased over the same period due to the increase in the Security Products gross margin percentage partially offset by the decrease in the Marine Components gross margin percentage.

Operating Costs and Expenses. Operating costs and expenses consist primarily of sales and administrative-related personnel costs, sales commissions and advertising expenses directly related to product sales and administrative costs relating to business unit and corporate management activities, as well as gains and losses on sales of property and equipment. Operating costs and expenses increased in 2022 compared to 2021 predominantly due to higher salary and employment related costs which increased by $.7 million. As a percentage of sales, operating costs and expenses decreased in 2022 compared to 2021 primarily due to the effect of higher sales.

Operating costs and expenses increased in 2021 compared to 2020 predominantly due to higher salary and benefit costs which increased by $.9 million. As a percentage of sales, operating costs and expenses decreased in 2021 compared to 2020 primarily due to the effect of higher sales.

Operating Income. As a percentage of net sales, operating income increased in 2022 compared to 2021 and increased in 2021 compared to 2020. Operating margins were primarily impacted by the factors impacting net sales, cost of sales, gross margin and operating costs discussed above.

General. Our profitability primarily depends on our ability to utilize our production capacity effectively, which is affected by, among other things, the demand for our products and our ability to control our manufacturing costs, primarily comprised of labor costs and materials. The materials used in our products consist of purchased components and raw materials some of which are subject to fluctuations in the commodity markets such as zinc, brass and stainless steel. Total material costs represented approximately 47% of our cost of sales in 2022, with commodity-related raw materials representing approximately 17% of our cost of sales. Prices for the primary commodity-related raw materials used in the manufacture of our locking mechanisms, primarily zinc and brass, generally increased throughout 2021 and the first half of 2022. Prices began to stabilize in the latter half of 2022, although at elevated levels. The prices for stainless steel, the primary raw material used for the manufacture of marine exhaust headers and pipes and wake enhancement systems, experienced significant volatility during 2021 and 2022. Based on current economic conditions, we expect the prices for zinc, brass, stainless steel and other manufacturing materials in 2023 to be relatively stable, although at the elevated levels we experienced in the second half of 2022.

We occasionally enter into short-term commodity-related raw material supply arrangements to mitigate the impact of future increases in commodity related raw material costs. See Item 1 - “Business- Raw Materials.”

Interest Income. Interest income in 2022 increased compared to 2021 primarily due to higher interest rates and increased investment balances, partially offset by lower average loan balances on our loan to an affiliate. Interest income in 2021 decreased compared to 2020 primarily due to lower average loan balances on our loan to an affiliate. See Notes 3 and 10 to our Consolidated Financial Statements.

Provision for income taxes. A tabular reconciliation of our actual tax provision to the U.S. federal statutory income tax rate of 21% is included in Note 8 to the Consolidated Financial Statements. As a member of the group of companies consolidated for U.S. federal income tax purposes with Contran, the parent of our consolidated U.S. federal

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income tax group, we compute our provision for income taxes on a separate company basis, using the tax elections made by Contran.

Our effective income tax rate was 24% in each of 2020, 2021 and 2022. See Notes 8 and 11 to our Consolidated Financial Statements. We currently expect our effective income tax rate for 2023 to be comparable to our effective income tax rate for 2022.

Segment Results

The key performance indicator for our segments is the level of their operating income (see discussion below). For additional information regarding our segments refer to Note 2 to our Consolidated Financial Statements.

[[GREPCENT_TABLE]]
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[[/GREPCENT_TABLE]]

​

Security Products. Security Products net sales increased 9% to $114.5 million in 2022 compared to $105.1 million in 2021 due to increased sales across a variety of markets. Relative to prior year, sales were $3.8 million higher to the government security market, $1.8 million higher to the office furniture market, $1.5 million higher to distributors, $1.0 million higher to the tool storage market, and $.9 million higher to the gas station security market. Gross margin as a percentage of net sales for 2022 decreased as compared to 2021 primarily due to higher cost of sales, most significantly in the third and fourth quarters of 2022, as price increases and surcharges did not fully offset higher cost inventory sold in the latter half of the year. Operating income margin decreased for 2022 compared to 2021 primarily due to the factors impacting gross margin, as well as increased operating costs and expenses, resulting from higher salaries and employment related costs, partially offset by increased coverage of operating costs and expenses from higher sales.

Security Products net sales increased 20% to $105.1 million in 2021 compared to $87.9 million in 2020 when it experienced reduced demand across a variety of markets due to COVID-19. Compared to 2020, sales were $7.2 million higher to the government security market, $4.9 million higher to the transportation market, and $2.0 million higher to distribution customers. Gross margin as a percentage of net sales for 2021 increased as compared to 2020 due to increased coverage of fixed costs from higher sales, partially offset by higher production costs including increased raw materials costs across a variety of commodities and component inputs, higher shipping costs, and increased labor costs primarily due to higher overtime costs and increased headcount. Operating income margin increased for 2021 compared to 2020 primarily due to increased coverage of operating costs and expenses on higher sales, partially offset by the higher production costs impacting gross margin and increased sales and administrative-related salary and benefit costs of $.7 million.

- 14 -

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[[/GREPCENT_TABLE]]

​

Marine Components. Marine Components net sales increased 46% in 2022 as compared to 2021. Relative to prior year, sales were $11.5 million higher to the towboat market (primarily to original equipment boat manufacturers), $2.1 million higher to the engine builder market, and $2.0 million higher to the industrial market. Gross margin as a percentage of sales increased slightly in 2022 compared to 2021 with increased sales due to price increases and surcharges more than offsetting higher production costs, as well as increased coverage of cost of sales from higher sales. Operating income as a percentage of net sales increased in 2022 compared to 2021 primarily due to the factors impacting gross margin, as well as increased coverage of operating costs and expenses from higher sales.

Marine Components net sales increased 34% in 2021 as compared to 2020 primarily due to increased sales of $7.2 million to several original equipment boat manufactures in the towboat market. Gross margin as a percentage of sales decreased in 2021 compared to 2020 as increased coverage of fixed costs from higher sales were more than offset by higher production costs including raw materials costs (primarily stainless steel), higher shipping costs, and increased labor costs resulting from higher overtime costs and increased headcount. Operating income as a percentage of net sales increased slightly in 2021 compared to 2020 due to increased coverage of operating costs and expenses from higher sales, partially offset by the factors impacting gross margin.

Outlook. While we continued to experience strong demand at both our segments during the fourth quarter of 2022, the order rate and backlog at both segments began to soften late in the fourth quarter. We operated our manufacturing facilities at elevated production rates throughout 2022 in line with the strong demand and we continue to monitor demand levels and will adjust production rates accordingly. While labor markets continue to be competitive in each of the regions in which we operate and labor costs continue to rise, we have been able to achieve and maintain more balanced staffing levels aligned with current and forecasted demand, particularly at our Marine Components segment. We continue to face shortages related to certain electronic components; however, our supply chains are generally stable and recently transportation and logistical delays have been minimal.

We expect gross margins at Security Products will continue to be challenged during 2023 as higher cost inventory continues to work its way through cost of sales and anticipated reduced demand may limit our ability to implement further price increases. While we expect Marine Components net sales to remain strong during the first quarter, we expect net sales will decline as compared to 2022 as marine market demand is being challenged by higher interest rates and several original equipment boat manufacturers, including certain of our customers, have publicly announced reduced production schedules in 2023 compared to 2022. We currently expect Marine Components gross margins as a percentage of net sales in 2023 to be comparable to 2022. Based on the softening demand and general economic conditions in North America, we currently expect to report lower net sales and operating income at both segments during 2023 compared to 2022. We are focused on managing inventory levels to support anticipated lower demand in 2023. With raw materials and other components more readily available, we believe we will be able to achieve additional operating efficiencies during the year although the extent and impact of such efficiencies is not yet known.  

Our expectations for our operations and the markets we serve are based on a number of factors outside our control. As noted above, there continue to be some global and domestic supply chain challenges and any future impacts on our operations will depend on, among other things, any future disruption in our operations or our suppliers’ operations, the impact of economic conditions and geopolitical events on demand for our products or our customers’ and suppliers’ operations, all of which remain uncertain and cannot be predicted.

​

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Critical Accounting Policies and Estimates

Our significant accounting policies are more fully described in Note 1 to our Consolidated Financial Statements. Our Consolidated Financial Statements have been prepared in conformity with accounting principles generally accepted in the United States of America (GAAP) which requires us to make estimates, judgments, and assumptions we believe are reasonable based on our historical experience, contract terms, observations of known trends in our company and the industry as a whole and information available from other outside sources. Our estimates affect the reported amounts of assets and liabilities and related disclosures of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expense during the reporting period. Actual results may differ from initial estimates.

We believe the most critical accounting policies and estimates involving significant judgments and estimates primarily relate to the considerations in the impairment assessments for goodwill and certain long-lived assets. We have discussed the development, selection and disclosure of our critical accounting estimates with the Audit Committee of our Board of Directors.

[[GREPCENT_TABLE]]
[["","\u25cf","Goodwill \u2013 Our goodwill totaled $23.7 million at December 31, 2022, all relating to our Security Products reporting unit, which corresponds to our Security Products operating segment. Goodwill is required to be tested annually or at other times whenever an event occurs or circumstances change that would more-likely-than-not reduce the fair value of a reporting unit below its carrying value. We perform our annual goodwill impairment test in the third quarter of each year, or at other times whenever an event occurs or circumstances change that would more-likely-than-not reduce the fair value of a reporting unit below its carrying value. Such events or circumstances may include: adverse industry or economic trends, lower projections of profitability, or a sustained decline in our market capitalization. These events or circumstances, among other items, may be indications of potential impairment issues which are triggering events requiring the testing of an asset\u2019s carrying value for recoverability. An entity may first assess qualitative factors to determine whether it is necessary to complete a quantitative impairment test using a more-likely-than-not criteria. If an entity believes it is more-likely-than-not the fair value of a reporting unit is greater than its carrying value, including goodwill, the quantitative impairment test can be bypassed. Alternatively, an entity has an unconditional option to bypass the qualitative assessment and proceed directly to performing the quantitative impairment test."]]
[[/GREPCENT_TABLE]]

When performing a qualitative assessment, considerable management judgment is necessary to evaluate the qualitative impact of events and circumstances on the fair value of a reporting unit. Events and circumstances considered in our impairment evaluations, such as historical profits and stability of the markets served, are consistent with factors utilized with our internal projections and operating plan. However, future events and circumstances could result in materially different findings which could result in the recognition of a material goodwill impairment.

Evaluations of possible impairment utilizing the quantitative impairment test require us to estimate, among other factors: forecasts of future operating results, revenue growth, operating margin, tax rates, capital expenditures, depreciation, working capital, weighted average cost of capital, long-term growth rates, risk premiums, terminal values, and fair values of our reporting units and assets. The goodwill impairment test is subject to uncertainties arising from such events as changes in competitive conditions, the current general economic environment, material changes in growth rate assumptions that could positively or negatively impact anticipated future operating conditions and cash flows, changes in the discount rate, and the impact of strategic decisions. If any of these factors were to materially change, such change may require revaluation of our goodwill. Changes in estimates or the application of alternative assumptions could produce significantly different results.

In 2022, we used the qualitative assessment for our annual impairment test and determined it was not necessary to perform the quantitative goodwill impairment test, as we concluded it is more-likely- than-not the fair value of the Security Products reporting unit exceeded its carrying amount. See Notes 1 and 6 to our Consolidated Financial Statements.

[[GREPCENT_TABLE]]
[["","\u25cf","Long-lived assets \u2013 The net book value of our property and equipment totaled $28.7 million at December 31, 2022. We assess property and equipment for impairment only when circumstances indicate an impairment may exist. Our determination is based upon, among other things, our estimates of the amount of future net cash flows to be generated by the long-lived asset (Level 3 inputs) and our estimates of the current fair value of the asset."]]
[[/GREPCENT_TABLE]]

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Significant judgment is required in estimating such cash flows. Adverse changes in such estimates of future net cash flows or estimates of fair value could result in an inability to recover the carrying value of the long-lived asset, thereby possibly requiring an impairment charge to be recognized in the future. We do not assess our property and equipment for impairment unless certain impairment indicators are present. We did not evaluate any long-lived assets for impairment during 2022 because no such impairment indicators were present.

Liquidity and Capital Resources

Summary

Our primary source of liquidity on an on-going basis is our cash flow from operating activities, which is generally used to (i) fund capital expenditures, (ii) repay short-term or long-term indebtedness incurred primarily for capital expenditures, business combinations or buying back shares of our outstanding stock and (iii) provide for the payment of dividends (if declared). From time-to-time, we may incur indebtedness to fund capital expenditures, business combinations or other investment activities. In addition, from time-to-time, we may also sell assets outside the ordinary course of business, the proceeds of which are generally used to repay indebtedness (including indebtedness which may have been collateralized by the assets sold) or to fund capital expenditures or business combinations.

Consolidated cash flows

Operating activities. Trends in cash flows from operating activities, excluding changes in assets and liabilities, for the last three years have generally been similar to the trends in our earnings. Depreciation and amortization were comparable in each of 2022, 2021 and 2020. See Note 1 to our Consolidated Financial Statements.

Changes in assets and liabilities result primarily from the timing of production, sales and purchases. Such changes in assets and liabilities generally tend to even out over time. However, year-to-year relative changes in assets and liabilities can significantly affect the comparability of cash flows from operating activities. Cash provided by operating activities was $16.9 million in 2022 compared to $10.5 million in 2021. The $6.4 million increase in cash provided by operating activities was primarily the net result of:

[[GREPCENT_TABLE]]
[["","\u25cf","A $4.9 million increase in operating income in 2022,"]]
[[/GREPCENT_TABLE]]

[[GREPCENT_TABLE]]
[["","\u25cf","A lower amount of net cash used by relative changes in inventories, receivables, payables and non-tax accruals of $3.9 million,"]]
[[/GREPCENT_TABLE]]

[[GREPCENT_TABLE]]
[["","\u25cf","A $3.1 million increase in cash paid for taxes in 2022 due to higher operating income, and"]]
[[/GREPCENT_TABLE]]

[[GREPCENT_TABLE]]
[["","\u25cf","A $.7 million increase in interest received in 2022 due to higher interest rates and increased investment balances, partially offset by lower average loan balances on our loan to an affiliate."]]
[[/GREPCENT_TABLE]]

Cash provided by operating activities was $10.5 million in 2021 compared to $15.5 million in 2020. The $5.0 million decrease in cash provided by operating activities was primarily the net result of:

[[GREPCENT_TABLE]]
[["","\u25cf","A higher amount of net cash used by relative changes in inventories, receivables, payables and non-tax accruals of $11.3 million,"]]
[[/GREPCENT_TABLE]]

[[GREPCENT_TABLE]]
[["","\u25cf","A $8.7 million increase in operating income in 2021,"]]
[[/GREPCENT_TABLE]]

[[GREPCENT_TABLE]]
[["","\u25cf","A $1.4 million increase in cash paid for taxes in 2021 due to higher operating income, and"]]
[[/GREPCENT_TABLE]]

[[GREPCENT_TABLE]]
[["","\u25cf","A $1.0 million decrease in interest received in 2021 due to lower average loan balances on our loan to an affiliate and the relative timing of interest received."]]
[[/GREPCENT_TABLE]]

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Relative changes in working capital can have a significant effect on cash flows from operating activities. As shown below, the total average days sales outstanding was generally consistent from December 31, 2021 to December 31, 2022 and is primarily impacted by the timing of sales and collections in the last month of the year. For comparative purposes, we have provided 2020 numbers below.

[[GREPCENT_TABLE]]
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[[/GREPCENT_TABLE]]

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As shown below, our average number of days in inventory increased from December 31, 2021 to December 31, 2022 due to increased inventories of certain components and raw materials that had longer lead times or for which we have experienced availability issues and from the timing of sales relative to the end of the fourth quarter, primarily at Security Products. For comparative purposes, we have provided 2020 numbers below.

[[GREPCENT_TABLE]]
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[[/GREPCENT_TABLE]]

Investing activities. Capital expenditures have primarily emphasized improving our manufacturing facilities and investing in manufacturing equipment, utilizing new technologies and increased automation of the manufacturing process, to provide for increased productivity and efficiency in order to meet expected customer demand and properly maintain our facilities and technology infrastructure. Capital expenditures were $1.7 million in 2020, $4.1 million in 2021 and $3.7 million in 2022. As a result of the COVID-19 pandemic, we limited 2020 expenditures to those required to meet our expected customer demand and those required to properly maintain our facilities and technology infrastructure. Our 2021 capital expenditures increased above pre-pandemic levels as we accelerated the timeline for certain projects designed to increase capacity and improve our capabilities in response to strong customer demand. Beginning in the latter half of 2022, we limited investments primarily to those expenditures required to meet our existing customer demand and to properly maintain our facilities and technology infrastructure. See Note 2 to our Consolidated Financial Statements.

We expect our capital expenditures for 2023 will be approximately $3.0 million primarily to meet our expected customer demand and those required to properly maintain our facilities and technology infrastructure. Capital spending for 2023 is expected to be funded through cash on hand and cash generated from operations.

We have entered into an unsecured revolving demand promissory note with Valhi under which, as amended, we have agreed to loan Valhi up to $25 million. Our loan to Valhi, as amended, bears interest at prime rate plus 1.00%, payable quarterly, with all principal due on demand, but in any event no earlier than December 31, 2024. Loans made to Valhi at any time under the agreement are at our discretion. Under the promissory note, Valhi borrowed a net $1.4 million in 2020 ($34.8 million of gross borrowings and $33.4 million of gross repayments), repaid a net $10.8 million in 2021 ($29.8 million of gross borrowings and $40.6 million of gross repayments) and repaid a net $5.5 million in 2022 ($24.3 million of gross borrowings and $29.8 million of gross repayments). See Note 10 to our Consolidated Financial Statements.

During 2022 we purchased marketable debt securities totaling $33.0 million. See Note 3 to our Consolidated Financial Statements.

Financing activities. Regular quarterly dividends paid totaled $5.0 million ($.40 per share, or $.10 per share per quarter) in 2020, $9.9 million ($.80 per share, or $.20 per share per quarter) in 2021, and $12.4 million ($1.00 per share, or $.25 per share per quarter) in 2022. In addition, our board of directors declared a special dividend on our Class A common stock which totaled $21.5 million ($1.75 per share) that we paid on August 30, 2022. On March 1, 2023 our board of directors declared a first quarter 2023 dividend of $.25 per share, to be paid on March 21, 2023 to CompX stockholders of record as of March 13, 2023. The declaration and payment of future dividends and the amount thereof, if any, is discretionary and is dependent upon our results of operations, financial condition, cash requirements for our businesses, contractual requirements and restrictions and other factors deemed relevant by our board of directors. The

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amount and timing of past dividends is not necessarily indicative of the amount or timing of any future dividends which we might pay.

During 2021, we acquired 75,000 shares of our Class A common stock in market transactions for $1.3 million. During 2022, we acquired 78,900 shares of our Class A common stock (8,900 shares from affiliates and 70,000 shares in a single market transaction) for an aggregate purchase price of $1.7 million. See Note 9 to our Consolidated Financial Statements.

Future Cash Requirements

We believe cash generated from operations together with cash on hand will be sufficient to meet our liquidity needs for working capital, capital expenditures, debt service and dividends (if declared) for the next twelve months and our long term obligations for the next five years. To the extent that actual operating results or other developments differ materially from our expectations, our liquidity could be adversely affected.

All of our $59.9 million aggregate cash, cash equivalents and marketable securities at December 31, 2022 were held in the U.S.

We periodically evaluate our liquidity requirements, alternative uses of capital, capital needs and available resources in view of, among other things, our capital expenditure requirements, dividend policy and estimated future operating cash flows. As a result of this process, we have in the past and may in the future seek to raise additional capital, refinance or restructure indebtedness, issue additional securities, repurchase shares of our common stock, modify our dividend policy or take a combination of such steps to manage our liquidity and capital resources. In the normal course of business, we may review opportunities for acquisitions, joint ventures or other business combinations in the component products industry. In the event of any such transaction, we may consider using available cash, issuing additional equity securities or increasing our indebtedness or that of our subsidiaries.

Commitments and contingencies

As more fully described in the Notes to the Consolidated Financial Statements, we are a party to various agreements that contractually and unconditionally commit us to pay certain amounts in the future. See Note 11 to our Consolidated Financial Statements. Additionally, we have purchase obligations of $17.7 million ($16.3 million payable in 2023 and $1.4 million payable in 2024) which consists of open purchase orders and contractual obligations, primarily commitments to purchase raw materials and for capital projects in process at December 31, 2022. The timing and amount for purchase obligations are based on the contractual payment amount and the contractual payment date for those commitments.

Recent accounting pronouncements

None.