EASTERN CO (EML) FY 2022 MD&A

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

The Company’s fiscal year ends on the Saturday nearest to December 31.  Fiscal year 2021 was 52 weeks in length and fiscal year 2020 was 53 weeks in length. References in this Management’s Discussion and Analysis of Financial Condition and Results of Operations to results for “2021” or “fiscal year 2021” mean the fiscal year ended January 1, 2022, and references to results for “2020” or “fiscal year 2020” mean the fiscal year ended January 2, 2021. References to the “fourth quarter of 2021” or the “fourth fiscal quarter of 2021” mean the thirteen-week period from October 3, 2021 to January 1, 2022, and references to the “fourth quarter of 2020” or the “fourth fiscal quarter of 2020” mean the thirteen-week period from October 4, 2020 to January 2, 2020.

The following analysis excludes discontinued operations.

Summary

Sales for 2021 were $246.5 million compared to $197.6 million for 2020.  Net income for 2021 was $16.2 million, or $2.58 per diluted share, compared to $11.0 million, or $1.76 per diluted share, for 2020.  Sales for the fourth quarter of 2021 were $59.6 million compared to $50.6 million for the same period in 2020.  Net income for the fourth quarter of 2021 was $3.9 million, or $0.62 per diluted share compared to $3.2 million, or $0.50 per diluted share, for the comparable 2020 period.

During 2021, the Company experienced rising material costs, supply chain disruption, labor shortages and abnormally high freight costs all having a negative impact on our gross margin.  Despite all these challenges, demand for our products are at an all-time high. The Company’s backlog was $82.8 million on January 1, 2022, compared to $64.7 million on January 2, 2021, primarily due to an increase of $10.1 million in backlog for locks and hardware at Eberhard due to new product launches and an increase of $8.5 million in backlog related to the launch of new mirror programs for Class 8 trucks being awarded to our Velvac subsidiary.

During 2021 the Company experienced price increases for many of the raw materials used in producing its products, including: scrap iron, stainless steel, hot and cold rolled steel, zinc, copper, aluminum, and nickel.  These increases could negatively impact the Company’s gross margin if raw material prices increase too rapidly for the Company to recover those cost increases through either price increases to our customers or cost reductions in other areas of the business.

Critical Accounting Estimates

The preparation of financial statements in accordance with accounting principles generally accepted in the United States (“U.S. GAAP”) requires management to make judgments, estimates and assumptions regarding uncertainties that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities and the reported amounts of revenues and expenses. Areas of uncertainty that require judgments, estimates and assumptions include items such as the accounting for derivatives; environmental matters; the testing of goodwill and other intangible assets for impairment; proceeds on assets to be sold; pensions and other postretirement benefits; leases; and tax matters. Management uses historical experience and all available information to make its estimates and assumptions, but actual results will inevitably differ from the estimates and assumptions that are used to prepare the Company’s financial statements at any given time. Despite these inherent limitations, management believes that Management’s Discussion and Analysis of Financial Condition and Results of Operations and the financial statements and related footnotes provide a meaningful and fair presentation of the Company’s financial position and results of operations.

Management believes that the application of these estimates and assumptions on a consistent basis enables the Company to provide the users of the financial statements with useful and reliable information about the Company’s operating results and financial condition.

Allowance for Doubtful Accounts

The Company maintains an allowance for doubtful accounts for estimated losses resulting from the inability of its customers to make required payments. The Company reviews the collectability of its receivables on an ongoing basis, considering a combination of factors. The Company reviews potential problems, such as past due accounts, a bankruptcy filing or deterioration in the customer’s financial condition, to ensure that the Company has adequately accrued for potential loss. Accounts are considered past due based on when payment was originally due. If a customer’s situation changes, such as a bankruptcy or a change in its creditworthiness, or there is a change in the current economic climate, the Company may modify its estimate of the allowance for doubtful accounts.  The Company will write off accounts receivable after reasonable collection efforts have been made and the accounts are deemed uncollectible.

Inventory

Inventories are valued at the lower of cost or net realizable value. Cost is determined by the last-in, first-out (“LIFO”) method at Eberhard while Big 3 Precision and Velvac are valued on a first-in, first-out (“FIFO”) method. Accordingly, a LIFO valuation reserve is calculated using the dollar value link chain method.

We review the net realizable value of inventory in detail on an ongoing basis, considering deterioration, obsolescence, and other factors. Based on these assessments, we provide for an inventory reserve in the period in which an impairment is identified. The reserve fluctuates with market conditions, design cycles, and other economic factors.

Goodwill and Other Intangible Assets

Intangible assets with finite useful lives are generally amortized on a straight-line basis over the periods benefited. Goodwill and other intangible assets with indefinite useful lives are not amortized. The Company performed its annual qualitative assessment as of the end of fiscal 2021 on the carrying value of goodwill and determined that it is more likely than not that no impairment of goodwill existed at the end of 2021.  See Note 4 – Accounting Policies – Goodwill, in Item 8, Financial Statements and Supplementary Data for more detail.  The Company will perform annual qualitative assessments in subsequent years as of the end of each fiscal year.  Additionally, the Company will perform an interim analysis whenever conditions warrant.

Pension and Other Postretirement Benefits

The amounts recognized in the consolidated financial statements related to pension and other postretirement benefits are determined from actuarial valuations. Inherent in these valuations are assumptions about such factors as expected return on plan assets, discount rates at which liabilities could be settled, rate of increase in future compensation levels, mortality rates, and trends in health insurance costs. These assumptions are reviewed annually and updated as required. In accordance with U.S. GAAP, actual results that differ from the assumptions are accumulated and amortized over future periods and, therefore, affect the expense recognized and obligations recorded in future periods.

The discount rate used is based on a single equivalent discount rate derived with the assistance of our actuaries by matching expected future benefit payments in each year to the corresponding spot rates from the FTSE Pension Liability Yield Curve, comprised of high quality (rated AA or better) corporate bonds.  The Company calculates its service and interest costs in future years by applying the specific spot rates along the selected yield curve to the relevant projected cash flows.

The expected long-term rate of return on assets is also developed with input from the Company’s actuarial firms. We consider the Company’s historical experience with pension fund asset performance, the current and expected allocation of our plan assets and expected long-term rates of return. The long-term rate-of-return assumption used for determining net periodic pension expense was 7.5% for 2021 and 2020. The Company reviews the long-term rate of return each year.

Future actual pension income and expense will depend on future investment performance, changes in future discount rates and various other factors related to the population of participants in the Company’s pension plans.

The Company expects to make cash contributions of approximately $300,000 and $50,000 to our pension plans and other postretirement plan, respectively, in 2022.

In connection with our pension and other postretirement benefits, the Company reported income of $2.1 million and an expense of $5.7 million (net of tax) on its Consolidated Statement of Comprehensive Income for fiscal years 2021 and 2020, respectively.  The main factor driving this expense was the change in the discount rate during the applicable period.

Assumptions used to determine net periodic pension benefit cost for the fiscal years indicated were as follows:

Assumptions used to determine net periodic other postretirement benefit cost are the same as those assumptions used for the pension benefit cost, except that the rate of compensation is not applicable for other postretirement benefit cost.

The changes in assumptions had the following effect on the net periodic pension and other postretirement costs recorded in Other Comprehensive Income as follows:

The Plan has been investing a portion of the assets in long-term bonds to better match the impact of changes in interest rates on its assets and liabilities and thus reduce some of the volatility in Other Comprehensive Income.  Please refer to Note 11 – Retirement Benefit Plans in Item 8, Financial Statements and Supplementary Data of this Form 10-K for additional disclosures concerning the Company’s pension and other postretirement benefit plans.

RESULTS OF OPERATIONS

Fourth Quarter 2021 Compared to Fourth Quarter 2020

The following table shows, for the fourth quarter of 2021 and 2020, selected line items from the consolidated statements of income as a percentage of net sales for the Company’s operations.  The Company’s continuing operations include (1) Big 3 Precision, including Big 3 Products and Big 3 Mold, Hallink Moulds, and Associated Toolmakers; (2) Eberhard Manufacturing, Eberhard Hardware, Eastern Industrial Ltd., Illinois Lock Company/CCL Security Products, World Lock Company Ltd., Dongguan Reeworld Security Products Ltd., and World Security Industries Ltd.; and (3) Velvac Holdings.

Net sales in the fourth quarter of 2021 increased 18% to $59.6 million from $50.6 million in the fourth quarter of 2020.  Sales increases were due to higher demand for trucks accessories, distribution products and automotive returnable packaging and improved pricing.  Sales volume of existing products increased 6%, prices and new products contributed 12% in sales growth in the fourth quarter of 2021 when compared to sales in the fourth quarter of 2020.  New products included various truck, mirrors, latches, and accessories.

Sales of new products contributed 8% to sales growth in the fourth quarter compared to 4% sales growth from new products in the fourth quarter of 2020.  New products in the fourth quarter included various new truck mirrors and truck latches.

Cost of products sold in the fourth quarter of 2021 increased $8.5 million or 22% from the corresponding period in 2020.  The increase in cost of products sold is primarily attributable to increased sales volume, increases in the cost of materials, and increases in freight costs due to expedite fees associated with supply chain constraints.  During the fourth quarter of 2021, material costs have begun to decrease from the third quarter of 2021 levels with costs for hot rolled steel decreasing 16% and costs for cold roll steel decreasing by 7%. Material costs increased over the third quarter of 2021 for aluminum, copper, nickel, and zinc which increased by 2%, 4%, 5% and 15%, respectively.

Gross margin as a percentage of net sales for the fourth quarter of 2021 was 20% compared to 23% in the prior year fourth quarter. The decrease reflects the combination of higher material and freight costs.

Product development expenses in the fourth quarter of 2021 of $1.0 million were up 192% when compared to the fourth quarter of 2020.  As a percentage of net sales, product development costs were 1.7% and 0.7% for the fourth quarter of 2021 and 2020 respectively as part of our investment in new products at Eberhard and Velvac.

Selling and administrative expenses in the fourth quarter of 2021 increased 8% compared to the fourth quarter of 2020.  The increase was primarily the result of increased payroll and payroll related expenses, increased travel, and other expenses as business returned to more normal operations in 2021.

Goodwill impairment expense of $1.0 million was incurred in the fourth quarter of 2020 as the Company announced the closure of Eberhard Hardware in Ontario, Canada.

Restructuring expenses of $0.7 million were incurred in the fourth quarter of 2020 due to severance expenses related to the closure of Eberhard Hardware in Ontario Canada.

Net income for the fourth quarter of 2021 increased 24% to $3.9 million, or $0.62 per diluted share, from $3.2 million, or $0.50 per diluted share, in 2020.  In the fourth quarter of 2020, net income was negatively impacted by non-cash goodwill impairment charges of $0.7 million, net of tax, and non-recurring restructuring, factory relocation, and transaction costs of $0.9 million net of tax.

Fiscal Year 2021 Compared to Fiscal Year 2020

The following table shows, for fiscal year 2021 and fiscal year 2020, selected line items from the consolidated statements of income as a percentage of net sales for the Company’s operations. The Company’s continuing operations include (1) Big 3 Precision, including Big 3 Products, Big 3 Mold, Hallink Moulds and Associated Toolmakers Ltd.; (2) Eberhard Manufacturing Company, Eberhard Hardware, Eastern Industrial Ltd., Illinois Lock Company/CCL Security Products, World Lock Company Ltd., Dongguan Reeworld Security Products Ltd. and World Security Industries Ltd.; and (3) Velvac Holdings.

Summary

Net sales for 2021 increased 25% to $246.5 million from $197.6 million in 2020.  The sales increase was due to higher demand for trucks accessories, distribution products and automotive returnable packaging.  Sales volume of existing products increased by 15% in 2021 compared to 2020 while price increases and new products increased sales in 2021 by 10%.  Sales of new products contributed 8% to sales growth in 2021 compared to 4% sales growth from new products in 2020.  New products in 2021 included various new truck mirrors, truck compression latches, cable locks, and locking assemblies.

Cost of products sold increased by $40.2 million or 27% to $189.8 million in 2021 from $149.5 million in 2020.  The increase in cost of products sold is primarily attributable to increased sales volume, increases in the price of materials, and increases in freight costs due to expedite fees associated with supply chain constraints.  Material costs have increased substantially over prior year for hot rolled steel by 75%; cold rolled steel by 94%; aluminum by 66%; copper by 36%, nickel by 27% and zinc by 31%.  Many of our supply contracts contain price adjustment clauses when material cost increase by a certain percentage.  Tariffs incurred during 2021 were $2.9 million from China-sourced products as compared to $2.6 million in 2020. Most of the tariffs were recovered through price increases.

Gross margin as a percentage of sales was 23% in 2021 compared to 24% in 2020.  The decrease reflects the combination of higher material and freight costs.

Product development expenses as a percentage of sales increased to 1.6% 2021 from 1.4% in 2020.  The increase reflects the Company’s on-going efforts to continue developing new products to better serve our customers.

Selling and administrative expenses increased $5.0 million or 17% to $35.2 million in 2021 from $30.2 million in 2020.  The increase relates to increased payroll and payroll related costs, increased travel, and other expenses as our businesses returned to more normal operations in 2021.

Net income for 2021 increased by 47% to $16.2 million, or $2.58 per diluted share, from $11.0 million, or $1.76 per diluted share, in 2020.  In 2021, net income was positively impacted by a $1.4 million gain, net of tax, related to the sale of the Eberhard Hardware property in the first quarter, partially offset by one-time factory relocation and start-up costs of $0.5 million, net of tax.  Net income for 2020 was adversely impacted by non-cash goodwill impairment charges of $0.7 million, net of tax and non-recurring restructuring, factory relocation, and transaction costs of $1.3 million, net of tax.

Other Items

The following table shows the amount of change from the year ended January 2, 2021 as compared to the year ended January 1, 2022 in other items (dollars in thousands):

Interest expense decreased in 2021 from 2020 due to principal payments made on long-term debt.

Other income in 2021 increased $1.6 million over 2020. Other income in 2021 included a favorable $1.5 million pension cost adjustment and a $1.8 million gain on the sale of the Eberhard Hardware property.  In 2020, other income included a favorable $1.2 million pension cost adjustment and a $0.4 million gain on a sale/leaseback transaction.

The effective tax rate for 2021 was 8% compared to the 2020 effective tax rate of 10%.  The effective tax rate for 2021 was reduced due to the impact of foreign subsidiaries on the effective tax rate and the R&D credit.  Total income taxes paid were $2.3 million in 2021 and $3.8 million in 2020.

Liquidity and Sources of Capital

The primary source of the Company’s cash is earnings from operating activities adjusted for cash generated from or used for net working capital.  The most significant recurring non-cash items included in net income are depreciation and amortization expense.  Changes in working capital fluctuate with the changes in operating activities.  As sales increase, there generally is an increased need for working capital.  The Company closely monitors inventory levels and attempts to match production to expected market demand, keeping tight control over the collection of receivables, and optimizing payment terms on its trade and other payables.

The Company is dependent on continued demand for its products and subsequent collection of accounts receivable from its customers. The Company serves a broad base of customers and industries with a variety of products. As a result, any fluctuations in demand or payment from a particular industry or customer should not have a material impact on the Company’s sales and collection of receivables. Management expects that the Company’s foreseeable cash needs for operations, capital expenditures, debt service and dividend payments will continue to be met by the Company’s operating cash flows and available credit facility.

The following table shows key financial ratios at the end of each fiscal year:

The following table shows important liquidity measures as of the fiscal year-end balance sheet date for each of the preceding two years (in millions):

All cash held by foreign subsidiaries is readily convertible into other currencies, including the U.S. dollar.

Net cash used in by operating activities was $7.8 million in 2021 compared to $14.6 million net cash provided by operating activities in 2020.  In 2021 the Company contributed $2.3 million to its defined benefit retirement plan.

In 2021, cash used to support additional working capital requirements was $22.9 million, which was primarily due to management’s focus on ensuring availability of inventory to meet customer demands during the current supply chain constraints.  In 2020, cash used to support additional working capital requirements was $5.6 million.

The Company provided $13.6 million and used $8.4 million for investing activities in 2021 and 2020, respectively.  In 2021 the company sold businesses associated with its discontinued operations for $17.3 million and one of its buildings for $1.7 million, the Company also issued a note receivable of $2.5 million as part of the sale of the discontinued operations.  In 2020 the Company invested $7.2 million to acquire Hallink Moulds and received $3.2 million for divestures of subsidiaries and equipment.  The Company issued notes receivable of $2.2 million as part of the sale of its subsidiaries.  These transactions are more fully discussed in Note 2 to the 2021 Consolidated Financial Statements located in Item 8 of this Form 10-K. The Company invested in capital expenditures of $3.7 million and $2.3 million in 2021 and 2020, respectively.  Capital expenditures in fiscal year 2022 are expected to be approximately $5.3 million.

In 2021, the Company made total debt payments of $17.3 million, of which $11.0 million was an accelerated principal payment, and used $2.8 million for payment of dividends.  The Company did not draw down on its $20.0 million revolving credit facility in 2021.  On January 11, 2022, the Company drew down $5.0 million on its revolving credit facility to support ongoing working capital requirements brought on by current supply chain constraints.  The Company has $15.0 million available on its revolving line of credit.  See Note 7 - Debt for further discussion on the Company’s debt facilities.

In 2020, the Company made total debt payments of $10.0 million, of which $5.0 million was an accelerated principal payment, and used $2.8 million for payment of dividends.  The Company did not draw down on its $20.0 million revolving credit facility in 2020.

The Company leases certain equipment and buildings under cancelable and non-cancelable operating leases that expire at various dates up to five years. Rent expense amounted to approximately $2.3 million in 2021 and $1.9 million in 2020.

On August 30, 2019, the Company entered into the Credit Agreement with Santander Bank, N.A., for itself, People’s United Bank, National Association and TD Bank, N.A. as lenders, that included a $100.0 million term portion and a $20.0 million revolving commitment portion. Proceeds of the term loan were used to repay the Company’s remaining outstanding term loan (and to terminate its existing credit facility) with People’s United Bank, N.A. (approximately $19.0 million) and to acquire Big 3 Precision. The term portion of the loan requires quarterly principal payments of $1.25 million for an 18-month period beginning December 31, 2019. The repayment amount then increases to $1.875 million per quarter beginning September 30, 2021 and continues through June 30, 2023. The repayment amount then increases to $2.5 million per quarter beginning September 30, 2023 and continues through June 30, 2024. The term loan is a five-year loan with the remaining balance due on August 30, 2024. The revolving commitment portion has an annual commitment fee of 0.25% based on the unused portion of the revolver. The revolving commitment portion has a maturity date of August 30, 2024.  During 2021 and 2020, the Company did not borrow any funds on the revolving commitment portion of the facility. The interest rates on the term and revolving credit portion of the Credit Agreement vary.  The interest rates may vary based on the LIBOR rate plus a margin spread of 1.25% to 2.25%.  The Company’s obligations under the Credit Agreement are secured by a lien on certain of the Company’s and its subsidiaries’ assets pursuant to a Pledge and Security Agreement, dated as of August 30, 2019 with Santander Bank, N.A., as administrative agent.

The Company’s loan covenants under the Credit Agreement require the Company to maintain a senior net leverage ratio not to exceed 4.25 to 1.  In addition, the Company will be required to maintain a fixed charge coverage ratio to be not less than 1.25 to 1.

On August 30, 2019, the Company entered into an interest rate swap contract with Santander Bank, N.A., with an original notional amount of $50.0 million, which was equal to 50% of the outstanding balance of the term loan on that date.  The Company has a fixed interest rate of 1.44% on the swap contract and will pay the difference between the fixed rate and LIBOR when LIBOR is below 1.44% and will receive interest when the LIBOR rate exceeds 1.44%.  On January 2, 2021, the interest rate for half ($27.8 million) of the term portion was 1.6%, using a one-month LIBOR rate, and 3.19% on the remaining balance ($43.8 million) of the term loan based on a one-month LIBOR rate.

The interest rates on the Credit Agreement, and interest rate swap contract are susceptible to changes to the method that LIBOR rates are determined and to the potential phasing out of LIBOR after 2021.  Information regarding the potential phasing out of LIBOR is provided below.

On July 27, 2017, the Financial Conduct Authority (the “FCA”) (the authority that regulates LIBOR) announced that it would phase out LIBOR by the end of 2021. In December 2020, the ICE Benchmark Administration (the “IBA”) announced a market consultation regarding the extension of US dollar LIBOR tenors through June 30, 2023, which the FCA supports. On March 5, 2021, the IBA released its feedback statement reporting the results of the market consultation.  Pursuant to its feedback statement, the IBA intends to cease publication of all settings of non-US dollar LIBOR and only the one-week and two-month U.S. dollar LIBOR settings on December 31, 2021, with the publication of the remaining U.S. dollar LIBOR settings being discontinued after June 30, 2023. The Alternative Reference Rates Committee (ARRC), a financial industry group convened by the Federal Reserve Board, has recommended the use of SOFR to replace LIBOR. The difference between LIBOR and SOFR is that LIBOR is a forward-looking rate which means the interest rate is set at the beginning of the period with payment due at the end. SOFR is a backward-looking overnight rate which has implications for how interest and other payments are based. Changes in the method of calculating the replacement of LIBOR with a fallback rate (effectively SOFR plus a spread adjustment) will become effective in June 2023 unless adopted earlier.  The effect of this change is still unknown and could adversely affect the Company’s results of operations, cash flow, and liquidity.

Non-GAAP Financial Measures

The non-GAAP financial measures we provide in this report should be viewed in addition to, and not as an alternative for, results prepared in accordance with accounting principles generally accepted in the United States (“U.S. GAAP”).

To supplement the consolidated financial statements prepared in accordance with U.S. GAAP, we have presented Adjusted Net Income from Continuing Operations, Adjusted Earnings Per Share from Continuing Operations and Adjusted EBITDA from Continuing Operations, which are considered non-GAAP financial measures.  The non-GAAP financial measures presented may differ from similarly titled non-GAAP financial measures presented by other companies, and other companies may not define these non-GAAP financial measures in the same way.  These measures are not substitutes for their comparable U.S. GAAP financial measures, such as net sales, net income, diluted earnings per common share, or other measures prescribed by U.S. GAAP, and there are limitations to using non-GAAP financial measures.

Adjusted Net Income from Continuing Operations is defined as net income from continuing operations excluding, when they occur, the impacts of impairment losses, losses on sale of subsidiaries, transaction expenses, gain on sale of property, factory start-up costs, factory relocation expenses and restructuring costs.  Adjusted Net Income from Continuing Operations is a tool that can assist management and investors in comparing our performance on a consistent basis by removing the impact of certain items that management believes do not directly reflect our underlying operations.

Adjusted Earnings Per Share from Continuing Operations is defined as diluted earnings per share from continuing operations excluding, when they occur, the impacts of impairment losses, losses on sale of subsidiaries, transaction expenses, gain on sale of building, factory start-up costs, factory relocation expenses and restructuring costs.  We believe that Adjusted Earnings Per Share from Continuing Operations provides important comparability of underlying operational results, allowing investors and management to access operating performance on a consistent basis.

Adjusted EBITDA from Continuing Operations is defined as net income from continuing operations before interest expense, provision for income taxes, and depreciation and amortization and excluding, when they occur, the impacts of impairment losses, losses on sale of subsidiaries, transaction expenses, gain on sale of building, factory start-up costs, factory relocation expenses and restructuring expenses.  Adjusted EBITDA from Continuing Operations is a tool that can assist management and investors in comparing our performance on a consistent basis by removing the impact of certain items that management believes do not directly reflect our underlying operations.

Management uses such measures to evaluate performance period over period, to analyze the underlying trends in our business including our business operations, to assess our performance relative to our competitors, and to establish operational goals and forecasts that are used in allocating resources. These financial measures should not be considered in isolation from, or as a replacement for, U.S. GAAP financial measures.

We believe that presenting non-GAAP financial measures in addition to U.S. GAAP financial measures provides investors greater transparency to the information used by our management for its financial and operational decision-making. We further believe that providing this information better enables our investors to understand our operating performance and to evaluate the methodology used by management to evaluate and measure such performance.