FLEXSTEEL INDUSTRIES INC (FLXS) FY 2021 MD&A

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

General

The following analysis of the results of operations and financial condition of the Company should be read in conjunction with the consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K.

Statement Regarding the Impact of the COVID-19 Pandemic

The World Health Organization (“WHO”) on March 11, 2020, declared novel coronavirus 2019 (“COVID-19”) a global pandemic. In response to this declaration, the Company has taken the following actions to maneuver the current economic landscape:

Employees that can perform work outside of the workplace may work from home,

Suspension of the Company’s 401K match effective June 1, 2020, through December 31, 2020,

Temporary 50% reduction of cash compensation for the Company’s Board of Directors through October 1, 2020,

Temporary 25% reduction of salary compensation for the Company’s Chief Executive Officer and Chief Financial Officer / Chief Operating Officer through October 1, 2020,

Temporary elimination of all non-essential expenses and capital expenditures,

Temporary reduction of quarterly dividend payments; and

Negotiations with vendors to extend payment terms.

During the year ended June 30, 2021, we have seen improvement in our business conditions as retailers have reopened and orders have increased, however, we continue to see supply chain challenges faced by the furniture industry due to limited availability of ocean containers and significant increases in ocean container rates, limited availability and inflationary pressures in key materials, and labor shortages both in Asia and the United States. The COVID-19 pandemic remains fluid, including as a result of COVID-19 variants, and the extent of the ongoing impact to our business may be significant; however, we are unable to predict the extent or nature of these impacts at this time.

Business Update

On April 28, 2020, we announced the exit of our Vehicle Seating, and the remainder of the Hospitality product lines, and subsequently closed our Dubuque, Iowa and Starkville, Mississippi manufacturing facilities. We completed substantially all of the restructuring activities related to the exit of our Vehicle Seating and the remainder of the Hospitality product lines during fiscal 2021. Both product lines combined represented less than 1% of the Company’s total net sales for the fiscal year ended 2021.

Results of Operations

The following table has been prepared as an aid in understanding the Company’s results of operations on a comparative basis for the fiscal years ended June 30, 2021, 2020 and 2019. Amounts presented are percentages of the Company’s net sales.

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Fiscal 2021 Compared to Fiscal 2020

Net sales were $478.9 million for the year ended June 30, 2021, compared to net sales of $366.9 million in the prior year, an increase of 30.5%. The increase in sales of $112.0 million was primarily driven by $138.8 million, or an increase of 51.1%, related to home furnishing products sold through retailers and $5.9 million, or an increase of 9.7%, for home furnishing products sold through e-commerce. Net sales growth in our home furnishing products were virtually in all product categories due to increased demand, partially offset by a decline of $32.7 million primarily due to the exit from our Vehicle Seating and Hospitality product lines during the fourth quarter of fiscal 2020.

Gross margin as a percent of net sales for the year ended June 30, 2021, was 20.2%, compared to 14.5% for the prior year, an increase of 570 basis points (“bps”). The 570 bps increase was primarily driven by structural cost reductions, operational efficiencies, and fixed cost leverage due to higher sales volume as compared to the prior year and lower inventory reserve due to demand.

Selling, general and administrative expenses decreased $4.5 million in the year ended June 30, 2021, compared to the prior year. The decline in SG&A expenses was primarily due to a $3.5 million reduction in bad debt expense from the prior year driven by a customer bankruptcy. Higher sales commission expense resulting from increased sales was largely offset by other spending reductions and lower depreciation. As a percentage of net sales, SG&A was 14.2% in the year ended June 30, 2021, compared to the prior year of 19.7%. The 550 bps decline compared to the prior year was primarily due to cost leverage gained from higher sales, reductions in non-essential spending due to COVID-19, lower depreciation expense due to assets sold or being held for sale, and lower bad debt expense as discussed above during the year ended June 30, 2021.

Restructuring expenses were $3.5 million during the year ended June 30, 2021, primarily for on-going utilities and maintenance costs for our facilities listed as held for sale, professional fees, and employee termination costs as part of our previously announced comprehensive restructuring plan. See Note 5, Restructuring, of the Notes to Consolidated Financial Statements, included in this Annual Report on Form 10-K for more information.

During the year ended June 30, 2021, we completed the sale of our Dubuque, Iowa, Lancaster, Pennsylvania, and one of our Harrison, Arkansas facilities, resulting in total net proceeds of $16.4 million, and a total gain of $5.9 million.

Income tax expense was $8.4 million, or an effective rate of 26.8%, during the year ended June 30, 2021, compared to income tax benefit of $6.9 million in the prior year, or an effective tax rate of 20.5%.

Net income was $23.0 million, or $3.09 per diluted share for the year ended June 30, 2021, compared to net loss of $26.8 million, or $3.37 per diluted share in the prior year.

Fiscal 2020 Compared to Fiscal 2019

Net sales for fiscal year 2020 were $366.9 million compared to $443.6 million in the prior fiscal year, a decrease of 17.3%. For the fiscal year ended June 30, 2020, residential net sales were $331.9 million compared to $374.5 million for the year ended June 30, 2019, a decrease of 11.4%. The decline in residential net sales were primarily attributable to volume decreases on furniture imported from China as a result of the 25% tariff and the related price increases taken to the market, coupled with the COVID-19 pandemic. The decline was partially offset by an increase in our ready to assemble furniture sold through e-commerce, which grew 35.7% year over year, primarily driven by increased demand.

Contract net sales were $35.0 million for the year ended June 30, 2020, a decrease of 49.3% from net sales of $69.1 million for the year ended June 30, 2019. The decline in contract net sales was primarily driven by our decision to exit the Commercial Office and custom-designed Hospitality product lines, coupled with a decline in healthcare and Vehicle Seating products due to demand. In April 2020, we announced the exit of our Vehicle Seating, and the remainder of the Hospitality product lines.

Gross margin for the fiscal year ended June 30, 2020, was 14.5% compared to 15.8% for the prior year period, a decline of 130 bps. The 130 bps decline was primarily driven by a decline of 280 bps due to lower volume and product mix, a decline of 60 bps for increased costs to improve delivery lead times, partially offset by 120 bps from valuation allowance on foreign VAT as a result of collections made during the fiscal year and 80 bps from restructuring cost improvements.

Selling, general and administrative (SG&A) expenses for the twelve months ended June 30, 2020, decreased $8.9 million to $72.4 million compared to $81.3 million for the year ended June 30, 2019. As a percentage of net sales, SG&A was 19.7% for the year ended June 30, 2020, compared to 18.3% of net sales in the prior year period. The increase in SG&A as a percentage of net sales was primarily driven by higher bad debt expense of $5.0 million attributable to a customer bankruptcy and the current economic environment, right-of-use lease asset impairments of $2.9 million, partially offset by current year restructuring savings and lower expenses on reduced volume.

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During the fiscal year ended June 30, 2020, we incurred $34.2 million of restructuring expenses primarily for write-down of assets due to impairment, facility closures, professional fees, pension withdrawal liability and employee termination costs as part of our previously announced comprehensive transformation program. See Note 5 Restructuring of the Notes to Consolidated Financial Statements, included in this Annual Report on Form 10-K for more information.

During the fiscal year ended June 30, 2020, we completed the sale of our Riverside, California property for the sale price of $20.5 million generating net proceeds of $19.6 million after customary closing costs, prorations and commissions. This resulted in a recognized pre-tax gain on sale of $18.9 million.

For the twelve months ended June 30, 2020, the effective tax rate was 20.5% compared to 23.5% in the prior year period. The difference between the 2020 and 2019 rates relate to recording the current year benefit at a 35% federal tax rate rather than the current statutory rate of 21% due to the carryback benefit discussed below. In addition, we recorded an $8.4 million valuation allowance against the federal and state deferred tax assets of $10.6 million.

On March 27, 2020, the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”) was enacted and signed into law in response to the COVID-19 global pandemic. Certain provisions of the CARES Act impacted the current fiscal year 2020. The CARES Act permits net operating losses (“NOLs”) incurred in tax years 2018, 2019, and 2020, (the Company’s fiscal years 2019, 2020 and 2021) to offset 100% of taxable income and be carried back to each of the five preceding taxable years to generate a refund of previously paid income taxes. The Company evaluated the impact of the CARES Act during the year ended June 30, 2020 and recorded an income tax receivable of $4.5 million for the benefit of carrying back the fiscal year 2020 NOL and an income tax receivable of $8.2M for the benefit of carrying back the fiscal year 2019 NOL. As the Company is carrying the losses back to years beginning before January 1, 2018, the receivables were recorded at the previous 35% federal tax rate rather than the current statutory rate of 21%.

The above factors resulted in a net loss of $26.8 million or $3.37 per diluted share for fiscal year 2020 compared to a net loss of $32.6 million or $4.13 per diluted share in the prior year period.

Liquidity and Capital Resources

COVID-19 update

Due to continued uncertainties because of COVID-19, we implemented measures to enhance our liquidity position and improve working capital. During the fourth quarter of fiscal year 2020, we reduced our quarterly dividend from $0.22 per share to $0.05 per share. We extended a 25% salary reduction for our CEO and CFO/COO and 50% cash compensation reduction for our Board of Directors through October 1, 2020. To further bolster liquidity, on August 28, 2020, we entered into an agreement with Dubuque Bank & Trust Company, for a secured $25.0 million credit facility with a two-year term. The balance of borrowings on June 30, 2021, was $3.5 million.

Working capital (current assets less current liabilities) at June 30, 2021 was $128.8 million compared to $128.4 million at June 30, 2020. The $0.4 million increase in working capital reflects a $46.7 million increase in current assets offset by a $46.3 million increase in current liabilities. The increase in current assets is primarily due to a $90.6 million increase in inventory and a $25.2 million increase in trade receivables in response to increasing sales. These increases were offset by a decrease in cash of $46.9 million, a decline in other current assets of $9.1 million primarily due to a tax refund, and a decline of $11.7 million in assets held for sale due to the sale of facilities during the fiscal year. The increase in current liabilities is primarily due to an increase in accounts payable of $40.0 million and a $4.8 million increase in accrued liabilities primarily due to increases in advertising accruals, commission accruals and management incentive accruals. The decline in cash of $46.9 million was primarily due to $29.8 million share repurchases, and cash used in operating activities of $32.7 million, partially offset by $18.6 million of proceeds from the sale of the Company’s Dubuque, IA, Lancaster, PA and Harrison, AR, facilities. Capital expenditures were $2.6 million for the fiscal year ending June 30, 2021.

A summary of operating, investing and financing cash flow is shown in the following table:

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Net cash (used in) provided by operating activities

For the twelve months ended June 30, 2021, cash used in operating activities was $32.7 million, which primarily consisted of net income of $23.0 million, adjusted for non-cash items including depreciation of $5.2 million, gain from the sale of capital assets of $5.9 million, change in deferred income taxes of $2.1 million, stock-based compensation of $3.7 million and bad debt expense of $1.6 million. Net cash used in operating assets and liabilities was $62.7 million. The cash used in operating assets and liabilities of $62.7 million, was primarily due to an increase in trade receivables of $25.2 million due to higher sales, an increase in inventory of $90.6 million due to inventory build for the beginning of fiscal 2022, partially offset by $9.4 million decline in other current assets primarily due to receipt of an income tax net refund of $5.6 million and increases in accounts payable of $40.0 million and accrued liabilities of $4.0 million.

For the twelve months ended June 30, 2020, net cash provided by operating activities was $18.3 million, which primarily consisted of net loss of $26.8 million, adjusted for non-cash depreciation of $8.4 million, gain from sale of capital assets of $19.0 million, stock-based compensation of $4.9 million, asset impairment charges of $20.4 million, change in deferred income taxes of $5.5 million and change in accounts receivable and VAT allowance of $0.5 million. Net cash provided by operating assets and liabilities was $25.6 million. The cash provided by operating assets and liabilities of $25.6 million, was primarily due to a decline in inventory and accounts receivable of $23.1 million and $4.4 million, respectively, coupled with an increase in accounts payable of $9.3 million, partially offset by a decline in accrued liabilities of $6.0 million.

Net cash provided by investing activities

For the twelve months ended June 30, 2021, net cash provided by investing activities was $16.1 million, primarily due to proceeds of $18.6 million for the sale of our Dubuque, IA and Lancaster, PA, facilities and one of our Harrison, Arkansas facilities, partially offset by capital expenditures of $2.6 million.

For the twelve months ended June 30, 2020, net cash provided by investing activities was $16.8 million, due to proceeds of $20.5 million for the sale of our Riverside, California facility and other capital assets, partially offset by capital expenditures of $3.7 million.

Net cash used in financing activities

For the twelve months ended June 30, 2021, net cash used in financing activities was $30.2 million, primarily due to $29.8 million for treasury stock purchases, dividends paid of $2.6 million and $1.3 million for tax payments on employee vested restricted shares.

For the twelve months ended June 30, 2020, net cash used in financing activities was $9.1 million, primarily due to dividends paid of $7.0 million, treasury stock purchases of $1.6 million and $0.6 million for tax payments on employee vested restricted shares.

Line of Credit

On August 28, 2020, we entered into a secured $25.0 million credit facility with Dubuque Bank & Trust Company, with a two-year term and interest of 1.50% plus LIBOR, subject to a floor of 3.0%, which floor was in effect on June 30, 2021. If LIBOR is redefined or becomes unavailable, the Bank has sole discretion to substitute another index and adjust the rate spread, however it cannot materially change the total interest cost without the Company’s advance written consent. The credit facility expires on August 28, 2022. The credit facility is secured by essentially all of the Company’s assets, excluding real property and requires the Company maintain compliance with certain financial and non-financial covenants. On June 30, 2021, the balance of the line of credit was $3.5 million.

Letters of credit outstanding at Wells Fargo Bank N.A. (“Wells”) as of June 30, 2021, totaled $1.1 million, of which $1.2 million of our cash held at Wells is pledged as collateral.

Contractual Obligations

The following table summarizes our contractual obligations on June 30, 2021, and the effect these obligations are expected to have on our liquidity and cash flow in the future (in thousands):

On June 30, 2021, we had no capital lease obligations, and no purchase obligations for raw materials or finished goods.

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Financing Arrangements

See Note 9 Credit Arrangements of Notes to Consolidated Financial Statements of this Annual Report on Form 10-K.

Outlook

The COVID-19 global pandemic presented unprecedented challenges during fiscal 2021. Our focus for fiscal 2022 will be to remain financially agile with strong liquidity, accelerate profitable long-term growth in both retail and e-commerce sales channels, build global supply chain resiliency, expand sourcing, manufacturing and distribution capacity to support future growth, strengthen digital capabilities, reimagine the customer experience, and build strong culture and talent.

During fiscal 2022, the Company anticipates spending $11.5 million to $13.5 million for capital expenditures. The Company plans to spend approximately $7 million for manufacturing capacity expansion, approximately $2.5 million for manufacturing productivity improvements, and the remaining amounts for software maintenance and general maintenance. The Company believes it has access to adequate working capital to meet these requirements.

Critical Accounting Policies

The discussion and analysis of our consolidated financial statements and results of operations are based on consolidated financial statements prepared in accordance with generally accepted accounting principles (GAAP) in the United States of America. Preparation of these consolidated financial statements requires the use of estimates and judgments that affect the reported results. We use estimates based on the best information available in recording transactions and balances resulting from business operations. Estimates are used for such items as collectability of trade accounts receivable and inventory valuation. Ultimate results may differ from these estimates under different assumptions or conditions.

Accounts Receivable Allowances – we establish accounts receivable allowances to reduce trade accounts receivable to an amount that reasonably approximates their net realizable value. Our accounts receivable allowances consist of an allowance for doubtful accounts which is established through review of open accounts, historical collection, and historical write-off amounts. The amount ultimately realized from trade accounts receivable may differ from the amount estimated in the consolidated financial statements.

Inventories – we value inventory at the lower of cost or net realizable value. Our inventory valuation reflects markdowns for the excess of the cost over the amount expected to be realized and considers obsolete and excess inventory. Markdowns establish a new cost basis for the Company’s inventory. Subsequent changes in facts or circumstances do not result in the reversal of previously recorded markdowns or an increase in that newly established cost basis.

Valuation of Long–Lived Assets – we periodically review the carrying value of long-lived assets and estimated depreciable or amortizable lives for continued appropriateness. This review is based upon projections of anticipated future cash flows and is performed whenever events or changes in circumstances indicate that asset carrying values may not be recoverable or that the estimated depreciable or amortizable lives may have changed. For assets held for sale, if the net book value of the asset is greater than its estimated fair value less cost to sell, an impairment is recorded for the excess of net book value over estimated fair value less cost to sell. We recorded impairments of none and $20.4 million in fiscal 2021 and 2020, respectively. The $20.4 million impairment recorded in fiscal 2020 include $2.9 million related to our leases of two showroom spaces.

Restructuring Costs – The Company groups exit or disposal cost obligations into three categories: Involuntary employee termination benefits, costs to terminate contracts, and other associated costs. Involuntary employee termination benefits must be a one-time benefit, and this element of restructuring cost is recognized as incurred upon communication of the plan to the identified employees. Costs to terminate contracts are recognized upon termination agreement with the provider. Other associated restructuring costs are expensed as incurred. Any inventory impairment costs as a result of restructuring activities are accounted for as cost of goods sold.

Recently Issued Accounting Pronouncements

See Item 8. Note 1 Significant Accounting Policies of the Notes to the Company’s consolidated financial statements.

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