LSI INDUSTRIES INC (LYTS) FY 2021 MD&A

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

The Company’s “forward looking statements” and disclosures as presented earlier in this Form 10-K in the “Safe Harbor” Statement, as well as the Company’s consolidated financial statements and accompanying notes presented later in this Form 10-K should be referred to when reading Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Overview

LSI is a leading producer of non-residential lighting and retail display solutions. Non-residential lighting consists of high-performance, American-made lighting products. The Company’s strength in outdoor lighting applications creates opportunities for it to introduce additional solutions to its customers. Retail display solutions consist of graphics solutions, digital signage, and technically advanced food display equipment for strategic vertical markets. LSI’s team of internal specialists also provide comprehensive project management services in support of large-scale rollouts.

COVID-19 Pandemic

The COVID-19 pandemic continues to impact business activity across industries in the U.S. and worldwide, including, but not limited to, workforce and supply chain disruptions. We remain committed to taking actions to address the health, safety and welfare of our employees, customers, agents and suppliers. Future developments, such as the actions taken by governmental authorities in response to future outbreaks that are highly uncertain and unpredictable, will determine the extent to which COVID-19 continues to impact our results of operations and financial conditions. See the risk factor captioned “Our financial condition and results of operations for future periods may be adversely affected by the COVID-19 outbreak or other outbreaks of infectious disease or similar public health threats and the resulting economic impact” in Item 1A, Risk Factors, included in Part I of this Annual Report on Form 10-K for an additional discussion of risks related to COVID-19.

Summary of Consolidated Results

Fiscal 2021 net sales of $315.6 million increased $10.0 million or 3% as compared to fiscal 2020 net sales of $305.6 million. Net sales were favorably influenced by increased net sales in the Display Solutions Segment (up $27.3 million or 27%) and were unfavorably influenced by decreased net sales in the Lighting Segment (down $17.2 million or 8%).

Fiscal 2021 operating income of $8.0 million represents a $5.1 million decrease from fiscal 2020 operating income of $13.1 million. Current year results include $2.9 million of transaction costs related to the acquisition of JSI. Prior year results were favorably impacted by the $4.8 million pre-tax gain on the sale of the New Windsor, New York facility and the $3.7 million pre-tax gain on the sale of the North Canton, Ohio facility. Non-GAAP adjusted operating income in fiscal 2021 of $13.0 million increased $6.0 million or 86% from adjusted fiscal 2020 operating income of $7.0 million. Refer to “Non-GAAP Financial Measures” below for a reconciliation of Non-GAAP financial measures to U.S. GAAP measures. The increase in adjusted operating income was the net result of an increase in net sales, higher-value sales mix and lower selling and administrative expenses.

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Non-GAAP Financial Measures

We believe it is appropriate to evaluate our performance after making adjustments to the as-reported U.S. GAAP operating income, net income, and earnings per share. Adjusted operating income, net income and earnings per share, which exclude the impact of acquisition costs, stock compensation expense, severance costs and restructuring and plant closure (gains) costs are Non-GAAP financial measures. Also included below are Non-GAAP financial measures including Earnings before Interest, Taxes, Depreciation and Amortization (EBITDA and Adjusted EBITDA), Free Cash Flow, Net Debt and Organic Sales Growth. We believe that these adjusted supplemental measures are useful in assessing the operating performance of our business. These supplemental measures are used by our management, including our chief operating decision maker, to evaluate business results. We exclude these items because they are not representative of the ongoing results of operations of our business. These Non-GAAP measures may be different from Non-GAAP measures used by other companies. In addition, the Non-GAAP measures are not based on any comprehensive set of accounting rules or principles. Non-GAAP measures have limitations, in that they do not reflect all amounts associated with our results as determined in accordance with U.S. GAAP. Therefore, these measures should only be used to evaluate our results in conjunction with corresponding GAAP measures. Below is a reconciliation of these non-GAAP measures to operating income, net income, and earnings per share for the periods indicated along with the calculation of EBITDA and Adjusted EBITDA, Free Cash Flow, Net Debt and Organic Sales Growth.

Reconciliation of operating income to adjusted operating income:

Reconciliation of net income to adjusted net income

The following represents the income tax effects of the adjustments in the tables above, which were calculated using the estimated combined U.S., Canada and Mexico effective income tax rates for the periods indicated:

(1) $777

(2) $480

(3) $9

(4) ($3)

(5) $152

(6) $94

(7) ($1,481)

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The reconciliation of reported earnings per share to adjusted earnings per share may not produce identical amounts due to rounding differences.

Reconciliation of operating income to EBITDA and Adjusted EBITDA

Reconciliation of cash flow from operations to free cash flow

Reconciliation of net debt

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Reconciliation of net sales to organic net sales

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Results of Operations

2021 Compared to 2020

Lighting Segment

Lighting Segment net sales of $189.0 million in fiscal 2021 decreased 8% from fiscal 2020 net sales of $206.2 million. The 8% decrease is due to the impact of COVID-19 disruptions in construction markets. However, in the fiscal fourth quarter, the Lighting Segment generated sales growth of 30% compared to the prior year fourth quarter, with recovery in the construction market and significant increases in both project business and sales through distributor stock.

Gross profit of $57.0 million in fiscal 2021 remained relatively consistent with the same period of fiscal 2020. Gross profit as a percentage of net sales was 30.2% in fiscal 2021 compared to 27.6% in fiscal 2020. The growth in gross profit as a percentage of net sales reflects our continued focus on the entire lighting model, including higher value applications, price management, new and cost reduced products and supply chain and operations productivity.

Operating expenses of $43.7 million in fiscal 2021 increased $3.0 million or 7% from fiscal 2020 operating expenses of $40.7 million, primarily due to the $4.8 million pre-tax gain on the sale of the New Windsor facility in fiscal 2020 with no comparable event in fiscal 2021. When the $4.8 million gain is removed from the fiscal 2020 results, operating expenses in fiscal 2021 decreased from the prior year, driven by programs to reduce spending resulting from the pandemic.

The Lighting Segment fiscal 2021 operating income of $13.3 decreased $2.8 million from an operating income of $16.1 million in the same period of fiscal 2020 primarily due to the $4.8 million pre-tax gain on the sale of the New Windsor facility in fiscal 2020. Fiscal 2021 Non-GAAP adjusted operating income of $13.6 million increased $1.9 million from fiscal 2020 Non-GAAP adjusted operating income of $11.7 million (refer to the Non-GAAP table below for a reconciliation of Lighting Segment operating income to adjusted operating income). The increase in Non-GAAP adjusted operating income is primarily due to a favorable mix of sales on lower sales volume, improved productivity from manufacturing facility consolidation, and lower operating expenses.

Reconciliation of Lighting Segment operating income to adjusted operating income:

Display Solutions Segment

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Display Solutions Segment net sales of $126.6 million increased $27.2 million or 27% from fiscal 2020 net sales of $99.4 million. Of the $27.2 million increase, $9.1 million is a result of the acquisition of JSI. The remaining increase in sales is due to growth in our Quick-Service Restaurants and Grocery verticals partially offset by a reduction in our Petroleum vertical.

Gross profit of $22.0 million in fiscal 2021 increased $5.3 million or 32% from fiscal 2020. Gross profit as a percentage of net sales increased to 17.4% in fiscal 2021 compared to 16.8% in fiscal 2020, primarily within our Petroleum and Grocery verticals.

Operating expenses of $12.1 million in fiscal 2021 increased $3.7 million or 43% from fiscal 2020. Operating expenses in fiscal 2020 were impacted by the $3.7 million pre-tax gain on the sale of the North Canton, Ohio facility with no comparable event in fiscal 2021.

Display Solutions Segment fiscal 2021 operating income of $9.9 million increased $1.7 million from operating income of $8.2 million in fiscal 2020. Non-GAAP adjusted operating income was $10.0 million in fiscal 2021 compared to adjusted operating income of $5.9 million in fiscal 2020 (refer to the Non-GAAP table below for a reconciliation of Display Solutions Segment operating income to adjusted operating income). The increase is primarily due to improved gross profit margin.

Reconciliation of Display Solutions Segment operating income to adjusted operating income:

Corporate and Eliminations

The gross (loss) profit relates to the intercompany profit in inventory elimination.

Operating expenses of $15.2 million in fiscal 2021 increased $3.9 million or 35% from fiscal 2020. The increase is primarily due to $2.9 million of transaction costs related to the acquisition of JSI, an increase in stock compensation expense due to prior fiscal year forfeitures and an increase in the employer match related to the deferred compensation plan.

Consolidated Results

We reported $0.3 million net interest expense in fiscal 2021 compared to $0.9 million net interest expense in fiscal 2020. The decrease in interest expense from fiscal 2020 to fiscal 2021 is the result of reduced average borrowings against our line of credit. We also recorded other income of $0.1 million in fiscal 2021 and other expense of $0.5 million in fiscal 2020, both of which relate to net foreign currency transaction gains/losses through our Mexican and Canadian subsidiaries.

The $2.0 million of income tax expense represents a consolidated effective tax rate of 25.9%. The effective tax rate is impacted by non-deductible transaction costs related to the acquisition of JSI. The $2.1 million income tax expense in fiscal 2020 represents a consolidated effective tax rate of 18.0%. The effective tax rate was impacted by the following: 1) a tax rate benefit resulting from carryback of a net operating loss (NOL) allowed due to the enactment of the Coronavirus Aid, Relief and Economic Security (CARES) Act, and; 2) the utilization of a capital loss carryforward related to the capital gain on the sale of the North Canton facility.

We reported net income of $5.9 million in fiscal 2021 compared to net income of $9.6 million in fiscal 2020. Non-GAAP adjusted net income was $9.8 million in fiscal 2021 compared to adjusted net income of $4.1 million in fiscal 2020 (Refer to the Non-GAAP tables above). The increase in Non-GAAP adjusted net income is primarily the net result of an increase in net sales, improved gross profit margin and decreased interest expense and other expense. Diluted earnings per share of $0.21 was reported in fiscal 2021 compared to $0.36 diluted earnings per share in fiscal 2020. The weighted average common shares outstanding for purposes of computing diluted earnings per share in fiscal 2021 were 27,440,000 shares compared to 26,473,000 shares in fiscal 2020.

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Liquidity and Capital Resources

We consider our level of cash on hand, borrowing capacity, current ratio and working capital levels to be our most important measures of short-term liquidity. For long-term liquidity indicators, we believe our ratio of long-term debt to equity and our historical levels of net cash flows from operating activities to be the most important measures.

At June 30, 2021 we had working capital of $54.1 million, compared to $51.2 million at June 30, 2020. The ratio of current assets to current liabilities was 1.76 to 1 as of June 30, 2021 compared to a ratio of 2.48 to 1 as of June 30, 2020. The $2.9 million increase in working capital from June 30, 2020 to June 30, 2021 is primarily driven by a $20.1 million increase in inventory, a $19.8 million increase in accounts receivable, partially offset by a $18.8 million increase in accounts payable and a $17.5 million increase in accrued expenses.

Net accounts receivable were $57.7 million and $37.8 million at June 30, 2021 and June 30, 2020, respectively. Some of the increase in accounts receivable is due to the acquisition of JSI. DSO was 56 days at both June 30, 2021 and June 30, 2020. We believe that our receivables are ultimately collectible or recoverable, net of certain reserves, and that aggregate allowances for doubtful accounts are adequate.

Net inventories of $58.9 million at June 30, 2021 increased $20.1 million from $38.8 million at June 30, 2020. The increase of $20.1 million is the result of an increase in gross inventory of $21.4 million and an increase in obsolescence reserves of $1.2 million. Lighting Segment net inventory increased $9.0 million, in anticipation of an increase in market demand and ongoing supply chain challenges. Net inventory in the Display Solutions Segment increased $11.2 million, primarily due to the acquisition of JSI.

Cash generated from operations and borrowing capacity under our line of credit is our primary source of liquidity. In March 2021, the Company amended its secured line of credit to a $100 million facility from a $75 million facility, with $24 million of the credit line available as of August 26, 2021. This $100 million five-year credit line expires in the third quarter of fiscal 2026. We are in compliance with all of our loan covenants. We believe that our $100 million line of credit plus cash flows from operating activities are adequate for fiscal 2021 operational and capital expenditure needs. However, as the impact of COVID-19 on the economy and our operations continues to evolve, we will continue to assess our liquidity needs. We have on file with the SEC a shelf registration statement which allows us to sell any combination of common stock, preferred stock warrants, senior or subordinated debt securities or other securities in one or more offerings if we choose to do so in the future. We expect to maintain the effectiveness of this shelf registration statement for the foreseeable future.

We generated $28.0 million of cash from operating activities in fiscal 2021 compared to $29.7 million in fiscal 2020. The $1.7 million decrease in net cash flows from operating activity is the net result of increases in accounts receivable and inventory, partially offset by our improved earnings as well as increases in accounts payable, customer project prepayments and accrued FICA from deferred payroll taxes allowed under the CARES Act.

We used $93.0 million of cash in investing activities in fiscal 2021 compared to a source of cash of $17.4 million in fiscal 2020, resulting in a decrease of $110.4 million. Capital expenditures decreased from $2.7 million in fiscal 2020 to $2.3 million in fiscal 2021. We acquired JSI in May 2021 for $90.7 million, net of cash acquired. In addition, we sold our New Windsor manufacturing facility for $12.3 million and our North Canton facility for $7.7 million in fiscal 2020, which contributed to the source of cash. The acquisition of JSI and the sale of our two facilities were the primary contributing factors for the change in investing activities from fiscal 2020 to fiscal 2021.

We had a source of $63.6 million of cash related to financing activities in fiscal 2021 compared to use of cash of $44.4 million in fiscal 2020. The $108.0 million change in cash flow was primarily the net result of borrowings of long-term debt in excess of payments which was primarily driven by the acquisition of JSI.

We have on our balance sheet financial instruments consisting primarily of cash and cash equivalents, revolving lines of credit, and long-term debt. The fair value of these financial instruments approximates carrying value because of their short-term maturity and/or variable, market-driven interest rates.

Off-Balance Sheet Arrangements

We have no financial instruments with off-balance sheet risk.

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Cash Dividends

In August 2021, the Board of Directors declared a regular quarterly cash dividend of $0.05 per share payable September 7, 2021 to shareholders of record as of August 30, 2021. The indicated annual cash dividend rate for fiscal 2021 was $0.20 per share. The Board of Directors has adopted a policy regarding dividends which indicates that dividends will be determined by the Board of Directors at its discretion based upon its evaluation of earnings, cash flow requirements, financial conditions, debt levels, stock repurchases, future business developments and opportunities, and other factors deemed relevant.

Critical Accounting Policies and Use of Estimates

The preparation of the consolidated financial statements in conformity with U.S. GAAP requires us to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. We believe that such estimates have been based on reasonable and supportable assumptions and the resulting estimates are reasonable for use in the preparation of the consolidated financial statements. Actual results could differ from these estimates.

Accounting policies are an integral part of our financial statements. A thorough understanding of these accounting policies is essential when reviewing our reported results of operations and financial position. Management believes that the critical accounting policies and estimates involve the most difficult management judgments due to the sensitivity of the methods and assumptions used. We believe the following accounting topics represent our critical accounting estimates: warranty reserve, impairment of goodwill, stock-based compensation, income tax valuation allowance, revenue recognition and valuation of acquired intangible assets.

Our significant accounting policies are described in Note 2 in the accompanying consolidated financial statements of this Annual Report on Form 10-K.

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