Notes to Unaudited Consolidated Financial Statements
March 31, 2022
Note 1: Basis of Presentation and Summary of Significant Account Policies
The unaudited interim consolidated financial statements as of and for the nine months ended March 31, 2022 have been prepared by The L.S. Starrett Company (the “Company”) in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions of Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and notes required by generally accepted accounting principles for complete financial statements. These unaudited consolidated financial statements, which, in the opinion of management, reflect all adjustments (including normal recurring adjustments) necessary for a fair presentation, should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended June 30, 2021. The balance sheet as of June 30, 2021 has been derived from the audited consolidated financial statements as of and for the year ended June 30, 2021. Operating results are not necessarily indicative of the results that may be expected for any future interim period or for the entire fiscal year. The Company’s “fiscal year” begins July 1st and ends June 30th.
The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make judgments, assumptions and estimates that affect amounts reported in the consolidated financial statements and accompanying notes. Note 2 to the Company’s consolidated financial statements included in the Annual Report on Form 10-K for the year ended June 30, 2021 describes the significant accounting policies and methods used in the preparation of the consolidated financial statements.
Throughout the pandemic crisis, the Company's main focus has been on protecting the health and well-being of its employees, and the long-term financial health of the Company. It remains very difficult for management to predict when this crisis will no longer be a risk to future sales and operations. To the extent that pandemic-related events do not provide evidence about conditions that existed at the balance-sheet date, the Company considers it necessary to disclose it cannot estimate all aspects of the impact on the financial statements as a result of the on-going pandemic.
Note 2: Segment Information
The segment information and the accounting policies of each segment are the same as those described in the notes to the consolidated financial statements entitled “Financial Information by Segment & Geographic Area” included in our Annual Report on Form 10-K for the year ended June 30, 2021. The Company’s business is aggregated into two reportable segments based on geography of operations: North American Operations and International Operations. Segment income is measured for internal reporting purposes by excluding corporate expenses, which are included in the unallocated column in the table below. Other income and expense, including interest income and expense, and income taxes are excluded entirely from the table below. There were no significant changes in the segment operations or in the segment assets from the Annual Report. Financial results for each reportable segment are as follows (in thousands):
| | | | | | | | | | | | | | | | | | | | | | | |
| North American Operations | | International Operations | | Unallocated | | Total |
Three Months ended March 31, 2022 | | | | | | | |
| | | | | | | |
Sales1 | $ | 36,288 | | | $ | 24,191 | | | $ | — | | | $ | 60,479 | |
| | | | | | | |
Operating Income (Loss) | $ | 4,663 | | | $ | 2,627 | | | $ | (1,917) | | | 5,374 | |
| | | | | | | |
Three Months ended March 31, 2021 | | | | | | | |
| | | | | | | |
Sales2 | $ | 32,519 | | | $ | 22,425 | | | $ | — | | | $ | 54,944 | |
| | | | | | | |
Operating Income (Loss) | $ | 2,931 | | | $ | 2,692 | | | $ | (1,773) | | | $ | 3,850 | |
1.Excludes $1,148 of North American segment intercompany sales to the International segment, and $4,402 of International segment intercompany sales to the North American segment.
2.Excludes $1,338 of North American segment intercompany sales to the International segment, and $3,197 of International segment intercompany sales to the North American segment.
| | | | | | | | | | | | | | | | | | | | | | | |
| North American Operations | | International Operations | | Unallocated | | Total |
Nine Months ended March 31, 2022 | | | | | | | |
| | | | | | | |
Sales1 | $ | 102,763 | | | $ | 80,548 | | | $ | — | | | $ | 183,311 | |
Operating Income (Loss) | $ | 8,713 | | | $ | 10,604 | | | $ | (5,611) | | | $ | 13,706 | |
| | | | | | | |
Nine months ended March 31, 2021 | | | | | | | |
| | | | | | | |
Sales2 | $ | 85,609 | | | $ | 72,799 | | | $ | — | | | $ | 158,408 | |
Operating Income (Loss) | $ | 8,611 | | | $ | 8,804 | | | $ | (5,529) | | | $ | 11,886 | |
1.Excludes $2,827 of North American segment intercompany sales to the International segment, and $14,150 of International segment intercompany sales to the North American segment.
2.Excludes $3,075 of North American segment intercompany sales to the International segment, and $8,593 of International segment intercompany sales to the North American segment.
Note 3: Revenue from Contracts with Customers
Under ASC Topic 606, the Company is required to present a refund liability and a return asset within the Unaudited Consolidated Balance Sheet. As of March 31, 2022 and June 30, 2021, the balance of the return asset was $0.1 million and $0.2 million, respectively, and the balance of the refund liability as of March 31, 2022 and June 30, 2021 was $0.2 million. They are presented within prepaid expenses and other current assets and accrued expenses, respectively, on the Consolidated Balance Sheets.
The Company, in general, warrants its products against certain defects in material and workmanship when used as designed, for a period of up to one year. The Company does not sell extended warranties.
Contract Balances
Contract assets primarily relate to the Company’s rights to consideration for work completed but not billed at the reporting date on contracts with customers. Contract assets are transferred to receivables when the rights become unconditional. Contract liabilities primarily relate to contracts where advance payments or deposits have been received, but performance obligations have not yet been met, and therefore, revenue has not been recognized. The Company had no contract asset balances, but had contract liability balances of $0.9 million and $0.6 million at March 31, 2022 and June 30, 2021, respectively, located in Accounts Payable in the Consolidated Balance Sheets.
Disaggregation of Revenue
The Company operates in two reportable segments: North America and International. ASC Topic 606 requires further disaggregation of an entity’s revenue. In the following table, the Company's net sales by shipping origin are disaggregated accordingly for the three months ended March 31, 2022 and 2021 (in thousands):
| | | | | | | | | | | | | | | | | | | | | | | |
| Three Months Ended | | Nine Months Ended |
| 03/31/2022 | | 03/31/2021 | | 03/31/2022 | | 03/31/2021 |
North America | | | | | | | |
United States | $ | 34,181 | | | $ | 30,307 | | | $ | 97,049 | | | $ | 79,989 | |
Canada & Mexico | 2,107 | | | 2,212 | | | 5,714 | | | 5,620 | |
| 36,288 | | | 32,519 | | | 102,763 | | | 85,609 | |
International | | | | | | | |
Brazil | 15,980 | | | 14,901 | | | 54,063 | | | 47,302 | |
United Kingdom | 4,750 | | | 4,269 | | | 14,254 | | | 14,818 | |
China | 1,899 | | | 1,655 | | | 5,761 | | | 5,240 | |
Australia & New Zealand | 1,562 | | | 1,600 | | | 6,469 | | | 5,439 | |
| 24,191 | | | 22,425 | | | 80,548 | | | 72,799 | |
| | | | | | | |
Total Sales | $ | 60,479 | | | $ | 54,944 | | | $ | 183,311 | | | $ | 158,408 | |
Note 4: Recent Accounting Pronouncements
In June 2016, the FASB issued ASU 2016-13, “Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments,” and subsequent amendment to the guidance, ASU 2018-19 in November 2018. The standard significantly changes how entities will measure credit losses for most financial assets and certain other instruments that are not measured at fair value through net income. The standard will replace today’s “incurred loss” approach with an “expected loss” model for instruments measured at amortized cost. The amendment will affect loans, debt securities, trade receivables, net investments in leases, off balance sheet credit exposures, reinsurance receivables, and any other financial assets not excluded from the scope that have the contractual right to receive cash. ASU 2018-19 clarifies that receivables arising from operating leases are accounted for using lease guidance and not as financial instruments. The amendments should be applied on either a prospective transition or modified-retrospective approach depending on the subtopic. This ASU is effective for annual periods beginning after December 15, 2019, and interim periods therein. Early adoption was permitted for annual periods beginning after December 15, 2018, and interim periods therein. This pronouncement was extended for Small Reporting Companies and for the Company to July 1, 2022. The adoption of this standard does not have a material impact on the financial position and results of operations.
In August 2018, the FASB issued ASU No. 2018-14, "Compensation - Retirement Benefits - Defined Benefit Plans - General (Subtopic 715-20): Disclosure Framework - Changes to the Disclosure Requirements for Defined Benefit Plans." ASU 2018-14 removes certain disclosures that are not considered cost beneficial, clarifies certain required disclosures and added additional disclosures. This ASU was effective for the Company beginning July 1, 2021 and applied on a retrospective basis. The adoption of this standard did not have a material impact on the financial position and results of operations or the required disclosures.
Note 5: Leases
Operating lease cost amounted to $0.5 million and $2.1 million for the three and nine months period ended March 31, 2022 and $0.6 million and $1.8 million for the three and nine months period ended December 31, 2021. As of March 31, 2022, the Company’s right-of-use assets "ROU", lease obligations and remaining cash commitment on these leases (in thousands):
| | | | | | | | | | | | | | | | | |
| Right-of-Use Assets | | Operating Lease Obligations | | Remaining Cash Commitment |
Operating leases | $5,606 | | $5,766 | | $6,925 |
In March, the Company adopted a restructuring plan to close down Starrett Japan and Singapore operating units and continue to service that region out of Brazil and China with company agents servicing those countries. In the June quarter the Company expects to reduce its ROU asset and liabilities $0.1 million.
In September 2021, the Company entered into a six year lease in China for 100,682 square feet and recorded a right-of-use asset for $2.6 million. In July 2021, Starrett UK leased space to another company for annual rent of $0.2 million and incremental applicable service charges. The lease is a 20 year agreement with a contract review in 2026. The fees are recorded in Other Income in the Company's Consolidated Statement of Operations.
The Company has other operating lease agreements with commitments of less than one year or that are not significant. The Company elected the practical expedient option and as such, these lease payments are expensed as incurred. The Company’s weighted average discount rate and remaining term on lease liabilities is approximately 9.0% and 4.4 years. As of March 31, 2022, the Company’s financing leases are de minimis. The foreign exchange impact affecting the operating leases was de minimis in the March quarter and $0.1 million for the nine months ending March 31, 2022.
The Company entered into $0.2 million and $2.8 million in new operating lease commitments.
At March 31, 2022, the Company had the following fiscal year minimum operating lease commitments (in thousands)
| | | | | |
Nine months ended March 31, 2022 | Operating Lease Commitments |
2022 (Remainder of year) | $552 |
2023 | 1,813 |
2024 | 1,541 |
2025 | 1,143 |
2026 | 1,050 |
Thereafter | 826 |
Subtotal | $6,925 |
Imputed interest | (1,159) |
Total | 5,766 |
Note 6: Stock-based Compensation
On September 5, 2012, the Board of Directors adopted The L.S. Starrett Company 2012 Long Term Incentive Plan (the “2012 Stock Plan”). The 2012 Stock Plan was approved by shareholders on October 17, 2012 and the material terms of its performance goals were re-approved by shareholders at the Company’s Annual Meeting held on October 18, 2017. There are no shares available under the 2012 Plan.
On September 1, 2021, the Board of Directors adopted The L.S. Starrett Company 2021 Long Term Incentive Plan (the “2021 Stock Plan”). The 2021 Stock Plan was approved by shareholders on October 13, 2021.
Both the 2012 and 2021 Stock Plan permits the granting of the following types of awards to officers, other employees and non-employee directors: stock options; restricted stock awards; unrestricted stock awards; stock appreciation rights; stock units including restricted stock units; performance awards; cash-based awards; and awards other than previously described that are convertible or otherwise based on stock. The 2021 and 2012 Stock Plans provide for the issuance of up to 500,000 shares of common stock.
Under both plans, options granted vest in periods ranging from one year to three years and expire ten years after the grant date. Restricted stock units (“RSU”) granted generally vest from one year to three years. Vested restricted stock units will be settled in shares of common stock. As of March 31, 2022, there were no stock options and 196,307 restricted stock units outstanding. There were 441,901 shares available for grant under the 2021 Stock Plan as of March 31, 2022.
For stock option grants, the fair value of each grant is estimated at the date of grant using the Binomial Options pricing model. The Binomial Options pricing model utilizes assumptions related to stock volatility, the risk-free interest rate, the dividend yield, and employee exercise behavior. Expected volatilities utilized in the model are based on the historic volatility of the Company’s stock price. The risk-free interest rate is derived from the U.S. Treasury Yield curve in effect at the time of the grant. The expected life is determined using the average of the vesting period and contractual term of the options (Simplified Method).
No stock options were granted during the nine months ended March 31, 2022 and 2021.
There were no stock options outstanding as of March 31, 2022. There were no stock options exercisable as of March 31, 2022. In recognizing stock compensation expense for the 2012 and 2021 Stock Incentive Plan, management has estimated that there will be no forfeitures of options.
The Company accounts for stock options and RSU awards by recognizing the expense of the grant date fair value ratably over vesting periods generally ranging from one year to three years. The related expense is included in selling, general and administrative expenses.
There were 80,500 RSU awards with a fair value of $11.35 per RSU granted during the nine months ended March 31, 2022. There were 133,995 RSUs settled, and 11,174 RSUs forfeited during the nine months ended March 31, 2022. The aggregate intrinsic value of RSU awards outstanding as of March 31, 2022 was $1.5 million. As of March 31, 2022, all vested awards have been issued and settled.
On February 5, 2013, the Board of Directors adopted The L.S. Starrett Company 2013 Employee Stock Ownership Plan (the “2013 ESOP”). The purpose of the plan is to supplement existing Company programs through an employer funded individual account plan dedicated to investment in common stock of the Company, thereby encouraging increased ownership of the Company while providing an additional source of retirement income. The plan is intended as an employee stock ownership plan within the meaning of Section 4975 (e) (7) of the Internal Revenue Code of 1986, as amended. U.S. employees who have completed a year of service are eligible to participate. There are no longer any new entrants into this plan.
Compensation expense related to all stock-based plans for the three and nine-month periods ended March 31, 2022 were $0.1 million and $0.4 million as compared to the prior year three and nine months of $0.1 million and $0.6 million, respectively. As of March 31, 2022, there was $2.8 million of total unrecognized compensation costs related to outstanding stock-based compensation arrangements. Of this cost, $2.1 million relates to performance based RSU grants that are not expected to be awarded. The remaining $0.7 million is expected to be recognized over a weighted average period of 2.0 years.
Note 7: Inventories
Inventories consist of the following (in thousands):
| | | | | | | | | | | |
| 03/31/2022 | | 06/30/2021 |
Raw material and supplies | $ | 36,064 | | | $ | 29,271 | |
Goods in process and finished parts | 21,627 | | | 16,096 | |
Finished goods | 41,752 | | | 37,344 | |
| 99,443 | | | 82,711 | |
LIFO Reserve | (26,368) | | | (22,139) | |
| $ | 73,075 | | | $ | 60,572 | |
Of the Company’s $73.1 million and $60.6 million total inventory at March 31, 2022 and June 30, 2021, respectively, the $26.4 million and $22.1 million LIFO reserves belong to the U.S. Precision Tools and Saws Manufacturing “Core U.S.” business. The Core U.S. business total inventory was $37.5 million on a FIFO basis and $11.2 million on a LIFO basis at March 31, 2022. The Core U.S. business had total Inventory, on a FIFO basis, of $27.9 million and $5.7 million on a LIFO
basis as of June 30, 2021. The use of LIFO, as compared to FIFO, resulted in a $4.3 million increase in cost of sales for the goods sold in the period ending March 31, 2022 compared to $0.4 million increase in the nine months ended March 31, 2021.
Note 8: Goodwill and Intangible Assets
The Company’s acquisition of Bytewise in 2011 and a private software company in 2017 resulted in the recognition of goodwill totaling $4.7 million. During the fourth quarter of fiscal year 2020 the Company tested impairment of intangible assets according to ASC 360 "Property, Plant and Equipment" and determined the carrying value was deemed to be recoverable at Bytewise but not at the private software company where the impairment of intangibles was calculated. The Company concluded that intangible assets of the private software company were impaired by $2.9 million.
The Company then, according to ASC 350 Intangibles -Goodwill and Other, conducted a step one analysis performed based on the update carrying value for each reporting unit. Goodwill was determined to be impaired $0.6 million at the private software company and Goodwill of $3.0 million was impaired at the Bytewise reporting unit as of June 30, 2020. As a result, the balance of Goodwill at Bytewise is zero and $1.0 million at the private software company as of December 31, 2020.
The Company will continue to perform an annual assessment of goodwill associated with its purchase of a private software company. If future results significantly vary from current estimates, related projections, or business assumptions due to changes in industry or market conditions, the Company may be required to perform an impairment analysis prior to our annual test date if a triggering event is identified. As of March 31, 2022 , the Company did not identify a triggering event.
Amortizable intangible assets consist of the following (in thousands):
| | | | | | | | | | | |
| 03/31/2022 | | 6/30/2021 |
Trademarks and trade names | 2,070 | | | 2,070 | |
Completed technology | — | | | 2,010 | |
Customer relationships | 630 | | | 630 | |
Software development | 11,025 | | | 10,244 | |
| | | |
Total | 13,725 | | | 14,954 | |
Accumulated amortization and impairment | (9,012) | | | (10,066) | |
Total net balance | $ | 4,713 | | | $ | 4,888 | |
The category completed technology became fully amortized in November 2021. Amortizable intangible assets are being amortized on a straight-line basis over the period of expected economic benefit.
The estimated useful lives of the intangible assets subject to amortization range between 5 years for software development and 20 years for some trademark and trade name assets. The estimated aggregate amortization expense for the remainder of fiscal 2021 and for each of the next five years and thereafter, is as follows (in thousands):
| | | | | |
2022 (Remainder of year) | $ | 359 | |
2023 | 1,309 | |
2024 | 1,039 | |
2025 | 879 | |
2026 | 669 | |
2027 | 298 | |
Thereafter | 160 | |
Total net balance | $ | 4,713 | |
Note 9: Pension and Post-retirement Benefits
The Company has two defined benefit pension plans, one for U.S. employees and another for U.K. employees. The Company has a postretirement medical insurance benefit plan for U.S. employees. The Company also has defined contribution plans.
The U.K. defined benefit plan was closed to new entrants in fiscal 2009.
On December 21, 2016, the Company amended the U.S. defined benefit pension plan to freeze benefit accruals effective December 31, 2016. Consequently, the Plan is closed to new participants and current participants will no longer earn additional benefits after December 31, 2016.
Net periodic benefit costs for the Company's defined benefit pension plans are located in Other (expense), net in Consolidated Statements of Operations except (in the table below) for service cost. Service cost are in cost of sales and selling, general and administrative expenses. Net periodic benefit costs consist of the following (in thousands):
| | | | | | | | | | | | | | | | | | | | | | | |
| Three Months Ended | | Nine Months Ended |
| 03/31/2022 | | 03/31/2021 | | 03/31/2022 | | 03/31/2021 |
Interest cost | 1,026 | | | 1,120 | | | 3,090 | | | 3,351 | |
Expected return on plan assets | (1,092) | | | (1,115) | | | (3,290) | | | (3,336) | |
Amortization of net loss | 14 | | | 13 | | | 42 | | | 40 | |
| $ | (52) | | | $ | 18 | | | $ | (158) | | | $ | 55 | |
Net periodic benefit costs for the Company's Postretirement Medical Plan consists of the following (in thousands):
| | | | | | | | | | | | | | | | | | | | | | | |
| Three Months Ended | | Nine Months Ended |
| 03/31/2022 | | 03/31/2021 | | 03/31/2022 | | 03/31/2021 |
Service cost | $ | 9 | | | $ | 21 | | | $ | 27 | | | $ | 64 | |
Interest cost | 12 | | | 51 | | | 37 | | | 154 | |
Amortization of prior service credit | (369) | | | (134) | | | (1,106) | | | (403) | |
Amortization of net loss | 48 | | | 41 | | | 142 | | | 124 | |
| $ | (300) | | | $ | (21) | | | $ | (900) | | | $ | (61) | |
For the three months ended March 31, 2022 the Company did not contribute in the U.S. to the pension plan and contributed $0.3 million in the UK. For the nine month periods ended March 31, 2022, the Company contributed $1.5 million, in the U.S. and $0.8 million in the UK pension plans. Based upon the actuarial valuations performed on the Company’s defined benefit plans as of June 30, 2021, the contribution for fiscal 2022 for the U.S. plans would require a contribution of $5.6 million and the U.K. plan would require one of $1.0 million. However, as a result of the American Rescue Plan Act of 2021, the minimum required company contribution for the U.S. Plan in fiscal 2022 was reduced from $5.6 million to $0.6 million. The Company believes that government regulation is only a small part of deciding the pension funding, and as a result, has contributed more than the federal requirement. The Company will evaluate the U.S. future contribution on a quarterly basis.
The Company’s pension plans use fair value as the market-related value of plan assets and recognize net actuarial gains or losses in excess of ten percent (10)% of the greater of the market-related value of plan assets or of the plans’ projected benefit obligation in net periodic (benefit) cost as of the plan measurement date. Net actuarial gains or losses that are less than 10% of the thresholds noted above are accounted for as part of accumulated other comprehensive loss.
Note 10: Debt
Debt is comprised of the following (in thousands):
| | | | | | | | | | | |
| 03/31/2022 | | 06/30/2021 |
Short-term and current maturities | | | |
Loan and Security Agreement (Line of credit) | 15,013 | | | 9,153 | |
Loan and Security Agreement (Term Loan) | 1,660 | | | 1,509 | |
Brazil Loans | 6,159 | | | 5,297 | |
| 22,832 | | | 15,959 | |
Long-term debt (net of current portion) | | | |
Loan and Security Agreement (Term Loan) | 4,758 | | | 6,010 | |
Brazil Loans | 4,647 | | | — | |
| 9,405 | | | 6,010 | |
| $ | 32,237 | | | $ | 21,969 | |
See Note 12 Subsequent events: On April 29, 2022, the Company and certain of the Company’s domestic subsidiaries entered into a new Loan and Security agreement with HSBC Bank USA.
On December 31, 2019, the Company entered into the Tenth Amendment of its Loan and Security Agreement (“Tenth Amendment”). Under the revised agreement, the credit limit for the Revolving Loan was increased from $23.0 million to $25.0 million. In addition, the Company entered into a new $10.0 million 5-year Term Loan with a fixed interest rate of 4.0%. Under the Tenth Amendment, the credit limit for external borrowing was increased from $2.5 million to $5.0 million.
On June 25, 2020, the Borrowers and TD Bank entered into an amendment and restatement (the “Amendment and Restatement”) of the Loan Agreement. The Amendment and Restatement waived the fixed charge coverage ratio for the quarter ended June 30, 2020. In addition, the Amendment and Restatement clarifies that certain non-cash adjustments to the definition of EBITDA are permitted under the Loan Agreement, as amended. In addition, the Amendment and Restatement increases the permitted borrowings from a foreign bank from $5.0 million to $15.0 million and permits the Company to draw the remainder of the outstanding balance under the Loan Agreement.
Pursuant to the terms of the Company’s Amended and Restated Loan and Security Agreement of June 25, 2020, the “First Amendment” to this loan agreement was executed on September 17, 2020, which include, among other things, (i) pause testing of the Fixed Charge Coverage Ratio until September 30, 2021 and (ii) establishment of a new minimum cumulative EBITDA and minimum liquidity covenants in lieu thereof. TD Bank updated its security interests in the Company’s U.S. based assets, increased the maximum interest charged on the Line Of Credit from an annual interest rate of 2.25% plus Libor to 3.50% plus Libor, and amended the borrowing base for the line of credit from 80% of Qualified AR and 50% of the lower of Cost or Market of US inventory values to 80% of qualified AR plus 85% of the Net Orderly Liquidation Value (NOLV) of US Inventory plus 62.5% of total appraised US real estate values.
As a result of this change, the Company is projected to maintain its current borrowing capacity of $25,000,000 under the Line of Credit. The Company underwent a series of appraisals and field exams in all US locations as part of restructuring this agreement and will provide additional reporting supporting the borrowing base and covenants certifications. This minimum adjusted EBITDA covenant was based on the Company’s plan for a slow pandemic recovery throughout FY21 and the impact of the Company’s restructuring plan initiatives. As of September 30, 2021, the agreement has reverted to the prior covenant package. The Company was compliant with the minimum liquidity requirement and the minimum fixed charge coverage ratio required bank covenants as of March 31, 2022.
Total debt increased $10.3 million during the nine months ended March 31, 2022, $5.5 million of which was an increase in Brazil. This is in response to increased working capital levels required to meet strong customer demand and counteract pandemic related supply chain disruptions and increased transit times.
During the nine months ended March 31, 2022 the Brazilian subsidiary realized a build-up of ICMS (sales tax) credits, a consequence of the fiscal 2021 restructuring activities which increased the manufacturing activity and, therefore, raw material imports into Brazil. As the Company's Brazilian subsidiary is now exporting a larger proportion of its sales, its ability to re-claim these ICMS credits has been diminished. The Company is actively mitigating this consequence by filing applications with the relevant tax authorities to change the methodology of charging and re-claiming ICMS on imports and domestic sales so that this credit is subsequently relieved and does not increase at this rate again. This new methodology is common for similar sized, export focused companies in Brazil.
Availability under the Line of Credit remains subject to a borrowing base comprised of Accounts Receivable, Inventory, and Real Estate. The Company believes that the borrowing base will consistently produce availability under the Line of Credit of $25.0 million. A 0.25% commitment fee is charged on the unused portion of the Line of Credit.
The Company’s Brazilian subsidiary incurs short-term loans with local banks in order to support the Company’s strategic initiatives. The loans are backed by the entity’s US dollar denominated export receivables. The Company’s Brazilian subsidiary has the following loans of March 31, 2022 (in thousands):
| | | | | | | | | | | | | | | | | | | | | | | |
Lending Institution | Interest Rate | | Beginning Date | | Ending Date | | Outstanding Balance |
Banco do Brasil SA | 2.80% | | May 2021 | | May 2022 | | $ | 20 | |
Banco Bradesco SA | 1.88% | | July 2021 | | July 2022 | | $ | 671 | |
Banco Bradesco SA | 2.05% | | August 2021 | | July. 2022 | | $ | 284 | |
Banco Santander (Brasil) S.A | 2.15% | | August 2021 | | July 2022 | | $ | 399 | |
Banco do Brasil SA | 2.10% | | August 2021 | | August 2022 | | $ | 1,299 | |
Banco Itaú Unibanco | 4.52% | | October 2021 | | September 2024 | | $ | 4,000 | |
Banco Santander (Brasil) S.A | 2.71% | | December 2021 | | July 2022 | | $ | 1,000 | |
Banco Bradesco SA | 2.05% | | January 2022 | | January 2023 | | $ | 1,000 | |
Banco Itaú Unibanco | 4.98% | | February 2022 | | February 2024 | | 2,133 | |
| | | | | | | |
| | | | | | | $ | 10,806 | |
Note 11: Income Taxes
The Company is subject to U.S. federal income tax and various state, local, and foreign income taxes in numerous jurisdictions. The Company’s domestic and foreign tax liabilities are subject to the allocation of revenues and expenses in different jurisdictions and the timing of recognizing revenues and expenses. Additionally, the amount of income taxes paid is subject to the Company’s interpretation of applicable tax laws in the jurisdictions in which it files.
The Company provides for income taxes on an interim basis based on an estimate of the effective tax rate for the year. This estimate is reassessed on a quarterly basis. Discrete tax items are accounted for in the quarterly period in which they occur.
On December 22, 2017, the Tax Cuts and Jobs Act was enacted in the United States. The Act reduces the U.S. federal corporate tax rate from a graduated rate of 35% to a flat rate of 21%, requires companies to pay a one-time transition tax on earnings of certain foreign subsidiaries that were previously tax deferred and creates new taxes on certain foreign sourced earnings. Beginning in fiscal 2019, the Company incorporated certain provisions of the Act in the calculation of the tax provision and effective tax rate, including the provisions related to the Global Intangible Low Taxed Income (“GILTI”), Foreign Derived Intangible Income (“FDII”), Base Erosion Anti Abuse Tax (“BEAT”), as well as other provisions, which limit tax deductibility of expenses.
The GILTI provisions have had the most significant impact to the Company. Under the new law, U.S. taxes are imposed on foreign income in excess of a deemed return on tangible assets of its foreign subsidiaries. In general, this foreign income will effectively be taxed at an additional 10.5% tax rate reduced by any available current year foreign tax credits. The ability to benefit foreign tax credits may be limited under the GILTI rules as a result of the utilization of net operating losses, foreign sourced income and other potential limitations within the foreign tax credit calculation.
In July 2020, the IRS issued final regulations and additional proposed regulations that address the application of the high-taxed exclusion from GILTI. Under these regulations, the Company can make an annual election to exclude from its GILTI inclusion, income from its foreign subsidiaries that’s effective income tax rate exceeds 18.9% for that year. The regulations must be applied for tax years beginning after July 23, 2020 but companies have the option to apply retroactively for tax years beginning after December 31, 2017 and before July 23, 2020. In the first quarter of fiscal 2021 the Company recognized a discrete tax benefit of ($2.7) million related to the impact of electing to apply the high-tax exclusion retroactively for fiscal year 2019 and fiscal year 2020.
For the three month period ended March 31, 2022, the Company recognized tax expense of $1.8 million on a profit before tax of $6.1 million or an effective tax rate of 29%. For the three month period ended March 31, 2021, the Company recognized tax expense of $1.5 million on a profit before tax of $4.5 million or an effective tax rate of 33%. The tax rate for both fiscal 2022 and fiscal 2021 was higher than the U.S. statutory tax rate of 21% primarily due to the GILTI provisions and the jurisdictional mix of earnings, particularly Brazil with a statutory rate of 34%, offset by tax credits and permanent deductions generated from research expenses.
For the nine month period ended March 31, 2022, the Company recognized tax expense of $3.9 million on a profit before tax of $14.0 million or an effective tax rate of 28%. This was higher than the U.S. statutory tax rate of 21% primarily due to the GILTI
provisions and the jurisdictional mix of earnings, particularly Brazil with a statutory rate of 34%, offset by discrete tax benefits recognized from excess stock compensation deductions, tax credits, and permanent deductions generated from research expenses. For the nine month period ended March 31, 2021. the Company recognized tax expense of $1.1 million on a profit before tax of $12.1 million or an effective tax rate of 9%.This was lower than the U.S. statutory tax rate of 21% primarily due to the discrete benefits relating to legislation enacted during the first quarter of fiscal 2021 in the amount of ($2.7) million related to the impact of the GILTI high-tax exclusion and ($0.2) million related to the impact of the increase in UK corporate tax rate on the net deferred tax asset. Other factors impacting the tax rate include the GILTI provisions and the jurisdictional mix of earnings, particularly Brazil with a statutory rate of 34%, offset by tax credits and permanent deductions generated from research expenses.
U.S. Federal tax returns for years prior to fiscal 2018 are generally no longer subject to review by tax authorities; however, tax loss carryforwards from earlier years are still subject to adjustment. As of March 31, 2022, the Company has substantially resolved all open income tax audits and there were no other local or federal income tax audits in progress. In international jurisdictions including Australia, Brazil, Canada, China, Germany, Mexico, New Zealand, Singapore and the UK, which comprise a significant portion of the Company’s operations, the years that may be examined vary by country. The Company’s most significant foreign subsidiary in Brazil is subject to audit for the calendar years 2015 – present. During the next twelve months, it is possible there will be a reduction of $0.1 million in long-term tax obligations due to the expiration of the statute of limitations on prior year tax returns.
Accounting for income taxes requires estimates of future benefits and tax liabilities. Due to the temporary differences in the timing of recognition of items included in income for accounting and tax purposes, deferred tax assets or liabilities are recorded to reflect the impact arising from these differences on future tax payments. With respect to recorded tax assets, the Company assesses the likelihood that the asset will be realized by addressing the positive and negative evidence to determine whether realization is more likely than not to occur. If realization is in doubt because of uncertainty regarding future profitability, the Company provides a valuation allowance related to the asset to the extent that it is more likely than not that the deferred tax asset will not be realized. Should any significant changes in the tax law or the estimate of the necessary valuation allowance occur, the Company would record the impact of the change, which could have a material effect on the Company’s financial position.
No valuation allowance has been recorded for the Company’s U.S. federal and foreign deferred tax assets related to temporary differences included in taxable income. While the Company continues to believe that forecasted future taxable income provide sufficient evidence to, more likely than not, support the realization of the tax benefits provided by those differences; the impact of COVID-19 may significantly impact its ability to forecast future pre-tax earnings in certain jurisdictions.
In the U.S., a partial valuation allowance has been provided for foreign tax credit carryforwards due to the uncertainty of generating sufficient foreign source income to utilize those credits in the future and certain state net operating loss carryforwards that will expire in the near future unutilized.
Note 12: Restructuring
In March 2022, the Company adopted restructuring plans at a total projected cost of $1.6 million, of which $0.9 million related to the closure of its distribution and sales centers in Singapore and Japan, and $0.7 million for the refinancing of the Company's domestic credit facilities. The Company will continue to service Asia out of Brazil and China, and the plan is expected to be completed by June 30, 2022. The cost to close the Singapore and Japan operations is comprised of $0.6 million in headcount reduction, $0.2 in fixed asset and lease disposal, and $0.1 million in professional fees The Company anticipates an annualized savings reflected in the Consolidated Statements of Operations in Selling, General and Administrative expenses for this project of $0.6 million.
In the quarter ending March 31, 2022, the Company recorded $0.7 million in restructuring charges, of which $0.4 million was accrued and $0.1 million was incurred in relation to headcount reduction costs related to the Singapore and Japan closure and $0.2 million was incurred in relation to the refinancing of the Company's domestic credit facilities. Additional restructuring charges anticipated for both the Japan and Singapore closure and the residual amount for the refinancing of the Company's domestic credit facilities will be recorded as incurred in the quarter ending June 30, 2022.
Note 13: Contingencies
The Company is involved in certain legal matters, which arise, in the normal course of business. The Company does not believe it is reasonably possible that these matters will have a material impact on the Company's financial condition or cash flows
Note 14: Subsequent Events
On April 29, 2022, the Company and certain of the Company’s domestic subsidiaries entered into a new Loan and Security agreement with HSBC Bank USA.
These new credit facilities replaced the Company’s previous TD Bank credit facilities and are comprised of a $30 million revolving line of credit with a $10 million uncommitted accordion provision, a $12.1 million term loan and a $7 million Capital Expenditure draw down credit facility. The Facilities are secured by a valid first-priority security interest on substantially all existing and future assets of the Company and its domestic subsidiaries.
The interest rate on the new facilities is based on a grid which uses the percentage of the remaining availability of the revolving credit line to determine the floating margin to be added to the one month or three-month Secured Overnight Financing Rate, herein "SOFR". The initial rate for the first three months of the agreement is the one-month SOFR plus 1.60%. The new credit facilities mature on April 29, 2027.
Availability under the revolving line of credit is secured by and subject to a borrowing base comprised of eligible inventory and accounts receivable. The percentage of receivables included in the borrowing base is 90% for domestic investment grade and foreign insured accounts, 85% for domestic accounts that are neither investment grade nor insured, and 75% of foreign uninsured accounts. The percentage of inventory included in the borrowing base is the lower of 65% of the value of eligible inventory at cost or 85% of the net orderly liquidation value of eligible inventory at cost. The initial borrowing base is estimated at about $19 million. Receivables and inventory are reported monthly to HSBC and subject to an annual field exam and inventory appraisal by an independent auditor commissioned by the Bank. The Company believes that the agreement provides an initial borrowing base sufficient for current domestic working capital needs and flexibility to accommodate potential growth-related working capital needs.
Availability under the Term Loan facility was comprised of 70% of the fair market value of the Borrowers’ eligible real estate, which included facilities located in Westlake, Ohio, and Waite Park, Minnesota and totaled $4.6 million; and 85% of the net orderly liquidation value of the Borrowers’ machinery and equipment, capped at $7.5 million. The real estate portion of the Term facility is subject to a 12.5 year straight line amortization paid quarterly, and the machinery and equipment portion of the facility is subject to a 6.67 year straight line amortization, also paid quarterly. The term loan is subject to equal quarterly installments of $373,650, payable on the last day of each fiscal quarter.
The capital expenditure loan facility is available for the purchase of new machinery and equipment at 80% of the net invoice value of new machinery and equipment purchases, with a draw period of eighteen months past the closing date, with any amount outstanding under the facility subject to a 3.75% amortization rate per quarter.
The new credit facilities contain financial covenants with respect to a minimum fixed charge coverage ratio of 1.00, measured on a trailing twelve-month basis, for both the U.S. borrowing companies tested quarterly and the Consolidated L.S. Starrett Company tested semi-annually. The Loan and Security agreement also contains the customary affirmative and negative covenants, including limitations on indebtedness, liens, acquisitions, asset dispositions, fundamental corporate changes, excess pension contributions, and certain customary events of default. Upon the occurrence or continuation of an event of default, the Lender may terminate all commitments and facilities, and require the immediate payment of the entire unpaid principal balances, accrued interest, and all other obligations.