Notes to Unaudited Consolidated Financial Statements
September 30, 2022
Note 1: Basis of Presentation and Summary of Significant Accounting Policies
The unaudited interim consolidated financial statements as of and for the three months ended September 30, 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, 2022. The balance sheet as of June 30, 2022 has been derived from the audited consolidated financial statements as of and for the year ended June 30, 2022. 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.
Accounts Receivable and Allowance for Credit Losses
Trade accounts receivable are recorded at invoiced amount and do not bear interest. Allowance for doubtful accounts is the Company's estimate of current expected credit losses on its existing accounts receivable and determined based on historical customer assessments, current financial conditions and reasonable and supportable forecasts. Account balances are charged off against the allowance when the Company determines the receivable will not be recovered.
Fair Value Measurements
Certain of the Company’s financial instruments, including cash and cash equivalents, accounts receivable, accounts payable, accrued expenses and other liabilities are carried at cost, which approximates their fair value because of their short-term maturity. See Notes 10 and 11 for financial assets and liabilities held at carrying amount on the consolidated balance sheet.
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, 2022 describes the significant accounting policies and methods used in the preparation of the consolidated financial statements.
Note 2: Recently Adopted Accounting Pronouncements
In June 2016, the FASB issued ASU 2016-13 "Financial Instruments -Credit Losses" (ASC 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 historic 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 pronouncement was extended for Small Reporting Companies and for the Company beginning July 1, 2022. The adoption of this standard did not have a material impact on the Company's consolidated financial statements.
Note 3: 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, 2022. The Company’s business is aggregated into two reportable segments based on geography of operations: North American Operations and International Operations ("International"). 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 September 30, 2022 | | | | | | | |
| | | | | | | |
Sales1 | $ | 36,484 | | | $ | 23,977 | | | $ | — | | | $ | 60,461 | |
| | | | | | | |
Operating Income (Loss) | $ | 3,198 | | | $ | 2,836 | | | $ | (2,318) | | | $ | 3,716 | |
| | | | | | | |
Three Months Ended September 30, 2021 | | | | | | | |
| | | | | | | |
Sales2 | $ | 33,809 | | | $ | 27,705 | | | $ | — | | | $ | 61,514 | |
| | | | | | | |
Operating Income (Loss) | $ | 2,501 | | | $ | 3,583 | | | $ | (1,951) | | | $ | 4,133 | |
1.Excludes $927 of North American segment intercompany sales to the International segment, and $5,035 of International segment intercompany sales to the North American segment.
2.Excludes $749 of North American segment intercompany sales to the International segment, and $5,336 of International segment intercompany sales to the North American segment.
Note 4: 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 September 30, 2022, and June 30, 2022, the balance of the return asset was $0.1 million and $0.1 million, respectively, and the balance of the refund liability was $0.2 million and $0.2 million, respectively. 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 $0.5 million and $0.9 million at September 30, 2022 and June 30, 2022, 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 September 30, 2022 and 2021 (in thousands):
| | | | | | | | | | | | | | | | | |
| Three Months Ended | | |
| 9/30/2022 | | 9/30/2021 | | | | |
North America | | | | | | | |
United States | $ | 34,272 | | | $ | 32,020 | | | | | |
Canada & Mexico | 2,212 | | | 1,789 | | | | | |
| 36,484 | | | 33,809 | | | | | |
International | | | | | | | |
Brazil | 17,248 | | | 19,203 | | | | | |
United Kingdom | 3,201 | | | 4,968 | | | | | |
China | 1,686 | | | 1,618 | | | | | |
Australia & New Zealand | 1,842 | | | 1,916 | | | | | |
| 23,977 | | | 27,705 | | | | | |
| | | | | | | |
Total Sales | $ | 60,461 | | | $ | 61,514 | | | | | |
Note 5: Leases
Operating lease cost amounted to $0.5 million and $0.7 million for three months period ended September 30, 2022 and 2021. As of September 30, 2022, the Company’s right-of-use "ROU" assets, lease obligations and remaining cash commitment on these leases (in thousands):
| | | | | | | | | | | | | | | | | |
| Right-of-Use Assets | | Operating Lease Obligations | | Remaining Cash Commitment |
Operating leases | 5,026 | | | $ | 5,209 | | | $ | 6,637 | |
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 3.9 years. As of September 30, 2022, the Company’s financing leases are de minimis. The foreign exchange impact affecting the operating leases are de minimis.
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.
Note 6: Stock-based Compensation
Compensation expense related to all stock-based plans for the three-month periods ended September 30, 2022 and 2021 was $0.1 million, for both periods.
Note 7: Inventories
Inventories consist of the following (in thousands):
| | | | | | | | | | | |
| 9/30/2022 | | 6/30/2022 |
Raw material and supplies | $ | 36,668 | | | $ | 35,752 | |
Goods in process and finished parts | 23,205 | | | 22,268 | |
Finished goods | 36,212 | | | 35,589 | |
| 96,085 | | | 93,609 | |
LIFO Reserve | (26,000) | | | (26,709) | |
| $ | 70,085 | | | $ | 66,900 | |
Of the Company’s $70.1 million and $66.9 million total inventory at September 30, 2022 and June 30, 2022, respectively, the $26.0 million and $26.7 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 $41.6 million on a FIFO basis and $15.6 million on a LIFO basis at September 30, 2022. The Core U.S. business had total Inventory, on a FIFO basis, of $39.3 million and $12.6 million on a LIFO basis as of June 30, 2022. The use of LIFO, as compared to FIFO, resulted in a $0.7 million decrease in cost of sales for the goods sold in the period ended September 30, 2022 compared to $4.6 million decrease in fiscal 2022.
Note 8: Goodwill and Intangible Assets
Amortizable intangible assets consist of the following (in thousands):
| | | | | | | | | | | |
| 9/30/2022 | | 6/30/2022 |
Trademarks and trade names | 2,070 | | | 2,070 | |
Completed technology | — | | | — | |
Customer relationships | 630 | | | 630 | |
Software development | 11,471 | | | 11,269 | |
| | | |
Gross intangible assets | 14,171 | | | 13,969 | |
Accumulated amortization and impairment | (9,665) | | | (9,329) | |
| | | |
Net intangible assets | $ | 4,506 | | | $ | 4,640 | |
The estimated useful lives of the intangible assets subject to amortization range between 5 years for software development and 20 years for trademark and trade name assets.
The goodwill balance at June 30, 2022, gross $4.7 million and accumulated impairment of $3.7 million. There was no change to goodwill in the three months ended September 30, 2022 and the balance is a net $1.0 million.
Note 9: Accrued Expenses (in thousands):
| | | | | | | | | | | |
| 09/30/2022 | | 06/30/2022 |
Sales related programs (commissions, rebates, distributor programs, warranty and related) | $ | 2,868 | | | $ | 2,733 | |
Income taxes | 614 | | | 2,420 | |
Professional fees | 1,669 | | | 1,758 | |
Other | 1,562 | | | 1,463 | |
Current portion pension cost | 1,297 | | | 1,289 | |
Taxes other than income tax | 1,058 | | | 1,243 | |
Workers compensation and employee deposits | 558 | | | 518 | |
Freight | 803 | | | 352 | |
Total | $ | 10,429 | | | $ | 11,776 | |
Note 10: 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 and 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) in the 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 | | |
| 9/30/2022 | | 9/30/2021 | | | | |
| | | | | | | |
Interest cost | 1,482 | | | 1,033 | | | | | |
Expected return on plan assets | (1,032) | | | (1,100) | | | | | |
Amortization of net loss | 10 | | | 14 | | | | | |
| $ | 460 | | | $ | (53) | | | | | |
Net periodic benefit costs for the Company's Postretirement Medical Plan consists of the following (in thousands):
| | | | | | | | | | | | | | | | | |
| Three Months Ended | | |
| 9/30/2022 | | 9/30/2021 | | | | |
Service cost | $ | 6 | | | $ | 9 | | | | | |
Interest cost | 18 | | | 12 | | | | | |
Amortization of prior service credit | (369) | | | (368) | | | | | |
Amortization of net loss | 44 | | | 47 | | | | | |
| $ | (301) | | | $ | (300) | | | | | |
For the three month period ended September 30, 2022, the Company contributed zero in the U.S. and $0.2 million in the UK pension plans. Based upon the actuarial valuations performed on the Company’s defined benefit plans as of September 30, 2022, the contribution for fiscal 2023 for the U.S. plans would require a contribution of $1.4 million and the U.K. plan would require one of $0.8 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 $1.4 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, may contribute more than the federal requirement. The Company contributed $2.5 million in total during fiscal year 2022, with $1.5 million in the U.S. and $1.0 million in the U.K.
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 11: Debt
Debt is comprised of the following (in thousands):
| | | | | | | | | | | |
| 9/30/2022 | | 6/30/2022 |
Short-term and current maturities | | | |
| | | |
Loan and Security Agreement (Term loan) | 1,495 | | | 1,495 | |
Brazil Loans | 3,889 | | | 5,052 | |
| 5,384 | | | 6,547 | |
Long-term debt (net of current portion) | | | |
Loan and Security Agreement (Term Loan) | 9,878 | | | 10,252 | |
Loan and Security Agreement (Line of Credit) | 11,397 | | | 11,397 | |
Brazil Loans | 3,220 | | | 3,771 | |
Debt Reacquisition Cost | (488) | | | (515) | |
| | | |
| | | |
| 24,007 | | | 24,905 | |
Total Debt | $ | 29,391 | | | $ | 31,452 | |
On April 29, 2022, the Company and certain of the Company’s domestic subsidiaries entered into a Loan and Security agreement with HSBC Bank USA (the "Loan and Security Agreement"). The Company incurred an increase in debt of $0.5 million as a result of debt reacquisition cost.
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 (collectively, the "Facilities"). 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 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, ("SOFR)". The initial rate for the first three months of the Loan and Security Agreement is the one-month SOFR plus 1.60%. The 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. 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 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.
The TD Bank loan was retired in the quarter ended June 2022.. Prior to the Loan and Security Agreement with HSBC, 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.
Total debt decreased $2.1 million during the three months ended September 30, 2022 and $1.7 million of which was a decrease in Brazilian loans. This is a result of cash provided from operations of $0.6 million and the use of the credit balance of $0.6 million of the contingency gain, related to exclusion of ICMS.
In Brazil, the Company is actively mitigating this consequence of the build-up of ICMS (sales tax) credits 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. The ICMS balance as of June 30, 2022 was $5.4 million and as of September 30, 2022 was $4.9 million.
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 September 30, 2022 (in thousands):
| | | | | | | | | | | | | | | | | | | | | | | |
Lending Institution | Interest Rate | | Beginning Date | | Ending Date | | Outstanding Balance |
Itau | 4.52 | % | | October 2021 | | September 2024 | | $ | 4,000 | |
Santander | 2.71 | % | | December 2021 | | December 2022 | | 275 | |
Bradesco | 2.52 | % | | January 2022 | | January 2023 | | 443 | |
Itau | 4.98 | % | | February 2022 | | February 2024 | | 1,828 | |
Brasil | 4.95 | % | | August 2022 | | July 2025 | | 401 | |
Brasil | 3.80 | % | | September 2022 | | August 2024 | | 115 | |
Brasil | 4.18 | % | | September 2022 | | September 2023 | | 48 | |
| | | | | | | |
| | | | | | | |
| | | | | | | $ | 7,110 | |
Note 12: Income Taxes
Tax expense for the three month period ended September 30, 2022 was $1.0 million on profit before tax of $3.0 million (an effective tax rate of 32%). Tax expense for the three month period ended September 30, 2021 was $1.1 million on profit before tax of $4.4 million (an effective tax rate of 26%). The effective tax rate for the three month periods ended September 30, 2022 and 2021 were 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. Tax expense for the three month period ended September 30, 2022 reflects the impact of final U.S. foreign tax credit regulations effective in fiscal 2023 that result in an increase in tax expense from the GILTI inclusion. In the period ended September 30, 2022 the GILTI impact resulted in a 7.27% rate as compared to the period ended September 30, 2021 resulting in a rate of 2.22%.
The Company has considered the positive and negative evidence to determine the need for a valuation allowance offsetting the deferred tax assets in the U.S. and has concluded that a partial valuation allowance is required against foreign tax credit carryforwards and certain state net operating loss carryforwards at September 30, 2022 and June 30, 2022. The Company had long term tax obligations related primarily to transfer pricing adjustments at September 30, 2022 and 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 results of operations or cash flows.