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SYPRIS SOLUTIONS INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

May 6, 2014

Overview

We are a diversified provider of outsourced services and specialty products. We perform a wide range of manufacturing, engineering, design and other technical services, typically under sole-source contracts with corporations and government agencies principally in the markets for industrial manufacturing and aerospace and defense electronics. We are organized into two business groups, the Industrial Group and the Electronics Group. The Industrial Group, which is comprised of Sypris Technologies, Inc. and its subsidiaries, generates revenue primarily from the sale of manufacturing services to customers in the market for truck components and assemblies and from the sale of products to the energy and chemical markets. The Electronics Group, which is comprised of Sypris Electronics, LLC and its subsidiary, generates revenue primarily from the sale of manufacturing services, technical services and products to customers in the market for aerospace and defense electronics. We focus on those markets where we have the expertise, qualifications and leadership position to sustain a competitive advantage. We target our resources to support the needs of industry leaders that embrace multi-year contractual relationships as a strategic component of their supply chain management. These contracts, many of which are sole-source by part number and, historically, have been renewed for terms of five years or more, enable us to invest in leading-edge processes or technologies to help our customers remain competitive. The productivity, flexibility and economies of scale that can result offer an important opportunity for differentiating ourselves from our competitors when it comes to cost, quality, reliability and customer service. Industrial Group Outlook General economic and industry specific conditions have begun to stabilize for our Industrial Group, and improvements in the overall U.S. economy contributed to improved consumer confidence levels in 2014. In North America, production levels for light, medium and heavy duty trucks have steadily increased over the past four years from a low in the depressed economic environment of 2008 and 2009. Subject to the renewal status of our supply contracts with Dana and Meritor, we continue to expect modest growth in production levels within our Industrial Group through 2014 and 2015. Our supply agreement with Dana Holding Corporation ("Dana") expires on December 31, 2014 and our supply agreements with Meritor, Inc. (Meritor) expire on December 31, 2014 and May 2, 2015. For the three months ended March 30, 2014, Dana and Meritor represented approximately 59% and 16%, of our net revenue, respectively. Sypris and Dana have recently signed an amended and restated supply agreement, the binding effect of which is currently in dispute. Dana has repudiated this agreement and purported to exercise its rights under the prior agreement to begin exploring alternative supply relationships with third parties, including the right to sign new supply agreements, authorize tooling expenditures and engage in certain production part approval processes (PPAP) with respect to the goods currently supplied by Sypris. Sypris disputes Dana's ability to exercise such rights. In addition, Dana has notified us that it intends to terminate its supply relationship with us effective December 31, 2014 and to transition over 2,000 active part numbers, which we currently manufacture for Dana, to alternative suppliers at the expiration date of the original supply agreement. The failure to resolve this dispute with Dana on acceptable terms would have a material adverse effect on our financial condition and financial performance. In addition, the failure to enter into an agreement with Meritor on acceptable terms, or the entry into agreements for fewer products or reduced volumes or prices would have a material adverse effect on our financial condition and financial performance. The Company is exploring alternatives to address the various range of outcomes for both the Dana and Meritor supply agreements, including the complete or partial renewal of either or both supply agreements, pursuing new business opportunities with existing and potential customers, identifying alternative uses for the assets and certain other contingency plans. The Company expects to have plans established and executed prior to December 31, 2014 to support its operations and provide sufficient liquidity to finance its operations for 2014 and the foreseeable future. 13

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Electronics Group Outlook We continue to face challenges within the Electronics Group, such as the conclusion of several U.S. Department of Defense programs that the Company supported as a subcontractor, the loss of a key commercial space customer who decided to begin insourcing programs that had been previously outsourced to the Electronics Group, the uncertainty in the worldwide macroeconomic climate and its impact on aerospace and defense spending patterns globally, the emergence of new competitors to our product and service offerings, as well as federal government spending uncertainties in the U.S. The Electronics Group's revenue has declined year-over-year since 2009 primarily due to our inability to replace the declining demand for certain legacy products and services with competitive new offerings. While we do not yet have a pipeline of programs or other contract awards to replace these legacy programs in the near term, the Company is currently developing new products and pursuing new programs to attempt to replenish its revenue stream within the Electronics Group. The U.S. Government's continued focus on addressing federal budget deficits and the growing national debt exacerbates this challenging environment for the Electronics Group. In addition, the Budget Control Act commits the U.S. Government to reduce the federal deficit by $1.2 trillion over ten years through a combination of automatic, across-the-board spending cuts and caps on discretionary spending. The deficit-reduction "sequestration" under the Budget Control Act is split equally between defense and non-defense programs and went into effect on March 1, 2013. However, the Bipartisan Budget Act of 2013 provided some budget relief, reducing the discretionary sequester (and increasing funding) for fiscal year 2014 and fiscal year 2015 for both defense and non-defense programs. Unless Congress passes a similar law providing budget relief beyond fiscal year 2015, the full sequester cuts will go back into effect for fiscal year 2016. In addition, in February 2014, the Pentagon announced that its budget request for fiscal year 2015 would exceed the sequester caps but would be below the funding in the President's fiscal year 2014 budget request. Congress and the Administration continue to debate these long- and short-term funding issues, but reductions in U.S. military spending could materially and adversely affect the results of our Electronics Group, and we expect that certain military and defense programs will experience delays while the receipt of government approvals remain pending. As a result, the Company expects ongoing uncertainty and the potential for further revenue declines within this segment for at least the next twelve months. For the longer term, we are continuing to make investments and evaluate new investments in products and programs to further improve the attractiveness of our business portfolio, with a specific emphasis on trusted solutions for identity management, cryptographic key distribution and cyber analytics. There can be no assurance that the Company's investment in and efforts to introduce new products and services will result in new business or revenue. In addition, while the Company continues to evaluate and implement cost reduction measures in this segment, the Company may not be able to reduce its cost structure to offset the impact of lower revenues. Should revenues decrease further in the coming periods, the Company might be required to implement further cost reductions or other downsizing measures, which could be costly and adversely impact our financial performance. Results of Operations The table below compares our segment and consolidated results for the first quarterly period of operations of 2014 to the first quarterly period of operations of 2013. It presents the results for each period, the change in those results from 2013 to 2014 in both dollars and as a percentage, as well as the results for each period as a percentage of net revenue.



? The first two columns in the table show the absolute results for each period

presented.



? The columns entitled "Year Over Year Change" and "Year Over Year Percentage

Change" show the change in results, both in dollars and percentages. These two

columns show favorable changes as positive and unfavorable changes as

negative. For example, when our net revenue increases from one period to the

next, that change is shown as a positive number in both columns. Conversely,

when expenses increase from one period to the next, that change is shown as a

negative number in both columns. ? The last two columns in the table show the results for each period as a



percentage of net revenue. In these two columns, the cost of sales and gross

profit for each segment are given as a percentage of that segment's net revenue. These amounts are shown in italics.



In addition, as used in the table, "NM" means "not meaningful."

14 -------------------------------------------------------------------------------- Three Months Ended March 30, 2014 Compared to Three Months Ended March 31, 2013 Year Over Year Over Year Results as Percentage of Year Percentage Net Revenue for the Three Three Months Ended, Change Change Months Ended March 30, March 31, Favorable Favorable March 30, March 31, 2014 2013 (Unfavorable) (Unfavorable) 2014 2013 (in thousands, except percentage data) Net revenue: Industrial Group $ 75,839$ 71,149 $ 4,690 6.6 % 90.0 % 90.7 % Electronics Group 8,405 7,262 1,143 15.7 10.0 9.3 Total 84,244 78,411 5,833 7.4 100.0 100.0 Cost of sales: Industrial Group 64,685 63,039 (1,646 ) (2.6 ) 85.3 88.6 Electronics Group 8,995 7,296 (1,699 ) (23.3 ) 107.0 100.5 Total 73,680 70,335 (3,345 ) (4.8 ) 87.5 89.7 Gross profit (loss): Industrial Group 11,154 8,110 3,044 37.5 14.7 11.4 Electronics Group (590 ) (34 ) (556 ) NM (7.0 ) (0.5 ) Total 10,564 8,076 2,488 30.8 12.5 10.3 Selling, general and administrative 7,992 7,158 (834 ) (11.7 ) 9.5 9.1 Research and development 151 877 726 82.8 0.2 1.1 Amortization of NM intangible assets 0 22 22 0.0 0.0 Impairment of goodwill 0 6,900 6,900 NM 0.0 8.8 Operating income (loss) 2,421 (6,881 ) 9,302 NM 2.8 (8.7 ) Interest expense, net 132 146 14 9.6 0.1 0.2 Other (income), net (528 ) (1,195 ) (667 ) (55.8 ) (0.6 ) (1.5 ) Income (loss) before NM taxes 2,817 (5,832 ) 8,649 3.3 (7.4 ) Income tax expense 1,165 627 (538 ) (85.8 ) 1.4 0.8 Net income (loss) $ 1,652$ (6,459 ) $ 8,111 NM 1.9 % (8.2 )% Net Revenue. The Industrial Group primarily derives its revenue from manufacturing services and product sales. Net revenue in the Industrial Group increased 6.6% or $4.7 million for the first quarter of 2014 compared to the first quarter of 2013. Increased volumes accounted for $4.4 million of the increase in revenue for the first quarter of 2014, while pricing accounted for $0.3 million. The increases in volumes and pricing are partially attributable to the gradual stabilization of conditions in the industry and the U.S. economy generally, which have resulted in corresponding improvements in consumer confidence levels in 2014. The Electronics Group derives its revenue from product sales and technical outsourced services. Net revenue in the Electronics Group for the first quarter of 2014 increased 15.7% or $1.1 million compared to the same period in 2013, reflecting the ramp up of new electronic manufacturing service programs, partially offset by declines within the space business. Despite the increase over the prior year period, the Electronics Group's outlook continues to be negatively affected by budgetary and funding uncertainty within the U.S. Department of Defense. Gross Profit. The Industrial Group's gross profit increased $3.0 million to $11.2 million in the first quarter of 2014 as compared to $8.1 million in the first quarter of 2013. The net increase in sales volumes included a favorable mix of higher margin products, which resulted in an increase in gross profit of approximately $1.7 million. Additionally, productivity improvements and increased pricing contributed to an increase in gross profit of $1.0 million and $0.3 million, respectively, when compared to the prior year period. The Electronics Group's gross profit decreased in the first quarter of 2014 resulting in a loss of $0.6 million as compared to loss of $34 thousand for the first quarter of 2013. The decline in gross profit was primarily as a result of an unfavorable mix in sales of lower margin products and services. 15 -------------------------------------------------------------------------------- Selling, General and Administrative. In the first quarter of 2014, selling, general and administrative expense increased $0.8 million as compared to the same period in 2013 as a result of an increase in legal expenses regarding contract negotiations and an increase in incentive compensation expenses (see Note 3 "Customer Contract Negotiations" to the consolidated financial statements in this Quarterly Report on Form 10-Q). Selling, general and administrative expense increased as a percentage of revenue to 9.5% for the first three months of 2014 as compared to 9.1% for the prior year period. Research and Development. Research and development costs were $0.2 million in the first quarter of 2014 as compared to $0.9 million for the same period of 2013 in support of the Electronics Group's self-funded product and technology development activities. As certain projects become customer funded, the Company expects total research and development costs to decrease for the year ending December 31, 2014 in comparison to 2013. Impairment of Goodwill. Goodwill is tested for impairment annually as of December 31 or more frequently if impairment indicators arise. If impairment indicators arise, a step one assessment is performed to identify any possible goodwill impairment in the period in which the indicator is identified. Beginning in March 2013, we noted certain indicators relating to our Electronics Group reporting unit that were significant enough to conclude that an impairment indicator existed as of March 31, 2013. Specifically, the Company experienced emerging uncertainty regarding certain key programs within the Electronics Group's space business beginning in the latter part of the first quarter of 2013, as one key customer communicated its strategic sourcing decision to begin insourcing programs that had been previously outsourced to the Electronics Group. Overall, the Electronics Group has been more impacted by declines in the overall government defense market than originally anticipated as the effects of sequestration have become clearer since its initial effective date on March 1, 2013. For example, sales of certain data recording products were significantly reduced due to the impact of sequestration on our customers, and the loss of commercial space business was due in part to our customer's efforts to offset unrelated losses of government business due to sequestration. As a result, the Electronics Group's short term revenue forecasts were materially affected. Further, the Company experienced a decline in the market value of its equity subsequent to March 31, 2013. As a result of the analysis, the Electronics Group's goodwill was deemed to be impaired, resulting in a non-cash impairment charge of $6.9 million, representing the segment's entire goodwill balance. Interest Expense. Interest expense for the first quarter of 2014 remained flat at $0.1 million. The weighted average interest rate decreased to 2.4% in the first quarter of 2014 as compared to 2.5% in the first quarter of 2013. Additionally, our weighted average debt outstanding decreased to $14.0 million for the first quarter of 2014 from $16.8 million during the first quarter of 2013. Other (Income), Net. The Company recognized other income, net of $0.5 million for the first quarter of 2014 compared to $1.2 million for the first quarter of 2013. Other income, net for the first quarter of 2014 includes gains of $0.6 million within the Industrial Group from the receipt of federal grant funds for improvements made under a flood relief program. Other expense, net for the first quarter of 2013 includes gains of $1.7 million from the sale of idle assets within the Industrial Group partially offset by foreign currency related losses of $0.6 million related to the net U.S. dollar denominated monetary asset position of our Mexican subsidiaries for which the Mexican peso is the functional currency. Income Tax Expense. Income tax expense for the first quarter of 2014 increased to $1.2 million as compared to $0.6 million in the first quarter of 2013. The $1.2 million income tax expense includes $1.1 million of tax on foreign operations at the statutory rate of 30% and $0.1 million of state tax from U.S. operations. In the U.S., our recent history of operating losses does not allow us to satisfy the "more likely than not" criterion for recognition of deferred tax assets. Therefore, there is generally no federal income tax recognized on the pre-tax income or losses in the U.S. as valuation allowance adjustments offset the associated tax effect. However, the Company has provided for certain state taxes expected to be paid in the U.S.



Liquidity, Capital Resources

The Company's Credit Facility provides potential total availability of up to $50.0 million with an option, subject to certain conditions, to increase total potential availability to $60.0 million in the future. Loans made under the Credit Facility will mature and the commitments thereunder will terminate in May 2016. Actual borrowing availability under the Credit Facility depends upon a monthly borrowing base collateral calculation that is based on specified percentages of the value of eligible accounts receivable, inventory and machinery and equipment, less certain reserves and subject to certain other adjustments. Based on that calculation, at March 30, 2014, we had actual total borrowing availability under the Credit Facility of $39.9 million, of which we had drawn $23.0 million, leaving $16.1 million available for borrowing, after accounting for the letter of credit described below. Along with an unrestricted cash balance of $19.1 million, we had total cash and available borrowing capacity of $35.2 million as of March 30, 2014. Approximately $5.7 million of the unrestricted cash balance relates to our Mexican subsidiaries. Standby letters of credit up to a maximum of $5.0 million may be issued under the Credit Facility of which $0.8 million were issued at March 30, 2014. Obligations under the Credit Facility are guaranteed by all of our U.S. subsidiaries and are secured by a first priority lien on substantially all domestic assets of the Company. 16

-------------------------------------------------------------------------------- The Credit Facility contains a number of covenants that, among other things, limit or restrict our ability to dispose of assets, incur additional indebtedness, incur guarantee obligations, engage in sale and leaseback transactions, prepay other indebtedness, modify organizational documents and certain other agreements, create restrictions affecting subsidiaries, pay dividends and other restricted payments, create liens, make investments, make acquisitions, engage in mergers, change the nature of our business and engage in certain transactions with affiliates. In addition, if the Company's availability under the Credit Facility falls below $6.0 million (or $8.0 million for a period of 5 or more consecutive days), the Company must maintain a fixed charge coverage ratio of at least 1.15 to 1.00. As of March 30, 2014, the Company was in compliance with all covenants.



We also had purchase commitments totaling approximately $8.7 million at March 30, 2014, primarily for inventory and manufacturing equipment.

The Company expects to repatriate available non-U.S. cash holdings in 2014 and 2015 to support management's strategic objectives and fund ongoing U.S. operational cash flow requirements; therefore current earnings from non-U.S. operations are not treated as permanently reinvested. The U.S. income tax recorded in 2014 on these non-U.S. earnings is expected to be offset by the benefit of a partial release of a valuation allowance on U.S. net operating loss carryforwards. Should the U.S. valuation allowance be released at some future date, the U.S. tax on foreign earnings not permanently reinvested might have a material effect on our effective tax rate, however it would not significantly impact our current income tax liability.



There are numerous risks and uncertainties relating to the global economy and the commercial vehicle and aerospace and defense industries that could materially affect our financial condition, future results of operations and liquidity. These risks and uncertainties could result in decreased sales, limited access to credit, rising costs, increased competition, customer or supplier bankruptcies, delays in customer payment terms and acceleration of supplier payments, growing inventories and failure to meet debt covenants.

Based on our current forecast for 2014, we expect to be able to meet the financial covenants of our Credit Facility and have sufficient liquidity to finance our operations for 2014 and the foreseeable future. However, changing business, regulatory and economic conditions may mean that actual results will vary from our forecasts. The outcome of the Dana and Meritor contract negotiations could have a significant impact on our liquidity, however, the Company expects to have plans established and executed prior to December 31, 2014 to support its operations and provide sufficient liquidity to finance its operations for 2014 and the foreseeable future. Our ability to service our indebtedness will require a significant amount of cash. Our ability to generate this cash will depend largely on future operations. Based upon our current level of operations and our 2014 business forecast, we believe that cash flow from operations, available cash and available borrowings under our Credit Facility will be adequate to meet our liquidity needs for 2014 and the foreseeable future. Financial Condition Operating Activities. Net cash provided by operating activities was $2.5 million in the first quarter of 2014, as compared to net cash provided of $0.6 million in the same period of 2013. Cash of $20.0 million was used to finance increased accounts receivables in the first quarter of 2014 resulting from higher revenues of $10.4 million in the first quarter of 2014 over the fourth quarter of 2013 in addition to the timing of revenue being weighted toward the last month of the quarter. Similarly, increases in accounts payable provided cash of $17.9 million. Cash of $2.2 million was used to finance an increase in inventory during the first quarter of 2014 in order to support higher volumes. Accrued liabilities increased and provided $2.5 million primarily as a result of a $2.1 million prepayment by a customer within the Electronics Group. Additionally, prepaid expenses and other assets decreased and provided $1.7 million primarily as a result of the timing of VAT tax payments within our Industrial Group and the timing of insurance related payments. 17 -------------------------------------------------------------------------------- Investing Activities. Net cash used in investing activities was $0.6 million for the first quarter of 2014 as compared to cash provided of $1.2 million for the first quarter of 2013. Net cash used in investing activities for the first quarter of 2014 included $0.6 million of capital expenditures. Net cash provided by investing activities for the first quarter of 2013 included proceeds of $2.1 million from the sale of idle assets within the Industrial Group, partially offset by $0.9 million of capital expenditures during the first quarter of 2013. Financing Activities. Net cash used in financing activities was $1.6 million in the first quarter of 2014 as compared to $2.0 million during the first quarter of 2013. Net cash used in financing activities in the first quarter of 2014 includes a debt reduction of $1.0 million on the Credit Facility, dividend payments of $0.4 million and payments of $0.1 million for the repurchase of stock and minimum statutory tax withholdings on stock-based compensation. During the first quarter of 2013, the company reduced debt by $1.5 million on the Credit Facility and made payments of $0.5 million for minimum statutory tax withholdings on stock-based compensation. Critical Accounting Policies See the information concerning our critical accounting policies included under Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operation - Critical Accounting Policies and Estimates" in our Annual Report on Form 10-K for the fiscal year ended December 31, 2013. There have been no significant changes in our critical accounting policies during the three months ended March 30, 2014. Forward-looking Statements This Quarterly Report on Form 10-Q, and our other oral or written communications, may contain "forward-looking" statements. These statements may include our expectations or projections about the future of our industries, business strategies, potential acquisitions or financial results and our views about developments beyond our control, including domestic or global economic conditions, trends and market developments. These statements are based on management's views and assumptions at the time originally made, and, except as required by law, we undertake no obligation to update these statements, even if, for example, they remain available on our website after those views and assumptions have changed. There can be no assurance that our expectations, projections or views will come to pass, and undue reliance should not be placed on these forward-looking statements. A number of significant factors could materially affect our specific business operations and cause our performance to differ materially from any future results projected or implied by our prior statements. Many of these factors are identified in connection with the more specific descriptions contained throughout this report. Other factors which could also materially affect such future results currently include: reliance on major customers or suppliers, especially in the automotive or aerospace and defense electronics sectors, including the risk of potentially adverse outcomes in ongoing contract renewal disputes and negotiations with Dana and Meritor; declining revenues and backlog in our aerospace and defense business lines as we attempt to transition from legacy products and services into new market segments and technologies; our ability to successfully develop, launch or sustain new products and programs; dependence on, retention or recruitment of key employees especially in challenging markets; inventory valuation risks including excessive or obsolescent valuations; adverse impacts of new technologies or other competitive pressures which increase our costs or erode our margins; volatility of our customers' forecasts, production levels, financial conditions, market shares, product requirements or scheduling demands; cost and availability of raw materials such as steel, component parts, natural gas or utilities; the costs of compliance with our auditing, regulatory or contractual obligations; potential impairments, non-recoverability or write-offs of assets or deferred costs; the cost, quality, timeliness, efficiency and yield of our operations and capital investments, including working capital, production schedules, cycle times, scrap rates, injuries, wages, overtime costs, freight or expediting costs; the costs and supply of, or access to, debt, equity capital, or insurance; fees, costs or other dilutive effects of refinancing, or compliance with covenants; regulatory actions or sanctions (including FCPA, OSHA and Federal Acquisition Regulations, among others); potential weaknesses in internal controls over financial reporting and enterprise risk management; disputes or litigation involving customer, supplier, employee, lessor, landlord, creditor, stockholder, product liability or environmental claims; U.S. government spending on products and services that our Electronics Group provides, including the timing of budgetary decisions; changes in licenses, security clearances, or other legal rights to operate, manage our work force or import and export as needed; breakdowns, relocations or major repairs of machinery and equipment; pension valuation, health care or other benefit costs; labor relations; strikes; union negotiations; cyber security threats and disruptions; changes or delays in customer budgets, funding or programs; failure to adequately insure or to identify environmental or other insurable risks; revised contract prices or estimates of major contract costs; risks of foreign operations; currency exchange rates; war, terrorism, or political uncertainty; unanticipated or uninsured disasters, losses or business risks; inaccurate data about markets, customers or business conditions; or unknown risks and uncertainties and the risk factors disclosed in Item 1A of our Annual Report on Form 10-K for the fiscal year ended December 31, 2013. 18



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Source: Edgar Glimpses