News Column

TOROTEL INC - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations

July 3, 2014

Torotel, Inc. ("Torotel") conducts business primarily through its wholly owned subsidiary, Torotel Products, Inc. ("Torotel Products"), but it also operates another wholly owned subsidiary Electronika, Inc. ("Electronika"). Another subsidiary, Torotel Manufacturing Corporation ("TMC"), provided manufacturing services to Torotel Products. TMC ceased activities on December 31, 2012.

Overview

Introduction

Torotel Products specializes in the custom design and manufacture of a wide variety of precision magnetic components and electro-mechanical assemblies for use in military, commercial aerospace and industrial electronic applications. These products are used to modify and control electrical voltages and currents in electronic devices. Torotel Products sells these magnetic components and electro-mechanical assemblies to original equipment manufacturers, which use them in products such as:

aircraft navigational equipment;

digital control devices; medical equipment; avionics systems; radar equipment; down-hole drilling;



conventional missile guidance systems; and

other aerospace and defense applications.

The primary factors that drive our gross profit and net earnings are sales volume and product mix. The gross profits on mature products/programs and complex transformer devices tend to be higher than those that are still in the prototyping or early production stages and simpler inductor devices. As a result, in any given accounting period the mix of product shipments between higher and lower margin jobs has a significant impact on our gross profit and net earnings. Our operating plan continues to focus on expanding the product base beyond electronic components.

9 --------------------------------------------------------------------------------



The industry mix of Torotel Products' net sales in fiscal year 2014 was 65% defense, 26% commercial aerospace and 9% industrial compared to 64% defense, 26% commercial aerospace and 10% industrial in fiscal year 2013. We believe the mix in fiscal year 2015 will remain weighted primarily towards defense.

Electronika is a marketing and licensing company selling ballast transformers to the airline industry. These transformers activate and control the lights in airplane cockpits and passenger compartments. Electronika's ballast transformers are used as spare and replacement parts in older DC and MD model aircraft. Electronika's net sales continue to be impacted by the decline in the number of active DC-8 and DC-9 aircraft. We expect these sales to continue to decline and eventually phase out as more of these aircraft are retired.

Business and Industry Considerations

Defense Markets

During fiscal years 2014 and 2013, the amount of consolidated revenues derived from contracts with prime contractors of the U.S. Department of Defense ("DoD") was approximately 65% and 64%, respectively. As a result, our financial results in any period could be impacted substantially by spending cuts in the DoD budget and the funds appropriated for certain military programs.

Notwithstanding the uncertainty associated with the DoD budget, we believe our overall defense business outlook remains favorable due to the present demand for the potted coil assembly for the Hellfire II missile system and other existing orders for electro-mechanical assemblies from major defense contractors. As of April 30, 2014, our consolidated order backlog for the defense market was nearly $5.4 million, which included approximately $4.3 million for the potted coil assembly.

Commercial Aerospace and Industrial Markets

We provide magnetic components and electro-mechanical assemblies for a variety of applications in the aerospace and industrial markets. The primary demand drivers for these markets include commercial aircraft orders, oil and gas drilling exploration activity, and general economic growth. While global economic growth remains positive, the above demand drivers could be impacted by short-term changes in the economy such as spikes in the price of oil, war, terrorism, or changes in regulation. Other threats to our anticipated positive near-term and long-term market outlook include delays on the development and production of new commercial aircraft and competition from international suppliers. As of April 30, 2014, our consolidated order backlog for the aerospace and industrial markets was $1.7 million.

Business Outlook

Our order activity for fiscal year 2014, exclusive of the potted coil assembly, increased 15% to $7.7 million. This amount consisted of $6.5 million in magnetic components, $800,000 for electro-mechanical assemblies and $400,000 for large dry-type transformers. As for the potted coil assembly, $4.3 million remains to be produced on the $8.3 million contract award received at the end of fiscal year 2013. As a result, our consolidated order backlog for all products heading into the new fiscal year is approximately $7.2 million. We do anticipate a new contract for the potted coil assembly will be awarded in the second half of fiscal year 2015. We also anticipate contract awards for new electro-mechanical assemblies, as well as for several new magnetic component opportunities in the commercial aerospace and defense markets, which should contribute to our continued sales growth in fiscal year 2015.

Consolidated Results of Operations

The following management comments regarding Torotel's results of operations and outlook should be read in conjunction with the Consolidated Financial Statements included pursuant to Item 8 of this Annual Report. The results of Torotel Products and TMC have been consolidated for discussion purposes. While each company's results are included in the following discussion, segment reporting is not applicable because the products offered are similar in form and function, and target similar markets.

10 --------------------------------------------------------------------------------

Net Sales Years ended April 30, 2014 2013 Torotel Products: Magnetic components $ 6,302,000$ 5,759,000



Potted coil assembly $ 5,326,000$ 4,738,000 Electro-mechanical assemblies $ 1,296,000$ 1,409,000 Injection molded products $ - $ 70,000

Large Transformers $ 174,000 $ - Total Torotel Products $ 13,098,000$ 11,976,000 Electronika

$ 2,000$ 5,000



Total consolidated net sales $ 13,100,000$ 11,981,000

Consolidated net sales in fiscal year 2014 increased nearly 9%, or $1,119,000, as compared to fiscal year 2013. For that period, Torotel Products' net sales increased $1,122,000, or 9%, primarily due to higher demand for magnetic components, and a higher number of potted coil assembly units shipped. Electronika's net sales represented a small portion of consolidated net sales and sales continue to fluctuate within a small range as overall demand for the ballast transformers is very limited. Consolidated net sales in fiscal year 2013 increased nearly 11%, or $1,153,000, as compared to fiscal year 2012. For that period, Torotel Products' net sales increased $1,168,000, or 11%, primarily due to higher unit volume for magnetic components combined with a higher average unit selling price, and higher shipments of electro-mechanical assemblies. These sales increases were offset partially by lower shipments of the potted coil assembly due to production delays resulting from a customer requested change in the painting process. As disclosed previously in Item 1 Business, production of the injection molded products was discontinued in the first quarter of fiscal year 2013. Electronika's net sales represented a small portion of consolidated net sales and decreased $15,000 from fiscal year 2012 to fiscal year 2013. Electronika's sales continue to fluctuate within a small range as overall demand for the ballast transformers is very limited.

Gross Profit Years ended April 30, 2014 2013 Torotel Products: Gross profit $ 4,591,000$ 4,099,000



Gross profit % of net sales 35 % 34 % Electronika: Gross profit

$ 1,000$ 3,000



Gross profit % of net sales 60 % 60 % Combined: Gross profit

$ 4,592,000$ 4,102,000



Gross profit % of net sales 35 % 34 %

Gross profit as a percentage of net sales in fiscal year 2014 increased 1% as compared to fiscal year 2013. The gross profit percentage of Torotel Products for that period increased because of higher sales without a corresponding increase in fixed production costs and higher direct margins associated with the product mix. The gross profit percentage of Electronika represented a small portion of consolidated gross profit. Gross profit as a percentage of net sales in fiscal year 2013 increased 7% as compared to fiscal year 2012. The gross profit percentage of Torotel Products for that period increased 7% because of lower direct labor costs associated with the personnel reductions implemented in the prior year, higher sales without a corresponding increase in fixed production costs, and higher margins associated with the product mix. The gross profit percentage of Electronika remained unchanged as it is fixed by the Manufacturing Agreement with Magnetika, Inc.

11 -------------------------------------------------------------------------------- Operating Expenses Years ended April 30, 2014 2013 Engineering $ 602,000$ 535,000



Selling, general and administrative 3,187,000 2,519,000 Total

$ 3,789,000$ 3,054,000



Engineering expense increased 13%, or $67,000, in fiscal year 2014 as compared to fiscal year 2013. This increase primarily resulted from an increase in compensation costs due to the hiring of additional engineers to provide expanded technical capabilities.

Engineering expense increased 2% in fiscal year 2013 as compared to fiscal year 2012. This increase was primarily due to higher travel costs. Selling, general and administrative expenses increased 27%, or $668,000, in fiscal year 2014 as compared to fiscal year 2013. This increase primarily resulted from an increase of $279,000 in payroll, an increase of $154,000 in stock appreciation rights, an increase of $85,000 in accounting and professional fees, an increase of $75,000 in training, a $53,000 increase in health insurance costs, an increase of $50,000 in travel and entertainment expenses, a $17,000 increase in advertising, and a $16,000 increase in commissions. These increases were partially offset by decreases in recruiting costs, equipment rental, and janitorial expenses. Selling, general and administrative expenses increased nearly 6%, or $153,000, in fiscal year 2013 as compared to fiscal year 2012. This increase primarily resulted from a $72,000 increase in deferred compensation expense related to the change in fair value of stock appreciation rights, a $68,000 change in stock compensation expense related to the forfeiture of restricted stock in both years, a $66,000 increase in operating expenses, a $41,000 increase in insurance costs, and a $38,000 increase in professional fees including legal fees and accounting fees. These increases were partially offset by a $39,000 decrease in training costs, a $42,000 decrease in sales discounts not taken by large customers, and a $64,000 decrease in travel costs. Earnings from Operations

Years ended April 30, 2014 2013 Torotel Products $ 1,286,000$ 1,336,000 Electronika - 3,000 Torotel (483,000 ) (291,000 ) Total $ 803,000$ 1,048,000



For the reasons discussed in the Net Sales, Gross Profit, and Operating Expenses found above, consolidated earnings from operations decreased by 23%, or $245,000, in fiscal year 2014 as compared to fiscal year 2013, and increased by 97%, or $1,017,000, in fiscal year 2013 as compared to fiscal year 2012. Other Earnings Items

Years ended April 30, 2014 2013 Earnings from operations $ 803,000$ 1,048,000 Interest expense (34,000 ) (42,000 ) Loss on asset disposal - (3,000 )



Earnings before income taxes 769,000 1,003,000 Benefit for income taxes (103,000 ) (218,000 ) Net earnings (loss) $ 872,000$ 1,221,000

Interest expense decreased by 19%, or $8,000, in fiscal year 2014 as compared to fiscal year 2013 primarily due to lower levels of capital leases and debt. Income tax benefit decreased by $115,000 in fiscal year 2014 as compared to fiscal year 2013.

12 -------------------------------------------------------------------------------- Interest expense decreased $5,000 in fiscal year 2013 as compared to fiscal year 2012 primarily due to a lower debt level. Loss on asset disposal increased by $3,000 in fiscal year 2013 as compared to fiscal year 2012 due to the disposal of damaged assets. Income tax benefit increased by $218,000 in fiscal year 2013 as compared to fiscal year 2012. We have adjusted the valuation allowance because we anticipate the realization of a portion of our deferred income tax assets that are expected to reverse within the next few fiscal years, which has reduced the provision for income taxes. The remaining valuation allowance is specifically related to impairment on an investment that would result in a capital loss for tax purposes that we do not anticipate realizing due to the absence of offsetting capital gain income. We evaluate the appropriateness of our deferred income tax asset valuation allowance on a quarterly basis and continue to consider positive and negative trends in our industry that could affect our determination. We believe that our current adjustment to the valuation allowance is appropriate due to anticipated stronger demand over the next few fiscal years related to a number of anticipated contract awards for new business in the aerospace and defense markets. The information regarding these new anticipated awards was made available to us during the fourth quarter. We believe that this increase in demand should generate sufficient taxable earnings to enable us to realize our net deferred tax assets except as discussed above, thus outweighing any negative evidence concerning the cyclical and competitive nature of our industry. Also, we have achieved consistent taxable earnings in recent fiscal years, we have established a recent history of utilizing our net deferred tax asset, our available carryforward periods of our net operating losses are of sufficient length and are at minimum risk of expiring unused, and our products are included in applications that generally have a longer lifecycle. Return on Capital Employed Return on Capital Employed ("ROCE") is the primary benchmark used by management to evaluate Torotel's performance. ROCE measures how effectively and efficiently net operating assets (NOA) are used to generate earnings before interest and taxes (EBIT). For these purposes, NOA, or Capital Employed, is defined as "accounts receivable + inventory + net fixed assets + miscellaneous operating assets - accounts payable - miscellaneous operating liabilities". The performance of Torotel's management and the majority of its decisions will be measured by whether Torotel's ROCE improves. For the fiscal years ended April 30, 2014 and 2013, Torotel's ROCE was 20.70% and 29.41%, respectively. The decrease in ROCE for fiscal year 2014 is largely attributed to the higher raw materials inventory related to products anticipated to ship in fiscal year 2015, higher accounts receivable amounts in fiscal year 2014, an increase in the deferred tax asset, higher stock appreciation rights expense, and lower earnings from operations in fiscal year 2014.



Financial Condition and Liquidity

Cash generated by operations is our primary source of liquidity. The following table highlights the funds available to us as of April 30, 2014 and 2013:

2014 2013 Cash $ 2,038,000$ 1,593,000



Amount available under our line of credit $ 500,000$ 500,000 Amount available under our equipment loan $ 236,000$ 120,000

Operating Activities

2014 2013



Net cash provided by operating activities $ 724,000$ 1,664,000

The decrease of $940,000 between fiscal year 2014 and fiscal year 2013 is primarily due to a decrease in earnings from operations, a decrease in customer deposits, an increase in trade receivables, and an increase in inventory. The decrease in customer deposits is due to management's decision to forego milestone payments on the new potted coil assembly contract. The increase in trade receivables is due to higher business volume. The average days to collect accounts receivable is currently 39 days as of April 30, 2014, which is consistent with our industry. The increase in inventory is related to a build-up of raw material for assembly production that was delayed by the customer from fiscal year 2014 to fiscal year 2015.

13 --------------------------------------------------------------------------------



Investing Activities

2014 2013



Net cash provided by investing activities $ (135,000 )$ (229,000 )

The change of $94,000 was due to lower capital expenditures in fiscal year 2014 as compared to fiscal year 2013. During fiscal year 2013, the capital expenditures were mostly due to the implementation of a new enterprise resource planning system. Capital expenditures during fiscal year 2014 were primarily related to purchases of new production equipment and machinery. We expect capital expenditure spending to increase during fiscal year 2015 to $250,000 which is consistent with the anticipated needs of our business. Financing Activities

2014 2013



Net cash provided by financing activities $ (144,000 )$ (150,000 )

We have used cash generated by operating activities as the primary source for the repayment of our debt. The change of $6,000 between fiscal year 2014 and fiscal year 2013 is due to a reduction in capital lease obligations. Subsequent to April 30, 2014, we received proceeds of $100,000 from additional borrowing on our existing equipment loan to purchase additional machinery and equipment. Please see Note 16 of Notes to the Consolidated Financial Statements for more information on this activity. Capital Resources We believe that the projected cash flow from operations, combined with existing cash balances, will be sufficient to meet our funding requirements for the foreseeable future. We have a $500,000 bank line of credit available which could be utilized to help fund any working capital requirements, subject to the adequacy of our borrowing base and other conditions. During fiscal year 2014 we did not utilize this line of credit. We believe that inflation will have only a minimal effect on future operations since such effects should be offset by sales price increases, which are not expected to have a significant effect upon demand. In addition, we do not believe that inflation had a significant effect on our operations during the past two fiscal years.



Critical Accounting Policies

The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect certain reported amounts and disclosures. Such judgments affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We continuously evaluate our estimates and assumptions including those related to computing the carrying value of equipment, allowance for doubtful accounts receivable, the valuation allowance on deferred tax assets and the reserve for warranty costs. Accordingly, actual results could differ from those estimates, and such differences may be material. Any changes in estimates are recorded in the period in which they become known.

The following is a summary of the most critical accounting policies used in the preparation of our consolidated financial statements.

Revenue Recognition

Revenue is recognized when a fixed price contract or purchase order exists; delivery has occurred; and collection is reasonably assured. Selling terms are FOB Shipping Point so we consider products delivered once they have been shipped and title and risk of loss have been transferred. Our consolidated net sales arising from contracts having deliveries scheduled over a period of more than one year for fiscal years 2014 and 2013 were approximately 40% and 40%, respectively, primarily because of the contract for the potted coil assembly.

Allowance for Doubtful Accounts

Gross trade accounts receivable are offset with an allowance for doubtful accounts. The allowance for doubtful accounts is our best estimate of the amount of probable credit losses in our existing accounts receivable. We review the allowance for doubtful accounts on a regular basis, and all past due balances are reviewed individually for collectability. Account balances are

14 --------------------------------------------------------------------------------



charged against the allowance when placed for collection. Recoveries of receivables previously written off are recorded when received. The majority of the customer accounts are considered past due after the invoice becomes older than the customer's normal credit terms. Interest is not charged on past due accounts. The allowance for doubtful accounts was $12,000 at the end of eachof fiscal years 2014 and 2013.

Inventories

Inventories are stated at the lower of cost or market. Cost is determined using a FIFO approximated weighted average costing method of valuation. Our industry is characterized by short-term customer commitments and changes in demand, as well as other market considerations. Provisions for obsolete and excess inventory are based on reviews of inventory usage, quantities on hand and latest product demand information from customers. Inventories are reviewed in detail utilizing a 12-month time horizon. Individual part numbers that have not had any usage or purchases in a 12-month time period and do not have any known usage requirements are categorized as obsolete; individual part numbers having more than a 12-month supply based on the current year's usage are categorized as excess. Once specific inventory has been identified as excess or obsolete, the cost of the identified inventory is fully reserved and the cost of the inventory is not recovered until it is sold. The reserve balance is analyzed for adequacy as part of the inventory review each quarter.

Income Taxes

Our annual tax rate is based on our income, statutory tax rates and tax planning opportunities available to us in the various jurisdictions in which we operate. Significant judgment is required in determining our annual tax rate and in evaluating our tax positions. An estimated effective tax rate for a year is applied to our quarterly operating results. In the event there is a significant or unusual item recognized in our quarterly operating results, the tax attributable to that item is separately calculated and recorded at the same time as that item. Tax law requires items to be included in our tax returns at different times than the items are reflected in our financial statements. As a result, our annual tax rate reflected in our financial statements is different than that reported in our tax returns (our cash tax rate). Some of these differences are permanent, such as expenses that are not deductible in our tax return, and some differences reverse over time, such as depreciation expense. These temporary differences create deferred tax assets and liabilities. Deferred tax assets generally represent items that can be used as a tax deduction or credit in our tax returns in future years for which we have already recorded the tax benefit in our income statement. We establish valuation allowances for our deferred tax assets if, based on the available evidence, it is more likely than not that some portion or all of the deferred tax assets will not be realized. Deferred tax liabilities generally represent tax expense recognized in our financial statements for which payment has been deferred, or expense for which we have already taken a deduction in our tax return but have not yet recognized as expense in our financial statements. The accounting for uncertainty in income taxes requires a more-likely-than-not threshold for financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. If necessary, we record a liability for the difference between the benefit recognized and measured for financial statement purposes and the tax position taken or expected to be taken on our tax return. To the extent that our assessment of such tax positions changes, the change in estimate is recorded in the period in which the determination is made. If applicable in a given year, tax-related interest and penalties are classified as a component of income tax expense.


For more stories covering the world of technology, please see HispanicBusiness' Tech Channel



Source: Edgar Glimpses


Story Tools






HispanicBusiness.com Facebook Linkedin Twitter RSS Feed Email Alerts & Newsletters