Daktronics Inc: Form 10-Q for the period ended Jan 27, 2024

FORWARD-LOOKING STATEMENTS

This section entitled "Management’s Discussion and Analysis of Financial Condition and Results of Operations" (“MD&A”) is intended to provide a reader of our financial statements with a narrative from the perspective of management on our financial condition, results of operations, liquidity, and certain other factors that may affect our future results. The MD&A provides a narrative analysis explaining the reasons for material changes in the Company’s (i) financial condition during the period from the most recent fiscal year-end, April 29, 2023, to and including January 27, 2024 and (ii) results of operations during the current fiscal period(s) as compared to the corresponding period(s) of the preceding fiscal year.

This Quarterly Report on Form 10-Q, including the MD&A, contains "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. These statements reflect our current views with respect to future events and financial performance. The words "may," "would," "could," "should," "will," "expect," "estimate," "anticipate," "believe," "intend," "plan," "forecast," "project" and similar expressions are intended to identify forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Any and all forecasts and projections in this document are “forward-looking statements” and are based on management’s current expectations or beliefs. From time to time, we may also provide oral and written forward-looking statements in other materials we release to the public, such as press releases, presentations to securities analysts or investors, or other communications by us. Any or all forward-looking statements in this report and in any public statements we make could be materially different from actual results. Accordingly, we wish to caution investors that any forward-looking statements made by or on behalf of us are subject to uncertainties and other factors that could cause actual results to differ materially from such statements. Important factors that may cause actual results to differ materially from those in the forward-looking statements include, but are not limited to, the uncertainties related to market conditions and entry into a financing transaction; the Company’s potential need to seek additional strategic alternatives, including seeking additional debt or equity capital or other strategic transactions and/or measures; the Company’s ability to finalize or fully execute actions and steps that would be probable of mitigating the existence of any “substantial doubt” regarding the Company’s ability to continue as a going concern; the Company’s ability to increase cash flow to support the Company’s operating activities and fund its obligations and working capital needs; our ability to obtain additional financing on terms favorable to us, or at all; any future goodwill impairment charges; and the other risk factors described more fully in the Company’s Annual Report on Form 10-K for the fiscal year ended April 29, 2023 filed with the Securities and Exchange Commission, as well as other publicly available information about the Company.

We also wish to caution investors that other factors might in the future prove to be important in affecting our results of operations. New factors emerge from time to time; it is not possible for management to predict all of such factors, nor can it assess the impact of each such factor on the business or the extent to which any factor, or a combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements.

We undertake no obligation to update publicly or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

Our MD&A should be read in conjunction with the Consolidated Financial Statements and related Notes included in Item 1 of Part 1 of this Quarterly Report on Form 10-Q and our Annual Report on Form 10-K for the fiscal year ended April 29, 2023 (including the information presented therein under Risk Factors), as well as other publicly available information about our Company.

OVERVIEW

We are engaged principally in the design, marketing, and manufacture of a wide range of integrated electronic display systems and related products which are sold in a variety of markets throughout the world and the rendering of related maintenance and professional services. We focus our sales and marketing efforts on markets, geographical regions and products. Our five business segments consist of four domestic business units and the International business unit. The four domestic business units consist of Commercial, Live Events, High School Park and Recreation, and Transportation, all of which include the geographic territories of the United States and Canada.

The following selected financial data should be read in conjunction with our Annual Report on Form 10-K for the fiscal year ended April 29, 2023 and the consolidated financial statements set forth in that Annual Report on Form 10-K, including the notes to consolidated financial statements included therein.

CURRENT CONDITIONS

Our past investments in people and plant capacity and the continued stable supply chain environment have allowed for efficient production and fulfillment of orders. Although the post-pandemic geopolitical situation and global trade patterns continue to evolve, we believe that the levels of uncertainty and volatility in supply chain and demand will not be as great as it was through the pandemic and will continue to stabilize during this fiscal year.

We believe the audiovisual industry fundamentals of increased use of LED display systems across industries and our development of new technologies, services, and sales channels will drive long-term growth for our Company. Orders and revenue levels are expected to be impacted by the timing of multi-million dollar projects and the impacts of global economic conditions, war and geopolitical situations, or other factors outside of our control.

RESULTS OF OPERATIONS

COMPARISON OF THE THREE MONTHS ENDED JANUARY 27, 2024 AND JANUARY 28, 2023

Product Order Backlog

Backlog represents the dollar value of orders for integrated electronic display systems and related products and services which are expected to be recognized in net sales in the future. Orders are contractually binding purchase commitments from customers. Orders are included in backlog when we are in receipt of an executed contract and any required deposits or security and have not yet been recognized into net sales. Certain orders for which we have received binding letters of intent or contracts will not be included in backlog until all required contractual documents and deposits are received. Orders and backlog are not measures defined by accounting principles generally accepted in the United States of America ("GAAP"), and our methodology for determining orders and backlog may vary from the methodology used by other companies in determining their orders and backlog amounts.

Order and backlog levels provide management and investors additional details surrounding the results of our business activities in the marketplace and highlight fluctuations caused by seasonality and multi-million dollar projects. Management uses orders to evaluate market share and performance in the competitive environment. Management uses backlog information for capacity and resource planning. Order fulfillment timing is dependent on customer schedules, supply chain conditions, and our capacity availability. We believe order information is useful to investors because it provides an indication of our market share and future revenues.

Our product order backlog as of January 27, 2024 was $328.3 million as compared to $429.1 million as of January 28, 2023 and $400.7 million at April 29, 2023. The decrease in backlog is trending down to more historical levels as a result of fulfilling orders at a greater pace as supply chain conditions stabilized and production lead times improved, utilizing our increased capacity, and order pace returning to more normalized rates.

We expect to fulfill the backlog as of January 27, 2024 within the next 24 months. The timing of backlog fulfillment may be impacted by project delays resulting from parts availability and other constraints stemming from the supply chain disruptions or by customer site conditions, which are outside our control.

Net Sales

The following table shows information regarding net sales for the three months ended January 27, 2024 and January 28, 2023:

(in thousands)

(1) Orders are not measures defined by GAAP, and our methodology for determining orders may vary from the methodology used by other companies in determining their orders and amounts.

For the fiscal 2024 third quarter, net sales were $170.3 million, a decrease of $14.7 million from net sales in the prior year's third quarter. The third quarter of every year is characterized by seasonally lower volume, and the decrease is attributable to the year-ago period’s unseasonably record revenue driven by high backorder fulfillment resulting from recovery of pandemic-related supply chain challenges and labor availability. The sales decrease was driven by comparatively lower volumes in the Commercial and International business units, partially offset by order fulfillments in the Live Events, High School Park and Recreation, and Transportation business units.

Orders for the third quarter of fiscal 2024 increased by 29.4 percent from the third quarter of fiscal 2023 driven by strong demand in the Live Events business unit, rebounding demand in the Spectacular and Out-of-Home markets in our Commercial business unit, and solid growth in the High School Parks and Recreation and Transportation business units. These higher orders offset an order decrease in the International business unit.

Gross Profit and Contribution Margin

(in thousands)

The gross profit improvement for the third quarter of fiscal 2024 as compared to the same period in fiscal 2023 is due to strategic pricing, greater efficiency of sales volume generation over the cost structure, and a more stable operating environment.

Total warranty costs as a percent of sales for the three months ended January 27, 2024 compared to the same period one year ago increased to 1.9 percent from 1.7 percent.

(in thousands)

Contribution margin is a non-GAAP measure and consists of gross profit less selling expenses. Selling expenses consist primarily of personnel-related costs, travel and entertainment expenses, marketing related expenses (show rooms, product demonstration, depreciation and maintenance, conventions and trade show expenses), the cost of customer relationship management/marketing systems, bad debt expenses, third-party commissions, and other expenses.

Contribution margin as a percent of net sales for the fiscal quarter ended January 27, 2024 was positively impacted by the previously discussed impacts on gross profit.

Reconciliation from non-GAAP contribution margin to the operating income GAAP measure is as follows:

(in thousands)

General and administrative expenses in the third quarter of fiscal 2024 increased as compared to the third quarter of fiscal 2023 primarily due to an increase in personnel-related expenses.

Product design and development expenses in the third quarter of fiscal 2024 increased as compared to the third quarter of fiscal 2023 primarily due to an increase in personnel-related expenses.

We recorded a $4.6 million non-cash goodwill impairment charge during the third quarter of fiscal 2023 that was not repeated in the third quarter of fiscal 2024.

Other Income and Expenses

(in thousands)

Interest (expense) income, net: The increase in interest income and expense, net for the third quarter of fiscal 2024 compared to the same period one year ago was primarily due to closing in May 2023 on the convertible note (the "Convertible Note") and asset-based and mortgage financings at higher values and interest rates than were in effect under our previous line of credit during the 2023 third quarter.

Change in fair value of Convertible Note: For the three months ended January 27, 2024, we recorded income of $6.3 million related to the change in fair value of the Convertible Note payable, which is accounted for under the fair value option. The fair value change was primarily caused by the decrease in our stock price during the third quarter of fiscal year 2024 compared to the second quarter of fiscal year 2024.

Other expense, net: The change in other expense, net for the third quarter of fiscal 2024 as compared to the same period one year ago was primarily due to losses recorded for equity method affiliates and foreign currency volatility.

Income Taxes

Our effective tax rate for the third quarter of fiscal 2024 was 15.0 percent as compared to an effective tax rate of 30.5 percent for the third quarter of fiscal 2023. The lower tax rate for the third quarter of fiscal 2024 is caused by the reduction in fair value adjustment to income that is not taxable.

RESULTS OF OPERATIONS

COMPARISON OF THE NINE MONTHS ENDED JANUARY 27, 2024 AND JANUARY 28, 2023

Net Sales

The following table shows information regarding net sales for the nine months ended January 27, 2024 and January 28, 2023:

(in thousands)

(1) Orders are not measures defined by GAAP, and our methodology for determining orders may vary from the methodology used by other companies in determining their orders and amounts.

For the first nine months of fiscal 2024, net sales were $602.2 million, an increase of $57.9 million from the prior year's first nine-month period. This increase was primarily due to higher throughput from our past investments in capacity and the more stable operating environment. During the nine-month period ended January 28, 2023, we faced material supply and labor shortages which extended lead times and delayed the conversion of orders into sales.

Order volume increased in the first nine months of fiscal 2024 from the prior year's nine-month period. Higher orders from customers in the Live Events, High School Park and Recreation, and Transportation business units offset decreases in the Spectacular and Out-of-Home markets in our Commercial business unit. The change in the Commercial business unit was caused by volatility in bookings of larger sized Spectacular LED video displays projects and a contraction in advertising spend. Orders in the International business unit in the first nine months of fiscal 2024 were lower due to a weakening economic outlook relating to inflationary pressures, geopolitical events, and currency headwinds.

Gross Profit and Contribution Margin

(in thousands)

The increase in gross profit percentage in the nine months ended January 27, 2024 as compared to the same nine-month period in fiscal 2023 is attributable to the record sales volume over our fixed manufacturing cost structure, past strategic pricing actions, stabilization of input costs, and fewer supply chain and operational disruptions during the first nine months of fiscal 2024 as compared to a year earlier. The effect of employee benefit programs activation in fiscal year 2024 reduced gross profit by $2.8 million in the nine months ended January 27, 2024.

Total warranty costs as a percent of sales for the nine months ended January 27, 2024 compared to the same period one year ago increased to 2.1 percent from 2.0 percent.

(in thousands)

Contribution margin is a non-GAAP measure and consists of gross profit less selling expenses. Selling expenses consist primarily of personnel-related costs, travel and entertainment expenses, marketing related expenses (show rooms, product demonstration, depreciation and maintenance, conventions and trade show expenses), the cost of customer relationship management/marketing systems, bad debt expenses, third-party commissions, and other expenses.

Contribution margin for the first nine months of fiscal 2024 was positively impacted by the previously discussed sales levels and impacts on gross profit. Employee benefit programs activation reduced contribution margin by $1.0 million in the nine months ended January 27, 2024.

Reconciliation from non-GAAP contribution margin to the operating income GAAP measure is as follows:

(in thousands)

General and administrative expenses in the first nine months of fiscal 2024 increased primarily due to an increase in personnel-related expenses.

Product design and development expenses in the first nine months of fiscal 2024 increased as compared to the first nine months of fiscal 2023 primarily due to an increase in personnel-related expenses.

We recorded a $4.6 million non-cash goodwill impairment charge during the third quarter of fiscal 2023 that was not repeated in the third quarter of fiscal 2024.

Other Income and Expenses

(in thousands)

Interest (expense) income, net: The increase in interest income and expense, net in the first nine months of fiscal 2024 compared to the same period one year ago was primarily due to closing in May 2023 on the Convertible Note and asset-based and mortgage financings at higher values and interest rates than the utilization of our previous line of credit during the first nine months of fiscal 2023.

Change in fair value of Convertible Note: For the nine months ended January 27, 2024, we recorded an expense of $11.6 million related to the change in fair value of the Convertible Note payable which is accounted for under the fair value option. The fair value change was primarily caused by the increase in our stock price over the conversion price and the decline in market interest rates making the value of potentially converted shares higher than at the debt issuance.

Other expense, net: The change in other expense, net for the first nine months of fiscal 2024 as compared to the same period one year ago was primarily due to losses recorded for equity method affiliates and foreign currency volatility and expensing of $3.4 million of debt issuance costs related to the Convertible Note carried at fair value.

Income Tax

We have recorded an effective tax rate of 31.5 percent for the nine months ended January 27, 2024. The tax rate for the first nine months of fiscal 2024 is caused by the fair value adjustment to expense that is not deductible for tax purposes. The effective tax rate for the first nine months of fiscal 2023 was skewed due a full valuation allowance placed on deferred taxes. Absent any major tax changes, we expect our full year effective tax rate to be in the mid-twenties, before the impacts of fair value accounting for the Convertible Note.

LIQUIDITY AND CAPITAL RESOURCES

(in thousands)

Net cash provided by (used in) operating activities: Net cash provided by operating activities was $53.8 million for the first nine months of fiscal 2024 compared to net cash used in operating activities of $9.5 million in the first nine months of fiscal 2023. The $63.3 million change in cash provided by (used in) operating activities was primarily the result of an increase in net income of $46.7 million in the first nine months of fiscal 2024 compared to the same period in fiscal 2023 as strategic pricing actions and operating conditions improved, the $11.6 million of non-cash fair value change of our Convertible Note impacting net income, and improved working capital positions. We also had strategically invested in inventory through the first nine months of fiscal 2023 as a reaction to supply chain constraints and historic backlog, which consumed cash. Since January 28, 2023, we have reduced inventory and related payables for inventory as we reduced backlog and generated cash from inventory reduction. Increases in contract asset levels have used some cash for working capital because of business increases.

The changes in net operating assets and liabilities consisted of the following:

31

Net cash used in investing activities: Net cash used in investing activities totaled $17.1 million in the first nine months of fiscal 2024 compared to net cash used in investing activities of $20.9 million in the first nine months of fiscal 2023. Purchases of property and equipment totaled $13.6 million in the first nine months of fiscal 2024 compared to $21.8 million in the first nine months of fiscal 2023. Fiscal 2023 purchases were higher because of initiatives to upgrade existing or purchase new manufacturing equipment for capacity and automation.

Net cash provided by financing activities: Net cash provided by financing activities was $15.7 million for the nine months ended January 27, 2024 due to cash provided by the closing of a $25.0 million Convertible Note financing and the $15.0 million mortgage financing offset by the payoff of our previous credit line of $17.8 million, expending $6.8 million of debt issuance costs, and principal payments on the mortgage, as compared to $23.5 million of cash provided by financing due to draws on our line of credit in the first nine months of fiscal 2023.

Debt and cash

We maintain a $60.0 million asset-based revolving credit facility ("ABL") with a maturity date of May 11, 2027 subject to customary covenants and conditions. As of January 27, 2024, we had no borrowings against the ABL and $5.4 million used to secure letters of credit outstanding. We also have a mortgage of $14.3 million secured by a first priority lien on our Brookings, South Dakota real estate and $25.0 million evidenced by the Convertible Note secured by a second priority lien on assets securing the ABL facility and a first priority lien on substantially all the other assets of the Company, excluding all real property.

As of January 27, 2024, we had $76.8 million in cash and cash equivalents and $32.9 million in borrowing capacity under our ABL. We believe cash flow from operations, existing lines of credit, and access to debt and capital markets will be sufficient to meet our current liquidity needs, and we have committed liquidity and cash reserves in excess of our anticipated funding requirements.

Our cash and cash equivalent balances consist of high-quality, short-term money market instruments.

Working Capital

Working capital was $205.3 million and $132.5 million as of January 27, 2024 and April 29, 2023, respectively. We had $10.4 million of retainage on long-term contracts included in receivables and contract assets as of January 27, 2024 which we expect to collect within one year and which are included in the short-term asset portion of working capital.

Other Liquidity and Capital Uses

We are sometimes required to obtain performance bonds for display installations; we have a bonding line available through surety companies for an aggregate of $190.0 million in bonded work outstanding. If we were unable to complete the installation work, and our customer would call upon the bond for payment, the surety company would subrogate its loss to Daktronics. As of January 27, 2024, we had $45.7 million of bonded work outstanding.

Our business growth and profitability improvement strategies depend on investments in capital expenditures and strategic investments. We are projecting total fiscal 2024 capital expenditures to be approximately $19 million, of which we have incurred $13.6 million for the first nine months of the fiscal 2024. Projected capital expenditures include purchasing manufacturing equipment for new or enhanced product production and expanded capacity and increased automation of processes; investments in quality and reliability equipment and demonstration and showroom assets; and continued information infrastructure investments.

We also evaluate and may make strategic investments in new technologies or in our affiliates or acquire companies aligned with our business strategy. We are committed to invest an additional $0.8 million for the remainder of fiscal 2024 in our current affiliates. We may make additional investments beyond our commitments.

Contractual Obligations and Commercial Commitments

During the first nine months of fiscal 2024, we entered into a new credit facility and mortgage and the Convertible Note as disclosed herein. There have been no other material changes in our contractual obligations since the end of fiscal 2023. See our Annual Report on Form 10-K for the fiscal year ended April 29, 2023 for additional information regarding our contractual obligations and commercial commitments.

Significant Accounting Policies and Estimates

We describe our significant accounting policies in "Note 1. Nature of Business and Summary of Significant Accounting Policies" of the Notes to Consolidated Financial Statements included in our Annual Report on Form 10-K for the fiscal year ended April 29, 2023. We discuss our critical accounting estimates in "Part II, Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations" in our Annual Report on Form 10-K for the fiscal year ended April 29, 2023.

New Accounting Pronouncements

For a summary of recently issued accounting pronouncements and the effects of those pronouncements on our financial results, refer to "Note 1. Basis of Presentation" of the Notes to the Condensed Consolidated Financial Statements.

We are exposed to certain interest rate, foreign currency, and commodity risks as disclosed in our Annual Report on Form 10-K for the fiscal year ended April 29, 2023. During the first quarter of fiscal 2024, we entered into the ABL and the $15.0 million delayed draw loan, which are subject to interest rate risks.

There have been no other material changes in our exposure to these risks during the first nine months of fiscal 2024.

Evaluation of Disclosure Controls and Procedures

Management of our Company is responsible for establishing and maintaining effective disclosure controls and procedures as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934. As of January 27, 2024, an evaluation was performed, under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that as of January 27, 2024, our disclosure controls and procedures were not effective due to the material weakness in internal control over financial reporting described below.

Notwithstanding this identified material weakness, our Chief Executive Officer and Chief Financial Officer believe the condensed consolidated financial statements included in this Quarterly Report on Form 10-Q fairly represent, in all material respects, our financial condition, results of operations and cash flows for the periods presented in conformity with accounting principles generally accepted in the United States of America. We are in the process of remediating the material weakness in our internal control, as described below under the section entitled "Remediation Plan".

Material Weakness in Internal Control Over Financial Reporting

In Part 2, Item 9A of our Annual Report on Form 10-K for the fiscal year ended April 29, 2023, which was filed with the Securities and Exchange Commission on July 12, 2023, management concluded that our internal control over financial reporting was not effective as of April 29, 2023. Management identified a material weakness related to the ineffective operation of certain transactional level controls related to revenue contracts recognized over time. These controls operated ineffectively due to insufficient training of the control operators as to the level of precision expected when executing the revenue controls in accordance with the Company's policy.

Remediation Plan

Our remediation plan includes providing training to the revenue control operators relating to the level of precision expected when executing these controls in accordance with the Company's policy. During the first nine months of fiscal 2024, we conducted additional training of our control operators. In conjunction with the training, management made enhancements to improve and ensure operation of certain transactional level controls.

Changes in Internal Control Over Financial Reporting

During the quarter ended January 27, 2024, there have been no changes in our internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

The discussion of our business and operations included in this Quarterly Report on Form 10-Q should be read together with the risk factors described in Item 1A. of Part I of our Annual Report on Form 10-K for the fiscal year ended April 29, 2023. They describe various risks and uncertainties to which we are or may become subject. These risks and uncertainties, together with other factors described elsewhere in this Report, have the potential to affect our business, financial condition, results of operations, cash flows, strategies or prospects in a material and adverse manner. New risks may emerge at any time, and we cannot predict those risks or estimate the extent to which they may affect our financial condition or financial results.