Motorcar Parts of America Inc: Form 10-Q for the period ended Jun 30, 2013

The following discussion and analysis presents factors that Motorcar Parts of America, Inc. and its subsidiaries (“our,” “we” or “us”) believe are relevant to an assessment and understanding of our consolidated financial position and results of operations. This financial and business analysis should be read in conjunction with our March 31, 2013 audited consolidated financial statements included in our Annual Report on Form 10-K filed with the SEC on June 17, 2013, as amended by the Form 10-K/A filed with the SEC on July 29, 2013.

Disclosure Regarding Private Securities Litigation Reform Act of 1995

This report contains certain forward-looking statements with respect to our future performance that involve risks and uncertainties. Various factors could cause actual results to differ materially from those projected in such statements. These factors include, but are not limited to: the bankruptcy of the Fenco Entities, concentration of sales to certain customers, changes in our relationship with any of our major customers, the increasing customer pressure for lower prices and more favorable payment and other terms, the increasing demands on our working capital, the significant strain on working capital associated with large Remanufactured Core inventory purchases from customers, our ability to obtain any additional financing we may seek or require, our ability to achieve positive cash flows from operations, potential future changes in our previously reported results as a result of the identification and correction of errors in our accounting policies or procedures or the potential material weaknesses in our internal controls over financial reporting, lower revenues than anticipated from new and existing contracts, our failure to meet the financial covenants or the other obligations set forth in our credit agreements and the lenders’ refusal to waive any such defaults, any meaningful difference between projected production needs and ultimate sales to our customers, increases in interest rates, changes in the financial condition of any of our major customers, the impact of high gasoline prices, the potential for changes in consumer spending, consumer preferences and general economic conditions, increased competition in the automotive parts industry, including increased competition from Chinese and other offshore manufacturers, difficulty in obtaining Used Cores and component parts or increases in the costs of those parts, political, criminal or economic instability in any of the foreign countries where we conduct operations, currency exchange fluctuations, unforeseen increases in operating costs, the strategic cooperation agreement, and other factors discussed herein and in our other filings with the SEC.

Management Overview

We are a leading manufacturer, remanufacturer, and distributor of alternators and starters for import and domestic cars, light trucks, heavy duty, agricultural and industrial applications.

Subsequent to the bankruptcy filing of the Fenco Entities, we began selling wheel hub assemblies and wheel hub bearings. These operations were not significant during the three months ended June 30, 2013.

The aftermarket for automobile parts is divided into two markets. The first market is the do-it-yourself (“DIY”) market, which is generally serviced by the large retail chain outlets. Consumers who purchase parts from the DIY channel generally install parts into their vehicles themselves. In most cases, this is a less expensive alternative than having the repair performed by a professional installer. The second market is the professional installer market, commonly known as the do-it-for-me (“DIFM”) market. This market is serviced by the traditional warehouse distributors, the dealer networks, and the commercial divisions of retail chains. Generally, the consumer in this channel is a professional parts installer.

Our products are distributed to both the DIY and DIFM markets and are distributed predominantly throughout North America. We sell our products to the largest auto parts retail and traditional warehouse chains and to major automobile manufacturers for both their aftermarket programs and their warranty replacement programs (“OES”). Demand and replacement rates for aftermarket remanufactured automobile parts generally increase with the age of vehicles and increases in miles driven.

Historically, the largest share of our business was in the DIY market. While that is still the case, our DIFM business is now a significant part of our business. In difficult economic times, we believe consumers are more likely to purchase lower cost replacement parts in both the DIY and DIFM markets. We focus on supplying both these channels with the most cost efficient replacement parts for the consumer to purchase.

The DIFM market is an attractive opportunity for growth. We are positioned to benefit from this market opportunity in two ways: (1) our auto parts retail customers are expanding their efforts to target the DIFM market and (2) we sell our products under private label and our own brand names directly to suppliers that focus on professional installers. In addition, we sell our products to OE manufacturers for distribution to the professional installer both for warranty replacement and their general aftermarket channels. We have been successful in growing sales to this market.

As a result of the deconsolidation of Fenco, we now have one reportable segment based on the way we manage, evaluate and internally report our business activities.

Results of Operations for the Three Months Ended June 30, 2013 and 2012

The following discussion and analysis should be read in conjunction with the financial statements and notes thereto appearing elsewhere herein.

The following table summarizes certain key operating data of our continuing operations for the periods indicated:

(1) Annualized finished goods turnover for the fiscal quarter is calculated by multiplying cost of sales for the quarter by 4 and dividing the result by the average between beginning and ending non-core finished goods inventory values for the fiscal quarter. We believe this provides a useful measure of our ability to turn production into revenues.

(2) Annualized return on equity is computed as income from continuing operations for the fiscal quarter multiplied by 4 and dividing the result by beginning shareholders’ equity of continuing operations. Annualized return on equity measures our ability to invest shareholders’ funds profitably.

Net Sales and Gross Profit

The following table summarizes net sales and gross profit of our continuing operations for the three months ended June 30, 2013 and 2012:

Net Sales. Our net sales for the three months ended June 30, 2013 increased by $3,446,000, or 7.4%, to $50,245,000 compared to net sales for the three months ended June 30, 2012 of $46,799,000. The increase in net sales was due primarily to increased sales to our existing customers.

Cost of Goods Sold/Gross Profit. Our cost of goods sold as a percentage of net sales decreased during the three months ended June 30, 2013 to 68.1% from 68.3% for the three months ended June 30, 2012, resulting in a corresponding increase in our gross profit to 31.9% for the three months ended June 30, 2013 from 31.7% for the three months ended June 30, 2012. This increase in gross profit was due primarily to lower per unit manufacturing costs partly offset by a reduction in scrap metal prices that resulted in a decrease in revenue for our scrap metal compared to the three months ended June 30, 2012.

Operating Expenses

The following table summarizes operating expenses of our continuing operations for the three months ended June 30, 2013 and 2012:

General and Administrative. Our general and administrative expenses for the three months ended June 30, 2013 were $9,632,000, which represents an increase of $3,718,000, or 62.9%, from general and administrative expenses for the three months ended June 30, 2012 of $5,914,000. The increase in general and administrative expenses was primarily due to (i) $1,560,000 of increased loss recorded due to the change in the fair value of the warrant liability, (ii) a loss of $733,000 recorded due to the change in the value of the forward foreign currency exchange contracts subsequent to entering into the contracts compared to a loss of $91,000 recorded during the three months ended June 30, 2012, (iii) $493,000 of increased legal fees, (iv) $178,000 of increased general and administrative expenses at our offshore locations, (v) $155,000 of increased consulting expenses primarily related to the requirements of Section 404 of the Sarbanes-Oxley Act of 2002, and (vi) $111,000 of increased share-based compensation expense. These increases were partly offset by $750,000 of decreased bonus expense due to the payment of one-time awards under our Chief Executive Officer’s new employment agreement during the three months ended June 30, 2012. In addition, general and administrative expenses increased during the three months ended June 30, 2013 due to (i) $814,000 of Fenco-related legal and external audit fees and (ii) $304,000 in professional fees incurred in connection with the restructuring of FAPL.

Sales and Marketing. Our sales and marketing expenses for the three months ended June 30, 2013 decreased $41,000, or 2.3%, to $1,731,000 from $1,772,000 for the three months ended June 30, 2012. The decrease was due primarily to $131,000 of decreased advertising and catalog expenses partly offset by $79,000 of increased commissions.

Research and Development. Our research and development expenses increased by $113,000, or 25.9%, to $549,000 for the three months ended June 30, 2013 from $436,000 for the three months ended June 30, 2012. The increase was due primarily to $75,000 of increased consulting fees and $31,000 of increased purchased supplies.

Interest Expense

Interest Expense. Our interest expense for the three months ended June 30, 2013 increased $1,029,000, or 35.5%, to $3,925,000 from $2,896,000 for the three months ended June 30, 2012. Our prior year interest expense reflects $896,000 of interest income in connection with the long-term note receivable from Fenco. The remaining increase in interest expense was due primarily to increased outstanding loan balances and interest on certain vendor payable balances. In addition, our interest expense during the three months ended June 30, 2013 was favorably impacted by lower discount rates on the factored receivables and by a lower balance of receivables discounted.

Provision for Income Taxes

Income Tax. Our income tax expense from continuing operations was $74,000 and $1,434,000 during the three months ended June 30, 2013 and 2012, respectively. The income tax expenses reflect effective income tax rates of 41.8% and 37.7% for the three months ended June 30, 2013 and 2012, respectively. The income tax rates were higher than the federal statutory rates primarily due to state income taxes, which were partially offset by the benefit of lower statutory tax rates in foreign taxing jurisdictions.

Income (Loss) from Discontinued Operations

Income (Loss) from Discontinued Operations. Our income from discontinued operations was $100,877,000 during the three months ended June 30, 2013 compared to a loss from discontinued operations of $12,229,000 for the three months ended June 30, 2012. The income from discontinued operations during the three months ended June 30, 2013 consists of (i) a $118,095,000 gain on the deconsolidation of Fenco, (ii) a loss of approximately $20,464,000 in connection with the guarantee of obligations to certain Fenco suppliers, and (iii) losses of approximately $5,910,000 incurred by Fenco from April 1, 2013 to May 31, 2013. In addition, we recorded income tax benefits of $9,156,000 during the three months ended June 30, 2013.

Liquidity and Capital Resources

Overview

At June 30, 2013, we had working capital of $30,573,000, a ratio of current assets to current liabilities of 1.5:1, and cash of $15,191,000, compared to working capital for our continuing operations of $32,676,000, a ratio of current assets to current liabilities of 1.5:1, and cash of $19,346,000 at March 31, 2013.

During the three months ended June 30, 2013, we used cash generated from the use of our receivable discount programs with certain of our major customers. This source was primarily used to pay down our accounts payable balances, build up our long-term core inventory, repay our term loan, and pay for capital expenditure obligations.

We believe our cash on hand, short-term investments, use of receivable discount programs with certain of our major customers, amounts available under our credit agreement, and other sources are sufficient to satisfy our expected future working capital needs, repayment of the current portion of our term loans, capital lease commitments, and capital expenditure obligations over the next twelve months.

Cash Flows

Net cash used in operating activities from continuing operations was $3,072,000 and $10,606,000 during the three months ended June 30, 2013 and 2012, respectively. The significant changes in our operating activities from continuing operations were due primarily to less significant decreases in accounts payable and accounts receivable during the three months ended June 30, 2013 as compared to the three months ended June 30, 2012.

Net cash used in investing activities of continuing operations was $391,000 and $405,000 during the three months ended June 30, 2013 and 2012, respectively. Our capital expenditures from continuing operations during the three months ended June 30, 2013 and 2012 were $381,000 and $398,000, respectively, primarily related to the purchase of office equipment and equipment for our manufacturing and warehousing facilities.

Net cash used in financing activities of continuing operations was $664,000 for the three months ended June 30, 2013 compared to net cash provided by financing activities from continuing operations of $23,148,000 for the three months ended June 30, 2012. This decrease was due to the repayment of our term loan during the three months ended June 30, 2013 compared to additional borrowings and the net proceeds received from our private placement during the three months ended June 30, 2012.

Capital Resources

Debt

We have the following outstanding credit agreements.

Financing Agreement

We are party to the Financing Agreement, which consists of the Term Loans and the Revolving Loans. The Loans mature on January 17, 2017. The lenders hold a security interest in substantially all of our assets.

The Term Loans require quarterly principal payments of $600,000 per quarter beginning April 1, 2013 and increase to $1,350,000 on October 1, 2013 until the final maturity date. The Term Loans bear interest at rates equal to, at our option, either LIBOR plus 8.5% or a base rate plus 7.5%.

In June 2013, we entered into the Sixth Amendment, under the terms of which the agents and lenders agreed to waive any event of default that would otherwise arise under the Financing Agreement due to the qualification in the opinion by our certified public accountants with respect to the financial statements for the fiscal year ended March 31, 2013. In addition, the Sixth Amendment (i) added a reporting requirement with respect to our liquidity levels and certain inventory purchases and (ii) added a financial covenant under which we must maintain the following levels of liquidity on the following dates unless otherwise consented to by the lenders: on June 28, 2013, an aggregate amount of at least $25,000,000, subject to certain adjustments; on July 31, 2013, an aggregate amount of at least $26,000,000, subject to certain adjustments; and on August 30, 2013, an aggregate amount of at least $27,000,000, subject to certain adjustments. As of June 28, 2013, our liquidity balance exceeded the minimum required amount, subject to certain adjustments, by $6,141,000.

The Financing Agreement, among other things, requires us to maintain certain financial covenants including a maximum senior leverage ratio, a minimum fixed charge coverage ratio, and minimum consolidated earnings before interest, income tax, depreciation and amortization expenses (“EBITDA”). We were in compliance with all financial covenants and reporting requirements under the Financing Agreement as of June 30, 2013.

The following table summarizes the financial covenants required under the Financing Agreement as of June 30, 2013:

There was no outstanding balance on the Revolving Loans at June 30, 2013 and March 31, 2013. As of June 30, 2013, $14,389,000 was available under the Revolving Loans. We had reserved $476,000 of the Revolving Loans for standby letters of credit for workers’ compensation insurance and $1,522,000 for commercial letters of credit as of June 30, 2013.

Strategic Cooperation Agreement

In August 2012, we entered into the Agreement with the Supplier and FAPL. Under the terms of the Agreement, the Supplier agreed to provide a revolving credit line for purchases of automotive parts and components by Fenco in an aggregate principal amount not to exceed $22,000,000, of which $2,000,000 would only be available for accrued interest and other amounts payable. Payment for all purchases became due and payable 120 days after the date of the bill of lading. Any amounts remaining unpaid following the due date would bear interest at a rate of 1% per month. The Fenco Credit Line would have matured on July 31, 2017. After July 1, 2014, the Supplier has the right to settle up to $8,000,000 of our outstanding Obligations in exchange, at our option, for (i) shares of our common stock valued at $7.75 per share, subject to certain adjustments, or (ii) cash in an amount equal to 135% of the amount of the outstanding Obligations sold to us. Any outstanding Obligations settled by the Supplier would reduce the Fenco Credit Line. Pursuant to the Guaranty, the Obligations under the Agreement are guaranteed by us and certain of our subsidiaries. Under the terms of the Guaranty, the Supplier also has the right to sell accrued interest to us for shares of our common stock at a price, subject to certain adjustments, that is the lower of (i) $7.75 per share and (ii) 105% of the market value of our common stock, which market value is defined in the terms of the Guaranty.

On July 9, 2013, we received notice from the Supplier that the filing of the voluntary petition for relief under Chapter 7 of Title 11 of the United States Code in the U.S. Bankruptcy Court for the District of Delaware by the Fenco Entities constituted an “Event of Default” under the Agreement. As a result of the Event of Default, all amounts outstanding under the Agreement together with all accrued interest and all other amounts payable automatically became immediately due and payable subject to the terms of the subordination agreement described below. In addition, subject to certain adjustments, the interest rate applicable to all amounts remaining unpaid will increase, to the extent permitted by law, to 1.25% per month, compounding monthly, on December 10, 2013, and to 1.50% per month, compounding monthly, on June 10, 2014. As of June 10, 2013, there was approximately $19,864,000 outstanding under the Fenco Credit Line. Pursuant to a subordination agreement between the Supplier and Cerberus, the lender under the Financing Agreement, the Supplier may not take any enforcement action against the Company until the earlier of July 31, 2018 or the date on which all obligations under the Financing Agreement are satisfied, and any payments made by us pursuant to the Guarantee are subject to such subordination agreement for the benefit of Cerberus under the Financing Agreement.

In connection with the Agreement, we also issued a warrant to the Supplier to purchase up to 516,129 shares of our common stock for an initial exercise price of $7.75 per share exercisable at any time after two years from August 22, 2012 and on or prior to September 30, 2017. The exercise price is subject to adjustments, among other things, for sales of common stock by us at a price below the exercise price. We are obligated to issue no more than an aggregate of 1,032,258 shares of our common stock in connection with the Receivable Sale Option and Supplier Warrant, and no more than an aggregate of 1,572,342 shares of our common stock in connection with the Unpaid Interest Sale Option. The Obligations under this Agreement are subordinated to our obligations under the Financing Agreement. The fair value of the Supplier Warrant using the Monte Carlo simulation model was $2,779,000 and $1,639,000 at June 30, 2013 and March 31, 2013, respectively. This amount is recorded as a warrant liability which is included in other liabilities in the consolidated balance sheets at June 30, 2013 and March 31, 2013. During the three months ended June 30, 2013, a loss of $1,140,000 was recorded in general and administrative expenses due to the change in the fair value of this warrant liability.

Receivable Discount Programs

We use receivable discount programs with certain customers and their respective banks. Under these programs, we have options to sell those customers’ receivables to those banks at a discount to be agreed upon at the time the receivables are sold. These discount arrangements allows us to accelerate collection of customers’ receivables. While these arrangements have reduced our working capital needs, there can be no assurance that these programs will continue in the future. Interest expense resulting from these programs would increase if interest rates rise, if utilization of these discounting arrangements expands or if the discount period is extended to reflect more favorable payment terms to customers.

The following is a summary of the receivable discount programs from continuing operations:

Off-Balance Sheet Arrangements

At June 30, 2013, we had no off-balance sheet financing or other arrangements with unconsolidated entities or financial partnerships (such as entities often referred to as structured finance or special purpose entities) established for purposes of facilitating off-balance sheet financing or other debt arrangements or for other contractually narrow or limited purposes.

Capital Expenditures and Commitments

Capital Expenditures

Our capital expenditures were $381,000 and $398,000 for the three months ended June 30, 2013 and 2012, respectively. Our capital expenditures were primarily related to the purchase of office equipment and equipment for our manufacturing and warehousing facilities. We expect our fiscal year 2014 capital expenditures to be in the range of $2,000,000 to $3,000,000. We expect to use our working capital and incur additional capital lease obligations to finance these capital expenditures.

Related Party Transactions

Our related party transactions primarily consist of employment and director agreements and stock option agreements. Our related party transactions have not changed since March 31, 2013, except as described below.

During the three months ended June 30, 2013, we incurred $304,000 of expense payable to Houlihan Lokey Howard & Zukin Capital, Inc. in connection with the restructuring of FAPL. Scott J. Adelson, a member of the Company’s Board of Directors, is a Co-President and Global Co-Head of Corporate Finance for Houlihan Lokey Howard & Zukin Capital, Inc.

Critical Accounting Policies

There have been no material changes to our critical accounting policies and estimates that are presented in our Annual Report on Form 10-K for the year ended March 31, 2013, which was filed on June 17, 2013.

There have been no material changes in market risk from the information provided in Item 7A. “Quantitative and Qualitative Disclosures About Market Risk” in our Annual Report on Form 10-K as of March 31, 2013, which was filed on June 17, 2013.

Evaluation of Disclosure Controls and Procedures

We have established disclosure controls and procedures designed to ensure that the information required to be disclosed by the Company in the reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC rules and forms and that such information is accumulated and communicated to management, including our Chief Executive Officer, Chief Financial Officer, and Chief Accounting Officer, as appropriate to allow timely decisions regarding required disclosures.

Under the supervision and with the participation of management, including our Chief Executive Officer, Chief Financial Officer, and Chief Accounting Officer, we have conducted an evaluation of the effectiveness of our disclosure controls and procedures as defined in Exchange Act Rules 13a-15(e) and 15d-15(e). Based on this evaluation, our Chief Executive Officer, Chief Financial Officer, and Chief Accounting Officer concluded that MPA’s disclosure controls and procedures were effective as of June 30, 2013.

Inherent Limitations Over Internal Controls

The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Exchange Act Rules 13a-15(f) and 15d-15(f).

Internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America, applying certain estimates

and judgments as required.

Internal control over financial reporting includes those policies and procedures that:

1. Pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company;

2. Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and

3. Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

Changes in Internal Control Over Financial Reporting

There were no changes in MPA’s internal control over financial reporting during the first quarter ended June 30, 2013 that have materially affected, or are reasonably likely to materially affect, MPA’s internal control over financial reporting.

In addition to the risk factors set forth in Item 1A to Part I of our Annual Report on Form 10-K for the fiscal year ended March 31, 2013, filed on June 17, 2013, there may be claims filed against us by the trustee and some or all of the creditors in connection with the bankruptcy proceedings involving the Fenco Entities. We do not know what forms these claims, if any, may take, the basis on which these claims may be asserted, or their ultimate resolution. Any litigation to determine the validity of these claims, regardless of their merit or resolution, may be costly and time consuming and divert the efforts and attention of our management from our business strategy.