Motorcar Parts of America Inc: Form 10-Q for the period ended Jun 30, 2019

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, 2019 audited consolidated financial statements included in our Annual Report on Form 10-K filed with the SEC on June 28, 2019.

Disclosure Regarding Private Securities Litigation Reform Act of 1995

This report may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 with respect to our future performance that involve risks and uncertainties. Various factors could cause actual results to differ materially from those expressed or implied by such statements. These factors include, but are not limited to: concentration of sales to a small number of customers; changes in the financial condition of or our relationship with any of our major customers; increases in the average accounts receivable collection period; the loss of sales to customers; delays in payments by customers; the increasing customer pressure for lower prices and more favorable payment and other terms; lower revenues than anticipated from new and existing contracts; the increasing demands on our working capital; the significant strain on working capital associated with large inventory purchases from customers; any meaningful difference between expected production needs and ultimate sales to our customers; investments in operational changes or acquisitions; our ability to obtain any additional financing we may seek or require; our ability to maintain 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 material weaknesses in our internal controls over financial reporting; our failure to meet the financial covenants or the other obligations set forth in our credit agreement and the lenders’ refusal to waive any such defaults; increases in interest rates; the impact of high gasoline prices; 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; potential tariffs, unforeseen increases in operating costs; risks associated with cyber-attacks; risks associated with conflict minerals; the impact of new accounting pronouncements and tax laws and interpretations thereof; uncertainties affecting our ability to estimate our tax rate and other factors discussed herein and in our other filings with the Securities and Exchange Commission (the “SEC”). These and other risks and uncertainties may cause our actual results to differ materially and adversely from those expected in any forward-looking statements. Readers are directed to risks and uncertainties identified below under “Risk Factors” and elsewhere in this report for additional detail regarding factors that may cause actual results to be different than those expressed in our forward-looking statements. Except as required by law, we undertake no obligation to revise or update publicly any forward-looking statements for any reason.

Management Overview

We have been focused on implementing a multi-pronged platform for growth within the non-discretionary automotive aftermarket for the replacement parts and diagnostic testing industry, through organic growth and acquisitions. Our investments in infrastructure and human resources, including the consolidation of our distribution in Mexico and the significant expansion of manufacturing capacity, are expected to be transformative and scalable. As a result, gross profit and net income continues to be impacted, and our future performance and opportunities should be considered with these factors in mind.

New products introduced through our growth strategies noted above include: (i) turbochargers through an acquisition in July 2016; (ii) brake power boosters in August 2016; (iii) the design and manufacture of diagnostics systems for alternators, starters, belt-start generators (stop start and hybrid technology), and electric power trains for electric vehicles through an acquisition in July 2017; (iv) the design and manufacture of advanced power emulators (AC and DC) and custom power electronic products for the automotive and aerospace industries through an acquisition in December 2018; and (v) alternators and starters for medium truck, farm, and marine applications through an acquisition in January 2019.

Pursuant to the guidance provided under the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) for segment reporting, we have identified our chief operating decision maker (“CODM”), reviewed the documents used by the CODM, and understand how such documents are used by the CODM to make financial and operating decisions. We have determined through this review process that due to recent acquisitions, our business comprises three separate operating segments. Two of the operating segments meet all of the aggregation criteria, and are aggregated. The remaining operating segment does not meet the quantitative thresholds for individual disclosure. Since this immaterial operating segment meets the aggregation criteria of ASC 280, we have combined our operating segments into a single reportable segment.

Results of Operations for the Three Months Ended June 30, 2019 and 2018

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

The following summarizes certain key operating data:

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

Net Sales and Gross Profit

The following summarizes net sales and gross profit:

Net Sales. Our net sales for the three months ended June 30, 2019 increased by $17,480,000, or 19.1%, to $109,148,000 compared to net sales for the three months ended June 30, 2018 of $91,668,000, reflecting continued growth for our rotating electrical products, wheel hub products, brake power booster products, and diagnostic equipment. In addition, our net sales were positively impacted by $5,258,000 in connection with acquisitions completed during the latter part of fiscal 2019.

Gross Profit. Our gross profit was $17,583,000, or 16.1% of net sales for the three months ended June 30, 2019 compared to $16,352,000 or 17.8% of net sales for the three months ended June 30, 2018. The gross profit was impacted by a non-cash quarterly revaluation write-down of $4,564,000 compared to $2,626,000 for the three months ended June 30, 2019 and 2018, respectively, for remanufactured cores held at customers’ locations, which are included in contract assets.

In addition, gross profit for the three months ended June 30, 2019 was further impacted by (i) transition expenses of $1,354,000 in connection with the expansion of our operations in Mexico, (ii) $1,108,000 of amortization of core buy-back premiums paid to customers related to new business, (iii) net tariff costs of $1,067,000 paid for products sold before price increases were effective, (iv) cost of $426,000 in connection with the cancellation of a customer contract, and (v) $100,000 of stock adjustment costs related to new business.

Gross profit for the three months ended June 30, 2018 was impacted by (i) transition expenses of $1,755,000 in connection with the expansion of our operations in Mexico, (ii) $1,175,000 of customer allowances related to new business, and (iii) $967,000 of amortization of core buy-back premiums paid to customers related to new business.

Operating Expenses

The following summarizes operating expenses:

General and Administrative. Our general and administrative expenses for the three months ended June 30, 2019 were $12,000,000, which represents a decrease of $91,000, or 0.8%, from general and administrative expenses for the three months ended June 30, 2018 of $12,091,000. This decrease was due to (i) $35,000 gain compared to a loss of $2,666,000 recorded due to the change in the fair value of the forward foreign currency exchange contracts during the three months ended June 30, 2019 and 2018, respectively and (ii) a gain of $502,000 due to the remeasurement of foreign currency-denominated lease liabilities during the three months ended June 30, 2019. These decreases were partially offset by (i) $1,233,000 of increased professional services, (ii) $783,000 of general and administrative expenses attributable to our fiscal 2019 acquisitions, (iii) $385,000 of increased amortization of intangible assets in connection with our fiscal 2019 acquisitions, (iv) $327,000 of increased general and administrative expenses at our offshore locations to support our growth initiatives, and (v) $287,000 for personnel to support our growth initiatives.

Sales and Marketing. Our sales and marketing expenses for the three months ended June 30, 2019 increased $527,000, or 12.0%, to $4,919,000 from $4,392,000 for the three months ended June 30, 2018 primarily due to sales and marketing expenses attributable to our fiscal 2019 acquisitions.

Research and Development. Our research and development expenses increased by $636,000, or 36.3%, to $2,372,000 for the three months ended June 30, 2019 from $1,736,000 for the three months ended June 30, 2018. The increase was due primarily to (i) $368,000 for personnel to support our growth initiatives, (ii) $212,000 of research and development expenses attributable to our fiscal 2019 acquisitions, and (iii) $43,000 of increased outside services to support our growth initiatives.

Interest Expense

Interest Expense, net. Our interest expense, net for the three months ended June 30, 2019 increased $1,098,000, or 21.6%, to $6,173,000 from $5,075,000 for the three months ended June 30, 2018. The increase in interest expense was due primarily to (i) increased average outstanding borrowings in connection with our growth initiatives and as we build our inventory levels to support anticipated higher sales and (ii) an increase in the utilization of our accounts receivable discount programs.

Provision for Income Taxes

Income Tax. We recorded an income tax benefit of $1,730,000, or an effective tax rate of 22.0%, and $1,447,000, or an effective tax rate of 20.8%, for the three months ended June 30, 2019 and 2018, respectively. The estimated effective tax rate for the entire year is based on current estimates and any changes to those estimates in future periods could result in an effective tax rate that is materially different from the current estimate.

Liquidity and Capital Resources

Overview

We had working capital (current assets minus current liabilities) of $69,069,000 and $73,528,000, a ratio of current assets to current liabilities of 1.2:1.0 and 1.3:1.0, at June 30, 2019 and March 31, 2019, respectively. The decrease in working capital was due primarily to increased borrowing under our credit facility.

We generated cash during the three months ended June 30, 2019 from the use of receivable discount programs as well as from our credit facility. The cash generated from these activities was primarily used for our growth initiatives and to build our inventory levels to support anticipated higher sales.

In June 2019, we entered into a second amendment to the credit facility, which, among other things, increased our revolving loan facility from $200,000,000 to $238,620,000.

We believe our cash and cash equivalents, short-term investments, use of receivable discount programs, amounts available under our credit facility, and other sources are sufficient to satisfy our expected future working capital needs, repayment of the current portion of our term loans, and lease and capital expenditure obligations over the next 12 months.

Share Repurchase Program

As of June 30, 2019, $15,692,000 of the $37,000,000 authorized share repurchase program had been utilized and $21,308,000 remained available to repurchase shares, subject to the limit in our credit facility. Our credit facility permits the payment of up to $20,000,000 of dividends and share repurchases per fiscal year, subject to a minimum availability threshold and pro forma compliance with financial covenants. We retired the 675,561 shares repurchased under this program through June 30, 2019. Our share repurchase program does not obligate us to acquire any specific number of shares and shares may be repurchased in privately negotiated and/or open market transactions.

Cash Flows

The following summarizes cash flows as reflected in the consolidated statements of cash flows:

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Net cash used in operating activities was $18,379,000 and $924,000 during the three months ended June 30, 2019 and 2018, respectively. Our operating activities continue to be significantly impacted by our growth initiatives, including our product line expansion. Operating activities for the three months ended June 30, 2019 include (i) expenses incurred in connection with the expansion of our Mexico operations, (ii) the build-up of inventory to support anticipated higher sales, (iii) payments made to customers for core buy-backs made in connection with new business expansion, and (iv) a less significant decrease in accounts receivable during the three months ended June 30, 2019 as compared to the three months ended June 30, 2018.

Net cash used in investing activities was $2,668,000 and $1,701,000 during the three months ended June 30, 2019 and 2018, respectively, due primarily to increased purchases of equipment for our current operations and the expansion of our operations in Mexico. This increase was partially offset by the redemption of short-term investments during the three months ended June 30, 2019.

Net cash provided by financing activities was $22,328,000 and $1,955,000 during the three months ended June 30, 2019 and 2018, respectively, due mainly to increased net borrowings under our credit facility.

Capital Resources

Credit Facility

We are a party to a $230,000,000 senior secured financing, (as amended from time to time, the “Credit Facility”) with a syndicate of lenders, and PNC Bank, National Association, as administrative agent, consisting of (i) a $200,000,000 revolving loan facility, subject to borrowing base restrictions, a $20,000,000 sublimit for borrowings by Canadian borrowers, and a $15,000,000 sublimit for letters of credit (the “Revolving Facility”) and (ii) a $30,000,000 term loan facility (the “Term Loans”). The loans under the Credit Facility mature on June 5, 2023. The Credit Facility permits the payment of up to $20,000,000 of dividends and share repurchases per fiscal year, subject to a minimum availability threshold and pro forma compliance with financial covenants. In connection with the Credit Facility, the lenders have a security interest in substantially all of our assets.

In June 2019, we entered into a second amendment to the Credit Facility (the “Second Amendment”). The Second Amendment, among other things, (i) increased the total size of the Revolving Facility to $238,620,000, (ii) modified the fixed charge coverage ratio financial covenant, (iii) modified the definition of “Consolidated EBITDA”, (iv) modified the borrowing base definition to, among other things, include brake-related products as eligible inventory, (v) increased the letter of credit sublimit to $20,000,000, (vi) increased the Canadian revolving sublimit and swing line sublimit to $24,000,000, (vii) increased the swing line sublimit to $23,862,000, (viii) permitted up to $5,000,000 of sale and lease back transactions per fiscal year, (ix) increased the permitted amount of certain capital expenditures, (x) increased the permitted amount of operating lease obligations per fiscal year, and (xi) increased certain other covenant-related baskets. We capitalized $889,000 of new debt issuance costs in connection with the Second Amendment.

The Term Loans require quarterly principal payments of $937,500 beginning October 1, 2018. The Credit Facility bears interest at rates equal to either LIBOR plus a margin of 2.25%, 2.50% or 2.75% or a reference rate plus a margin of 1.25%, 1.50% or 1.75%, in each case depending on the senior leverage ratio as of the applicable measurement date. There is also a facility fee of 0.375% to 0.50%, depending on the senior leverage ratio as of the applicable measurement date. The interest rate on our Term Loans and Revolving Facility was 5.19% and 5.16%, respectively, as of June 30, 2019 and 5.24% as of March 31, 2019.

The Credit Facility, among other things, requires us to maintain certain financial covenants including a maximum senior leverage ratio and a minimum fixed charge coverage ratio. We were in compliance with all financial covenants as of June 30, 2019.

The following summarizes the financial covenants required under the Credit Facility:

In addition to other covenants, the Credit Facility places limits on our ability to incur liens, incur additional indebtedness, make loans and investments, engage in mergers and acquisitions, engage in asset sales, redeem or repurchase capital stock, alter the business conducted by us and our subsidiaries, transact with affiliates, prepay, redeem or purchase subordinated debt, and amend or otherwise alter debt agreements.

We had $135,400,000 and $110,400,000 outstanding under the Revolving Facility at June 30, 2019 and March 31, 2019, respectively. In addition, $4,039,000 was outstanding for letters of credit at June 30, 2019. At June 30, 2019, after certain contractual adjustments, $72,400,000 was available under the Revolving Facility.

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 allow us to accelerate receipt of payment on 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, if customers extend their payment to us, 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:

Off-Balance Sheet Arrangements

At June 30, 2019, 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 total capital expenditures, including finance leases, were $4,653,000 and $1,546,000 for the three months ended June 30, 2019 and 2018, respectively. These capital expenditures primarily include the purchase of equipment for our current operations and the expansion of our operations in Mexico. We expect to incur approximately $7,000,000 of capital expenditures for our current operations and approximately $18,000,000 for continued expansion of our operations in Mexico during fiscal 2020. We have used and expect to continue using our working capital and additional capital lease obligations to finance these capital expenditures.

Litigation

There have been no material changes to our litigation matters that are presented in our Annual Report on Form 10-K for the year ended March 31, 2019, which was filed on June 28, 2019.

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, 2019, which was filed on June 28, 2019, except as discussed below.

New Accounting Pronouncements Recently Adopted

Leases

In February 2016, the FASB issued new guidance that requires balance sheet recognition of a lease asset and lease liability by lessees for all leases, other than leases with a term of 12 months or less if the short-term lease exclusion expedient is elected. The new guidance also requires new disclosures providing additional qualitative and quantitative information about the amounts recorded in the financial statements. The new guidance requires a modified retrospective approach with optional practical expedients. The FASB provided entities with an additional transition method, which allows an entity to apply this guidance as of the beginning of the period of adoption instead of the beginning of the earliest comparative period presented in the entity’s financial statements. We adopted this guidance on April 1, 2019 using the additional transition method. We also elected certain practical expedients permitted under the transition guidance, including the package of practical expedients, which allowed us not to reassess lease classification for leases that commenced prior to the adoption date. In addition, we elected to exempt leases with an initial term of 12 months or less from balance sheet recognition and, for all classes of assets, combining non-lease components with lease components.

Upon adoption, we recorded operating lease liabilities of $53,043,000 and corresponding operating lease assets of $50,773,000. The difference between the operating lease assets and liabilities recognized on our consolidated balance sheet primarily related to accrued rent on existing leases that were offset against the operating lease asset upon adoption. There was an immaterial reclassification of non-lease components to finance lease assets and finance lease liabilities upon adoption due to our election to combine non-lease components with lease components. The adoption of the new guidance did not have any impact on our rent expense and consolidated statement of cash flows. However, we have material nonfunctional currency leases that could have a material impact on our consolidated statements of operations. As required for other monetary liabilities, lessees shall remeasure a foreign currency-denominated lease liability using the exchange rate at each reporting date, but the lease assets are nonmonetary assets measured at historical rates, which are not affected by subsequent changes in the exchange rates. We recorded a gain of $502,000 in general and administrative expenses in connection with the remeasurement of foreign currency-denominated lease liabilities during the three months ended June 30, 2019. See Note 10 for additional discussion of the adoption of ASC 842 and the impact on our financial statements.

New Accounting Pronouncements Not Yet Adopted

Measurement of Credit Losses on Financial Instruments

In June 2016, the FASB issued an accounting pronouncement related to the measurement of credit losses on financial instruments. This pronouncement, along with a subsequent ASU issued to clarify certain provisions of the new guidance, changes the impairment model for most financial assets and will require the use of an “expected loss” model for instruments measured at amortized cost. Under this model, entities will be required to estimate the lifetime expected credit loss on such instruments and record an allowance to offset the amortized cost basis of the financial asset, resulting in a net presentation of the amount expected to be collected on the financial asset. This pronouncement is effective for fiscal years, and for interim periods within those fiscal years, beginning after December 15, 2019. We plan to adopt this pronouncement for our fiscal year beginning April 1, 2020. We are currently evaluating the impact this guidance will have on our consolidated financial statements, as well as any impacts on our business processes, systems and internal controls.

Fair Value Measurements

In August 2018, the FASB issued guidance, which changes the disclosure requirements for fair value measurements by removing, adding and modifying certain disclosures. The standard is effective for financial statements issued for fiscal years, and for interim periods within those fiscal years, beginning after December 15, 2019. Early adoption is permitted. We are currently evaluating the impact this guidance will have on our consolidated financial statements.

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, 2019, which was filed with the SEC on June 28, 2019.

Evaluation of Disclosure Controls and Procedures

Our management, with the participation of our Chief Executive Officer (“CEO”), Chief Financial Officer (“CFO”) and Chief Accounting Officer (“CAO”), evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended) as of June 30, 2019. Based on this evaluation, our CEO, CFO and CAO concluded that our disclosure controls and procedures were not effective at the reasonable assurance level as of June 30, 2019 as a result of the material weakness described in our Annual Report on Form 10-K and below.

A “material weakness” is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the Company’s annual or interim financial statements will not be prevented or detected on a timely basis.

As disclosed in more detail in Item 9A. “Controls and Procedures” in our Annual Report on Form 10-K for the fiscal year ended March 31, 2019, we identified the following material weakness in internal control over financial reporting:

(1) We did not perform a sufficient review of certain accounting policies and lacked oversight of the compliance with those policies, which resulted in inconsistent application, inadequate analysis and deficient documentation to support the financial statement presentation and disclosures over certain accounts, including inventory.

(2) Our lack of sufficient technical accounting resources resulted in inadequate oversight of process level controls of one of our subsidiaries.

Management’s Remediation Efforts

We have designed and begun to implement several steps, as further described below, to remediate the material weakness described in this Item 4 and enhance our overall control environment.

1. Management plans to hire and has hired additional finance and accounting personnel with the requisite experience and skill levels, supplemented by third-party technical accounting resources, sufficient to enable the proper and timely review of accounting analyses and memos in various technical areas.

2. Management will continue to formalize the assessment and documentation of the Company’s accounting and financial reporting policies and procedures and enhance controls over the monitoring of compliance with those accounting policies and procedures.

3. Management will enhance the accounting and internal control training program provided to staff of new and existing subsidiaries. Management will enhance its internal control processes to continuously monitor the subsidiaries’ compliance with and documentation of the Company’s accounting and financial reporting policies and procedures, including internal control over financial reporting.

4. Management has enhanced and will continue to enhance the risk assessment process and design of internal control over financial reporting at its subsidiary.

The actions that we are taking are subject to ongoing review by our management, including our CEO, CFO and CAO, as well as Audit Committee oversight. Management expects the remediation plan to extend over multiple financial reporting periods throughout fiscal year 2020. The material weakness will not be considered remediated until the applicable remedial controls operate for a sufficient period of time and management has concluded, through testing, that these controls are operating effectively. We expect that the remediation of this material weakness will be completed prior to the end of fiscal year 2020.

While the foregoing measures are intended to effectively remediate the material weakness described in this Item 4, it is possible that additional remediation steps will be necessary. As such, as we continue to evaluate and implement our plan to remediate the material weakness, management may decide to take additional measures to address the material weakness or modify the remediation steps described above. Until the material weakness is remediated, we plan to continue to perform additional analyses and other procedures to help ensure that our consolidated financial statements are prepared in accordance with GAAP.

Inherent Limitations on Effectiveness of Controls

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

We are taking actions to remediate the material weakness relating to our internal controls over financial reporting, as described above. Additionally, during the quarter ended June 30, 2019, the Company adopted a comprehensive new lease standard which superseded previous lease guidance and, as a result, changes were made to related business processes and control activities in order to monitor and maintain appropriate controls over financial reporting. Except as discussed above, there have been no changes in our internal control over financial reporting (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended) that occurred during the three months ended June 30, 2019 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

There have been no material changes in 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, 2019, filed on June 28, 2019.