Sono Tek Corp: Form 10-Q for the period ended Aug 31, 2023

FORWARD-LOOKING STATEMENTS

We discuss expectations regarding our future performance, such as our business outlook, in our annual and quarterly reports, news releases, and other written and oral statements. These “forward-looking statements” are based on currently available competitive, financial and economic data and our operating plans. They are inherently uncertain, and investors must recognize that events could turn out to be significantly different from our expectations and could cause actual results to differ materially. These factors include, among other considerations, general economic and business conditions; political, regulatory, tax, competitive and technological developments affecting our operations or the demand for our products; inflationary and supply chain pressures; the continued abatement of the COVID-19 pandemic and any residual effects; the recovery of the Electronics/Microelectronics and Medical markets following COVID-19 related slowdowns; and further adverse effects to our supply chain; maintenance of increased order backlog, including effects of any COVID-19 related cancellations; the imposition of tariffs; timely development and market acceptance of new products and continued customer validation of our coating technologies; adequacy of financing; capacity additions, the ability to enforce patents; maintenance of operating leverage; maintenance of increased order backlog; consummation of order proposals; completion of large orders on schedule and on budget; continued sales growth in the medical and alternative energy markets; successful transition from primarily selling ultrasonic nozzles and components to a more complex business providing complete machine solutions and higher value subsystems; and realization of quarterly and annual revenues within the forecasted range of sales guidance.

We undertake no obligation to update any forward-looking statement.

Overview

Founded in 1975, Sono-Tek Corporation designs and manufactures ultrasonic coating systems that apply precise, thin film coatings to a multitude of products for the microelectronics/electronics, alternative energy, medical and industrial markets, including specialized glass applications in construction and automotive. We also sell our products to emerging research and development and other markets. We have invested significant resources to enhance our market diversity by leveraging our core ultrasonic coating technology. As a result, we have increased our portfolio of products, the industries we serve and the countries in which we sell our products.

Our ultrasonic nozzle systems use high frequency, ultrasonic vibrations that atomize liquids into minute drops that can be applied to surfaces at low velocity providing thin layers of functional or protective materials over surfaces such as glass or metals. Our solutions are environmentally-friendly, efficient and highly reliable. They enable dramatic reductions in overspray, savings in raw materials, water and energy usage and provide improved process repeatability, transfer efficiency, high uniformity and reduced emissions.

We believe product superiority is imperative and that it is attained through the extensive experience we have in the coatings industry, our proprietary manufacturing know-how and skills and the unique work force we have built over the years. Our growth strategy is to leverage our innovative technologies, proprietary know-how, unique talent and experience, and global reach to further advance the use of ultrasonic coating technologies for the microscopic coating of surfaces in a broader array of applications that enable better outcomes for our customers’ products and processes.

We are a global business with approximately 40% of our sales generated from outside the United States and Canada in the first six months of fiscal 2024. Our direct sales team and our distributor and sales representative network are located in North America, Latin America, Europe and Asia. We continue to expand our sales capabilities by increasing the size of our direct sales force and adding new distributors and sales representatives. In addition, we have established testing labs at our distribution partner sites in China, Taiwan, Germany, Turkey, Korea and Japan, while also expanding our first testing lab that is co-located with our manufacturing facilities in New York. These labs provide significant value for demonstrating to prospective customers the capabilities of our equipment and enabling us to develop custom solutions to meet their needs. Providing customers that visit our labs with a high level of application engineering expertise to develop their unique coating processes is an area of focus in our sales efforts, as we continually expand Sono-Tek’s services to best support the needs of our customers.

Over the last decade, we have shifted our business from primarily selling our ultrasonic nozzles and components to a more complex business providing complete machine solutions and higher value subsystems to original equipment manufacturers (“OEMs”). This strategy has resulted in significant growth of our average unit selling price; with our larger machines often selling for over $300,000 and system prices sometimes reaching over $1,000,000. As a result of this transition, we have broadened our addressable market and we believe that we can grow sales on a larger scale. We expect that we will experience wide variations in both order flow and shipments from quarter to quarter in part due to the increase of larger orders in the Company’s sales mix.

Second Quarter Fiscal 2024 Highlights (compared with the second quarter of fiscal 2023 unless otherwise noted) We refer to the three-month periods ended August 31, 2023 and 2022 as the second quarter of fiscal 2024 and fiscal 2023, respectively.

• Net Sales for the quarter increased by 50% or $1,876,000 to $5,639,000. The increase in sales is due to strong shipments to the alternative/clean energy, medical and industrial markets, resulting from the easing of previous supply-constrained bottlenecks. Net Sales increased 57% or over $2.0 million from the $3,603,000 Net Sales reported in the first quarter of fiscal 2024 (ended May 31, 2023).
• Gross Profit increased 48% or $905,000 to $2,801,000 and Gross Margin decreased by 70 basis points to 49.7% due to product mix.
• Operating income increased 219% or $388,000,to $566,000 due to the increase in gross profit offset by increases in operating expenses.
• Income before taxes nearly tripled to $683,000, an increase of $506,000, reflecting positive operating leverage from the rebound in quarterly sales.
• Interest income, dividend income and unrealized gain on marketable securities increased to $117,000 due to the current high interest rate environment.
• Despite near record sales, backlog on August 31, 2023 reached a record high of $10,707,000, an increase of 26% compared with backlog of $8.5 million on February 28, 2023. The increase in backlog resulted from the growing orders from the clean energy sector.
• The Alternative/Clean Energy Market grew by 161%, an increase of $1.12 million, primarily due to the shipment of a $1.1 million system.
• The Medical Market and Industrial Market grew by 117% and 104%, respectively. The medical market was positively impacted by several large multi-national companies taking delivery of specialty implantable medical device coating systems, while the industrial market was positively impacted by a large float glass coating machine shipment to Latin America.

First Half Fiscal 2024 Highlights (compared with the first half of fiscal 2023 unless otherwise noted) We refer to the six-month periods ended August 31, 2023 and 2022 as the first half of fiscal 2024 and fiscal 2023, respectively.

• Net Sales for the first half of fiscal 2024 increased by 18% or $1,427,000 to $9,242,000, strongly impacted by increased sales of multi-axis coating systems to the Alternative Energy market and Industrial market.
• Gross Profit increased 14% to $4,578,000 as a result of increased net sales, and Gross Margin decreased 170 basis points to 49.5% primarily due to product mix.
• Operating Income decreased $84,000 to $474,000 due to increases in operating expenses.
• Interest income, dividend income and unrealized gain on marketable securities increased to $241,000 due to the current high interest rate environment.
• Income before taxes increased $162,000 or 29% to $715,000.
• As of August 31, 2023, the Company had no outstanding debt and had cash, cash equivalents and marketable securities totaling $12.3 million.

RESULTS OF OPERATIONS

Sales:

Product Sales

Total sales for the second quarter and first half of fiscal 2024 grew by 50% and 18%, respectively, driven by increased demand for our Multi-Axis Coating systems which are commonly used in the clean energy sector and medical device markets. In addition, Integrated Coating System sales accelerated from sales of our newly developed float glass coating platform which is continuing to gain acceptance in the market. Fluxing system sales dipped, although the outlook for this product line remains positive as indicated by quoting activity. A dip in OEM sales occurred as many of our OEM partners had previously built up excess inventory to combat supply chain concerns. This, was largely offset by an increase in spare parts and service related revenue, which is a growing revenue stream that falls in the Other product category.

Market Sales

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Sales to the Alternative/Clean Energy market recorded growth of 161% in the second quarter of fiscal 2024, and 103% for the first half of fiscal 2024, which were positively impacted by a growing number of our customers transitioning from our R&D systems to production scale systems that carry much higher average selling prices. Electronics market revenue decreased for the first half of fiscal year 2024, influenced by softening sales of our PCB spray fluxers in Latin America. Medical sales rebounded strongly with 117% growth in the second quarter of fiscal 2024, however, sales for the first half of fiscal year 2024 were down 15% year over year. Industrial Sales remain very strong, showing growth of 104% and 144%, respectively, in the second quarter and first half of fiscal 2024, influenced by several new generation systems introduced to the market.

Geographic Sales

In the first half of fiscal 2024, approximately 40% of sales originated outside of the United States and Canada compared with 54% in the first half of fiscal 2023.

In the second quarter of fiscal 2024, approximately 43% of sales originated outside of the United States and Canada compared with 56% in the second quarter of fiscal 2023.

We continue to record strong sales from the U.S., growing 94% and 55%, respectively in the second quarter of fiscal 2024 and the first half of fiscal 2024. U.S. government initiatives such as the CHIPS ACT and the Inflation Reduction Act have influenced these strong sales, as well as the continuing trend of onshoring for high technology products. Asia sales dropped 35% and 28% respectively, for the second quarter of fiscal 2024 and first half of fiscal 2024. This dip was due to decreased sales to China, while other areas of Asia remain more resilient.

Gross Profit:

For the second quarter of fiscal 2024, gross profit increased by $905,000, or 48%, compared with the prior year period. The gross profit margin was 49.7% compared with 50.4% for the prior year period. The decrease in the gross profit margin was influenced by product mix, inclusive of a decrease in OEM systems sales which typically have high profit margins.

For the first half of fiscal 2024, gross profit increased by $575,000, or 14%, to $4,578,000 compared with $4,003,000 in the first half of fiscal 2023. The gross profit margin was 49.5% compared with 51.2% for the prior year period. The decrease in the gross profit margin is due to changes in product mix, particularly decreased OEM sales.

Operating Expenses:

Research and Product Development:

Research and product development costs increased in the second quarter of fiscal 2024 due to increased salaries and research and development materials and supplies, which are used in the focused growth initiatives that we continue to implement.

Over the past twelve months the number of full-time employees engaged primarily in our research and product development efforts increased by approximately 40%. We added headcount in this area to facilitate completion of complex engineered systems that comprise much of our backlog and to accelerate the development of future custom machine solutions and higher value subsystems that we expect to be the cornerstone of our future business.

Marketing and Selling:

Marketing and selling expenses increased in the second quarter of fiscal 2024 due to increased salaries, commissions, travel and trade show expenses. These increases were partially offset by a decrease in insurance expenses.

Marketing and selling costs increased in the first half of fiscal 2024 due to increased salaries, travel and trade show expenses. These increases were partially offset by decreases in commission and insurance expenses.

Over the past twelve months the number of full-time employees engaged in our sales and marketing efforts increased by approximately 21%. We have primarily added more technical personnel to support the growing diversity and complexity of our customers’ requirements for thin film coating applications.

General and Administrative:

General and administrative expenses increased in the second quarter of fiscal 2024 due to increased salaries and professional fees. These increases were partially offset by a decrease in stock based compensation expense.

General and administrative expenses increased in the first half of fiscal 2024 due to increased salaries and professional fees. These increases were partially offset by decreases in stock based compensation, insurance and corporate expenses.

Operating Income:

In the second quarter of fiscal 2024, operating income increased $388,000, or 218%, to $566,000 compared with $178,000 for the second quarter of fiscal 2023. Operating margin for the quarter increased to 10% compared with 5% in the prior year period. In the second quarter of fiscal 2024, increases in revenue and gross profit offset by an increase in operating expenses were key factors in the increase of operating income.

In the first half of fiscal 2024, operating income decreased by $84,000, to $474,000, compared with $558,000 for the first half of fiscal 2023. Operating margin for the first half of fiscal 2024 decreased to 5% compared with 7% in the first half of fiscal 2023. In the first half of fiscal 2024, an increase in operating expenses partially offset by an increase gross profit were key factors in the decrease of operating income.

Interest and Dividend Income:

Interest and dividend income increased by $105,000 to $124,000 in the second quarter of fiscal 2024 as compared with $19,000 for the second quarter of fiscal 2023. In the first half of fiscal 2024 interest and dividend income increased by $204,000 to $230,000 as compared with $26,000 for the first half of fiscal 2023. Our present investment policy is to invest excess cash in highly liquid, lower risk US Treasury securities. At August 31, 2023, the majority of our holdings are rated at or above investment grade.

Income Tax Expense:

We recorded income tax expense of $142,000 for the second quarter of fiscal 2024 compared with $15,000 for the second quarter of fiscal 2023. For the first half of fiscal 2024, we recorded income tax expense of $121,000 compared with $85,000 for the first half of fiscal 2023.

The increase in income tax expense in the second quarter and first half of fiscal 2024 is due to the increase in income before income taxes partially offset by an increase in permanent timing differences and the application of available research and development tax credits.

Net Income:

Net income increased by $379,000 to $541,000 for the second quarter of fiscal 2024 compared with $162,000 for the second quarter of fiscal 2023. The increase in net income during the second quarter is primarily a result of an increase in gross profit and interest and dividend income partially offset by an increase in operating expenses and an increase in income tax expense.

Net income increased by $127,000 to $595,000 for the first half of fiscal 2024 compared with $468,000 for the first half of fiscal 2023. The increase in net income during the first half of fiscal 2024 is primarily a result of an increase in gross profit and interest and dividend income partially offset by an increase in operating expenses and an increase in income tax expense.

Impact of COVID-19

With the exception of some lingering supply chain challenges, the residual effects of the COVID-19 pandemic did not have a significant impact on the Company's results of operations or financial condition for the three months ended August 31, 2023.

Liquidity and Capital Resources

Working Capital – Our working capital increased $452,000 to $11,569,000 at August 31, 2023 from $11,117,000 at February 28, 2023. The increase in working capital was mostly the result of the current period’s net income and noncash charges partially offset by purchases of equipment.

The Company aggregates cash and cash equivalents and marketable securities in managing its balance sheet and liquidity. For purposes of the following analysis, the total is referred to as “Cash.” At August 31, 2023 and February 28, 2023, our working capital included:

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The following table summarizes the accounts and the major reasons for the $871,000 increase in “Cash”:

Stockholders’ Equity – Stockholders’ Equity increased $689,000 from $14,634,000 at February 28, 2023 to $15,323,000 at August 31, 2023. The increase is a result of the current period’s net income of $594,000 and $95,000 in additional equity related to stock-based compensation awards.

Operating Activities – We generated $1,107,000 of cash in our operating activities in the first half of fiscal 2024 compared to $224,000 of cash in the first half of fiscal 2023, an increase of $883,000. The increase was mostly the result of decreases in accounts receivable and prepaid expenses combined with increases in accounts payable and customer deposits. These sources of cash were partially offset by an increase in inventories.

Investing Activities – We used $1,007,000 in the first half of fiscal 2024 in our investing activities compared with using $755,000 in the first half of fiscal 2023. For the first halves of fiscal years 2024 and 2023, we used $246,000 and $244,000, respectively, for the purchase or manufacture of equipment, furnishings and leasehold improvements. For the first half of fiscal 2024 and 2023, we invested $761,000 and $511,000, respectively, in our marketable securities.

Net Changes in Cash and Cash Equivalents – In the first half of fiscal 2024, our cash balance increased by $100,000 as compared to a decrease of $532,000 in the first half of 2023. In the first half of fiscal 2024, our operating activities generated $1,107,000 of cash. In addition, we invested $761,000 in marketable securities and used $246,000 for the purchase or manufacture of equipment, furnishings and leasehold improvements.

Critical Accounting Policies

The discussion and analysis of the Company’s financial condition and results of operations are based upon the unaudited condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires the Company to make estimates and judgments that affect the reported amount of assets and liabilities, revenues and expenses, and related disclosure on contingent assets and liabilities at the date of the financial statements. Actual results may differ from these estimates under different assumptions and conditions.

Critical accounting policies are defined as those that are reflective of significant judgments and uncertainties and may potentially result in materially different results under different assumptions and conditions. The Company believes that critical accounting policies are limited to those described below. For a detailed discussion on the application of these and other accounting policies see Note 2 to the Company’s consolidated financial statements included in Form 10-K for the year ended February 28, 2023.

Accounting for Income Taxes

The Company accounts for income taxes under the asset and liability method. Under this method, deferred income taxes are recognized for the tax consequences of “temporary differences” by applying enacted statutory tax rates applicable to future years to differences between the financial statement carrying amounts and the tax basis of existing assets and liabilities. If it is more likely than not that some portion or all of a deferred tax asset will not be realized, a valuation allowance is recognized. We use a recognition threshold and a measurement attribute for financial statement recognition and measurement tax positions taken or expected to be taken in a return. For those benefits to be recognized, a tax position must be more likely than not to be sustained upon examination by taxing authorities.

Stock-Based Compensation

The computation of the expense associated with stock-based compensation requires the use of a valuation model. ASC 718 is a complex accounting standard, the application of which requires significant judgment and the use of estimates, particularly surrounding Black-Scholes assumptions such as stock price volatility, expected option lives, and expected option forfeiture rates, to value equity-based compensation. The Company currently uses a Black-Scholes option pricing model to calculate the fair value of its stock options. The Company primarily uses historical data to determine the assumptions to be used in the Black-Scholes model and has no reason to believe that future data is likely to differ materially from historical data. However, changes in the assumptions to reflect future stock price volatility and future stock award exercise experience could result in a change in the assumptions used to value awards in the future and may result in a material change to the fair value calculation of stock-based awards. ASC 718 requires the recognition of the fair value of stock compensation in net income. Although every effort is made to ensure the accuracy of our estimates and assumptions, significant unanticipated changes in those estimates, interpretations and assumptions may result in recording stock option expense that may materially impact our financial statements for each respective reporting period.

Impact of New Accounting Pronouncements

Accounting pronouncements issued but not yet effective have been deemed to be not applicable or the adoption of such accounting pronouncements is not expected to have a material impact on the financial statements of the Company.

The Company does not issue or invest in financial instruments or derivatives for trading or speculative purposes. Substantially all of the operations of the Company are conducted in the United States, and, as such, are not subject to material foreign currency exchange rate risk. All of our sales transactions are completed in US dollars.

Although the Company's assets included $3,454,000 in cash and $8,862,000 in marketable securities, the market rate risk associated with changing interest rates in the United States is not material.

The Company has established and maintains “disclosure controls and procedures” (as those terms are defined in Rules 13a –15(e) and 15d-15(e) under the Securities and Exchange Act of 1934 (the “Exchange Act”). Christopher L. Coccio, Chief Executive Officer (principal executive) and Stephen J. Bagley, Chief Financial Officer (principal accounting officer) of the Company, have evaluated the Company’s disclosure controls and procedures as of August 31, 2023. Based on this evaluation, they have concluded that the Company’s disclosure controls and procedures were effective to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is (1) recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms, and (2) accumulated and communicated to Management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding timely disclosure.

In addition, there were no changes in the Company’s internal controls over financial reporting during the second fiscal quarter of 2024 that have materially affected, or are reasonably likely to materially affect, internal controls over financial reporting.

There are no material changes from risk factors previously disclosed in the Company’s Annual Report on Form 10-K for the year ended February 28, 2023.