Gencor Industries Inc: Form 10-Q for the period ended Jun 30, 2014

Overview

Gencor Industries, Inc. (the “Company”) is a leading manufacturer of heavy machinery used in the production of highway construction materials, synthetic fuels, and environmental control equipment. The Company’s core products include asphalt plants, combustion systems and fluid heat transfer systems. The Company’s products are manufactured in two facilities in the United States.

Because the Company’s products are sold primarily to the highway construction industry, the business is seasonal in nature. Traditionally, the Company’s customers do not purchase new equipment for shipment during the summer and fall months to avoid disrupting their peak season for highway construction and repair work. The majority of orders for the Company’s products are thus received between October and February, with a significant volume of shipments occurring prior to June. The principal factors driving demand for the Company’s products are the overall economic conditions, the level of government funding for domestic highway construction and repair, infrastructure development in emerging economies, the need for spare parts, fluctuations in the price of crude oil (liquid asphalt, as well as fuel costs), and a trend towards larger plants, resulting from industry consolidation.

On July 6, 2012, President Obama signed a $118 billion transportation bill, Moving Ahead for Progress in the 21st Century Act (“MAP-21”). MAP-21 included a final three-month extension of the previous SAFETEA-LU bill at then current spending levels combined with a new two-year, $105 billion authorization of the federal highway, transit, and safety programs effective October 1, 2012. The bill provided states with two years of funding to build roads, bridges, and transit systems. On July 31, 2014 Senate approved the House version of a $10.8 billion short-term bill to fund Federal highway and Mass-transit programs through May 31, 2015. The bill will go to President Obama for signature. The level of future domestic highway construction funding is uncertain. Future funding may be at lower levels than in the past.

The Canadian government enacted major infrastructure stimulus programs, which benefitted the Company in prior years. In 2007, the Building Canada Plan provided $33 billion in infrastructure funding through 2014. As part of the Building Canada Plan, the Gas Tax Fund was approved in 2009, providing $2 billion in annual infrastructure spending.

Nominal domestic economic growth and the lack of a fully funded, multi-year federal highway bill have resulted in reduced capital equipment purchases within the Company’s served markets. This continues to have an adverse impact on sales and pricing pressures on the Company’s products, resulting in lower revenues and margins.

In addition to government funding and the overall economic conditions, fluctuations in the price of oil, which is a major cost of asphalt mix, may affect the Company’s financial performance. An increase in the price of oil increases the cost of liquid asphalt and could, therefore, decrease demand for hot mix asphalt paving materials and certain of the Company’s products. Increases in oil prices also drive up the cost of gasoline, which results in increased freight costs. Where possible, the Company will pass increased freight costs on to its customers. However, the Company may not be able to recapture all of the increased costs and thus could have a negative impact on the Company’s financial performance.

Steel is a major component used in manufacturing the Company’s equipment. Fluctuations in the price of steel can have a significant impact on the Company’s financial results. Where possible, the Company will pass on increased steel costs to its customers. However, the Company may not be able to recapture all of the increased steel costs and thus its financial results could be negatively affected.

For the long term, the Company believes the strategy of continuing to invest in product engineering and development and its focus on delivering a high-quality product and superior service will strengthen the Company’s market position when demand for its products rebound. In response to the current outlook, the Company continues to take actions to conserve cash, right-size its operations and cost structure, and will continue to do so until conditions in the industry improve. These actions included adjustments to workforce, reduced purchasing and reductions in selling, general, and administrative expenses. The Company continues to review its internal processes to identify inefficiencies and cost reduction opportunities. The Company will continue to scrutinize its relationships with external suppliers to ensure it is achieving the highest quality materials and services at the most competitive cost.

Results of Operations

Quarter Ended June 30, 2014 versus June 30, 2013

Net revenue for the quarter ended June 30, 2014 was $10,547,000, as compared to $18,690,000 for the quarter ended June 30, 2013, a decrease of 43.6%. Net revenues declined from the prior year, as the domestic highway construction industry continues to remain cautious due to the shortfall in Federal funding of the Highway Trust Fund and the lack of an approved multi-year highway bill after September 30, 2014.

As a percent of net revenue, gross profit margins decreased from 26.6% in the quarter ended June 30, 2013 to 21.6% in the quarter ended June 30, 2014. Gross margins decreased in the quarter on lower production volumes.

Product engineering and development expenses decreased $68,000 to $352,000 in the quarter ended June 30, 2014, as compared to the quarter ended June 30, 2013, on reduced headcount. Selling, general and administrative expenses decreased $310,000 to $1,557,000 in the quarter ended June 30, 2014, compared to $1,867,000 in the quarter ended June 30, 2013. The decrease was primarily due to reduced commissions on lower revenues and the timing of certain professional fees.

The Company had operating income of $372,000 for the quarter ended June 30, 2014 versus operating income of $2,683,000 for the quarter ended June 30, 2013. The reduced operating income was due to lower revenues and gross margins.

For the quarter ended June 30, 2014, investment interest and dividend income, net of fees, from the investment portfolio was $168,000, as compared to $516,000 in the quarter ended June 30, 2013. The lower interest and dividend income was due to the sale of the corporate and municipal bonds in March 2014. The resulting proceeds from sale of these investments were reinvested in United States treasury bills. The net realized and unrealized gains on marketable securities were $1,658,000 for the quarter ended June 30, 2014 versus net realized and unrealized gains of $145,000 for the quarter ended June 30, 2013. During the quarter ended June 30, 2014, the Company recognized in other income a gain of $442,000 on the disposal of property in the Untied Kingdom which was previously used as an operating facility.

The effective income tax rate for the quarter ended June 30, 2014 was 37.0% versus 26.0% for the quarter ended June 30, 2013. The effective income tax rate in 2013 was positively impacted by a $350,000 research and development tax credit on amended returns filed for the Company’s 2009 tax year. In addition to the positive impact of the research and development tax credits on the fiscal 2013 tax expense, the effective income tax rate for fiscal 2013 also decreased by the impact of tax-exempt interest income and premium amortization on municipal bonds.

Net income for the quarter ended June 30, 2014 was $1,663,000 versus $2,489,000 for the quarter ended June 30, 2013. The reduced net income in 2014 was primarily due to lower revenues and gross margins partially offset by higher realized and unrealized gains on marketable securities, and the positive impact of the tax credits on the 2013 results.

Nine Months Ended June 30, 2014 versus June 30, 2013

Net revenue for the nine months ended June 30, 2014 and 2013 were $35,107,000 and $41,375,000, respectively, a decrease of 15.1%. Net revenues declined from the prior year, as the domestic highway construction industry continues to remain cautious due to the shortfall in Federal funding of the Highway Trust Fund and the lack of an approved multi-year highway bill after September 30, 2014.

As a percent of net revenue, gross profit margins decreased to 21.4% in the nine months ended June 30, 2014 from 23.5% in the nine months ended June 30, 2013. The lower gross margins resulted from the lower production volumes.

Product engineering and development expenses decreased $239,000, on reduced headcount. Selling, general and administrative expenses decreased $1,000,000 in the nine months ended June 30, 2014, compared to the nine months ended June 30, 2013, due primarily to the $393,000 second fiscal quarter recovery of a previously reserved receivable, reduced commission on reduced sales, reduced advertising and travel expenses related to construction industry events and the timing of professional fees.

The Company had operating income of $1,610,000 for the nine months ended June 30, 2014 versus operating income of $2,581,000 for the nine months ended June 30, 2013. The reduced operating results were primarily due to lower net revenues and gross margins.

For the nine months ended June 30, 2014, investment interest and dividend income, net of fees, from the investment portfolio was $1,598,000, as compared to $1,759,000 in the 2013 comparable period. The net realized and unrealized gains on marketable securities were $2,881,000 for the nine months ended June 30, 2014 versus net realized and unrealized gains of $888,000 for the nine months ended June 30, 2013. During the nine months ended June 30, 2014, the Company recognized in other income a gain of $442,000 on the disposal of property in the United Kingdom which was previously used as an operating facility.

The effective income tax rate for the nine months ended June 30, 2014 was 38.5% versus 14.7% for the nine months ended June 30, 2013. The effective income tax rate in 2014 was impacted by a $129,000 increase in the prior year federal tax provision estimate. The effective income tax rate in 2013 was positively impacted by $1,100,000 in research and development tax credits on amended returns filed for tax years 2006 through 2009. In addition to the positive impact of the research and development tax credits on the fiscal 2013 tax expense, the effective income tax rates for both years were impacted by tax-exempt interest income and premium amortization on municipal bonds.

Net income for the nine months ended June 30, 2014 was $4,010,000 versus $4,490,000 for the nine months ended June 30, 2013.

Liquidity and Capital Resources

The Company does not currently require a credit facility but continues to review and evaluate its needs and options for such a facility.

The Company had no long-term or short-term interest bearing debt outstanding at June 30, 2014 or September 30, 2013. As of June 30, 2014, the Company has funded $135,000 in cash deposits at insurance companies to cover related collateral needs.

As of June 30, 2014, the Company had $9,737,000 in operating cash and cash equivalents, and $87,592,000 in its investment portfolio, including $18,944,000 in equities, $24,608,000 in mutual funds, $40,000,000 in United States treasury bills, $2,010,000 in exchange traded funds and $2,030,000 in cash. The investment portfolio is managed by a global professional investment management firm. The securities in the portfolio may be liquidated into cash at any time.

The Company’s working capital (defined as current assets less current liabilities) was $108.5 million at June 30, 2014 and $102.8 million at September 30, 2013. Cash provided by operations during the nine months ended June 30, 2014 was $96,000. The significant purchases, sales and maturities of marketable securities shown on the condensed consolidated statement of cash flows in 2014 reflects the sale of all corporate and municipal bonds in March 2014 and subsequent recurring purchase and sale of United States treasury bills with 30 day maturities. The net gains on disposal of property and equipment primarily relates to the sale of the UK property. For the nine months ended June 30, 2014, inventories decreased $1.5 million as prior stock build was used to satisfy current sales demands. Accrued expenses and other decreased $583,000, as the Company paid out estimated taxes related to fiscal 2013. Customer deposits decreased, as down payments were applied to completed projects.

Cash flows provided by investing activities for the nine months ended June 30, 2014 of $84,000 included $685,000 of proceeds related to the sale of the UK property and $(601,000) related to capital expenditures on manufacturing equipment. There were no cash disbursements or receipts related to financing activities during the nine months ended June 30, 2014.

Seasonality

The Company’s operations are concentrated in the asphalt-related business and are typically subject to a seasonal slow-down during the third and fourth quarters of the calendar year. This slow-down often results in lower revenues, and earnings or losses during the first and fourth quarters of each fiscal year ended September 30.

Customers with 10% (or greater) of Net Revenues

Approximately 6% of net revenues in the June 30, 2014 quarter and 2% of net revenues for the June 30, 2013 quarter were from entities owned by a global company. For the nine months ended June 30, 2014 and June 30, 2013, this company represented 17% and 13% of total net revenue, respectively.

Forward-Looking Information

This Report on Form 10-Q contains certain “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), which represent the Company’s expectations and beliefs, including, but not limited to, statements concerning gross margins, sales of the Company’s products and future financing plans. These statements by their nature involve substantial risks and uncertainties, some of which are beyond the Company’s control. Actual results may differ materially depending on a variety of important factors, including the financial condition of the Company’s customers, changes in the economic and competitive environments and demand for the Company’s products.

For information concerning these factors and related matters, see the following sections of the Company’s Annual Report on Form 10-K for the year ended September 30, 2013: (a) “Risk Factors” in Part I and (b) “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II. However, other factors besides those referenced could adversely affect the Company’s results, and you should not consider any such list of factors to be a complete set of all potential risks or uncertainties. Any forward-looking statements made by the Company herein speak as of the date of this Report. The Company does not undertake to update any forward-looking statements, except as required by law.

Critical Accounting Policies, Estimates and Assumptions

The Company believes the following discussion addresses its most critical accounting policies, which are those that are most important to the portrayal of the financial condition and results of operations and require management’s most difficult, subjective, or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. Accounting policies, in addition to the critical accounting policies referenced below, are presented in Note 1 to the Company’s Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the year ended September 30, 2013, “Accounting Policies.”

Estimates and Assumptions

In preparing the Consolidated Financial Statements, the Company uses certain estimates and assumptions that may affect reported amounts and disclosures. Estimates and assumptions are used, among other places, when accounting for certain revenue (e.g., contract accounting), expense, and asset and liability valuations. The Company believes that the estimates and assumptions made in preparing the Consolidated Financial Statements are reasonable, but are inherently uncertain. Assumptions may be incomplete or inaccurate and unanticipated events may occur. The Company is subject to risks and uncertainties that may cause actual results to differ from estimated results.

Revenues & Expenses

Revenues from contracts for the design, manufacture and sale of asphalt plants are recognized under the percentage-of-completion method. The percentage-of-completion method of accounting for these contracts recognizes revenue, net of any promotional discounts, and costs in proportion to actual labor costs incurred, as compared with total estimated labor costs expected to be incurred during the entire contract. Pre-contract costs are expensed as incurred. Changes to total estimated contract costs or losses, if any, are recognized in the period in which they are determined. Revenue recognized in excess of amounts billed is classified as current assets under “costs and estimated earnings in excess of billings.” The Company anticipates that all incurred costs associated with these contracts at June 30, 2014 will be billed and collected within one year.

Revenues from all other contracts for the design and manufacture of custom equipment, for service and for parts sales, net of any discounts and return allowances, are recorded when the following four revenue recognition criteria are met: product is delivered or service is performed, persuasive evidence of an arrangement exists, the selling price is fixed or determinable, and collectability is reasonably assured.

Return allowances, which reduce product revenue, are estimated using historical experience. The Company’s customers may qualify for certain cash rebates generally based on the level of sales attained during a twelve-month period. Provisions for these rebates, as well as estimated returns and allowances and other adjustments, are provided for in the same period the related sales are recorded.

Product warranty costs are estimated using historical experience and known issues and are charged to production costs as revenue is recognized.

All product engineering and development costs, and selling, general and administrative expenses are charged to operations as incurred. Provision is made for any anticipated contract losses in the period that the loss becomes evident.

The allowance for doubtful accounts is determined by performing a specific review of all account balances greater than 90 days past due and other higher risk amounts to determine collectability and also adjusting for any known customer payment issues with account balances in the less-than-90-day past due aging buckets. Account balances are charged off against the allowance for doubtful accounts when they are determined to be uncollectable. Any recoveries of account balances previously considered in the allowance for doubtful accounts reduce future additions to the allowance for doubtful accounts.

Inventories

Inventories are valued at the lower of cost or market, with cost being determined principally by using the last-in, first-out (“LIFO”) method and market defined as replacement cost for raw materials and net realizable value for work in process and finished goods. Appropriate consideration is given to obsolescence, excessive levels, deterioration, possible alternative uses and other factors in determining net realizable value. The cost of work in process and finished goods includes materials, direct labor, variable costs and overhead. The Company evaluates the need to record inventory adjustments on all inventories, including raw material, work in process, finished goods, spare parts and used equipment. Used equipment acquired by the Company on trade-in from customers is carried at estimated net realizable value. Unless specific circumstances warrant different treatment regarding inventory obsolescence, the cost basis of inventories three to four years old are reduced by 50%, while the cost basis of inventories four to five years old are reduced by 75%, and the cost basis of inventories greater than five years old are reduced to zero. Inventory is typically reviewed for obsolescence on an annual basis computed as of September 30, the Company’s fiscal year end. If significant known changes in trends, technology or other specific circumstances that warrant consideration occur during the year, then the impact on obsolescence is considered at that time.

Investments

The Company marks to market all trading securities and records unrealized gains or losses as income or loss in the current period.

Long-Lived Asset Impairment

Property and equipment and intangible assets subject to amortization are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset (or asset group) may not be recoverable. An impairment loss would be recognized when the carrying amount of an asset exceeds the estimated undiscounted cash flows expected to result from the use of the asset and its eventual disposition. The amount of the impairment loss to be recorded is calculated by the excess over its fair value of the asset’s carrying value. Fair value is generally determined using a discounted cash flow analysis.

Off-Balance Sheet Arrangements

None

The Company operates manufacturing facilities and sales offices principally located in the United States. The Company is subject to business risks inherent in non-U.S. activities, including political and economic uncertainty, import and export limitations, and market risk related to changes in interest rates and foreign currency exchange rates. The Company may use derivative financial instruments consisting primarily of interest rate hedge agreements to manage exposure to interest rate changes. The Company’s objective in managing its exposure to changes in interest rates on any future variable rate debt is to limit the impact on earnings and cash flow and reduce overall borrowing costs.

At June 30, 2014 and September 30, 2013, the Company had no interest-bearing debt outstanding. The Company’s marketable securities are invested primarily in stocks, U.S. treasury bills, mutual funds and exchange traded funds through a professional investment management firm. Investment securities are exposed to various risks, such as interest rate, market and credit risks. Due to the level of risk associated with investment securities, it is possible that changes in these risk factors could have an adverse, material impact on the Company’s results of operations or equity.

The Company’s sensitivity analysis for interest rate risk excludes accounts receivable, accounts payable, and accrued liabilities, because of the short-term maturity of such instruments. The analysis does not consider the effect on other variables, such as changes in sales volumes or management’s actions with respect to levels of capital expenditures, future acquisitions or planned divestures, all of which could be significantly influenced by changes in interest rates.

Evaluation of Disclosure Controls and Procedures

The Company’s Chief Executive Officer and Chief Financial Officer evaluated the effectiveness of the design and operation of the Company’s “disclosure controls and procedures” (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended) as of the end of the period covered by this Report. Based upon that evaluation, the Chief Executive Officer and the Chief Financial Officer concluded that, as of the end of the period covered by this Report, the Company’s disclosure controls and procedures are effective.

Because of inherent limitations, the Company’s disclosure controls and procedures, no matter how well-designed and operated, can provide only reasonable, and not absolute, assurance that the objectives of such disclosure controls and procedures are met, and no evaluation can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected.

Changes in Internal Control over Financial Reporting

The Company’s management, including the Chief Executive Officer and Chief Financial Officer, has reviewed the Company’s internal control over financial reporting. There were no changes in the Company’s internal control over financial reporting during the quarter and nine months ended June 30, 2014 that materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.