Omega Flex, Inc.: Form 10-Q for the period ended Sep 30, 2023

You should read the following discussion and analysis of our financial condition and results of operations together with our condensed consolidated financial statements and related notes thereto included in Part I, Item 1 of this Form 10-Q. This discussion and other parts of this report contain forward-looking statements that involve risks and uncertainties, such as statements of our plans, objectives, expectations, and intentions that are based on the beliefs of our management, as well as assumptions made by, and information currently available to, our management. Our actual results could differ materially from those discussed in these forward-looking statements. See “Cautionary Note Regarding Forward-Looking Statements” in this Form 10-Q.

OVERVIEW

The Company is a leading manufacturer of flexible metal hose and is currently engaged in a number of different markets, including construction, manufacturing, transportation, petrochemical, pharmaceutical and other industries.

The Company’s business is managed as a single operating segment that consists of the manufacture and sale of flexible metal hose, fittings, and accessories. The Company’s products are concentrated in residential and commercial construction, and general industrial markets, with a comprehensive portfolio of intellectual property and patents issued in various countries around the world. The Company’s primary product, flexible gas piping, is used for gas piping within residential and commercial buildings. Through its flexibility and ease of use, the Company’s TracPipe® and TracPipe® CounterStrike® flexible gas piping, along with its fittings distributed under the trademarks AutoSnap® and AutoFlare®, allows users to substantially cut the time required to install gas piping, as compared to traditional methods. The Company’s newest product line MediTrac® corrugated medical tubing is used for piping medical gases (oxygen, nitrogen, nitrous oxide, carbon dioxide, and medical vacuum) in health care facilities. Building on the recognized strengths and strategies employed in the flexible gas piping market, MediTrac® can be used in place of rigid copper pipe, and due to its long continuous lengths and flexibility, it can be installed approximately five times faster than rigid copper pipe, saving on installation labor and construction schedules. The Company’s products are manufactured at its Exton, Pennsylvania and Houston, Texas facilities in the U.S., and in Banbury, Oxfordshire in the U.K. A majority of the Company’s sales across all industries are generated through independent outside sales organizations such as sales representatives, wholesalers and distributors, or a combination of both. The Company has a broad distribution network in North America and to a lesser extent in other global markets.

CHANGES IN FINANCIAL CONDITION

For the period ended September 30, 2023 vs. December 31, 2022

The Company’s cash balance of $37,954,000 on September 30, 2023 increased $251,000 (0.7%) from a $37,703,000 balance at December 31, 2022 mainly due to cash provided by operating activities of $11,496,000 partially offset by dividend payments of $9,793,000, as detailed in Note 9, Shareholders’ Equity, to the Condensed Consolidated Financial Statements included in this report. See the Company’s Condensed Consolidated Cash Flow Statements for further details regarding the change in cash.

Other Liabilities were $3,910,000 and $7,530,000 as of September 30, 2023 and December 31, 2022, respectively. The decrease of $3,620,000 or 48.1% mainly relates to the payment of an accrual for legal and product liability matters associated with two cases provided for in the previous year, which were resolved through settlement.

Retained earnings were $66,936,000 and $60,954,000 as of September 30, 2023 and December 31, 2022, respectively, increasing $5,982,000 or 9.8%. The increase was primarily due to net income during the year, as provided on the Company’s Condensed Consolidated Statements of Income, partially offset by dividends declared during 2023, as discussed in detail in Note 9, Shareholders’ Equity, to the Condensed Consolidated Financial Statements included in this report.

RESULTS OF OPERATIONS

Three months ended September 30, 2023 compared to three months ended September 30, 2022

The Company reported comparative results from operations for the three month periods ended September 30, 2023 and 2022 as follows:

Net Sales. The Company’s 2023 third quarter sales of $27,496,000 decreased $4,133,000 or 13.1% compared to the third quarter of 2022, which generated sales of $31,629,000. The decrease in sales is mainly due to lower sales unit volumes as a result of the overall market being suppressed because of, among other factors, a decline in housing starts.

Gross Profit. The Company’s gross profit margins were 61.6% and 62.5% for the quarters ended September 30, 2023 and 2022, respectively. Gross profit for the third quarter of 2023 declined mainly due to an increase in the provision for excess inventories for the new corrugated medical tubing (“CMT”) products. Higher amounts of materials for the new CMT products were initially purchased for cost considerations and because of longer required lead times. Lower production, which caused lower absorption of factory labor and overhead costs, also contributed to the lower gross profit margin.

Selling Expenses. Selling expenses consist primarily of employee salaries and associated overhead costs, commissions, and the cost of marketing programs such as advertising, trade shows and related communication costs, and freight. Selling expenses were $5,059,000 and $5,261,000 for the quarters ended September 30, 2023 and 2022, respectively, representing a decrease of $202,000 or 3.8%. The decrease is mostly related to commissions, due to lower sales, and freight. Freight costs decreased because of lower sales volumes and lower carrier rates. These decreases were partially offset by higher staffing related costs and travel. Selling expenses increased as a percent of net sales compared to last year, being 18.4% for the quarter ended September 30, 2023, and 16.6% for the quarter ended September 30, 2022.

General and Administrative Expenses. General and administrative expenses consist primarily of employee salaries, benefits for administrative, executive and finance personnel, legal and accounting, and corporate general and administrative services. General and administrative expenses were $4,037,000 and $4,754,000 for the quarters ended September 30, 2023 and 2022, respectively, decreasing by $717,000 or 15.1%. Product liability reserves and expenses were lower by $1,524,000, associated primarily with one case, which was provided for in the previous year and subsequently resolved through settlement. This was mainly offset by an increase in the incentive compensation component, which is aligned with profitability of $948,000, mainly because of the changes in the executive management team in the previous year. As a percentage of sales, general and administrative expenses decreased to 14.7% for the quarter ended September 30, 2023 from 15.0% for the quarter ended September 30, 2022.

Engineering Expense. Engineering expenses consist of development expenses associated with the development of new products and enhancements to existing products, and manufacturing engineering costs. Engineering expenses were $992,000 and $1,101,000 for the quarters ended September 30, 2023 and 2022, respectively, decreasing by $109,000 or 9.9%, mainly associated with decreases in staffing related costs partially offset by increases in experimental material and product certification related costs. Engineering expenses increased slightly as a percentage of sales, being 3.6% for the quarter ended September 30, 2023, and 3.5% for the same quarter in 2022.

Operating Profits. Reflecting all of the factors mentioned above, operating profits were $6,859,000 and $8,641,000 for the quarters ended September 30, 2023 and 2022, respectively, decreasing by $1,782,000 or 20.6%.

Interest Income. Interest income is recorded on cash investments, and interest expense is recorded at times when the Company has debt amounts outstanding on its line of credit. The Company recorded $502,000 of interest income for the third quarter of 2023 and $32,000 for the third quarter of 2022. Higher interest rates are mainly responsible for the higher interest income.

Other Income (Expense). Other income (expense) primarily consists of foreign currency exchange gains (losses) on transactions settled in currencies other than the Company’s local currency, typically related to the Company’s foreign U.K. and France subsidiaries. There was a loss of $41,000 during the third quarter of 2023 compared to a loss of $210,000 during the third quarter of 2022. The British Pound had weakened during each of the third quarters of 2023 and 2022.

Income Tax Expense. Income tax expense was $1,746,000 for the third quarter of 2023, compared to $1,924,000 for the third quarter in 2022, decreasing $178,000 or 9.3%, mostly the result of lower current quarter income before income taxes.

Nine months ended September 30, 2023 compared to nine months ended September 30, 2022

The Company reported comparative results from operations for the nine month periods ended September 30, 2023 and 2022 as follows:

Net Sales. The Company’s sales for the first nine months of 2023 of $83,318,000 decreased $11,352,000 or 12.0% compared to the first nine months of 2022, which generated sales of $94,670,000. The decrease in sales is mainly due to lower sales unit volumes as a result of the overall market being suppressed because of, among other factors, a decline in housing starts.

Gross Profit. The Company’s gross profit margins were 61.7% and 63.0% for the nine months ended September 30, 2023 and 2022, respectively. The decline in gross profit margin is mainly due to an increase in the provision for excess inventories for the new CMT products. Higher amounts of materials for the new CMT products were initially purchased for cost considerations and because of longer required lead times. Also, lower production, which caused lower absorption of factory labor and overhead costs, contributed to the lower gross profit margin.

Selling Expenses. Selling expenses consist primarily of employee salaries and associated overhead costs, commissions, and the cost of marketing programs such as advertising, trade shows and related communication costs, and freight. Selling expenses were $15,631,000 and $16,545,000 for the nine months ended September 30, 2023 and 2022, respectively, representing a decrease of $914,000 or 5.5%. The decreases are mostly related to commissions and freight. In the previous year, commissions increased partly because of a shift of more shipments from third party warehouses, whose shipments are subject to commission, compared to those directly from the manufacturing facilities, whose shipments are not subject to commission. Freight costs decreased because of lower sales volumes and lower carrier rates. These decreases were partially offset by higher staffing related costs and travel. Selling expenses increased as a percent of net sales compared to last year, being 18.8% for the nine months ended September 30, 2023, and 17.5% for the nine months ended September 30, 2022.

General and Administrative Expenses. General and administrative expenses consist primarily of employee salaries, benefits for administrative, executive and finance personnel, legal and accounting, and corporate general and administrative services. General and administrative expenses were $13,204,000 and $16,257,000 for the nine months ended September 30, 2023 and 2022, respectively, decreasing by $3,053,000 or 18.8%. Product liability reserves and expenses were lower by $3,479,000, associated primarily with two cases, which were provided for in the previous year and subsequently resolved through settlement. There also was a decrease in the incentive compensation component which is aligned with profitability. These were partly offset by increases in staffing related costs and stock based compensation, which moves in relation to the Company’s stock price, as detailed in Note 7, Stock Based Compensation Plans. As a percentage of sales, general and administrative expenses decreased to 15.8% for the nine months ended September 30, 2023 from 17.2% for the nine months ended September 30, 2022.

Engineering Expense. Engineering expenses consist of development expenses associated with the development of new products and enhancements to existing products, and manufacturing engineering costs. Engineering expenses were $2,854,000 and $3,514,000 for the nine months ended September 30, 2023 and 2022, respectively, decreasing by $660,000 or 18.8%, mainly associated with decreases in staffing related costs. Engineering expenses decreased as a percentage of sales, being 3.4% for the nine months ended September 30, 2023, and 3.7% for the nine months ended September 30, 2022.

Operating Profits. Reflecting all of the factors mentioned above, operating profits were $19,686,000 and $23,349,000 for the nine months ended September 30, 2023 and 2022, respectively, decreasing by $3,663,000 or 15.7%.

Interest Income. Interest income is recorded on cash investments, and interest expense is recorded at times when the Company has debt amounts outstanding on its line of credit. The Company recorded $1,179,000 and $52,000 of interest income during the first nine months of 2023 and 2022, respectively. Higher interest rates are mainly responsible for the higher interest income.

Other Income (Expense). Other income (expense) primarily consists of foreign currency exchange gains (losses) on transactions settled in currencies other than the Company’s local currency, typically related to the Company’s foreign U.K. and France subsidiaries. There was a gain of $14,000 during the first nine months of 2023 compared to a loss of $374,000 during the first nine months of 2022. The British Pound had strengthened slightly during the first nine months of 2023 and weakened during the first nine months of 2022.

Income Tax Expense. Income tax expense was $5,014,000 for the first nine months of 2023, compared to $5,558,000 for the same period in 2022, decreasing $544,000 or 9.8%, mostly the result of lower current income before income taxes.

LIQUIDITY AND CAPITAL RESOURCES

Historically, the Company’s primary cash needs have been related to working capital items, which the Company has largely funded through cash generated from operations.

As of September 30, 2023, the Company had a cash balance of $37,954,000. Additionally, the Company has a $15,000,000 line of credit available, as discussed in detail in Note 5, which had no borrowings outstanding upon it as of September 30, 2023. As of December 31, 2022, the Company had a cash balance of $37,703,000, with no borrowings against the line of credit.

We believe our existing cash and cash equivalents, along with our borrowing capacity, will be sufficient to meet our anticipated cash needs for at least the next twelve months. Our future capital requirements will depend upon many factors including our rate of revenue growth, the timing and extent of any expansion efforts, and the potential for investments in, or the acquisition of any complementary products, businesses, or supplementary facilities for additional capacity.

See Notes 6 and 8 to the Company’s Condensed Consolidated Financial Statements included in this Form 10-Q for a description of the Company’s commitments and contingencies.

CASH FLOWS

Operating Activities

Cash provided or used by operating activities is net income adjusted for certain non-cash items and changes in certain assets and liabilities, such as those included in working capital.

For the nine months ended September 30, 2023, the Company’s operating activities provided cash of $11,496,000, compared to the nine months ended September 30, 2022 which provided cash of $4,569,000, a difference of $6,927,000. For details of the operating cash flows refer to the Condensed Consolidated Statements of Cash Flows in Part I – Financial Information on page nine.

As a general trend, the Company tends to deplete or generate lower amounts of cash early in the year, as significant payments are typically made for incentive compensation and accrued promotional incentives. Cash has then historically shown a tendency to be restored and accumulated during the latter portion of the year.

Investing Activities

Cash used in investing activities during the nine months ended September 30, 2023 and 2022 was $1,455,000 and $817,000, respectively, as a result of payments for mainly manufacturing equipment capital expenditures.

Financing Activities

All financing activities relate to dividend payments, which are detailed in Note 9, Shareholders’ Equity. Dividend payments through the first nine months of 2023 and 2022 amounted to $9,793,000 and $6,258,000, respectively.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

See our Annual Report on Form 10-K for the year ended December 31, 2022 for a discussion of our critical accounting policies and estimates. There have been no material changes to our critical accounting policies and estimates discussed in such report.

RECENT ACCOUNTING PRONOUNCEMENTS

In March 2020, the FASB issued Accounting Standards Update (“ASU”) No. 2020-04, Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting, updated in December 2022 by ASU No. 2022-06, Deferral of Sunset Date of Topic 848. The ASUs apply to all entities that have contracts, hedging relationships, and other transactions that reference LIBOR or another reference rate expected to be discontinued because of reference rate reform. The ASUs provide optional expedients and exceptions for applying GAAP to contracts, hedging relationships, and other transactions affected by reference rate reform if certain criteria are met. The expedients and exceptions provided by the ASUs do not apply to contract modifications made and hedging relationships entered into or evaluated after December 31, 2024, except for hedging relationships existing as of December 31, 2024, that an entity has elected certain optional expedients for and that are retained through the end of the hedging relationship. ASU 2020-04, as updated by ASU 2022-06, is effective for all entities as of March 12, 2020, through December 31, 2024. The impact of the adoption did not have a material impact on the Company’s Condensed Consolidated Financial Statements.

The Company does not engage in the purchase or trading of market risk sensitive instruments. The Company does not presently have any positions with respect to hedge transactions such as forward contracts relating to currency fluctuations. No market risk sensitive instruments are held for speculative or trading purposes.

(a) Evaluation of Disclosure Controls and Procedures.

Our management, with the participation of our Chief Executive Officer and our Chief Financial Officer, have evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this Form 10-Q. Based on that evaluation, our Chief Executive Officer and our Chief Financial Officer have concluded that, as of the end of the period covered by this Form 10-Q, our disclosure controls and procedures were effective at the reasonable assurance level. In designing and evaluating our disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. In addition, the design of disclosure controls and procedures must reflect the fact that there are resource constraints and that management is required to apply judgment in evaluating the benefits of possible controls and procedures relative to their costs.

(b) Changes in Internal Controls.

There were no changes in our internal control over financial reporting (as defined in Rule 13a-15(f) and 15d-15(f) under the Exchange Act) during the most recent quarter ended September 30, 2023, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

In addition to the risk factors described under Item 1A of the Company’s Form 10-K for the year ended December 31, 2022, readers should also carefully consider the risks, uncertainties and other factors described below, in addition to the other information set forth in this report, because they could materially and adversely affect the Company’s business, operating results, financial condition, cash flows, prospects, and the value of an investment in the Company’s common stock.

Our credit facility bears a variable rate of interest that is based on the Secured Overnight Financing Rate (“SOFR”), which may have consequences for us that cannot be reasonably predicted and may adversely affect our liquidity, financial condition, and earnings.

Borrowings under our credit facility bear interest at a rate per annum of either, at our election, (i) Term SOFR plus a margin or (ii) the Prime Rate plus a margin, with the applicable margin depending on specified financial ratios. Since the initial publication of SOFR, daily changes in the rate have, on occasion, been more volatile than daily changes in comparable benchmark or market rates, and SOFR over time may bear little or no relation to the historical actual or historical indicative data. As of September 30, 2023, we had no outstanding borrowings under this credit facility. If we were to borrow under this credit facility, it is possible that the volatility of SOFR could result in higher borrowing costs for us and could adversely affect our liquidity, financial condition, and earnings. See Note 5, Line of Credit and Other Borrowings, to the Condensed Consolidated Financial Statements included in this Form 10-Q for additional information.