Strattec Security Corp: Form 10-Q for the period ended Sep 27, 2020

MANAGEMENT’S DISCUSSION AND ANALYSIS

OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following Management’s Discussion and Analysis should be read in conjunction with STRATTEC SECURITY CORPORATION’s accompanying Condensed Consolidated Financial Statements and Notes thereto and its 2020 Form 10-K, which was filed with the Securities and Exchange Commission on September 3, 2020. Unless otherwise indicated, all references to quarters and years refer to fiscal quarters and fiscal years.

Outlook

Refer to discussion of Risks and Uncertainties included in the Notes to Condensed Consolidated Financial Statements beginning on page 6 of this Form 10-Q.

During the fourth quarter of our fiscal year ended June 2020, we responded to the COVID-19 pandemic and the temporary OEM customer plant shutdowns by implementing a permanent reduction in our salaried workforce, instituting temporary layoffs, reducing working hours, allowing (and in some cases encouraging) remote working from home, temporarily suspending our quarterly cash dividend, delaying capital expenditures and eliminating nonessential operating costs, all to preserve cash flow. In addition, during the fourth quarter of the prior fiscal year, we produced additional finished goods inventory in anticipation of our OEM customers pipeline fill to their dealers once vehicle production began starting up in June 2020.

During the first quarter ended September 2020, the Company experienced a strong sales recovery as our customers ramped up vehicle production as they restarted their assembly plant operations in order to replenish low inventory levels at the dealers. Likewise, our manufacturing operations in Milwaukee, WI and in Mexico ramped up production to meet this increased sales demand. However, these actions were, and continue to be hampered by, requirements imposed by the Mexican Government at our Mexican facilities that continue to limit operating capacity in Mexico due to COVID-19 which may in the future impact our ability to meet customer sales demand depending upon their order levels.

The sales outlook over the next few quarters appears strong as our customers continue to restock dealer inventories. However, this sales demand going forward is contingent on the impact and severity of the COVID-19 pandemic, including any potential worsening thereof, on the North American and overall global economy.

Analysis of Results of Operations

Three months ended September 27, 2020 compared to the three months ended September 29, 2019

Net sales to each of our customers or customer groups in the current year quarter and prior year quarter were as follows (in millions):

19

The increase in sales to General Motors Company in the current year quarter as compared to the prior year quarter was attributed to higher production volumes on models for which we supply components. The impact of the UAW strike reduced net sales by an estimated $3.0 million in the prior year quarter. Sales to Fiat Chrysler Automobiles decreased slightly in the current year quarter as compared to the prior year quarter due to lower vehicle production volumes on the FCA minivans for which we supply components. The Dodge Grand Caravan minivan went out of production during July 2020. Sales to Ford Motor Company, Tier 1 Customers and Commercial and Other OEM Customers were flat in the current year quarter compared to the prior year quarter. Sales to Tier 1 Customers, Commercial and Other OEM Customers primarily represent purchasers of vehicle access control products, such as latches, key fobs, driver controls, steering column locks and door handles, that we have developed in recent years to complement our historic core business of locks and keys. The increased sales to Hyundai / Kia in the current year quarter as compared to the prior year quarter were due to higher levels of production on their new, recently launched Kia Sedona minivan for which we supply components.

Direct material costs are the most significant component of our cost of goods sold and comprised $70.5 million or 68.0 percent of our cost of goods sold in the current year quarter compared to $68.5 million or 65.8 percent of our cost of goods sold in the prior year quarter. The increase in our direct material costs between these quarters of $2.0 million or 2.9 percent was due to increased sales volumes in the current year quarter as compared to the prior year quarter and increased obsolescence costs in the current year quarter resulting from the discontinuance of a customer program. The increase in our direct material costs as a percentage of our cost of goods sold in the current year quarter as compared to the prior year quarter was due to reduced labor and overhead costs between periods as discussed below.

The remaining components of our cost of goods sold consist of labor and overhead costs which decreased $2.4 million or 6.7 percent to $33.2 million in the current year quarter from $35.6 million in the prior year quarter. The prior year quarter costs included a $1.4 million non-cash compensation expense charge related to the transfer of excess Qualified Pension Plan assets as described under Pension and Postretirement Benefits within Notes to Condensed Consolidated Financial Statement included herein. Additionally, labor and overhead costs in the current year quarter were favorably impacted by cost improvements implemented at our Milwaukee, WI and Mexico facilities, along with a favorable Mexican peso to U.S. dollar exchange rate affecting our operations in Mexico, which favorable impacts were partially offset by an increase in the variable portion of our labor and overhead costs as a result of the increase in sales volumes in the current year quarter as compared to the prior year quarter. The U.S. dollar value of our Mexican operations was favorably impacted by approximately $2.0 million in the current year quarter as compared to the prior year quarter due to a favorable Mexican peso to U.S. dollar exchange rate between these quarterly periods. The average U.S. dollar / Mexican peso exchange rate increased to approximately 22.21 pesos to the dollar in the current year quarter from approximately 19.61 pesos to the dollar in the prior year quarter.

Gross profit dollars increased in the current year quarter as compared to the prior year quarter as a result of both an increase in sales and an increase in cost of goods sold between periods, as discussed above. Gross profit as a percentage of net sales increased between periods. The increase was due to the prior year quarter non-cash compensation expense charge as well as cost improvements implemented at our Milwaukee and Mexico production facilities in the current year quarter as compared to the prior year quarter and a favorable Mexican peso to U.S. dollar exchange rate affecting our operations in Mexico as discussed above.

Engineering, selling and administrative expenses in the current year quarter and prior year quarter were as follows:

The decrease in engineering, selling and administrative expenses in the current year quarter decreased in comparison to the prior year quarter due to lower new product development costs, a temporary reduction in salary work force wages, permanent layoffs, and improved operating expense management in the current year quarter as compared to the prior year quarter. Additionally, the prior year quarter costs included an $862,000 non-cash compensation expense charge related to the transfer of excess Qualified Pension

Plan assets as described under Pension and Postretirement Benefits within Notes to Condensed Consolidated Financial Statement included herein.

Income from operations was $11.2 million in the current year quarter compared to $2.9 million in the prior year quarter due to an increase in gross profit margin dollars and a decrease in engineering, selling and administrative expenses between quarters, all as discussed above.

The equity earnings of joint ventures was $825,000 in the current year quarter compared to $484,000 in the prior year quarter. Higher profitability from our Vehicle Access Systems Technology LLC (“VAST LLC”) joint ventures is due to higher profitability in our VAST China operation between periods. Our VAST LLC joint ventures in India and Brazil continue to report losses due to our limited amount of business in both regions.

Included in Other Expense, net in the current year quarter and prior year quarter were the following items (in thousands):

Foreign currency transaction losses during the current year quarter and prior year quarter resulted from activity associated with foreign denominated assets held by our Mexican subsidiaries. We entered into the Mexican peso currency forward contracts to minimize earnings volatility resulting from changes in exchange rates affecting the U.S. dollar cost of our Mexican operations. Unrealized gains and losses on the peso forward contracts recognized as a result of mark-to-market adjustments as of September 27, 2020 may or may not be realized in future periods, depending on actual Mexican peso to U.S. dollar exchange rates experienced during the balance of the contract period. Pension and postretirement plan impacts include the components of net periodic benefit cost other than the service cost component. Our Rabbi Trust assets fund our amended and restated supplemental executive retirement plan. The investments held in the Trust are considered trading securities.

Our effective tax rate was 13.5% and 10.0% for the three months ended September 27, 2020 and September 29, 2019, respectively. Effective July 20, 2020, the U.S Treasury Department finalized and enacted previously proposed regulations regarding the Global Intangible Low Taxed Income (GILTI) tax provisions of the Tax Cuts and Jobs Act of 2017 (TCJA). Prior to this enactment, GILTI represented a significant U.S. income tax on our foreign earnings during fiscal 2020. With the enactment of these final regulations, we are now eligible for an exclusion from GILTI since we meet the provisions for the GILTI High-Tax exception included in the final regulations. In addition, the enactment of the new regulations and our eligibility for the GILTI High-Tax exception are retroactive to the original enactment of the GILTI tax provision, which includes our 2020 fiscal year. As a result of the newly enacted regulations, we recorded an income tax benefit of $675,000 during the three month period ended September 27, 2020. During the three month period ended September 29, 2019, our effective tax rate was impacted by the discrete impact of the non-cash compensation expense, as discussed under Pension and Postretirement Benefits below. Our effective tax rate differs from the statutory tax rate due to the GILTI provisions, our available R&D tax credit and the non-controlling interest portion of our pre-tax income. The non-controlling interest impacts the effective tax rate as ADAC-STRATTEC LLC and STRATTEC POWER ACCESS LLC entities are taxed as partnerships for U.S. tax purposes.

Liquidity and Capital Resources

Working Capital (in millions)

21

Outstanding Receivable Balances from Major Customers

Our primary source of cash flow is from our major customers, which include Fiat Chrysler Automobiles, General Motors Company and Ford Motor Company. As of the date of filing this Form 10-Q with the Securities and Exchange Commission, all of our major customers are making payments on their outstanding accounts receivable in accordance with the payment terms included on their purchase orders. A summary of our outstanding receivable balances from our major customers as of September 27, 2020 was as follows (in millions):

Cash Balances in Mexico

We earn a portion of our operating income in Mexico. As of September 27, 2020, $4.2 million of our $12.0 million cash and cash equivalents balance was held in Mexico. These funds are available for repatriation as deemed necessary.

Cash Flow Analysis (in millions)

The decrease in cash provided by operating activities between periods is due to a net increase in our working capital requirements between periods of approximately $13.2 million which was partially offset by improvement in our financial results between periods. The net increase in our working capital requirements between periods was made up of the following working capital changes (in millions):

22

The period over period change in the accounts receivable balances is the result of the amount and timing of sales during each period. The increase in accounts receivable balances during the current year period reflected reduced sales levels from the end of March 2020 through June 2020, which reduction was primarily due to our OEM customers reducing production schedules and closing their assembly plants due to the COVID-19 outbreak. The reduction in accounts receivable balances during the prior year period reflected reduced sales levels toward the end of our September 2019 period as compared to the end of our June 2019 period. The period over period change in inventory reflected a decrease in inventory balances during the current year period due to an inventory build-up as of June 2020 resulting from our OEM customers reducing production schedules and closing their assembly plants due to COVID-19 and an increase in inventory balances during the prior year period due to an inventory build-up of General Motors components stemming from the impacts of the General Motors strike. The period over period change in other assets reflected a reduction in our other assets balances in the prior year period, which was driven by changes in customer tooling balances. Customer tooling balances consisted of costs incurred for the development of tooling that will be directly reimbursed by our customer whose parts are produced from the tool. The prior year change in customer tooling balances was the result of the timing of tooling development spending required to meet customer production requirements and related customer billing for tooling cost reimbursement. The period over period change in accounts payable and accrued liability balances was primarily the result of an increase in accounts payable balances during the current year period. Accounts payable balances were significantly reduced as of June 2020 due to the impact of COVID-19. Accounts payable balances increased as of September 2020 as our business ramped-up along with the automotive industry. Accounts payable balances reflect the timing of purchases and payments with our vendors based on normal payment terms.

Net cash used by investing activities of $1.5 million during the current year period and $4.3 million during the prior year period were the result of capital expenditures made in support of requirements for new product programs and the upgrade and replacement of existing equipment.

Net cash used in financing activities during the current year period of $5.5 million included repayments of borrowings under credit facilities of $5.0 million and $490,000 of dividend payments to non-controlling interests in our subsidiaries. Net cash used in financing activities of $7.3 million during the prior year period included repayments of borrowings under credit facilities of $6.0 million, $522,000 of regular quarterly dividend payments to shareholders and $980,000 of dividend payments to non-controlling interests in our subsidiaries.

VAST LLC Cash Requirements

We currently anticipate that VAST China has adequate debt facilities in place over the next fiscal year to cover the future operating and capital requirements of its business. No capital contributions were made to VAST LLC during the three months ended September 27, 2020 or September 29, 2019. Due to economic conditions in Brazil, we anticipate Sistema de Acesso Veicular Ltda will require a capital contribution of approximately $300,000 collectively by all VAST LLC partners to fund operations during fiscal year 2021. STRATTEC’s portion of the capital contributions is anticipated to be $100,000. During the three months ended September 27, 2020, VAST LLC made no capital contributions to Minda-VAST Access Systems. Due to Minda-VAST Access System recently experiencing losses and due to the COVID-19 outbreak, future capital contributions may be required.

Future Capital Expenditures

We anticipate capital expenditures will be approximately $12 million in total in fiscal 2021, of which $1.5 million has been made through September 27, 2020, in support of requirements for new product programs and the upgrade and replacement of existing equipment.

Stock Repurchase Program

Our Board of Directors has authorized a stock repurchase program to buy back outstanding shares of our common stock. Shares authorized for buy back under the program totaled 3,839,395 at September 27, 2020. A total of 3,655,322 shares have been repurchased over the life of the program through September 27, 2020, at a cost of approximately $136.4 million. No shares were repurchased during the three month periods ended September 27, 2020 or September 29, 2019. Additional repurchases may occur from time to time and are expected to continue to be funded by cash flow from operations and current cash balances. Based on the current economic environment and our preference to conserve cash for other uses, we anticipate modest or no stock repurchase activity for the remainder of fiscal year 2021.

Credit Facilities

STRATTEC has a $40 million secured revolving credit facility (the “STRATTEC Credit Facility”) with BMO Harris Bank N.A. ADAC-STRATTEC LLC has a $25 million secured revolving credit facility (the “ADAC-STRATTEC Credit Facility”) with BMO Harris Bank N.A., which is guaranteed by STRATTEC. The credit facilities both expire August 1, 2022. Borrowings under either credit facility are secured by our U.S. cash balances, accounts receivable, inventory, and fixed assets located in the U.S. Interest on borrowings under the STRATTEC Credit Facility is at varying rates based, at our option, on the London Interbank Offering Rate (“LIBOR”) plus 1.0 percent or the bank’s prime rate. Interest on borrowings under the ADAC-STRATTEC Credit Facility is at varying rates based, at our option, on LIBOR plus 1.25 percent or the bank’s prime rate. Both credit facilities contain a restrictive financial covenant that requires the applicable borrower to maintain a minimum net worth level. As of September 27, 2020, we were in compliance with all financial covenants required by these credit facilities. The ADAC-STRATTEC Credit Facility includes an additional restrictive financial covenant that requires the maintenance of a minimum fixed charge coverage ratio. Outstanding borrowings under the STRATTEC Credit Facility totaled $13 million at September 27, 2020 and $18 million at June 28, 2020. The average outstanding borrowings and weighted average interest rate on the STRATTEC Credit Facility loans were approximately $17.2 million and 1.2 percent, respectively, during the three months ended September 27, 2020. Outstanding borrowings under the ADAC-STRATTEC Credit Facility totaled $17 million at September 27, 2020 and $17.0 million at June 28, 2020. The average outstanding borrowings and weighted average interest rate on the ADAC-STRATTEC Credit Facility loans were approximately $17.0 million and 1.4 percent, respectively, during the three months ended September 27, 2020.

Inflation and Other Changes in Prices

Inflation Related Items: Over the past several years, we have been impacted by rising health care costs, which have increased our cost of associate medical coverage. A portion of these increases have been offset by plan design changes and associate wellness initiatives. We have also been impacted by increases in the market price of metals (zinc, steel, brass, nickel silver and aluminum) and inflation in Mexico, which impacts the U. S. dollar costs of our Mexican operations. We have negotiated raw material price adjustment clauses with certain, but not all, of our customers to offset some of the market price fluctuations in the cost of zinc. We have from time to time entered into contracts with Bank of Montreal that provide for bi-weekly and monthly Mexican peso currency forward contracts for a portion of our estimated peso denominated operating costs to minimize our earnings volatility resulting from changes in exchange rates affecting the U.S. dollar cost of our Mexican operations. Refer to discussion under Notes to Condensed Consolidated Financial Statements: Derivative Instruments included herein.

Joint Ventures and Majority Owned Subsidiaries

Refer to the discussion of Investment in Joint Ventures and Majority Owned Subsidiaries and discussion of Equity Earnings of Joint Ventures included in Notes to Condensed Consolidated Financial Statements included within this Form 10-Q.

We maintain disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act")), that are designed to ensure that information required to be disclosed in the Company’s reports filed or submitted under the Exchange Act, are recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and that the information required to be disclosed by the Company in reports that it files or submits under the Exchange Act are accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. As of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of the end of such period, our disclosure controls and procedures were effective at reaching a level of reasonable assurance. It should be noted that in designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating the cost benefit relationship of possible controls and procedures. We have designed our disclosure controls and procedures to reach a level of reasonable assurance of achieving the desired control objectives.

There was no change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during our most recently completed fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

Part II

Other Information

There have been no material changes to the risk factors disclosed in our Form 10-K as filed with the Securities and Exchange Commission on September 3, 2020.