Strattec Security Corp: Form 10-Q for the period ended Sep 26, 2021

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 2021 Form 10-K, which was filed with the Securities and Exchange Commission on September 2, 2021. 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 fiscal year 2020, 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 nine month period ended March 28, 2021, 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. During the fourth quarter of fiscal year 2021, we were impacted by supply chain shortages of critical electronic component parts, primarily semiconductor chips, and certain raw materials which impacted the production schedules for our customers and, therefore, our production levels. These shortages continued into our fiscal 2022 first quarter and continue to impact customer production schedules and our ability to meet customer sales demand depending upon fluctuations in our customers’ production order levels.

Additionally, during the first quarter of fiscal year 2022, certain of our customers temporarily closed several of their assembly plants in North America due to these continuing global supply chain shortages of critical electronic component parts, including the semiconductor chips, which could continue to disrupt production levels, supply chain costs and volumes for several more quarters.

The sales outlook over the next few quarters may be strong as we expect our customers to seek to restock dealer inventories based on their consumers’ demand, which are in short supply. However, this strong sales demand going forward is contingent on the impact of the supply chain part shortages referenced above and on the ongoing severity of the COVID-19 pandemic, including any potential worsening thereof, on the North American and overall global economy and its impact on the supply chain shortages of critical electronic component parts seen across the world.

Analysis of Results of Operations

Three months ended September 26, 2021 compared to the three months ended September 27, 2020

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

Current year quarter sales were adversely impacted by the global semiconductor chip shortage that temporarily closed several of our customers’ assembly plants in North America and caused production schedule reductions and which reduced our net sales to all customer groups in the current year quarter as compared to the prior year quarter. The following items further impacted sales to the noted customer groups between quarters:

• Sales to Ford Motor Company were positively impacted in the current quarter due to higher product content, and in particular for the new power tailgate program on the F-150 pickup trucks. The favorable impact of this higher product content more than offset the volume reduction resulting from the global semiconductor chip shortage.
• Hyundai / Kia sales were positively impacted in the current quarter due to higher levels of production on their recently launched Kia Carnival, formerly the Kia Sedona, and Hyundai Starex minivans for which we supply primarily power sliding door components. These higher production levels more than offset the volume reduction resulting from the global semiconductor chip shortage.
• Commercial and Other OEM Customers, along with Tier 1 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 direct material cost decrease was due to reduced sales volumes between quarters, as discussed above, which more than offset an increase in direct material costs in the current year quarter as compared to the prior year quarter resulting from higher costs for both raw materials and purchased components. Overall, our direct material cost decrease between quarters was in line with our reduced sales dollars between quarters, as discussed above. Our labor and overhead cost decrease between quarters, as discussed below, did not match the pace of our reduced sales dollars between quarters. This resulted in a reduction in our direct material costs as a percentage of cost of goods sold between quarters and an increase in our labor and overhead costs as a percentage of cost of goods sold between quarters.

Labor and overhead costs decreased between quarters. The variable portion of our labor and overhead cost decreased as a result of the reduction in sales volumes between quarters, which was driven by the global semiconductor chip shortage as previously discussed. Labor and overhead costs were further impacted by the following:

Cost Increases:

• The U.S. dollar value of our Mexican operations was negatively impacted by approximately $1.7 million in the current year quarter as compared to the prior year quarter due to an unfavorable Mexican peso to U.S. dollar exchange rate between these periods. The average U.S. dollar / Mexican peso exchange rate increased to approximately 20.00 pesos to the dollar in the current quarter from approximately 22.21 pesos to the dollar in the prior year quarter.
• Mexico wages and benefits increased $900,000 as a result of a January 1, 2021 minimum wage increase.
• Current year quarter costs included lump sum bonuses totaling $100,000 paid to our Milwaukee represented hourly workers upon the ratification of a new four-year labor contract, which contract is effective through November 1, 2025.

Cost Decreases:

• Expense provisions under our incentive bonus plan impacting cost of goods sold decreased $970,000 between periods.

Gross profit dollars decreased in the current year quarter as compared to the prior year quarter as a result of the reduction in sales between periods, which was partially offset by a decrease in cost of goods sold between periods, as discussed above. Gross profit as a percentage of net sales decreased between periods. The decrease was the result of the reduced sales, an unfavorable Mexican peso to U.S. dollar exchange rate affecting our operations in Mexico, and increases in Mexico wages resulting from a January 1, 2021 minimum wage increase, all of which were partially offset by a decrease in expense provisions for the accrual of bonuses under our incentive bonus plan, all as discussed above.

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

Engineering, selling and administrative expenses in the current year quarter increased in comparison to the prior year quarter due to higher costs for our salaried workforce as the prior year quarter included temporary wage reductions that we implemented to address the impact of the COVID-19 pandemic on our operations. These increased costs were partially offset by a decrease of approximately $700,000 in expense provisions for the accrual of bonuses under our incentive bonus plan between quarters.

Income from operations was $428,000 in the current year quarter compared to $11.2 million in the prior year quarter due to a decrease in gross profit margin dollars and an increase in engineering, selling and administrative expenses between quarters, all as discussed above.

The equity loss of joint ventures was $251,000 in the current year quarter compared to equity earnings of joint ventures of $825,000 in the prior year quarter. Lower profitability from our VAST LLC joint venture resulted from reduced net sales and reduced profitability in our VAST China operation between quarters. The reduced profitability in our VAST China operation stemmed from the current global semiconductor chip shortage described above. VAST LLC, including VAST China, is a crucial part of our global strategy and we anticipate that it will contribute to our overall long-term market and financial strength as the China market continues to expand and as it seeks to rebound from the ongoing impacts of the COVID-19 pandemic and resulting supply chain shortages of critical electronic component parts. Our VAST LLC joint ventures in India and Brazil continue to report losses due to our limited amount of business in both regions as well as the impact of COVID-19 and the global semiconductor chip shortage described above.

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

Set forth below is a discussion of the items comprising certain of the components of our Other Income (Expense), net account:

• Foreign currency transaction gains and losses resulted from activity associated with foreign denominated assets held by our Mexican subsidiaries.
• The Rabbi Trust assets fund our amended and restated supplemental executive retirement plan. The investments held in the Trust are considered trading securities.
• We entered into the Mexican peso currency forward contracts during fiscal 2022 and 2021 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 26,

2021 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 costs include the components of net periodic benefit cost other than the service cost component.

Our effective tax rate was 14.3% and 13.5% for the three months ended September 26, 2021 and September 27, 2020, 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 our fiscal 2020. With the enactment of these final regulations, we became eligible for an exclusion from GILTI since we met 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 was retroactive to the original enactment of the GILTI tax provision, which included our 2020 fiscal year. As a result, we recorded an income tax benefit of $675,000 during the three month period ended September 27, 2020. 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)

Outstanding Receivable Balances from Major Customers

Our primary source of cash flow is from our major customers, which include General Motors Company, Stellantis 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 26, 2021 was as follows (in millions):

Cash Balances in Mexico

We earn a portion of our operating income in Mexico. As of September 26, 2021, $1.9 million of our $7.0 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 reduction in net income between periods along with a net increase in our working capital requirements between periods of approximately $8.2 million. The net increase in our working capital requirements between periods was made up of the following working capital changes (in millions):

Set forth below is a summary of the items impacting the change in our working capital requirements between quarters:

• The change in the accounts receivable balances is the result of the amount and timing of sales during each year. The decrease in accounts receivable balances during the current year quarter is the result of reduced sales in the quarter stemming from the global semiconductor chip shortage. The increase in accounts receivable balances during the prior year quarter 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 change in inventory levels reflected an increase in inventory balances during the current year quarter and a decrease in inventory balances during the prior year quarter. The current year period increase was due to an inventory build-up during our fiscal 2022 first quarter while our OEM customers experienced assembly plant shut-downs and reduced production schedules due to certain part shortages, including semiconductor chips. The prior year quarter decrease was due to an inventory build-up from the end of March 2020 through June 2020 as a result of our OEM customers reducing production schedules and closing their assembly plants due to COVID-19 during this time. Inventory balances then decreased during the fiscal 2021 first quarter as inventory was shipped to meet increased OEM production schedules as customer plants reopened.
• The change in other assets was the result of an increase in our customer tooling balances in the current quarter. Customer tooling balances during each quarter 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 current year quarter change in customer tooling balances was the result of the timing of tooling development spending required to meet customer production requirements and the timing of related customer billings for tooling cost reimbursement.
• The change in accounts payable and accrued liability balances was primarily the result of the payment of fiscal 2021 accrued bonuses during the current year quarter and an increase in accounts payable balances during the prior year quarter. Bonus accruals at June 2021, which were paid during the current year quarter, totaled $6.6 million. The prior year quarter accounts payable balance increase resulted from accounts payable balances being significantly reduced as of June 2020 due to the impact of COVID-19 and lower production levels stemming from that impact. Accounts payable balances increased during our fiscal 2021 first quarter as our business ramped-up to support increased OEM production schedules as customer plants reopened. Accounts payable balances for each quarter reflected the timing of purchases and payments with our vendors based on normal, established payment terms.

Net cash used by investing activities of $2.8 million during the current year quarter and $1.5 million during the prior year quarter 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 provided by financing activities during the current year quarter of $5.0 million included increased borrowings under our credit facilities of $7.0 million and $619,000 received for the exercise of stock options under our stock incentive plan and purchases under our employee stock purchase plan, partially offset by $2.0 million of repayments of borrowings under our credit facilities and $600,000 of dividend payments to non-controlling interests in our subsidiaries. Net cash used in financing activities of $5.5 million during the prior year quarter included repayments of borrowings under credit facilities of $5.0 million and $490,000 of dividend payments to non-controlling interests in our subsidiaries, partially offset by $19,000 received for purchases under our employee stock purchase plan.

VAST LLC Cash Requirements

We currently anticipate that VAST China has adequate debt facilities in place over the remainder of the 2022 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 26, 2021 or September 27, 2020. Due to economic conditions in Brazil, we anticipate Sistema de Acesso Veicular Ltda may require an additional capital contribution of approximately $300,000 collectively by all VAST LLC partners to fund operations during our fiscal year 2022. STRATTEC’s portion of these capital contributions is anticipated to be $100,000. During the three months ended September 26, 2021 and 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 continuing impacts of the COVID-19 pandemic and the continuing supply chain shortages of critical electronic component parts, future capital contributions may be required by the partners in this joint venture.

Future Capital Expenditures

We anticipate capital expenditures will be approximately $13 million in total in fiscal 2022, of which $2.8 million has been made through September 26, 2021, 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 26, 2021. A total of 3,655,322 shares have been repurchased over the life of the program through September 26, 2021, at a cost of approximately $136.4 million. No shares were repurchased during the three month periods ended September 26, 2021 or September 27, 2020. 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 2022.

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, 2024. 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 through May 31, 2021 was 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 through May 31, 2021 was at varying rates based, at our option, on LIBOR plus 1.25 percent or the bank’s prime rate. Effective June 1, 2021 interest on borrowings under both credit facilities were at varying rates based, at our option, on the London Interbank Offering Rate (“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. The ADAC-STRATTEC Credit Facility includes an additional restrictive financial covenant that requires the maintenance of a minimum fixed charge coverage ratio. As of September 26, 2021, we were in compliance with all financial covenants required by these credit facilities. Outstanding borrowings under the STRATTEC Credit Facility totaled $1 million at September 26, 2021. There were no outstanding borrowings under the STRATTEC Credit Facility at June 27, 2021. The average outstanding borrowings and weighted average interest rate on the STRATTEC Credit Facility loans were approximately $330,000 and 2.9 percent, respectively, during the three months ended September 26, 2021. Outstanding borrowings under the ADAC-STRATTEC Credit Facility totaled $16 million at September 26, 2021 and $12 million at June 27, 2021. The average outstanding borrowings and weighted average interest rate on the ADAC-STRATTEC Credit Facility loans were approximately $13.3 million and 1.4 percent, respectively, during the three months ended September 26, 2021.

Inflation and Other Changes in Prices

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 zinc, steel, brass, nickel silver, and aluminum as well as inflation and wage increases 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 own and operate manufacturing operations in Mexico. As a result, a portion of our manufacturing costs are incurred in Mexican pesos. 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 elsewhere herein.

Joint Ventures and Majority Owned Subsidiaries

Refer to the discussion of Investment in Joint Ventures and Majority Owned Subsidiaries and discussion of Equity (Loss) Earnings of Joint Ventures included elsewhere in Notes to Condensed Consolidated Financial Statements 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 2, 2021.