Strattec Security Corp: Form 10-Q for the period ended Oct 2, 2022

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 2022 Form 10-K, which was filed with the Securities and Exchange Commission on September 8, 2022. 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.

Starting during the fourth quarter of our fiscal year ended June 2020, the automotive industry has experienced significant volatility due to the COVID-19 pandemic which resulted in periods of shutdowns as well as a subsequent demand-led production recovery. During the fourth quarter of fiscal year 2021, we were impacted by supply chain shortages in the automotive supply chain 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 throughout our fiscal 2022, which resulted in some of our customers temporarily closing several of their assembly plants or reducing their production schedules in North America.

While supply chain shortages improved in the first quarter of fiscal year 2023 relative to the prior year quarter, they continued to constrain a return to production levels commensurate with the existing consumer demand in the market, resulting in a continuation of low dealer inventories in North America. The sales outlook from our customers over the next few quarters continues to project growth as we expect our customers to seek to restock dealer inventories. However, this stronger sales outlook is contingent on both the improvement of the supply chain part shortages referenced above, which continue to be at risk of negative impact by the lingering effects of the COVID-19 pandemic, and any potential worsening of the North American and overall global economy due to higher inflation and interest rates and the economic implications from the conflict in the Ukraine and other international political unrest.

Analysis of Results of Operations

Three months ended October 2, 2022 compared to the three months ended September 26, 2021

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

Overall, the quarter-over-quarter sales increase was due to improved global semiconductor chip availability in the current year quarter relative to the prior year quarter. The following items specifically impacted sales to the above noted customer groups between quarters:

• Sales to General Motors Company, Ford Motor Company and Stellantis were positively impacted in the current year quarter due to higher vehicle production volumes resulting from improved global semiconductor chip availability relative to the prior year quarter. Specifically, sales growth to General Motors Company and Ford Motor Company in the current

year quarter was attributed to higher production volumes of the GMC Sierra, Chevy Silverado and Ford F-150 family of pickup trucks for which we supply a wide range of components.

• Sales to Tier 1 Customers improved in the current year quarter compared to the prior year quarter due to higher vehicle production volumes relating to the semiconductor chip availability referenced above.
• Sales to Commercial and Other OEM Customers, which are comprised of aftermarket products and vehicle access control products, such as latches, fobs, driver controls and door handles, declined in the current year quarter as compared to the prior year quarter due to continued semiconductor chip availability issues for aftermarket keys. The increases in availability of semiconductor chips were allocated toward the production of components for production vehicles ahead of aftermarket products and therefore, sales to aftermarket customers continued to be negatively impacted in the current year quarter by the global semiconductor chip shortage.
• Sales to Hyundai / Kia decreased quarter-over-quarter due to lower levels of production of the Kia Carnival, for which we supply components, in the current year quarter as compared to the prior year quarter.

The direct material cost increase between quarters was due to increased sales volumes between quarters, as discussed above, higher costs for raw material and purchased components in the current year quarter as compared to the prior year quarter, and a change in product mix between quarters. The current year quarter as compared to the prior year quarter included reduced services sales and increased latch sales, which service products have lower purchased material content and latch products have higher purchased material contents in comparison to our other products. Additionally, our increased sales dollars between quarters outpaced our increased labor and overhead costs between quarters, as discussed below. This, along with the product mix change and higher costs for raw material and purchased components in the current year quarter as compared to the prior year quarter, resulted in an increase in our direct material costs as a percentage of cost of goods sold between quarters and a decrease in our labor and overhead costs as a percentage of cost of goods sold between quarters.

Labor and overhead costs increased $3.8 million between quarters. The variable portion of our labor and overhead costs increased in the current year quarter as compared to the prior year quarter as a result of the production volume increase between quarters to support the increased sales volumes. This impact was partially offset by production efficiencies that controlled headcount and overtime costs at our Milwaukee and Mexico facilities. Labor and overhead costs were further impacted by the following:

Cost Increase:

• Mexico wages and benefits increased $1.4 million in the current year quarter as compared to the prior year quarter as a result of a January 1, 2022 government mandated minimum wage increase.

Cost Decreases:

• Royalty costs paid on sales of certain aftermarket products decreased $450,000 in the current year quarter as compared to the prior year quarter due to lower volumes stemming from the current semiconductor chip shortage.
• Prior 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.

Gross profit dollars in the current year quarter were consistent with the prior year quarter as the increase in sales between quarters was offset by an increase in cost of goods sold between quarters, as discussed above. Gross profit as a percentage of net sales decreased between quarterly periods. The decrease was the result of higher costs for direct materials and purchased parts, a product mix change involving service products and latch products that reduced margins between quarters, and increases in Mexico wages resulting from a January 1, 2022 government mandated minimum wage increase. These unfavorable impacts were partially offset by production efficiencies at our Milwaukee and Mexico facilities, a reduction in royalty costs and the impact of prior year quarter bonuses paid for the ratification of a new labor contract, 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 outside expenditures on new product development costs associated with utilizing third party vendors for a portion of our development work as well as an increase in engineering costs related to our ADAC-STRATTEC LLC door handle and exterior trim products. These expenses decreased as a percentage of net sales due to the increase in sales between quarters as previously discussed.

Loss from operations was $204,000 in the current year quarter compared to income from operations of $428,000 in the prior year quarter due to consistent gross profit margin dollars with an increase in engineering, selling and administrative expenses between quarters, all as discussed above.

The equity earnings of joint ventures was $527,000 in the current year quarter compared to equity loss of joint ventures of $251,000 in the prior year quarter. Improved profitability from our VAST LLC joint venture resulted from increased net sales and increased profitability in VAST China’s operations between quarters. VAST China’s profitability in the prior year quarter was negatively impacted by the current global semiconductor chip shortage described above. We currently believe a presence in the China market is a key component of our global strategy. 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. Due to our limited amount of business in both India and Brazil as well as the impact of COVID-19 and the global semiconductor chip shortage described above, our VAST LLC joint venture in India continues to have break-even operating results and our VAST LLC joint venture in Brazil continues to report losses.

Included in Other (Expense) Income, 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 (Expense) Income, net:

• Foreign currency transaction losses and gains 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 2023 and 2022 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 October 2, 2022 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 37.5% and 14.3% for the three months ended October 2, 2022 and September 26, 2021, respectively. The current year effective tax rate prior to a favorable discrete benefit related to stock-based compensation was 14.8%. Our effective tax rate differs from the statutory tax rate due to the application of the Global Intangible Low Taxed Income (GILTI) tax provisions, our available R&D tax credit and the non-controlling interest portion of our pre-tax income. The non-controlling interest portion 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 October 2, 2022 was as follows (in millions):

Cash Balances in Mexico

We earn a portion of our operating income in Mexico. As of October 2, 2022, $1.6 million of our $10.3 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 improvement in cash provided by operating activities between periods was due changes in our working capital requirements between periods, which changes were comprised of the following items (in millions):

Set forth below is a summary of the items impacting the change in our working capital requirements between year to date periods:

• The change in accounts receivable balances reflected a decrease in such balances in the prior year quarter. This prior year decrease was the result of reduced sales in the prior year quarter stemming from the global semiconductor chip shortage.
• The change in inventory levels reflected a decrease in inventory balances during the current year quarter and an increase in inventory balances during the prior year quarter. The current year quarter decrease was due to a reduction in finished goods inventory to align with historical customer production patterns. The prior year quarter 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 change in other assets in both the current year quarter and the prior year quarter is primarily the result of the change in customer tooling balances. Customer tooling balance changes result from 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 due to a decrease in the balances in the prior year quarter. The prior year quarter decrease resulted from the payment of fiscal 2021 accrued bonuses during August 2021, which payment totaled $6.6 million, and an increase in accounts payable balances during the prior year quarter. The prior year quarter accounts payable balance increase was due to 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 in investing activities included capital expenditures made in support of requirements for new product programs and the upgrade and replacement of existing equipment of $4.7 million during the current year quarter and $2.8 million during the prior year quarter.

Net cash provided by financing activities during the current year quarter of $1.5 million included increased borrowings under our credit facilities of $5.0 million and $126,000 received for the exercise of stock options under our stock incentive plan and purchases under our employee stock purchase plan, partially offset by $3.0 million of repayments of borrowings under our credit facilities and $600,000 of dividend payments to non-controlling interests in our subsidiaries. Net cash provided by financing activities during the prior 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.

VAST LLC Cash Requirements

We currently anticipate that VAST China has adequate debt facilities in place over the remainder of our 2023 fiscal year to cover the future operating and capital requirements of its business. During the three month periods ended October 2, 2022 and September 26, 2021, no capital contributions were made to VAST LLC by any of the members. 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 2023. STRATTEC’s portion of these capital contributions is anticipated to be $100,000. During the three months ended October 2, 2022 and September 26, 2021, VAST LLC made no capital contributions to Minda-VAST Access Systems. We currently anticipate no required future capital contributions to Minda-VAST Access Systems over the remainder of our 2023 fiscal year.

Future Capital Expenditures

We anticipate capital expenditures will be approximately $13.0 million in total in fiscal 2023, of which $4.7 million has been made through October 2, 2022, 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 October 2, 2022. A total of 3,655,322 shares have been repurchased over the life of the program through October 2, 2022, at a cost of approximately $136.4 million. No shares were repurchased during the three month periods ended October 2, 2022 or September 26, 2021. 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 2023.

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 both credit facilities were at varying rates based, at our option, on the 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 October 2, 2022, we were in compliance with all financial covenants required by these credit facilities. Outstanding borrowings under the STRATTEC Credit Facility totaled $1 million at October 2, 2022. There were no outstanding borrowings under the STRATTEC Credit Facility at July 3, 2022. The average outstanding borrowings and weighted average interest rate on the STRATTEC Credit Facility loans were approximately $3.0 million and 3.8 percent, respectively, during the three months ended October 2, 2022. Outstanding borrowings under the ADAC-STRATTEC Credit Facility totaled $12 million at October 2, 2022 and $11 million at July 3, 2022. The average outstanding borrowings and weighted average interest rate on the ADAC-STRATTEC Credit Facility loans were approximately $11.4 million and 3.5 percent, respectively, during the three months ended October 2, 2022.

Joint Ventures and Majority Owned Subsidiaries

Refer to the discussion of Investment in Joint Ventures and Majority Owned Subsidiaries and discussion of Equity Earnings (Loss) 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 8, 2022.