GENCOR INDUSTRIES INC Management's Discussion and Analysis of Financial Condition and Resultsof Operations (form 10-Q)

GENC

Forward-Looking Information

This Quarterly Report contains certain "forward-looking statements" within the meaning of the Exchange Act, which represent the Company's expectations and beliefs, including, but not limited to, statements concerning gross margins, sales of the Company's products and future financing plans, income from investees and litigation. These statements by their nature involve substantial risks and uncertainties, certain of which are beyond the Company's control. Actual results may differ materially depending on a variety of important factors, including the financial condition of the Company's customers, changes in the economic and competitive environments, the performance of the investment portfolio and the demand for the Company's products.

Overview

Gencor is a leading manufacturer of heavy machinery used in the production and application of highway construction materials and environmental control equipment. The Company's core products include asphalt plants, combustion systems, fluid heat transfer systems and asphalt pavers. The Company's products are manufactured at three facilities in the United States.

Because the Company's products are sold primarily to the highway construction industry, the business is seasonal in nature. Traditionally, the Company's customers reduce their purchases of new equipment for shipment during the summer and fall months to avoid disrupting their peak season for highway construction and related repair work. The majority of orders for the Company's products are thus received between October and February, with a significant volume of shipments occurring in the late winter and spring. The principal factors driving demand for the Company's products are the overall economic conditions, the level of government funding for domestic highway construction and repair, Canadian infrastructure spending, the need for spare parts, fluctuations in the price of liquid asphalt, and a trend towards larger more efficient asphalt plants.

On November 15, 2021, President Biden signed into law a five-year, $1.2 trillion infrastructure bill, the Infrastructure Investment and Jobs Act (the "IIJ Act"), including $550 billion in new spending and reauthorization of $650 billion in previously allocated funds. The IIJ Act provides $110 billion for the nation's highways, bridges and roads.

California's Senate Bill 1 ("SB1"), the Road Repair and Accountability Act of 2017, was signed into law on April 28, 2017. The legislative package invests $54 billion over the next decade to fix roads, freeways and bridges in communities across California and puts more dollars towards transit and safety. These funds will be allocated to state and local projects. Additionally, numerous other states have taken steps to increase their gas tax revenues in recent years.

Fluctuations in the price of carbon steel, which is a significant cost and material used in the manufacturing of the Company's equipment, may affect the Company's financial performance. The Company is subject to fluctuations in market prices for raw materials, such as steel. If the Company is unable to purchase materials it requires or is unable to pass on price increases to its customers or otherwise reduce its cost of goods sold, its business results of operations and financial condition may be adversely affected.

Also, a significant increase in the price of liquid asphalt could decrease demand for hot mix asphalt paving materials and certain of the Company's products. Increases in oil prices also drive up the cost of gasoline and diesel, which results in increased freight costs. Where possible, the Company will pass increased freight costs on to its customers. However, the Company may not be able to recapture all of the higher costs and thus could have a negative impact on the Company's financial performance.

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The Company believes its strategy of continuing to invest in product engineering and development and its focus on delivering the highest quality products and superior service will strengthen the Company's market position. The Company continues to review its internal processes to identify inefficiencies and cost-reduction opportunities. The Company will continue to scrutinize its relationships with suppliers to ensure it is achieving the highest quality materials and services at the most competitive cost.

COVID-19

Pandemic

Global, market and economic conditions may negatively impact our business, financial condition and share price.

Concerns over inflation, geopolitical issues, global financial markets and the COVID-19 pandemic have led to increased economic instability and expectations of slower global economic growth. Our business may be adversely affected by any such economic instability or unpredictability. Russia's invasion of Ukraine and related sanctions has led to increased oil and natural gas prices. Such sanctions and disruptions to the global economy may lead to additional inflation and may disrupt the global supply chain and could have a material adverse effect on our ability to secure supplies. The increased cost of oil, along with increased or prolonged periods of inflation, would likely increase our costs in the form of higher wages, further inflation on supplies and equipment necessary to operate our business. There is a risk that one or more of our suppliers could be negatively affected by global economic instability, which could adversely affect our ability to operate efficiently and timely complete our operational goals.

Results of Operations

Quarter Ended March 31, 2022 versus March 31, 2021

Net revenues for the quarters ended March 31, 2022 and March 31, 2021 were $30,654,000 and $21,352,000, respectively, an increase of $9,302,000. The increased revenues reflect the impact of the new five year, $1.2 trillion infrastructure bill, the IIJ Act, signed into law in November 2021.

As a percent of sales, gross profit margins were 20.2% in the quarter ended March 31, 2022, compared to 28.8% in the quarter ended March 31, 2021. During the quarter ended March 31, 2022, the Company continued to experience higher manufacturing costs associated with wages, steel and OEM parts pricing.

Product engineering and development expenses decreased $149,000 to $920,000 for the quarter ended March 31, 2022, as compared to $1,069,000 for the quarter ended March 31, 2021 due primarily to reduced headcount. Selling, general and administrative ("SG&A") expenses decreased by $474,000 to $3,364,000 for the quarter ended March 31, 2022, compared to $3,838,000 for the quarter ended March 31, 2021. The higher fiscal 2021 SG&A expenses were primarily due to professional fees to support business development efforts.

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Operating income increased from $1,239,000 for the quarter ended March 31, 2021 to $1,908,000 for the quarter ended March 31, 2022, due primarily to increased sales and reduced professional fees.

For the quarter ended March 31, 2022, interest and dividend income, net of fees, was $296,000 as compared to $327,000 in the quarter ended March 31, 2021. The net realized and unrealized losses on marketable securities were $(1,488,000) for the quarter ended March 31, 2022 versus net realized and unrealized gains of $1,294,000 for the quarter ended March 31, 2021. The fiscal 2022 investment losses reflect the decline in equity markets due to higher interest rates, inflation, and the Federal Reserve's recent monetary tightening policy.

The effective income tax rates for the quarters ended March 31, 2022 and March 31, 2021, were 24.2% and 20.0%, respectively, based on the expected annual effective income tax rate.

Net income for the quarter ended March 31, 2022 was $439,000, or $0.03 basic and diluted earnings per share, versus $2,288,000, or $0.16 basic and diluted earnings per share, for the quarter ended March 31, 2021.

Six Months Ended March 31, 2022 versus March 31, 2021

Net sales for the six months ended March 31, 2022 and 2021 were $50,760,000 and $40,316,000, respectively, an increase of $10,444,000. The increased revenues reflect the impact of the new five year, $1.2 trillion infrastructure bill, the IIJ Act, signed into law in November 2021. There were no revenues generated by Blaw-Knox during the first quarter of fiscal 2021, as the facility was being readied to begin production.

Gross profit margins decreased to 19.5% for the six months ended March 31, 2022 from 22.6% for the six months ended March 31, 2021. Increases in wages, steel and OEM parts prices contributed to the lower overall gross margins during the six months ended March 31, 2022.

Product engineering and development expenses increased $355,000 in the six months ended March 31, 2022, compared to the six months ended March 31, 2021 due primarily to salary increases as well as a full six months of engineering wages and benefits related to Blaw-Knox. SG&A expenses decreased $269,000 in the six months ended March 31, 2022, compared to the six months ended March 31, 2021. The increase in SG&A expenses from a full six months of SG&A wages and benefits related to Blaw-Knox employees was offset by reduced professional fees to support business development efforts.

The Company had operating income of $865,000 for the six months ended March 31, 2022 versus $181,000 for the six months ended March 31, 2021. The improved operating income was due primarily to the improved revenues.

For the six months ended March 31, 2022, interest and dividend income, net of fees, from the investment portfolio was $573,000, as compared to $1,130,000 for the six months ended March 31, 2021. Interest income for the six months ended March 31, 2021, included $456,000 of interest collected from a customer. Net realized and unrealized losses on marketable securities was $(1,065,000) for the six months ended March 31, 2022 versus net realized and unrealized gains of $3,488,000 for the six months ended March 31, 2021. The fiscal 2022 investment losses reflect the decline in equity markets due to higher interest rates, inflation, and the Federal Reserve's recent monetary tightening policy.

The effective income tax rates for the six months ended March 31, 2022 and March 31, 2021, were 30.0% and 20.0%, respectively, based on the expected annual effective income tax rate. Net income for the six months ended March 31, 2022 was $165,000, or $0.01 basic and diluted earnings per share, versus $3,839,000, or $0.26 basic and diluted earnings per share for the six months ended March 31, 2021.

Liquidity and Capital Resources

The Company generates capital resources through operations and returns on its investments.

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The Company had no long-term or short-term debt outstanding at March 31, 2022 or September 30, 2021. As of March 31, 2022, the Company has funded $85,000 in cash deposits at insurance companies to cover related collateral needs. In April 2020, a financial institution issued an irrevocable standby letter of credit ("letter of credit") on behalf of the Company for the benefit of one of the Company's insurance carriers. The maximum amount that can be drawn by the beneficiary under the letter of credit is $150,000. The letter of credit expires in April 2023, unless terminated earlier, and can be extended, as provided by the agreement. The Company intends to renew the letter of credit for as long as the Company does business with the beneficiary insurance carrier. The letter is collateralized by restricted cash of the same amount on any outstanding drawings. To date, no amounts have been drawn under the letter of credit.

As of March 31, 2022, the Company had $22,571,000 in cash and cash equivalents, and $94,501,000 in marketable securities, including $24,022,000 in corporate bonds, $19,998,000 in equities, $10,130,000 in mutual funds, $9,849,000 in exchange-traded funds, $27,960,000 in government securities, and $2,542,000 in cash and money funds. The marketable securities are invested through a professional investment management firm. These securities may be liquidated at any time into cash and cash equivalents.

The Company's backlog was $44.9 million at March 31, 2022 compared to $42.6 million at March 31, 2021. The Company's working capital (defined as current assets less current liabilities) was $154.7 million at March 31, 2022 and $155.4 million at September 30, 2021. Cash provided by operations during the six months ended March 31, 2022 was $1,045,000. The significant purchases, sales and maturities of marketable securities shown on the condensed consolidated statements of cash flows reflect the recurring purchases and sales of United States treasury bills. Inventories increased by $5.3 million due to progress on several large contract orders where revenue is recognized at a point in time and some stock build to compensate for the increasing lead times from suppliers. Prepaid expenses increased $1.6 million due to estimated income tax deposits in excess of accrued income taxes, annual insurance contract renewals as well as deposits made on new equipment. Customer deposits increased by $5.0 million reflecting down payments on contract jobs, including several recent orders where revenues are recognized over time but work is yet to begin.

Cash flows used in investing activities for the six months ended March 31, 2022 of $1,706,000 were related to capital expenditures, primarily for manufacturing processing and finishing equipment.

Seasonality

The Company's primary business is the manufacture of asphalt plants and related components and asphalt pavers. These products typically experience a seasonal slowdown during the third and fourth quarters of the calendar year. This slowdown often results in lower reported sales and operating results during the first and fourth quarters of the fiscal year ended September 30.

Critical Accounting Policies, Estimates and Assumptions

The Company believes the following discussion addresses its most critical accounting policies, which are those that are most important to the portrayal of the financial condition and results of operations and require management's most difficult, subjective, or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. Accounting policies, in addition to the critical accounting policies referenced below, are presented in Note 1 to the Company's consolidated financial statements included in the Company's Annual Report on Form 10-K for the year ended September 30, 2021, "Nature of Operations and Summary of Significant Accounting Policies."

Estimates and Assumptions

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

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Revenues & Expenses

Contract assets (excluding accounts receivable) under contracts with customers represent revenue recognized in excess of amounts billed on equipment sales recognized over time. These contract assets were $1,629,000 and $1,903,000 at March 31, 2022 and September 30, 2021, respectively, and are included in current assets as costs and estimated earnings in excess of billings on the Company's condensed consolidated balance sheets. The Company anticipates that all of the contract assets at March 31, 2022, will be billed and collected within one year.

Revenues from all other contracts for the design and manufacture of equipment, for service and for parts sales, net of any discounts and return allowances, are recorded at a point in time when control of the goods or services has been transferred. Control of the goods or service typically transfers at time of shipment or upon completion of the service.

Payment for equipment under contract with customers is typically due prior to shipment. Payment for services under contract with customers is due as services are completed. Accounts receivable related to contracts with customers for equipment sales were $130,000 and $210,000 at March 31, 2022 and September 30, 2021, respectively.

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

Under certain contracts with customers, recognition of a portion of the consideration received may be deferred and recorded as a contract liability if the Company has to satisfy a future obligation, such as to provide installation assistance. There were no contract liabilities other than customer deposits at March 31, 2022 and September 30, 2021. Customer deposits related to contracts with customers were $10,286,000 and $5,244,000 at March 31, 2022 and September 30, 2021, respectively, and are included in current liabilities on the Company's condensed consolidated balance sheets.

The Company records revenues earned for shipping and handling as freight revenue at the time of shipment, regardless of whether or not it is identified as a separate performance obligation. The cost of shipping and handling is classified as cost of goods sold concurrently with the revenue recognition.

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

The allowance for doubtful accounts is determined by performing a specific review of all account balances greater than 90 days past due and other higher risk amounts to determine collectability, and also adjusting for any known customer payment issues with account balances in the less-than-90-day past due aging category. Account balances are charged off against the allowance for doubtful accounts when they are determined to be uncollectible. Any recoveries of account balances previously considered in the allowance for doubtful accounts reduce future additions to the allowance for doubtful accounts. The allowance for doubtful accounts also includes an estimate for returns and allowances. Provisions for estimated returns and allowances and other adjustments, are provided for in the same period the related sales are recorded. Returns and allowances, which reduce product revenue, are estimated using known issues and historical experience.

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Inventories

Marketable Securities and Fair Value Measurements

Marketable debt and equity securities are categorized as trading securities and are thus marked to market and stated at fair value. Fair value is determined using the quoted closing or latest bid prices for Level 1 investments and market standard valuation methodologies for Level 2 investments. Realized gains and (losses) on investment transactions are determined by specific identification and are recognized as incurred in the condensed consolidated statements of income. Net unrealized gains and (losses) are reported in the condensed consolidated statements of income in the current period and represent the change in the fair value of investment holdings during the period.

Long-Lived Asset Impairment

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

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