GRB: Analyzing Debt Disclosures – A Gerber Scientific Case Study

I recently published this article at Financial Education, and thought Stock Market Beat readers might also find it interesting.

The balance sheet typically includes all debt maturing in more than 12 months as a single line item. However, additional disclosures can be found throughout the firm’s financial reports. As an example, I examine the recently filed 10K for Gerber Scientific (GRB - Annual Report.

LIQUIDITY AND CAPITAL RESOURCES

The Company’s primary ongoing cash requirements, both in the short and long-term, will be to fund operating and capital expenditures, product development, acquisitions, expansion in China, pension plan funding and debt service. The primary sources of liquidity are internally generated cash flows from operations and available borrowings under the Company’s credit facility. These sources of liquidity are subject to all of the risks of the Company’s business and could be adversely affected by, among other factors, a decrease in demand for the Company’s products, charges that may be required because of changes in market conditions or other costs of doing business, delayed product introductions, or adverse changes to the Company’s availability of funds.

The Company believes that its cash on hand, cash flows from operations and borrowings expected to be available under the Company’s revolving credit facility will enable the Company to meet its ongoing cash requirements. As of April 30, 2007, the Company had $20.5 million available for borrowing under its revolving credit facility based on its borrowing base.

The following table shows information about the Company’s capitalization as of the dates indicated:


In thousands except ratio amounts

April 30,
2007

April 30,
2006

Cash and cash equivalents

$ 8,052

$ 14,145

Total debt

$ 33,376

$ 37,120

Net debt (total debt less cash and cash equivalents)

$ 25,324

$ 22,975

Shareholders’ equity

$144,481

$125,616

Total capital (net debt plus shareholders’ equity)

$169,805

$148,591

Net debt-to-total capital ratio

14.9%

15.5%

Cash Flows

The following table summarizes the Company’s consolidated cash flows by major activity.

 

For the Fiscal Years Ended April 30,

In thousands

2007

2006

2005

Cash flows provided by operating activities

$ 272

$24,646

$ 17,607

Cash flows used for investing activities

$(5,901)

$ (7,266)

$ (4,907)

Cash flows provided by (used for) financing activities

$ 117

$ (8,288)

$(13,373)

Cash Flows from Operating Activities – The $24.4 million decrease in cash flows from operations in fiscal 2007, as compared with fiscal 2006, was primarily driven by increased accounts receivable and inventory as well as lower accounts payable. The increase in accounts receivable was primarily related to elevated sales volume during the Company’s fourth quarter as compared with the same period in fiscal 2006. As revenue continues to increase, the Company expects that its accounts receivable balances will similarly increase.

Analysis: Considering that data, an investor would be pleased by the reduction in debt and improved solvency ratios, but concerned by the steep drop in cash from operations. It would be prudent to monitor the receivables, in particular, to confirm management’s explanation that the rise was due to timing (in which case they should decline relative to sales as the receivables are collected) or due to collection problems (in which case they would not.)

Long-term Debt - The Company’s primary source of debt is a $50.0 million asset-based revolving line of credit with a group of banking institutions, which matures in 2008. The Company also has a term loan that is payable in monthly installments through 2010 and $6.0 million of industrial development bonds that mature in 2014.

The Company was in compliance with its financial covenants as of April 30, 2007. The Company’s future compliance with its covenants will depend primarily on its success in growing the business and generating operating cash flows. Future compliance with the financial covenants may be adversely affected by various economic, financial and industry factors. Noncompliance with the covenants would constitute an event of default under the credit facility, allowing the lenders to accelerate repayment of any outstanding borrowings. In the event of potential failure by the Company to continue to be in compliance with any covenants, the Company would seek to negotiate amendments to the applicable covenants or obtain compliance waivers from its lenders.

The Company entered into a third amendment to its credit facility with Citizens Bank of Massachusetts and Sovereign Bank (the “Third Amendment”) during May 2007. The Third Amendment provides for a line of credit available in the form of term loans with a maximum aggregate amount of $10.0 million for permitted acquisitions. Principal amounts outstanding under the Third Amendment are payable in 30 equal installments. The Third Amendment provides that borrowings accrue interest, payable monthly, at an annual rate equal to the specified London Interbank Offer Rate (”LIBOR”) plus 175 basis points or the designated prime rate at the Company’s option. In addition, a fee of 25 basis points is incurred on the difference between $10.0 million and the average daily principal amount outstanding under the Third Amendment. Term loan borrowings may be made through October 31, 2008 so long as the aggregate principal amount of outstanding term loans does not exceed $10.0 million.

OFF-BALANCE SHEET ARRANGEMENTS

The Company’s participation in financing arrangements to assist customers in obtaining leases with third parties constitute the only off-balance sheet arrangements as defined in Item 303(a)(4) of the SEC’s Regulation S-K. The Company has agreements with major financial services institutions to assist purchasers of its equipment. These leases typically have terms ranging from three to five years. As of April 30, 2007, the amount of lease receivables financed under these agreements between the external financial services institutions and the lessees was $16.8 million. The Company’s net exposure related to recourse provisions under these agreements was approximately $5.6 million. The equipment sold generally collateralizes the lease receivables. In the event of default by the lessee, the Company has liability to the financial services institution under recourse provisions once the institution repossesses the equipment from the lessee and returns it to the Company. The Company then can resell the equipment, the proceeds of which are expected to substantially cover a majority of the liability to the financial services institution. As of April 30, 2007 and 2006, the Company recorded undiscounted accruals for the expected losses under recourse provisions of $0.4 million and $0.6 million, respectively.

CONTRACTUAL CASH OBLIGATIONS AND COMMITMENTS

As of April 30, 2007, the Company had the following contractual cash obligations and commercial commitments (including restructuring related commitments):

 

Payments Due by Period


In thousands


Total

Less Than
1 Year


1-3 Years


3-5 Years

More than
5 Years

Long-term debt obligations

$ 31,836

$ 233

$25,467

$ 136

$ 6,000

Lease obligations

65,075

9,047

14,678

12,655

28,695

Inventory and other purchase obligations

13,371

11,102

2,269

Qualified and non-qualified pension funding

4,388

4,388

Total

$114,670

$24,770

$42,414

$12,791

$34,695

Analysis: Investors should watch for the credit line expiration date and any signs that it might not be renewed (it most likely will be.) If not there could be difficulties repaying it, particularly if the cash from operations remains depressed. The company also has significant other contractual financial commitments due during that time.

Note 8. Borrowings

The Company’s outstanding debt is comprised of the following:

   

April 30,

In thousands

Effective rate(s)

2007

2006

Short-term lines of credit

5.10 – 6.75%

$ 1,540

$ 51

Revolvers

7.07%

25,000

30,000

Term loans

7.36 – 8.25%

836

1,069

Industrial development bonds

3.89%

6,000

6,000

   

33,376

37,120

Less portion due within one year  

(1,773)

(284)

Total long-term debt

 

$31,603

$36,836

All of the Company’s outstanding debt was at variable interest rates as of April 30, 2007. As the underlying interest rates are believed to represent market rates, the carrying amounts are considered to approximate fair value.

Credit Facility - The Company has a credit facility (the “Credit Facility”) with Citizens Bank of Massachusetts, the Export-Import Bank of the United States (”Ex-Im”) and Sovereign Bank. The Credit Facility consists of a $50.0 million asset-based revolving line of credit (the “Revolver”) that includes a $13.0 million working capital loan guarantee from Ex-Im. The Credit Facility also includes a $1.2 million term loan (the “Term Loan”) and a $6.5 million standby letter of credit. The Revolver matures on October 31, 2008. The Term Loan requires 60 equal monthly principal payments that began in December 2005 and matures in November 2010. Weighted average interest rates of the Company’s primary credit facility, inclusive of deferred debt issue costs amortized, were 9.5 percent in the fiscal year ended April 30, 2007, 11.0 percent in the fiscal year ended April 30, 2006 and 13.5 percent in the fiscal year ended April 30, 2005.

The Credit Facility obligations are collateralized by selected assets of the Company in the United States and its subsidiaries in the United Kingdom and Canada, including inventory, accounts receivable, and real estate and leasehold improvements. The Credit Facility obligations are also collateralized by the capital stock of certain subsidiaries of the Company.

Under the Revolver, the Company can terminate its commitment at any time, subject to a prepayment fee. If the Company were to terminate its commitment by October 31, 2007, the fee would be 2.0 percent of the outstanding balance, and if it were to terminate its commitment between November 1, 2007 and October 31, 2008, the fee would be 1.0 percent of the outstanding balance. The Company may permanently reduce the Revolver commitment by up to $10.0 million without any prepayment fee.

Revolver borrowings are subject to a borrowing base formula based upon eligible accounts receivable and eligible inventory. The Company must maintain a minimum availability of $1.0 million. Interest on obligations under the Revolver is charged, at the option of the Company, at the London Interbank Offered Rate (”LIBOR”) plus 1.75 percent, or at the lender’s prime rate. As of April 30, 2007, the Company had $20.5 million available for borrowing on the Revolver based on its borrowing base.

The Company is required to pay an annual commitment fee on a monthly basis of 0.25 percent of the daily difference between the total commitment amount of the Revolver and the aggregate outstanding principal amount of the loans under the Revolver.

Interest on obligations under the Term Loan is charged, at the option of the Company, at LIBOR plus 2.0 percent, or at the lender’s prime rate.

The Company is required to maintain certain financial covenants, including leverage and debt service coverage ratios. The agreement also includes limitations on additional indebtedness and liens, investments, legal entity restructurings, changes in control and restrictions on dividend payments. The Company was in compliance with all of the covenants under its financing arrangements as of April 30, 2007.

In May 2007, the Company amended its Credit Facility to include term loans for acquisitions. See Note 19.

Industrial Development Bonds - The Company has outstanding $6.0 million of Variable Rate Demand Industrial Development Bonds (”Industrial Development Bonds”). The interest rate is adjusted to market rates on a weekly basis. During the fiscal years ended April 30, 2007 and 2006, the weighted average interest rate was 3.6 percent and 2.7 percent, respectively. The Industrial Development Bonds are collateralized by certain property, plant and equipment and mature in 2014.

The demand feature of the Industrial Development Bonds is supported by a letter of credit from a major United States commercial bank. The letter of credit, which expires in September 2007, automatically renews on an annual basis through an evergreen clause and carries a fee of 1.75 percent of the face amount. Advances under the letter of credit become a note payable on demand at the bank’s prime interest rate. The bank providing the letter of credit has a mortgage and security interest in certain property. There were no outstanding amounts under this letter of credit as of April 30, 2007 or 2006.

Short-term Lines of Credit - The Company had short-term bank lines of credit with several international banks of approximately $4.8 million as of April 30, 2007.

Analysis: This final section did not present any additional issues. Overall, Gerber Scientific has been reducing its debt load dramatically and will likely extend its credit facilities before they expire. Investors will want to closely monitor cash from operations, and particularly accounts receivable, to either confirm management’s evaluation or for signs that something less benign is the cause.

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