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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

☒  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended July 2, 2016

☐ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

For the transition period from ________________________________ to ________________________________

Commission File Number 1-9789

SEVCON, INC.

(Exact name of registrant as specified in its charter)

155 Northboro Road, Southborough, Massachusetts 01772

(Address of principal executive offices and zip code)

(508) 281-5510

(Registrant's telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒  No ☐

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes  ☒  No ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Indicate by check mark whether the registrant is a shell company (as defined in rule 12b-2 of the Exchange Act). Yes ☐  No ☒

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.

 

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SEVCON, INC.

FORM 10-Q

FOR THE QUARTER ENDED JULY 2, 2016

INDEX

 

PART I.

FINANCIAL INFORMATION

Item 1

Financial Statements

CONSOLIDATED BALANCE SHEETS

Sevcon, Inc. and Subsidiaries

 

The accompanying notes are an integral part of these consolidated financial statements.

 

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

Sevcon, Inc. and Subsidiaries

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(Unaudited)

Sevcon, Inc. and Subsidiaries

The accompanying notes are an integral part of these consolidated financial statements.

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

Sevcon, Inc. and Subsidiaries

 

The accompanying notes are an integral part of these consolidated financial statements.

 

SEVCON, INC.

Notes to Consolidated Financial Statements – July 2, 2016

(Unaudited)

(1)	Basis of presentation

Sevcon, Inc. (or the “Company”) is a Delaware corporation organized on December 22, 1987 to carry on the electronic controls business previously performed by Tech/Ops, Inc. (Tech/Ops). Through wholly-owned subsidiaries located in the United States, England, France, South Korea and Japan and a 50% owned joint venture located in China, and through an international dealer network, the Company designs and sells, under the Sevcon name, motor controllers for zero emission electric and hybrid vehicles (EVs). The controls are used to vary the speed and movement of vehicles, to integrate specialized functions and to optimize the energy consumption of the vehicle's power source. Through a wholly-owned subsidiary in Italy acquired in January 2016, the Company also designs, manufactures and sells battery chargers for electric vehicles and power management and uninterrupted power source systems for industrial, medical and telecom applications, as well as electronic instrumentation for battery laboratories. Sevcon's customers are manufacturers of on and off-road vehicles, including cars, trucks, buses, motorcycles, fork lift trucks, aerial lifts, mining vehicles, airport tractors, sweepers and other electrically powered vehicles. Through another subsidiary located in the United Kingdom, Sevcon, Inc. manufactures special metalized film capacitors that are used as components in the power electronics, signaling and audio equipment markets.

Accounting for wholly-owned subsidiaries

The accompanying consolidated financial statements include the accounts of the Company’s wholly-owned subsidiaries; Sevcon USA, Inc., Sevcon Ltd, Industrial Capacitors (Wrexham) Ltd., Sevcon Asia Limited, Sevcon Japan KK, Sevcon Security Corp., Sevcon S.r.l. and Bassi S.r.l., in accordance with the provisions required by the Consolidation Topic 810 of the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”).  All material intercompany transactions have been eliminated.

Accounting for joint-venture subsidiary

For the Company's less than wholly owned joint venture subsidiary, Sevcon New Energy Technology (Hubei) Company Limited, the Company first analyzes whether this joint venture is a variable interest entity (a “VIE”) in accordance with ASC 810 and if so, whether the Company is the primary beneficiary requiring consolidation. A VIE is an entity that has (i) insufficient equity to permit it to finance its activities without additional subordinated financial support or (ii) equity holders that lack the characteristics of a controlling financial interest. VIEs are consolidated by the primary beneficiary, which is the entity that has both the power to direct the activities that most significantly impact the entity’s economic performance and the obligation to absorb losses or the right to receive benefits from the entity that potentially could be significant to the entity. Variable interests in a VIE are contractual, ownership, or other financial interests in a VIE that change with changes in the fair value of the VIE’s net assets. The Company continuously re-assesses (i) whether the joint venture is a VIE, and (ii) if the Company is the primary beneficiary of the VIE. If it is determined that the joint venture qualifies as a VIE and the Company is the primary beneficiary, it is consolidated.

Based on the Company's analysis for this joint venture, the Company has determined that it is a VIE and that the Company is the primary beneficiary. While the Company owns 50% of the equity interest in the joint venture, the other 50% is owned by a local unrelated third party, and the joint venture agreement with that third party provides the Company with greater voting rights. Accordingly, the Company consolidates its joint venture under the VIE rules and reflects the third party’s 50% interest in the consolidated financial statements as a non-controlling interest. The Company records this non-controlling interest at its initial fair value, adjusting the basis prospectively for the third party’s share of the respective consolidated investments’ net income or loss or equity contributions and distributions. This non-controlling interest is not redeemable by the equity holders and is presented as part of permanent equity. Income and losses are allocated to the non-controlling interest holder based on its economic ownership percentage.

In the opinion of management, the accompanying unaudited consolidated financial statements contain all adjustments (consisting of only normally recurring accruals) necessary to present fairly the financial position of Sevcon, Inc. as of July 2, 2016 and the results of operations and cash flows for the three and nine month periods ended July 2, 2016. These unaudited interim financial statements should be read in conjunction with the 2015 annual consolidated financial statements and related notes included in the 2015 Sevcon, Inc. Annual Report filed on Form 10-K (the “2015 consolidated financial statements and related notes included in the 2015 Sevcon, Inc. Annual Report filed on Form 10-K (the “2015 10-K”). Unless otherwise indicated, each reference to a year means the Company’s fiscal year, which ends on September 30.

 

The results of operations for the three and nine month periods ended July 2, 2016 are not necessarily indicative of the results to be expected for the full year.

(2)	Summary of significant accounting policies

There have been no changes since the end of 2015 to the significant accounting policies followed by Sevcon, Inc.

(3)	Acquisitions

 

Bassi Unipersonale S.r.l (“Bassi”)

 

On January 26, 2016, the Company, and its wholly-owned indirect subsidiary, Sevcon S.r.l., (“Sevcon Italy”) entered into a Quota Sale and Purchase Agreement with Bassi Holding S.r.l., (“Bassi Holding”) an Italian limited liability company, and the quota owners of Bassi Holding, to acquire all the outstanding quotas of Bassi, a limited liability company located in Lugo, Italy. Bassi designs, manufactures and sells battery chargers for electric vehicles and power management and uninterrupted power source systems for industrial, medical and telecom applications, as well as electronic instrumentation for battery laboratories. The principal reasons for the acquisition were to enable the Company to expand its addressable share of the high-growth electrification market and enhance earnings by adding an immediately accretive business.

 

In order to fund the cash element of the acquisition price, on January 27, 2016, the Company also entered into a Term Loan Agreement providing for a credit facility with Banca Monte dei Paschi di Siena S.p.A. The acquisition was closed on January 29, 2016.

Purchase Price

The total purchase price was approximately $19.1 million and included (1) cash consideration of €10.0 million ($10.8 million) and (2) 500,000 shares of the Company’s common stock ($4.8 million at the Company’s Closing Date stock price of $9.52) and (3) the fair value of assumed dividends payable to the former owner of Bassi, Bassi Holding of €3.23 million ($3.5 million).

Sevcon Italy is required to distribute to the former owner of Bassi, Bassi Holding, outstanding dividends at fair value aggregating €3.23 million (approximately $3.5 million) in increments over a three-year period, post-closing.

During the nine months ended July 2, 2016, the Company incurred $1.4 million in costs and expenses related to the Company’s acquisition of Bassi that are included in the consolidated statement of operations.

The Company accounted for the transaction using the acquisition method and, accordingly, the consideration has been allocated to the tangible and intangible assets acquired and liabilities assumed on the basis of their respective estimated fair values on the acquisition date. Goodwill resulting from this acquisition is largely attributable to the experienced workforce of Bassi and synergies expected to arise after the integration of Bassi’s products and operations into those of the Company. Goodwill resulting from this acquisition is not deductible for tax purposes. Identifiable intangible assets acquired as part of the acquisition included definite-lived intangible assets for developed technologies, customer relationships, order backlog and trade names, which are being amortized using the straight-line method over their estimated useful lives, as well as goodwill.

 

The fair value of the total consideration has been allocated based on the estimated fair values of assets acquired and liabilities assumed as follows (in thousands)

The above fair value allocation is considered preliminary and is subject to revision during the measurement period. Management is in the process of completing its evaluation of acquired intangible assets. Additionally, the Company is continuing to validate the fair values of working capital including inventory and property and equipment.

 

The preliminary fair value of the assets acquired includes accounts receivable of $3,318,000. The gross amount due under contracts is $3,428,000 of which $110,000 is expected to be uncollectible.

 

Valuation of Intangible Assets Acquired

 

The following table sets forth the components of intangible assets acquired in connection with the Bassi acquisition (dollars in thousands):

 

Actual Results of Bassi Acquisition

Bassi’s net revenues and operating income following the acquisition included in the Company’s operating results for the nine months ended July 2, 2016 were $9.0 million and nil, respectively.

 

Pro Forma Summary

The unaudited consolidated pro forma results for the nine month periods ended July 2, 2016 and July 4, 2015 are set out in the table below.  The pro forma consolidated results combine the results of operations of the Company and Bassi as though Bassi had been acquired on October 1, 2014 and include amortization charges for the acquired intangibles and interest expense related to the Company’s borrowings to finance the acquisition.  The 2016 pro forma results were adjusted to exclude $1,425,000 of acquisition costs to date related to Bassi and $257,000 of non-recurring expense relating to the fair value adjustments to acquisition date inventory and property and equipment. The pro forma financial information is presented for informational purposes only and is not necessarily indicative of the results of operations that would have been achieved if the acquisition had taken place on October 1, 2014.

(4)	Stock-based compensation plans

Under the Company’s 1996 Equity Incentive Plan (the “Plan”) there were 336,990 shares reserved and available for grant at July 2, 2016. There were 139,578 shares reserved and available for grant at September 30, 2015.

The Plan, which is shareholder-approved, permits the grant of Restricted Stock, Restricted Stock Units, Options and Stock Appreciation Rights (“SARs”). SARs may be awarded either separately, or in relation to options granted, and for the grant of bonus shares. The Company believes that such awards better align the interests of the employees with those of its shareholders. Options granted are exercisable at a price not less than fair market value on the date of grant. Recipients of grants of options must execute a standard form of non-competition agreement.

Share options

The Company estimated the fair values of its stock options using the Black-Scholes-Merton option-pricing model, which was developed for use in estimating the fair values of stock options. Option valuation models, including the Black-Scholes-Merton option-pricing model, require the input of assumptions, including stock price volatility. Changes in the input assumptions can materially affect the fair value estimates and ultimately how much the Company recognizes as stock-based compensation expense. The fair values of the Company’s stock options were estimated at the grant dates. The weighted average input assumptions used and resulting fair values of stock options were as follows for fiscal 2016:

 

Expected Life

The expected term represents the period of time that options are expected to be outstanding. As the Company does not have sufficient historical evidence for determining the expected term of the stock option awards granted, the expected life assumption has been determined using the simplified method, which is an average of the contractual term of the option and its ordinary vesting period.

Risk-free Interest Rate

The Company bases the risk-free interest rate assumption on zero-coupon U.S. treasury instruments appropriate for the expected term of the stock option grants.

Expected Volatility

The expected stock price volatility for the Company’s common stock is estimated based on the historic volatility of the Company’s common stock for a period equivalent to the expected term of the stock option grants.

Expected Dividend Yield

The Company bases the expected dividend yield assumption on the fact that there is no present intention to pay cash dividends. Therefore an expected dividend yield of zero has been used.

Performance based awards

Stock options:

In December 2015, the Compensation Committee awarded performance-based equity compensation to nine executives and managers, including the principal executive officer and principal financial officer, consisting of 38,460 shares in the form of stock options. The performance options have an exercise price of $9.94 per share, representing the average of the highest intraday bid and ask quotes for the Company’s common stock on the date of grant, December 16, 2015, and the preceding four trading days. The performance options will vest subject to the Company meeting an earnings per share target applicable to fiscal year 2018 set by the Compensation Committee so long as the employee is then employed by the Company.  The estimated fair value of the stock on the date of the grant was $185,000 based on the fair market value of stock on the date of issue. The unvested compensation is being charged to income over three years. The charge to income for this employee stock option grant will be approximately $14,000 on a quarterly basis.

A summary of option activity under the employee share option plan as of July 2, 2016, and changes during the nine months then ended is presented below:

 

Restricted stock:

In December 2015, the Company granted 11,540 shares of restricted stock to four employees which will vest subject to the Company meeting the same earnings per share target applicable to fiscal year 2018, so long as the employee is then employed by the Company. The estimated fair value of the stock on the date of the grant was $116,000 based on the fair market value of stock on the date of issue. The unvested compensation is being charged to income over three years. The charge to income for this employee stock option grant was $8,000 and $18,000 for the three and nine months ended July 2, 2016 and will be approximately $8,000 on a quarterly basis.

 

Management has assessed the performance criteria relating to these grants and concluded that they are likely to be met. Accordingly the relevant portion of the charge has been taken to income in the three and nine months ended July 2, 2016.

Time-based awards

Restricted stock:

In February 2016, the Company granted 29,700 shares of restricted stock to nine non-employee directors, which will vest on the day before the 2017 annual general meeting providing that the grantee remains a director of the Company, or as otherwise determined by the Compensation Committee.  The aggregate fair value of the stock measured on the date of the grant was $292,000 based on the closing sale price of the stock on the date of grant.  Subsequent to this, 3,300 of these granted shares of restricted stock were cancelled and returned to the Plan following the resignation of a director. Compensation expense is being charged to income on a straight line basis over the twelve month period during which the forfeiture conditions lapse.  The charge to income for these restricted stock grants in the nine months to July 2, 2016 was $65,000 and the subsequent charge will be approximately $65,000 on a quarterly basis.

In February 2015, the Company granted 30,600 shares of restricted stock to nine non-employee directors, which vested on the day before the 2016 annual meeting. The aggregate fair value of the stock measured on the date of grant was $225,000, based on the closing sale price of the stock on the date of grant. Compensation expense was charged to income on a straight line basis over the twelve month requisite service period during which the forfeiture conditions lapsed. The charge to income for these restricted stock grants in 2015 was $131,000 and the charge in the nine months to July 2, 2016 was $94,000.

For the purposes of calculating average issued shares for basic earnings per share these shares are only considered to be outstanding when the forfeiture conditions lapse and the shares vest.

A summary of restricted stock and stock option activity, including both performance based awards and time-based awards, for the nine months ended July 2, 2016 is as follows:

Stock-based compensation expense was $169,000 and $527,000 for the three and nine month periods ended July 2, 2016 and $147,000 and $406,000 for the three and nine months ended July 4, 2015 respectively. At July 2, 2016, there was $679,000 of unrecognized compensation expense related to restricted stock and stock options granted under the Plan. The Company expects to recognize that cost over a weighted average period of 1.9 years.

 

(5)	Cash dividends

Common stock dividends

The Company is not paying a dividend at the present time and the Board of Directors will consider whether to pay a common stock dividend in the future.

Preferred Stock dividends

At July 2, 2016 there were 449,011 shares of Series A Convertible Preferred Stock issued and outstanding. The preferred stock, which has a stated value of $24 per share, pays a 4% cumulative annual dividend semi-annually on October 15 and April 15 each year. A semi-annual dividend of $216,816 was paid on April 15, 2016.  The next semi-annual dividend will be paid on October 15, 2016.

(6)	Calculation of earnings per share and weighted average shares outstanding

Basic earnings per share is computed by dividing the net income or loss for the period by the weighted average number of shares of common stock outstanding during the period. The computation of diluted earnings per share is similar to the computation of basic earnings per share, except that the denominator is increased for the assumed exercise of dilutive options and other potentially dilutive securities, including convertible preferred stock, using the treasury stock method, unless the effect is anti-dilutive.

Basic and diluted net income per common share for the three and nine month periods ended July 2, 2016 and July 4, 2015 were calculated as follows:

 

(7)	Segment information

The Company has three reportable segments: electronic controls, capacitors and battery chargers. The electronic controls segment produces microprocessor based control systems for zero emission and hybrid electric vehicles. The capacitor segment produces special-metalized film capacitors for sale to electronic equipment manufacturers.  The battery chargers segment designs and manufactures battery chargers for electric vehicles. Each segment has its own management team and sales force and the capacitor and battery charger segments have their own manufacturing facilities.

The significant accounting policies of the segments are the same as those described above and in Note 1 to the Notes to Consolidated Financial Statements in the 2015 10-K. Inter-segment revenues are accounted for at current market prices. The Company evaluates the performance of each segment principally based on operating income. The Company does not allocate income taxes, interest income and expense or foreign currency translation gains and losses to segments. Information concerning operations of these businesses is as follows:

 

 

In the electronic controls segment, revenues derive from the following products and services:

(8)	Research and development

The cost of research and development programs is charged against income as incurred and was as follows:

In recent years the Company has received several awards of research and development grants by public bodies established by the U.K. government to stimulate technology-enabled innovation.

In 2011, the Company was awarded a research and development grant by the Technology Strategy Board to lead a collaborative project with Cummins Generator Technologies and Newcastle University in the U.K. to develop an innovative electric drive system for electric vehicles using advanced switched reluctance motor technology. The Company recorded grant income from this Technology Strategy Board project of $Nil  in the nine month period ended July 2, 2016, associated with research and development expense of $7,000 in the period. The Company recorded grant income of $56,000 in the nine month period ended July 4, 2015, associated with research and development expense of $245,000 in the same period.

In 2015 the Company was awarded a grant of approximately $625,000 by the U.K. Regional Growth Fund, a U.K. government body.  The grant is to develop an innovative range of low voltage motor controls which are designed to serve the emerging needs for on-road, automotive electrification.  The grant includes a commitment to create or safeguard a total of twenty jobs at the Company’s U.K. facility over the period of the project.  The Company recorded grant income from this project of $115,000 in the nine month period ended July 2, 2016 associated with research and development expense of $392,000 in the period. The Company recorded grant income of $27,000 in the nine month period ended July 4, 2015, associated with research and development expense of $149,000 in the same period.

The grant income in the first nine months of 2016 and 2015 was recorded as a reduction of research and development expense.

In the three and nine month periods ended July 2, 2016, the Company recorded refundable tax credits of $315,000 related to certain research and development incentives in the U.K.  These amounts have been recorded in operating income, as they are refunded without regard to actual tax liability.

(9)	Income Taxes

The Company’s effective tax rate of 4% is significantly lower than the U.S. statutory rate of 34%, primarily due to the fact that certain current year operating losses in the U.K. have been foregone in exchange for a cash refund. As mentioned in Note 8, this benefit is recorded in operating income, as such amounts are refundable without regard to actual tax liability.

 

(10)	Employee benefit plans

Sevcon, Inc. has defined contribution plans covering the majority of its U.S. and U.K. employees in the controls business. There is also a small defined contribution plan covering senior managers in the capacitor business.

The Company’s French subsidiary, Sevcon S.A.S., has a liability to pay its employees a service and salary based award when they reach retirement age and leave the Company’s employment. This liability, which is unfunded, is recognized in accrued expenses and was $161,000 and $152,000 at July 2, 2016 and July 4, 2015, respectively. The obligation to pay this award is a French legal requirement and is only payable if the employee is employed by the Company when they retire; if they leave the Company prior to that time the award is no longer payable.

The Company’s Italian subsidiary, Bassi S.r.l., has a liability to pay its employees a severance indemnity, ‘Trattamento di fine Rapporto’ (“TFR”) when they leave the Company’s employment.  TFR, which is mandatory for Italian companies, is deferred compensation and is based on the employees’ years of service and the compensation earned by the employee during the service period.  TFR is considered a “Defined Benefit Plan” and the related liability is recognized in the consolidated balance sheet within “Liability for pension benefits”.  This liability, which is unfunded, was $1,245,000 at July 2, 2016.

The Company has frozen the U.K. and U.S. defined benefit plans for which no future benefits are being earned by employees. The Company uses a September 30 measurement date for its defined benefit pension plans.

The following table sets forth the movement in the liability for pension benefits in the nine month periods ended July 2, 2016 and July 4, 2015, respectively:

Amounts recognized in the balance sheet consist of:

 

Amounts recognized in accumulated other comprehensive loss consist of:

Sevcon, Inc. contributed $150,000 to its frozen U.S. defined benefit plan in the nine months ended July 2, 2016; it presently anticipates contributing a further $50,000 to fund its U.S. plan in the remainder of fiscal 2016. In addition, employer contributions to the frozen U.K. defined benefit plan were $327,000 in the first nine months and are estimated to total $426,000 in 2016.

The table below presents information about the Company’s pension plan assets measured and recorded at fair value as of July 2, 2016 and indicates the fair value hierarchy of the inputs utilized by the Company to determine the fair values.

 

 

*	Level 1 investments represent mutual funds for which a quoted market price is available on an active market. These investments primarily hold stocks or bonds, or a combination of stocks and bonds.

**

Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. The Company’s pension plan financial assets held in the Adept Strategy 9 Fund and the Schroder investments are Level 2 assets. The Company uses the Net Asset Value to determine the fair value of underlying investments which (a) do not have readily determinable fair value; and (b) prepare their financial statements consistent with the measurement principles of an investment company. The Funds are not exchange traded. The Funds are not subject to any redemption notice periods or restrictions and can be redeemed on a daily basis. No gates or holdbacks or dealing suspensions are being applied to the Funds. The Funds are of perpetual duration.

***	The Company currently does not have any Level 3 pension plan financial assets.

The following estimated benefit payments have been, or are expected, to be paid:

(11)	Inventories

Inventories, net of reserve, were comprised of:

(12)	Fair value of financial instruments

The Company's financial instruments consist mainly of cash and cash equivalents, short-term investments, accounts receivable and accounts payable. The carrying amount of these financial instruments as of July 2, 2016 approximates fair value due to the short-term nature of these instruments. The fair value of the Company’s long-term bank debt at July 2, 2016 approximated $15,448,000 (the gross carrying value on the consolidated balance sheet at July 2, 2016) based on recent financial market pricing. The current portion of long-term debt represented a Level 2 liability in accordance with the fair value hierarchy described in Note 10.

 

(13)	Accrued expenses

Set out below is an analysis of other accrued expenses at July 2, 2016 and September 30, 2015, which shows separately any items in excess of 5% of total current liabilities:

(14)	Warranty reserves

The movement in warranty reserves was as follows:

(15)

Debt

The Company’s U.K. controls and capacitor subsidiaries each have multi-currency overdraft facilities which together total $1,200,000 and which are secured against real estate owned by those companies. In July 2016, the Company’s U.K. bank renewed these facilities for a twelve month period, although they can be withdrawn on demand by the bank. The facilities were unused at July 2, 2016 and at September 30, 2015.

The Company entered into a €14,000,000 ($15,448,000 at July 2, 2016) credit facility with Banca Monte dei Paschi di Siena S.p.A. (“MPS Bank”) on January 27, 2016. The loan and security agreement will expire on January 27, 2021 when all outstanding principal and unpaid interest will be due and payable in full.  The facility may be paid before maturity in whole or in part at the option of the Company, on or after the six-month anniversary of the funding date, without penalty or premium.  Interest on the loan is payable quarterly at a margin of 3% over EuroLIBOR, with a minimum EuroLIBOR rate of 0.0%.  Under the facility, the Company must maintain, on an annual basis, a net debt to EBITDA ratio of no more than 3.5:1 for fiscal years 2016 and 2017 and a net debt to EBITDA ratio of no more than 3.0:1 thereafter.  Upon entering into the credit facility, the Company drew down €14,000,000 ($15,448,000), which was the total amount outstanding at July 2, 2016.  This amount is shown in the accompanying consolidated balance sheet under long-term debt. The carrying value of the debt approximated to fair value based on current interest rates.

Annual principal payments on long term bank debt, net of debt issuance costs, and converted to U.S. dollars at the  July 2, 2016 exchange rate of $0.906 Euros per U.S. dollar, are as follows (in thousands of dollars):

 

(16)	Commitments and Contingencies

Sevcon, Inc. is involved in various legal proceedings in the ordinary course of business but believes that it is remote that the outcome will be material to operations.

The Company maintains a directors' retirement plan which provides for certain retirement benefits to non-employee directors. Effective January 1997 the plan was frozen and no further benefits are being accrued. While the cost of the plan has been fully charged to expense, the plan is not separately funded. The estimated maximum liability which has been recorded based on the cost of buying deferred annuities at July 2, 2016 and September 30, 2015 was $144,000 and $153,000, respectively.

Minimum rental commitments under all non-cancelable leases are as follows for the years ended September 30,  2016 - $604,000; 2017 - $580,000; 2018 - $536,000; 2019 - $492,000; 2020 - $492,000 and $2,237,000 thereafter.

The U.K. subsidiaries of the Company have given to a bank a security interest in certain leasehold and freehold property assets as security for overdraft facilities of $1,200,000. There were no amounts outstanding on the overdraft facilities at July 2, 2016 and at September 30, 2015.

(17)	Changes in Other Comprehensive Loss

The following table illustrates changes in the balances of each component of accumulated other comprehensive loss in 2016 and 2015:

(18)	Related Parties

Bassi Holding (see Note 3) is considered a related party as a stockholder of the Company.

As at July 2, 2016 there was a balance of $2,478,000 payable by the Company to Bassi Holding included in Debt to related parties. This debt relates to dividends payable to Bassi Holding as a result of the acquisition on January 29, 2016.

During the three and nine month periods ended July 2, 2016 the Company also paid rent to Bassi Holding in the amounts of $83,000 and $138,000 respectively. No rent was paid in the three and nine month periods ended July 4, 2015.

On August 2, 2016, Ryan Morris, a member of the Board, was elected Executive Chairman of the Board. Mr. Morris is considered a related party as he is President of Meson Capital Partners LLC, a shareholder of the Company

(19)	Subsequent events

In preparing these interim consolidated financial statements, the Company has evaluated, for potential recognition or disclosure, events or transactions subsequent to the end of the most recent quarterly period, the issuance date of these financial statements.

On July 6, 2016, the Company entered into a Securities Purchase Agreement with certain institutional and accredited investors, under which it agreed to sell 1,124,000 units, each consisting of one share of common stock, $0.10 par value, and half a warrant to purchase one share of common stock, at a price of $9.12 per unit, for total gross proceeds of $10,250,880.  The participating investors include funds affiliated with the principal institutional stockholders of the Company and funds managed by two of the Company’s directors.

No further material subsequent events were identified that require recognition or disclosure in these financial statements.

 

Item 2

Management's Discussion and Analysis of Financial Condition and Results of Operations.

FORWARD LOOKING STATEMENTS

Statements in this discussion and analysis about the Company’s anticipated financial results and growth, as well as those about the development of its products and markets, including without limitation statements about the benefits that may be obtained from certain customer contracts, are forward-looking statements that are based on management’s present expectations and involve risks and uncertainties that could cause actual results to differ materially from those projected. Important factors that could cause these statements not to be realized are set forth in the following discussion and also include the risks discussed under “Risk Factors” below and elsewhere in this report.

CRITICAL ACCOUNTING ESTIMATES

As of July 2, 2016, there have been no material changes to the critical accounting estimates described in the Company’s 2015 10-K. However, if the business and economic realities vary from those assumed in these judgments and estimates, actual operating results may differ materially from the amounts derived from these judgments and estimates. In addition, if the continuing worldwide economic troubles continue to have a negative effect on our business, estimates used in future periods may vary materially from those included in the Company’s previous disclosures.

For example:

 

(i)	if the financial condition of any of the Company's customers deteriorates as a result of further business declines, the Company may be required to increase its estimated allowance for bad debts;

 

(ii)	if actual future demand is less than previously projected, inventory write-downs may be required; or

 

(iii)

significant negative industry or economic trends that adversely affect our future revenues and profits, or a reduction of our market capitalization relative to net book value, among other factors, may change the estimated future cash flows or other factors that we use to determine whether or not goodwill has been impaired and lead us to conclude that an impairment charge is required.

 

(iv)

if the allocation of the total consideration for Bassi, to the fair values of the tangible and intangible assets acquired, differs from the management estimates and judgments, the Company may be required to write-down the values of certain tangible or intangible assets or conclude that an impairment charge is required.

 

All of these factors, and others resulting from the current economic situation, may have a material adverse impact on the Company’s results.

 

OVERVIEW OF THIRD QUARTER AND FIRST NINE MONTHS

Results of Operations

Three months ended July 2, 2016 and July 4, 2015

The following table compares the results by segment for the three months ended July 2, 2016 with the same period in the prior year. The table shows the effect of currency and volume changes in percentage terms:

 

On January 29, 2016 the Company closed the acquisition of Bassi S.r.l. (Bassi), a company which makes battery chargers for a range of Electric Vehicle (“EV”) applications. The operating performance of Bassi is included for the first time in the consolidated accounts in this fiscal year. We record the performance of Bassi as the chargers segment in our financial reporting.

Revenues in the third quarter of 2016 were $13,913,000 compared to $10,346,000 in the same quarter last year, a 34% increase year-on-year that reflected the acquisition of Bassi. Bassi revenues were $5,046,000 for the third quarter, and revenues in the controls and capacitors businesses combined were $8,867,000 compared to $10,346,000 in the same fiscal quarter last year, a reduction of 14.3%. Foreign currency fluctuations decreased reported sales by $792,000, or 7.7%, mainly due to a stronger U.S. dollar compared with both the British pound and the euro, than in the same fiscal period last year. Excluding the impact of the chargers segment and foreign currency fluctuations, sales would have been 6.6% lower than the prior-year period.

The weak demand conditions experienced in the first half year in our industrial off-road markets continued in the third quarter of 2016. Aerial work platform, fork-lift truck and mining markets were all down by double-digits.  While the performance in these sectors is not where we would like it to be, there are signs of improvement, particularly in sales to fork-lift truck manufacturers.

In the on-road sector, sales for two-wheel applications were up 27% in the third quarter compared to the prior year, which largely reflects increased sales to an electric motorcycle manufacturer in the USA. In the four-wheel, on-road, sector, sales decreased 16% compared to the same period in 2015. This was largely due a significant customer, which uses our controllers for an all-electric drivetrain designed for the Chinese market, deciding to move drivetrain production to China, causing a pause in demand from us. We expect demand in the four-wheel, on-road sector to improve in the fourth fiscal quarter of 2016 and to continue into 2017

In the second quarter of 2016 we were awarded a multiyear, contract by a manufacturer of performance cars. This is one among several contracts of its type we are currently working on, which are described in more detail in the discussion of engineering services below. The contract is for the development of the controller to allow electrification of the drive system. The contract covers engineering time and materials and is likely to last four years. The customer has provided a follow-on, non-binding production forecast that contemplates up to $41 million in product purchases over a five-year period following successful completion of the development phase, i.e., expected to commence in 2020. Whether or not the manufacturer purchases any product from us, let alone in such amounts, will depend on a number of factors that cannot be assured, including without limitation our successfully completing the development of the controller, the manufacturer’s deciding to commence production of the car, which will be in its sole discretion, and whether or not the market for the car develops as the manufacturer hopes. In addition to this program we also continued to make progress on the electrification project with a large German manufacturer of trucks, buses, engines and transportation solutions.

The Company’s joint venture in China continues to make progress; in the third quarter we received a contract from a supplier of electric motors for the development of a controller for on road applications. We expect to ship prototypes of these controllers in the fourth quarter. We are able to achieve these challenging timescales because of the work we have already completed on our generic Gen5 product. In other projects, we have had another quarter of testing with one substantial Chinese OEM and we expect to begin production shipments by the end of calendar 2016.  In general, with the Chinese JV we are initially targeting electric and hybrid vehicle applications in what is becoming the world’s largest market for two- and four-wheel electric vehicles.

In the controls business segment, sales in North America were down 18% compared with the same period last year due to continued softness in demand from both industrial and on road customers.  There was some improvement compared to the second quarter of 2016, but comparing demand with the third quarter last year, industrial markets were mainly lower due to weakness in the construction sector and also the reduction caused by the customer which moved drivetrain production to China, referred to above. Sales in the quarter in Asia were down 58% due mainly to an aerial work platform customer in the region who last year provided us with a large stocking order prior to moving to an indirect sales channel.

Sales in Europe increased by 16% year-over-year. We have seen recent signs of some improvement across Western Europe which rose 23%, as controller shipments to customers, including Polaris, drove on-road performance in that market. This improvement in Europe in controller sales was offset by lower sales in our capacitor segment for railway signaling projects in the region.

 

The new project wins described above are examples of the opportunities we have been pursuing recently and were part of the pipeline we have discussed in previous quarters. We continue to have an expanding pipeline of projects related to the global desire for electrification. Most important for the long term, the Company is gaining a reputation as an electrification solution provider and technology partner. The electrification project award in our second quarter is a good example of the type of project in the pipeline. However, we cannot predict the timing or the magnitude of any potential resulting improvements in our revenues or margin from these projects and opportunities.

An increasingly important element of our revenue in our controls segment comes from engineering services, which represented 4% of sales in the quarter. Many new customers, mainly on-road vehicle manufacturers, require a bespoke product to meet their specific needs. They pay us to engineer existing Sevcon products to provide them with a reliable solution. This process results in a shorter time to market and lower development costs for our customer. We believe that our experience allows us to complete projects faster than the competition, and with known system performance. We generally account for engineering services under the “percentage of completion” accounting method.  As a result, our revenue for engineering services is a function of the number of hours worked by individuals on a project at specified rates as a proportion of an agreed program of work. Our cost to deliver the project is a function of labor cost and overhead recovery. Reported progress on projects is the achievement of project milestones. The number and timing of milestones differs from project to project, in general, however, achievement of a milestone brings the prospect of production ever nearer.

We are currently conducting engineering services work on several projects, all of which are expected to go into production in 2019 and beyond. A multi-year project is very intense in terms of hours worked for the first 12 months as we develop the product. Subsequent time is spent on the refinement of the initial development, product testing, the validation of the product to safety standards and product certification.  We believe our progress in milestones on an engineering services contract is a good way to assess the likelihood that a production program will commence at some point in the future.

Gross profit of $4,752,000 was 34.2% of sales in the third quarter, compared to $3,856,000 or 37.3% of sales in the same quarter last year. Gross profit in the Charger business was $1,376,000 (27.2% of sales) for the third quarter.

Gross profit for the controls and capacitors segments combined was $3,377,000 (38.1% of sales) in the third quarter, compared to $3,856,000 (37.3% of sales) in the same quarter last year.

Selling, research and development and general and administrative expenses, including Bassi acquisition costs in the third quarter, were $5,683,000, including $1,633,000 of charger business costs, compared to $3,595,000 in the same quarter last year when there were no charger business costs. Included in the charger business expense in the quarter of $1,633,000, we recorded $687,000 of non-cash expense from the amortization of intangible assets and fair value adjustments arising from the business combination with Bassi. Operating expenses in the controls and capacitors business combines were $3,893,000 compared to $3,509,000 in the prior year period.

There was an operating loss for the third quarter of $931,000 compared with income of $261,000 in the same period last year.  Acquisition costs increased operating loss by $8,000.

Excluding acquisition costs and unallocated corporate expense of $157,000, the operating loss for the controls and capacitors businesses combined, was $516,000 for the third quarter, compared to operating income of $347,000 in the same period last year.  The main reason for the operating loss in the controls and capacitors business were lower sales to our industrial customers and higher operating costs associated with the pipeline of new projects.

The table on page 21 shows the favorable and unfavorable percentage change for each income statement line item due to the impact of foreign currency exchange rate movements and volume impacts.

Included in other income and expense for the quarter was a foreign currency loss of $522,000 compared with a loss of $21,000 in the third quarter of last year. The significant loss in the quarter reflects the impact of the weakening of the British pound following the referendum on the U.K’s membership in the European Union, which advised for the exit of the U. K. from the European Union (“Brexit”). During the third quarter, we recorded a charge of $116,000 for interest due to MPS Bank on the credit facility partly used to finance the Bassi acquisition.

The Company recorded a loss before income taxes of $1,589,000 in the third quarter of 2016, compared to income before income taxes of $362,000 in the same period last year. There was an income tax benefit of $60,000 in the period compared with an income tax provision of $83,000, in the same period last year. The low effective tax rate in the third quarter is largely a result of our U.K. business representing a higher proportion of the pre-tax result in Q3 2016 than in the prior year. In the U.K. we benefit from a very low effective tax rate due to the favorable tax treatment of the R&D activity that we conduct there.

 

After adjusting for a $84,000 net loss relating to the Company’s non-controlling interest in the Chinese joint venture and recording a preference share dividend of $93,000, there was a net loss attributable to the stockholders of Sevcon, Inc. of $1,538,000 or a loss of ($0.38) per diluted share, compared to net income of $171,000, or $0.04 per diluted share, in the same quarter last year after recording a preference share dividend of $110,000.

Nine months ended July 2, 2016 and July 4, 2015

The following table compares the results by segment for the nine months ended July 2, 2016 with the same period in the prior year.  The table shows the effect of currency and volume changes in percentage terms.