Quarterly Report (10-q)

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 31, 2019

☐TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from _____ to _____

Commission File No. 001-8125

TOROTEL, INC.

(Exact name of registrant as specified in its charter)


MISSOURI		44-0610086
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

520 N. ROGERS ROAD, OLATHE, KANSAS		66062
(Address of principal executive offices)		(Zip Code)

(913) 747-6111

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:


Title of each class	Trading Symbol	Name of each exchange on which registered
None	N/A	N/A

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 every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ☒ No ☐

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


Large accelerated filer ◻	Accelerated filer ◻	Non-accelerated filer ◻	Smaller Reporting Company ☒	Emerging growth company ◻

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ◻

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Securities Exchange Act of 1934). Yes ☐ No ☒

As of September 13, 2019, there were 5,995,750 shares of Common Stock, $0.01 par value, outstanding.

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TOROTEL, INC. AND SUBSIDIARIES

INDEX

Part I. Financial Information (Unaudited)		3

Item 1	Financial Statements	3
	Consolidated Condensed Balance Sheets	3
	Consolidated Condensed Statements of Operations	4
	Consolidated Condensed Statements of Changes in Stockholders’ Equity	5
	Consolidated Condensed Statements of Cash Flows	6
	Notes to Consolidated Condensed Financial Statements	7

Forward-Looking Information		19

Item 2	Management's Discussion and Analysis of Financial Condition and Results of Operations	20

Item 3	Quantitative and Qualitative Disclosures About Market Risk	24

Item 4	Controls and Procedures	24

Part II. Other Information		25

Item 5 Other Information		25

Item 6	Exhibits	25

Signatures		26

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

CONSOLIDATED CONDENSED BALANCE SHEETS


	(Unaudited)
	July 31, 2019		April 30, 2019
ASSETS
Current assets:
Cash	$	353,000	$	58,000
Trade receivables, net		2,468,000		2,590,000
Contract assets		1,173,000		1,104,000
Inventories		3,256,000		3,054,000
Prepaid expenses		385,000		152,000
		7,635,000		6,958,000

Land		265,000		265,000
Buildings and improvements		1,578,000		1,569,000
Equipment		4,152,000		4,045,000
		5,995,000		5,879,000
Less accumulated depreciation		4,148,000		4,056,000
Property, plant and equipment, net		1,847,000		1,823,000

Operating right-of-use assets		2,214,000		—
Deferred income taxes		34,000		34,000
Other assets		152,000		186,000

Total Assets	$	11,882,000	$	9,001,000

LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Current maturities of long-term debt	$	666,000	$	1,121,000
Current maturities of operating lease liabilities		378,000		—
Current maturities of finance lease liabilities		73,000		—
Trade accounts payable		1,671,000		1,625,000
Accrued liabilities		1,129,000		824,000
Customer deposits		26,000		24,000
		3,943,000		3,594,000

Long-term debt, less current maturities		811,000		801,000
Operating lease liabilities, less current maturities		2,042,000		—
Finance lease liabilities, less current maturities		9,000		—
		2,862,000		801,000
Stockholders' equity:
Common stock; par value $0.01; 6,000,000 shares authorized; 5,995,750 shares issued and outstanding		60,000		60,000
Capital in excess of par value		12,572,000		12,545,000
Accumulated deficit		(7,555,000)		(7,999,000)
		5,077,000		4,606,000

Total Liabilities and Stockholders' Equity	$	11,882,000	$	9,001,000

The accompanying notes are an integral part of these statements.

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CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS (Unaudited)


	Three Months Ended
	July 31, 2019		July 31, 2018
Net sales	$	6,346,000	$	4,473,000
Cost of goods sold		3,953,000		2,994,000
Gross profit		2,393,000		1,479,000
Operating expenses:
Engineering		388,000		302,000
Selling, general and administrative		1,423,000		1,211,000
		1,811,000		1,513,000
Income (loss) from operations		582,000		(34,000)
Other expense:
Interest expense, net		27,000		24,000
Income (loss) before income tax expense		555,000		(58,000)
Income tax expense (benefit)		111,000		(15,000)
Net income (loss)	$	444,000	$	(43,000)
Basic earnings (loss) per share	$	0.07	$	(0.01)

The accompanying notes are an integral part of these statements.

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CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (Unaudited)


				Capital In				Total
		Common		Excess of		Accumulated		Stockholders'
	Shares	Stock		Par Value		Deficit		Equity
For The Three Months Ended July 31, 2018:
Balance, April 30, 2018	5,995,750	$	60,000	$	12,437,000	$	(8,743,000)	$	3,754,000
Stock compensation earned	—		—		27,000		—		27,000
Net loss	—		—		—		(43,000)		(43,000)
Cumulative effect of adoption of new accounting principle	—		—		—		102,000		102,000
Balance, July 31, 2018	5,995,750		60,000		12,464,000		(8,684,000)		3,840,000

For The Three Months Ended July 31, 2019:
Balance, April 30, 2019	5,995,750	$	60,000	$	12,545,000	$	(7,999,000)	$	4,606,000
Stock compensation earned	—		—		27,000		—		27,000
Net income	—		—		—		444,000		444,000
Balance, July 31, 2019	5,995,750		60,000		12,572,000		(7,555,000)		5,077,000

The accompanying notes are an integral part of these statements.

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CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS (Unaudited)


	Three Months Ended
	July 31, 2019		July 31, 2018
Cash flows from operating activities:
Net income (loss)	$	444,000	$	(43,000)
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:
Stock compensation cost amortized		27,000		27,000
Depreciation		92,000		84,000
Deferred income taxes		—		(15,000)
Changes in operating assets and liabilities:
Trade receivables		122,000		174,000
Contract assets		(69,000)		(233,000)
Inventories		(202,000)		(539,000)
Prepaid expenses and other assets		(199,000)		71,000
Operating lease right-of-use assets		53,000		—
Trade accounts payable		46,000		59,000
Accrued liabilities		511,000		218,000
Current and long-term operating lease liabilities		(53,000)		—
Customer deposits		2,000		(61,000)
Net cash provided by (used in) operating activities		774,000		(258,000)
Cash flows from investing activities:
Capital expenditures		(116,000)		(50,000)
Net cash used in investing activities		(116,000)		(50,000)
Cash flows from financing activities:
Principal payments on long-term debt		(7,000)		(19,000)
Principal payments under capital and financing lease obligations		(16,000)		(27,000)
Payments on line of credit		(3,777,000)		—
Proceeds from line of credit		3,437,000		—
Net cash used in financing activities		(363,000)		(46,000)
Net increase (decrease) in cash		295,000		(354,000)
Cash, beginning of period		58,000		575,000
Cash, end of period	$	353,000	$	221,000
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash paid during the period for:
Interest	$	27,000	$	24,000
Capital leases reclassified from long-term debt to finance lease liabilities		98,000		—
Deferred lease reclassified from accrued liabilities to operating right-of-use assets		206,000		—

The accompanying notes are an integral part of these statements.

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NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

NOTE 1 — BASIS OF PRESENTATION

The consolidated condensed balance sheet as of April 30, 2019, which has been derived from the audited financial statements of Torotel, Inc. ("Torotel" or the “Company”), is accompanied by the unaudited interim consolidated condensed financial statements, which reflect the normal recurring adjustments that in the opinion of management are necessary to present fairly Torotel’s consolidated financial position at July 31, 2019, and the consolidated results of operations and cash flows for the three months ended July 31, 2019, and 2018, respectively.

The unaudited interim consolidated condensed financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission ("SEC"). Certain information and note disclosures normally included in the annual financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to those rules and regulations, although management believes the disclosures made are adequate to make the information not misleading. The financial statements contained herein should be read in conjunction with Torotel’s consolidated financial statements and related notes filed on Torotel's Form 10-K for the year ended April 30, 2019 as filed with the SEC on July 23, 2019.

Accounting Pronouncements Recently Adopted

The Company adopted the guidance of ASU No. 2016-02, Leases, (“ASC 842”) as of May 1, 2019 using the modified retrospective transition approach with the cumulative effect recognized at the date of initial application. The comparative information in the prior year has not been adjusted and continues to be reported under ASC 840, Leases, which was the accounting standard in effect for that period. ASC 842 requires lessees to recognize leases on-balance sheet and disclose key information about leasing arrangements. The new standard establishes a right-of-use model (“ROU”) that requires a lessee to recognize a ROU asset and lease liability on the balance sheet for all leases with a term longer than 12 months. Leases are classified as finance or operating, with classification affecting the pattern and classification of expense recognition in the statement of operations and presentation of cash flows. See Note 5—Leases for the required disclosures of the nature, amount, timing, and uncertainty of cash flows arising from leases.

NOTE 2 — NATURE OF OPERATIONS

Torotel conducts business through its wholly owned subsidiary, Torotel Products, Inc. (“Torotel Products”). Torotel Products specializes in the custom design and manufacture of a wide variety of precision magnetic components, consisting of transformers, inductors, reactors, chokes, toroidal coils, high voltage transformers, dry-type transformers and electro-mechanical assemblies, for use in commercial, industrial and military electronics.

NOTE 3—INVENTORIES

The following table summarizes the components of inventories:


		July 31, 2019		April 30, 2019
Raw materials	$	1,786,000	$	1,723,000
Work in process		1,345,000		1,052,000
Finished goods		125,000		279,000
	$	3,256,000	$	3,054,000

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NOTE 4—REVENUE

We determine revenue recognition through the following steps:


1)	Identification of the contract, or contracts, with a customer A contract with a customer exists when (i) the Company enters into an enforceable contract with a customer that defines each party’s rights regarding the services to be transferred and identifies the payment terms related to these services, (ii) the contract has commercial substance and, (iii) the Company determines that collection of substantially all consideration for goods or services that are transferred is probable based on the customer’s intent and ability to pay the promised consideration. The Company applies judgment in determining the customer’s ability and intention to pay, which is based on a variety of factors including the customer’s historical payment experience or, in the case of a new customer, published credit and financial information pertaining to the customer.
2)	Identification of the performance obligations in the contract Performance obligations promised in a contract are identified based on the goods or services that will be transferred to the customer that are both capable of being distinct, whereby the customer can benefit from the service either on its own or together with other resources that are readily available from third parties or from the Company, and are distinct in the context of the contract, whereby the transfer of the goods or services are separately identifiable from other promises in the contract. To the extent a contract includes multiple promised goods or services, the Company must apply judgment to determine whether promised goods or services are capable of being distinct and distinct in the context of the contract. If these criteria are not met the promised goods or services are accounted for as a combined performance obligation.
3)	Determination of the transaction price The transaction price is determined based on the consideration to which the Company will be entitled in exchange for transferring goods or services to the customer. To the extent the transaction price includes variable consideration, the Company estimates the amount of variable consideration that should be included in the transaction price utilizing either the expected value method or the most likely amount method depending on the nature of the variable consideration. Variable consideration is included in the transaction price if, in the Company’s judgment, it is probable that a significant future reversal of cumulative revenue under the contract will not occur. None of the Company's contracts as of July 31, 2019 contained a significant financing component. Determining the transaction price requires significant judgment, which is discussed by revenue category in further detail below.
4)	Allocation of the transaction price to the performance obligations in the contract If the contract contains a single performance obligation, the entire transaction price is allocated to the single performance obligation. However, if a series of distinct goods or services that are substantially the same qualifies as a single performance obligation in a contract with variable consideration, the Company must determine if the variable consideration is attributable to the entire contract or to a specific part of the contract. Contracts that contain multiple performance obligations require an allocation of the transaction price to each performance obligation based on a relative standalone selling price basis unless the transaction price is variable and meets the criteria to be allocated entirely to a performance obligation or to a distinct service that forms part of a single performance obligation. The Company determines standalone selling price based on the price at which the performance obligation is sold separately. If the standalone selling price is not observable through past transactions, the Company estimates the standalone selling price taking into account available information such as market conditions and internally approved pricing guidelines related to the performance obligations.

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Recognition of revenue when, or as, we satisfy a performance obligation

The Company satisfies performance obligations either over time or at a point in time as discussed in further detail below. Revenue is recognized at the time the related performance obligation is satisfied by transferring a promised service to a customer.

Performance Obligations Satisfied Over Time

We recognize revenue on agreements for the sale of customized goods for use in commercial aerospace and military electronics on an over time basis.

Commercial Aerospace and Defense Parts

Performance obligations under long-term agreements are considered to be under contract at the time that authorization to ship has been obtained from the customer, except for one long-term agreement which provides a contract for two specific parts if the ship date is within 21 days. Performance obligations under standalone purchase orders are considered to be under contract at the time that the purchase order is received. Parts manufactured for customers in our aerospace and defense product revenue stream must be built to certain specifications that are then qualified by the customer. Due to the proprietary nature of our custom-built products designed for a specific use by our aerospace and defense customers, control is considered to be with the customer as the products are finalized and placed into finished goods. Goods within this revenue stream do not provide simultaneous receipt and benefit to the customer. The goods are controlled by our customers once the finished parts are created. The customers prevent any alternative use of the asset and an enforceable right to payment does exist. We provide for potential losses on any of these agreements when it is probable that we will incur the loss.

Our billing terms for these over-time contracts vary, but are generally based on ship date. Control is transferred as products are completed and closed to finished goods.

Product fees and engineering and design services

For product fees along with engineering and design services, transfer of control is determined by the revenue stream of the associated product. Percentage-of-completion revenue recognition is utilized when revenue recognized exceeds the amount billed to the customer for any project-related services, utilizing labor as the input method.

Performance Obligations Satisfied at a Point in Time

We recognize revenue on agreements for the sale of customized goods for use in the industrial and commercial market on point in time basis.

Industrial and Commercial Parts

Performance obligations under long-term agreements are considered to be under contract at the time that authorization to ship has been obtained from the customer. Performance obligations under standalone purchase orders are considered to be under contract at the time that the purchase order is received. For our commercial customers, control of the underlying product design is retained by Torotel, therefore the products are considered in our control until the moment of shipment. Also, upon shipment the customers have an obligation to pay for the asset and we have an enforceable right to payment. We provide for potential losses on any of these agreements when it is probable that we will incur the loss.

Our billing terms for these point in time sales are generally based on ship date. Control is transferred as products are shipped to the customers.

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Taxes assessed by a governmental authority that are both imposed on and concurrent with a specific revenue-producing transaction, that are collected by the Company from a customer, are excluded from revenue. Shipping and handling costs do not have a material impact to the financial statements. No impairment losses were recognized in the three months ending July 31, 2019 and 2018, relating to receivables or contract assets arising from contracts with customers.

Disaggregation of Revenue

The following tables summarize revenue from contracts with customers for the three months ended July 31, 2019 and 2018.


	Three Months Ended
	July 31, 2019		July 31, 2018
Markets
Commercial Aerospace	$	2,410,000	$	1,760,000
Defense		3,823,000		2,277,000
Industrial		113,000		436,000
Total consolidated net sales	$	6,346,000	$	4,473,000


	Three Months Ended
	July 31, 2019		July 31, 2018
Product Line
Magnetic components	$	3,254,000	$	2,157,000
Potted coil assembly		1,519,000		1,279,000
Electro-mechanical assemblies		1,573,000		757,000
Large transformers		—		280,000
Total consolidated net sales	$	6,346,000	$	4,473,000


	Three Months Ended
	July 31, 2019		July 31, 2018
Geography
Domestic	$	6,098,000	$	4,094,000
Foreign		248,000		379,000
Total consolidated net sales	$	6,346,000	$	4,473,000

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Contract balances

All contract asset balances relate to customer contracts entered into during the fiscal year ending April 30, 2020. We have no contract liabilities other than customer deposits which represent prepaid consideration for contracts with customers. There have been no significant adjustments to contract asset balances related to contract modifications. We have certain customers totaling revenue of $1,592,000 with variable payment terms related to discounts in the amount of $12,000 in the fiscal year ending April 30, 2020.

Remaining performance obligation

As of July 31, 2019, the aggregate amount of the contracted revenues allocated to our unsatisfied (or partially unsatisfied) performance obligations was $5,043,000. The balance of unsatisfied performance obligations excludes contracts with original maturities of one year or less. We expect to recognize revenue as we satisfy our remaining performance obligations. Total remaining performance obligation to be recognized in the fiscal year ending April 30, 2020 is expected to be $4,298,000. Total remaining performance obligation to be recognized in the fiscal year ending April 30, 2021 is expected to be $745,000.

NOTE 5—LEASES

The Company adopted ASC 842 on May 1, 2019 using the modified retrospective transition method; and therefore, the comparative information has not been adjusted for the three months ended July 31, 2018 or as of April 30, 2019. Upon transition to the new standard, the Company elected the package of practical expedients, which permitted the Company not to reassess under the new standard its prior conclusions about lease identification, lease classification and initial direct costs.

The Company leases buildings and equipment under operating and finance leases. The majority of the Company’s operations are conducted in premises occupied under lease agreements with initial base terms ranging from 5 to 15 years, with certain leases containing options to extend the leases for up to an additional 10 years. The Company typically does not believe that exercise of the renewal options is reasonably assured at the inception of the lease agreements and, therefore, considers the initial base term as the lease term. Lease terms vary but generally the leases provide for fixed and escalating rentals or contingent escalating rentals based on the Consumer Price Index.

Operating lease ROU assets and lease liabilities were recognized at commencement date based on the present value of minimum lease payments over the remaining lease term. The minimum lease payments include base rent payments. The Company’s leases have remaining lease terms of approximately 1 year to 8 years, which may include the option to extend the lease when it is reasonably certain the Company will exercise that option. The present value of the lease payments is calculated using the incremental borrowing rate for operating leases, which was determined using a portfolio approach based on the rate of interest that the Company would have to pay to borrow an amount equal to the lease payments on a collateralized basis over a similar term. Operating lease expense is recognized on a straight-line basis over the lease term.

The Company’s lease agreements do not contain any material residual value guarantees. The Company elected the practical expedient to not separate lease and non-lease components and also elected the short-term practical expedient for all leases that qualify. As a result, the Company will not recognize ROU assets or liabilities for short-term leases that qualify for the short-term practical expedient, but instead will recognize the lease payments as lease cost on a straight-line basis over the lease term.

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As a result of adopting ASC 842, the Company’s consolidated balance sheet includes additional operating ROU lease assets and total operating lease liabilities of $2,214,000 and $2,420,000, respectively, at July 31, 2019. The initial measurement occurring on May 1, 2019, resulted in operating lease ROU assets of $2,267,000, finance lease ROU assets of $98,000, current operating lease liabilities of $380,000, current finance lease liabilities of $73,000, noncurrent operating lease liabilities of $2,093,000, and noncurrent finance lease liabilities of $25,000. The difference of $206,000 between the ROU assets and the lease liabilities results from a reclassification of deferred rent to the operating lease ROU asset of $206,000.

The following table provides the operating and finance ROU assets and lease liabilities:


	Balance Sheet Classification		July 31, 2019
Assets
Operating lease right-of-use assets	Operating right-of-use assets	$	2,214,000
Finance lease right-of-use assets	Property, plant and equipment, net		82,000
Total leased assets		$	2,296,000

Liabilities
Current
Operating lease liabilities	Current maturities of operating lease liabilities	$	378,000
Finance lease liabilities	Current maturities of finance lease liabilities		73,000
Noncurrent
Operating lease liabilities	Operating lease liabilities, less current maturities		2,042,000
Finance lease liabilities	Finance lease liabilities, less current maturities		9,000
Total lease liabilities		$	2,502,000

The components of lease expense were as follows:


		July 31, 2019

Operating lease expense	$	112,000
Finance lease expense
Amortization of right-to-use assets		10,000
Interest on lease liabilities		3,000
Total finance lease expense		13,000
Total lease expense	$	125,000

The supplemental components of cash flows were as follows:


		July 31, 2019
Cash paid for amounts included in the measurement of lease liabilities
Operating cash flows from operating leases	$	112,000
Financing cash flows from finance leases		16,000
Total cash paid for amounts included in the measurement of lease liabilities	$	128,000

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The following table respresents the weighted-average remaining lease term and discount rate as of July 31, 2019:


	July 31, 2019
	Weighted Average	Weighted Average
	Remaining	Discount
Lease Term and Discount Rate	Lease Term (years)	Rate
Operating leases	7.24	4.51%
Finance leases	1.12	5.45%

Future minimum lease payments on the amended operating lease and future minimum finance lease payments as of July 31, 2019 are as follows:


	Finance Lease		Operating Lease
Fiscal Years Ending April 30,	Payments		Payments
2020	$	55,000	$	342,000
2021		27,000		418,000
2022		—		430,000
2023		—		442,000
2024		—		452,000
2025		—		456,000
2026		—		467,000
2027		—		350,000
		82,000		3,357,000

NOTE 6—FINANCING AGREEMENTS

On October 19, 2018, Torotel entered into three new business loan agreements (the “financing agreements”) with Cornerstone Bank (the “Bank”). The financing agreements provide for an asset-backed revolving line of credit, a guidance line of credit, and a real estate term loan. A summary of the notes issued under the financing agreements is provided below:


		July 31, 2019		April 30, 2019
6.25% asset-based revolving line of credit with a maturity date of October 19, 2019	$	636,000	$	975,000
6.25% guidance line of credit with a maturity date of October 19, 2019		-		54,000
5.35% mortgage note payable in monthly installments of $5,573, including interest, with final payment of $690,829 due October 19, 2023		789,000		795,000
5.50% equipment term loan note payable in monthly installments of $1,034, including interest, with final payment of $1,034 due on May 13, 2024		52,000		-
Capital lease obligations (see Note 5)		-		98,000
Total long-term debt		1,477,000		1,922,000
Less current installments		666,000		1,121,000
Long-term debt, excluding current installments	$	811,000	$	801,000

The asset-based revolving line of credit is intended to be used for working capital purposes and has a capacity of $1,500,000. The asset-based revolving line of credit is renewable annually upon mutual agreement of Torotel and the Bank. The Company intends to renew the asset-based revolving line of credit. The associated interest rate is equal to the greater of the floating Cornerstone Bank Corporate Base Rate (6.25% as of July 31, 2019) or a floor of 5% (as listed above). Monthly repayments of interest only are required under the asset-based revolving line of credit promissory note with the principal due at maturity. The borrowing base of the revolving line of credit is limited to 80% of eligible accounts receivable, plus 50% of eligible inventory, plus 80% of eligible equipment. This asset-based revolving line of credit is cross collateralized and cross defaulted with all other financing agreements of Torotel with the Bank. Pursuant to a

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Commercial Security Agreement dated October 19, 2018, between Torotel and the Bank (the “Commercial Security Agreement”), which was entered into in connection with the financiang agreements, the asset-based revolving line of credit is secured by a first lien on all business assets of Torotel. Under the revolving line of credit, if the aggregate principal amount of the outstanding advances exceeds the applicable borrowing base, Torotel must pay the Bank an amount equal to the difference between the outstanding principal balance of the revolving line of credit and the borrowing base.

The equipment note was a guidance line of credit to be used for equipment purchases and had a capacity of $250,000. On May 13, 2019, Torotel converted the guidance line of credit relating to the equipment note into an equipment term loan. The equipment term loan is in the principal amount of $54,000 and contains a 5-year term with a 5-year amortization period, with the balance at maturity on May 13, 2024. The associated interest rate is fixed at 5.50%. Monthly repayments of approximately $1,034, consisting of both interest and principal, are required. This final payment of approximately $1,034 is due on the maturity date. This equipment term loan is cross collateralized and cross defaulted with the other financing agreements of Torotel and is secured by a purchase money security interest in the assets purchased as well as a first lien on all business assets of Torotel.

The real estate term loan is in the principal amount of $815,000 and contains a 5-year term with a 20-year amortization period, with the balance at maturity on October 19, 2023. The associated interest rate is fixed at 5.35%. Monthly repayments of approximately $5,573, consisting of both interest and principal, are required. The final payment of approximately $690,829 is due on the maturity date. This real estate term loan is cross collateralized and cross defaulted with the other financing agreements. The real estate term loan is secured by a first lien priority real estate mortgage on the property located at 620 North Lindenwood Drive in Olathe, Kansas pursuant to the Commercial Security Agreement.

The financing agreements contain customary representations, warranties, and covenants of Torotel for the benefit of the Bank, as well as customary default provisions. Other than the borrowing base limitations under the asset-based revolving line of credit, none of the financing agreements requires Torotel to comply with any financial covenants. Prepayments are allowed without penalty under all of the financing agreements.

Irrevocable Standby Letter of Credit

Under the terms of a lease amendment for its manufacturing facility located in Olathe, Kansas, Torotel provided the landlord an irrevocable standby letter of credit in the original amount of $300,000 as additional security. The balance under the letter of credit will automatically reduce in accordance with the below schedule if not drawn upon:


Date of Reduction		Amount of Reduction		Balance of Letter of Credit
January 1, 2020	$	75,000	$	225,000
January 1, 2021		75,000		150,000
January 1, 2022		75,000		75,000
January 1, 2023		75,000		-

NOTE 7—INCOME TAXES

The Company incurred income tax expense of $111,000 during the three months ended July 31, 2019 with an effective tax rate of 19.9%, compared to income tax benefit of $15,000 during the three months ended July 31, 2018.

As of July 31, 2019, the federal tax returns for the fiscal years ended 2017 through 2019 are open to audit until the statute of limitations closes for the years in which our net operating losses are utilized. We would recognize interest and penalties accrued on unrecognized tax benefits as well as interest received from favorable tax settlements within income tax expense. As of July 31, 2019, we recorded no accrued interest or penalties related to uncertain tax positions. We expect no significant change in the amount of unrecognized tax benefit, accrued interest or penalties within the next twelve months.

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NOTE 8—RESTRICTED STOCK AGREEMENTS

Restricted Stock Agreements, and stock awards thereunder, are authorized by the Compensation and Nominating Committee (the "Committee") and the Board of Directors of Torotel (the "Board"). The terms of the Restricted Stock Agreements afford the grantees all of the rights of a stockholder with respect to the award shares, including the right to vote such shares and to receive dividends and other distributions payable with respect to such shares since the date of award. Under the terms of each agreement, the non-vested shares are restricted as to disposition and subject to forfeiture under certain circumstances. The Restricted Stock Agreements further provide, subject to certain conditions, that if prior to all of the restricted shares having vested, we undergo a change in control, then all of the restricted shares shall be vested and no longer subject to restrictions under the Restricted Stock Agreements. The restricted shares are treated as non-vested stock; accordingly, the fair value of the restricted stock at the date of award is offset against capital in excess of par value in the accompanying consolidated balance sheets under stockholders' equity.

Restricted Stock Grants

On September 21, 2016, we entered into Restricted Stock Agreements (“2016 Agreements”) with three key employees for the grant of an aggregate total of 730,000 restricted shares of the Company's common stock (the “Shares”). The Shares were granted, and the 2016 Agreements were entered into, pursuant to the Company’s Stock Award Plan (the “Plan”). The award of the Shares was authorized by both the Committee and the Board as a whole on September 19, 2016. Except for the number of shares granted to each recipient, the terms of each of the 2016 Agreements are identical.

The Shares were granted subject to restrictions that prohibit them from being sold, assigned, pledged or otherwise disposed of until the restrictions lapse. The restrictions will lapse on the fifth anniversary of the date of grant if during the five year restriction period, (1) the Company's cumulative annual growth in revenue is at least 10%, and (2) the average economic value added as a percentage of revenue is at least 2%. The economic value added, which attempts to capture the true economic profit, will be calculated as the operating profit less the cost of capital with adjustments made for taxes. The restrictions will also lapse, if prior to the fifth anniversary of the date of grant, (1) the grantee's employment with the Company is terminated by reason of disability, (2) the grantee dies, or (3) the Committee, in its sole discretion, terminates the restrictions. If the restrictions on the Shares have not lapsed by the fifth anniversary of the date of grant, the Shares will be forfeited to the Company.

Stock Compensation Costs and Restricted Stock Activity

Total stock compensation cost was $27,000 for each of the three months ended July 31, 2019 and 2018.

Restricted stock activity for each three month period through July 31 is summarized as follows:


	2019			2018
	Restricted	Weighted		Restricted	Weighted
	Shares	Average		Shares	Average
	Under	Grant		Under	Grant
	Option	Price		Option	Price
Outstanding at May 1	730,000	$	0.740	730,000	$	0.740
Granted	—		—	—		—
Forfeited	—		—	—		—
Outstanding at July 31	730,000	$	0.740	730,000	$	0.740

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NOTE 9—STOCKHOLDERS' EQUITY

The shares of common stock outstanding as each three month period ended as of July 31 are summarized as follows:


	2019	2018
Balance, May 1	5,995,750	5,995,750
Shares released from treasury for restricted stock grants	—	—
Newly issued shares for restricted stock grants	—	—
Shares reverted to treasury for restricted stock forfeitures	—	—
Balance, July 31	5,995,750	5,995,750

NOTE 10—EARNINGS PER SHARE

Basic and diluted earnings per share are computed using the two-class method. The two-class method is an earnings allocation formula that determines net income per share for each class of common stock and participating security according to dividends declared and participation rights in undistributed earnings. Per share amounts are computed by dividing net income attributable to common shareholders by the weighted average shares outstanding during each period.

The basic earnings (loss) per common share were computed as follows:


	Three Months Ended
	July 31, 2019		July 31, 2018
Net income (loss)	$	444,000	$	(43,000)
Amounts allocated to participating securities (nonvested restricted shares)		(54,000)		—
Net income (loss) attributable to common shareholders	$	390,000	$	(43,000)
Basic weighted average common shares		5,265,750		5,265,750
Earnings (loss) per share attributable to common shareholders:
Basic earnings (loss) per share	$	0.07	$	(0.01)

ASC 260, Earnings per Share, provides that unvested share-based payment awards that contain non-forfeitable rights to dividends are considered to be participating securities and must be considered in the computation of earnings per share pursuant to the two-class method. Diluted earnings per share is not presented as we do not have any shares considered incremental and dilutive.

NOTE 11—CONTRACT ASSETS

For each of our contracts, the timing of revenue recognition, customer billings, and cash collections results in a net contract asset or liability at the end of each reporting period. Contract assets consist of unbilled receivables typically resulting from revenue recognition under contracts when either control has passed to the customer but the product has not yet shipped or the percentage-of-completion of revenue recognition is utilized when revenue recognized exceeds the amount billed to the customer for any project-related services, utilizing labor as the input method.


	July 31, 2019		April 30, 2019
Contract assets	$	1,173,000	$	1,104,000

Contract assets increased $69,000 between April 30, 2019 and July 31, 2019 due to increased customer contracts, and relates to the recognition of revenue related to the satisfaction or partial satisfaction of performance obligations for which we have not yet billed.

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NOTE 12 — CUSTOMER DEPOSITS

For certain customers, we collect payment at the time the order is placed. These deposits are classified as a liability and will be recognized as revenue at the time performance obligations are satisfied in accordance with our revenue recognition policy. As of July 31, 2019 and April 30, 2019, we had approximately $26,000 and $24,000, respectively, in customer deposits related to these arrangements.

NOTE 13 — CONCENTRATIONS OF CREDIT RISK

Financial instruments that potentially subject us to concentrations of credit risk consist principally of cash and accounts receivable. We grant unsecured credit to most of our customers. We do not believe that we are exposed to any extraordinary credit risk as a result of this policy. At various times cash balances exceeded federally insured limits. However, we have incurred no losses in the cash accounts and we do not believe we are exposed to any significant credit risk with respect to our cash.

NOTE 14 – LEASED PROPERTY

On February 15, 2019, a lease agreement became effective for tenant occupancy of the 23,924 square foot building owned by Torotel. Monthly installment payments of $11,500 began to be paid to us on March 1, 2019. The lease is for a sixty-two month term with monthly payments escalating periodically from $11,500 to $15,500. The tenant has the right to elect to purchase the building. The election to purchase must be made within the lease term or Torotel is not prohibited from placing the building up for public sale.

Future minimum lease payments on the operating lease as of July 31, 2019 are as follows:


	Operating Lease
Fiscal Years Ending April 30,	Payments
2020	$	107,500
2021		154,000
2022		166,000
2023		178,000
2024		124,000
Total	$	729,500

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Torotel’s leased property (where Torotel is the leesor) by asset category was as follows:


	July 31, 2019		April 30, 2019
Land	$	265,000	$	265,000
Buildings and improvements		1,000,000		1,000,000
		1,265,000		1,265,000
Less accumulated depreciation		(672,000)		(659,000)
Net leased property	$	593,000	$	606,000

Depreciation resulting from the leased property amounted to $13,000 during the three months ending July 31, 2019.

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Forward-Looking Information

This report, as well as our other reports filed with or furnished to the Securities and Exchange Commission (the “SEC”), contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). The words “believe,” “estimate,” “anticipate,” “project,” “intend,” “expect,” “plan,” “outlook,” “forecast,” “may,” “should,” “predict,” and similar expressions are intended to identify forward-looking statements. Statements regarding expectations, including performance assumptions and estimates relating to capital requirements, as well as other statements that are not historical facts, are forward-looking statements. This report contains forward-looking statements regarding, among other topics, our expected financial position, results of operations, cash flows, strategy, budgets and management's plans and objectives. Accordingly, these forward-looking statements are based on management’s judgments based on currently available information and assumptions about a number of important factors. While we believe that our assumptions about such factors are reasonable, such factors involve risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements. These factors include,without limitation:

economic, political and legislative factors that could impact defense spending;

continued production of the Hellfire II missile system for which we supply parts;

loss of key customers and our relatively concentrated customer base;

risks in fulfilling military subcontracts;

our ability to finance operations;

our ability to adequately pass through to customers unanticipated future increases in raw material and labor costs;

delays in developing new products;

markets for new products and the cost of developing new markets;

expected orders that do not occur;

our ability to adequately protect and safeguard our network infrastructure from cyber security vulnerabilities;

our on-going ability to satisfy our debt repayment obligations;

our ability to generate sufficient taxable income to realize the amount of our deferred tax assets; and

the impact of competition and price erosion as well as supply and manufacturing constraints;

In light of these risks and uncertainties, there can be no assurance that the forward-looking information contained in this report will prove accurate, and actual results may differ materially from these forward-looking statements. We assume no obligation to update any forward-looking statements made herein.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Overview

Torotel, Inc. ("Torotel") conducts substantially all of its business primarily through its wholly owned subsidiary, Torotel Products, Inc. ("Torotel Products"). The terms “we,” “us,” “our,” and the “Company” as used herein include Torotel and all of its subsidiaries, including Torotel Products, unless the context otherwise requires. Torotel specializes in the custom design and manufacture of a wide variety of precision magnetic components consisting of transformers, inductors, reactors, chokes, toroidal coils, high voltage transformers, dry-type transformers and electro-mechanical assemblies for use in military, commercial aerospace and industrial electronic applications. These products are used to modify and control electrical voltages and currents in electronic devices. Torotel sells these products to original equipment manufacturers, which use them in applications such as:

aircraft navigational equipment;

digital control devices;

airport runway lighting devices;

medical equipment;

avionics systems;

radar systems;

down-hole drilling;

conventional missile guidance systems; and

other aerospace and defense applications.

Torotel markets its components primarily through an internal sales force and independent manufacturers’ representatives paid on a commission basis. These commissions are earned when a product is sold and/or shipped to a customer within the representative’s assigned territory. Torotel also utilizes its engineering department in its direct sales efforts for the purpose of expanding its reach into new markets and/or customers.

The industry mix of the customers that accounted for Torotel’s net sales for the first three months of the fiscal year ending April 30, 2020 (“fiscal year 2020”) was 60% defense, 38% commercial aerospace, and 2% industrial compared to 51% defense, 39% commercial aerospace, and 10% industrial for the same period in the fiscal year ending April 30, 2019 (“fiscal year 2019”). Approximately 96% of Torotel’s sales during the first three months of fiscal year 2020 have been derived from domestic customers.

Torotel is an approved source for magnetic components used in numerous military and commercial aerospace systems, which means Torotel is automatically solicited for any procurement needs for such applications. The magnetic components manufactured by Torotel are sold primarily in the United States, and most sales are awarded on a competitive bid basis. The markets in which Torotel competes are highly competitive. A substantial number of companies sell components of the type manufactured and sold by Torotel. In addition, Torotel sells to a number of customers who have the capability of manufacturing their own electronic components. The principal methods of competition for electronic products in the markets served by Torotel include, among other factors, price, on-time delivery performance, lead times, customized product engineering and technical support, marketing capabilities, quality assurance, manufacturing efficiency, and existing relationships with customers’ engineers. While we believe magnetic components are generally not susceptible to rapid technological change, Torotel’s sales, which do not represent a significant share of the industry’s market, are susceptible to decline given the competitive nature of the market.

Business and Industry Considerations

Defense Markets

During the first three months of fiscal years 2020 and 2019 the amount of consolidated revenues derived from contracts with prime contractors of the U.S. Department of Defense (“DoD”) was approximately 60% and 51%

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respectively. As a result, our financial results in any period could be impacted substantially by spending cuts or increases in the DoD budget and the funds appropriated for certain military programs.

Despite ongoing uncertainty associated with the DoD budget, we believe our overall defense business outlook remains favorable due to the present demand for the potted coil assembly and other existing orders from major defense contractors. As of July 31, 2019, our consolidated order backlog for the defense market was nearly $9.2 million, which included $2.8 million for the potted coil assembly.

Commercial Aerospace and Industrial Markets

We provide magnetic components and electro-mechanical assemblies for a variety of applications in the commercial aerospace and industrial markets. The primary demand drivers for these markets include commercial aircraft orders, oil and gas drilling exploration activity, and general economic growth. While domestic economic growth remains positive, the above demand drivers could be impacted by short-term changes in the economy such as spikes or declines in the price of oil, war, terrorism, or changes in regulation. Other threats to our anticipated positive near-term and long-term market outlook include delays on the development and production of new commercial aircraft and competition from international suppliers. As of July 31, 2019, our consolidated order backlog for the aerospace and industrial markets was $3.8 million. However, a material portion of our business has been converted to long-term agreements.

Business Outlook

Our backlog as of July 31, 2019 as compared to July 31, 2018 increased from $9.6 million to $12.9 million, a 35% increase. This was due primarily to an increase in magnetics and assembly orders. We anticipate that net sales for fiscal year 2020 will improve from net sales for fiscal year 2019. This is primarily due to the timing of newer program revenue that is projected to ship in fiscal year 2020. We anticipate that 85% of our $12.9 million backlog as of July 31, 2019 is expected to ship and be converted to sales in fiscal year 2020.

Consolidated Results of Operations

The following management comments regarding Torotel’s results of operations and outlook should be read in conjunction with the Consolidated Condensed Financial Statements and Notes to the Consolidated Condensed Financial Statements included in Part I, Item 1 of this Quarterly Report.

This discussion and analysis of the results of operations include the operations of Torotel and its subsidiary Torotel Products as of July 31, 2019.

Net Sales


	Three Months Ended
	July 31, 2019		July 31, 2018
Magnetic components	$	3,254,000	$	2,157,000
Potted coil assembly		1,519,000		1,279,000
Electro-mechanical assemblies		1,573,000		757,000
Large transformers		—		280,000
Total	$	6,346,000	$	4,473,000

Consolidated net sales in the three months ended July 31, 2019 increased 42%, or $1,873,000, compared to the three months ended July 31, 2018. Consolidated net sales increased primarily because of increased demand in magnetic components and electro-mechanical assemblies.

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Gross Profit


	Three Months Ended
		July 31, 2019		July 31, 2018
Gross profit	$	2,393,000		$	1,479,000
Gross profit % of net sales		38	%		33	%

Consolidated gross profit increased by 62%, or $914,000, in the three months ended July 31, 2019 compared to the three months ended July 31, 2018. Consolidated gross profit increased primarily due to increased direct labor efficiencies during the first quarter of fiscal year 2020, as well as change in product mix.

Operating Expenses


	Three Months Ended
	July 31, 2019		July 31, 2018
Engineering	$	388,000	$	302,000
Selling, general and administrative		1,423,000		1,211,000
Total	$	1,811,000	$	1,513,000

Engineering expenses increased 28%, or $86,000, in the three months ended July 31, 2019 compared to the three months ended July 31, 2018. The increase primarily resulted from an increase in headcount during the first quarter of fiscal year 2020.

Selling, general and administrative expenses increased 18%, or $212,000, in the three months ended July 31, 2019 compared to the three months ended July 31, 2018. The increase primarily resulted from an increase in headcount during the first quarter of fiscal year 2020.

Earnings (loss) from Operations


	Three Months Ended
	July 31, 2019		July 31, 2018
Torotel Products	$	765,000	$	104,000
Torotel		(183,000)		(138,000)
Total	$	582,000