This Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 21E of the Exchange Act and Section 27A of the Securities Act. For this purpose, any statements contained herein that are not statements of historical fact may be deemed to be forward-looking statements. Without limiting the foregoing, the words "believes," "anticipates," "plans," "expects" and similar expressions are intended to identify forward-looking statements. Factors that could cause actual results to differ materially from those reflected in the forward-looking statements include, but are not limited to, those discussed in Item 1A. Risk Factors and elsewhere in this Report. For more information, see "Forward Looking Statements." Readers are cautioned not to place undue reliance on these forward-looking statements, which reflect management's analysis, judgment, belief or expectation only as of the date hereof. We do not undertake any obligation to update forward-looking statements whether as a result of new information, future events or otherwise. The following discussion and analysis of our financial condition and results of operations should be read together with our consolidated financial statements and related notes included in Part II, Item 8 of this Annual Report on Form 10-K, which recasts the financial information in the Company's Annual Report on Form 10-K for the year ended
July 31, 2021to present IWCO Direct(formerly our Direct Marketing segment) as a discontinued operation.
ModusLinkprovides digital and physical supply chain solutions to many of the world's leading brands across a diverse range of industries, including consumer electronics, telecommunications, computing and storage, software and content, consumer packaged goods, medical devices, retail and luxury and connected devices. These solutions are delivered through a combination of industry expertise, innovative service solutions, and integrated operations, proven business processes, an expansive global footprint and world-class technology. With a global footprint spanning North America, Europeand the Asia Pacificregion, the Company's solutions and services are designed to improve end-to-end supply chains in order to drive growth, lower costs, and improve profitability.
Beginning in the second quarter of 2020, with the shutdown of the
U.S.economy due to the COVID-19 pandemic, IWCO Direct'sbusiness was significantly and adversely affected by a material reduction in customer mailing activities. Against this backdrop, the Company held, on behalf of IWCO Direct, extensive discussions with Cerberus about amending and extending IWCO Direct'scredit facility with Cerberus under which there was approximately $361 millionoutstanding as of January 31, 2022that was to mature in December 2022. In addition, the Company's Board of Directors considered a range of 22 -------------------------------------------------------------------------------- Table of Contents strategic options to address the impending maturity. In mid-January 2022, it became apparent that it would not be possible to extend or refinance the credit facility prior to its maturity. In addition, short-term funding under the revolving credit facility became unavailable. IWCO Directwas in the process of implementing the previously disclosed competitive improvement plan ("CIP") intended to address the changing requirements of its customers and markets. Despite initial favorable outcomes and improving prospects from the CIP, the Company was unable to amend IWCO Direct'scredit facility or identify alternatives to refinance IWCO Direct'sindebtedness given the magnitude of that indebtedness relative to the performance of IWCO Direct'sbusiness. In light of these developments, the Board of Directors determined that it was in the best interests of the Company's stockholders to pursue an orderly and consensual disposition of IWCO Directto the Cerberus-led investor group. Although the Board of Directors considered other alternatives for IWCO Direct, the Board of Directors concluded that such alternatives would not be viable and on February 25, 2022, the Company completed the disposition of IWCO Directto the Cerberus-led investor group (the entire transaction being referred to as the "IWCO Direct Disposal"). The Company did not receive any cash consideration from the Cerberus-led investor group in exchange for the disposition of IWCO Direct. The Company deconsolidated IWCO Directas of February 25, 2022as it no longer held a controlling financial interest as of that date. The results of IWCO Directare presented as a discontinued operation in all periods reported. Refer to Notes 1 and 3 to the consolidated financial statements in Part II, Item 8 of this Annual Report on Form 10-K for further information on the IWCO DirectDisposal.
Historically, a limited number of key clients have accounted for a significant percentage of the Company's revenue. For the fiscal years ended
July 31, 2022and 2021, the Company's 10 largest clients accounted for approximately 78% and 81% of consolidated net revenue from continuing operations, respectively. Two customers accounted for approximately 31% and 12% of the Company's consolidated net revenue from continuing operations for the fiscal year ended July 31, 2022, and one customer accounted for 42% of the Company's consolidated net revenue from continuing operations for the fiscal year ended July 31, 2021. No other clients accounted for greater than 10% of the Company's consolidated net revenue from continuing operations for the fiscal year ended July 31, 2022and 2021. In general, the Company does not have any agreements that obligate any client to buy a minimum amount of services from it or designate it as an exclusive service provider. Consequently, the Company's net revenue is subject to demand variability by our clients. The level and timing of orders placed by the Company's clients vary for a variety of reasons, including seasonal buying by end-users, the introduction of new technologies and general economic conditions. By diversifying into new markets and improving the operational support structure for its clients, the Company expects to offset the adverse financial impact such factors may bring about. Impact of COVID-19 The ongoing COVID-19 pandemic (in particular, the emergence of new variants of the virus across the globe) has caused, and continues to cause, significant disruptions in the U.S.and global economies. For example, national and local governments in the United Statesand around the world continue to implement measures to prevent the spread of COVID-19 and its variants, including travel bans, prohibitions on group events and gatherings, shutdowns of certain businesses, quarantines, curfews, and recommendations to practice physical distancing. Such measures have restricted and continue to restrict individuals' daily activities and curtail or cease many businesses' normal operations. The COVID-19 pandemic has adversely impacted, and is likely to further adversely impact, nearly all aspects of our business and markets, including our workforce and the operations of our clients, suppliers, and business partners. Beginning in March 2020, when the World Health Organizationcategorized COVID-19 as a pandemic and the President of the United Statesdeclared the COVID-19 outbreak a national emergency, we experienced impacts to our customers' demand, facility operations, supply chain, availability and productivity of personnel, while also working to comply with rapidly evolving international, federal, state and local restrictions and recommendations on travel and workplace health and safety. We experienced disruptions to our business continuity as a result of temporary closures of certain of ModusLink'sfacilities in the third and fourth quarters of fiscal year 2020, as well as the four quarters of fiscal year 2021. However, these temporary closures did not have a significant impact on ModusLink'soperations. An outbreak in Mainland China forced temporary lockdown orders from March 14, 2022to March 20, 2022in several cities in which ModusLinkoperates. In April and May 2022, there were further temporary lockdown orders which impacted several ModusLinkfacilities in China; however, ModusLinkwas able to resume operations on May 5, 2022at one site and at another site on May 31, 2022. In July 2022, there were further temporary lockdown orders which impacted one ModusLinkfacility in China. In September and October 2022, there were further temporary lockdown order which impacted several ModusLinkfacilities in China. The lockdowns in Chinahave not had a significant impact to ModusLink'soperations 23 -------------------------------------------------------------------------------- Table of Contents through the filing of this Annual Report on Form 10- K. Ifthe situation continues at this level or worsens, however, it could result in a potential adverse impact on our business, results of operations and financial condition. We will evaluate further actions if circumstances warrant. Beginning in the second quarter of 2020, with the shutdown of the U.S.economy due to the COVID-19 pandemic, IWCO Direct'sbusiness was also significantly and adversely affected by a material reduction in customer mailing activities. Additionally, although IWCO Directoperated as an essential business, it had reduced operating levels and labor shifts due to lower sales volume during the third quarter of fiscal year 2020. To help combat these impacts and mitigate the financial impact of the COVID-19 pandemic on our business, during fiscal year 2020 we took proactive measures by initiating cost reduction actions, including the waiver of board fees, hiring freezes, staffing and force reductions, company-wide salary reductions, bonus payment deferrals and temporary 401(k) match suspension. The temporary waiver of board fees and company-wide salary reduction actions taken in the prior fiscal year were fully restored prior to the beginning of fiscal year 2021, and the majority of salary reductions were repaid prior to the fiscal quarter ended January 31, 2021. Additionally, against the backdrop of the reduction in IWCO Direct'sbusiness, the Company held extensive discussions with Cerberus about amending and extending IWCO Direct'scredit facility with Cerberus under which there was approximately $361.3 millionoutstanding as of January 31, 2022that was to mature in December 2022. These discussions ultimately resulted in the disposition of IWCO Direct. For more information, see "Disposition of IWCO Direct" above and Note 3 below. We continue our focus on cash management and liquidity, which includes aggressive working capital management. We continue to closely monitor the impact of COVID-19 on all aspects of our business and geographies, including its impact on our clients, employees, suppliers, vendors, business partners and distribution channels. We believe that such impacts could include, the continued disruption to the demand for our businesses' products and services; disruptions in or closures of our business operations or those of our customers or suppliers; the impact of the global business and economic environment on liquidity and the availability of capital; increased costs and delays in payments of outstanding receivables beyond normal payment terms; supply chain disruptions; uncertain demand; and the effect of any initiatives or programs that we may undertake to address financial and operational challenges faced by our customers. Despite indications of economic recovery, the severity of the impact of the COVID-19 pandemic on the Company's business in the fiscal year ending July 31, 2022and beyond is difficult to predict and will depend on a number of uncertain factors and trends. Such factors and trends include, but are not limited to: the duration and severity of the virus and its current variants; the emergence of new variant strains; the availability and widespread use of vaccines; the impact of the global business and economic environment on liquidity and the availability of capital; the extent and severity of the impact on our customers and suppliers; and U.S.and foreign government actions that have been taken, or may be taken in the future, to mitigate adverse economic or other impacts or to mitigate the spread of the virus and its variants. The Company continues to monitor for any developments or updates to COVID-19 guidelines from public health and governmental authorities, as well as the protection of the health and safety of its personnel, and is continuously working to ensure that its health and safety protocols, business continuity plans and crisis management protocols are in place to help mitigate any negative impacts of the COVID-19 pandemic on the Company's employees, business or operations.
Merger project with
June 12, 2022, the Company, Steel Partners Holdings L.P. (" Steel Holdings") and SP Merger Sub, Inc., a wholly-owned subsidiary of Steel Holdings("Merger Sub"), entered into an agreement and plan of merger (the "Merger Agreement"), pursuant to which Merger Sub will merge with and into the Company (the "Merger"), with the Company surviving the Merger as a wholly-owned subsidiary of Steel Holdings. The Merger Agreement provides that each share of the Company's common stock issued and outstanding immediately prior to the effective time of the Merger (other than dissenting shares and shares owned by the Company, Steel Holdingsor any of their respective subsidiaries) will, subject to the terms and conditions set forth in the Merger Agreement, be converted into the right to receive (i) $1.35in cash, without interest and (ii) one contingent value right to receive a pro rata share of the proceeds received by the Company, Steel Holdingsor any of their affiliates with respect to the sale, transfer or other disposition of all or any portion of the assets currently owned by ModusLinkwithin two years of the Merger's closing date, to the extent such proceeds exceed $80 millionplus certain related costs and expenses. Steel Holdingsand certain of its affiliates have also entered into a Voting and Support Agreement pursuant to which, among other things, they have agreed to vote all shares of common stock and Series C Preferred Stock beneficially owned by them in favor of the adoption of the Merger Agreement and the Merger and any alternative acquisition agreement approved by the Company's Board of Directors (acting on the recommendation of the special committee (the "Special Committee") of independent and disinterested directors formed to consider and negotiate the terms and conditions of the Merger and to make a recommendation to our Board of Directors). 24
The Merger Agreement includes a "go-shop" period that expired at
11:59 p.m. Eastern timeon July 12, 2022, during which the Company was authorized to actively solicit and consider alternative acquisition proposals. Although the Company's financial advisor contacted or held discussions with numerous parties, no offers were received during the go shop period. The closing of the Merger is conditioned upon receipt of approval of the Merger from (i) the holders of a majority in voting power of the outstanding shares of common stock and Series C Preferred Stock of the Company (voting on an as converted to shares of common stock basis), voting together as a single class, (ii) a majority of the outstanding shares of common stock of the Company not owned, directly or indirectly, by Steel Holdingsand its affiliates and related parties, and any other officers or directors of the Company, and (iii) the holders of a majority of the outstanding shares of Series C Preferred Stock of the Company, voting as a separate class, as well as other customary closing conditions. Accordingly, there can be no assurance that the Company will be able to complete the Merger on the expected timeline or at all. See "Part I, Item 1A. Risk Factors" included in this Annual Report on Form 10-K. Our Board of Directors, acting on the unanimous recommendation of the Special Committee, and the Board of Directors of Steel Partner Holdings GP Inc., the general partner of Steel Holdings, approved the Merger Agreement and the transactions contemplated by the Merger Agreement (such transactions, collectively, the "Transactions") and resolved to recommend the stockholders adopt the Merger Agreement and approve the Transactions. The Special Committee, which is comprised solely of independent and disinterested directors of the Company whoare unaffiliated with Steel Holdings, exclusively negotiated the terms of the Merger Agreement with Steel Holdings, with the assistance of its independent financial and legal advisors. Subject to the satisfaction of all of the conditions to closing, including the receipt of the requisite stockholder approvals, the Merger is expected to close in the last quarter of calendar 2022.
Unless otherwise stated, this analysis of operating results relates to our continuing operations.
Fiscal 2022 vs. Fiscal 2021
Fiscal Year Ended Fiscal Year Ended July 31, 2022 July 31, 2021 $ Change1 % Change1 (In thousands) Net revenue
$ 203,272 $ 226,256 $ (22,984)(10.2) % Cost of revenue (161,736) (178,552) 16,816 9.4 % Gross profit 41,536 47,704 (6,168) (12.9) % Gross margin percentage 20.4 % 21.1 % Selling, general and administrative (40,373) (49,274) 8,901 18.1 % Interest expense (3,120) (2,615) (505) (19.3) % Other gains, net 4,089 1,187 2,902 244.5 % Income (loss) from continuing operations before income taxes 2,132 (2,998) 5,130 171.1 % Income tax expense (11,388) (8,837) (2,551) (28.9) % Net loss from continuing operations (9,256) (11,835) 2,579 21.8 % Net loss from discontinued operations (1,712) (32,556) 30,844 94.7 %
1 favorable (unfavourable) change
Consolidated net revenue from continuing operations, for the fiscal year ended
July 31, 2022, decreased by approximately $23.0 million, as compared to the fiscal year ended July 31, 2021. This decrease in net revenue was primarily driven by lower volume associated with clients in the computing and consumer electronics markets which have been negatively impacted by global market shortage of semiconductor and other electrical component supplies. Fluctuations in foreign currency exchange rates had an insignificant impact on the net revenue for the fiscal year ended July 31, 2022, as compared to the same period in the prior year. 25 -------------------------------------------------------------------------------- Table of Contents Cost of Revenue: Consolidated cost of revenue from continuing operations consists primarily of expenses related to the cost of materials purchased in connection with the provision of supply chain management services as well as costs for salaries and benefits, contract labor, consulting, fulfillment and shipping, and applicable facilities costs. Supply Chain's cost of revenue decreased by $16.8 millionfor the fiscal year ended July 31, 2022, as compared to the prior year, primarily due to a $17.0 milliondecrease in materials procured on behalf of clients. Supply Chain's gross margin percentage for the fiscal year ended July 31, 2022decreased 70 basis points to 20.4% from 21.1% in the fiscal year ended July 31, 2021, primarily due to lower revenues and higher labor costs. Fluctuations in foreign currency exchange rates had an insignificant impact on Supply Chain's gross margin for the fiscal year ended July 31, 2022, as compared to the same period in the prior year.
Selling, general and administrative expenses:
Consolidated selling, general and administrative expenses ("SG&A") from continuing operations consist primarily of compensation and employee-related costs, sales commissions and incentive plans, information technology expenses, travel expenses, facilities costs, consulting fees, fees for professional services, depreciation expense, marketing expenses, share-based compensation expense, transaction costs, restructuring and public reporting costs. SG&A expenses for the fiscal year ended
July 31, 2022decreased by approximately $8.9 million, as compared to the same period in the prior year. Supply Chain's SG&A expenses decreased by $10.7 millionprimarily due to lower costs associated with the information technology function for the Supply Chain segment. Corporate-level activity increased by $1.8 million, primarily due to an increase in professional fees. Fluctuations in foreign currency exchange rates had an insignificant impact on SG&A expenses for the fiscal year ended July 31, 2022.
Total interest expense, net, for the year ended
Other earnings, net:
Other gains, net for the fiscal year ended
July 31, 2022were approximately $4.1 million. Other gains, net included gains of $0.9 millionfrom the derecognition of accrued pricing liabilities in the Supply Chain segment, net realized and unrealized foreign exchange gains of $2.4 million, and $0.7 millionof sublease income in the Supply Chain segment. Other gains, net for the fiscal year ended July 31, 2021were approximately $1.2 million. Other gains, net included gains of $3.2 millionfrom the derecognition of accrued pricing liabilities in the Supply Chain segment, partially offset by net realized and unrealized foreign exchange losses of $1.9 millionin the Supply Chain segment.
The income tax charge:
Company recorded income tax expense of approximately
$11.4 millionand $8.8 millionfor the fiscal years ended July 31, 2022and 2021, respectively. The increase in income tax expenses for the year ended July 31, 2022is primarily due to the income tax expense associated with an increase in the valuation allowance recorded on deferred tax assets as a result of the IWCO Directdisposal.
Net loss from continuing operations:
Net loss from continuing operations for the year ended
July 31, 2022decreased $2.6 million, as compared to the same period in the prior year. The decrease in net loss from continuing operations is primarily due an increase in foreign exchange gains and an increase in operating income, partially offset by an increase in income taxes.
Net loss from discontinued operations:
Net loss from discontinued operations for the year ended
July 31, 2022and 2021 were $1.7 millionand $32.6 million, respectively, and reflects the net loss for IWCO Direct. See Note 3 to the Consolidated Financial Statements in "Part II, Item 8. Financial Statements and Supplementary Data" included in this Annual Report on Form 10-K.
Cash and capital resources
26 -------------------------------------------------------------------------------- Table of Contents Anticipated Sources and Uses of Cash Flow Historically, the Company has financed its operations and met its capital requirements primarily through funds generated from operations, the sale of its securities, borrowings from lending institutions and sale of facilities that were not fully utilized. The Company believes it has access to adequate resources to meet its needs for normal operating costs, debt obligations and working capital for at least the next twelve months. The following table summarizes our liquidity: July 31, 2022 (In thousands) Cash and cash equivalents
$ 53,142Readily available borrowing capacity under Umpqua Revolver 11,890 $ 65,032Due to the changes reflected in the U.S.Tax Cuts and Jobs Act in December 2017(" U.S.Tax Reform"), there is no U.S.tax payable upon repatriating the undistributed earnings of foreign subsidiaries considered not subject to permanent investment. Foreign withholding taxes would range from 0% to 10% on any repatriated funds. For the Company, earnings and profits have been calculated at each subsidiary. The Company's foreign subsidiaries are in an overall net deficit for earnings and profits purposes. As such, no adjustment was made to U.S.taxable income in the fiscal year ended July 31, 2022relating to this aspect of the U.S.Tax Reform. In future years, the Company believes that it will be able to repatriate its foreign earnings without incurring additional U.S.tax as a result of a 100% dividends received deduction. The Company believes that any future withholding taxes or state taxes associated with such a repatriation would be minor. However, foreign laws may delay or add cost to any repatriation of cash from outside the U.S., which costs or delays may be significant. Disposal of IWCO DirectAs a result of the IWCO Direct Disposal, the Company has no debt outstanding under the Cerberus Credit Facility (as defined below) as of July 31, 2022. Additionally, the CIP, which had estimated future cash outflows remaining of approximately $44 million, is no longer a future cash outflow of the Company. Consolidated net working capital was $26.0 millionat July 31, 2022, compared with $22.3 millionat July 31, 2021. Included in net working capital were cash and cash equivalents of $53.1 millionat July 31, 2022and $58.1 millionat July 31, 2021. The improvement in net working capital was primarily related to an increase in accounts receivable of $3.5 millionfrom the fiscal year ended July 31, 2021.
Sources and uses of cash for the year ended
Fiscal Year Ended July 31, 2022 2021 Change (In thousands) Net cash used in operating activities
$ (3,134) $ (8,110) $ 4,976Net cash used in investing activities (1,485) (1,035) (450) Net cash used in financing activities (2,297) (2,195) (102) Operating Activities: Net cash used in operating activities was $3.1 millionfor the fiscal year ended July 31, 2022, compared to $8.1 millionfor the fiscal year ended July 31, 2021. The Company's future cash flows related to operating activities are dependent on several factors, including profitability, accounts receivable collections, effective inventory management practices and optimization of the credit terms of certain vendors of the Company, and overall performance of the technology sector impacting the Supply Chain segment. The decrease in cash used as compared to the prior fiscal year was primarily due to an increase in working capital of $3.8 million. Investing Activities: Net cash used in investing activities was $1.5 millionand $1.0 millionfor the fiscal year ended July 31, 2022and 2021, respectively, and was primarily comprised of capital expenditures. The increase in capital expenditures in the fiscal year ended July 31, 2022is primarily due to reduced capital spending in the prior year as a result of the COVID-19 pandemic. 27
Table of Contents Fundraising Activities: The
Below is a summary of the Company’s outstanding debt and financing arrangements and preferred stock. Refer to notes 7 and 19 of our consolidated financial statements for more information.
7.50% Convertible Senior Note
February 28, 2019, the Company entered into that certain 7.50% Convertible Senior Note Due 2024 Purchase Agreement with SPHG Holdingswhereby SPHG Holdingsloaned the Company $14.9 millionin exchange for a 7.50% Convertible Senior Note due 2024 (the "SPHG Note"). The SPHG Note bears interest at the fixed rate of 7.50% per year, payable semi-annually in arrears on March 1and September 1of each year, beginning on September 1, 2019. The SPHG Note will mature on March 1, 2024(the "SPHG Note Maturity Date"), unless earlier repurchased by the Company or converted by the holder in accordance with its terms prior to such maturity date. At its election, the Company may pay some or all of the interest due on each interest payment date by increasing the principal amount of the SPHG Note in the amount of such interest due or any portion thereof (such payment of interest by increasing the principal amount of the SPHG Note referred to as "PIK Interest"), with the remaining portion of the interest due on such interest payment date (or, at the Company's election, the entire amount of interest then due) to be paid in cash by the Company. Following an increase in the principal amount of the SPHG Note as a result of a payment of PIK Interest, the SPHG Note will bear interest on such increased principal amount from and after the date of such payment of PIK Interest. SPHG Holdingshas the right to require the Company to repurchase the SPHG Note upon the occurrence of certain fundamental changes, subject to certain conditions, at a repurchase price equal to 100% of the principal amount of the SPHG Note plus accrued and unpaid interest. The Company will have the right to elect to cause the mandatory conversion of the SPHG Note in whole, and not in part, at any time on or after March 6, 2022, subject to certain conditions including that the stock price of the Company exceeds a certain threshold. SPHG Holdingshas the right, at its option, prior to the close of business on the business day immediately preceding the SPHG Note Maturity Date, to convert the SPHG Note or a portion thereof that is $1,000or an integral multiple thereof, into shares of common stock (if the Company has not received a required stockholder approval) or cash, shares of common stock or a combination of cash and shares of common stock, as applicable (if the Company has received a required stockholder approval), at an initial conversion rate of 421.2655 shares of common stock, which is equivalent to an initial conversion price of approximately $2.37per share (subject to adjustment as provided in the SPHG Note) per $1,000principal amount of the SPHG Note (the "Conversion Rate"), subject to, and in accordance with, the settlement provisions of the SPHG Note. For any conversion of the SPHG Note, if the Company is required to obtain and has not received approval from its stockholders in accordance with Nasdaq Stock Market Rule 5635 to issue 20% or more of the total shares of common stock outstanding upon conversion (including upon any mandatory conversion) of the SPHG Note prior to the relevant conversion date (or, if earlier, the 45th scheduled trading day immediately preceding the SPHG Note Maturity Date), the Company shall deliver to the converting holder, in respect of each $1,000principal amount of the SPHG Note being converted, a number of shares of common stock determined by reference to the Conversion Rate, together with a cash payment, if applicable, in lieu of delivering any fractional share of common stock based on the volume weighted average price (VWAP) of its common stock on the relevant conversion date, on the third business day immediately following the relevant conversion date. As of July 31, 2022and 2021, outstanding debt in both periods consisted of the $14.9 million7.50% Convertible Senior Note due March 1, 2024. As of July 31, 2022and July 31, 2021, the net carrying value of the SPHG Note was $11.0 million, and $9.3 million, respectively.
March 16, 2022, ModusLink, as borrower, submitted a notice of termination to MidCap Financial Trustfor its $12.5 millionrevolving credit facility (the "MidCap Credit Facility"), and entered into a new credit agreement with Umpqua Bank(the "Umpqua Revolver"), as lender and as agent. There was no balance outstanding on the Midcap Credit Facility of at the time of its termination. The Umpqua Revolver provides for a maximum credit commitment of $12.5 millionand a sublimit of $5.0 millionfor letters of credit and expires on March 16, 2024. Steel Connect, Inc.("Parent") is not a borrower or a guarantor under the Umpqua Revolver. Under the Umpqua Revolver, ModusLinkis permitted to make distributions to the Parent, in an aggregate amount not to exceed $10.0 millionin any fiscal year.
outstanding for letters of credit.
Cerberus Credit Facility
28 -------------------------------------------------------------------------------- Table of Contents The Cerberus Credit Facility consisted of a term loan facility (the "Cerberus Term Loan") and a
$25 millionrevolving credit facility (the "Revolving Facility") (together the "Cerberus Credit Facility") which was to mature on December 15, 2022. On February 25, 2022, the Company transferred all of its interests in IWCO Directand the financial obligations of the Cerberus Credit Facility as part of the IWCO Direct Disposal. As a result, the Company has no debt or access to future borrowings under the Cerberus Credit Facility.
December 15, 2017, the Company entered into a Preferred Stock Purchase Agreement (the "Purchase Agreement") with SPHG Holdings, pursuant to which the Company issued 35,000 shares of the Company's newly created Series C Convertible Preferred Stock, par value $0.01per shares, or the Preferred Stock, to SPHG Holdingsat a price of $1,000per share, for an aggregate purchase consideration of $35.0 million(the "Preferred Stock Transaction"). The terms, rights, obligations and preferences of the Preferred Stock are set forth in a Certificate of Designations, Preferences and Rights of Series C Convertible Preferred Stock of the Company (the "Series C Certificate of Designations"), which has been filed with the Secretary of State of the State of Delaware. Under the Series C Certificate of Designations, each share of Preferred Stock can be converted into shares of the Company's Common Stock at an initial conversion price equal to $1.96per share, subject to appropriate adjustments for any stock dividend, stock split, stock combination, reclassification or similar transaction. Holders of the Preferred Stock will also receive dividends at 6% per annum payable, at the Company's option, in cash or Common Stock. If at any time the closing bid price of the Company's Common Stock exceeds 170% of the conversion price for at least five consecutive trading days (subject to appropriate adjustments for any stock dividend, stock split, stock combination, reclassification or similar transaction), the Company has the right to require each holder of Preferred Stock to convert all, or any whole number, of shares of the Preferred Stock into Common Stock. Upon the occurrence of certain triggering events such as a liquidation, dissolution or winding up of the Company, either voluntary or involuntary, or the merger or consolidation of the Company or significant subsidiary, or the sale of substantially all of the assets or capital stock of the Company or a significant subsidiary, the holders of the Preferred Stock are entitled to receive, prior and in preference to any distribution of any of the assets or funds of the Company to the holders of other equity or equity equivalent securities of the Company other than the Preferred Stock by reason of their ownership thereof, an amount per share in cash equal to the sum of (i) 100% of the stated value per share of Preferred Stock (initially $1,000per share) then held by them (as adjusted for any stock dividend, stock split, stock combination, reclassification or other similar transactions with respect to the Preferred Stock), plus (ii) 100% of all declared but unpaid dividends, and all accrued but unpaid dividends on each such share of Preferred Stock, in each case as the date of the triggering event. On or after December 15, 2022, each holder of Preferred Stock can also require the Company to redeem its Preferred Stock in cash at a price equal to the Liquidation Preference (as defined in the Series C Certificate of Designations), or approximately $35.2 million. If holders of the Preferred Stock exercise this right to require the Company to redeem all the Preferred Stock, the Company may have insufficient liquidity to pay the redemption price, or the Company's payment of the redemption price would likely adversely impact the Company's liquidity and ability to finance its operations.
The Parent believes it has access to adequate resources to meet its needs for normal operating costs, debt obligations and working capital for at least the next twelve months. Upon a redemption request of the Preferred Stock (as discussed above), the Parent believes it is probable that it has access to adequate resources, including cash on hand and potential dividends from
ModusLink, to pay the redemption price and continue its operations. ModusLinkbelieves that if dividends to the Parent are required, it would have access to adequate resources to meet its operating needs while remaining in compliance with the Umpqua Revolver's covenants over the next twelve months. However, there can be no assurances that ModusLinkwill continue to have access to its line of credit if its financial performance does not satisfy the financial covenants set forth in its financing agreement, which could also result in the acceleration of its debt obligations by its lender, adversely affecting liquidity.
Our principal uses of cash will be to provide working capital, meet debt service requirements, fund capital expenditures and execute management's strategic plans including the IWCO Direct CIP. As of
July 31, 2022, we had contractual cash 29
Table of Contents obligations to repay debt, make payments under operating and capital leases and pay dividends. From
Less than 1 year 2-3 years 4-5 years More than 5 years Total (In thousands) Debt(1) $ -
$ 14,940$ - $ - $ 14,940Interest payments(2) 1,136 1,139 - - 2,275 Operating lease liabilities 7,151 7,941 4,819 - 19,911 Financing lease liabilities 38 - - - 38 Preferred dividend payments 2,100 4,200 4,200 † 10,500 $ 10,425 $ 28,220 $ 9,019$ - $ 47,664(1) Represents principal amount of debt and only includes scheduled principal payments. (2) Represents expected interest payments on debt. Interest payments based on variable interest rates were determined using the interest rate in effect as of July 31, 2022. † Holders of the Preferred Stock receive dividends at 6% per annum. In addition, beginning December 15, 2022, each holder of the Preferred Stock can require the Company to redeem its Preferred Stock in cash at a price equal to the Liquidation Preference (as defined in Series C Certificate of Designations).
Critical accounting policies
Our significant accounting policies are discussed in Note 2 to our audited consolidated financial statements. The discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in
the United States of America. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenue and expenses during the reporting period. The most significant of these estimates and assumptions relate to: (1) revenue recognition; (2) valuation allowances for trade and other receivables and inventories; (3) the valuation of long-lived assets; (4) contingencies, including litigation reserves; (5) restructuring charges and related severance expenses; (6) litigation reserves; (7) pension obligations; (8) going concern assumptions; (9) accrued pricing and tax related liabilities and; (10) incremental borrowing rate to determine present value of lease payments. Of the accounting estimates we routinely make relating to our critical accounting policies, those estimates made in the process of: recognition of revenue; determining the valuation of inventory and related reserves; accounting for impairment of long-lived assets; and establishing income tax valuation allowances and liabilities are the estimates most likely to have a material impact on our financial position and results of operations. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Changes in estimates are reflected in the periods in which they become known. However, because these estimates inherently involve judgments and uncertainties, there can be no assurance that actual results will not differ materially from those estimates. We believe that our critical accounting estimates have the following attributes: (1) we are required to make assumptions about matters that are uncertain and require judgment at the time of the estimate; (2) use of reasonably different assumptions could have changed our estimates, particularly with respect to recoverability of assets; and (3) changes in the estimate could have a material effect on our financial condition or results of operations. We believe the critical accounting policies below contain the more significant judgments and estimates used in the preparation of our financial statements: •Revenue recognition •Accounting for impairment of long-lived assets •Income taxes •Leases Revenue Recognition The Company recognizes revenue from its contracts with customers primarily from the sale of supply chain management services. Revenue is recognized when control of the promised goods or services is transferred to a customer, in an amount that reflects the consideration the Company expects to be entitled to in exchange for those goods or services. For ModusLink'ssupply chain management services arrangements, the services are considered to be transferred over time as they are performed. 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. 30
Supply chain management services.
ModusLink'srevenue primarily comes from the sale of supply chain management services to its clients. Amounts billed to customers under these arrangements include revenue attributable to the services performed as well as for materials procured on the customer's behalf as part of its service to them. The majority of these arrangements consist of two distinct performance obligations (i.e, warehousing/inventory management service and a separate kitting/packaging/assembly service), revenue related to each of which is recognized over time as services are performed using an input method based on the level of efforts expended.
Other revenue consists of cloud-based software subscriptions, software maintenance and support service contracts, fees for professional services and fees for the sale of perpetual software licenses in
ModusLink'se-Business operations. Except for perpetual software licenses, revenue related to these arrangements is recognized on a straight-line basis over the term of the agreement or over the term of the agreement in proportion to the costs incurred in satisfying the obligations under the contract. Revenue from the sale of perpetual licenses is recognized at a point in time upon execution of the relevant license agreement and when delivery has taken place.
Performance obligations and autonomous selling price
The Company's contracts with customers may include promises to transfer multiple products and services to a customer. Determining whether products and services are considered distinct performance obligations that should be accounted for separately versus together may require certain judgment. For arrangements with multiple performance obligations, the Company allocates revenue to each performance obligation based on its relative standalone selling price. Judgment is required to determine the standalone selling price for each distinct performance obligation. The Company generally determines standalone selling prices based on the prices charged to customers and uses a range of amounts to estimate standalone selling prices when we sell each of the products and services separately and need to determine whether there is a discount that needs to be allocated based on the relative standalone selling prices of the various products and services. The Company typically has more than one range of standalone selling prices for individual products and services due to the stratification of those products and services by customers and circumstances. In these instances, the Company may use information such as the type of customer and geographic region in determining the range of standalone selling prices.
The Company may provide credits or incentives to customers, which are accounted for as variable consideration when estimating the transaction price of the contract and amounts of revenue to recognize. The amount of variable consideration to include in the transaction price is estimated at contract inception using either the estimated value method or the most likely amount method based on the nature of the variable consideration. These estimates are updated at the end of each reporting period as additional information becomes available and revenue is recognized only to the extent that it is probable that a significant reversal of any amounts of variable consideration included in the transaction price will not occur.
Recognition of Principal vs. Agent Revenue
For revenue generated from contracts with customers involving another party, the Company considers whether it maintains control of the specified goods or services before they are transferred to the customer, as well as other indicators such as the party primarily responsible for fulfillment and discretion in establishing price. Revenues are recognized on a gross basis if the Company is acting in the capacity of a principal and on a net basis if it's acting in the capacity of an agent.
Accounting for impairment of long-lived assets
Our long-lived assets include property, plant and equipment, capitalized software development costs for software to be sold, leased or otherwise marketed, and certain long-term investments. From
31 -------------------------------------------------------------------------------- Table of Contents long-lived assets whenever events or changes in circumstances indicate that the carrying amount of these assets may not be recoverable. An impairment loss is recognized when the carrying amount of a long-lived asset exceeds its fair value or net realizable value expected to result from the asset's use and eventual disposition. We use a variety of factors to assess valuation, depending upon the asset. Long-lived assets are evaluated based upon the expected period the asset will be utilized and other factors depending on the asset, including estimated future sales, profits and related cash flows. Changes in estimates and judgments on any of these factors could have a material impact on our results of operations and financial position.
The Company has net operating loss carryforwards for federal and state tax purposes of approximately
$2.2 billionand $153.7 million, respectively, as of July 31, 2022. Income taxes are accounted for under the provisions of ASC 740, Income Taxes, using the asset and liability method whereby deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates in effect for the year in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Deferred tax assets are reduced by a valuation allowance, if based on the weight of available evidence, it is more likely than not that some portion or all of the recorded deferred tax assets will not be realized in future periods. This methodology is subjective and requires significant estimates and judgments in the determination of the recoverability of deferred tax assets and in the calculation of certain tax liabilities. As of July 31, 2022and 2021, a valuation allowance has been recorded against the deferred tax asset in the U.S.and certain of its foreign subsidiaries since management believes that after considering all the available objective evidence, both positive and negative, historical and prospective, with greater weight given to historical evidence, it is more likely than not that these assets will not be realized. In each reporting period, we evaluate the adequacy of our valuation allowance on our deferred tax assets. In the future, if the Company is able to demonstrate a consistent trend of pre-tax income, then at that time management may reduce its valuation allowance accordingly. The Company also performs a valuation allowance scheduling exercise based on the deferred tax assets and liabilities as of July 31, 2022. In addition, the calculation of the Company's tax liabilities involves dealing with uncertainties in the application of complex tax regulations in several tax jurisdictions. The Company is periodically reviewed by domestic and foreign tax authorities regarding the amount of taxes due. These reviews include questions regarding the timing and amount of deductions and the allocation of income among various tax jurisdictions. In evaluating the exposure associated with various filing positions, we record estimated reserves for exposures. Based on our evaluation of current tax positions, the Company believes it has appropriately accrued for exposures as of July 31, 2022.
In order to calculate the operating ROU asset and operating lease liability for a lease, a lessee is required to apply a discount rate equal to the rate implicit in the lease whenever that rate is readily determinable. The Company's lease agreements generally do not provide a readily determinable implicit rate, nor is the rate available to the Company from its lessors and, therefore, the Company determines an incremental borrowing rate to determine the present value of the lease payments. The incremental borrowing rate represents the rate of interest the Company would have to pay to borrow on a collateralized basis over a similar lease term to obtain an asset of similar value.
Recent accounting pronouncements
For a discussion of new or recently adopted accounting pronouncements by the Company, see Note 2 to the consolidated financial statements found elsewhere in this Form 10-K.
Tax Benefit Preservation Plan
Our past operations generated significant net operating losses, or NOLs. On
March 27, 2020, the Coronavirus Aid, Relief, and Economic Security Act was enacted in response to the COVID-19 pandemic which among, other things, amends the treatment of NOLs. Under federal tax laws, for NOLs arising in tax years beginning before January 1, 2018, we generally can use any such NOLs and certain related tax credits to reduce ordinary income tax paid in our prior two tax years or on our future taxable income for up to 20 years, at which point they "expire" for such purposes. Until they expire, we can "carry forward" NOLs and certain related tax credits that we do not use in any particular year to offset taxable income in future years. For NOLs arising in tax years beginning after December 31, 2017and before January 1, 2021, we are allowed to carryback such NOLs to each of the five taxable years preceding the taxable year of such losses and generally can use any such NOLs and certain related tax credits to reduce ordinary income tax paid on our future taxable income indefinitely; however, except for NOLs generated 32 -------------------------------------------------------------------------------- Table of Contents in tax years beginning after December 31, 2017and prior to January 1, 2021(which can be carried back to reduce taxable income for the prior five tax years), any such NOLs cannot be used to reduce ordinary income tax paid in prior tax years. In addition, the deduction for NOLs arising in tax years beginning after December 31, 2020is limited to 80% of our taxable income for any tax year (computed without regard to the NOL deduction). NOLs arising in tax years beginning before January 1, 2018, are referred to herein as "Current NOLs." The Company had net NOL carryforwards for federal and state tax purposes of approximately $2.2 billionand $153..7 million, respectively, at July 31, 2022, $2.02 billionof the federal NOL arose in tax years ending before January 1, 2018and $138 millionarose post January 1, 2018. We cannot estimate the exact amount of NOLs that we will be able use to reduce future income tax liability because we cannot predict the amount and timing of our future taxable income. For more information, see "Part I, Item 1A. Risk Factors-Risks Related to Taxation-We may be unable to realize the benefits of our net operating loss carry-forwards and other tax benefits (collectively, the 'NOLs' or 'Tax Benefits')." In early 2018, Company's board of directors adopted the Protective Amendment and Tax Plan, each designed to preserve the Company's ability to utilize its NOLs, by preventing an "ownership change" within the meaning of Section 382 of the Internal Revenue Code that would impair the Company's ability to utilize its NOLs. Later that year, the stockholders of Steel Connectapproved the Protective Amendment and Tax Plan. The federal net operating losses will expire from fiscal year 2023 through 2038, and the state net operating losses will expire from fiscal year 2023 through 2041. The Company's ability to use its Tax Benefits would be substantially limited if the Company undergoes an Ownership Change. The Protective Amendment and Tax Plan are intended to prevent an Ownership Change of the Company that would impair the Company's ability to utilize its Tax Benefits. The Protective Amendment generally restricts any direct or indirect transfer if the effect would be to (i) increase the direct, indirect or constructive ownership of any stockholder from less than 4.99% to 4.99% or more of the shares of common stock then outstanding or (ii) increase the direct, indirect or constructive ownership of any stockholder owning or deemed to own 4.99% or more of the shares of common stock then outstanding. Pursuant to the Protective Amendment, any direct or indirect transfer attempted in violation of the Protective Amendment would be void as of the date of the prohibited transfer as to the purported transferee (or, in the case of an indirect transfer, the ownership of the direct owner of the shares would terminate simultaneously with the transfer), and the purported transferee (or in the case of any indirect transfer, the direct owner) would not be recognized as the owner of the shares owned in violation of the Protective Amendment (the "excess stock") for any purpose, including for purposes of voting and receiving dividends or other distributions in respect of such shares, or in the case of options, receiving shares in respect of their exercise. In addition to a prohibited transfer being void as of the date it is attempted, upon demand, the purported transferee must transfer the excess stock to an agent of the Company along with any dividends or other distributions paid with respect to such excess stock. The agent is required to sell such excess stock in an arm's-length transaction (or series of transactions) that would not constitute a violation under the Protective Amendment. As part of the Tax Plan, the Board declared a dividend of one right (a "Right") for each share of common stock then outstanding. The dividend was payable to holders of record as of the close of business on January 29, 2018. Any shares of common stock issued after January 29, 2018, will be issued together with the Rights. Each Right initially represents the right to purchase one one-thousandth of a share of newly created Series D Junior Participating Preferred Stock. Initially, the Rights will be attached to all certificates representing shares of common stock then outstanding, and no separate rights certificates will be distributed. In the case of book entry shares, the Rights will be evidenced by notations in the book entry accounts. Subject to certain exceptions specified in the Tax Plan, the Rights will separate from the common stock and a distribution date (the "Distribution Date") will occur upon the earlier of (i) ten (10) business days following a public announcement that a stockholder (or group) has become a beneficial owner of 4.99% or more of the shares of common stock then outstanding or (ii) ten (10) business days (or such later date as the Board determines) following the commencement of a tender offer or exchange offer that would result in a person or group becoming a 4.99% stockholder. Pursuant to the Tax Plan and subject to certain exceptions, if a stockholder (or group) becomes a new 4.99% stockholder after adoption of the Tax Plan, the Rights would generally become exercisable and entitle stockholders (other than the new 4.99% stockholder or group) to purchase additional shares of the Company at a significant discount, resulting in substantial dilution in the economic interest and voting power of the 4.99% stockholder (or group). In addition, under certain circumstances in which the Company is acquired in a merger or other business combination after a non-exempt stockholder (or group) becomes a 4.99% stockholder, each holder of the Right (other than the 4.99% stockholder or group) would then be entitled to purchase shares of the acquiring company's common stock at a discount. 33
Table of Contents The Protective Amendment does not expire. The Rights are not exercisable until the Distribution Date and will expire at
11:59 p.m., on January 18, 2024, unless the Rights are earlier redeemed or exchanged as provided in the Tax Plan or the Board of Directors earlier determines that the Tax Plan is no longer necessary or desirable for the preservation of the Tax Benefits. For more information, see "Part I, Item 1A. Risk Factors-Risks Related to Taxation-We may be unable to realize the benefits of our net operating loss carry-forwards and other tax benefits (collectively, the 'NOLs' or 'Tax Benefits')."
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