IEC ELECTRONICS CORP – 10-K – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The information in this Management's Discussion & Analysis should be read in conjunction with the accompanying Consolidated Financial Statements, the related Notes and the five-year summary of Selected Financial Data. Forward-looking statements in this Management's Discussion and Analysis are qualified by the cautionary statement preceding Item 1 of this Form 10-K and the risk factors identified in Item 1A.

Overview

Since 2004, we have focused our efforts on developing relationships with customers who manufacture advanced technology products and who are unlikely to utilize offshore suppliers due to the proprietary nature of their products, governmental restrictions or volume considerations. We have continued to expand our business by adding new customers and markets, and our customer base is stronger and more diverse as a result. We proactively invest in areas we view as important for our continued growth. IEC is ISO 9001:2008 certified; an NSA approved supplier under the COMSEC standard; and ISO 13485 certified to serve the medical market sector. Five of our units (IEC in Newark, NY, Wire and Cable in Victor, NY, Albuquerque in New Mexico, Celmet in Rochester, NY and SCB in California) are AS9100 certified to serve the military and commercial aerospace market sector, and are ITAR registered. In addition, the Company's locations in Newark, NY and Albuquerque, NM are Nadcap accredited for electronics manufacturing to support the most stringent quality requirements of the aerospace industry. Our Newark, NY environmental systems are ISO 14001:2004 certified.

We have identified and gained entry into markets through our strategic acquisitions and by leveraging across our businesses the ability to provide products of the highest quality and reliability, including highly complex assemblies that we are able to produce efficiently irrespective of run size. We predominantly serve the military, aerospace, communications, medical, and industrial market sectors.

We continue to invest in improving our management talent pool and employee skills, as well as our reliability testing capabilities and our machinery and equipment infrastructure to optimize production performance and effectively manage our growth, both in volume of customers and complexity of products.

Full-Year Results

A summary of selected income statement amounts for the twelve months ended September 30, 2011 and 2010 follows:

                                                Fiscal Years ended September 30,          Income Statement Data                          2011                  2010                                                          (thousands)  Net sales                                  $         133,296       $        96,674 Gross profit                                          24,257                16,263 Selling & administrative expenses                     13,868                 8,576 Interest & financing expense                           1,601                   814 Other (income) expense                                (1,028 )                (182 ) Income before provision for income taxes               9,816                 7,055 Provision for income taxes                             3,056                 2,400 Net income                                 $           6,760       $         4,655   

IEC's top-line growth during fiscal 2011 improved 38% over sales generated in 2010. 18% of this sales increase was organic growth fueled by expansion of our product offerings and by furthering our sales efforts in certain market sectors, particularly medical. The inroads made in the medical equipment sector in recent years have benefited our business not only by growing our sales volumes but also by diversifying our customer base. The medical/other sector now generally represents over 20% of our business, up from 13% during fiscal 2010. IEC's business in all three sectors has increased during the past fiscal year, with military/aerospace up $18.3 million (33%), industrial/communications up $ 919 thousand (3%) and medical/other up $17.1 million (134%).

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At 18.2% of sales, full-year gross profit is also above full-year 2010 gross profit of 16.8% of sales. Progress made with respect to our margins is a direct result of adding favorable mix changes, cost-effective capital equipment, continuously refining processes to incorporate lean-manufacturing concepts, our focus on training, and the accretive margins associated with our acquisitions. Favorable changes in mix as well as sales increases have enabled our continuing businesses to further leverage existing resources and infrastructure, also improving our gross profit.

Selling and administrative ("S&A") expense increases in relation to the prior year reflect the addition of three new businesses since the start of fiscal 2010, one of which was not present in the prior year and a second of which was present for only two months. As a percent of sales, S&A expenses have increased from 8.9% in fiscal 2010 to 10.4% in fiscal 2011. A large portion of the increase results from SCB operating with a somewhat higher cost structure than our other units, but typically generating more favorable product margins. S&A expenses also include salaries for certain positions added to execute the Company's growth strategies and cost increases associated with IEC's health insurance program for employees. We remain focused on cost control and believe that full-year targets for consolidated S&A expense in the range of 10% of sales will be attainable over the next few years, despite variations from quarter to quarter.

We have used bank borrowings to fund 99% of the cost of our three acquisitions during the past two years. As a result, the Company's interest costs, which have been incurred at rates ranging from approximately 3.25% to 4.00%, have increased from $814 thousand in fiscal 2010 to $1.6 million in fiscal 2011. However, rate reductions of approximately 0.50% on variable-rate borrowings and principal payments on amortizing debt have favorably affected interest costs. With respect to ongoing operations, we are committed to managing working capital, maximizing positive cash flow and reducing the level of our debt and corresponding interest expense. We have reduced our total debt by approximately $12 million since acquisition of SCB. Detailed information regarding our borrowings is provided in the Credit Facilities note to the consolidated financial statements included in Item 8 of this Form 10-K.

IEC utilizes the other income/expense category of the income statement for non-operating items such as acquisition costs and various gains or losses. Significant fiscal 2011 items include (i) a first quarter gain of $170 thousand on the Albuquerque acquisition attributable to refund of part of the price paid for that unit, and (ii) an estimated $1.1 million refund of contingent consideration held in escrow that will be due from the sellers of SCB if the unit does not achieve calendar-2011 sales and backlog targets. Accounting rules (ASC 805-30-35) require us to estimate and record the fair value of contingent consideration even though the actual amount, if any, will not be known until the end of calendar-year 2011. Prior year "other income" includes a $418 thousand gain on the Albuquerque acquisition, representing the excess value of net assets acquired over the purchase price. Other less significant items recorded in both years include acquisition-related legal, accounting, valuation and travel expenses.

Our upward trend in pretax income produced an increase in income tax expense as compared to the prior year. Our effective rate decreased to 31.1% in fiscal 2011 due to the reduction in valuation allowance of $236 thousand and an increase in tax attributes (primarily alternative minimum tax credits and state tax credits) of $360 thousand, partially offset by the absence of non taxable gain on acquisition and additional state income tax. The reduction in valuation allowance is the result of a release of valuation allowance as there is now a greater than 50 percent likelihood that the tax benefit will be realized.

In the near-term, IEC's federal and New York State taxable income is sheltered by net operating loss carryforwards that substantially offset tax payments that would otherwise be required. However, those carryforwards are not available to offset state taxable income generated in the states of New Mexico and California by Albuquerque and SCB, respectively. The Company's remaining federal and state net operating loss carryforwards at the end of fiscal 2011 amounted to approximately $24.5 million and $37.7 million, respectively and if unused, will expire at various times between 2020 and 2025.

Fourth Quarter Results

A summary follows of selected income statement amounts for the fourth quarters of fiscal 2011 and 2010:

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                                               Three months ended September 30,          Income Statement Data                        2011                  2010                                                         (thousands)  Net sales                                  $        34,941       $        27,287 Gross profit                                         6,574                 4,776 Selling & administrative expenses                    4,094                 2,654 Interest & financing expense                           387                   220 Other (income) expense                              (1,162 )                (387 ) Income before provision for income taxes             3,255                 2,289 Provision for income taxes                             624                   661 Net income                                 $         2,631       $         1,628   

IEC's top-line growth during the fourth quarter of fiscal 2011 was 28% over sales generated in the comparable fiscal 2010 quarter. 16% of this sales increase was organic growth fueled by expansion of our product offerings and by furthering our sales efforts in certain market sectors, particularly medical. IEC's business in all three sectors increased during the fourth quarter, with military/aerospace up $2.6 million (17%), industrial/communications up $333 thousand (4%) and medical/other up $4.6 million (102%) as compared to the prior-year quarter.

Our fourth-quarter gross profit also grew from last year's level, increasing from 17.5% to 18.8% of sales. This increase is primarily the result of a favorable change in product mix.

Selling and administrative ("S&A") expense increases in relation to the 2010 fourth quarter reflect the addition of two businesses since the beginning of the prior-year period, one of which was not present in the fourth quarter of 2010 and the second of which was present for two months. As a percent of sales, expenses increased from 9.7% in the 2010 quarter to 11.7% in the current quarter. A large portion of the increase results from SCB operating with a higher cost structure than our other units. S&A expenses also include salaries for certain positions added to support the Company's growth strategies and cost increases associated with IEC's health insurance program for employees.

We have used bank borrowings to fund 98% of the cost of our two most recent acquisitions. As a result of the acquisitions, the Company's interest costs, which have been incurred at rates ranging from approximately 3.25% to 4.00%, have increased from $220 thousand in the fourth quarter of fiscal 2010 to $387 thousand in the fourth quarter of this year. Rate reductions of approximately 0.25% on variable-rate borrowings and principal payments on amortizing debt have favorably affected interest costs. With respect to ongoing operations, the Company is committed to managing working capital, maximizing positive cash flow and reducing the level of debt and interest expense. Detailed information regarding our borrowings is provided in the Credit Facilities note to the consolidated financial statements included in Item 8 of this Form 10-K.

IEC utilizes the other income/expense category of the income statement for non-operating items such as acquisition costs and various gains or losses. In the fourth quarter of fiscal 2011, we recorded income of $1.1 million associated with contingent consideration currently held in escrow that will be returned to us by the sellers of SCB if the unit does not achieve certain calendar-2011 sales and backlog targets, as provided for in the acquisition agreement. Accounting rules (ASC 805-30-35) require us to estimate and record the fair value of the contingent consideration refund even though the actual amount, if any, will not be known until the end of calendar-year 2011. In the fourth quarter of fiscal 2010, a $418 thousand gain was recorded on the Albuquerque acquisition, representing the excess value of net assets acquired over the purchase price. Other less significant items typically categorized as "other income/expense" include acquisition-related legal, accounting, valuation and travel expenses.

Fourth-quarter income tax expense for fiscal 2011 decreased to $624 thousand as compared to $661 thousand in the prior year. Our effective rate for the fourth quarter decreased to 19.2% in fiscal 2011 due to the reduction in valuation allowance of $236 thousand and an increase in tax attributes (primarily alternative minimum tax credit and state tax credit) of $192 thousand, partially offset by additional state income tax and the absence of a non taxable gain on acquisition. The reduction in valuation allowance is the result of a release of a portion of the allowance as there is now a greater than 50 percent likelihood that the tax benefit will be realized.

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In the near-term, IEC's federal and New York State taxable income is sheltered by net operating loss carryforwards that substantially offset tax payments that would otherwise be required. However, those carryforwards are not available to offset state taxable income generated in the states of New Mexico and California by Albuquerque and SCB, respectively. The Company's remaining federal and state net operating loss carryforwards at the end of fiscal 2011 amounted to approximately $24.5 million and $37.7 million, respectively and if unused, will expire at various times between 2020 and 2025.

Liquidity and Capital Resources

Cash flow from operations, before considering changes in IEC's working capital accounts, amounted to $13.3 million in the fiscal year ended September 30, 2011, compared to $7.9 million in fiscal 2010. The increase was driven by higher net income of $2.1 million as well as higher add-backs for non-cash expenses such as depreciation and deferred taxes. The net change in current asset and liability accounts provided $0.7 million of cash in fiscal 2011 and utilized $0.1 million in fiscal 2010.

Investing activities utilized $30.5 million of cash flow in fiscal 2011, compared to $19.0 million in fiscal 2010. In December 2010, we acquired SCB for cash of $25.8 million plus common stock, while in the prior fiscal year period $16.8 million was disbursed to acquire Albuquerque and Celmet. Equipment added in fiscal 2011 to enhance productivity and facilitate growth amounted to $4.9 million, compared to $2.2 million in fiscal 2010.

Bank funding for acquisitions, through term loans, a mortgage loan and the Revolver, represented most of the cash generated from financing activities in both twelve-month periods. In addition to satisfying scheduled debt service requirements, favorable operating cash flows enabled us to repay Revolver borrowings of $4.4 million in fiscal 2011 and $4.0 million in fiscal 2010 that had been used to fund the SCB and Albuquerque acquisitions, respectively.

As of September 30, 2011, Revolver borrowings amounted to $7.2 million, and the maximum available under the line of credit was $19.7 million. The Company believes that its liquidity is sufficient to satisfy anticipated operating requirements during the next twelve months.

The Company's primary borrowing arrangement is contained in the Third Amended and Restated Credit Facility Agreement ("Credit Agreement") entered into with Manufacturers and Traders Trust Company ("M&T") in December 2010 as amended and supplemented to date. The Credit Agreement contains a borrowing base as well as various affirmative and negative covenants, including financial covenants. We are required to maintain (i) a minimum level of quarterly EBITDARS, (ii) a ratio of debt to twelve-month EBITDARS that is below a specified limit, and (iii) a minimum fixed charge coverage ratio. The Company was in compliance with each of the covenants on September 30, 2011, as summarized in a table below.

                                                                Actual at          Debt Covenant                   Limit            September 30, 2011 Quarterly EBITDARS (000's)        Must be above $1,500   $              4,904 Total debt to EBITDARS            Must be below 3.50x                    2.08 x Fixed charge coverage ratio (a)   Must be above 1.25x                    2.03 x    

(a) The ratio compares (i) 12-month EBITDA plus non-cash stock compensation expense minus unfinanced capital expenditures minus cash taxes paid, to (ii) the sum of interest expense, principal payments, sale-leaseback payments and dividends, if any (fixed charges).

Off-Balance Sheet Arrangements

IEC is not a party to any material off-balance sheet arrangements.

Critical Accounting Policies and Use of Estimates

IEC's financial statements and accompanying notes are prepared in accordance with generally accepted accounting principles in the United States of America, as presented in the Financial Accounting Standards Board's (FASB) Accounting Standards Codification (ASC). In preparing financial statements, management is required to (i) determine the manner in which accounting principles are applied and (ii) make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses. A discussion of the Company's critical accounting policies follows.

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Revenue recognition: Under FASB ASC 605-10 (Revenue Recognition), revenue from sales is recognized when (i) goods are shipped or title and risk of ownership have passed, (ii) the price to the buyer is fixed or determinable, and (iii) realization is reasonably assured. Service revenues are generally recognized as services are rendered or, in the case of material management contracts, in proportion to materials procured to date. Provisions for discounts and rebates to customers, estimated returns and allowances and other adjustments are recorded in the period the related sales are recognized.

Doubtful accounts: FASB ASC 310-10-35 (Receivables) requires us to establish an allowance for doubtful accounts when it is probable that losses have been incurred in the collection of accounts receivable and the amount of loss can reasonably be estimated. If losses are probable and estimable, they are to be accrued even though the particular customer accounts on which losses will be incurred cannot yet be identified.

Inventory reserves: FASB ASC 330-10-35 (Inventory) requires us to reduce the carrying value of inventory when there is evidence that the utility of goods will be less than cost, whether due to physical deterioration, obsolescence, changes in price levels or other causes. Inventory balances are generally reduced to the lower of cost or market value by establishing offsetting balance sheet reserves.

Intangible assets: FASB ASC 805-20 (Business Combinations) requires corporate acquirers to recognize, separately from goodwill, intangible assets that meet either a separability or contractual-legal criterion. Establishing the initial value for such intangible assets typically involves estimating cash flows to be derived from the assets and discounting the cash flows back to the acquisition date. Significant judgment is required in estimating future cash flows, selecting discount rates and determining useful lives over which to amortize the assets. In connection with recent corporate acquisitions, IEC has established intangible assets for customer relationships, a property-tax abatement, and a non-compete agreement.

Goodwill: Goodwill represents the excess of cost over fair value of net assets acquired in a corporate acquisition. Under ASC 350, goodwill is not amortized but is required to be reviewed for impairment at least annually or when events or circumstances indicate that carrying value may exceed fair value. The review process entails comparing the overall fair value of the unit to which goodwill relates to carrying value. If fair value exceeds carrying value, no goodwill write-down is required. If fair value of the unit is less than carrying value, a valuation of the unit's individual assets and liabilities is required to determine whether or not goodwill is impaired. Quantitative evaluations of goodwill may be avoided if qualitative assessments indicate a greater-than-50 percent likelihood that fair value of the corresponding unit exceeds its carrying value.

Impairment of long-lived assets: FASB ASC 360-10 (Property, Plant and Equipment) and 350-30 (Intangibles) require the Company to test long-lived assets (PP&E and amortizing intangible assets) for recoverability whenever events or circumstances indicate that the carrying amount may not be recoverable. If carrying value exceeds undiscounted future cash flows attributable to an asset, it is considered impaired and carrying amount must be reduced to fair value.

Legal contingencies: When legal proceedings are brought or claims are made against us and the outcome is uncertain, FASB ASC 450-10 (Contingencies) requires that we accrue an estimated loss if it is probable that an asset has been impaired or a liability has been incurred and the amount of the loss can be reasonably estimated. Any such accruals are charged to earnings. No charges for legal contingencies were recorded by IEC during fiscal 2011 or 2010.

Disclosure of a contingency is required if there is at least a reasonable possibility that a loss will be incurred. In determining whether to accrue or disclose a loss, we evaluate, among other factors, the probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount. Changes in these factors may materially affect our financial position or results of operations.

Income taxes: FASB ASC 740 (Income Taxes) describes the manner in which income taxes are to be provided for in the Company's financial statements. We are required to recognize (i) the amount of taxes payable or refundable for the current period and (ii) deferred tax assets and liabilities for the future tax consequences of events that have been reported in IEC's financial statements or tax returns. With respect to uncertain positions that may be taken on a tax return, we recognize related tax benefits only if it is more likely than not that the position will be sustained under examination based on the technical merits of the position. The determination of income tax balances for financial statement purposes requires significant judgment, and actual outcomes may vary from the amounts recorded.

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Recently Issued Accounting Standards

Information with respect to recently issued accounting standards is provided in the Accounting Policies note to the consolidated financial statements included in Item 8 of this Form 10-K.