UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

OR

COMMISSION FILE NUMBER 0-31051

SMTC CORPORATION

(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

7050 WOODBINE AVE.

MARKHAM, ONTARIO, CANADA L3R 4G8

(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)

(905) 479-1810

(REGISTRANT’S TELEPHONE NUMBER, INCLUDING AREA CODE)

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).   Yes  ☒    No  ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, 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 Exchange Act).    Yes  ☐    No  ☒

As of July 28, 2017, SMTC Corporation had 16,825,197 shares of common stock, par value $0.01 per share, outstanding.

SMTC CORPORATION

Table of Contents

 Part I FINANCIAL INFORMATION

Item 1 Financial Statements

SMTC CORPORATION

Interim Consolidated Balance Sheets

(Expressed in thousands of U.S. dollars)

(Unaudited)

Commitments (note 12)

See accompanying notes to interim consolidated financial statements.

SMTC CORPORATION

Interim Consolidated Statements of Operations and Comprehensive Income (Loss)

(Expressed in thousands of U.S. dollars, except number of shares and per share amounts)

(Unaudited)

See accompanying notes to interim consolidated financial statements.

SMTC CORPORATION

Interim Consolidated Statements of Changes in Shareholders’ Equity

(Expressed in thousands of U.S. dollars)

Six months ended July 2, 2017

(Unaudited)

See accompanying notes to interim consolidated financial statements.

SMTC CORPORATION

Interim Consolidated Statements of Cash Flows

(Expressed in thousands of U.S. dollars)

(Unaudited)

See accompanying notes to interim consolidated financial statements.

SMTC CORPORATION

Notes to Interim Consolidated Financial Statements

SMTC Corporation (the “Company”) is a worldwide provider of advanced electronics manufacturing services to original equipment manufacturers. The Company services its customers through manufacturing and technology centers located in the United States, Mexico and China. All facilities provide a full suite of integrated manufacturing services including assembly, testing, box build, final product integration, and expanded supply chain capabilities. In addition, the Company operates an international sourcing and procurement office in Hong Kong.

The accompanying unaudited interim consolidated financial statements of the Company have been prepared in accordance with the accounting principles and methods of application disclosed in the audited consolidated financial statements within the Company’s Annual Report on Form 10-K for the fiscal period ended January 1, 2017 (“Form 10-K”) filed with the Securities and Exchange Commission (the “SEC”) on March 9, 2017. The accompanying unaudited interim consolidated financial statements include adjustments of a normal, recurring nature that are, in the opinion of management, necessary for a fair statement of the consolidated financial statements under generally accepted accounting principles in the United States (“U.S. GAAP”). These unaudited interim consolidated financial statements should be read in conjunction with the Company’s audited consolidated financial statements contained in the Company’s Form 10-K. The consolidated balance sheet at January 1, 2017 was derived from the audited annual consolidated financial statements, but does not contain all of the footnote disclosures from the annual consolidated financial statements.

Unless otherwise specified or the context requires otherwise, all statements in these notes to the interim consolidated financial statements regarding financial figures are expressed in thousands of U.S. dollars.

As at July 2, 2017, the Company’s liquidity is comprised of $4,107 in cash on hand and $4,136 of funds available to borrow under the PNC Revolving Credit facility. The Company funds its operations by regularly utilizing its PNC Facilities (refer to Note 5). The Company manages its capital requirements through budgeting and forecasting processes while monitoring for compliance with bank covenants under the PNC Facilities. Funds available under the PNC Revolving Credit Facility are managed on a weekly basis based on the cash flow requirements of the various operating segments. Cash flows generated from operations are immediately applied towards paying down the PNC Revolving Credit Facility, which has a maximum limit of $30,000, of which $4,136 of funds were available to borrow under the PNC Revolving Credit facility as at July 2, 2017 which was limited by certain borrowing base restrictions under the PNC Facilities.

The Company has experienced significant reductions in revenue throughout 2016 and the first six months of 2017 when compared to prior periods, which impacts its cash flows from operations. The Company incurred a net loss in 2016 of $232 and a net loss in the first six months of 2017 of $6,390. Revenues have declined due to the loss of customers that represented a large concentration of the Company’s business. The Company believes this loss of customers is largely due to competitive pressures from larger organizations. This decline in revenues has directly impacted the Company’s gross profit and its ability to generate cash flows from operations. During the quarter, the Company recorded $0.8 million of bad debt expense, due to the further credit deterioration of a specific customer.

Given our results of operations in this challenging business environment, in accordance with ASC 205-40 management is required to consider whether these conditions give rise to substantial doubt about the Company’s ability to meet its obligations within one year from the financial statement issuance date, and if so, whether management’s plans to negate these conditions will alleviate this substantial doubt.

In order to address the Company’s liquidity, on May 15, 2017, the Board of Directors of the Company approved a corporate restructuring plan (the “Restructuring Plan”) for its manufacturing facilities and corporate level operations, which includes the closure of the Suzhou, China facility (“Suzhou Facility”) and a reduction in its labor force. The Restructuring Plan is expected to deliver annualized cost savings during the remainder of 2017 and thereafter. The Restructuring Plan, including the wind down and closure of the Suzhou Facility was initiated in the second quarter of 2017 and is expected to be substantially complete by the end of the third quarter of 2017.  Also, effective May 15, 2017, the Company entered into the Twelfth Amendment to the PNC Facilities, which amended its financial covenant requirement for the quarter ending April 2, 2017 and adjusted these financial covenant requirements and conditions for future periods as well (refer to note 5). The Company is in compliance with the financial covenants included in the PNC Facilities as at July 2, 2017. The Company anticipates that it will continue to be in compliance with the amended financial covenants in the PNC Facilities. 

In July 2015, the FASB published ASU 2015-11: Simplifying the Measurement of Inventory (Topic 330). The amendments in this Update more closely align the measurement of inventory in U.S. GAAP with the measurement of inventory in International Financial Reporting Standards (IFRS). FASB has amended some of the other guidance in Topic 330 to more clearly articulate the requirements for the measurement and disclosure of inventory. However, the FASB does not intend for those clarifications to result in any changes in practice. Other than the change in the subsequent measurement guidance from the lower of cost or market to the lower of cost and net realizable value for inventory within the scope of this Update, there are no other substantive changes to the guidance on measurement of inventory. For public business entities, the amendments in this Update are effective for fiscal years beginning after December 15, 2016, including interim periods within those fiscal years. The adoption of ASU 2015-11 had no impact on the consolidated financial statements.

In November 2015, the FASB published ASU 2015-17: Income Taxes (Topic 740). The amendment requires that deferred tax assets and liabilities be classified as non-current in a classified statement of financial position. The amendments in this Update are effective for public business entities for financial statements issued for fiscal years beginning after December 15, 2016, and interim periods within those fiscal years. The adoption of ASU 2015-17 resulted in the presentation of the Company’s deferred tax assets as non-current.

In March 2016, the FASB published ASU 2016-09: Compensation – Stock Compensation (Topic 718). The amendment simplifies several aspects of accounting for share-based payment transactions including income tax consequences, classification of awards as either equity or liabilities, classification on the statement of cash flows and accounting for forfeitures. Some of the areas for simplification apply only to nonpublic entities. The amendments in this ASU are effective for public business entities for fiscal years beginning after December 15, 2016, and interim periods within those fiscal years. The adoption of ASU 2016-09 had no impact on the consolidated financial statements.

Recent Accounting Pronouncements Not Yet Adopted

In March 2016, the FASB published ASU 2016-08: Revenue from Contracts with Customers (Topic 606). The amendment clarifies the implementation guidance on principal versus agent considerations. In April 2016, the FASB published ASU 2016-10: Revenue from Contracts with Customers (Topic 606), which clarified application of the standard in identifying performance obligations and licensing arrangements. In May 2016, the FASB published ASU 2016-12: Revenue from Contracts with Customers (Topic 606), which included narrow-scope improvements and practical expedients. Specifically the update addresses application of collectability, presentation of sales taxes, noncash consideration, and completed contracts and contract modifications at transition. In May 2014, the FASB published ASU 2014-09: Revenue from Contracts with Customers (Topic 606), which supersedes (i) revenue recognition requirements in Topic 605 and most related industry-specific guidance, and (ii) cost guidance included in Subtopic 605-35, Revenue Recognition—Construction-Type and Production-Type Contracts, and amends existing requirements for recognition of a gain/loss on the transfer of nonfinancial assets that are not in a contract with a customer (for example, assets within the scope of Topic 360, Property, Plant, and Equipment, and intangible assets within the scope of Topic 350, Intangibles—Goodwill and Other) to be consistent with the new requirements. In August 2015, the FASB published ASU 2015-14 Topic 606 which effectively postponed the effective adoption requirement by one year such that the standard is effective for years beginning after December 15, 2017 including interim periods with those years. Early adoption is permitted only for those annual reporting periods beginning on or after December 15, 2016. Management is currently evaluating the impact of the new standard, analyzing and performing a diagnostic on the various revenue streams within our manufacturing services. We anticipate a modified retrospective adoption effective December 15, 2017.

In January 2016, the FASB published ASU 2016-01: Financial Instruments - Overall (Topic 825-10). The amendment addresses certain aspects of recognition, measurement, presentation and disclosure of financial assets and liabilities. The amendments in this ASU are effective for public business entities for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. The impact of adoption of the standard has not yet been determined.

In February 2016, the FASB published ASU 2016-02: Leases (Topic 842). The amendment proposes that all lessees should recognize the assets and liabilities that arise from leases. Elections may be available for those leases with terms of 12 months or less. The amendment still retains the distinction between finance leases and operating leases. The amendments in this ASU are effective for public business entities for financial statements issued for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. The impact of the adoption of the standard is expected to result in the recognition of all leases with the corresponding assets and liabilities recorded in the consolidated financial statements. Management is currently evaluating the qualitative and quantitative impact of this standard.

In May 2016, the FASB published ASU 2016-13 Financial Instruments – Credit losses (Topic 326): Measurement of Credit Losses on Financial Instruments. The main objective of this Update is to provide financial statement users with more decision-useful information about the expected credit losses on financial instruments and other commitments to extend credit held by a reporting entity at each reporting date. To achieve this objective, the amendments in this Update replace the incurred loss impairment methodology in current U.S. GAAP with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to inform credit loss estimates. The amendment is effective for years beginning after December 15, 2019 including interim periods with those years. Early adoption is permitted only for those annual reporting periods beginning on or after December 15, 2018. The Company continues to evaluate the impact of this accounting standard. The impact of adoption of the standard has not yet been determined.

In August 2016, the FASB published ASU 2016-15 Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments. This Accounting Standards Update addresses the following eight specific cash flow issues: Debt prepayment or debt extinguishment costs; settlement of zero-coupon debt instruments or other debt instruments with coupon interest rates that are insignificant in relation to the effective interest rate of the borrowing; contingent consideration payments made after a business combination; proceeds from the settlement of insurance claims; proceeds from the settlement of corporate-owned life insurance policies (COLIs) (including bank-owned life insurance policies (BOLIs)); distributions received from equity method investees; beneficial interests in securitization transactions; and separately identifiable cash flows and application of the predominance principle. The amendment is effective for years beginning after December 15, 2017 including interim periods with those years. Early adoption is permitted. The impact of adoption of the standard has not yet been determined.

In November 2016, the FASB published ASU 2016-18 Statement of Cash Flows (Topic 230): Restricted Cash. This update addresses the requirement that a statement of cash flows explain the change during the period in the total of cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents. Therefore, amounts generally described as restricted cash and restricted cash equivalents should be included with cash and cash equivalents when reconciling the beginning-of-period and end-of-period total amounts shown on the statement of cash flows. The amendment is effective for years beginning after December 15, 2017 including interim periods with those years. Early adoption is permitted. The impact of adoption of the standard is expected to result in a modification to the current presentation of the statement of cash flows such that restricted cash is not presented as an investing activity, but is presented as part of the net change in cash from beginning to the ending balance.

The following consolidated financial statement details are presented as of the period ended for the consolidated balance sheets and for the periods ended for each of the consolidated statements of operations and comprehensive income (loss).

Consolidated Balance Sheets

 Accounts receivable – net:

The increase in the allowance for doubtful accounts from January 1, 2017 to July 2, 2017 predominantly related to one customer for which management has concluded a provision was required for the outstanding accounts receivable due to the deterioration of the credit risk associated with one customer.

Inventories:

Inventories are recorded net of a provision for obsolescence as at July 2, 2017 and January 1, 2017 of $865 and $442, respectively. The increase in the provision for obsolescence was due primarily to an identified collection risk related to aged inventory for a small number of customers.

Property, plant and equipment – net:

Accrued liabilities:

Interim consolidated statements of operations and comprehensive income (loss)

Interest expense:

(a) Revolving credit facility

The Company borrows money under a Revolving Credit and Security Agreement with PNC Bank, National Association (“PNC”) which governs the PNC Facilities. The PNC Facilities have a term ending on January 2, 2021. Advances made under the PNC Revolving Credit Facility bear interest at the U.S. base rate plus 0.75%. The applicable interest rate for the Long-Term Debt Facility is U.S. base rate plus 1.25%. The base commercial lending rate should approximate prime rate. The weighted average interest rate increased to 4.6% for the first half of 2017 compared to 4.2% for the first half of 2016.  

As at July 2, 2017 the funds available to borrow under the PNC Revolving Credit Facility after deducting the current borrowing base conditions was $4,136 (January 1, 2017 - $7,377). The maximum amount of funds that could be available under the PNC Revolving Credit Facility is $30,000. However, availability under the PNC Revolving Credit Facility is subject to certain conditions, including borrowing base conditions based on eligible inventory and accounts receivable, and certain conditions as determined by the lender. The Company is required to use a “lock-box” arrangement for the PNC Revolving Credit Facility, whereby remittances from customers are swept daily to reduce the borrowings under this facility.

On May 15, 2017, the Company entered into the Twelfth Amendment (“Twelfth Amendment”) of the Revolving Credit and Security Agreement, which was initially entered into on September 14, 2011 with PNC Bank, National Association, as agent for the Lender.

Pursuant to the Twelfth Amendment, the Lender has modified the definition of EBITDA (as defined in the Twelfth Amendment) to include additional exclusions and limits.

In addition, the Lender has increased the interest rates by 0.25% during the quarter in accordance with the Twelfth Amendment; however if the Company maintains a specified fixed charge coverage ratio for a predetermined period of time and maintains its compliance with the terms of the PNC Facilities, interest rates will be reduced to the U.S. base rate plus 0.25% on advances made under the PNC Revolving Credit Facility and U.S. base rate plus 0.75% on advances made under the Long-Term Debt Facility.

   The PNC Long-Term Debt Facility of $10,000 matures on January 2, 2021 with quarterly principal payments of $500 with the remaining balance due at maturity.

At July 2, 2017, $5,488 (January 1, 2017 - $2,731) was outstanding under the PNC Revolving Credit Facility and is classified as a current liability based on the requirement to hold a “lock-box” under the terms of the PNC Revolving Credit Facility.

At July 2, 2017, $9,000 (January 1, 2017 – $10,000) was outstanding under the PNC Long-Term Debt Facility.

The PNC Facilities are a joint and several obligations of the Company and its subsidiaries that are borrowers under the facilities and are jointly and severally guaranteed by other subsidiaries of the Company. Repayment under the PNC Facilities is collateralized by the assets of the Company and each of its subsidiaries.

(b) Covenants

The PNC Facilities agreement contains certain financial and non-financial covenants.

As defined under the Twelfth Amendment, the Company must maintain a minimum EBITDA for the twelve months ended July 2, 2017 and the three months ended October 1, 2017. Subsequent thereafter, the financial covenant relating to a minimum consolidated fixed charge coverage ratio is in effect for the three months ended December 31, 2017, six months ended April 1, 2018, nine months ended July 1, 2018, twelve months ended September 30, 2018 and thereafter on a rolling twelve month basis until January 2, 2021.  The financial covenants also require that the Company limit unfunded capital expenditures (all as defined in the credit agreement governing the PNC Facilities). 

The Company is in compliance with the financial covenants included in the PNC Facilities as of July 2, 2017.

Common shares

Issued and outstanding:

The issued and outstanding number of common shares included in shareholders’ equity consisted of the following:

Stock Options

For more detailed information regarding the Company’s stock option arrangements, see Note 6 of the consolidated financial statements within the Company’s Form 10-K for the fiscal period ended January 1, 2017. The Company granted 1,343,716 stock options during the three and six month period ended July 2, 2017. A summary of stock option activity for the six month period ended July 2, 2017 is as follows:

During the three month period ended July 2, 2017, 1,343,716 stock options were granted to the executive officers of the Company. The stock options have an exercise price per share equal to the Company per share closing price on the grant date, and will vest at 20% of the covered shares upon the Company’s average closing share price being above each of $2.00, $3.00, $4.00, $5.00 and $6.00 for a 90 day period. If the share price does not meet the average closing share prices specified, the stock options will not vest. In the event of a Change in Control Event (as defined in the respective employment agreement), the options shall immediately expire to the extent they remain unvested; provided, however, the Company’s board of directors may, in its sole discretion, accelerate vesting effective immediately prior to, but contingent on, a Change in Control Event. To ensure alignment with shareholders, the options may not be exercised, and no option shares may be sold, within 180 days of any portion of the options vesting, unless a Change in Control Event occurs. The options shall otherwise reflect the Company’s standard terms and conditions for employee option grants, including a ten-year term, and will vest with respect to whole shares only.

A binomial model was utilized to determine the fair value of the stock options issued during the three months ended July 2, 2017. The following weighted average assumptions were used in calculating the estimated fair value of the stock options issued during the quarter with performance conditions used to compute stock-based compensation expense:

Stock-based compensation recognized during the three month period ended July 2, 2017 and July 3, 2016 related to the stock options was $11 and $21. During the six month periods ended July 2, 2017 and July 3, 2016, the Company recorded stock-based compensation expense and a corresponding increase in additional paid-in capital of $23 and $42, respectively.

Restricted Stock Units 

For more detailed information regarding the Company’s Restricted Stock Units (“RSUs”) arrangements, see Note 6 of the consolidated financial statements within the Company’s Form 10-K for the fiscal period ended January 1, 2017. There were 68,000 RSUs granted during the six months ended July 2, 2017. A summary of the RSUs activity for the six month period ended July 2, 2017 is as follows: 

Certain RSUs outstanding have a market condition such that the awards are vested and issuable only if the market price of the Company’s stock meets or exceeds a specified target during the vesting period. If the market condition is not met, the RSUs will not vest and will be forfeited.

Stock based compensation (recovery) recognized during the three month period ended July 2, 2017 and July 3, 2016 related to the RSUs was a recovery of ($18) and $107. The recovery of stock based compensation was due to the reversal of unvested RSUs for terminated employees. Stock based compensation recognized during the six month period ended July 2, 2017 and July 3, 2016 related to the RSUs was $173 and $182, respectively.

During the three months ended July 2, 2017 and July 3, 2016, the Company recorded current income tax expenses of $168 and $99, respectively on minimum taxes and taxes on profits in certain foreign jurisdictions. For the three months ended July 2, 2017 and July 3, 2016, deferred tax recovery of $14 and deferred tax charges of $31, respectively was recorded on temporary differences related to the Mexican operations. During the six months ended July 2, 2017 and July 3, 2016, the Company recorded current income tax expenses of $295 and $103, respectively on minimum taxes and taxes on profits in certain foreign jurisdictions. Current income taxes were partially offset for the six months ended July 3, 2016 by tax recoveries of $66. For the six months ended July 2, 2017 and July 3, 2016 deferred tax recoveries of $148 and $15 was recorded on temporary differences related to the Mexican operations.

In assessing the realization of deferred tax assets, management considers whether it is more likely than not that some portion or all of its U.S. deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income. Management considers the scheduled reversal of deferred tax liabilities, change of control limitations, projected future taxable income and tax planning strategies in making this assessment. Guidance under ASC 740, Income Taxes, (“ASC 740”) states that forming a conclusion that a valuation allowance is not needed is difficult when there is negative evidence, such as cumulative losses in recent years in the jurisdictions to which the deferred tax assets relate. The U.S., Canadian and Asian jurisdictions continue to have a full valuation allowance recorded against the deferred tax assets.

The following table details the weighted average number of common shares outstanding for the purposes of computing basic and diluted earnings per common share for the following periods:

General description

The Company is operated and managed geographically and has production facilities in the United States, Mexico and China. The Company utilizes reportable segment’s site contribution (site revenues minus operating expenses, excluding unrealized foreign exchange gain (loss) on unsettled forward exchange contracts, corporate allocations and restructuring expenses) to monitor reportable segment performance. Site contribution is utilized by the chief operating decision-maker as the indicator of reportable segment performance, as it reflects costs which our operating site management is directly responsible for. Intersegment adjustments reflect intersegment sales that are generally recorded at prices that approximate arm’s-length transactions. In assessing the performance of the reportable segments, management attributes site revenue to the reportable segment that ships the product to the customer, irrespective of the product’s destination. Information about the reportable segments is as follows:

Additions to property, plant and equipment

The following table contains additions to property, plant and equipment including those acquired through capital leases for the three and six months ended July 2, 2017 and July 3, 2016:

Property, plant and equipment ^(a)

Geographic revenues

The following table contains geographic revenues based on the product shipment destination, for the three and six months ended July 2, 2017 and July 3, 2016:

Significant customers and concentration of credit risk:

   Sales of the Company’s products are concentrated in certain cases among specific customers in the same industry. The Company is subject to concentrations of credit risk in trade receivables. The Company considers concentrations of credit risk in establishing the allowance for doubtful accounts and believes the recorded allowances are adequate. The increase in the allowance for doubtful accounts from January 1, 2017 to July 2, 2017 predominantly related to one customer for which management has concluded a provision was required for the outstanding accounts receivable due to the deterioration of the credit risk associated with one customer.

The Company expects to continue to depend upon a relatively small number of customers for a significant percentage of its revenue. In addition to having a limited number of customers, the Company manufactures a limited number of products for some customers. If the Company loses any of its larger customers or any product line manufactured for one of its larger customers, it could experience a significant reduction in revenue. Also, the insolvency of one or more of its larger customers or the inability of one or more of its larger customers to pay for its orders could decrease revenue. As many costs and operating expenses are relatively fixed, a reduction in net revenue can decrease profit margins and adversely affect the business, financial condition and results of operations.

During the three months ended July 2, 2017, four customers exceeded 10% of total revenues representing 13.5%, 11.4%, 11.0% and 10.3% respectively (July 3, 2016 – two customers represented 22.1% and 17.6%) of total revenue for the second quarter of 2017. During the six months ended July 2, 2017, three customers individually comprised 12.1%, 10.3% and 10.1% (July 3, 2016 – two customers individually comprised 18.2% and 15.8%) of total revenue for the six months ended July 2, 2017.

As of July 2, 2017, two customers represented 13.2% and 12.4% respectively, (January 1, 2017, one customer represented 11.8%) of the Company’s accounts receivable.

The Company enters into forward foreign exchange contracts to reduce its exposure to foreign exchange currency rate fluctuations related to a portion of the forecasted Canadian dollar and Mexican Peso denominated payroll, rent and utility cash flows for the six remaining months of fiscal 2017 and first six months of fiscal 2018. These contracts are effective economic hedges but do not qualify for hedge accounting under ASC 815 “Derivatives and Hedging”. Accordingly, changes in the fair value of these derivative contracts are recognized into cost of sales in the consolidated statement of operations and comprehensive income (loss). The Company does not enter into forward foreign exchange contracts for trading or speculative purposes.

The following table presents a summary of the outstanding foreign currency forward contracts as at July 2, 2017:

The unrealized gain recognized in earnings for the three month period as a result of revaluing the outstanding instruments to fair value on July 2, 2017 was $284 (July 3, 2016 – unrealized gain $47), and the unrealized gain for the six month period ended July 2, 2017 was $1,556 (July 3, 2016 – unrealized gain $999), which was included in cost of sales in the consolidated statement of operations and comprehensive income (loss). The realized gain on the settled contracts for the three months period ended July 2, 2017 was $14 (July 3, 2016 – realized loss $647), and the realized loss for the six month period ended July 2, 2017 was $450 (July 3, 2016 – realized loss $1,578), which is included in cost of sales in the consolidated statement of operations and comprehensive income (loss). Fair value was determined using the market approach with valuation based on market observables (Level 2 quantitative inputs in the hierarchy set forth under ASC 820 “Fair Value Measurements”).

The derivative asset as at July 2, 2017 was $300 ($Nil as at January 1, 2017) and derivative liability as at July 2, 2017 was $Nil ($1,256 as at January 1, 2017) which reflected the fair market value of the unsettled forward foreign exchange contracts.

Foreign exchange gains and losses are recorded in cost of sales in the consolidated statement of operations and comprehensive loss pertaining to translation of foreign denominated transactions during the period in addition to foreign denominated monetary assets and liabilities at the end of the reporting period. The total aggregate translated foreign exchange gain of $11 was recognized for the three months ended July 2, 2017 (July 3, 2016 – gain of $81). The total aggregate translated foreign exchange loss of $80 was recognized for the six months ended July 2, 2017 (July 3, 2016 – gain of $104).

During the three months ended July 2, 2017, in accordance with the restructuring plan communicated on May 15, 2017, restructuring charges of $1,351 were incurred related to 43 full-time equivalents (“FTEs”) in Mexico, 103 FTEs in China, 22 FTEs in the U.S., and 12 FTEs in Canada. It is expected that the restructuring accrual will be paid by the fourth quarter of 2017.

Purchase obligations not recorded on the balance sheet as at July 2, 2017 consist of open non-cancellable purchase orders for raw materials for $9,772 which are expected to be paid within 12 months of the PO issue date. Purchase obligations not recorded on the balance sheet as at January 1, 2017 consisted of open non-cancellable purchase orders for raw materials for $13,602 to be paid during calendar year 2017. 

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

Where we say “we”, “us”, “our”, the “Company” or “SMTC”, we mean SMTC Corporation or SMTC Corporation and its subsidiaries, as the context may require. Where we refer to the “industry”, we mean the electronics manufacturing services industry.

You should read this Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) in combination with the accompanying unaudited interim consolidated financial statements and related notes as well as the audited consolidated financial statements and the accompanying notes to the consolidated financial statements prepared in accordance with accounting principles generally accepted in the United States (“U.S. GAAP”) included within the Company’s Annual Report on Form 10-K filed on March 9, 2017. The forward-looking statements in this discussion regarding the electronics manufacturing services industry, our expectations regarding our future performance, liquidity and capital resources and other non-historical statements in this discussion include numerous risks and uncertainties, some of which are as described in the “Risk Factors” section in the Annual Report on Form 10-K filed on March 9, 2017, as updated by Item 1A in Part II of this quarterly report. Certain statements in this MD&A contain words such as “could”, “expects”, “may”, “anticipates”, “believes”, “intends”, “estimates”, “plans”, “envisions”, “seeks” and other similar language and are considered forward looking statements or information under applicable securities laws. These statements are based on our current expectations, estimates, forecasts and projections about the operating environment, economies and markets in which we operate. These statements are subject to important assumptions, risks and uncertainties, which are difficult to predict and the actual outcome may be materially different. Except as required by applicable law, we may not update these forward-looking statements after the date of this Form 10-Q, even though our situation may change in the future. All forward-looking statements attributable to us are expressly qualified by these cautionary statements.

This MD&A contains discussion in U.S. dollars (US$) unless specifically stated otherwise.

Background

  SMTC Corporation (the “Company” or “SMTC”) is a provider of end-to-end electronics manufacturing services, or EMS, including product design and sustaining engineering services, printed circuit board assembly, or PCBA, production, enclosure fabrication, cable assembly, systems integration and comprehensive testing services, configuration to order, build to order and direct order fulfilment. SMTC facilities span a broad footprint in the United States, Mexico, and China, with approximately 1,100 employees of which 1,040 are full-time employees. SMTC’s services extend over the entire electronic product life cycle from the development and introduction of new products through to growth, maturity and end of life phases. SMTC offers fully integrated contract manufacturing services to global original equipment manufacturers, or OEMs, and technology companies primarily within the industrial, computing and communications, power and energy and medical market segments. In addition, the Company operates an international sourcing and procurement office in Hong Kong and maintains its corporate headquarters in Markham, Canada.

Results of Operations

The interim consolidated financial statements of SMTC are prepared in accordance with U.S. GAAP.

Quarter ended July 2, 2017 compared with the quarter ended July 3, 2016:  

The following table sets forth summarized operating results in millions of US$ for the periods indicated:

Revenue 

Revenue decreased by $10.6 million from $43.6 million for the second quarter of 2016 to $33.0 million for the second quarter of 2017. The decrease was primarily the result of one networking and communications customer serviced out of China that has experienced volume reductions as a result of transfer of a portion of the business to other contract manufacturers. This customer represented a decrease in revenue quarter over quarter of $9.3 million. One industrial customer serviced out of Mexico had slower end customer demand which resulted in a reduction quarter over quarter of $3.2 million. This was partially offset by an increase in revenue from another industrial customer serviced in Mexico, which represented an increase in revenue quarter over quarter of $2.1 million.

During the three months ended July 2, 2017 and July 3, 2016, the Company recorded approximately $0.9 million of sales of raw materials inventory to customers, which carried limited margin. The Company purchases raw materials based on customer purchase orders. When a customer requires an order to be altered or changed, the customer is generally obligated to purchase the original on-order raw material at cost, to the extent the materials are not consumed within a specified period.

Due to changes in market conditions, the life cycle of products, the nature of specific programs and other factors, revenues from a particular customer typically varies from quarter-to-quarter and year-to-year. The Company’s ten largest customers represented 83.1% of revenue during the second quarter of 2017, compared with 85.5% in the second quarter of 2016. Revenue from the four largest customers during the second quarter of 2017 was $4.5 million, $3.8 million, $3.6 million and $3.4 million representing 13.5%, 11.4%, 11.0% and 10.3% respectively of total revenue for the second quarter of 2017. This compares with revenues from the largest customers during the second quarter of 2016 which was $9.6 million and $7.7 million representing 22.1% and 17.6% respectively of total revenue for the second quarter of 2016. No other customers represented more than 10% of revenue in either period.

During the second quarter of 2017, 72.7% of our revenue was attributable to production from our operations in Mexico, 15.5% in China and 11.8% in the U.S. During the second quarter of 2016, 58.5% of our revenue was attributable to production from our operations in Mexico, 31.1% in China and 10.4% in the U.S.

Gross Profit 

Gross profit for the second quarter of 2017 decreased by $1.7 million to $1.4 million or 4.3% of revenue compared with $3.1 million or 7.1% of revenue for the same period in 2016. When removing the impact of the unrealized foreign exchange on unsettled forward contracts the adjusted gross profit percentage in the second quarter of 2017 was 3.4% compared to 7.2% in the same period of prior year. The reduction in gross margin is due to reduced revenue and the resulting impact to cover fixed costs and product mix for the three months ended July 2, 2017 compared to the same period in prior year. In addition, for the three months ended July 2, 2017, there were additional inventory provisions for excess and obsolete materials of $0.5 million.

Non-GAAP Gross Profit and Adjusted Gross Profit Reconciliation:

The Company presents this adjusted gross profit amount as we evaluate gross margins internally excluding the unrealized foreign exchange gain (loss) on unsettled forward exchange contracts as this is not a relevant financial indicator to evaluate the Company’s operating performance. Below is the reconciliation from the U.S. GAAP measure of gross profit to adjusted gross profit:

The Company entered into forward foreign exchange contracts to reduce its exposure to foreign exchange currency rate fluctuations related to forecasted Canadian dollar and Mexican peso expenditures. These contracts were effective as hedges from an economic perspective, but did not meet the requirements for hedge accounting under ASC Topic 815 “Derivatives and Hedging”. Accordingly, changes in the fair value of these contracts were recognized into cost of sales in the consolidated statement of operations and comprehensive income (loss). Included in cost of sales for the second quarter of 2017 was an unrealized gain recognized as a result of revaluing the instruments to fair value of $0.3 million, and a realized gain of $0.01 million. Included in cost of sales for the second quarter of 2016 was an unrealized loss recognized as a result of revaluing the instruments to fair value of $0.05 million, and a realized loss of $0.6 million.

Non-GAAP EBITDA and Adjusted EBITDA Reconciliation:

Management has presented EBITDA and adjusted EBITDA, as it is utilized to monitor performance against budget. We also believe EBITDA and adjusted EBITDA provides useful information to investors in understanding and evaluating our operating results in the same manner as management.

Below is the reconciliation of net earnings (loss) to EBITDA and adjusted EBITDA, both of which are non-GAAP measures.

Adjusted EBITDA reduced to $(3.6) million in the second quarter of 2017 from $0.9 million for the same period in the prior year due to lower revenue and gross profit. In addition, there were charges incurred in the three months ended July 2, 2017 for an impairment of property, plant and equipment related to the U.S. segment of $1.0 million. Additionally, as a result of the Company’s assessment of its capital requirements and capabilities during the quarter, assets of $0.6 million were impaired during the three months ended July 2, 2017. Included in selling, general and administrative expenses for the three months ended July 2, 2017 was an additional provision for bad debt expense of $0.8 million related to amounts that management does not believe are collectible.

Selling, General and Administrative Expenses

Selling, general and administrative expenses increased by $0.7 million during the second quarter of 2017 to $4.1 million compared to $3.4 million in the second quarter of 2016. The increase relates primarily to an additional provision for bad debt expense of $0.8 million incurred during the quarter related to one customer which has experienced financial issues which management does not believe are collectible. Professional services increased quarter over quarter in addition to incurring move related costs that were not incurred in the same period last year as the corporate head office was relocated during the second quarter of 2017. These increases were offset by corporate headcount reductions as a result of the 2017 restructuring plan.

Restructuring Expense

During the three months ended July 2, 2017, the Company recorded $1.4 million in restructuring charges made up predominantly of severance charges in accordance with the restructuring plan as announced on May 15, 2017. Restructuring charges were incurred related to the reduction in workforce of 43 full-time equivalents (“FTE’s”) in Mexico, 103 FTE’s in China, 22 FTE’s in the U.S., and 12 FTE’s in Canada.

Impairment of property, plant and equipment

An impairment loss of $1.0 million was recorded in the second quarter of 2017 related to the U.S segment asset group. Indicators of impairment continued to be triggered with the U.S segment, specifically due to continued site operating losses. As a result the Company calculated the impairment loss by discounting the future cash flows which was determined to represent the fair value of the asset group and deducted $1.0 million from the carrying amount of the segment asset group.  

During the quarter ended July 2, 2017, the Company recorded an impairment loss of 0.6 million related predominantly to machinery and equipment in the China segment. These assets were identified as part of the Company’s assessment of its capital requirements and capabilities during the quarter.

Interest Expense

Interest expense was $0.2 million in the second quarter of 2017 and 2016. The average debt balance was reduced in the second quarter ended in 2017 compared to the same period in 2016, however was offset by the increased weighted average interest rates in the three months ended July 2, 2017 compared to the same period in the prior year. The weighted average interest rates with respect to the debt were 4.8% and 4.1% for the second quarters of 2017 and 2016, respectively.

Income Tax Expense

The Company recorded income tax expense of $0.1 million and $0.1 million in the second quarter of 2017 and 2016, respectively due to minimum taxes and taxes on profits in certain jurisdictions. For the second quarters of 2017 and 2016 a deferred income tax recovery and expense of less than $0.1 million was recorded on temporary differences related to the Mexican operations.

Six months ended July 2, 2017 compared with six months ended July 3, 2016:

The following table sets forth summarized operating results in millions of US$ for the periods indicated:  

Revenue 

Revenue decreased by $19.3 million from $85.5 million for the first six months of 2016 to $66.2 million for the first six months of 2017. The decrease was primarily the result of one networking and communications customer serviced out of China that has experienced volume reductions as a result of transfer of a portion of the business to other contract manufacturers. This customer represented a decrease in revenue for the six months period ended July 2, 2017 of $14.7 million compared to the same period in the prior year. One industrial customer serviced out of Mexico had slower end customer demand which resulted in a reduction for the six months period ended July 2, 2017 of $5.6 million compared to the same period in 2016. An additional customer serviced out of Mexico in the networking and communication sector represented a decrease of $2.8 million from the same period in the prior year as the product went end of life. This was partially offset by an increase in revenue from a new medical sector customer in China, which represented an increase of $2.8 million from the same period in the prior year. There was also a new customer in the power and energy sector serviced out of Mexico that began ramping production in the second quarter of 2017 representing an increase in revenue of $1.2 million.

During the first half of 2017, the Company recorded approximately $1.2 million of sales of raw materials inventory to customers, which carried limited margin, compared with $2.4 million in the first half of 2016. The Company purchases raw materials based on customer purchase orders. When a customer requires an order to be altered or changed, the customer is generally obligated to purchase the original on-order raw material at cost, to the extent the materials are not consumed within a specified period.

Due to changes in market conditions, the life cycle of products, the nature of specific programs and other factors, revenues from a particular customer typically varies from quarter to quarter and year to year. The Company’s ten largest customers represented 78.0% of revenue from continuing operations during the first half of 2017, compared with 81.8% in the first half of 2016. Revenue from the three largest customers during the first half of 2017 was $8.0 million, $6.8 million, and $6.7 million representing 12.1%, 10.3% and 10.1%, respectively of total revenue for the first half of 2017. Revenue from the two largest customers during the first half of 2016 was $15.6 million and $13.6 million, representing 18.2% and 15.8%, respectively of total revenue for the first half of 2016. No other customers represented more than 10% of revenue in either period.

During the first half of 2017, 70.2% of our revenue was attributable to production from our operations in Mexico, 16.5% in China and 13.3% in the U.S. During the first half of 2016, 61.0% of our revenue was attributable to production from our operations in Mexico, 26.8% in China and 12.2% in the U.S.

Gross Profit 

Gross profit for the first half of 2017 decreased by $3.0 million to $5.0 million or 7.6% of revenue compared with 9.4% of revenue for the same period in 2016. When removing the effects of unrealized foreign exchange gains on unsettled forward exchange contracts, the adjusted gross profit is 5.2% for 2017 compared with 8.1% for 2016. The reduction in gross margin in the first half of 2017 is due to reduced revenue and the resulting impact to cover fixed costs and product mix compared to the same period in prior year. In addition, for the six months ended July 2, 2017, there was an additional inventory provision for excess and obsolete materials of $0.5 million.

Non-GAAP Gross Profit and Adjusted Gross Profit Reconciliation:

The Company presents this adjusted gross profit amount as we evaluate gross margins internally excluding the unrealized foreign exchange gain on unsettled forward exchange contracts as this is not a relevant financial indicator to evaluate the Company’s operating performance. Below is the reconciliation from the U.S. GAAP measure of gross profit to adjusted gross profit:

The Company entered into forward foreign exchange contracts to reduce its exposure to foreign exchange currency rate fluctuations related to forecasted Canadian dollar and Mexican peso expenditures. These contracts were effective as hedges from an economic perspective, but did not meet the requirements for hedge accounting under ASC Topic 815 “Derivatives and Hedging”. Accordingly, changes in the fair value of these contracts were recognized into cost of sales in the consolidated statement of operations and comprehensive income (loss). Included in cost of sales for the first half of 2017 was an unrealized gain recognized as a result of revaluing the instruments to fair value of $1.6 million, and a realized loss of $0.5 million. Included in cost of sales for the first half of 2016 was an unrealized gain recognized as a result of revaluing the instruments to fair value of $1.0 million, and a realized loss of $1.6 million.