Cautionary Note Regarding Forward-Looking Statements
This Quarterly Report on Form 10-Q contains "forward-looking statements" (as
defined in Section 27A of the Securities Act of 1933, as amended, and Section
21E of the Securities Exchange Act of 1934, as amended). These forward-looking
statements are based on our management's beliefs, assumptions, and expectations
and on information currently available to our management. Generally, you can
identify forward-looking statements by terms such as "may," "will," "should,"
"could," "would," "expects," "plans," "anticipates," "believes," "estimates,"
"projects," "predicts," "potential" and similar expressions intended to identify
forward-looking statements, which generally are not historical in nature. All
statements that address operating or financial performance, events, or
developments that we expect or anticipate will occur in the future are
forward-looking statements, including without limitation our expectations with
respect to the timing for our planned manufacturing expansion, the benefits of
our products, customer leads, product sales, financings, or the commercial
viability of, and prospects for, our business model. We may not actually achieve
the plans, projections or expectations disclosed in forward-looking statements,
and actual results, developments or events (including, without limitation, those
related to our planned manufacturing capacity expansion and our sales and
marketing initiatives) could differ materially from those disclosed in the
forward-looking statements. Our management believes that these forward-looking
statements are reasonable as and when made. However, you should not place undue
reliance on forward-looking statements because they speak only as of the date
when made. We do not assume any obligation to publicly update or revise any
forward-looking statements, whether as a result of new information, future
events or otherwise, except as may be required by federal securities laws and
the rules of the Securities and Exchange Commission (the "SEC"). We may not
actually achieve the plans, projections or expectations disclosed in our
forward-looking statements, and actual results, developments or events could
differ materially and adversely from those disclosed in the forward-looking
statements. Forward-looking statements are subject to a number of significant
risks and uncertainties, including without limitation those described from time
to time in our reports filed with the SEC.
The following discussion and analysis of our financial condition and results of
operations should be read together with our unaudited interim condensed
consolidated financial statements and related notes appearing elsewhere in this
Quarterly Report on Form 10-Q as well as the risk factors and other disclosures
contained in our Annual Report on Form 10-K for the period ended November 30,
2021.
Surge Components, Inc., and its wholly owned subsidiaries are referred to in
this discussion as the "Company", "we", "our", or "us". "Common stock" refers to
the common stock of the Company.
Overview
The Company operates with two sales groups, Surge Components ("Surge") and
Challenge Electronics ("Challenge"). Surge is a supplier of electronic products
and components. These products include capacitors, which are electrical energy
storage devices, and discrete semiconductor components, such as rectifiers,
transistors and diodes, which are single function low power semiconductor
products that are packaged alone as compared to integrated circuits such as
microprocessors. The products sold by Surge are typically utilized in the
electronic circuitry of diverse products, including, but not limited to,
automobiles, audio products, temperature control products, lighting products,
energy related products, computer related products, various types of consumer
products, garage door openers, household appliances, power supplies and security
equipment. These products are sold to both original equipment manufacturers,
commonly referred to as OEMs, who incorporate them into their products, and to
distributors of the lines of products we sell, who resell these products within
their customer base. These products are manufactured predominantly in Asia by
approximately sixteen independent manufacturers. We act as the master
distribution agent utilizing independent sales representative organizations in
North America to sell and market the products for one such manufacturer pursuant
to a written agreement. When we act as a sales agent, our supplier who sold the
product to the customer that we introduced to our supplier pays us a commission.
The amount of the commission is determined on a sale by sale basis depending on
the profit margin of the product. Commission revenue totaled $159,796 and
$169,360 for the nine months ended August 31, 2022 and August 31, 2021
respectively.
Challenge is engaged in the sale of electronic components. In 1999, Challenge
began as a division to sell audible components. We have been able to increase
the types of products that we sell because some of our suppliers introduced new
products, and we also located other products from new suppliers. Our core
products include buzzers, speakers, microphones, resonators, alarms, chimes,
filters, and discriminators. We now also work with our suppliers to have our
suppliers customize many of the products we sell for many customers through the
customers' own designs and those that we work with our suppliers to have our
suppliers redesign for them at our suppliers' factories. We have an engineer on
our staff who works with our suppliers on such redesigns and assists with the
introduction of new product lines. We are continually looking to expand the line
of products that we sell. We sell these products through independent
representatives that earn a commission on the products we sell. We are also
working with local, regional, and national distributors to sell these products
to local accounts in every state. Challenge also at times handles the brokering
of certain products, helping their customers find parts that that regular
suppliers can't deliver.
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The Company has a Hong Kong office to effectively handle the transfer business
from United States customers purchasing and manufacturing in Asia after
designing the products in the United States. This office has strengthened the
Company's global position, improving our capabilities and service to our
customer base.
The world of business continues to change because of "disruptors," which are
significant changes in traditional business practices that did not previously
exist. For example, customers continue to centralize purchasing from regional
purchasing and are stretching their payment terms. These changes also include
customers moving their manufacturing operations from North America to Asia, and
the trend of globalization. Some of our customers have been involved in mergers
and acquisitions, causing consolidation. This trend makes business more
complicated and costly for the Company. The Company must have a presence in Asia
to service and further develop the business. For these reasons, we established
Surge Ltd., our Hong Kong subsidiary. Currency fluctuations may also have an
effect on doing business outside of North America. Customers have moved to
reduce their supply chain, which could adversely affect the Company. In some
market segments, demand for electronic components have decreased, and in other
segments, the demand is still strong. Some technologies have become obsolete,
while customers develop new products using different kinds of components.
Management expects 2022 to be a year of continued change, in regards to pandemic
healing, inflation and general economic conditions, challenge, in regards to
maintaining consistent flow of products during shortages of certain products,
and growth as we see our customers return to full production pace. These
challenges could affect the Company in negative ways, possibly reducing sales
and or profitability. Because of a labor shortage, our customers engineering
staff has been challenged, so getting our products approved has been and will
continue to take longer to achieve. Additionally, the cost of raw materials has
increased, and due to that fact, factories have increased our costs. Our
year-to-date sales reflect strong growth and the Company has a strong backlog
with customers due to the increased demand for products and the fact that
customers are placing orders further into 2023. The Company has also been able
to handle the brokering of certain semiconductor products, helping their
customers to keep product lines up and running by locating products that their
regular suppliers can't deliver. In order for the Company to continue to grow,
we will depend on, among other things, the continued growth of the electronics
and semiconductor industries, our ability to withstand intense price
competition, our ability to obtain new customers, our ability to retain and
attract sales and other key personnel in order to expand our marketing
capabilities, our ability to secure adequate sources of products, which are in
demand on commercially reasonable terms, our success in executing and managing
growth, including monitoring an expanded level of operations and systems,
controlling costs, the availability of adequate financing, the continued supply
of products from our factories, the ability to withstand higher transportation
costs and longer travel times due to the backup at the ports and our ability to
deal successfully, with new and future disruptors. The tariffs continue to
impact the Company. At this time there is a shortage of electronics components
which could impact the Company's growth. . The general supply chain challenges
presents both a challenge and opportunity to the Company. The Company is
cautiously optimistic about its ability to meet these challenges with continued
growth, unless the general economic conditions deteriorate. Financial news has
been talking about the decreases in consumer demand for certain consumer goods
such as PC's and smartphones and the possibility of a recession in 2023. These
economic conditions could have a negative impact on sales in the remainder of
2022 and in 2023. The combination of disruptors such as increased costs and
longer lead times from factories to the Company could also have negative impacts
on the business in the future.
Known Factors, Trends and Risks Impacting Our Business
Inflation
In the past two fiscal years, inflation has not had a significant impact on our
business. However, any significant increase in inflation and interest rates
could have a significant effect on the economy in general and, thereby, could
affect our future operating results.
Interest Rate Sensitivity
We are not subject to interest rate sensitivities.
Impact of Covid-19
In March 2020, the World Health Organization categorized COVID-19 as a pandemic
and it continues to impact the global economy. During the pandemic we did
everything we could do to keep customers production running and keep operations
as smooth and stable as possible, and we will continue to do our best to do so.
The Company has experienced order cancellations and order hold notices from
customers and we expect this could continue. While the worst effects of the
pandemic may be behind us in the United States, the virus situation is still
serious globally, and business with customers in different regions is impacted
more or less based on the Covid status in that region. Spikes of Covid that may
cause China lockdowns can have an adverse impact on manufacturing stability and
the ability of our Asia salespeople to visit customers. Although the Company's
business has improved in the nine months ended August 31, 2022 and our
customers' outlook for their business is stronger than it was previously, we
cannot guarantee that the increase in subsequent quarters will continue as the
coronavirus conditions may change. Additionally, the spread of COVID-19 and the
related actions implemented by governments of the United States and elsewhere
across the globe, may worsen again over time. Thus, the pandemic may have an
impact on the Company's operations, the future effect of which will largely
depend on future developments which are highly uncertain and cannot be predicted
at this time. The Company continues to monitor its operations and applicable
government recommendations and requirements.
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Critical Accounting Estimates
Accounts Receivable
The allowance for doubtful accounts is based on the Company's assessment of the
collectability of specific customer accounts and an assessment of international,
political and economic risk as well as the aging of the accounts receivable. If
there is a change in actual defaults from the Company's historical experience,
the Company's estimates of recoverability of amounts due could be affected and
the Company would adjust the allowance accordingly.
Revenue Recognition
Revenue is recognized when persuasive evidence of an arrangement exists,
delivery has occurred, the price is fixed and determinable, collectability is
reasonably assured and title and risk of loss have been transferred to the
customer. This occurs when product is shipped from the Company's warehouse. For
direct shipments from our suppliers to our customer, revenue is recognized when
product is shipped from the Company's supplier. The Company acts as a sales
agent for certain customers buying direct from one of its suppliers. The Company
reports these commissions as revenues in the period earned.
The Company performs ongoing credit evaluations of its customers and maintains
reserves for potential credit losses.
Inventory Valuation
Inventories are recorded at the lower of cost or net realizable value.
Write-downs of inventories to net realizable value are based on stock rotation,
historical sales requirements and obsolescence as well as in the changes in the
backlog. Reserves required for obsolescence were not material in any of the
periods in the financial statements presented. If market conditions are less
favorable than those projected by management, additional write-downs of
inventories could be required. For example, each additional 1% of obsolete
inventory would reduce operating income by approximately $73,000.
The Company does not have price protection agreements with any of its vendors
and assumes the risk of changes in the prices of its products. The Company does
not believe there to be a significant risk with regards to the lack of price
protection agreements as many of its inventory items are purchased to fulfill
purchase orders received.
Results of Operations
Consolidated net sales for the nine months ended August 31, 2022 increased by
$11,994,412 or 42.3%, to $40,375,448 as compared to net sales of $28,381,036 for
the nine months ended August 31, 2021. Consolidated net sales for the three
months ended August 31, 2022, increased by $3,323,680 or 31.3%, to $13,955,954
as compared to net sales of $10,632,274 for the three months ended August 31,
2021. We attribute the increase to an increase in business with new customers as
well as an increase in business with existing customers. We can also attribute
some of the increase in sales during the nine and three months ended August 31,
2022, to one of the Company's divisions brokering certain products. In
Brokering, the Company helps customers find parts that their regular suppliers
can not deliver. Net sales for the nine months ended August 31, 2022, and August
31, 2021 reflect $1,035,423 and $611,252, respectively of tariff costs that the
Company was able to pass on to its customers.
Our gross profit for the nine months ended August 31, 2022, increased by
$3,019,085 to $10,963,086, or 38%, as compared to $7,944,001 for the nine months
ended August 31, 2021. Gross margin as a percentage of net sales decreased to
27.2% for the nine months ended August 31, 2022, compared to 28% for the nine
months ended August 31, 2021. Gross profit for the three months ended August 31,
2022, increased by $542,216 to $3,628,929, or 17.6%, as compared to $3,086,713
for the three months ended August 31, 2021. Gross margin as a percentage of net
sales decreased to 26% for the three months ended August 31, 2022, compared to
29% for the three months ended August 31, 2021. We attribute the increase in
gross margin to an increase in sales volume in the nine and three months ended
August 31, 2022. We attribute the decreae in gross margin as a perentage of
sales to the Company selling certain products at a lower profit marging. Our
industry will continue to receive pressure from customers for price reductions.
Some of them further demand periodic price reductions on a quarterly or
semi-annual basis, as opposed to annual fixed pricing. We work with electronic
manufacturing service subcontractor customers who manufacture products for other
customers who do not have their own manufacturing operations. At times we are
not able to recover these price reductions from our suppliers. The Company has
agreements with these subcontractor customers to provide periodic cost
reductions through rebates in the amount of 5%. These reductions only affect
future shipments of our products, and do not affect existing orders. These
reductions can have a negative impact on our profit margins since they reduce
the amount of commissions we can earn. Even though this rebate can impact the
Company's gross profit margin, these subcontractor customers represent very
significant potential growth for the Company, because they can help the Company
become an approved supplier at the customers they manufacture for, and they
purchase our components for these customers. We believe it would be very
difficult for the Company to achieve business at these customers without the
help of these subcontractor customers. During the nine months ended August 31,
2022, the Company was impacted by tariff costs on certain products imported from
China, which went into effect as of July 6, 2018. The Company has been able to
pass along a portion of these costs to its customers. The Company also moved
some customer deliveries directly to Hong Kong in order to mitigate some of
these costs. In the remainder of 2022, the Company expects the effects of the
tariffs to be similar to 2021.
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Selling and shipping expenses for the nine months ended August 31, 2022 was
$2,501,208, an increase of $607,479, or 32.1%, as compared to $1,893,729 for
nine months ended August 31, 2021. Selling and shipping expenses for the three
months ended August 31, 2022 was $823,133, an increase of $204,787, or 33.1%, as
compared to $618,346 for three months ended August 31, 2021. We attribute
the increase to an increase in salesman payroll and commission expenses, as well
as auto, travel and entertainment expenses and messenger and delivery expenses.
These increases were offset by a decrease in freight out costs.
General and administrative expenses for the nine months ended August 31, 2022
was $4,767,820, an increase of $996,903, or 26.4%, as compared to $3,770,917 for
the nine months ended August 31, 2021. General and administrative expenses for
the three months ended August 31, 2022 was $1,395,580, an increase of $198,888,
or 16.6% as compared to $1,196,692 for the three months ended August 31, 2021.
The increase for the nine and three months ended August 31, 2022 is due
primarily to increases in rent, utilities, health insurance and general
insurance expenses, professional fees, office expenses as well as salaries and
related payroll taxes, directors fees, bad debt expenses, consulting expenses,
option expenses and public company expenses. These increases were offset by
decreases in computer expenses as well as settlement expenses due to a
settlement with a customer in the nine months ended August 31, 2021.
Depreciation expense for the nine months ended August 31, 2022 was $58,799, an
increase of $6,226, or 11.8%, as compared to $52,573 for the nine months ended
August 31, 2021. Depreciation expense for the three months ended August 31, 2022
was $20,728, an increase of $3,204, or 18.3%, as compared to $17,524 for the
three months ended August 31, 2021. The increase is due to the company
purchasing new equipment during 2021 and 2022.
Tax expense for the nine months ended August 31, 2022 was $894,212, an increase
of $80,829 as compared to a tax expense of $813,383 for the nine months ended
August 31, 2021. Tax expense for the three months ended August 31, 2022 was
$181,392, a decrease of $191,536 as compared to a tax expense of $372,928 for
the three months ended August 31, 2021. The changes result from our increase in
net income for such periods.
As a result of the foregoing, net income for the nine months ended August 31,
2022 was $2,769,586, compared to a net income of $1,863,012 for the nine months
ended August 31, 2021. The net income for the three months ended August 31, 2022
was $1,235,423, compared to a net income of $881,240 for the three months ended
August 31, 2021.
Liquidity and Capital Resources
As of August 31, 2022 we had cash of $7,694,084, and working capital of
$15,851,511. We believe that our working capital levels are adequate to meet our
operating requirements during the next twelve months. The Company is exploring
and evaluating opportunities for growth and expansion using the Company's cash
resources.
During the nine months ended August 31, 2022, we had net cash flow provided by
operating activities of $1,237,795, as compared to net cash flow provided by
operating activities of $1,297,266 for the nine months ended August 31, 2021.
The decrease in cash flow from operating activities resulted from an increase in
inventory and a smaller increase in accounts payable, offset by increases in net
income, stock based compensation and a smaller increase in accounts receivable.
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We had net cash flow used in investing activities of $(48,351) for the nine
months ended August 31, 2022, as compared to net cash flow used in investing
activities of $(192,397) for the nine months ended August 31, 2021. We attribute
the change to the Company purchasing more new equipment during the nine months
ended August 31, 2021 than in 2022.
We had net cash flow used by financing activities of $(6,948) during the nine
months ended August 31, 2022 as compared to $(6,331) provided by financing
activities for nine months ended August 31, 2021.
As a result of the foregoing, the Company had a net increase in cash of
$1,182,496 for the nine months ended August 31, 2022, as compared to a net
increase in cash of $1,098,538 for the nine months ended August 31, 2021.
The table below sets forth our contractual obligations, including long-term
debt, operating leases and other long-term obligations, as of August 31, 2022:
Payments due
0 - 12 13 - 36 37 - 60 More than
Contractual Obligations Total Months Months Months 60 Months
Capital Lease Obligations $ 1,613 $ 1,613 $ - $ - $ -
Operating leases
$ 1,664,002 332,767 432,285 431,306 467,644
Total obligations $ 1,665,615 $ 334,380 $ 432,285 $ 431,306 $ 467,644
Off Balance Sheet Arrangements
We do not have any off balance sheet arrangements.
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SURGE COMPONENTS, INC. 
