STEEL CONNECT, INC. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL POSITION AND OPERATING RESULTS (Form 10-K)
This Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 21E of the Exchange Act and Section 27A of the Securities Act. For this purpose, any statements contained herein that are not statements of historical fact may be deemed to be forward-looking statements. Without limiting the foregoing, the words "believes," "anticipates," "plans," "expects" and similar expressions are intended to identify forward-looking statements. Factors that could cause actual results to differ materially from those reflected in the forward-looking statements include, but are not limited to, those discussed in Item 1A. Risk Factors and elsewhere in this Report. For more information, see "Forward Looking Statements." Readers are cautioned not to place undue reliance on these forward-looking statements, which reflect 23 -------------------------------------------------------------------------------- Table of Contents management's analysis, judgment, belief or expectation only as of the date hereof. We do not undertake any obligation to update forward-looking statements whether as a result of new information, future events or otherwise.
Steel Connect, Inc.is a diversified holding company with two, wholly-owned subsidiaries, IWCO Directand ModusLink, which serve the direct marketing and supply chain management markets, respectively. For a more complete description of the Company's segments, see "Item 1. Business" found elsewhere in this Form 10-K. Impact of COVID-19 The ongoing COVID-19 pandemic has adversely impacted, and is likely to further adversely impact, nearly all aspects of our business and markets, including our workforce and the operations of our clients, suppliers, and business partners. Beginning in March 2020, when the World Health Organizationcategorized COVID-19 as a pandemic and the President of the United Statesdeclared the COVID-19 outbreak a national emergency, we experienced impacts to our customers' demand, facility operations, supply chain, availability and productivity of personnel, while also working to comply with rapidly evolving international, federal, state and local restrictions and recommendations on travel and workplace health and safety. We experienced disruptions to our business continuity as a result of temporary closures of certain of ModusLink'sfacilities in the third and fourth quarters of fiscal year 2020, as well as the fourth quarter of fiscal year 2021. However, these temporary closures did not have a significant impact on ModusLink'soperations. Additionally, although IWCO Directoperated as an essential business, it had reduced operating levels and labor shifts due to lower sales volume during the third quarter of fiscal year 2020. To help combat these impacts and mitigate the financial impact of the COVID-19 pandemic on our business, during fiscal year 2020 we took proactive measures by initiating cost reduction actions, including the waiver of board fees, hiring freezes, staffing and force reductions, company-wide salary reductions, bonus payment deferrals and temporary 401(k) match suspension. The temporary waiver of board fees and company-wide salary reduction actions taken in the prior fiscal year were fully restored prior to the beginning of fiscal year 2021, and the majority of salary reductions were repaid prior to the fiscal quarter ended January 31, 2021.We continue our focus on cash management and liquidity, which includes aggressive working capital management. In addition, we aim to closely monitor the impact of COVID-19 on all aspects of our business and geographies, including its impact on our clients, employees, suppliers, vendors, business partners and distribution channels. We believe that such impacts could include, but are not limited to, the extent and severity of the impact on our customers and suppliers; the continued disruption to the demand for our businesses' products and services; the impact of the global business and economic environment on liquidity and the availability of capital; delays in payments of outstanding receivables beyond normal payment terms; supply chain disruptions; uncertain demand; and the effect of any initiatives or programs that we may undertake to address financial and operational challenges faced by our customers. The full extent to which the pandemic will directly or indirectly impact our business, results of operations and financial condition, is difficult to predict and will depend on the duration and spread of the ongoing COVID-19 pandemic (including new variants of COVID-19), its severity, the actions to contain the virus or address its impact, the timing, distribution, and efficacy of vaccines and other treatments, U.S.and foreign government actions to respond to the reduction in global economic activity, and how quickly and to what extent normal economic and operating conditions can resume. As of the filing of this Form 10-K, all of our facilities were open and able to operate at normal capacities. We will evaluate further actions if circumstances warrant while continuing to strategically support the Company's future growth initiatives (including its Competitive Improvement Plan for IWCO Direct), sales and marketing activities and supply chain solutions and services.
June 2, 2021, the Board approved a Competitive Improvement Plan ("CIP") for IWCO Direct, which addresses the changing requirements of its customers and markets it serves, as well as the current competitive landscape. The CIP seeks to expand IWCO Direct'smarketing services capabilities, and upgrade its production platform to new digital and inserting technology, while reducing its overall production costs to enhance its competitive pricing capabilities. The CIP contemplates a total investment of approximately $54 millionprimarily over a 24-month period. The Company estimates the CIP cost will consist of approximately: (1) $38 millionfor digital press and insertion equipment, and technology build out cost (of which approximately $34 millionin lease/purchase agreements were entered into subsequent to year-end), and (2) $16 millionfor severance, employee retention, facilities optimization, and other implementation costs. In addition, the Company expects to incur approximately $12 millionfor non-cash accelerated depreciation expense. The cost estimates do not include amounts for potential non-cash asset impairment charges relating to facilities and equipment optimization. The timing and amount of the costs will depend on a number of factors. 24
Reverse stock split
At our 2020 Annual Meeting of Stockholders, our stockholders approved a reverse stock split of the issued and outstanding shares of our common stock at the ratio of one-for-ten (the "Reverse Stock Split"). Our board is authorized to determine when to file the necessary amendment to our Restated Certificate of Incorporation for the Reverse Stock Split with the
DelawareSecretary of State at any time on or before the 12-month anniversary of stockholder approval thereof. The board may, at its discretion, cause the filing of the amendment to effect the Reverse Stock Split or abandon the amendment and not effect the Reverse Stock Split if it determines that any such action is or is not in the best interests of the Company and its stockholders. The board's decision as to whether and when to effect the Reverse Stock Split will be based on a number of factors, including market conditions, existing and expected trading prices for our common stock and the Nasdaq Rules. Upon consummation of the Reverse Stock Split, every ten shares of common stock held by a stockholder at that time will be combined into one share of common stock. The Reverse Stock Split will affect all of our stockholders uniformly and will not affect any stockholder's percentage ownership interests in the Company or proportionate voting power, except for minor adjustments due to the treatment of fractional shares. No fractional shares will be issued in connection with the Reverse Stock Split. Additionally, at our 2020 Annual Meeting of Stockholders, our stockholders also approved the amendment to our Restated Certificate of Incorporation to reduce the number of shares of authorized common stock (the "Authorized Shares Reduction"), from 1,400,000,000 to 140,000,000. While our board currently intends to implement the Authorized Shares Reduction to the extent that it implements the Reverse Stock Split, our board reserves its right to elect not to proceed with the Authorized Shares Reduction if it determines, in its sole discretion, following stockholder approval, that this proposal is no longer in the best interests of the Company or its stockholders. For the risks associated with the Reverse Stock Split and the Authorized Shares Reduction, including risks arising from their implementation or non-implementation, see "Item 1A. Risk Factors-Risks Related to Ownership of Our Common Stock - Our board may effect a reverse split of the issued and outstanding shares of our common stock at the ratio of one-for-ten, the effects of which we cannot predict with certainty and which may be materially adverse to the value of your investment in our common stock."
Results of operations
Fiscal year 2021 compared to fiscal year 2020
Net Revenue: As a % As a % of of Fiscal Year Total Fiscal Year Total Ended Net Ended Net July 31, 2021 Revenue July 31, 2020 Revenue $ Change % Change (In thousands) Direct Marketing
$ 387,51063.1 % $ 444,36056.8 % $ (56,850)(12.8) % Supply Chain 226,256 36.9 % 338,453 43.2 % (112,197) (33.1) % Total $ 613,766100.0 % $ 782,813100.0 % $ (169,047)(21.6) %
Consolidated net sales for the year ended
Direct Marketing segment net revenue for the fiscal year ended
July 31, 2021decreased by approximately $56.9 millionas compared with the prior fiscal year. Direct Marketing segment net revenue decreased by: (1) approximately $36.2 milliondue to lower volume from client exits and (2) approximately $20.7 milliondue to overall lower customer demand. The client exits in the year ended July 31, 2021are expected to result in further decreases of Direct Marketing's net revenue for the fiscal year ending July 31, 2022. Supply Chain net revenue for the fiscal year ended July 31, 2021decreased by approximately $112.2 millionas compared with the prior fiscal year. Supply Chain net revenue decreased by: (1) approximately $60.0 milliondue to lower volume from client exits and (2) approximately $52.2 milliondue to lower client volume, the majority of which is associated with a client in the computing market. Fluctuations in foreign currency exchange rates had an insignificant impact on the Supply Chain segment's net revenues for the fiscal year ended July 31, 2021, as compared to the same period in the prior year. 25
Table of Contents Cost of Revenue: As a % As a % of of Fiscal Year Segment Fiscal Year Segment Ended Net Ended Net July 31, 2021 Revenue July 31, 2020 Revenue $ Change % Change (In thousands) Direct Marketing
$ 305,60178.9 % $ 345,17377.7 % $ (39,572)(11.5) % Supply Chain 178,552 78.9 % 274,681 81.2 % (96,129) (35.0) % Total $ 484,15378.9 % $ 619,85479.2 % $ (135,701)(21.9) % Consolidated cost of revenue consists primarily of expenses related to the cost of materials purchased in connection with the provision of direct marketing and supply chain management services as well as costs for salaries and benefits, contract labor, consulting, paper for direct mailing, fulfillment and shipping, and applicable facilities costs. Cost of revenue for the fiscal year ended July 31, 2021included materials procured on behalf of our Supply Chain clients of $109.0 million, as compared to $190.3 millionfor the prior year, a decrease of $81.2 million. Consolidated cost of revenue decreased by $135.7 millionfor the fiscal year ended July 31, 2021, as compared to the prior year, primarily due to lower labor and material costs as a result of the decrease in revenue. Consolidated gross margin percentage for the fiscal year ended July 31, 2021increased 30 basis points to 21.1% from 20.8% in the fiscal year ended July 31, 2020, primarily due to favorable changes in sales mix, our focus on customer rationalization to improve profitability, as well as cost reduction initiatives in both segments to offset the impact of COVID-19. Direct Marketing's cost of revenue decreased by $39.6 millionfor the fiscal year ended July 31, 2021, as compared to the prior fiscal year. The decrease was primarily due to lower material and labor costs as a result of lower sales volume. The Direct Marketing segment's gross margin percentage decreased by 120 basis points to 21.1% for the fiscal year ended July 31, 2021, as compared to 22.3% for the fiscal year ended July 31, 2020primarily due to changes in customer mix and the competitive pricing pressures within the marketplace. Supply Chain's cost of revenue decreased by $96.1 millionduring the fiscal year ended July 31, 2021, as compared to the prior fiscal year. The decrease was primarily due to lower material and labor costs due to lower sales volume. The Supply Chain segment's gross margin percentage increased by 230 basis points to 21.1% for the fiscal year ended July 31, 2021, as compared to 18.8% for the fiscal year ended July 31, 2020, primarily due to improved sales mix towards higher margin services. Fluctuations in foreign currency exchange rates had an insignificant impact on the Supply Chain segment's gross margin for the fiscal year ended July 31, 2021, as compared to the same period in the prior year.
Selling, general and administrative expenses:
As a % As a % of of Fiscal Year Segment Fiscal Year Segment Ended Net Ended Net July 31, 2021 Revenue July 31, 2020 Revenue $ Change % Change (In thousands) Direct Marketing
$ 47,25412.2 % $ 58,99213.3 % $ (11,738)(19.9) % Supply Chain 40,877 18.1 % 35,820 10.6 % 5,057 14.1 % Sub-total 88,131 14.4 % 94,812 12.1 % (6,681) (7.0) % Corporate-level activity 8,397 8,449 (52) (0.6) % Total $ 96,52815.7 % $ 103,26113.2 % $ (6,733)(6.5) % Consolidated selling, general and administrative expenses for the fiscal year ended July 31, 2021decreased by approximately $6.7 million, as compared to the same period in the prior year. Direct Marketing's selling, general and administrative expenses for the fiscal year ended July 31, 2021decreased by approximately $11.7 million, primarily due to a lower employee-related costs, sales and marketing, and other expenses. Supply Chain's selling, general and administrative expenses for the fiscal year ended July 31, 2021increased approximately $5.1 million, primarily due to an increase in costs associated with the information technology function, offset partially by a decrease compensation costs. Corporate-level activity decreased slightly compared to the prior year. Fluctuations in foreign currency exchange rates had an insignificant impact on the Supply Chain segment's selling, general and administrative expenses for the fiscal year ended July 31, 2021.
Goodwill impairment charge:
During the fiscal year ended
July 31, 2021, the Company recorded a non-cash pre-tax goodwill impairment charge of $25.7 millionfor the Direct Marketing segment. The Company did not record any goodwill impairment charge during the prior fiscal year. For a discussion of the drivers of the goodwill impairment charge, see Note 5 to the consolidated financial statements found elsewhere in this Form 10-K.
Amortization of intangible assets:
Intangible asset amortization expense of
$20.3 millionand $27.3 millionduring the fiscal years ended July 31, 2021and 2020, respectively, relates to intangible assets acquired by the Company in connection with its acquisition of IWCO Direct. Amortization expense decreased by approximately $7.0 millionfor the year ended July 31, 2021as compared to the prior fiscal year due to trademarks and tradenames that became fully amortized in December 2020and lower amortization expense with respect to the customer relationship intangible assets. The customer relationship intangible assets are amortized using an accelerated method, which reflects the pattern in which we receive the economic benefit of the asset. Interest Expense: Interest expense of $31.1 millionfor the year ended July 31, 2021decreased by approximately $2.8 millionas compared to the prior fiscal year primarily due to lower average outstanding debt balances.
Other gains, net:
Other gains, net for the fiscal year ended
July 31, 2021were approximately $1.2 million. Other gains, net included gains of $3.2 millionfrom the derecognition of accrued pricing liabilities in the Supply Chain segment, partially offset by $1.9 millionin net realized and unrealized foreign exchange losses in the Supply Chain segment. Other gains, net for the fiscal year ended July 31, 2020were approximately $2.1 million. Other gains, net included gains of $0.8 millionfrom the derecognition of accrued pricing liabilities in the Supply Chain segment and $0.9 millionin net realized and unrealized foreign exchange gains in the Supply Chain segment.
The income tax charge:
The company recorded a tax charge of approximately
Liquidity and capital resources
Sources and Intended Uses of Cash Flows
Historically, the Company has financed its operations and met its capital requirements primarily through funds generated from operations, the sale of it securities, borrowings from lending institutions and sale of facilities that were not fully utilized. The following table summarizes our liquidity: July 31, 2021 (In thousands) Cash and cash equivalents
$ 96,931Readily available borrowing capacity under Cerberus Credit Facility 25,000
Easily available borrowing capacity under the Midcap credit facility
$ 130,618Due to the changes reflected in the U.S.Tax Cuts and Jobs Act in December 2017(" U.S.Tax Reform"), there is no U.S.tax payable upon repatriating the undistributed earnings of foreign subsidiaries considered not subject to permanent investment. Foreign withholding taxes would range from 0% to 10% on any repatriated funds. For the Company, earnings and profits have been calculated at each subsidiary. The Company's foreign subsidiaries are in an overall net deficit for earnings and profits purposes. As such, no adjustment was made to U.S.taxable income in the fiscal year ended July 31, 2021relating to this aspect of the U.S.Tax Reform. In future years, the Company will be able to repatriate its foreign earnings without incurring additional 27 -------------------------------------------------------------------------------- Table of Contents U.S.tax as a result of a 100% dividends received deduction. The Company believes that any future withholding taxes or state taxes associated with such a repatriation would be minor. Consolidated net working capital deficit was $4.6 millionat July 31, 2021, compared with $26.4 millionat July 31, 2020. Included in net working capital were cash and cash equivalents of $96.9 millionat July 31, 2021and $75.9 millionat July 31, 2020. The improvement in the net working capital deficit was primarily driven by higher cash and cash equivalents and lower accounts payable, partially offset by lower accounts receivable due to earlier customer cash receipts, reflecting our focus on cash collection, and reduced sales levels at IWCO Direct, as well as increased lease liabilities recognized due to the adoption of new accounting standards.
Sources and Uses of Cash for the Year Ended
Fiscal Year Ended
July 31, 20212020 (In thousands)
Net cash flow generated by operating activities
Net cash used in investing activities
Net cash used in financing activities
Operating Activities: Net cash provided by operating activities was
$23.1 millionfor the fiscal year ended July 31, 2021. The $48.6 milliondecrease as compared to the prior fiscal year was primarily due lower gross profits, as a result of lower sales volumes, and a reduction in funds held for clients. The Company's cash flows related to operating activities are dependent on several factors, including profitability, accounts receivable collections, effective inventory management practices and optimization of the credit terms of certain vendors of the Company, the market for outsourcing services, overall performance of the technology sector impacting the Supply Chain segment and the strength of the Direct Marketing segment. Investing Activities: Net cash used in investing activities was $3.3 millionand $11.9 millionfor the fiscal year ended July 31, 2021and 2020, respectively, and was primarily comprised of capital expenditures. The decrease in capital expenditures in the fiscal year ended July 31, 2021is primarily due to capital expenditure management as a result of the COVID-19 pandemic. Financing Activities: The $9.8 millionof cash used in financing activities during the fiscal year ended July 31, 2021was primarily due to $7.6 millionin payments of long-term debt and $2.1 millionin payment of preferred dividends. The $12.3 millionof cash used in financing activities during the fiscal year ended July 31, 2020was primarily due to $6.0 millionof net payments under revolving credit facilities, $3.2 millionin payments of long-term debt, $2.1 millionin payment of preferred dividends and $0.9 millionin payments for financing the MidCap Credit Agreement and amending the Cerberus Credit Facility.
IWCO Direct'sCIP contemplates a total investment of approximately $54.0 millionprimarily over a 24-month period. The Company estimates the CIP cost will consist of approximately: (1) $38.0 millionfor digital press and insertion equipment, and technology build out cost (of which approximately $34 millionin lease/purchase agreements were entered into subsequent to year-end), and (2) $16.0 millionfor severance, employee retention, facilities optimization, and other implementation costs. The Company currently expects approximately half of cash CIP costs will be expended within the next 12 months, however, the timing and amount of costs will depend on a number of factors.
Debt and financing terms
July 31, 2021(In thousands)
Cerberus term loan due
7.50% convertible bond at maturity
The following is a summary of the Company’s outstanding debts and financing agreements. Refer to note 7 of our consolidated financial statements for more information.
Cerberus Credit Facility
December 15, 2017, the Company entered into a Financing Agreement (the "Financing Agreement"), by and among the Company, Instant Web, LLC, a Delawarecorporation and wholly-owned subsidiary of IWCO Direct(as "Borrower"), IWCO Direct, and certain of IWCO Direct'ssubsidiaries (together with IWCO Direct, the "Guarantors"), the lenders from time to time party thereto and Cerberus Business Finance, LLC, as collateral agent and administrative agent for the lenders. Steel Connect, Inc.is not a borrower or a guarantor under the Financing Agreement. The Financing Agreement which matures on December 15, 2022, provides for a $393.0 millionterm loan facility (the "Term Loan") and a $25.0 millionrevolving credit facility (the "Revolving Facility") (together, the "Cerberus Credit Facility"). Proceeds of the Cerberus Credit Facility were used (i) to finance a portion of the Company's acquisition of IWCO Direct(the " IWCO DirectAcquisition"), (ii) to repay certain existing indebtedness of the Borrower and its subsidiaries, (iii) for working capital and general corporate purposes and (iv) to pay fees and expenses related to the Financing Agreement and the IWCO Direct Acquisition. Borrowings under the Cerberus Credit Facility bear interest, at the Borrower's option, at a Reference Rate plus 3.75% or a LIBOR Rate plus 6.5%, each as defined the Financing Agreement. The initial interest rate under the Cerberus Credit Facility is at the LIBOR Rate option. The Term Loan under the Cerberus Credit Facility is repayable in consecutive quarterly installments, each of which will be in an amount equal per quarter of $1.5 millionand each such installment to be due and payable, in arrears, on the last day of each calendar quarter commencing on March 31, 2018and ending on the earlier of (a) December 15, 2022and (b) upon the payment in full of all obligations under the Financing Agreement and the termination of all commitments under the Financing Agreement. Further, the Term Loan would be permanently reduced pursuant to certain mandatory prepayment events including an annual "excess cash flow sweep" of 50% of the consolidated excess cash flow, with a step-down to 25% when the Leverage Ratio (as defined in the Financing Agreement) is below 3.50:1.00; provided that, in any calendar year, any voluntary prepayments of the Term Loan shall be credited against the Borrower's "excess cash flow" prepayment obligations on a dollar-for-dollar basis for such calendar year. On March 30, 2020, IWCO Directentered into Amendment No. 2 to the Financing Agreement ("Amendment No. 2"). Amendment No. 2 amended the Financing Agreement to permit Borrower to defer approximately $3.0 millionin principal payments, due between March 31, 2020and June 30, 2020, until loan maturity and to forgo the payment of approximately $4.3 millionin principal payments pursuant to the excess cash flow sweep in the Financing Agreement. In addition, while Amendment No. 2 limited the total amount Borrower may distribute to the Company for management fees and tax sharing to $5.0 millionduring the calendar year ended December 31, 2020, Amendment No. 2 also amended the calculation of the excess cash flow defined in the Financing Agreement, for the same period, to eliminate any adverse impact to Borrower from the distribution limit or from the deferral of principal payments. Borrower is required to continue to make all interest payments. In addition, Amendment No. 2 amended the liquidity requirement from $15.0 millionto $14.5 million. Amendment No. 2 was part of a comprehensive precautionary approach to increase the IWCO Direct'scash position and maximize its financial flexibility in light of the volatility in the global markets resulting from the COVID-19 outbreak. Borrowings under the Financing Agreement are fully guaranteed by the Guarantors and are collateralized by substantially all the assets of the Borrower and the Guarantors and a pledge of all of the issued and outstanding equity interests of each of IWCO Direct'ssubsidiaries. The Financing Agreement contains certain representations, warranties, events of default, mandatory prepayment requirements, as well as certain affirmative and negative covenants customary for financing agreements of this type. These covenants include restrictions on borrowings, investments and dispositions, as well as limitations on the ability of the Borrower and the Guarantors to make certain capital expenditures and pay dividends. IWCO Direct'sfailure to maintain compliance with the covenants could prevent the Borrower from borrowing additional amounts and could result in a default under any of the debt agreements. Such default could cause the outstanding indebtedness to become immediately due and payable, by virtue of cross-acceleration or cross-default provisions. Upon the occurrence and during the continuation of an event of default under the Financing Agreement, the lenders under the Financing Agreement may, among other things, terminate all commitments and declare all or a portion of the loans under the Financing Agreement immediately due and payable and increase the interest rate at which loans and obligations under the Financing Agreement bear interest. If IWCO Direct'sindebtedness is accelerated, it 29 -------------------------------------------------------------------------------- Table of Contents cannot be certain that it will have sufficient funds available to pay the accelerated indebtedness (together with accrued interest and fees), or that it will have the ability to refinance the accelerated indebtedness on terms favorable to IWCO Director at all. This could have serious consequences to its financial condition, operating results and business, and could cause the Borrower to become insolvent or enter bankruptcy proceedings, and shareholders may lose all or a portion of their investment because of the priority of the claims of its creditors on its assets. During the fiscal year ended July 31, 2021, the IWCO Directdid not trigger any of these covenants. IWCO Directbelieves it will remain in compliance with the Financing Agreement's covenants for the next twelve months. While IWCO Directcurrently expects to be in compliance in future periods with all of the financial covenants, there can be no assurance that these covenants will continue to be met if the Company does not achieve its earnings and operating cash flow projections. As of July 31, 2021, and the date of the filing of this Form 10-K, IWCO Directhad the full $25.0 millionreadily available borrowing capacity under its Revolving Facility. As of July 31, 2021, the principal amount outstanding on the Term Loan was $364.3 million, and the current and long-term net carrying value of the Term Loan was $363.8 million. IWCO Directintends to refinance this debt, however its ability to refinance this debt is not guaranteed. IWCO Direct'sability to refinance this debt will depend on the capital and credit markets and our financial condition at such time. It may not be able to engage in any of these activities or engage in these activities on desirable terms, which could result in a default on its debt obligations and have a material adverse effect on the Company's financial condition and liquidity.
Senior 7.50% convertible note
February 28, 2019, the Company entered into that certain 7.50% Convertible Senior Note Due 2024 Purchase Agreement with SPHG Holdingswhereby SPHG Holdingsloaned the Company $14.9 millionin exchange for a 7.50% Convertible Senior Note due 2024 (the "SPHG Note"). The SPHG Note bears interest at the fixed rate of 7.50% per year, payable semi-annually in arrears on March 1and September 1of each year, beginning on September 1, 2019. The SPHG Note will mature on March 1, 2024(the "SPHG Note Maturity Date"), unless earlier repurchased by the Company or converted by the holder in accordance with its terms prior to such maturity date. At its election, the Company may pay some or all of the interest due on each interest payment date by increasing the principal amount of the SPHG Note in the amount of such interest due or any portion thereof (such payment of interest by increasing the principal amount of the SPHG Note referred to as "PIK Interest"), with the remaining portion of the interest due on such interest payment date (or, at the Company's election, the entire amount of interest then due) to be paid in cash by the Company. Following an increase in the principal amount of the SPHG Note as a result of a payment of PIK Interest, the SPHG Note will bear interest on such increased principal amount from and after the date of such payment of PIK Interest. SPHG Holdingshas the right to require the Company to repurchase the SPHG Note upon the occurrence of certain fundamental changes, subject to certain conditions, at a repurchase price equal to 100% of the principal amount of the SPHG Note plus accrued and unpaid interest. The Company will have the right to elect to cause the mandatory conversion of the SPHG Note in whole, and not in part, at any time on or after March 6, 2022, subject to certain conditions including that the stock price of the Company exceeds a certain threshold. SPHG Holdingshas the right, at its option, prior to the close of business on the business day immediately preceding the SPHG Note Maturity Date, to convert the SPHG Note or a portion thereof that is $1,000or an integral multiple thereof, into shares of common stock (if the Company has not received a required stockholder approval) or cash, shares of common stock or a combination of cash and shares of common stock, as applicable (if the Company has received a required stockholder approval), at an initial conversion rate of 421.2655 shares of common stock, which is equivalent to an initial conversion price of approximately $2.37per share (subject to adjustment as provided in the SPHG Note) per $1,000principal amount of the SPHG Note (the "Conversion Rate"), subject to, and in accordance with, the settlement provisions of the SPHG Note. For any conversion of the SPHG Note, if the Company is required to obtain and has not received approval from its stockholders in accordance with Nasdaq Stock Market Rule 5635 to issue 20% or more of the total shares of common stock outstanding upon conversion (including upon any mandatory conversion) of the SPHG Note prior to the relevant conversion date (or, if earlier, the 45th scheduled trading day immediately preceding the SPHG Note Maturity Date), the Company shall deliver to the converting holder, in respect of each $1,000principal amount of the SPHG Note being converted, a number of shares of common stock determined by reference to the Conversion Rate, together with a cash payment, if applicable, in lieu of delivering any fractional share of common stock based on the volume weighted average price (VWAP) of its common stock on the relevant conversion date, on the third business day immediately following the relevant conversion date. As of July 31, 2021, the net carrying value of the SPHG Note was $9.3 million. MidCap Credit Facility On December 31, 2019, ModusLink, as borrower, and certain of its subsidiaries as guarantors (the "MidCap Guarantors"), entered into a revolving credit and security agreement (the "MidCap Credit Agreement"), with MidCap Financial Trust, as lender and as agent ("MidCap"). The MidCap Credit Agreement, which expires on December 31, 2022, provides for a maximum credit commitment of $12.5 millionand a sublimit of $5.0 millionfor letters of credit. The actual maximum credit 30 -------------------------------------------------------------------------------- Table of Contents available under the MidCap Credit Agreement varies from time to time and is determined by calculating the applicable borrowing base, which is based upon applicable percentages of the values of (a) eligible accounts receivable; plus (b) the least of (i) the orderly liquidation value of eligible inventory, (ii) the value of eligible inventory based on first-in-first-out cost or market cost and other adjustments, and (iii) $4.5 million; minus (c) reserves; all as specified in the MidCap Credit Agreement. Amounts borrowed under the MidCap Credit Agreement are due and payable, together with all unpaid interest, fees and other obligations, on December 31, 2022. Generally, borrowings under the MidCap Credit Agreement bear interest at a rate per annum equal to the LIBOR Rate (as defined in the MidCap Credit Agreement), which is subject to adjustment by MidCap, plus a margin of 4% per annum. In addition to paying interest on outstanding principal under the MidCap Credit Agreement, ModusLinkis required to pay an unused line fee of 0.50% per annum. ModusLinkis also required to pay a customary letter of credit fee equal to the applicable margin on loans bearing interest at the LIBOR Rate. Obligations under the MidCap Credit Agreement are guaranteed by the MidCap Guarantors, and the MidCap Credit Agreement is secured by security interests in substantially all of the assets of ModusLinkand the MidCap Guarantors, including a pledge of all of the equity interests of each subsidiary of ModusLinkthat is a domestic entity (subject to certain limited exceptions). Steel Connect, Inc.is not a borrower or a guarantor under the MidCap Credit Agreement. The MidCap Credit Agreement includes certain representations and warranties of ModusLink, as well as events of default and certain affirmative and negative covenants that are customary for credit agreements of this type. These covenants include restrictions on borrowings, investments and dispositions by ModusLink, as well as limitations on ModusLink'sability to make certain distributions and to enter into transactions with affiliates. The MidCap Credit Agreement requires compliance with certain financial covenants providing for the maintenance of a minimum fixed charge coverage ratio, all as more fully described in the MidCap Credit Agreement. On December 9, 2020, ModusLinkentered into a First Amendment to the MidCap credit agreement ("Amendment No. 1") by and among ModusLink, certain of ModusLink'ssubsidiaries and MidCap as lender and agent. Amendment No. 1 amended the MidCap credit agreement to permit special cash dividends to be made on or prior to July 31, 2021in an aggregate amount not to exceed $50.0 million(the "Special Distributions") to the Company. Payment of the Special Distributions will eliminate the availability of the general dividend basket for the fiscal year ending July 31, 2021. Special Distributions totaling $40.0 millionwere made by ModusLinkto the Company during the fiscal year ended July 31, 2021. In addition, Amendment No. 1 incorporated a new minimum liquidity financial covenant, which required that the sum of excess availability under the MidCap credit agreement and the amount of qualified cash and cash equivalents of the borrower was not less than $3.0 millionuntil the earlier of July 31, 2021or the date on which the borrower has either distributed the maximum amount of the Special Distributions or waived the ability to make further Special Distributions. Among other things, Amendment No. 1 also increased the percentage of eligible accounts included in the borrowing base from 50% to 75% and amended the condition for borrowing of revolving loans after the effective date of Amendment No. 1 to require evidence that specified availability (the sum of excess availability and the difference between the borrowing base and the aggregate revolving loan commitments) is not less than $3.0 millionprior to giving effect to any such borrowing. On June 2, 2021, ModusLinkentered into a Second Amendment to the MidCap credit agreement ("Amendment No. 2") by and among ModusLink, certain of ModusLink'ssubsidiaries, and MidCap as lender and agent. Amendment No. 2 amended the MidCap Credit Agreement to extend the time period for payment from ModusLinkto the Company of special distributions to July 31, 2022. In addition, the unused line fee was increased to 0.65% in Amendment No. 2 and certain other technical amendments were incorporated. On July 1, 2021, ModusLinkentered into a Third Amendment to the Credit Agreement ("Amendment No. 3") which increases the effective cap on eligibility of unpaid Eligible Accounts, as defined in the Credit Agreement, from a certain obligor to $8.0 million. In addition, Amendment No. 3 amended the Credit Agreement to require disclosure by ModusLinkof certain discount payments owing to certain of its customers which are not expected to be deducted from the Borrowing Base in the future. Upon the occurrence and during the continuation of an event of default under the MidCap Credit Agreement, MidCap may, among other things, declare all obligations under the MidCap Credit Agreement immediately due and payable and increase the interest rate at which loans and other obligations under the MidCap Credit Agreement bear interest. The MidCap Credit Agreement expires on December 31, 2022. ModusLinkintends to refinance this revolving credit agreement. ModusLink'sability to refinance this revolving credit agreement will depend on the capital and credit markets and our financial condition at such time. As of and during the fiscal year ended July 31, 2021, ModusLinkwas in compliance with all financial covenants in the MidCap Credit Agreement. ModusLinkbelieves it will remain in compliance with the MidCap Credit 31 -------------------------------------------------------------------------------- Table of Contents Agreement's covenants for the next twelve months. At July 31, 2021, the Company did not have any balance outstanding under the MidCap Credit Facility and had a readily available borrowing capacity of $8.7 million.
As indicated above,
Steel Connect, Inc.(excluding its operating subsidiaries, the "Parent") is not a borrower or a guarantor under its subsidiaries' credit facilities, and these credit facilities place limits on distributions to the Parent. Under the Financing Agreement, IWCO Directis permitted to make distributions to the Parent, in an aggregate amount not to exceed $5.0 millionin any fiscal year for management service fees. The Parent is entitled to receive additional cash remittances under a tax sharing agreement from IWCO Direct; however, the total amount that IWCO Directmay distribute to the Parent for management fees and tax sharing during the calendar year ended December 31, 2020, was limited to $5.0 million. Distributions by ModusLinkto the Parent are limited to $2.0 millionin any fiscal year under the terms of the MidCap Credit Agreement; provided, however, pursuant to the MidCap Credit Agreement amendments described above the ModusLinkis permitted to make a special cash dividends to be made on or prior to July 31, 2022in an aggregate amount not to exceed $50.0 millionto the Company. Payment of this Special Distributions will eliminate the availability of the general dividend basket for the fiscal year ending July 31, 2021and July 31, 2022. Special Distributions totaling $40.0 millionwere made by ModusLinkto the Company during the fiscal year ended July 31, 2021. Distributions by ModusLinkto the Parent, other than periods in which Special Distributions are permitted, are limited to $2.0 millionin any fiscal year under the terms of the MidCap Credit Agreement. The Parent believes it has access to adequate resources to meet its needs for normal operating costs, debt obligations and working capital for at least the next twelve months; however, there can be no assurances that the Parent and its operating businesses will continue to have access to their lines of credit if their financial performance does not satisfy the financial covenants set forth in their respective financing agreements, which could also result in the acceleration of their debt obligations by their respective lenders, adversely affecting liquidity.
Off-balance sheet financing arrangements
The Company has no significant off-balance sheet financing agreements.
Our principal uses of cash will be to provide working capital, meet debt service requirements, fund capital expenditures and execute management's strategic plans including the IWCO Direct CIP. As of
July 31, 2021, we had contractual cash obligations to repay debt, to purchase goods and services and to make payments under operating and capital lease leases. As of July 31, 2021, payments due under these long-term obligations are as follows: Less than 1 More than 5 year 2-3 years 4-5 years years Total (In thousands) Debt(1) $ 6,000 $ 373,270$ - $ - $ 379,270Interest payments(2) 30,045 12,581 - - 42,626 Operating lease liabilities 15,362 17,242 13,528 14,255 60,387 Financing lease liabilities 6 114 - - 120 Preferred dividend payments 2,100 4,200 4,200 † 10,500 $ 53,513 $ 407,407 $ 17,728 $ 14,255 $ 492,903(1) Represents principal amount of debt and only includes scheduled principal payments. (2) Represents expected interest payments on debt. Interest payments based on variable interest rates were determined using the interest rate in effect as of July 31, 2021. † Holders of the Preferred Stock receive dividends at 6% per annum.
Critical accounting policies
Our significant accounting policies are discussed in Note 2 to our audited consolidated financial statements. The discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in
the United States of America. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial 32 -------------------------------------------------------------------------------- Table of Contents statements and the reported amounts of revenue and expenses during the reporting period. The most significant of these estimates and assumptions relate to: (1) revenue recognition; (2) valuation allowances for trade and other receivables and inventories; (3) the valuation of goodwill, other intangible assets and long-lived assets; (4) contingencies, including litigation reserves; (5) restructuring charges and related severance expenses; (6) litigation reserves; (7) pension obligations, (8) going concern assumptions, and (9) accrued pricing and tax related liabilities. Of the accounting estimates we routinely make relating to our critical accounting policies, those estimates made in the process of: recognition of revenue; determining the valuation of inventory and related reserves; accounting for impairment of goodwill, other intangible assets and long-lived assets; and establishing income tax valuation allowances and liabilities are the estimates most likely to have a material impact on our financial position and results of operations. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Changes in estimates are reflected in the periods in which they become known. However, because these estimates inherently involve judgments and uncertainties, there can be no assurance that actual results will not differ materially from those estimates. We believe that our critical accounting estimates have the following attributes: (1) we are required to make assumptions about matters that are uncertain and require judgment at the time of the estimate; (2) use of reasonably different assumptions could have changed our estimates, particularly with respect to recoverability of assets; and (3) changes in the estimate could have a material effect on our financial condition or results of operations. We believe the critical accounting policies below contain the more significant judgments and estimates used in the preparation of our financial statements:
• Revenue recognition • Recognition of goodwill, other intangible assets and long-term assets • Income taxes
The Company recognizes revenue from its contracts with customers primarily from the sale of marketing solutions offerings and supply chain management services. Revenue is recognized when control of the promised goods or services is transferred to a customer, in an amount that reflects the consideration the Company expects to be entitled to in exchange for those goods or services. For
IWCO Direct'smarketing solutions offerings and ModusLink'ssupply chain management services arrangements, the goods and services are considered to be transferred over time as they are performed. Taxes assessed by a governmental authority that are both imposed on and concurrent with a specific revenue-producing transaction, that are collected by the Company from a customer, are excluded from revenue.
Marketing solutions offers.
IWCO Direct'srevenue is generated through the provision of data-driven marketing solutions, primarily through providing direct mail products to customers. Revenue related to the majority of IWCO Direct'smarketing solutions contracts, which typically consist of a single integrated performance obligation, is recognized over time as the Company performs because the products have no alternative use to the Company.
Supply chain management services.
ModusLink'srevenue primarily comes from the sale of supply chain management services to its clients. Amounts billed to customers under these arrangements include revenue attributable to the services performed as well as for materials procured on the customer's behalf as part of its service to them. The majority of these arrangements consist of two distinct performance obligations (i.e, warehousing/inventory management service and a separate kitting/packaging/assembly service), revenue related to each of which is recognized over time as services are performed using an input method based on the level of efforts expended.
Other revenue consists of cloud-based software subscriptions, software maintenance and support service contracts, fees for professional services and fees for the sale of perpetual software licenses in
ModusLink'se-Business operations. Except for perpetual software licenses, revenue related to these arrangements is recognized on a straight-line basis over the term of the agreement or over the term of the agreement in proportion to the costs incurred in satisfying the obligations under the contract. Revenue from the sale of perpetual licenses is recognized at a point in time upon execution of the relevant license agreement and when delivery has taken place. 33 -------------------------------------------------------------------------------- Table of Contents Significant Judgments The Company's contracts with customers may include promises to transfer multiple products and services to a customer. Determining whether products and services are considered distinct performance obligations that should be accounted for separately versus together may require significant judgment. For arrangements with multiple performance obligations, the Company allocates revenue to each performance obligation based on its relative standalone selling price. Judgment is required to determine the standalone selling price for each distinct performance obligation. The Company generally determines standalone selling prices based on the prices charged to customers and uses a range of amounts to estimate standalone selling prices when we sell each of the products and services separately and need to determine whether there is a discount that needs to be allocated based on the relative standalone selling prices of the various products and services. The Company typically has more than one range of standalone selling prices for individual products and services due to the stratification of those products and services by customers and circumstances. In these instances, the Company may use information such as the type of customer and geographic region in determining the range of standalone selling prices. The Company may provide credits or incentives to customers, which are accounted for as variable consideration when estimating the transaction price of the contract and amounts of revenue to recognize. The amount of variable consideration to include in the transaction price is estimated at contract inception using either the estimated value method or the most likely amount method based on the nature of the variable consideration. These estimates are updated at the end of each reporting period as additional information becomes available and revenue is recognized only to the extent that it is probable that a significant reversal of any amounts of variable consideration included in the transaction price will not occur.
Accounting for principal’s income against the agent
For revenue generated from contracts with customers involving another party, the Company considers whether it maintains control of the specified goods or services before they are transferred to the customer, as well as other indicators such as the party primarily responsible for fulfillment and discretion in establishing price. Revenues are recognized on a gross basis if the Company is acting in the capacity of a principal and on a net basis if its acting in the capacity of an agent. Certain of
IWCO Direct'smarketing services revenues are presented on a net basis as it does not maintain control of the specified goods or services before they are transferred to the client nor is IWCO Directprimarily responsible for fulfillment.
Recognition of depreciation of long-term assets,
Goodwill, which is not amortized, represents the difference between the purchase price and the fair value of identifiable net assets acquired in a business combination. The Company's goodwill of $231.5 millionas of July 31, 2021relates to the Company's Direct Marketing reporting unit, which is the only reporting unit in the Direct Marketing reportable segment. We review goodwill for impairment annually in the fourth quarter and test for impairment during the year if an event occurs or circumstances change that would indicate the carrying amount may be impaired. An entity can choose between using the qualitative or Step 0 approach, or perform a quantitative test for impairment. For the Step 0 approach, an entity may assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. An entity has an unconditional option to bypass the Step 0 assessment for any reporting unit in any period and proceed directly to performing the quantitative goodwill impairment test. An entity may resume performing the Step 0 assessment in any subsequent period. For the quantitative test, the Company will calculate the fair value of a reporting unit and compare it to its carrying amount. There are several methods that may be used to estimate a reporting unit's fair value, including the income approach, the market approach and/or the cost approach. The Company generally determines the fair value of its reporting unit using a discounted cash flow valuation approach. If a potential impairment is identified, the Company will determine the amount of goodwill impairment by comparing the fair value of a reporting unit with its carrying amount. To the extent the carrying value of a reporting unit exceeds its fair value, a goodwill impairment charge is recognized. During the three months ended April 30, 2021, IWCO Directwas informed by two significant customers that they would be transitioning their direct marketing services to other providers by the end of the fiscal year ending July 31, 2021and another customer that it would have significantly lower volumes of sales in at least the fiscal quarter ending July 31, 2021. In connection with its quarterly close procedures, the Company assessed the anticipated negative impact on revenue and earnings 34 -------------------------------------------------------------------------------- Table of Contents from these changes in demand, along with the previously reported notification of another significant customer transitioning its direct marketing services to another company, and determined these factors were indicators that goodwill and other long-lived assets may be impaired. The customers whoare transitioning their direct marketing spending to other companies accounted for approximately $10.9 millionor 7.0% and $13.1 millionor 7.0% of the Company's revenues for the three months ended April 30, 2021and 2020, respectively. As a result, the Company performed an interim impairment test of Direct Marketing's goodwill and other long-lived assets as of April 30, 2021. The Company determined that the goodwill was impaired, and recorded a non-cash impairment charge of $25.7 millionfor the three months ended April 30, 2021. As of the Company's annual impairment test date on June 30, 2021, the Company performed a quantitative impairment test of goodwill. The Company calculated the fair value of the Direct Marketing reporting unit which indicated the fair value of the reporting unit exceeded its carrying value by greater than 10%, and therefore, as of June 30, 2021, there was no goodwill impairment. For each of the goodwill impairment tests performed during the year ended July 31, 2021, the fair value of the Direct Marketing reporting unit was calculated using a discounted cash flow ("DCF") model (a form of the income approach) using the Company's current projections, which are subject to various risks and uncertainties associated with its forecasted revenue, expenses and cash flows, as well as the duration and expected impact on its business from the COVID-19 pandemic. The DCF calculation was dependent on estimates for future sales, operating income, depreciation and amortization, income tax payments, working capital changes and capital expenditures, as well as expected long-term growth rates for cash flows. All of these factors are affected by economic conditions related to the industries in which the Company and its customers operate, as well as in conditions in the global capital markets. The discount rates utilized in the DCF valuation are based upon our weighted average cost of capital, which takes into account the relative weights of each component of capital structure (equity and debt) and represents the expected cost of new capital adjusted as appropriate to consider the risk inherent in future cash flows of the reporting unit. Future cash flow estimates are, by their nature, subjective, and actual results may differ materially from the Company's estimates. The Company's estimates of future cash flows are based on current economic climates, recent operating results and planned business strategies. These estimates could be negatively affected by decreased customer demand for IWCO's services, changes in regulations, further economic downturns, increased customer attrition or an inability to execute IWCO's business strategies. If the Company's ongoing cash flow projections are not met, the Company may have to record further impairment charges in future periods. Other intangible assets, net, as of July 31, 2021, include customer relationships with a gross balance of $192.7 millionand carrying balance of $115.0 million. The customer relationship intangible assets are being amortized on an accelerated basis over an estimated useful life of 15 years. Intangible assets are reviewed for impairment on an interim basis when certain events or circumstances exist. If the carrying amount of other intangible assets, net is not recoverable, the carrying amount of such assets is reduced to fair value. The Company performed a qualitative assessment of whether it was more likely than not that its other intangibles assets were impaired as of July 31, 2021. The Company reviewed its previous forecasts and assumptions based on the Company's current projections, that are subject to various risks and uncertainties, including forecasted revenues, expenses and cash flows, including the duration and extent of impact to our businesses from the COVID-19 pandemic. Based upon that assessment, the Company concluded it was not more likely than not that the other intangible assets were impaired as of July 31, 2021. In addition to goodwill and identifiable intangible assets recognized in connection with our business acquisitions, our long-lived assets also include property, plant and equipment, capitalized software development costs for software to be sold, leased or otherwise marketed, and certain long-term investments. As July 31, 2021, the consolidated carrying values of our property, plant and equipment were $58.9 million, which represented 8.7% of total assets. We review the valuation of our long-lived assets whenever events or changes in circumstances indicate that the carrying amount of these assets may not be recoverable. An impairment loss is recognized when the carrying amount of a long-lived asset exceeds its fair value or net realizable value expected to result from the asset's use and eventual disposition. We use a variety of factors to assess valuation, depending upon the asset. Long-lived assets are evaluated based upon the expected period the asset will be utilized and other factors depending on the asset, including estimated future sales, profits and related cash flows. Changes in estimates and judgments on any of these factors could have a material impact on our results of operations and financial position.
The Company has net operating loss carryforwards for federal and state tax purposes of approximately
$2.1 billionand $111.1 million, respectively, as of July 31, 2021. A 5% reduction in the Company's current valuation allowance on these federal and state net operating loss carryforwards would result in an income tax benefit of approximately $23.4 million. Income taxes are accounted for under the provisions of ASC 740, Income Taxes, using the asset and liability method whereby deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates in effect for the year in which those temporary differences are expected to be recovered or 35 -------------------------------------------------------------------------------- Table of Contents settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Deferred tax assets are reduced by a valuation allowance, if based on the weight of available evidence, it is more likely than not that some portion or all of the recorded deferred tax assets will not be realized in future periods. This methodology is subjective and requires significant estimates and judgments in the determination of the recoverability of deferred tax assets and in the calculation of certain tax liabilities. As of July 31, 2021and 2020, a valuation allowance has been recorded against the deferred tax asset in the U.S.and certain of its foreign subsidiaries since management believes that after considering all the available objective evidence, both positive and negative, historical and prospective, with greater weight given to historical evidence, it is more likely than not that these assets will not be realized. In each reporting period, we evaluate the adequacy of our valuation allowance on our deferred tax assets. In the future, if the Company is able to demonstrate a consistent trend of pre-tax income, then at that time management may reduce its valuation allowance accordingly. The Company also performs a valuation allowance scheduling exercise based on the deferred tax assets and liabilities as of July 31, 2021. From a state perspective, the Company does not have enough deferred tax assets in certain state jurisdictions to offset future income from the reversal of its deferred tax liabilities, and therefore a state deferred tax liability was recorded in the period ending July 31, 2021. In addition, the calculation of the Company's tax liabilities involves dealing with uncertainties in the application of complex tax regulations in several tax jurisdictions. The Company is periodically reviewed by domestic and foreign tax authorities regarding the amount of taxes due. These reviews include questions regarding the timing and amount of deductions and the allocation of income among various tax jurisdictions. In evaluating the exposure associated with various filing positions, we record estimated reserves for exposures. Based on our evaluation of current tax positions, the Company believes it has appropriately accrued for exposures as of July 31, 2021.
Recent accounting positions
For a discussion of new or recently adopted accounting pronouncements by the Company, see Note 2 to the consolidated financial statements found elsewhere in this Form 10-K.
Plan to preserve tax advantages
Our past operations generated significant net operating losses, or NOLs. On
March 27, 2020, the Coronavirus Aid, Relief, and Economic Security Act was enacted in response to the COVID-19 pandemic which among, other things, amends the treatment of NOLs. Under federal tax laws, for NOLs arising in tax years beginning before January 1, 2018, we generally can use any such NOLs and certain related tax credits to reduce ordinary income tax paid in our prior two tax years or on our future taxable income for up to 20 years, at which point they "expire" for such purposes. Until they expire, we can "carry forward" NOLs and certain related tax credits that we do not use in any particular year to offset taxable income in future years. For NOLs arising in tax years beginning after December 31, 2017and before January 1, 2021, we are allowed to carryback such NOLs to each of the five taxable years preceding the taxable year of such losses and generally can use any such NOLs and certain related tax credits to reduce ordinary income tax paid on our future taxable income indefinitely; however, except for NOLs generated in tax years beginning after December 31, 2017and prior to January 1, 2021(which can be carried back to reduce taxable income for the prior five tax years), any such NOLs cannot be used to reduce ordinary income tax paid in prior tax years. In addition, the deduction for NOLs arising in tax years beginning after December 31, 2020is limited to 80 percent of our taxable income for any tax year (computed without regard to the NOL deduction). NOLs arising in tax years beginning before January 1, 2018, are referred to herein as "Current NOLs." The Company had net NOL carryforwards for federal and state tax purposes of approximately $2.1 billionand $111.0 million, respectively, at July 31, 2021, substantially all of which arose in tax years ending before January 1, 2018. While we cannot estimate the exact amount of NOLs that we will be able use to reduce future income tax liability because we cannot predict the amount and timing of our future taxable income, we believe our NOLs are a very valuable asset. For more information, see "Item 1A. Risk Factors-Risks Related to Taxation-We may be unable to realize the benefits of our net operating loss carry-forwards and other tax benefits (collectively, the 'NOLs' or 'Tax Benefits')." In early 2018, Company's board of directors adopted the Protective Amendment and Tax Plan, each designed to preserve the Company's ability to utilize its NOLs, by preventing an "ownership change" within the meaning of Section 382 of the Internal Revenue Code that would impair the Company's ability to utilize its NOLs. Later that year, the stockholders of Steel Connectapproved the Protective Amendment and Tax Plan. The federal net operating losses will expire from fiscal year 2022 through 2038, and the state net operating losses will expire from fiscal year 2019 through 2039. The Company's ability to use its Tax Benefits would be substantially limited if the Company undergoes an Ownership Change. The Protective Amendment and Tax Plan are intended to prevent an Ownership Change of the Company that would impair the Company's ability to utilize its Tax Benefits. 36
Table of Contents The Protective Amendment generally restricts any direct or indirect transfer if the effect would be to (i) increase the direct, indirect or constructive ownership of any stockholder from less than 4.99 percent to 4.99 percent or more of the shares of common stock then outstanding or (ii) increase the direct, indirect or constructive ownership of any stockholder owning or deemed to own 4.99 percent or more of the shares of common stock then outstanding. Pursuant to the Protective Amendment, any direct or indirect transfer attempted in violation of the Protective Amendment would be void as of the date of the prohibited transfer as to the purported transferee (or, in the case of an indirect transfer, the ownership of the direct owner of the shares would terminate simultaneously with the transfer), and the purported transferee (or in the case of any indirect transfer, the direct owner) would not be recognized as the owner of the shares owned in violation of the Protective Amendment (the "excess stock") for any purpose, including for purposes of voting and receiving dividends or other distributions in respect of such shares, or in the case of options, receiving shares in respect of their exercise. In addition to a prohibited transfer being void as of the date it is attempted, upon demand, the purported transferee must transfer the excess stock to an agent of the Company along with any dividends or other distributions paid with respect to such excess stock. The agent is required to sell such excess stock in an arm's-length transaction (or series of transactions) that would not constitute a violation under the Protective Amendment. As part of the Tax Plan, the Board declared a dividend of one right (a "Right") for each share of common stock then outstanding. The dividend was payable to holders of record as of the close of business on
January 29, 2018. Any shares of common stock issued after January 29, 2018, will be issued together with the Rights. Each Right initially represents the right to purchase one one-thousandth of a share of newly created Series D Junior Participating Preferred Stock. Initially, the Rights will be attached to all certificates representing shares of common stock then outstanding, and no separate rights certificates will be distributed. In the case of book entry shares, the Rights will be evidenced by notations in the book entry accounts. Subject to certain exceptions specified in the Tax Plan, the Rights will separate from the common stock and a distribution date (the "Distribution Date") will occur upon the earlier of (i) ten (10) business days following a public announcement that a stockholder (or group) has become a beneficial owner of 4.99-percent or more of the shares of common stock then outstanding or (ii) ten (10) business days (or such later date as the Board determines) following the commencement of a tender offer or exchange offer that would result in a person or group becoming a 4.99 percent stockholder. Pursuant to the Tax Plan and subject to certain exceptions, if a stockholder (or group) becomes a new 4.99-percent stockholder after adoption of the Tax Plan, the Rights would generally become exercisable and entitle stockholders (other than the new 4.99-percent stockholder or group) to purchase additional shares of the Company at a significant discount, resulting in substantial dilution in the economic interest and voting power of the 4.99-percent stockholder (or group). In addition, under certain circumstances in which the Company is acquired in a merger or other business combination after a non-exempt stockholder (or group) becomes a 4.99-percent stockholder, each holder of the Right (other than the 4.99-percent stockholder or group) would then be entitled to purchase shares of the acquiring company's common stock at a discount. The Protective Amendment does not expire. The Rights are not exercisable until the Distribution Date and will expire at 11:59 p.m., on January 18, 2024, unless the Rights are earlier redeemed or exchanged as provided in the Tax Plan or the board earlier determines that the Tax Plan is no longer necessary or desirable for the preservation of the Tax Benefits. For more information, see "Item 1A. Risk Factors-Risks Related to Taxation-We may be unable to realize the benefits of our net operating loss carry-forwards and other tax benefits (collectively, the 'NOLs' or 'Tax Benefits')."
© Edgar online, source