Note A – Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with the instructions to Form 10-Q and Rule 8-03 of Regulation S-X and do not include all of the information and footnotes required by generally accepted accounting principles in the United States (“GAAP”) for complete financial statements. Refer to the consolidated financial statements of The Eastern Company (together with its consolidated subsidiaries, the “Company,” “we,” “us” or our”) and the notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 28, 2019, filed with the Securities and Exchange Commission on March 5, 2020 (the “2019 Form 10-K”), for additional information.

The accompanying condensed consolidated financial statements are unaudited. However, in the opinion of management, all adjustments (consisting only of normal recurring accruals) necessary for a fair presentation of the results of operations for interim periods have been reflected therein. Operating results for interim periods are not necessarily indicative of the results that may be expected for the full year. All intercompany accounts and transactions are eliminated.

The condensed consolidated balance sheet as of December 28, 2019 has been derived from the audited consolidated balance sheet at that date.

The Company’s fiscal year is a 52-53-week fiscal year ending on the Saturday nearest to December 31. References to 2019 or the 2019 fiscal year mean the 52-week period ended on December 28, 2019 and references to 2020 or the 2020 fiscal year mean the 53-week period ending on January 2, 2021. In a 52-week fiscal year, each quarter is 13 weeks long. In a 53-week fiscal year, each of the first two fiscal quarters and the fourth quarter are 13 weeks long, and the third fiscal quarter is 14 weeks long. References to the third quarter of 2019, the third fiscal quarter of 2019 or the three months ended September 28, 2019 mean the period from June 30, 2019 to September 28, 2019. References to the third quarter of 2020, the third fiscal quarter of 2020 or the three months ended October 3, 2020 mean the 14-week period from June 28, 2020 to October 3, 2020. References to the nine months ended September 28, 2019 or the first nine months of fiscal 2019 mean the 39-week period from December 30, 2018 to September 28, 2019. References to the nine months ended October 3, 2020 or the first nine months of 2020 mean the 40-week period from December 29, 2019 to October 3, 2020.

Certain amounts in the 2019 financial statements have been reclassified to conform with the 2020 presentation with no impact or change to previously reported net income or shareholder’s equity.

Note B – Earnings Per Share

The denominators used to calculate earnings per share are as follow:

Note C – Inventories

Inventories consist of the following components:

Note D - Goodwill

The Company maintains 12 reporting units, seven of which comprise the goodwill balance. These seven units have an aggregate carrying amount of goodwill of approximately $77.8 million as of October 3, 2020.

The Company tests its reporting units for impairment annually in December, or more frequently if events or circumstances indicate it is more likely than not that the fair value of a reporting unit is less than its carrying amount. Such events and circumstances could include, among other things, increased competition or unexpected loss of market share, significant adverse changes in the markets in which the Company operates, or unexpected business disruptions. The Company tests reporting units for impairment by comparing the estimated fair value of each reporting unit with its carrying amount. If the carrying amount of a reporting unit exceeds its estimated fair value, the Company records an impairment loss based on the difference between fair value and carrying amount not to exceed the associated carrying amount of goodwill. Determining the fair value of a reporting unit involves the use of significant estimates and assumptions. The values assigned to the key assumptions represent management’s assessment of future trends in the relevant industry and have been based on historical data from both external and internal sources.

In the second quarter of 2020, management determined that it was more likely than not that the estimated fair value of Greenwald Industries was below its carrying amount. The factors that led to this determination included additional competition, industry movement away from legacy products and intense competition in new mobile payment apps. This fundamental shift in lower cost mobile payment systems away from the higher cost electronic smart card payment systems resulted in our belief that the carrying value of Greenwald exceeded its fair value. As a result, an independent valuation was conducted which estimated that the carrying value exceeded the fair value by approximately $4.0 million. Management recognized this impairment charge in the second quarter.

In the third quarter of 2020, management performed assessments to determine if there were any events, circumstances or indicators of impairment among the Company’s reporting units as a result of the operating conditions resulting from the COVID-19 pandemic. Management concluded that the Company has not experienced any specific indicators of impairment for goodwill among its reporting units that would require additional impairment tests. There were no goodwill impairments in the third quarter of 2020.

Note E – Leases

The Company presents right-of-use (ROU) assets and lease liabilities on the balance sheet for all leases with terms longer than 12 months, in accordance with the Financial Accounting Standards Board (“FASB”) Accounting Standards Update (“ASU”) 2016-02, Leases. The Company elected to account for non-lease components as part of the lease component to which they relate. Lease accounting involves significant judgements, including making estimates related to the lease term, lease payments, and discount rate.

The Company has operating leases for buildings, warehouse and office equipment. The Company determines whether an arrangement is, or contains, a lease at contract inception. An arrangement contains a lease if the Company has the right to direct the use of and obtain substantially all of the economic benefits of an identified asset. ROU assets and lease liabilities are recognized at lease commencement based on the present value of lease payments over the lease term. Leases with an initial term of 12 months or less are not recorded on the balance sheet; we recognize lease expense for these leases on a straight-line basis over the lease term. Most leases include one or more options to renew. The exercise of lease renewal options is at our sole discretion. The Company’s option to extend certain leases ranges from 2 – 131 months. All options to extend, when it is reasonably certain the option will be exercised, have been included in the calculation of the ROU asset and lease liability.

Currently, the Company has 36 operating leases and four finance leases with a lease liability of $11,248,144 as of October 3, 2020. The finance lease arrangements are immaterial. The basis, terms and conditions of the leases are determined by the individual agreements. The leases do not contain residual value guarantees, restrictions, or covenants that could cause the Company to incur additional financial obligations. We rent or sublease a part of one real estate property to a third party. There are no related party transactions. There are no leases that have not yet commenced that could create significant rights and obligations for the Company.

Total lease expense for each of the next five fiscal years is estimated to be as follows: remainder of 2020 - $824,251; 2021 - $3,011,067; 2022 - $2,067,173; 2023 - $1,699,249; 2024 - $1,223,651and $2,422,753thereafter. The weighted average remaining lease term is 6 years. The interest rate used was 5.0%.

Note F - Debt

On August 30, 2019, the Company entered into a credit agreement with Santander Bank, N.A., for itself, People’s United Bank, National Association and TD Bank, N.A. as lenders (the “Credit Agreement”), that included a $100 million term portion and a $20 million revolving commitment portion. Proceeds of the term loan were used to repay the Company’s remaining outstanding term loan (and to terminate its existing credit facility) with People’s United Bank, N.A. (approximately $19 million) and to acquire certain subsidiaries of Big 3 Holdings, LLC (collectively “Big 3 Precision”). The term portion of the loan requires quarterly principal payments of $1,250,000for an 18-month period beginning December 31, 2019. The repayment amount then increases to $1,875,000 per quarter beginning September 30, 2021 and continues through June 30, 2023. The repayment amount then increases to $2,500,000per quarter beginning September 30, 2023 and continues through June 30, 2024. The term loan is a 5-year loan with the remaining balance due on August 30, 2024. The revolving commitment portion has an annual commitment fee of 0.25% based on the unused portion of the revolver. The revolving commitment portion has a maturity date of August 30, 2024. As of October 3, 2020, the Company has not borrowed any funds on the revolving commitment portion of the facility. The term loan bears interest at a variable rate based on the LIBOR rate plus an applicable margin of 1.25% to 2.25%, depending on the Company’s senior net leverage ratio. Borrowings under the revolving portion bear interest at a variable rate based on, at the Company’s election, a base rate plus an applicable margin of 0.25% to 1.25% or the LIBOR rate plus an applicable margin of 1.25% to 2.25%, with such margins determined based on the Company’s senior net leverage ratio. The Company’s obligations under the Credit Agreement are secured by a lien on certain of Company’s and its subsidiaries’ assets pursuant to a Pledge and Security Agreement, dated August 30, 2019 with Santander Bank, N.A., as administrative agent.

The Company’s loan covenants under the Credit Agreement require the Company to maintain a senior net leverage ratio not to exceed 4.25 to 1. In addition, the Company is required to maintain a fixed charge coverage ratio to be not less than 1.25 to 1. The Company was in compliance with all of its covenants under the Credit Agreement at October 3, 2020 and through the date of filing this Form 10-Q.

On August 30, 2019, the Company entered into an interest rate swap contract with Santander Bank, N.A., with an original notational amount of $50,000,000, which was equal to 50% of the outstanding balance of the term loan on that date. The Company has a fixed interest rate of 1.44% on the swap contract and will pay the difference between the fixed rate and LIBOR when LIBOR is below 1.44% and will receive interest when the LIBOR rate exceeds 1.44%. On October 3, 2020, the interest rate for half ($47.5 million) of the term portion was 1.66%, using a one month LIBOR rate, and 2.94% on the remaining balance ($47.5 million) of the term loan based on a one month LIBOR rate.

The interest rates under the Credit Agreement and the interest rate swap contract are susceptible to changes to the method of determining LIBOR rates and to the potential phasing out of LIBOR after 2021. Information regarding the potential phasing out of LIBOR is provided below.

On July 27, 2017, the U.K. Financial Conduct Authority announced that it intends to stop persuading or compelling banks to submit LIBOR rates after 2021. In the United States, the Federal Reserve Board and the Federal Reserve Bank of New York, in conjunction with the Alternative Reference Rates Committee, identified the Secured Overnight Financing Rate (“SOFR”) as its preferred benchmark alternative to U.S. dollar LIBOR. SOFR represents a measure of the cost of borrowing cash overnight, collateralized by U.S. Treasury securities, and is calculated based on directly observable U.S. Treasury-backed repurchase transactions. In March 2020, in response to this transition, the FASB issued ASU 2020-04, Reference Rate Reform (Topic 848) – Facilitation of the Effects of Reference Rate Reform on Financing Reporting, which provides optional expedients and exceptions for applying U.S. GAAP to contracts, hedging relationships and other transactions that reference LIBOR or another reference rate expected to be discontinued by reference rate reform, and addresses operational issues likely to arise in modifying contracts to replace discontinued reference rates with new rates. ASU 2020-04 is effective as of March 12, 2020 through December 31, 2022. The Company is evaluating the potential impact of the replacement of LIBOR, which ultimately may or may not be SOFR, from both a risk management and financial reporting perspective, as well as the guidance under ASU 2020-04. At this time, it is not possible to predict whether any such changes to LIBOR will occur, whether SOFR will attain market traction as a LIBOR replacement, whether LIBOR will be phased out or any such alternative reference rates, other than SOFR, or other reforms to LIBOR will be enacted in the United Kingdom, the United States or elsewhere or the effect that any such changes, phase-out, SOFR or other alternative reference rates, or other reforms, if they occur, would have on the amount of interest paid on the Company’s LIBOR-based borrowings. Uncertainty as to the nature of such potential changes, phase-out, SOFR or other alternative reference rates, or other reforms may materially adversely affect interest rates paid by the Company on its borrowings. Reform of, or the replacement or phasing out of, LIBOR and proposed regulation of LIBOR and other “benchmarks”, including SOFR, may materially adversely affect the amount of interest paid on the Company’s LIBOR-based borrowings and could have a material adverse effect on the Company’s business, financial condition and results of operations.

The Eastern Company 2010 Executive Stock Incentive Plan (the “2010 Plan”), for officers, other key employees, and non-employee Directors expired in February 2020.  On February 19, 2020, the board of directors of the Company adopted the Eastern Company 2020 Stock Incentive Plan (the “2020 Plan”).   On April 29, 2020, at the Company’s 2020 Annual Meeting of Shareholders, the shareholders of the Company approved and adopted the 2020 Plan.  The 2020 Plan replaced the 2010 Plan.  The Company has no other existing plan pursuant to which equity awards may be granted.

Incentive stock options granted under the 2010 Plan and the 2020 Plan must have exercise prices that are not less than 100% of the fair market value of the Company’s common stock on the dates the stock options are granted.  Restricted stock awards may also be granted to participants under the 2010 Plan and the 2020 Plan with restrictions determined by the Compensation Committee of the Company’s Board of Directors.  Under the 2010 Plan and the 2020 Plan, non-qualified stock options granted to participants will have exercise prices determined by the Compensation Committee of the Company’s Board of Directors. During the first nine months of fiscal 2020 and 2019, no stock options or restricted stock were granted that were subject to the meeting of performance measurements.  For the first nine months of fiscal 2019, the Company used several assumptions which included an expected term of 3.5 to 4 years, volatility deviation of 28.88% to 32.33% and a risk free rate of 1.42% to 2.48%.  For the first nine months of fiscal 2020, the Company used several assumptions which included an expected term of 4.0 years, volatility deviation of 38.62% and a risk free rate of 0.26% for the purposes of measuring compensation under the Black Scholes Method. 

The 2010 Plan and the 2020 Plan also permit the issuance of Stock Appreciation Rights (“SARs”).  The SARs are in the form of an option with a cashless exercise price equal to the difference between the fair value of the Company’s common stock at the date of grant and the fair value as of the exercise date resulting in the issuance of the Company’s common stock.  During the first nine months of fiscal 2020, the Company issued 44,000 SARs under the 2020 Plan, and during the first nine months of fiscal 2019, 96,000 SARs were issued under the 2010 Plan.

Stock-based compensation expense in connection with SARs previously granted to employees was approximately $85,000 and $108,000 in the third quarter of 2020 and 2019 respectively and was approximately $279,000 and $281,000 in the first nine months of fiscal years 2020 and 2019 respectively. 

As of October 3, 2020, there were 818,864 shares of Company common stock reserved and available for future grant under the 2020 Plan.

The following tables set forth the outstanding SARs for the period specified:

The following tables set forth the outstanding stock grants for the period specified:

As of October 3, 2020, outstanding SARs and grants had an intrinsic value of $558,000.

Note H – Share Repurchase Program

On May 3, 2018, the Company announced that its Board of Directors had authorized a new program to repurchase up to 200,000 shares of the Company’s common stock. The Company’s share repurchase program does not obligate it to acquire the Company’s common stock at any specific cost per share. Under this program, shares may be repurchased in privately negotiated and/or open market transactions, including under plans complying with Rule 10b5-1 under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). The Company did not repurchase any shares under its share repurchase program during the third quarter of 2020.

Note I – Revenue Recognition

The Company’s revenues result from the sale of goods and services and reflect the consideration to which the Company expects to be entitled. The Company records revenues based on a five-step model in accordance with FASB Accounting Standards Codification (“ASC”) Topic 606, “Revenue from Contracts with Customers.” The Company has defined purchase orders as contracts in accordance with ASC Topic 606. For its customer contracts, the Company identifies its performance obligations, which are delivering goods or services, determines the transaction price, allocates the contract transaction price to the performance obligations (when applicable), and recognizes the revenue when (or as) the performance obligation is transferred to the customer. A good or service is transferred when the customer obtains control of that good or service. The Company’s revenues are recorded at a point in time from the sale of tangible products. Revenues are recognized when products are shipped.

Customer volume rebates, product returns, discount and allowance are variable consideration and are recorded as a reduction of revenue in the same period that the related sales are recorded. The Company has reviewed the overall sales transactions for variable consideration and has determined that these costs are not material.

Refer to Note L for revenues reported by segment. Refer to Note D for a discussion of goodwill impairment. The Company has no future performance obligations and does not capitalize costs to obtain or fulfill contracts.

Note J - Income Taxes

The Company files income tax returns in the U.S. federal jurisdiction, and in various states and foreign jurisdictions. With limited exceptions, the Company is no longer subject to U.S. federal, state and local income tax examinations by tax authorities for years before 2015 and is no longer subject to non-U.S. income tax examinations by foreign tax authorities for years prior to 2013.

In December 2019, the FASB issued ASU 2019-12, Simplifying the Accounting for Income Taxes. The changes implemented in ASU 2019-12 include removing exceptions to incremental intraperiod tax allocation of losses and gains from different financial statement components, exceptions to the method of recognizing income taxes on interim period losses and exceptions to deferred tax liability recognition related to foreign subsidiary investments. In addition, ASU 2019-12 requires that entities recognize franchise tax based on an incremental method, requires an entity to evaluate the accounting for step-ups in the tax basis of goodwill as inside or outside of a business combination, and removes the requirement to allocate the current and deferred tax provision among entities in standalone financial statement reporting. The ASU also now requires that an entity reflect enacted changes in tax laws in the annual effective rate, and other codification adjustments have been made to employee stock ownership plans. For public business entities, the amendments in ASU 2019-12 are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2020. Early adoption of ASU 2019-12 is permitted, including adoption in any interim period for public business entities for periods for which financial statements have not yet been issued. The Company will adopt ASU 2019-12 in 2021.

Note K - Retirement Benefit Plans

The Company has non-contributory defined benefit pension plans covering most U.S. employees. Plan benefits are generally based upon age at retirement, years of service and, for the plan covering salaried employees, the level of compensation. The Company also sponsors unfunded non-qualified supplemental retirement plans that provide certain former officers with benefits in excess of limits imposed by federal tax law.

The Company also provides health care and life insurance for retired salaried employees in the United States who meet specific eligibility requirements.

Note L – Segment Information

For the third quarter of 2020, financial information by segment is as follows: