AMERICAN VANGUARD CORP (AVD) FY 2022 MD&A

ITEM 7 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

FORWARD-LOOKING STATEMENTS/RISK FACTORS:

The Company, from time-to-time, may discuss forward-looking statements including assumptions concerning the Company’s operations, future results and prospects. Generally, “may,” “could,” “will,” “would,” “expect,” “believe,” “estimate,” “anticipate,” “intend,” “continue” and similar words identify forward-looking statements. Forward-looking statements appearing in this Report are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are based on our current expectations and are subject to risks and uncertainties that can cause actual results and events to differ materially from those set forth in or implied by the forward-looking statements and related assumptions contained in the entire Report. Such factors include, but are not limited to: product demand and market acceptance risks; the effect of economic conditions; weather conditions; changes in regulatory policy; the impact of competitive products and pricing; changes in foreign exchange rates; product development and commercialization difficulties; capacity and supply constraints or difficulties; availability of capital resources; general business regulations, including taxes and other risks as detailed from time-to-time in the Company’s reports and filings filed with the U.S. Security and Exchange Commission (“SEC”). It is not possible to foresee or identify all such factors. We urge you to consider these factors carefully in evaluating the forward-looking statements contained in this Report.

The discussion and analysis of our financial condition and results of operations for 2022, as compared to 2021 appears below. As permitted by SEC rules, we have omitted the discussion and analysis of our financial condition and results of operations for 2021 compared to 2020. See Item 7, “Management’s Discussions and Analysis of Financial Condition and Results of Operations”, in our Annual Report on Form 10-K for the year ended December 31, 2021, for this discussion.

MANAGEMENT OVERVIEW

The Company’s performance in 2022 was stronger in most all respects as compared to the prior year. The domestic agricultural economy continued its second upcycle year following a multi-year downcycle that concluded at the end of 2020. With that trend, commodity prices for many crops, including corn, soybeans and cotton, rose and remained strong. Further, with greater confidence in the post-pandemic agricultural and chemical market and improved availability within the shipping industry, growers and distribution relaxed their procurement patterns from a mode of ordering months in advance of the planting season (in 2021) to more of a just-in-time approach (in 2022). While the Company had enjoyed a strong growth trajectory for the first three quarters of 2022, that curve flattened during the fourth quarter, as temporary supply chain disruptions (described below) prevented the production and sale of the Company’s leading corn soil insecticide during that period. It is also worth noting that, while shipping services had become more readily available during 2022, the cost of freight rose to its highest point since the start of the pandemic. We expect that those costs will recede to more normalized levels in 2023.

In summary, net sales for 2022 rose 9%, as compared to 2021 (to $609,615 from $557,676), and net income was up about 43% (to $26,618 from $18,587). Operating income rose 31% (to $40,651 in 2022 from $30,946 in 2021). With respect to our businesses, net sales of our U.S. Crop rose by 9%, while gross profit rose 22%. In the U.S., non-Crop net sales declined by 2%, while gross profit dropped by 6%. Our international business increased net sales by 13% and gross profit by 9%.

As a result of the sales dynamics just described, gross profit during 2022 was approximately 13% above that of 2021 ($241,352 vs. $214,047). Further, gross profit when expressed as a percentage of sales was 40%, as compared to 38% in the prior year. Operating expenses increased by 10% ending at $200,701 as compared to $183,272 in 2021. Further, operating expenses (which include outbound freight) as a percent of net sales remained flat at 33%, as compared to 2021.

Despite numerous increases in the interest rate by the Federal Open Market Committee over the course of the year, our interest expense remained approximately even with that of the prior year ($3,954 in 2022 vs. $3,687 in 2021). This performance was due to timing of our borrowings, continued strong cash generated from increased sales, continued focus on working capital management and a high level of participation by customers in our prepayment programs. For 2022, our effective tax rate decreased (at 23.8% in 2022 vs. 30.1% in 2021). Our net income was $27,404 in 2022, as compared to $18,587 in 2021, which represents an increase of about 47%.

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When considering the consolidated balance sheets, long-term debt decreased to $51,477 as of December 31, 2022, from $52,240 as of December 31, 2021. The decreased level of debt was driven by the Company’s strong cash management during 2022, including a continued strong response from the Company’s largest customers to our early-pay programs, offset by the decision to repurchase $34,002 of the Company's stock. The Company’s liquidity position improved to $200,372 as of December 31, 2022, as compared to $178,705 as of December 31, 2021.

Results of Operations

2022 Compared with 2021:

Net sales of our U.S. crop business were about 9% higher than those of the prior year ($288,624 vs. $263,632). With the second full year of high commodity prices and a strong farm economy, the Company experienced strong demand for its crop protection products. The pacing of procurement practices in the distribution channel, however, relaxed from advance purchasing in 2021 (for the 2021-2022 season) to more of a just-in-time approach in 2022 (for the 2022-2023 season). The Company experienced strong sales of its corn products, particularly soil insecticides and post-emergent herbicides (Impact, Impact Core, Sinate, and Impact Z) notwithstanding a 20% drop in sales of our leading corn soil insecticide, Aztec, which we were unable to make and sell in the fourth quarter of 2022, due to unavailability of a key intermediate from both a domestic supplier (which experienced capacity constraints) and a China-based supplier (which experienced widespread COVID infection followed by a temporary shutdown). With respect to our cotton products, strong commodity prices stimulated demand for our Bidrin foliar insecticides and Folex harvest defoliant, which together generated sales that were up 33%, as compared to those of 2021. We also recorded stronger sales of our soil fumigants (for use on a wide range of fruit and vegetables), Thimet (for use of peanuts and sugar beets), our herbicide, Dacthal (for use on high-value crops, including onions) and our soybean herbicide products.

Cost of sales within the domestic crop business was flat compared to 2021, on sales that increased 9%, gross profit improved by 21% ($132,509 in 2022 vs. $109,568 in 2021), and gross margin was 46% of sales as compared to 42% last year.

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Net sales of our U.S. non-crop business were down about 2% ($76,709 in 2022 vs. $78,605 in 2021). This decline was driven primarily by the nationwide consumer pest-control market, which dropped by 30% year-over-year, due to US workers returning to the workplace post-COVID. Net sales from our OHP nursery and ornamental business were about even with those of 2021, as US consumer demand for plant materials remained level. During 2022, we posted relatively flat Dibrom® mosquito adulticide sales. By contrast, sales of insecticides for commercial applications rose during the year, as the professional pest-control market began to regain its footing. Finally, TyraTech/Envance extended the scope of a license agreement in 2021 and benefited from a one-time non-refundable up-front fee.

Cost of sales in our U.S. non-crop business remained flat with the prior year and gross profit decreased by 6% (to $35,257 in 2022 from $37,443 in 2021), and gross margin percentage decreased to 46% in 2022, as compared to 48% in 2021.

Net sales of our international businesses increased by 13% in 2022 ($244,282 vs. $215,439 in 2021). During 2022, our international group continued to successfully integrate two important new businesses, AgNova in Australia, and Agrinos biological products in more than a half dozen countries worldwide. We enjoyed strong demand for our soil fumigants, particularly in Mexico and Australia, and experienced increased sales of our Counter nematicide in Brazil. Further, we experienced higher sales in our AgriCenter Central American distribution business and achieved a record $100 million in net sales from our LATAM region. Expansion of our Green Solutions product portfolio has significantly enhanced our penetration of international markets and drawn us much closer to many key customers.

Cost of sales in our international business increased by 15% (to $170,696 in 2022 from $148,403 in 2021) on sales that increased 13%, gross profit rose 10% from the prior year (to $73,586 in 2022 from $67,036 in 2021), and gross margin percentage ended at 30% in 2022, as compared to 31% in 2021.

Operating expenses (which include outbound freight costs) increased by $17,429 in 2022, to $200,701 or 33% of net sales, as compared to $183,272 or 33% in 2021. The differences in operating expenses by department are as follows:

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Selling expenses increased by 6% to $52,512 for the year ended December 31, 2022, as compared to $49,409 in 2021. This included increased costs associated with travel expenses (as the in-person business interactions with customers continue to increase), inflation related increased wages, increased spending on advertising and promoting the Company’s products, and the cost of commissions associated with sales growth in Brazil. These increased costs were somewhat offset by beneficial exchange rate movement in key currencies.

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General and administrative expenses increased by 8% to $51,671 for the year ended December 31, 2022, as compared to $47,971 in 2021. The main drivers were the net increase in short-term and long-term incentive compensation, as a result of improved financial performance and increased bad debt expenses related to our businesses in Central America. In addition, wages, travel expense and other administrative costs increased in support of our growing business.

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The Company spent $1,785 in fees associated with our Proxy defense activities; there were no such fees in the comparative period of the prior year.

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Research, product development and regulatory expenses increased by 10% to $31,816 in 2022, as compared to $28,855 in 2021. The main drivers were increases in our product development costs, primarily resulting from increased international regulatory activities and work in support of our SIMPAS/ULTIMUS technology platform. In addition, wages and travel expenses increased in support of our growing business.

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Freight, delivery and warehousing costs for the year ended December 31, 2022, increased by 13% (on sales up 9%) to $48,964, as compared to $43,324 in 2021. This is mainly due to increases in freight rates, and changes in volume, product mix and customer destinations. When expressed as a percentage of sales, freight costs remained essentially flat at 8% of net sales.

In July 2020, the Company made a strategic investment in Clean Seed Inc. (Clean Seed) in the amount of $1,190. The investment is carried at fair value on the Company’s consolidated balance sheets. The Company recorded losses to Clean Seed’s fair value in the amount of $732 and $391 in 2022 and 2021, respectively.

In February 2016, AMVAC BV made an equity investment of $3,283 in Biological Products for Agriculture (“Bi-PA”). The Company has elected to measure the investment at cost less impairment, if any, and to record an increase or decrease for changes resulting from observable price changes in orderly transactions for the identical or a similar investment of Bi-PA. The Company recorded an impairment in the amount of $399 during the year ended December 31, 2021. No impairment was recorded for the year ended December 31, 2022.

Net interest expense was $3,954 in 2022, as compared to $3,687 in 2021. Interest costs are summarized in the following table:

The Company’s average debt for the year ended December 31, 2022, was $134,158, as compared to $142,238 for the year ended December 31, 2021. The decrease in average debt can be attributed to improved cash management, partially offset by the Company repurchasing $34,002 of its common stock. On a gross basis, after adjustments related to capitalized interest and expenses related to the amortization of deferred liabilities, our effective interest rate on our working capital revolver increased to 2.9%, as compared to 2.4% in 2021 due to increases in the LIBOR rate driven by U.S. fiscal policy.

Our provision for income taxes for 2022 was $8,561, as compared to $8,166 for 2021. The effective tax rate for 2022 was 23.8%, as compared to 30.1% in 2021. The decrease of the effective tax rate in 2022, as compared to 2021, was primarily due to a non-cash charge related to a valuation allowance associated with a deferred tax asset in Brazil established in 2021.

The Company is subject to U.S. federal income tax as well as to income tax in multiple state jurisdictions. Federal income tax returns of the Company are subject to Internal Revenue Service (“IRS”) examination for the 2019 through 2021 tax years. State income tax returns are subject to examination for the 2018 through 2021 tax years. The Company has other foreign income tax returns subject to examination.

Net income was $27,404 or $0.94 per basic share and $0.92 per diluted share in 2022, as compared to $18,587 or $0.62 per basic share and $0.61 per diluted share in 2021.

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Liquidity and Capital Resources

The Company generated $57,105 of cash from operating activities during the year ended December 31, 2022, as compared to $86,361 in the prior year. Included in the $57,105 are net income of $27,404, plus non-cash depreciation, amortization of intangibles and other long-term assets in the amount of $25,711, loss on disposal of property, plant and equipment of $268, amortization of deferred loan fees and discounted liabilities of $289, provision for bad debts in the amount of $1,171, provision for inventory obsolescence in the amount of $340, and revisions of contingent consideration of $610. In addition, stock-based compensation of $5,684, change in fair value of investments of $732, change in value of deferred income taxes of $5,278, change in liabilities for certain tax positions or unrecognized tax benefits of $1,441, non-cash lease expense of $68 and net foreign currency adjustment of $29, resulted in net cash provided by operating activities (prior to changes in assets and liabilities associated with operations, net of business combinations) of $55,529 as compared to $50,989 for the same period of 2021.

The Company’s working capital increased by $3,027 at December 31, 2022, as comparted to the prior year ($121,966 compared to $118,939). Accounts receivables increased by $6,447, inventories increased by $29,560, tax receivable, net increased by $4,910, and prepaid expenses increased by $3,082. Deferred revenue increased by $47,551, driven by customer decisions to make early payments in return for early cash incentive programs. Our accounts payable balances increased by $1,704, program accruals decreased by $2,449 and other payables and accrued expenses increased by $90. The Company also paid $1,321 in contingent consideration (in addition to $68 included in cash used in financing activities).

With regard to our program accrual, the year-over-year change is primarily driven by the mix of product line sales and customers in 2022, as compared to the prior year. The Company accrues programs in line with the growing season upon which specific products are targeted. Most of our programs relate to domestic sales. Typically, domestic crops have a growing season that ends on August 31st of each year. During 2022, the Company made accruals in the amount of $111,649 and made payments in the amount of $114,151. During 2021, the Company made accruals in the amount of $99,482 and made payments in the amount of $81,678.

Because the estimate for the program accrual is a material component of the Company’s overall financial performance, the Company believes that the process it uses is critical in setting the accrual at the appropriate level. The Company’s process for developing the estimate involves a detailed review of each related transaction and includes the input of a significant number of senior employees to enable the Company to set the accrual using consistently applied judgements, subject to the particular circumstances of any individual transaction.

Cash used for investing activities amounted to $14,470 for the year ended December 31, 2022, as compared to $20,042 in 2021. In 2022, the Company spent $13,261 on capital expenditures primarily focused on continuing to invest in manufacturing infrastructure to expand production efficiency and capabilities. In addition, the Company made a payment of $1,000 to Clean Seed to amend a license agreement under which royalty-bearing license rights were converted to fully paid-up, royalty-free, perpetual license rights, and spent $293 on registrations and patents. In 2021, the Company spent $10,524 in business and product acquisitions including intangible assets, goodwill, working capital and fixed assets as well as patent application costs, and $9,518 on capital expenditures primarily focused on our manufacturing facilities.

During the year ended December 31, 2022, financing activities used $38,260, as compared to $65,871 during the prior year. This included making repayments of $254,000 and borrowings of $253,000 on the Company’s senior credit facility during the year ended December 31, 2022. During 2021, the Company made repayments in the amount of $186,569 and borrowings of $131,000. During 2022, the Company paid dividends to stockholders amounting to $2,787, as compared to $2,382 in 2021. Furthermore, the Company paid contingent consideration in the amount of $68 (in addition to the $1,321 included in cash provided by operating activities) and $1,301 for the years ended December 31, 2022 and 2021, respectively. Finally, the Company used $34,002 to repurchase common stock in 2022, as compared to $4,579 in 2021.

The Company has long-term debt as of December 31, 2022 and 2021 relating to a revolving line of credit as summarized in the following table:

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The Company’s main bank is Bank of the West, a wholly owned subsidiary of BMO Financial Group. Bank of the West has been the Company’s bank for more than 30 years and is the syndication manager for the Company’s loans.

The Company and certain of its affiliates are parties to a revolving line of credit agreement entitled the “Third Amended and Restated Loan and Security Agreement” dated as of August 5, 2021 (the “Credit Agreement”), which is a senior secured lending facility among AMVAC, the Company’s principal operating subsidiary, as Borrower Agent (including the Company and AMVAC BV), as Borrowers, on the one hand, and a group of commercial lenders led by Bank of the West as administrative agent, documentation agent, syndication agent, collateral agent and sole lead arranger, on the other hand. The Credit Agreement consists of a line of credit of up to $275,000, an accordion feature of up to $150,000, a letter of credit and swingline sub-facility (each having limits of $25,000) and has a maturity date of August 5, 2026. The Credit Agreement amends and restates the previous credit facility, which had a maturity date of June 30, 2022. With respect to key financial covenants, the Credit Agreement contains two: namely, borrowers are required to maintain a Total Leverage (“TL”) Ratio of no more than 3.5-to-1, during the first three years, stepping down to 3.25-to-1 as of September 30, 2024, and a Fixed Charge Coverage Ratio of at least 1.25-to-1. In addition, to the extent that it completes acquisitions totaling $15 million or more in any 90-day period, AMVAC may step-up the TL Ratio by 0.5-to-1, not to exceed 4.00-to-1, for the next three full consecutive quarters. Acquisitions below $50 million do not require Agent consent.

The Company’s borrowing capacity varies with its financial performance, measured in terms of Consolidated EBITDA as defined in the Credit Agreement, for the trailing twelve-month period. Under the Credit Agreement, revolving loans bear interest at a variable rate based, at borrower’s election with proper notice, on either (i) LIBOR plus the “Applicable Margin” which is based upon the Total Leverage (“TL”) Ratio (“LIBOR Revolver Loan”) or (ii) the greater of (x) the Prime Rate, (y) the Federal Funds Rate plus 0.5%, and (z) the Daily One-Month LIBOR Rate plus 1.00%, plus, in the case of (x), (y) or (z) the Applicable Margin (“Adjusted Base Rate Revolver Loan”). Interest payments for LIBOR Revolver Loans are payable on the last day of each interest period (either one-, three- or six- months, as selected by the borrower) and the maturity date, while interest payments for Adjusted Base Rate Revolver Loans are payable on the last business day of each month and the maturity date. The interest rate on December 31, 2022, was 5.67%.

At December 31, 2022, according to the terms of the Credit Agreement, as amended, and based on our performance against the most restrictive covenant listed above, the Company had the capacity to increase its borrowings by up to $200,372. This compares to an available borrowing capacity of $178,705 as of December 31, 2021. The level of borrowing capacity is driven by three factors: (1) our financial performance, as measured in EBITDA for trailing twelve-month period, (2) the inclusion of proforma EBITDA related to acquisitions completed during the preceding twelve months and (3) the leverage covenant (being the number of times EBITDA the Company may borrow under its credit facility agreement).

The Company and the Lenders entered into an amendment to the Credit Agreement (“Amendment”), effective March 9, 2023, whereby LIBOR was replaced by SOFR with a credit spread adjustment of 10.0 bps for all SOFR periods. The revolving loans now bear interest at a variable rate based at borrower’s election with proper notice, on either (i) SOFR plus 0.1% per annum and the “Applicable Margin” or (ii) the greater of (x) the Prime Rate, (y) the Federal Funds Rate plus 0.5%, and (z) the Daily One-Month SOFR Rate plus 1.10%, plus, in the case of (x), (y) or (z) the Applicable Margin (“Adjusted Base Rate Revolver Loan”). In addition, the Amendment waived the minimum fixed charge coverage ratio (“FCCR”) requirement for the year ended December 31, 2022, and adjusted the terms of the FCCR for the periods ending March 31, 2023 and June 30, 2023. The Company was in compliance with all other debt covenants as of December 31, 2022.

We believe that the combination of our cash flows from future operations, current cash on hand and the availability under the Company’s credit facility will be sufficient to meet our working capital and capital expenditure requirements and will provide us with adequate liquidity to meet our anticipated operating needs for at least the next 12 months from the issuance of the Annual Report. Although operating activities are expected to provide cash, to the extent of growth in the future, our operating and investing activities will use cash and, consequently, this growth may require us to access some or all of the availability under the credit facility. It is also possible that additional sources of finance may be necessary to support additional growth.

Substantially all the Company’s assets are pledged as collateral under the Credit Agreement, as amended.

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Recently Issued Accounting Guidance

Please refer to Note 3 of the Notes to the Consolidated Financial Statements in Part II, Item 8 of this Annual Report for recently issued and adopted accounting standards.

Foreign Exchange

The Company faces market risk to the extent that changes in foreign currency exchange rates affect our non-U.S. dollar functional currency for some of our foreign subsidiaries’ revenues, expenses, assets and liabilities. We currently do not engage in hedging activities with respect to such exchange rate risks.

Assets and liabilities outside the U.S. are located in regions where we have subsidiaries or joint ventures: Central America, South America, North America, Europe, Asia, and Australia. Our investments in foreign subsidiaries and joint ventures with a functional currency other than the U.S. dollar are generally considered long-term. Accordingly, we do not hedge these net investments.

Inflation

Management believes inflation has had minimal impact on the Company's operations during the past two years. The Company is working diligently with its critical raw material suppliers to control inflationary pressures, conducting contract negotiations with focus on the following: reducing or delaying price increases due to higher environmental costs from suppliers mainly in China and India, managing the tariff impacts by sourcing and leveraging alternate geographies where possible, and lastly, monitoring strengths of the U.S. dollar vs other currencies in order to secure benefits and balance tariff effects. The Company recognizes there is long-term pressure on demand for raw materials in the developing world and is utilizing its expertise to minimize inflationary pressure. The Company has been able to push back on many of the proposed price increases for actives and intermediates that are shipped to our U.S. factories, to either avoid, minimize or forestall them. In response to inflation and other factors that have increased the cost of goods and services, the Company has successfully implemented price increases on its products.

CRITICAL ACCOUNTING ESTIMATES

Certain of the Company’s policies require the application of judgment by management in selecting the appropriate assumptions for calculating financial estimates. These judgments are based on historical experience, terms of existing contracts, commonly accepted industry practices and other assumptions that the Company believes are reasonable under the circumstances. These estimates and assumptions are reviewed periodically, and the effects of revisions are reflected in the consolidated financial statements in the period that revisions are determined to be necessary. Actual results may differ from these estimates under different outcomes or conditions.

The Company’s critical accounting policies and estimates include:

Revenue Recognition — Revenues from sales are recognized at the time control is transferred to the customer. This is typically the case when the customer has made the fixed commitment to purchase the goods, the products are shipped per the customer’s instructions, the sales price can be identified, and collection is probable. The Company has adopted procedures to ensure that revenues are recognized when earned. The procedures are subject to management’s review and from time-to-time certain revenues are excluded until it is clear that the title has passed and there is no further recourse to the Company. We also have some arrangements whereby revenues are recognized over time for certain products that are deemed to have no alternative use accompanied by an enforceable right to payment for performance completed to date. From time-to-time, the Company may offer a program to eligible customers, in good standing, that provides extended payment terms on a portion of the sales on selected products. The Company analyzes these extended payment programs in connection with its revenue recognition policy to ensure all revenue recognition criteria are satisfied at the time of sale. The Company also earns royalty income from its licensing arrangements which qualify as functional licenses rather than symbolic licenses. Upon signing a new licensing agreement, we typically receive up-front fees, which are generally characterized as non-refundable royalties. These fees are recognized as revenue upon the execution of the license agreements. Minimum royalty fees are recognized once the Company has an enforceable right for payment. Sales-based royalty fees are typically

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recognized when the sales occur. We calculate and accrue estimated royalties based on the agreement terms and correspondence with the licensees regarding actual sales.

Accrued Program Costs— The Company offers various discounts to customers based on the volume purchased within a defined period, other pricing adjustments, some grower volume incentives or other key performance indicator driven payments made to distributors, retailers or growers, usually at the end of a growing season. The Company describes these payments as “Programs.” Programs are a critical part of doing business in both the U.S. crop and non-crop chemicals marketplaces. These discount Programs represent variable consideration. Revenues from sales are recorded at the net sales price, which is the transaction price, less an estimate of variable consideration. Variable consideration includes amounts expected to be paid to its customers using the expected value method. Each quarter management compares individual sale transactions with Programs to determine what, if any, estimated Program liabilities have been incurred. Once this initial calculation is made for the specific quarter, sales and marketing management, along with executive and financial management, review the accumulated Program balance and, for volume driven payments, make assessments of whether or not customers are tracking in a manner that indicates that they will meet the requirements set out in agreed upon terms and conditions attached to each Program. Following this assessment, management will adjust to the accumulated accrual to properly reflect the Company’s best estimate of the liability at the balance sheet date. Programs are paid out predominantly on an annual basis, usually in the final quarter of the financial year or the first quarter of the following year.

Allowance for Doubtful Accounts or Current Expected Credit Losses —The Company maintains an allowance to cover its Current Expected Credit Losses ("CECL") on its trade receivables, other receivables and contract assets arising from the failure of customers to make contractual payments. The Company estimates credit losses expected over the life of its trade receivables, other receivables and contract assets based on historical information combined with current conditions that may affect a customer’s ability to pay and reasonable and supportable forecasts. In most instances, the Company’s policy is to write-off trade receivables when they are deemed uncollectible. The vast majority of the Company's trade receivables, other receivables and contract assets are less than 365 days. Under the CECL impairment model, the Company develops and documents its allowance for credit losses on its trade receivables based on multiple portfolios. The determination of portfolios is based primarily on geographical location, type of customer and aging.

Inventories — The Company values its inventories at lower of cost or net realizable value. Cost is determined by the first-in, first-out (“FIFO”) or average cost method, including, as appropriate, raw materials, labor, factory overhead and subcontracting services. The Company writes down its inventory to the net realizable value following assessments of slow moving and obsolete inventory and other annual adjustments to ensure that our standard costs continue to closely reflect actual manufacturing cost.

Leases —The Company has operating leases for warehouses, manufacturing facilities, offices, cars, railcars and certain equipment. The Company recognizes operating lease right-of-use (ROU) assets and lease liabilities for all leases. The Company measures ROU assets throughout the lease term at the carrying amount of the lease liability, plus initial direct costs, plus (minus) any prepaid (accrued) lease payments, less the unamortized balance of lease incentives received. The lease liabilities are measured at the present value of the unpaid lease payments at the lease commencement date. Leases that include both lease and non-lease components are accounted for as a single lease component for each asset class, except for warehouses. The minimum payments under operating leases are recognized on a straight-line basis over the lease term in the consolidated statements of operations. Operating lease expenses related to variable lease payments are recognized in cost of sales or as operating expenses in a manner consistent with the nature of the underlying lease and as the events, activities, or circumstances in the lease agreement occur. Leases with a term of less than 12 months are not recognized on the consolidated balance sheets, and the related lease expenses are recognized in the consolidated statements of operations on a straight-line basis over the lease term. The accounting for leases requires management to exercise judgment and make estimates in determining the applicable discount rate, effective lease term and payments due under a lease. Most of our leases do not provide an implicit interest rate, nor is it available to us from our lessors. As an alternative, we use our estimated incremental borrowing rate, which is derived from information available at the lease commencement date, including publicly available data, in determining the present value of lease payments. We also estimated the fair value of the lease and non-lease components for some of our warehouse leases based on market data and cost data. The lease term includes the non-cancellable period of the lease plus any additional periods covered by either an option to extend (or not terminate) that the Company is reasonably certain to exercise. The Company has leases with a lease term ranging from 1 year to 20 years. The operating leases of the Company do not contain major restrictions or covenants such as those relating to dividends or additional financial obligations. Finance leases are immaterial to the consolidated financial statements.

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Intangible Assets—The primary identifiable intangible assets of the Company relate to assets associated with its product and business acquisitions. All of the Company’s intangible assets have finite lives and are amortized. The estimated useful life of an identifiable intangible asset is based upon a number of factors including the effects of demand, competition, and expected changes in the marketability of the Company’s products.

Business Combinations—The Company uses its best estimates and assumptions to assign fair value to the tangible and intangible assets acquired and liabilities assumed at the acquisition date. The Company’s estimates are inherently uncertain and subject to refinement. During the measurement period, which may be up to one year from the acquisition date, the Company may record adjustments to the fair value of these tangible and intangible assets acquired and liabilities assumed, with the corresponding offset to goodwill or an adjustment to the gain from a bargain purchase. In addition, uncertain tax positions and tax-related valuation allowances are initially recorded in connection with a business combination as of the acquisition date. The Company continues to collect information and reevaluates these estimates and assumptions quarterly and records any adjustments to the Company’s preliminary estimates to goodwill provided that the Company is within the measurement period. Upon the conclusion of the measurement period or final determination of the fair value of assets acquired or liabilities assumed, whichever comes first, any subsequent adjustments are recorded to the Company’s consolidated statement of operations.

From time to time, certain of our acquisition agreements include contingent earn-out arrangements, which are generally based on the achievement of future income thresholds. The fair values of these earn-out arrangements are included as part of the purchase price of the acquired companies on their respective acquisition dates. For each transaction, we estimate the fair value of contingent earn-out payments as part of the initial purchase price and record the estimated fair value of contingent consideration as a liability on the consolidated balance sheets.

We review and re-assess the estimated fair value of contingent consideration on a quarterly basis until the contingent period ends, and the updated fair value could be materially different from the initial estimates or prior quarterly amounts. Changes in the estimated fair value of our contingent earn-out liabilities are reported in operating results.

Asset Acquisitions—If an acquisition of an asset or group of assets does not meet the definition of a business, the transaction is accounted for as an asset acquisition rather than a business combination. An asset acquisition does not result in the recognition of goodwill and transaction costs are capitalized as part of the cost of the asset or group of assets acquired. The Company uses its best estimates and assumptions to assign fair value to the tangible and intangible assets acquired and liabilities assumed at the acquisition date. The acquisitions costs are allocated to the assets acquired on a relative fair value basis. From time to time, certain of our acquisition agreements include contingent earn-out arrangements, which are recognized only when the contingency is resolved, and the consideration is paid or becomes payable.

Impairment—The carrying values of long-lived assets other than goodwill are reviewed for impairment annually and/or whenever events or changes in circumstances indicate that the carrying value of such assets may not be recoverable. In such circumstances, the Company evaluates recoverability of an asset group by comparing the carrying value to the future undiscounted cash flows that it expects to generate from the asset group. If the comparison indicates that the carrying value of an asset group is not recoverable, measurement of the impairment loss is based on the fair value of the asset.

The Company reviews goodwill for impairment utilizing either a qualitative or quantitative assessment. If the Company decides that it is appropriate to perform a qualitative assessment and concludes that the fair value of a reporting unit more likely than not exceeds its carrying value, no further evaluation is necessary. If the Company performs a quantitative assessment, the Company compares the fair value of a reporting unit with its carrying values and recognizes an impairment charge for the amount that the carrying amount exceeds the reporting unit’s fair value. The Company annually tests goodwill for impairment at the beginning of the fourth quarter, or earlier if triggering events occur.

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Fair Value of Financial Instruments—The accounting standard for fair value measurements provides a framework for measuring fair value and requires expanded disclosures regarding fair value measurements. Fair value is defined as the price that would be received for an asset or the exit price that would be paid to transfer a liability in the principal or most advantageous market in an orderly transaction between market participants on the measurement date. This accounting standard established a fair value hierarchy, which requires an entity to maximize the use of observable inputs, where available. The following summarizes the three levels of inputs required:

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Level 1 – Quoted prices in active markets for identical assets or liabilities.

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Level 2 – Observable inputs other than quoted prices in active markets for identical assets and liabilities, quoted prices for identical or similar assets or liabilities in inactive markets, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.

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Level 3 – Inputs that are generally unobservable and typically reflect management’s estimate of assumptions that market participants would use in pricing the asset or liability.

The carrying amount of the Company’s financial instruments, which principally include cash and cash equivalents, short-term investments, accounts receivable, long-term investments, accounts payable and accrued expenses approximate fair value because of the relatively short maturity of such instruments. The carrying amount of the Company’s short-term and long-term borrowings, which are considered Level 2 liabilities, approximates fair value based upon current rates and terms available to the Company for similar debt.

We measure our contingent earn-out liabilities in connection with acquisitions at fair value on a recurring basis using significant unobservable inputs classified within Level 3 of the fair value hierarchy. We may use various valuation techniques depending on the terms and conditions of the contingent consideration including a Monte-Carlo simulation. This simulation uses probability distribution for each significant input to produce hundreds or thousands of possible outcomes and the results are analyzed to determine probabilities of different outcomes occurring.

Income taxes—Income tax expense, deferred tax assets and liabilities, and liabilities for unrecognized tax benefits reflect management’s best estimate of current and future taxes to be paid. The Company is subject to income taxes in the U.S. and several foreign jurisdictions. The Company assessed the ability to realize deferred tax assets and determined that based on the available evidence, including a history of taxable income and estimates of future taxable income, it is more likely than not that the net deferred tax assets relating to the Company’s operations in Brazil, Spain, and Ukraine will not be realized and a full valuation allowance was recorded in those jurisdictions. Significant management judgment is required in determining the provision for income taxes and deferred tax assets and liabilities. In the event that actual results differ from these estimates, we will adjust these estimates in future periods, which may result in a change in the effective tax rate in a future period. Accounting for income taxes involves uncertainty and judgment on how to interpret and apply tax laws and regulations within the Company’s annual tax filings. Such uncertainties from time to time may result in a tax position that may be challenged and overturned by a tax authority in the future, which could result in additional tax liability, interest charges and possibly penalties. The Company classifies interest and penalties as a component of income tax expense.