HELIOS TECHNOLOGIES, INC. (HLIO) FY 2022 MD&A

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

The operating results of the Hydraulics and Electronics segments included in Management’s Discussion and Analysis of Financial Condition and Results of Operations are presented on a basis consistent with our internal management reporting. Segment information included in Note 16 of the Notes to the Consolidated Financial Statements included in this Annual Report is also presented on this basis. All differences between our internal management reporting basis and accounting principles generally accepted in the U.S. (“U.S. GAAP”), specifically the allocation of certain corporate and acquisition-related costs, are included in Corporate and Other.

Overview

We are a global leader in highly engineered motion control and electronic controls technology for diverse end markets, including construction, material handling, agriculture, energy, recreational vehicles, marine and health and wellness.

We operate under two business segments: Hydraulics and Electronics. The Hydraulics segment designs and manufactures hydraulic cartridge valves, hydraulic quick release couplings as well as engineers complete hydraulic systems. The Electronics segment designs and manufactures customized electronic controls systems and displays for a variety of end markets including industrial and mobile, recreational and health and wellness.

In November 2016, we set out a vision to achieve $1 billion in sales in 2025 through a combination of organic growth and acquisitions and to deliver operating margins in excess of 20%. In 2021, we augmented our strategy and accelerated our growth plans to achieve the milestone of over $1 billion in sales with top tier adjusted EBITDA margin of approximately 25% in 2023.

Underpinning our expectation of compounded annual growth of approximately two times our market's growth rates, we have an active pipeline and a history of acquiring companies with niche technologies, as well as strong profitability.

Acquisitions

Our acquisition activity, driven by our strategic vision, has enabled us to diversify our product offerings and the markets we serve and expand our geographic presence. Prior to 2016, we operated primarily in the Hydraulics market with a small presence in electronics.

In November 2020, we acquired Balboa Water Group, further diversifying the markets we serve and expanding our technological capabilities in electronics. Balboa is an innovative market leader of electronic controls for the health and wellness industry with proprietary and patented technology that enables end-to-end electronic control systems for therapy baths and traditional and swim spas.

In January 2021, we acquired the assets of BJN Technologies, LLC, an innovative engineering solutions provider that was founded in 2014. With the acquisition, we formed the Helios Center of Engineering Excellence to centralize our innovation and technology advancements to better leverage existing talents across the electronics segment initially, and then throughout all of Helios.

In July 2021, we completed another flywheel acquisition with NEM S.r.l., an innovative hydraulic solutions company providing customized material handling, construction, industrial vehicle and agricultural applications to its global customer base, predominantly in Europe and Asia. NEM enhances the Helios electro-hydraulic product offering, provides geographic expansion and adds scale to address new markets.

In October 2021, we completed the acquisition of Joyonway. Joyonway is a fast-growing developer of control panels, software, systems and accessories for the health and wellness industry. Joyonway operates from two locations in China, Shenzhen and Dongguan, both of which are in the hub of electronics and software development in China and give us a foothold for electronics manufacturing in Asia.

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Global Economic Conditions

COVID-19 Update

The COVID-19 pandemic has caused, and continues to cause, economic disruption globally, and substantial uncertainty exists regarding the magnitude and duration of the pandemic and its economic impact.

Many of our customers and end markets are recovering from the substantial impacts of the pandemic experienced during 2020. Demand in 2021 for our products exceeded our expectations as end market recovery occurred sooner and was stronger than we projected. Demand in the health and wellness and recreational marine markets has been favorably impacted by the pandemic as consumers are investing in leisure products and activities. We face constraints on our ability to source certain electronic and other components, which originated from the high demand for these products caused by the pandemic. While we have been able to mitigate the majority of the impact with our procurement efforts and production schedule adjustments, we are experiencing delays in shipments as well as material and logistics cost increases.

We are also facing disruption to our workforce from the pandemic. While the impact has not been significant, the absenteeism has caused labor inefficiencies in production. The Omicron variant impacted fourth quarter labor efficiency, and we continued to experience the effects through January 2022. Additionally, in certain locations we are facing pressure from competitive labor markets; however, to date we have been successful at minimizing the impact on our operations using various methods including reallocating resources, attending job fairs and increasing wages when appropriate. We are closely monitoring the various laws, regulations and executive orders that could impact future periods relating to government-imposed requirements regarding mandatory testing for COVID-19 in the workplace and/or vaccination requirements for employees. The Company has taken and is in the process of taking necessary steps to comply with applicable requirements. At this time, we do not believe there will be a material impact on our operations due to these requirements.

Our outlook for the 2022 fiscal year assumes the global economy continues to recover; however, we cannot at this time predict any future impacts. The Company continues to monitor developments, new strains and variants of COVID-19 and government requirements and recommendations at the national, state and local levels, as well as vaccine mandates, to evaluate whether to reinstate and/or extend certain initiatives it implemented to help contain the spread of COVID-19. Refer to Item 1A Risk Factors of this Annual Report for additional COVID-19 related discussion.

Industry Conditions

Market demand for our products is dependent on demand for the industrial goods in which the products are incorporated. The capital goods industries in general, and the Hydraulics and Electronics segments specifically, are subject to economic cycles. We utilize industry trend reports from various sources, as well as feedback from customers and distributors, to evaluate economic trends. We also rely on global government statistics such as Gross Domestic Product and Purchasing Managers Index to understand higher level economic conditions.

Hydraulics

According to the National Fluid Power Association (the fluid power industry’s trade association in the U.S.), the U.S. index of shipments of hydraulic products increased 21% in 2021, after decreasing 20% in 2020 and decreasing 7% in 2019. In Europe, the CEMA Business Barometer reports that in January 2022, the business climate index for the European agricultural machinery industry stabilized at a high level after several months of slight downward correction since its peak in May and June. CEMA further reported that the near future turnover is already secured, and there is still growth potential for the time being, which might initially be delayed into the coming months due to the supply bottlenecks. The CECE (Committee for European Construction Equipment) business climate index went down slightly in November. They reported, however, that order intake and sales in Europe continue to be on a growth path as future sales expectations have stabilized or even slightly improved for virtually all market regions.

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Electronics

The Federal Reserve’s Industrial Production Index, which measures the real output of all relevant establishments located in the U.S., reports production of semiconductors and other electronics components continued to improve during the fourth quarter of 2021, exceeding fourth quarter 2020 levels. The Institute of Printed Circuits Association ("IPC") reported that total North American printed circuit board ("PCB") shipments in December 2021 were up 16.9% compared with the same month last year, and compared with November 2021, December shipments grew 21.5%. The IPC also reported that North American electronics manufacturing services ("EMS") shipments were up 0.9% compared to the same month last year, and compared to November 2021, shipments rose 8.0%. Demand continues to exceed supply for both PCB and EMS products as the book-to-bill ratios were at 1.17 and 1.55, respectively, in December 2021, as reported by the IPC.

2021 Results and Comparison of Years Ended January 1, 2022 and January 2, 2021

The following table sets forth our consolidated results of operations:

Consolidated net sales for the 2021 year totaled $869.2 million, an increase of 66.2% over the prior year. Acquisitive growth accounted for a large portion of the increase, $206.6 million, and we also experienced significant organic growth of $139.6 million, 26.7%. Changes in foreign currency exchange rates favorably impacted sales by $12.4 million, and earnings per share by $0.05 compared to 2020. The effect of price increases impacted 2021 organic sales by $4.4 million compared to 2020. We realized improved demand in all regions in both segments as our end markets recovered from the significant impacts of the COVID-19 pandemic. In early 2020, we experienced a considerable negative impact on sales due to facility closures, customer shut-downs and regulatory restrictions imposed on shipments. Our production capabilities recovered throughout the year and towards the end of the 2020, we began to experience end market recovery. Strong recovery continued throughout the 2021 year driven by demand in the European agricultural and U.S. recreational marine markets as well as the construction equipment and health and wellness industries. From a geographic perspective, our 2021 organic sales to the Americas, EMEA and APAC regions grew 31.1%, 30.3% and 17.1%, respectively.

Gross profit trended upward in 2021 compared to 2020 due to the increased sales volume. Gross profit margin declined 1.5 percentage points during 2021 to 36.0% from 37.5% as improved manufacturing labor efficiencies and leverage of our fixed cost base on the higher sales were more than offset by increases in logistic and raw material costs and the addition of sales from Balboa, which have a different margin profile compared to our legacy businesses (higher material and production costs with lower selling, engineering and administrative ("SEA") costs). Material costs as a percentage of sales, excluding pricing changes and acquisition-related sales, increased in 2021 by 3.0 percentage points compared to 2020 driven by raw material cost increases, primarily from supply shortages, higher freight and logistics costs and an unfavorable change in sales mix. We have passed on material and freight cost increases to customers by implementing price increases, which we expect to continue to realize the effects of in future quarters. The impact of amortization of acquisition-related inventory step up costs resulting from our acquisitions declined by $1.3 million in 2021 compared to 2020.

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Operating income as a percentage of sales increased 10.4 percentage points to 17.2% in 2021 compared to 6.8% in 2020. During the first quarter of 2020, current and expected economic impacts from the COVID-19 pandemic led to an impairment charge of $31.9 million. Excluding the impairment charge in 2020, operating income as a percentage of sales in 2021 improved 4.3 percentage points, up from 12.9%, resulting from improved leverage of our fixed cost base on the higher sales volume, the favorable operating margin profile of Balboa and a decrease in costs related to CEO and officer transitions of $2.4 million. Operating margin was unfavorably impacted during 2021 by a $10.7 million increase in intangible amortization from our recent acquisitions and higher corporate compensation and benefit costs of $6.3 million, which were primarily related to performance-based incentive compensation earned from the strong financial performance of the company in 2021.

Segment Results

Hydraulics

The following table sets forth the results of operations for the Hydraulics segment (in millions):

Net sales for the Hydraulics segment totaled $516.4 million in 2021, an increase of $109.2 million, 26.8%, over the prior year. Acquisition-related sales accounted for $10.4 million of the increase and sales from our organic businesses improved $98.8 million, 24.3%. Changes in foreign currency exchange rates favorably impacted sales for the year by $12.0 million compared to the 2020 year. The effect of price increases impacted 2021 organic sales by $0.8 million compared to 2020. Strong end market recovery from the pandemic led to improved demand in all regions and many of our end markets including U.S. and European agriculture and construction equipment markets as well as mobile and industrial equipment markets. The segment’s supply chain is experiencing constraints on its ability to source certain components. While the effect on sales has been mitigated by our increased procurement efforts and production schedule adjustments, we estimate that approximately $6.4 million of sales were delayed into future quarters due to the supply shortages.

The following table presents net sales based on the geographic region of the sale for the Hydraulics segment (in millions):

Demand in the Americas region drove sales growth of $37.2 million, 28.5%, compared with the prior year. Increased demand, primarily in the agriculture and construction equipment end markets, and our recent acquisition in the region generated an additional $48.8 million, 37.2%, of sales to the EMEA region compared with 2020, or 32.1% excluding positive impacts from foreign currency exchange rate fluctuations totaling $6.7 million. Sales to the APAC region were up $23.2 million, 15.9%, in 2021 over 2020, or 12.3% excluding positive impacts from foreign currency exchange rate fluctuations totaling $5.3 million. The APAC growth primarily resulted from increased demand in Korea and China.

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Gross profit in 2021 trended up from 2020, due to higher sales volume and a favorable impact from changes in foreign currency exchange rates of $3.7 million. Gross profit margin improved by 0.6 percentage points from improved leverage of our fixed manufacturing costs on the higher sales and labor efficiencies realized as our workforce was more normalized compared to the effects of the pandemic in 2020. Raw material costs increased in 2021, and supplier constraints led to higher material costs from second vendor sourcing efforts. Excess freight and logistics costs totaled $3.8 million in 2021. Material costs as a percentage of sales, excluding pricing changes and acquisition-related sales, increased by 1.9 percentage points in 2021, also impacted by an unfavorable change in sales mix.

SEA expenses increased $5.3 million, 7.8%, in 2021 compared with the prior year. During 2020, we instituted strict cost control measures in light of the COVID-19 pandemic and its expected impacts on the world economies and our operations. While costs related to travel and marketing continue to be low, other SEA costs returned to a more normal level in 2021. Salary and benefit costs have increased driven by wage increases and higher performance-based incentive compensation. Increased leverage of our fixed cost base on higher sales led to SEA as a percentage of sales decreasing 2.5 percentage points to 14.3% in 2021.

As a result of the impacts to gross profit and SEA costs noted above, 2021 operating income improved $37.8 million, 46.1%, compared with 2020, and 2021 operating margin improved 3.1 percentage points during the year.

Electronics

The following table sets forth the results of operations for the Electronics segment (in millions):

Net sales for the Electronics segment totaled $352.7 million in 2021, an increase of $236.9 million, 204.6%, over the prior year. Acquisition growth accounted for $196.2 million of current-year sales. The segment also realized solid organic growth of $40.7 million, 35.1% compared with 2020. The effect of price increases impacted 2021 organic sales by $3.6 million compared to 2020. Changes in foreign currency exchange rates favorably impacted 2021 sales by $0.4 million compared to 2020. During the 2020 year, we experienced significant demand reductions caused by the COVID-19 pandemic as many of our customers shut down operations for a period of time and several of our large OEM customers adjusted the timing of order request dates into later quarters.

Demand in the health and wellness and spa and bath industries has been boosted by the pandemic as consumers invest in health and leisure products. The same trend is occurring in the recreational vehicle and recreational marine industries in which demand continues to remain strong. We have taken swift and successful actions to expand production capacity in an effort to fulfill the high incoming order levels for our products. The segments’ supply chain is experiencing constraints on its ability to source certain electronic and other components. While the effect on sales has been mitigated by our increased procurement efforts and production schedule adjustments, we estimate that approximately $14.8 million of sales were delayed into future quarters due to the supply shortages.

The following table presents net sales based on the geographic region of the sale for the Electronics segment (in millions):

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During 2021, we experienced significant growth in all regions, which was primarily attributable to the acquisitions of Balboa Water Group and Joyonway as well as robust organic growth. Sales to the Americas region during 2021 accounted for 73.1% of total segment sales, a decrease from 81.1% in 2021, which is due to a variation in the regional footprint of our acquisitions. Similarly, sales to EMEA and APAC increased to 11.9% and 15.0% of total segment sales in 2021, respectively.

Gross profit increased $72.2 million compared with 2020 due to the increased sales volume. Gross profit margin for the same period decreased by 7.3 percentage points. Balboa product sales have a different margin profile than our historical business (higher material and production costs with lower SEA costs). The addition of Balboa sales in 2021 reduced profitability at the gross margin level while improving profitability at the operating margin level due to their lower operating cost structure. Additionally, the segment experienced an increase in raw material and freight and logistics costs during the year due to the high demand and shortages of materials in the market for electronic and other components used in our products. Excess freight and logistics costs on organic sales totaled $4.0 million in 2021. Material costs as a percentage of sales, excluding pricing changes and acquisition-related sales, increased in 2021 by 6.6 percentage points compared to the prior year.

SEA expenses increased by $19.9 million in 2021, compared with 2020, primarily from the Balboa acquisition. SEA costs as a percentage of sales declined 10.8 percentage points to 13.7% in 2021, compared to 24.5% in 2020. The improvement is due to the favorable cost structure of Balboa as well as increased leverage on our fixed cost base on higher sales in our legacy Electronics business. We also realized increases in personnel costs for wages and benefits primarily from higher payout of performance-based incentive compensation.

As a result of the impacts to gross profit and SEA costs noted above, operating income improved $52.3 million, over the 2020 year and operating margin improved 3.5 percentage points, to 20.3%.

Corporate and Other

Certain costs are excluded from business segment results as they are not used in evaluating the results of, or allocating resources to, our operating segments. For the year ended January 1, 2022, these costs totaled $42.2 million primarily for acquisition-related items such as (i) transaction costs of $4.0 million, (ii) charges related to inventory step-up to fair value of $0.6 million, (iii) amortization of acquisition-related intangible assets of $32.8 million, (iv) $4.6 million related to other acquisition and integration activities and (v) other costs not deemed allocable to either business segment of $0.2 million.

For the year ended January 2, 2021, these costs totaled $65.9 million for (i) goodwill impairment of $31.9 million, (ii) transition costs for two of our officers, including our former Chief Executive Officer totaling $2.6 million, (iii) acquisition-related items such as transaction costs of $6.6 million, (iv) charges related to inventory step-up to fair value of $1.9 million, (v) amortization of acquisition-related intangible assets of $22.1 million and (vi) $0.9 million related to other acquisition and integration activities.

Interest Expense, net

Net interest expense increased $3.6 million during 2021 to $16.9 million compared with $13.3 million in 2020. The increase is attributable to higher average debt levels during 2021 due to our borrowings used to fund the acquisitions of Balboa in November 2020 and NEM and Joyonway in 2021. Average net debt during 2021 totaled $426.9 million compared with $357.8 million in 2020.

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Income Taxes

The provision for income taxes for the year ended January 1, 2022, was 20.3% of pretax income compared with 17.6%, before non-deductible impairment related charges, for the year ended January 2, 2021. The difference relates principally to a shift in the mix of the company's worldwide income. The effective rate typically fluctuates relative to the levels of income and different tax rates in effect from year to year among the countries in which we sell our products. The Company benefited from statutory audit adjustments and certain COVID-19 related tax legislation, which favorably impacted the 2020 tax rate.

On March 27, 2020, the Coronavirus Aid, Relief and Economic Security Act (“CARES Act”) was enacted into law in response to the COVID-19 pandemic. The Company has evaluated the various income and payroll tax provisions and expects little or no impact to income tax expense. However, the Company is taking advantage of the various payment deferments allowed and employee retention credits afforded by the CARES Act and other similar state and/or foreign liquidity measures. The CARES Act allows employers to defer the deposit and payment of the employer's share of Social Security taxes. We deferred 50% of the $1.7 million in payroll taxes normally due between March 27, 2020 and December 31, 2020. We paid 50% of this amount during the fourth quarter of 2021. The remaining balance will be paid during the fourth quarter of 2022 and is included in the Accrued compensation and benefits line item in the accompanying Consolidated Balance Sheets.

As of January 1, 2022, the Company had approximately $23.7 million of undistributed earnings of its non-U.S. subsidiaries for which it has not provided for non-U.S. withholding taxes and state taxes because such earnings are intended to be reinvested indefinitely in international operations.

2020 Results and Comparison of Years Ended January 2, 2021 and December 28, 2019

For the discussion and analysis of our 2020 results compared with our 2019 results, refer to our Annual Report on Form 10-K for the fiscal year ended January 2, 2021, filed with the SEC on March 2, 2021. The discussion is incorporated herein by reference.

Liquidity and Capital Resources

Historically, our primary source of capital has been cash generated from operations. In recent years we have used borrowings on our credit facilities to fund acquisitions. During 2021, net cash provided by operating activities totaled $113.2 million and as of January 1, 2022 we had $28.6 million of cash on hand and $158.0 million of available credit on our revolving credit facilities. We also have a $300.0 million accordion feature available on our credit facility, which is subject to certain pro forma compliance requirements and is intended to support potential future acquisitions.

Our principal uses of cash have been paying operating expenses, making capital expenditures, servicing debt, making acquisition-related payments and paying dividends to shareholders.

We believe that cash generated from operations and our borrowing availability under our credit facilities will be sufficient to satisfy our operating expenses and capital expenditures for the foreseeable future. In the event that economic conditions were to severely worsen for a protracted period of time, we would have several options available to ensure liquidity in addition to increased borrowing. Capital expenditures could be postponed since they primarily pertain to long-term improvements in operations, operating expense reductions could be made and the dividend to shareholders could be reduced or suspended.

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Cash flows

The following table summarizes our cash flows for the periods (in millions):

Cash on hand increased $3.3 million from $25.3 million at the end of 2020 to $28.6 million at the end of 2021. Cash and cash equivalents were favorably impacted by changes in exchange rates during the year ended January 1, 2022 by $3.0 million and unfavorably impacted during the year ended January 2, 2021 by $7.3 million. Cash balances on hand are a result of our cash management strategy, which focuses on maintaining sufficient cash to fund operations while reinvesting cash in the Company and also paying down borrowings on our credit facilities.

Operating activities

Net cash from operations totaled $113.2 million in 2021, an increase of $4.6 million, 4.2%, compared with the prior year. Cash earnings in 2021 were higher by $65.5 million compared to 2020 from the increased sales. However, changes in net operating assets and liabilities reduced cash by $60.9 million compared to 2020, as higher working capital levels were necessary to support our significant increase in operations. Changes in inventory, net of acquisitions, reduced cash by $52.5 million in 2021 compared with an increase in cash of $0.6 million during 2020. Inventory on hand as of January 1, 2022 increased by $55.3 million, 50.1%, compared to the 2020 year end. The increase is primarily from supply chain constraints as well as higher demand expectations for the next few quarters. Some of the supply challenges that have resulted in higher inventory levels are: (i) making earlier purchases of material to avoid shortages, (ii) inventory on hand that is waiting on delayed components to complete and (iii) delayed orders by customers after we have already started the production process. Days of inventory on hand decreased to 91 days for the 2021 year, compared with 100 days during the 2020 year, favorably impacted by the addition of Balboas operations. Changes in accounts receivable, net of acquisitions, decreased cash by $32.4 million in 2021 compared with an increase in cash of $0.7 million in 2020, a direct result of higher sales in the last few months of the 2021 year compared to 2020. Days sales outstanding for the 2021 year went up slightly to 57 days, from 50 days during 2020.

Investing activities

Cash used in investing activities totaled $90.3 million in 2021, compared with $235.9 million in 2020. The decrease in acquisition-related payments accounted for $153.5 million of the fluctuation. Capital expenditures were $26.8 million during 2021, $12.2 million, 83.8%, higher than the prior year. Due to the economic conditions and uncertainty of future cash flows during the 2020 year, we only funded critical capital expenditure projects. In 2021, as the economy recovered we resumed our investments in capital projects. Capital expenditures for 2022 are forecasted to be approximately 3%-5% of sales, for investments in machinery and equipment for capacity expansion projects, improvements to manufacturing technology and maintaining/replacing existing machine capabilities.

Financing activities

Cash used in financing activities totaled $22.6 million in 2021, compared with cash provided by financing activities of $137.7 million in 2020.

Net repayments on our long-term non-revolving debt and revolving credit facilities in 2021 totaled $9.9 million as acquisition related borrowings of $56.7 million were more than offset by repayments during the year. In the 2020 year net borrowings on debt totaled $151.7 million, primarily for the acquisition of Balboa.

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Borrowings on our long-term non-revolving debt and our revolving credit facilities as of January 1, 2022 totaled $202.5 million and $243.0 million, respectively. See Note 10 of the Notes to the Consolidated Financial Statements included in this Annual Report for additional information regarding our credit facilities.

We have historically declared regular quarterly dividends to shareholders of $0.09 per share. We paid dividends totaling $11.6 million for the years ended January 1, 2022 and January 2, 2021. The declaration and payment of future dividends is subject to the sole discretion of the board of directors, and any determination as to the payment of future dividends will depend upon our profitability, financial condition, capital needs, acquisition opportunities, future prospects and other factors deemed pertinent by the board of directors.

Contractual obligations

Credit facilities

Information on our credit facilities, including future maturities, is presented in Note 10 of the Notes to the Consolidated Financial Statements included in this Annual Report. Our revolving credit facility with PNC Bank matures and is payable in full in October 2025; however, we may make earlier payments. Our term loan with PNC Bank is payable in quarterly installments of $3.8 million through 2023 and quarterly installments of $5.0 million thereafter through the maturity date of October 2025, at which time the remaining balance becomes due in full.

Interest rates on our credit facilities range from 2.0% to 5.3% as of January 1, 2022. Future interest payments are estimated to total $37.7 million, with annual payments ranging from $10.8 million to $7.8 million payable through the last maturity date of October 2025. Future payments assume the current interest rate environment, current currency exchange rates, future required payments on term loans and revolver borrowings consistent with January 1, 2022 debt levels. Future payments do not include an estimate of impacts from our derivative instruments.

Contingent consideration payments

Our contingent consideration liabilities total $6.4 million as of January 1, 2022. The balance represents the fair value estimate of contractual contingent payments related to our acquisitions of Balboa and NEM and are payable at various times through the first quarter of 2024.

Supplier purchase commitments

We enter into long-term commitments with key suppliers for minimum purchase quantities of inventory and we make commitments for capital expenditures. Obligations that are non-cancelable total $39.1 million, $43.3 million and $12.6 million for the 2022, 2023 and 2024 years, respectively.

Building purchase commitment

In 2020, the Company entered into a lease to buy agreement for the purchase of a building. We have the option to purchase the building at any time during the lease period and are committed to buy at the end of the 6-year lease term. The full purchase price is €26.7 million; however, the actual purchase price will be reduced by 60% of the payments made during the lease term.

Leases

We regularly enter into operating lease agreements for the use of machinery, equipment, vehicles, buildings and office space. Future maturities of our operating lease liabilities are presented in Note 7 of the Notes to the Consolidated Financial Statements included in this Annual Report.

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Critical Accounting Policies and Estimates

We prepare our Consolidated Financial Statements in conformity with U.S. GAAP, which requires management to make certain estimates and assumptions that affect reported amounts and related disclosures. Actual results could differ from those estimates. Based on facts and circumstances inherent in developing estimates and assumptions, we believe it is unlikely that applying other such estimates and assumptions would have caused materially different amounts to have been reported. The following policies are considered by management to be the most critical in understanding the judgements, estimates and assumptions that are involved in the preparation of our Consolidated Financial Statements.

Business Combinations

Business combinations are accounted for under the acquisition method of accounting, which requires recognition separately from goodwill, the assets acquired and the liabilities assumed at their acquisition date fair values. Assigning fair market values to the assets acquired and liabilities assumed at the date of an acquisition requires knowledge of current market values, and the values of assets in use, and often requires the application of judgment regarding estimates and assumptions. While the ultimate responsibility resides with management, for certain acquisitions we retain the services of certified valuation specialists to assist with assigning estimated values to certain acquired assets and assumed liabilities, including intangible assets and tangible long-lived assets. Acquired intangible assets, excluding goodwill, are valued using various methodologies such as the discounted cash flow method, which is based on future cash flows specific to the type of intangible asset purchased and the relief from royalty method, which is based on the present value of savings resulting from the right to manufacture or sell products that incorporate the intangible asset without having to pay a license for its use. These methodologies incorporate various estimates and assumptions, the most significant being estimated royalty rates, projected revenue growth rates, profit margins and forecasted cash flows based on the discount rate.

Goodwill

Goodwill, which represents the excess of the purchase price of an acquisition over the fair value of the net assets acquired, is carried at cost. Goodwill is tested for impairment annually, in our third and fourth fiscal quarters, or more frequently if events or circumstances indicate a reduction in the fair value below the carrying value. The carrying value of assets is calculated at the reporting unit level. An impairment loss is recorded to the extent that the fair value of the goodwill within the reporting unit is less than its carrying value.

The assessment of fair value for impairment purposes requires significant judgment by management. We generally use a combination of market and income approach methodologies to estimate the fair value of our reporting units. The income approach is generally based on a discounted cash flow analysis, which estimates the present value of the projected free cash flows to be generated by the reporting unit. Assumptions used in the analysis include estimated future revenues and expenses, weighted average cost of capital, capital expenditures and other variables. Assumptions made for future cash flows are developed based on consideration of current and future economic conditions, recent sales trends, planned timing of product launches or other relevant variables. The market approach estimates the value of reporting units by comparing to guideline public companies or guideline transactions. Various valuation multiples of companies that are economically and operationally similar are used as data points for selecting multiples for the reporting units. Changes in assumptions or estimates could materially affect the estimated fair value of our reporting units and the potential for impairment.

Income Taxes

Our income tax policy provides for a balance sheet approach under which deferred income taxes are provided for based upon enacted tax laws and rates applicable to the periods in which the taxes become payable. These differences result from items reported differently for financial reporting and income tax purposes, primarily depreciation, amortization, accrued expenses and reserves.

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Our annual tax rate fluctuates based on our income, statutory tax rates and tax planning opportunities available to us in the various jurisdictions in which we operate. Tax laws are complex and subject to different interpretations by the taxpayer and respective government taxing authorities. Significant judgment is required in determining our tax expense and in evaluating our tax positions, including evaluating uncertainties. We review our tax positions quarterly and adjust the balances as new information becomes available. Indefinite reinvestment is determined by management’s judgment about, and intentions concerning, our future operations.

We recognize and measure uncertain tax positions in accordance with ASC 740. We report a liability for unrecognized tax benefits resulting from uncertain tax positions taken or expected to be taken in a tax return. We file annual income tax returns in multiple taxing jurisdictions around the world. Many years may pass before an uncertain tax position is audited by the relevant tax authorities and finally resolved. While it is often difficult to predict the outcome or the timing of resolution of any particular uncertain tax position, we believe that our reserves for income taxes are adequate such that we reflect the benefits more likely than not to be sustained in an examination. We adjust these reserves, as well as the related interest and penalties, where appropriate in light of changing facts and circumstances. Settlement of any particular position could require the use of cash. We recognize interest and penalties, if any, related to unrecognized tax benefits in income tax expense.

See Note 12 of the Notes to the Consolidated Financial Statements included in this Annual Report for income tax amounts, including reserves.

Off Balance Sheet Arrangements

We do not engage in any off balance sheet financing arrangements. In particular, we do not have any material interest in variable interest entities, which include special purpose entities and structured finance entities.

Inflation

As more fully described above, we are experiencing supply shortages and increasing material and logistics costs. Continued increases in the global demand for the materials used in our products could result in significant increases in the costs of the components we purchase, and we may not be able to fully offset such higher costs through price increases. There is no assurance that our business will not be materially affected by inflation in the future.

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