HAWKINS INC (HWKN) FY 2023 MD&A

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

The following is a discussion and analysis of our financial condition and results of operations for fiscal 2023 and 2022. This discussion should be read in conjunction with the Consolidated Financial Statements and Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K.

We have omitted discussion of the earliest of the three years covered by our consolidated financial statements presented in this report because that disclosure was already included in our Annual Report on Form 10-K for fiscal 2022, filed with the SEC on May 18, 2022. You are encouraged to reference Part II, Item 7, within that report, for a discussion of our financial condition and results of operations for fiscal 2022 compared to fiscal 2021.

Overview

We derive substantially all of our revenues from the sale of specialty chemicals and ingredients that we formulate, distribute, blend and manufacture for our Industrial, Water Treatment and Health and Nutrition customers.

Financial Overview

Highlights of fiscal 2023 include:

•Sales of $935.1 million, a 21% increase from fiscal 2022;

•Gross profit of $165.1 million, an increase of $18.6 million, or 13% from fiscal 2022; and

•Diluted earnings per share (EPS) of $2.86, an increase of $0.42, or 17%, from fiscal 2022.

We focus on total profitability dollars when evaluating our financial results as opposed to profitability as a percentage of sales, as sales dollars tend to fluctuate as raw material prices rise and fall, particularly in our Industrial and Water Treatment segments. The costs for certain of our raw materials can rise or fall rapidly, causing fluctuations in gross profit as a percentage of sales.

We use the last in, first out (“LIFO”) method of valuing the majority of our inventory in our Industrial and Water Treatment segments, which causes the most recent product costs to be recognized in our income statement. The LIFO inventory valuation method and the resulting cost of sales are consistent with our business practices of pricing to current chemical raw material prices. Inventories in our Health and Nutrition segment are valued using the first-in, first-out (“FIFO”) method.

We disclose the sales of our bulk commodity products as a percentage of total sales dollars for our Industrial and Water Treatment segments. Our definition of bulk commodity products includes products that we do not modify in any way, but receive, store, and ship from our facilities, or direct ship to our customers in large quantities. We disclose the percentage of our overall sales that consist of sales of bulk commodity products as these products are generally distributed and we do not add significant value to these products in comparison to our non-bulk products. Sales of these products are generally highly competitive and price sensitive. As a result, bulk commodity products generally have our lowest margins.

Factors Affecting Comparability of Results

Asset Sales and Business Acquisitions

On March 30, 2023, we sold certain assets in our Industrial segment related to our consumer bleach packaging business for $7 million. These assets were not deemed core to our Industrial segment operations. The assets sold included plant equipment, inventory, and intangible assets, all related to the packaging of bleach. We realized a gain of $3 million on this sale, which has been recorded as a reduction to selling, general and administrative expenses.

In the fourth quarter of fiscal 2022, we acquired substantially all the assets of NAPCO Chemical Company, Inc. and its affiliates ("NAPCO") under the terms of an asset purchase agreement among us, NAPCO and certain other parties thereto. NAPCO manufactures and distributes water treatment chemicals from three locations in Texas. The results of operations are included as part of our Water Treatment segment.

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In the third quarter of fiscal 2022, we acquired substantially all the assets of Water and Waste Specialties, LLC, under the terms of an asset purchase agreement with Water and Waste Specialties and its shareholders. Water and Waste Specialties was a water treatment chemical distribution company operating primarily in Alabama. The results of operations since the acquisition date are included in our Water Treatment segment.

In the second quarter of fiscal 2022, we acquired substantially all the assets of Southeast Water Systems LLC, under the terms of an asset purchase agreement with Southeast Water Systems and its shareholders. Southeast Water Systems supplied and installed water treatment chemical equipment to its customers located primarily in Alabama, southern Georgia and the Florida panhandle. The results of operations since the acquisition date are included in our Water Treatment segment.

The aggregate annual revenue of these three businesses acquired in fiscal 2022 totaled approximately $17 million, as determined using the applicable twelve-month period preceding each respective acquisition date.

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Results of Operations

The following table sets forth certain items from our statement of income as a percentage of sales for fiscal 2023 and 2022:

Fiscal 2023 Compared to Fiscal 2022

Sales

Sales were $935.1 million for fiscal 2023, an increase of $160.6 million, or 21%, from sales of $774.5 million for fiscal 2022, driven primarily by increased selling prices. Fiscal 2022 included an additional week, which we estimated to add approximately $17.5 million in additional sales in that year.

Industrial Segment.  Industrial segment sales increased $83.9 million, or 22%, to $470.8 million for fiscal 2023, as compared to $386.9 million for fiscal 2022. Sales of bulk commodity products in the Industrial segment were approximately 16% of sales dollars in both fiscal 2023 and fiscal 2022. The increase in sales was driven by increased selling prices on many of our products driven primarily by higher costs on many of our raw materials, while total sales volumes were down approximately 11%. Average selling prices increased 36% over the prior year, in part due to higher raw material costs as well as product mix changes. Fiscal 2022 included an additional week, which we estimated to be approximately $10.0 million in additional sales in our Industrial segment in that year.

Water Treatment Segment.  Water Treatment segment sales increased $76.8 million, or 34%, to $304.9 million for fiscal 2023, as compared to $228.1 million for fiscal 2022. Sales of bulk commodity products in the Water Treatment segment were approximately 9% of sales dollars in both fiscal 2023 and fiscal 2022. Sales increased as a result of increased selling prices on many of our products driven by higher costs on many of our raw materials, with average selling prices increasing 28% over the prior year. In addition, a 4% increase in sales volume, due to the added sales from acquired businesses, contributed to the year-over-year increase in sales. Fiscal 2022 included an additional week, which we estimated to add approximately $3.9 million in additional sales in our Water Treatment segment in that year.

Health and Nutrition Segment. Health and Nutrition segment sales decreased $0.1 million, or less than 1%, to $159.4 million for fiscal 2023, as compared to $159.5 million for fiscal 2022. Sales of our manufactured products increased 40% year over year, but were offset by a 12% decline in sales of our specialty distributed products. Fiscal 2022 included an additional week, which we estimated to add approximately $3.6 million in additional sales in our Health and Nutrition segment in that year.

Gross Profit

Gross profit increased $18.6 million, or 13%, to $165.1 million, or 18% of sales, for fiscal 2023, from $146.5 million, or 19% of sales, for fiscal 2022. During fiscal 2023, the LIFO reserve increased, and gross profits decreased, by $18.5 million, primarily due to rising raw material costs. In fiscal 2022, the LIFO reserve increased, and gross profits decreased, by $15.8 million, primarily due to rising raw material costs. Gross profit increased due to increased revenue, partially offset by the unfavorable year-over-year impact of the increased LIFO reserve. Fiscal 2022 included an additional week, which we estimated to add approximately $3.6 million in additional gross profit in that year.

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Industrial Segment.  Gross profit for the Industrial segment increased $8.5 million, or 14%, to $68.1 million, or 14% of sales, for fiscal 2023, from $59.6 million, or 15% of sales, for fiscal 2022. During fiscal 2023, the LIFO reserve increased, and gross profits decreased, by $12.3 million, primarily due to rising raw material costs. In fiscal 2022, the LIFO reserve increased, and gross profits decreased, by $10.4 million, primarily due to rising raw material costs. Gross profit increased as a result of the increase in sales, partially offset by the unfavorable year-over-year impact of the increased LIFO reserve. Fiscal 2022 included an additional week, which we estimated to add approximately $1.9 million in additional gross profit in our Industrial segment in that year.

Water Treatment Segment.  Gross profit for the Water Treatment segment increased $12.6 million, or 23%, to $67.2 million, or 22% of sales, for fiscal 2023, from $54.6 million, or 24% of sales, for fiscal 2022. During fiscal 2023, the LIFO reserve increased, and gross profits decreased, by $6.2 million, primarily due to rising raw material costs. During fiscal 2022, the LIFO reserve increased, and gross profit decreased, by $5.4 million, primarily due to rising raw material costs. Gross profit increased as a result of the increase in sales. Fiscal 2022 included an additional week, which we estimated to add approximately $1.0 million in additional gross profit in our Water Treatment segment in that year.

Health and Nutrition Segment. Gross profit for our Health and Nutrition segment decreased $2.5 million, or 8%, to $29.8 million, or 19% of sales, for fiscal 2023, from $32.3 million, or 20% of sales, for fiscal 2022. Gross profit decreased as a result of a product mix shift. Fiscal 2022 included an additional week, which we estimated to add approximately $0.7 million in additional gross profit in our Health and Nutrition segment in that year.

Selling, General and Administrative Expenses

SG&A expenses increased $1.6 million to $77.0 million, or 8% of sales, for fiscal 2023, from $75.3 million, or 10% of sales, for fiscal 2022. Included in SG&A expenses for the current fiscal year was a gain of approximately $3.0 million related to the sale of certain assets related to our consumer bleach packaging business. In addition, a year-over-year decrease in compensation expense of $0.5 million related to our non-qualified deferred compensation plan reduced SG&A expenses, with the offset in Other Expense. In spite of these decreases in SG&A expense, expenses increased primarily due to the added costs from the acquired businesses in our Water Treatment segment and increased wages. Fiscal 2022 included an additional week, which we estimated to add approximately $1.0 million in additional SG&A expense in that year.

Operating Income

Operating income was $88.2 million, or 9% of sales, for fiscal 2023, as compared to $71.2 million, or 9% of sales, for fiscal 2022 due to the combined impact of the factors discussed above. Fiscal 2022 included an additional week, which we estimated to add approximately $3.0 million in additional operating income expense in that year.

Interest Expense, Net

Interest expense was $5.2 million for fiscal 2023, an increase of $3.8 million from interest expense of $1.4 million for fiscal 2022. The increase was due to an increase in borrowing interest rates as well as an increase in average outstanding borrowings due to increased capital needs.

Income Tax Provision

Our effective tax rate was approximately 27.3% for fiscal 2023 and 26.3% for fiscal 2022. The effective tax rate is impacted by projected levels of annual taxable income, permanent items, and state taxes. The current year increase in the effective tax rate was primarily driven by unfavorable book to tax LIFO differences.

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Selected Quarterly Financial Data

Selected financial data for our fiscal quarters is shown below. No changes have been made to previously reported information.

Earnings per share may not equal the face of the Consolidated Statements of Income due to rounding.

Liquidity and Capital Resources

Cash provided by operating activities in fiscal 2023 was $77.4 million compared to $42.8 million in fiscal 2022. Our net cash provided by operating activities increased $34.6 million compared to fiscal 2022. In the prior fiscal year, we expended significant working capital as accounts receivable and inventory increased over fiscal 2021 resulting in a net $37 million use of cash for working capital accounts. In fiscal 2023, we expended net $13 million in the aggregate for working capital accounts due to lower year-over-year changes. This, combined with improved net income, resulted in the year-over-year increase in net cash provided by operating activities. Due to the nature of our operations, which includes purchases of large quantities of bulk chemicals, the timing of purchases can result in significant changes in working capital and the resulting operating cash flow. Historically, our cash requirements for working capital increase during the period from March through November as caustic soda inventory levels increase as most of our barges are received during this period.

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Cash used in investing activities was $41.2 million in fiscal 2023 compared to $49.8 million in fiscal 2022. Capital expenditures for property, plant and equipment were $48.3 million in fiscal 2023 and $28.5 million in fiscal 2022. The current year increase in capital expenditures was primarily driven by increased expenditures for new trucks and facility improvements and expansions. Cash used in investing activities included no acquisition spending in fiscal 2023 compared to an aggregate of $21.5 million for Water Treatment group acquisitions in fiscal 2022. Cash used in investing activities also included proceeds from asset disposals of $7.0 million in fiscal 2023 compared to $0.3 million in fiscal 2022. The proceeds received in fiscal 2023 related primarily to our sale of certain assets related to our consumer bleach packaging business.

Cash used in financing activities was $32.1 million in fiscal 2023, as compared to cash provided by financing activities of $7.4 million in fiscal 2022. Cash used in financing activities included net debt repayments of $14.0 million in fiscal 2023, compared to net debt borrowings of $27.0 million in fiscal 2022, which was used primarily to fund our acquisitions in fiscal 2022. We paid out cash dividends of $12.0 million in fiscal 2023 and $11.1 million in fiscal 2022. In fiscal 2023, we used $6.6 million to repurchase shares under our board-authorized share repurchase program, and in fiscal 2022, we used $8.5 million to repurchase shares under the program.

Our cash balance was $7.6 million at April 2, 2023, an increase of $4.1 million as compared with April 3, 2022. Cash flows generated by operations during fiscal 2023 were offset by the cash expended for capital expenditures, repayments of debt and dividend payments in fiscal 2023.

We are party to a Credit Agreement with U.S. Bank as Sole Lead Arranger and Sole Book Runner, and other lenders from time to time party thereto, whereby U.S. Bank is also serving as Administrative Agent. The Credit Agreement provides us with a Revolving Loan Facility totaling $250.0 million. The Revolving Loan Facility includes a $10 million letter of credit subfacility and $25 million swingline subfacility. The Revolving Loan Facility has a five-year maturity date, maturing on April 30, 2027. The Revolving Loan Facility is secured by substantially all of our personal property assets and those of our subsidiaries.

Borrowings under the Revolving Loan Facility bear interest at a rate per annum equal to one of the following, plus, in both cases, an applicable margin based upon our leverage ratio: (a) Term SOFR, which includes a credit spread adjustment of 0.10%, for an interest period of one, three or six months as selected by us, reset at the end of the selected interest period, or (b) a base rate determined by reference to the highest of (1) U. S. Bank’s prime rate, (2) the Federal Funds Effective Rate plus 0.5%, or (3) one-month Term SOFR for U.S. dollars plus 1.0%. The Term SOFR margin is between 0.85% and 1.35%, depending on our leverage ratio. The base rate margin is between 0.00% and 0.35%, depending on our leverage ratio. At April 3, 2022, the effective interest rate on our borrowings was 4.3%.

In addition to paying interest on the outstanding principal under the Revolving Loan Facility, we are required to pay a commitment fee on the unutilized commitments thereunder. The commitment fee is between 0.15% and 0.25%, depending on our leverage ratio.

Debt issuance costs paid to the Lenders are being amortized as interest expense over the term of the Credit Agreement. As of April 2, 2023, the unamortized balance of these costs was $0.4 million, and is reflected as a reduction of debt on our balance sheet.

The Credit Agreement requires us to maintain (a) a minimum fixed charge coverage ratio of 1.15 to 1.00 and (b) a maximum total cash flow leverage ratio of 3.0 to 1.0. The Credit Agreement also contains other customary affirmative and negative covenants, including covenants that restrict our ability to incur additional indebtedness, dispose of significant assets, make certain investments, including any acquisitions other than permitted acquisitions, make certain payments, enter into sale and leaseback transactions, grant liens on our assets or enter into rate management transactions, subject to certain limitations. We are permitted to make distributions, pay dividends and repurchase shares so long as no default or event of default exists or would exist as a result thereof. We were in compliance with all covenants of the Credit Agreement as of April 2, 2023 and expect to remain in compliance with all covenants for the next 12 months.

The Credit Agreement contains customary events of default, including failure to comply with covenants in the Credit Agreement and other loan documents, cross default to other material indebtedness, failure by us to pay or discharge material judgments, bankruptcy, and change of control. The occurrence of an event of default would permit the lenders to terminate their commitments and accelerate loans under the Credit Facility.

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We have in place an interest rate swap agreement to manage the risk associated with a portion of our variable-rate long-term debt. We do not utilize derivative instruments for speculative purposes. The interest rate swap involves the exchange of fixed-rate and variable-rate payments without the exchange of the underlying notional amount on which the interest payments are calculated. The notional amount of the swap agreement is $60 million and it will terminate on May 1, 2027.

As part of our growth strategy, we have acquired businesses and may pursue acquisitions or other strategic relationships in the future that we believe will complement or expand our existing businesses or increase our customer base. We believe we could borrow additional funds under our current or new credit facilities or sell equity for strategic reasons or to further strengthen our financial position.

Material Cash Requirements

The following table provides aggregate information about our contractual payment obligations and the periods in which payments are due:

(1)    Represents balance outstanding as of April 2, 2023, and assumes such amount remains outstanding until its maturity date, as periodic payments are not required under the terms of our Credit Agreement. However, it is our intention to pay down our debt with available excess cash flow. See Note 8 of our consolidated Financial Statements for further information.

(2)    Represents interest payments and commitment fees payable on outstanding balances under our revolver and assumes interest rates remain unchanged from the rate as of April 2, 2023.

(3)    As reported under ASC Topic 842.

(4)    This relates to our withdrawal from a multiemployer pension plan. Payments on this obligation will continue through 2034.

In addition to the above contractual obligations, in the ordinary course of business we have routine cash requirements related to capital expenditures for new trucks, facility improvements and expansions, safety equipment and other additions of property, plant and equipment. Our capital expenditures in fiscal 2023 were $48.3 million and in fiscal 2023 were $28.5 million. We anticipate total capital expenditures to be in the range of $40 to $45 million for fiscal 2024.

Critical Accounting Estimates

In preparing the financial statements, we follow U.S. generally accepted accounting principles (“GAAP”). The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, sales and expenses, and related disclosure of contingent assets and liabilities. We re-evaluate our estimates on an ongoing basis. Our estimates are based on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions and conditions. We have determined we have no critical accounting estimates material to our consolidated financial position, results of operations or cash flow.