MasterBrand, Inc. (MBC) FY 2022 MD&A
This page reproduces the company's own Item 7 MD&A text from the linked SEC filing. It is filer text, not grepcent analysis, scoring, or investment advice.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
FORWARD-LOOKING STATEMENTS
This Annual Report on Form 10-K contains “forward-looking statements” regarding business strategies, market potential, future financial performance, and other matters. Statements preceded by, followed by or that otherwise include the word “believes,” “expects,” “anticipates,” “intends,” “projects,” “estimates,” “plans,” “may increase,” “may fluctuate,” and similar expressions or future or conditional verbs such as “will,” “should,” “would,” “may,” and “could,” are generally forward-looking in nature and not historical facts. Where, in any forward-looking statement, we express an expectation or belief as to future results or events, such expectation or belief is based on the current plans and expectations of our management. Although we believe that these statements are based on reasonable assumptions, they are subject to numerous factors, risks and uncertainties that could cause actual outcomes and results to be materially different from those indicated in such statements. These factors include those listed under “Risk Factors” in this Annual Report on Form 10-K.
The forward-looking statements included in this document are made as of the date of this Annual Report on Form 10-K and, except pursuant to any obligations to disclose material information under the federal securities laws, we undertake no obligation to update, amend or clarify any forward-looking statements to reflect events, new information or circumstances occurring after the date of this Annual Report on Form 10-K.
Some of the important factors that could cause our actual results to differ materially from those projected in any such forward-looking statements include:
◦Our ability to develop and expand our business;
◦Our anticipated financial resources and capital spending;
◦Our ability to manage costs;
◦The impact of our dependence on third parties with respect to sourcing our raw materials;
◦Our ability to accurately price our products;
◦Our anticipated future revenues and expectations of operational performance;
◦The effects of competition and consolidation of competitors in our industry;
◦Costs of complying with evolving regulatory requirements and the effect of actual or alleged violations of environmental laws;
◦The effect of climate change and unpredictable seasonal and weather factors;
◦Failure to realize the anticipated benefits of the Separation;
◦Conditions in the housing market in the United States and Canada;
◦The expected strength of our existing customers and consumers;
◦Worldwide economic, geopolitical and business conditions and risks associated with doing business on a global basis;
◦Unfavorable or unexpected effects of the Distribution and Separation;
◦The effects of the COVID-19 pandemic or another public health crisis or other unexpected event; and
◦Other statements contained in this Annual Report on Form 10-K regarding items that are not historical facts or that involve predictions.
Introduction
Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is a supplement to the accompanying consolidated financial statements of MasterBrand and its consolidated subsidiaries and provides additional information on our business, recent developments, financial condition, liquidity and capital resources, cash flows and results of operations.
MD&A is organized as follows:
•Overview: This section provides a general description of our business, as well as recent developments we believe are important in understanding our results of operations and financial condition or in understanding anticipated future trends.
•Separation from Fortune Brands: This section provides a general discussion of our Separation from Fortune Brands.
•Basis of Presentation: This section provides a discussion of the basis on which our consolidated financial statements were prepared, including our historical results of operations and adjustments thereto, primarily allocations of general corporate expenses from Fortune Brands.
27
Table of Contents
•Results of Operations: Our consolidated financial statements are based on a 52- or 53-week fiscal year ending on the last Sunday in December in each calendar year. This section provides an analysis of our results of operations for the 52-week period that ended on December 25, 2022 as compared to December 26, 2021. Unless the context otherwise requires, references to years and quarters contained in this Annual Report on Form 10-K pertain to our fiscal years and fiscal quarters. Additionally, unless the context otherwise requires, references in this Annual Report on Form 10-K to: (1) “2022,” “fiscal 2022” or our “2022 fiscal year” refers to our 2022 fiscal year that is a 52-week period that ended on December 25, 2022; (2)“2021,” “fiscal 2021” or our “2021 fiscal year” refers to our 2021 fiscal year that was a 52-week period that ended on December 26, 2021; and (3) “2020,” “fiscal 2020” or our “2020 fiscal year” refers to our 2020 fiscal year that was a 52-week period that ended on December 27, 2020.
•Liquidity and Capital Resources: This section provides a discussion of our financial condition and an analysis of our cash flows for our 2022 fiscal year as compared to our 2021 fiscal year. This section also provides a discussion of our contractual obligations, other purchase commitments and customer credit risk that existed at December 25, 2022 and December 26, 2021, as well as a discussion of our ability to fund our future commitments and ongoing operating activities through internal and external sources of capital.
•Recently Issued Accounting Standards: This section identifies our adoption of recently issued accounting standards.
•Critical Accounting Estimates: This section identifies and summarizes those accounting policies that significantly impact our reported results of operations and financial condition and require significant judgment or estimates on the part of management in their application.
Overview
Founded nearly 70 years ago, we are the largest manufacturer of residential cabinets in North America. Our superior product quality, innovative design and service excellence drives a compelling value proposition. We have insight into the fashion and features consumers desire, which we use to tailor our product lines across price points. Our volume leadership allows us to achieve an advantaged cost structure and service platform by standardizing product platforms and components to the greatest extent possible—resulting in an improved facility footprint and an efficient supply chain. Further, our decades of experience have informed how we use global geographies to optimize procurement and manufacturing costs. Finally, with the most extensive dealer network throughout the United States and Canada, we have an advantaged distribution model that cannot be easily replicated. We expect to further extend our competitive advantages by using technology and data to enhance the consumer’s experience from visualization to ordering to delivery and installation.
During 2022 as compared to 2021, our net sales grew $420.2 million, or 14.7 percent, as we benefited from favorable price, including price increases which helped to mitigate the impact of cumulative commodity and transportation cost increases, across our product portfolio. Operating income decreased in fiscal 2022 by $31.0 million, or 13.2 percent, as compared to fiscal 2021. This decrease in operating income included the impairment of indefinite-lived tradenames of $46.4 million, additional restructuring charges of $20.9 million as compared to 2021 and $30.1 million of increased corporate expense allocations from Fortune Brands during 2022 as compared to 2021. Aside from these factors, fiscal 2022 benefited from favorable price and manufacturing productivity improvements, partially offset by higher commodity, inbound transportation, distribution and employee-related costs, as well as lower volume.
Separation from Fortune Brands
On April 28, 2022, Fortune Brands announced that its Board of Directors approved in principle a separation of its Cabinets segment into a standalone publicly-traded company (the “Separation”). The Cabinets segment had historically been operated by MBCI. In July 2022, Fortune Brands incorporated MasterBrand, Inc. in the State of Delaware and subscribed to all shares of MasterBrand, Inc.’s common stock upon its incorporation. Following the incorporation of MasterBrand, Inc., the following occurred: (1) Fortune Brands contributed all of the issued and outstanding shares of capital stock of MBCI to MasterBrand, Inc., resulting in MBCI becoming a wholly-owned subsidiary of MasterBrand, Inc. through a transaction between entities under common control; and (2) MBCI was converted into a Delaware limited liability company, MasterBrand Cabinets LLC (collectively, the “Reorganization”).
On December 14, 2022, the Separation was completed by way of a pro rata dividend of our common stock to stockholders of Fortune Brands common stock (the “Distribution”). The Distribution is expected to be generally tax-free for U.S. federal income tax purposes to Fortune Brands, us and Fortune Brands stockholders. On December 14, 2022, the date of Separation, 128.0 million shares of MasterBrand, Inc. common stock were issued. Fortune Brand shareholders received one share of MasterBrand, Inc. common stock for each share of Fortune Brands common stock held on the record date.
28
Table of Contents
Following the Distribution, Fortune Brands stockholders owned 100 percent of the shares of MasterBrand, Inc. common stock and MasterBrand, Inc. became an independent, publicly-traded company, listed under the symbol “MBC” on the New York Stock Exchange beginning December 15, 2022. All share and per share amounts for all periods presented in the consolidated financial statements have been retroactively recast to reflect the effects of the changes in equity structure resulting from the Reorganization, Separation and Distribution. The historical activity of the Company is that of MBCI prior to the Reorganization. The Company’s equity structure prior to the Separation and Distribution included 5,000 shares of MasterBrand, Inc. common stock authorized and 100 shares issued. Prior to the incorporation of MasterBrand, Inc. in July 2022, the equity structure of MBCI included 1,000 authorized and issued shares of common stock. MasterBrand, Inc. is the registrant and the financial reporting entity following the consummation of the Separation and Distribution.
In order to govern the ongoing relationships between MasterBrand, Inc. and Fortune Brands after the Separation and to facilitate an orderly transition, the parties entered into a series of agreements including the following:
•Separation and Distribution Agreement – sets forth the principal actions to be taken in connection with the Separation, including the transfer of assets and assumption of liabilities, among others, and sets forth other agreements governing aspects of the relationship between MasterBrand, Inc. and Fortune Brands.
•Transition Services Agreement – allows for Fortune Brands and MasterBrand to provide certain transition services to each other for a limited time, up to 24 months following the Separation.
•Tax Allocation Agreement – governs the respective rights, responsibilities and obligations of MasterBrand, Inc. and Fortune Brands with respect to tax liabilities and benefits, tax attributes, tax contests and other matters regarding income taxes, non-income taxes and related tax returns.
•Employee Matters Agreement – addresses certain employment, compensation and benefits matters, including the allocation and treatment of certain assets and liabilities relating to MasterBrand, Inc. employees.
Separating the Cabinets segment into a standalone publicly-traded company significantly enhances the long-term growth and return prospects of our Company and offers substantially greater long-term value to stockholders, customers and employees. Moreover, separating the Cabinets segment into an independent, standalone company with publicly-traded stock provides our Company with a number of benefits, including:
•Strategic and Management Focus: The Separation enables our management team to better focus on strengthening our market-leading business and pursue targeted opportunities for long-term growth, profitability, and value creation. Like many of its competitors and peers, our Company believes that it will be more effective in managing its capital structure with credit tied more specifically to its industry and business performance and achieving greater margin expansion by focusing on its operational effectiveness specific to its products. A dedicated management team and board of directors streamlines operational and strategic decision-making, and ensures management incentives are optimized and aligned with our strategic priorities and financial objectives are in line with our industry.
•Resource Allocation and Capital Deployment: The Separation provides us an opportunity to implement a tailored capital structure that ties specifically to our industry and business that provides greater financial and operational flexibility and increased agility. We are better positioned to more effectively allocate resources to address unique operating needs relating to our manufacturing and marketing requirements within our specific markets, invest in strategic priorities that will maximize long-term potential, and manage capital return strategies. Our unique operating needs are tailored towards enhancing the standardization of our processes, including with respect to our supply chain, and the specific manufacturing needs of our products, and strengthening our lean manufacturing capabilities. The Separation provides an opportunity for us to more effectively focus on these unique operating needs and markets.
•Distinct Investment Opportunities and Investor Choice: The Separation creates a compelling investment opportunity for investors based on our unique operating model and financial profile. It also provides investors with enhanced insight into our distinct value drivers and allows for more targeted investment decisions.
Basis of Presentation
Our consolidated financial statements are based on a 52- or 53-week fiscal year ending on the last Sunday in December in each calendar year and have been principally derived from the consolidated financial statements of our Company and its consolidated subsidiaries using the historical results of operations, and historical basis of assets and liabilities. Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). Our historical financial statements through the date of Separation include allocations of expenses related to certain Fortune Brands corporate functions, including information technology, finance, executive,
29
Table of Contents
human resources, supply chain, internal audit, governance and legal services. These expenses have been allocated based on direct usage or benefit where specifically identifiable, with the remainder allocated on a proportional cost allocation method based primarily on net sales, employee headcount or number of facilities, as applicable. Prior to the Separation, total expenses allocated for our 2022, 2021, and 2020 fiscal years were $92.5 million, $62.0 million, and $61.6 million, respectively. Of these allocations, $72.4 million, $42.3 million, and $42.4 million, respectively, were not previously allocated to us for our 2022, 2021, and 2020 fiscal years. Such amounts are primarily included within selling, general and administrative expenses in our consolidated statements of income and comprehensive income. We consider the expense methodology and resulting allocation to be reasonable for all periods presented; however, the allocations may not be indicative of actual expenses that would have been incurred had we operated as an independent, publicly-traded company for the periods presented. Actual costs that we may have incurred had we been a standalone company would depend on a number of factors, including the chosen organizational structure, whether functions were outsourced or performed by our employees and strategic decisions made in areas such as manufacturing, selling and marketing, research and development, information technology and infrastructure. Accordingly, historical allocations may not be indicative of future costs we incur operating as an independent, publicly-traded company.
The income tax amounts in our consolidated financial statements have been calculated on a separate return method and presented as if our operations were separate taxpayers in the respective jurisdictions. For the pre-Separation period in 2022, including the Separation, federal and state income tax payments and refunds were paid and received by Fortune Brands on our behalf. The net taxes paid on our behalf are payable to Fortune Brands, as provided in the indemnification provisions of the Tax Allocation Agreement. Accordingly, the net tax payable of $32.6 million to Fortune Brands as of December 25, 2022, is recorded in accounts payable on the Consolidated Balance Sheets.
Following the Separation, a limited number of services that Fortune Brands provided to us, or we provided to them, prior to the Separation will continue to be provided for a period of time under a Transition Services Agreement. We expect to incur certain costs to establish ourselves as a standalone public company, including services provided by our own resources or through third-party service providers relating to corporate functions, including information technology, finance, executive, human resources, supply chain, internal audit, governance and legal services, as well as ongoing additional costs associated with operating as an independent, publicly-traded company.
All transactions between us and Fortune Brands previously resulting in related party balances were settled in our consolidated financial statements immediately prior to the Distribution, or were settled shortly thereafter, including by making a distribution of capital by us to Fortune Brands of any remaining related party receivable owed by Fortune Brands to us. For more information regarding related party transactions with Fortune Brands, see Note 20, “Related Party Transactions” of our audited consolidated financial statements within this Annual Report on Form 10-K. Fortune Brands utilized a central approach to treasury management, and we historically participated in related cash pooling arrangements. Our cash and cash equivalents on our consolidated balance sheets represent cash balances held in bank accounts owned by us and our consolidated subsidiaries. Prior to Separation, we had no third-party borrowings. All borrowings attributable to our business and due to Fortune Brands were recorded as “related party payable” in our consolidated balance sheets and classified as current or noncurrent based on loan maturity dates. Fortune Brands’ third-party debt and related interest expense have not historically been attributed to us as we were not the legal obligor of the debt, and the borrowings are not specifically identifiable to us. However, we incurred indebtedness in connection with the Separation and Distribution, which will result in additional interest expense in future periods.
Results of Operations
The following discussion includes a comparison of results of operations for the fifty-two weeks ended December 25, 2022 compared to the fifty-two weeks ended December 26, 2021. For comparisons of our 2021 fiscal year compared to our 2020 fiscal year and our 2020 fiscal year compared to our 2019 fiscal year, please refer to the section entitled, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” within the Information Statement filed with the SEC on December 1, 2022.
30
Table of Contents
Fiscal 2022 Compared to Fiscal 2021
| Fifty-Two Weeks Ended | |||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| (In millions) | December 25, 2022 | $ change | % change | December 26, 2021 | |||||||||
| Net sales | $ | 3,275.5 | $ | 420.2 | 14.7 | % | $ | 2,855.3 | |||||
| Cost of products sold | 2,335.0 | 263.6 | 12.7 | % | 2,071.4 | ||||||||
| Gross Profit | 940.5 | 156.6 | 20.0 | % | 783.9 | ||||||||
| Selling, general and administrative expenses | 648.5 | 120.9 | 22.9 | % | 527.6 | ||||||||
| Amortization of intangible assets | 17.2 | (0.6) | (3.4) | % | 17.8 | ||||||||
| Asset impairment charges | 46.4 | 46.4 | n/m(1) | — | |||||||||
| Restructuring charges | 25.1 | 20.9 | n/m(1) | 4.2 | |||||||||
| Operating income | 203.3 | (31.0) | (13.2) | % | 234.3 | ||||||||
| Related party interest income, net | (12.9) | (8.3) | 180.4 | % | (4.6) | ||||||||
| Interest expense | 2.2 | 2.2 | n/m(1) | — | |||||||||
| Other expense, net | 0.6 | — | n/m(1) | 0.6 | |||||||||
| Income before taxes | 213.4 | (24.9) | (10.4 | %) | 238.3 | ||||||||
| Income tax expense | 58.0 | 2.3 | 4.1 | % | 55.7 | ||||||||
| Net income | $ | 155.4 | $ | (27.2) | (14.9) | % | $ | 182.6 |
__________
(1)Not meaningful.
Net sales
Net sales were $3,275.5 million for 2022 compared to $2,855.3 million for 2021, an increase of $420.2 million, or 14.7 percent. The increase was due to favorable price, including price increases which helped to mitigate the impact of cumulative commodity and transportation cost increases, partially offset by lower sales volume of $41.6 million. Foreign currency impact was $4.8 million unfavorable during 2022 as compared to 2021.
Cost of products sold
Cost of products sold increased by $263.6 million, or 12.7 percent, to $2,335.0 million in 2022 as compared to $2,071.4 million in 2021, primarily due to commodity cost inflation, labor inflation and higher inbound transportation costs. These factors were partially offset by manufacturing productivity improvements, including cost reductions as we move our product portfolio more towards common platforms, and lower sales volume.
Selling, general and administrative expenses
Selling, general and administrative expenses increased by $120.9 million, or 22.9 percent, to $648.5 million (19.8 percent of net sales) in 2022 compared to $527.6 million (18.5 percent of net sales) in 2021, primarily due to higher distribution costs ($42.6 million) and employee-related costs ($7.6 million), as well as increased corporate expense allocations from Fortune Brands ($30.1 million), including costs incurred related to the Separation from Fortune Brands. We also incurred $15.4 million of additional costs in 2022 as compared to 2021 directly related to the Separation from Fortune Brands.
Asset impairment charges
During 2022, we incurred $46.4 million of asset impairment charges related to indefinite-lived tradenames. During the second quarter of 2022, we incurred an asset impairment charge of $26.0 million related to an indefinite-lived tradename, as production was shifted within our manufacturing footprint to enable what we expect to be a higher value purpose and growth opportunity, which led to downward revisions to forecasted revenue growth rates associated with the tradename and the recognition of the corresponding asset impairment charge. In the fourth quarter of 2022, we incurred an additional asset impairment charge of $12.8 million related to the same indefinite-lived tradename as a result of further shifts within our product portfolio to better align with forecasted future customer demand as a result of a significant decrease in sales during the fourth quarter of 2022, driven by continued and persistent inflation, as well as elevated interest rates and economic uncertainty. These downward revisions to forecasted revenue growth were not known when recording the impairment charge during the second quarter of 2022. In the fourth quarter of 2022, we also incurred an impairment charge of $7.6 million related to another indefinite-lived tradename, due to a shift in customer demand in the fourth quarter from
31
Table of Contents
this tradename to a lower price point product, as a result of continued and persistent inflation as well as elevated interest rates and economic uncertainty.
Restructuring charges
Restructuring charges were $25.1 million in 2022 as compared to $4.2 million in 2021. The increase in restructuring charges in 2022 was primarily related to the relocation and closure of certain production facilities within our manufacturing footprint, resulting in a more flexible facility footprint. These restructuring charges are primarily related to severance and other employee-related costs.
Operating income
We recorded operating income of $203.3 million for 2022, compared to operating income of $234.3 million for 2021. The $31.0 million, or 13.2 percent, decrease in operating income included the impairment of indefinite-lived tradenames of $46.4 million, $20.9 million of additional restructuring charges and $30.1 million of increased corporate expense allocations from Fortune Brands during fiscal 2022 as compared to fiscal 2021. We also incurred $15.4 million of additional costs in 2022 as compared to 2021 directly related to the Separation from Fortune Brands. Aside from these factors, fiscal 2022 benefited from favorable price and manufacturing productivity improvements, partially offset by higher commodity, inbound transportation, distribution and employee-related costs, as well as lower volume.
Related party interest income, net
Related party interest income, net, was $12.9 million in 2022 as compared to $4.6 million in 2021. The increase of $8.3 million was primarily due to an increase in a related party loan receivable from Fortune Brands, as excess cash generated by our operations was remitted to Fortune Brands on a regular basis through the cash pooling arrangements up to the date of the Separation, at which time such arrangements ceased.
Interest expense
Upon Separation, we incurred indebtedness in connection with the Separation and Distribution, which resulted in interest expense of $2.2 million in 2022. Prior to Separation, we had no third-party borrowings.
Other expense, net
Other expense, net was $0.6 million in 2022 was comparable to other expense, net of $0.6 million in 2021.
Income taxes
Our consolidated income tax expense, income before taxes, and effective tax rate for the years ended December 25, 2022 and December 26, 2021 were as follows:
| Fifty-Two Weeks Ended | |||||||
|---|---|---|---|---|---|---|---|
| (In millions) | December 25, 2022 | December 26, 2021 | |||||
| Income before taxes | $ | 213.4 | $ | 238.3 | |||
| Income tax expense | 58.0 | 55.7 | |||||
| Effective tax rate | 27.2 | % | 23.4 | % |
For 2022, the Company’s effective tax rate was 27.2 percent, compared to an effective tax rate of 23.4 percent for 2021. The increase in effective tax rate was primarily the result of state and local income taxes and IRS audit adjustments including recognition of a deferred tax liability for earnings of various foreign entities, partially offset by increased benefits for the release of uncertain tax positions and foreign income taxed at lower rates.
The 2022 effective income tax rate of 27.2 percent was unfavorably impacted by IRS audit adjustments including recognition of a deferred tax liability for earnings of various foreign entities, and state and local income taxes, partially offset by favorable benefits for the release of uncertain tax positions and foreign income taxed at lower rates. The 23.4 percent effective income tax rate for 2021 was unfavorably impacted by state and local income taxes, partially offset by a favorable benefit for the release of uncertain tax positions and foreign income taxed at lower rates.
32
Table of Contents
Net income
Net income was $155.4 million for 2022 compared to $182.6 million for 2021. The $27.2 million, or 14.9 percent, decrease in net income was primarily due to the decrease in operating income.
Liquidity and Capital Resources
Our primary liquidity needs have historically been to support working capital requirements and fund capital expenditures. Prospectively, we may have liquidity needs to finance acquisitions and return cash to stockholders, if and when appropriate. Historically, our principal sources of liquidity have been cash on hand, cash flows from operating activities and financial support from Fortune Brands via participation in Fortune Brands’ centralized approach to treasury, including financing and cash management activities. Subsequent to the Separation, we implemented our own centralized approach to treasury, including cash management performed through cash pooling arrangements. Certain of our entities have standalone cash accounts that are not included in the centralized cash pooling arrangements. All cash balances specifically identifiable to us are included in our consolidated balance sheets and statement of cash flows. The cash flows presented in our consolidated statement of cash flows may not be indicative of the cash flows we would have recognized had we operated as a standalone publicly-traded company for the periods presented prior to the Separation.
After the Separation, we no longer have financial support from Fortune Brands. Our operating income is generated by our subsidiaries. There are no restrictions on the ability of our subsidiaries to pay dividends or make other distributions to MasterBrand. We periodically review our portfolio of brands, manufacturing and supply chain footprint, and evaluate potential strategic transactions to increase stockholder value. However, we cannot predict whether or when we may enter into acquisitions, joint ventures or dispositions, or what impact any such transactions could have on our results of operations, cash flows or financial condition. Our cash flows from operations, borrowing availability and overall liquidity are subject to certain risks and uncertainties, including those described in the section entitled “Risk Factors” in this Annual Report on Form 10-K.
On November 18, 2022, we entered into a 5-year, $1.25 billion credit agreement, consisting of a $750 million term loan and a $500 million revolving credit facility (the “2022 Credit Agreement”). Initial proceeds of $955 million from the credit agreement were received at the time of Separation from Fortune Brands. The proceeds were primarily used to make a cash dividend payment of $940.0 million to Fortune Brands and to pay related fees and expenses at the Separation. The credit agreement is secured by certain assets as well as the guarantee of certain of our subsidiaries.
Interest rates under these facilities are variable based on the Secured Overnight Financing Rate (“SOFR”) at the time of the borrowing, and our net leverage ratio as measured by our Net Leverage to our consolidated earnings before interest, taxes, depreciation and amortization (“Consolidated EBITDA”). Net Leverage is defined as consolidated total indebtedness minus certain cash and cash equivalents. Consolidated EBITDA is defined as consolidated net income before interest expense, income taxes, depreciation, amortization of intangible assets, losses from asset impairments, and certain other one-time adjustments. The Net Leverage Ratio may not exceed 3.875 to 1.0 at the initial borrowing through the second fiscal quarter of 2023, adjusting downward in various future quarters before settling at 3.25 to 1.0 in January 2025. Interest rates can range from SOFR plus 1.85 percent to SOFR plus 2.60 percent. We also are required to maintain a minimum Interest Coverage Ratio of 3.0 to 1.0. The Interest Coverage Ratio is defined as Consolidated EBITDA to consolidated interest expense.
Our 2022 Credit Agreement contains additional covenants which limit or preclude certain corporate actions based upon the measurement of certain financial covenant metrics. The $750 million Term Loan has quarterly required amortization payments beginning in March 2023.
As of December 25, 2022, the Company was in compliance with all financial covenants set forth in the 2022 Credit Agreement, and expects to remain in compliance for the foreseeable future.
As of December 25, 2022, we had $985.0 million outstanding in third-party borrowings. We may also incur additional indebtedness in the future.
33
Table of Contents
Cash Flows
Below is a summary of cash flows for the fiscal years ended December 25, 2022 and December 26, 2021.
| For years ended | ||||||
|---|---|---|---|---|---|---|
| (In millions) | 2022 | 2021 | ||||
| Net cash provided by operating activities | 235.6 | 148.2 | ||||
| Net cash used in investing activities | (55.9) | (51.5) | ||||
| Net cash used in financing activities | (215.3) | (109.7) | ||||
| Effect of foreign exchange rate changes on cash | (4.7) | 0.1 | ||||
| Net (decrease) in cash and cash equivalents | $ | (40.3) | $ | (12.9) |
Fiscal 2022 as compared to Fiscal 2021
Net cash provided by operating activities included net income of $155.4 million in 2022, as compared to net income of $182.6 million in 2021. Net income in 2022 reflected non-cash asset impairment charges of $46.4 million, as well as non-cash restructuring charges of $13.0 million. Both periods reflected increases in inventory, with the increase in inventory in 2022 of $70.1 million the result of increased material costs, as well as an intentional build in inventory in the first half of 2022 in order to mitigate the impact of an uncertain and volatile global supply chain environment. The increase in inventory in 2021 of $58.5 million reflected actions to serve the increased sales volume in 2021 as compared to 2020. Accounts payable in 2022 increased $18.3 million, driven primarily by the $44.1 million payable to Fortune Brands at December 25, 2022, which was mainly related to federal and state income taxes, partially offset by reduced inventory purchasing in the second half of 2022. Accounts payable increased $44.7 million in 2021 as a result of the increased inventory purchases. In 2021, accounts receivable increased $72.2 million due to higher net sales as compared to the prior period, as 2020 was negatively impacted by the COVID-19 pandemic. While net sales increased again in 2022, accounts receivable decreased $13.5 million as a result of collection efforts.
Net cash used in investing activities was $55.9 million in 2022 compared to net cash used in investing activities of $51.5 million in 2021. The increase of $4.4 million was primarily due to continued investment in manufacturing capabilities and technology.
Net cash used in financing activities was $215.3 million in 2022 as compared to $109.7 million in 2021. Financing activities in 2022 reflect the payment of a dividend of $940.0 million to Fortune Brands in conjunction with the Separation. This dividend was funded by the borrowing of $985.0 million of external debt at, and subsequent to, the Separation date. The remaining activity in 2022, as well as that in 2021, primarily reflects our cash remittances to Fortune Brands, net of cash lending from Fortune Brands, to finance our operations prior to the Separation. The financing relationship with Fortune Brands ceased as of the date of Separation.
As of December 25, 2022, approximately $65.9 million of our $101.1 million of consolidated cash and cash equivalents were held at various foreign subsidiaries. Our operations in the United States generate sufficient cash flow to satisfy U.S. operating requirements. Refer to Note 13, “Income Taxes,” to the Consolidated Financial Statements for additional information regarding foreign earnings.
We believe that our cash and cash equivalent balances, along with available cash from operating cash flows and credit facilities, will be adequate to fund our typical needs, including working capital requirements and projected capital expenditures. We also believe we have access to additional funds from capital markets to fund strategic initiatives.
Customer Credit Risk
We routinely grant unsecured credit to customers in the normal course of business. Accounts receivable were $289.6 million and $305.3 million as of December 25, 2022 and December 26, 2021, respectively, and are recorded at their stated amount less allowances for discounts and doubtful accounts. Allowances for doubtful accounts include provisions for certain customers where a risk of default has been specifically identified, as well as provisions determined on a general formula basis when it is determined that the risk of some default is probable and estimable but cannot yet be associated with specific customers. The assessment of the likelihood of customer defaults is based on a variety of factors, including the length of time the receivables are past due, the historical collection experience, existing economic conditions and estimated future collection expectations. In accordance with our policy, our allowance for doubtful accounts was $11.6
34
Table of Contents
million and $2.5 million as of December 25, 2022 and December 26, 2021, respectively. The conditions in the global economy and ongoing market volatility may reduce our customers’ ability to access sufficient liquidity and capital to fund their operations and make our estimation of customer defaults inherently uncertain. While we believe current allowances for doubtful accounts are adequate, it is possible that continued weak economic conditions may cause significantly higher levels of customer defaults and bad debt expense in future periods.
Pension Plan
We sponsor a defined benefit pension plan. However, the plan has been frozen to new participants and benefit accruals were frozen for active participants on or prior to December 31, 2016. The defined benefit pension plan is funded with a portfolio of investments maintained within our benefit plan trust. As of December 25, 2022, the aggregate fair value of our pension plan assets was $119.4 million, representing 92.6 percent of the accumulated benefit obligation liability. During fiscal 2022, we made pension contributions of approximately $1.1 million. For the foreseeable future, we believe that we have sufficient liquidity to meet the minimum funding that may be required by the Pension Protection Act of 2006.
Contractual Obligations and Other Commercial Commitments
The following summarizes our contractual obligations and commitments as of December 25, 2022. Purchase obligations were $234.6 million, of which $223.9 million are due within one year. Purchase obligations include contracts for raw materials and finished goods purchases, selling and administrative services and capital expenditures. Total expected future lease payments under non-cancellable operating leases as of December 25, 2022 are $15.2 million in 2023, $13.5 million in 2024, $8.8 million in 2025, $6.2 million in 2026, $5.8 million in 2027 and $9.5 million thereafter.
In addition to the contractual obligations and commitments described above, we also had other corporate commercial commitments for which we are contingently liable as of December 25, 2022. Other corporate commercial commitments include standby letters of credit of $0.4 million as of December 25, 2022. We also have surety bonds outstanding of $3.5 million, of which $3.4 million are due in the next 12 months.
Debt payments due during the next five years as of December 25, 2022 are $18.8 million in 2023, $37.5 million in 2024, $37.5 million in 2025, $37.5 million in 2026, and $853.7 million in 2027. Interest payments due during the next five years as of December 25, 2022 are $70.6 million in 2023, $63.3 million in 2024, $60.8 million in 2025, $58.3 million in 2026, and $48.9 million in 2027.
We do not currently have any off-balance sheet arrangements that are material or reasonably likely to be material to our financial condition or results of operations.
Derivative Financial Instruments
In accordance with Accounting Standards Codification (“ASC”) requirements for derivatives and hedging, we recognize all derivative contracts as either assets or liabilities on the balance sheet, and the measurement of those instruments is at fair value. If the derivative is designated as a fair value hedge and is effective, the changes in the fair value of the derivative and of the hedged item attributable to the hedged risk are recognized in earnings in the same period. If the derivative is designated as a cash flow hedge, the changes in the fair value of the derivative are recorded in other comprehensive income (loss) (“OCI”) and are recognized in the consolidated statement of income when the hedged item affects earnings. If the derivative is designated as an effective economic hedge of the net investment in a foreign operation, the changes in the fair value of the derivative is reported in the cumulative translation adjustment section of OCI. Similar to foreign currency translation adjustments, these changes in fair value are recognized in earnings only when realized upon sale or upon complete or substantially complete liquidation of the investment in the foreign entity.
Deferred currency gains (losses) of $4.5 million, $2.9 million, and $(2.3) million (before tax impact) were reclassified into earnings for the 2022, 2021, and 2020 fiscal years, respectively. Based on foreign exchange rates as of December 25, 2022, we estimate that $2.8 million of net derivative gain included in other comprehensive income (“AOCI”) as of December 25, 2022, will be reclassified to earnings within the next twelve months.
Foreign Currency Risk
We have operations in various foreign countries, principally Canada and Mexico. Therefore, changes in the value of the related currencies affect our financial statements when translated into U.S. dollars. Certain anticipated transactions, assets and liabilities are exposed to foreign currency risk. Principal currencies hedged include the Canadian dollar and the Mexican peso. We regularly monitor our foreign currency exposures in order to maximize the overall effectiveness of our foreign currency hedge positions.
35
Table of Contents
Recently Issued Accounting Standards
The adoption of recent accounting standards, as discussed in Note 2, “Significant Accounting Policies” of our audited consolidated financial statements, which are included elsewhere in this Annual Report on Form 10-K, has not had and is not expected to have a significant impact on our revenue, earnings or liquidity.
Critical Accounting Estimates
Our significant accounting policies are described in Note 2, “Significant Accounting Policies” of our audited consolidated financial statements, which are included elsewhere in this Annual Report on Form 10-K. Our audited consolidated financial statements are prepared in conformity with GAAP. Preparation of the financial statements requires us to make judgments, estimates and assumptions that affect the amounts of assets and liabilities reflected in the financial statements and revenues and expenses reported for the relevant reporting periods. We believe the policies discussed below are our critical accounting policies as they include the more significant, subjective and complex judgments and estimates made when preparing our consolidated financial statements.
Inventories
Inventory provisions are recorded to reduce inventory to the net realizable dollar value for obsolete or slow moving inventory based on assumptions about future demand and marketability of products, the impact of new product introductions, inventory levels and turns, product spoilage and specific identification of items, such as product discontinuance, engineering/material changes, or regulatory-related changes. In accordance with this policy, our inventory provision was $19.6 million and $13.6 million as of December 25, 2022 and December 26, 2021, respectively.
Goodwill and Indefinite-lived Intangible Assets
In accordance with ASC Topic 350, Intangibles—Goodwill and Other, goodwill is tested for impairment at least annually in the fourth quarter and written down when impaired. An interim impairment test is performed if an event occurs or conditions change that would more likely than not reduce the fair value of the reporting unit below the carrying value.
To evaluate the recoverability of goodwill, we first assess qualitative factors to determine whether it is more likely than not that goodwill is impaired. Qualitative factors include changes in volume, margin, customers and the industry. If it is deemed more likely than not that goodwill for a reporting unit is impaired, we will perform a quantitative impairment test using a weighting of the income and market approaches. We may also elect to bypass the qualitative testing and proceed directly to the quantitative testing. For the income approach, we use a discounted cash flow model, estimating the future cash flows of the reporting units to which the goodwill relates and then discounting the future cash flows at a market-participant-derived discount rate. In determining the estimated future cash flows, we consider current and projected future levels of income based on management’s plans for that business; business trends, prospects and market and economic conditions; and market-participant considerations. For the market approach, we apply market multiples for peer groups to the current operating results of the reporting unit to determine the reporting unit’s fair value. Our reporting unit is our operating segment. When the estimated fair value of the reporting unit is less than its carrying value, we measure and recognize the amount of the goodwill impairment loss based on that difference.
The significant assumptions that are used to determine the estimated fair value for goodwill impairment testing include the following: third-party market forecasts of U.S. new home starts and home R&R spending; management’s sales, operating income and cash flow forecasts; peer company earnings before interest, taxes, depreciation and amortization (“EBITDA”) multiples; the market-participant-based discount rate; and the perpetuity growth rate. Our estimates of reporting unit fair values are based on certain assumptions that may differ from our historical and future actual operating performance. Specifically, assumptions related to growth in the new construction and R&R market of the U.S. home products markets drive our forecasted sales growth. The market forecasts are developed using independent third-party forecasts from multiple sources. In addition, estimated future operating income and cash flow consider our historical performance at similar levels of sales volume and management’s future operating plans as reflected in annual and long-term plans that are reviewed and approved by management.
Certain of our tradenames have been assigned an indefinite life as we currently anticipate that these tradenames will contribute cash flows to us indefinitely. Indefinite-lived intangible assets are not amortized, but are evaluated at least annually to determine whether the indefinite useful life is appropriate. We measure the fair value of identifiable intangible assets upon acquisition and we review for impairment annually in the fourth quarter and whenever market or business events indicate there may be a potential impairment of that intangible. Impairment losses are recorded to the extent that the
36
Table of Contents
carrying value of the indefinite-lived intangible asset exceeds its fair value. The significant assumptions that are used to determine the estimated fair value for indefinite-lived intangible assets upon acquisition and subsequent impairment testing are: forecasted revenue growth rates; the assumed royalty rates; and the market-participant discount rates.
Our cash flow projections used to assess impairment of our goodwill and other intangible assets are significantly influenced by our projection for the U.S. home products market, our annual operating plans finalized in the fourth quarter of each fiscal year and our ability to execute on various planned cost reduction initiatives supporting operating income improvements. Our projection for the U.S. home products market is inherently uncertain and is subject to a number of factors, such as employment rates, home prices, interest rates, credit availability, new home starts and the rate of home foreclosures.
We first assess qualitative factors to determine whether it is more likely than not that an indefinite-lived intangible asset is impaired. Qualitative factors include changes in volume, customers and the industry. If it is deemed more likely than not that an intangible asset is impaired, we will perform a quantitative impairment test. We may also elect to bypass the qualitative testing and proceed directly to the quantitative testing. We measure fair value of our indefinite-lived tradenames using the relief-from-royalty approach which estimates the present value of royalty income that could be hypothetically earned by licensing the brand name to a third party over the remaining useful life. The determination of fair value using this technique requires the use of estimates and assumptions related to forecasted revenue growth rates, the assumed royalty rates and the market-participant discount rates. During our 2022 annual impairment test, we elected to bypass the qualitative testing given the Separation from Fortune Brands and tested all of our indefinite-lived tradenames quantitatively. In 2022, we recognized impairment charges of $46.4 million.
In the second quarter ended June 26, 2022, we recognized an impairment charge of $26.0 million related to an indefinite-lived tradename. During the second quarter ended June 26, 2022, production was shifted within our manufacturing footprint to enable what we expect to be a higher value purpose and growth opportunity, which led to downward revisions to forecasted revenue growth rates associated with the tradename. In the fourth quarter ended December 25, 2022, we incurred an additional asset impairment charge of $12.8 million related to the same indefinite-lived tradename as a result of further shifts within our product portfolio to better align with forecasted future customer demand as a result of a significant decrease in sales during the fourth quarter of 2022, driven by continued and persistent inflation, as well as elevated interest rates and economic uncertainty. These downward revisions to forecasted revenue growth were not known when recording the impairment charge during the second quarter of 2022. As of December 25, 2022 and December 26, 2021, the carrying value of this tradename was $46.2 million and $85.0 million, respectively.
In the fourth quarter ended December 25, 2022, we incurred an impairment charge of $7.6 million to another indefinite-lived tradename. This was primarily due to a shift in customer demand from this tradename to a lower price point product, as a result of continued and persistent inflation as well as elevated interest rates and economic uncertainty. As of December 25, 2022 and December 26, 2021, the carrying value of this tradename was $19.1 million and $26.7 million, respectively.
In the first quarter ended March 29, 2020, we recognized an impairment charge of $9.5 million related to another indefinite-lived tradename. This charge was primarily the result of lower expected sales of premium cabinetry products related to the impact of COVID-19. As of December 25, 2022 and December 26, 2021, the carrying value of this tradename was $29.1 million.
The fair values of the impaired tradenames were measured using the relief-from-royalty approach, which estimates the present value of royalty income that could be hypothetically earned by licensing the tradename to a third party over its remaining useful life. Some of the more significant assumptions inherent in estimating the fair values include forecasted revenue growth rates, assumed royalty rates, and market-participant discount rates that reflect the level of risk associated with the tradenames’ future revenues and profitability. We selected the assumptions used in the financial forecasts using historical data, supplemented by current and anticipated market conditions, estimated growth rates, and management plans. These assumptions represent Level 3 inputs of the fair value hierarchy. See Note 8, “Goodwill and Identifiable Intangible Assets” and Note 10, “Fair Value Measurements” of our audited consolidated financial statements, which are included elsewhere in this Annual Report on Form 10-K, for additional information.
37
Table of Contents
The significant assumptions used to estimate the fair values of the tradenames tested quantitatively during the fiscal years ended December 25, 2022, December 26, 2021 and December 27, 2020 were as follows:
| 2022 | 2021 | 2020 | ||||||||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Unobservable Input | Min | Max | WtdAvg(a) | Min | Max | WtdAvg(a) | Min | Max | WtdAvg(a) | |||||||||||||||||
| Discount rate | 11.9 | % | 12.6 | % | 12.2 | % | 10.9 | % | 11.5 | % | 11.2 | % | 12.8 | % | 13.2 | % | 12.9 | % | ||||||||
| Royalty rate(b) | 2.5 | % | 4.0 | % | 3.5 | % | 2.4 | % | 4.0 | % | 3.4 | % | 2.4 | % | 4.0 | % | 3.3 | % | ||||||||
| Long-term revenue growth rate(c) | 1.0 | % | 3.0 | % | 2.0 | % | 1.0 | % | 3.0 | % | 2.6 | % | 1.0 | % | 3.0 | % | 2.6 | % |
__________
(a)Weighted by the relative fair value of the tradenames that were tested quantitatively.
(b)Represents estimated percentage of sales a market-participant would pay to license the tradenames that were tested quantitatively.
(c)Selected long-term revenue growth rate within 10-year projection period of the tradenames that were tested quantitatively.
A 50 basis point change in any of the significant assumptions used during the fiscal year ended December 25, 2022 would not have resulted in an impairment being recognized when estimating the fair value of our indefinite-lived tradenames, with the exception of the fourth quarter indefinite-lived tradename impairments noted above, which were subject to partial impairments of $20.4 million. A 50 basis point change in any of the significant assumptions used during the fiscal year ended December 26, 2021 would not have resulted in an impairment being recognized when estimating the fair value of our indefinite-lived tradenames. Relating to the impaired indefinite-lived tradenames in the fourth quarter of 2022, a 50 basis point change in the discount rate, royalty rate or long-term revenue growth rate at December 25, 2022 would have resulted in an incremental impairment of $2.8 million, $12.2 million and $1.5 million, respectively.
Defined Benefit Plan
We have a defined benefit pension plan in the United States covering many of our employees. However, the plan has been frozen to new participants and benefit accruals were frozen for active participants on or before December 31, 2016.
We recognize changes in the fair value of defined benefit pension plan assets and net actuarial gains or losses in excess of 10 percent of the greater of the fair value of defined benefit pension plan assets and the plan’s projected benefit obligation (the “corridor”) in earnings immediately upon remeasurement, which is at least annually in the fourth quarter of each fiscal year. Net actuarial gains and losses occur when actual experience differs from any of the assumptions used to value the defined benefit plan or when assumptions change as they may each year. The primary factors contributing to actuarial gains and losses are changes in the discount rate used to value obligations as of the measurement date and the differences between expected and actual returns on defined benefit pension plan assets. This accounting method results in the potential for volatile and difficult to forecast gains and losses. The pre-tax recognition of actuarial losses was $0.2 million, zero and $0.5 million for our 2022, 2021 and 2020 fiscal years, respectively. The total net actuarial losses in accumulated other comprehensive income for the defined benefit pension plan were $12.8 million and $7.2 million as of December 25, 2022 and December 26, 2021, respectively.
We record amounts relating to the defined benefit plan based on various actuarial assumptions, including discount rates, assumed rates of return, turnover and mortality rates and health care cost trend rates. We review our actuarial assumptions on an annual basis and make modifications to the assumptions based on current economic conditions and trends. We believe that the assumptions utilized in recording our obligations under our plan are reasonable based on our experience and on advice from our independent actuaries; however, differences in actual experience or changes in the assumptions may materially affect our financial condition or results of operations. The expected rate of return on plan assets is determined based on the nature of the plan’s investments, our current asset allocation and our expectations for long-term rates of return. The weighted-average long-term expected rate of return on pension plan assets for the fiscal years ended December 25, 2022 and December 26, 2021 was 6.2 percent and 4.5 percent, respectively. The discount rate used to measure obligations is based on a spot-rate yield curve that matches projected future benefit payments with the appropriate interest rate applicable to the timing of the projected future benefit payments. The bond portfolio used for the selection of the discount rate is from the top quartile of bonds rated by nationally recognized statistical rating organizations, and includes only non-callable bonds and those that are deemed to be sufficiently marketable with a Moody’s credit rating of
38
Table of Contents
Aa or higher. The weighted-average discount rate for defined benefit liabilities as of December 25, 2022 and December 26, 2021 was 5.2 percent and 3.0 percent, respectively.
Below is a table showing pre-tax pension expense (income), including the impact of actuarial losses:
| (In millions) | 2022 | 2021 | 2020 | |||||||
|---|---|---|---|---|---|---|---|---|---|---|
| Total pension expense (income) | $ | (2.0) | $ | (2.8) | $ | (0.2) | ||||
| Actuarial loss component of expense (income) above | 0.2 | — | 0.5 |
The actuarial losses in 2022 were principally due to negative asset returns, partially offset by the change in discount rates. Discount rates in 2022 used to determine benefit obligations increased by 220 basis points for pension benefits. Discount rates in 2021 used to determine benefit obligations increased by 30 basis points for pension benefits. Our actual loss on plan assets in 2022 was 24.1 percent compared to an actuarial assumption of 4.5 percent expected return. Our actual return on plan assets in 2021 was 7.1 percent compared to an actuarial assumption of 4.8 percent expected return. Significant actuarial losses in future periods would be expected if discount rates decline, actual returns on plan assets are lower than our expected return, or a combination of both occurs.
A 25 basis point change in our discount rate assumption would lead to an increase or decrease in our pension liability of approximately $3.2 million. A 25 basis point change in the long-term rate of return on plan assets used in accounting for our pension plan would have a $0.3 million impact on pension expense. In addition, if required, actuarial gains and losses will be recorded in accordance with our defined benefit plan accounting method as previously described. It is not possible to forecast or predict whether there will be actuarial gains and losses in future periods, and if required, the magnitude of any such adjustment. These gains and losses are driven by differences in actual experience or changes in the assumptions that are beyond our control, such as changes in interest rates and the actual return on pension plan assets.
Income Taxes
For taxable periods prior to and including the Separation, our operations were included in the consolidated U.S. federal and certain state and local income tax returns of Fortune Brands, as applicable. We filed separate foreign income tax returns. The income tax expense in our Consolidated Financial Statements has been determined on a stand-alone return basis in accordance with ASC Topic 740, Income Taxes, which requires the recognition of income taxes using the liability method. The tax provision and current and deferred tax balances have been prepared on a separate-return basis as if we were a separate filer. Indemnification related tax balances, including allocated amounts of estimated income taxes for the year ended December 25, 2022, will be settled with Fortune Brands pursuant to their filing of the relevant income tax returns, including our operations for taxable periods prior to and including the Separation.
Post-Separation, our income tax provisions are calculated based on our operating footprint, as well as our tax return elections and assertions. For taxable periods ended after the Separation, we will file a consolidated U.S. federal income tax return and various state and local income tax returns. Our foreign income tax returns will continue to be filed on a full-year basis.
Deferred tax assets and liabilities are determined based on the differences between the financial statements and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. The recognition and measurement of deferred tax asset and liability balances, and the corresponding deferred tax expense or benefit, are determined for each tax-paying component in each relevant jurisdiction. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in income in the period the new tax rate is enacted.
We recognize liabilities for unrecognized tax benefits which are recognized if the weight of available evidence indicates that it is not more-likely-than-not that the positions will be sustained on examination, including resolution of the related appeals or litigation processes, if any. We record liabilities for uncertain income tax positions based on a two-step process. The first step is recognition, where we evaluate whether an individual tax position has a likelihood of greater than 50 percent of being sustained upon examination based on the technical merits of the position, including resolution of any related appeals or litigation processes. For tax positions that are currently estimated to have a less than 50 percent likelihood of being sustained, no tax benefit is recorded. Considerable management judgment is necessary to assess the inherent uncertainties related to the interpretations of complex tax laws, regulations, and taxing authority rulings. For tax positions that have met the recognition threshold in the first step, we perform the second step of measuring the benefit to be recorded. The actual benefits ultimately realized may differ from our estimates. As of each balance sheet date, unrecognized tax benefits are reassessed and adjusted if our judgment changes as a result of new information, and changes
39
Table of Contents
in facts or circumstances. Changes in recognition and measurement estimates are recorded in the Consolidated Statements of Income and Consolidated Balance Sheets in the period in which such changes occur.
We reduce our deferred tax assets by a valuation allowance if it is more likely than not that we will not realize some portion or all of the deferred tax assets. In making such a determination, we consider all available positive and negative evidence, including future reversals of existing taxable temporary differences, projected future taxable income, tax planning strategies and recent financial operations. In the event we were to determine that we would be able to realize our deferred income tax assets in the future in excess of their net recorded amount, we would make an adjustment to the valuation allowance in the period in which such changes occur, which would reduce the provision for income taxes.
Customer Program Costs
Customer programs and incentives are a common practice in our business. Our business incurs customer program costs to obtain favorable product placement, to promote sales of products and to maintain competitive pricing. We record estimates to reduce revenue for customer programs and incentives, which are considered variable consideration, and include price discounts, volume-based incentives, promotions and cooperative advertising when revenue is recognized in order to determine the amount of consideration we will ultimately be entitled to receive. These estimates are based on historical and projected experience for each type of customer. In addition, for certain customer program incentives, we receive an identifiable benefit in exchange for the consideration given and record the associated expenditure in selling, general and administrative expenses. Volume allowances are accrued based on management’s estimates of customer volume achievement and other factors incorporated into customer agreements, such as new products, store sell-through, merchandising support, levels of returns and customer training. Management periodically reviews accruals for these rebates and allowances, and adjusts accruals when circumstances indicate, typically as a result of a change in volume expectations.