METHODE ELECTRONICS INC (MEI) FY 2023 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
Management’s Discussion and Analysis of Financial Condition and Results of Operations is based upon our consolidated financial statements, which have been prepared in accordance with GAAP. You should read the following discussion and analysis in conjunction with our consolidated financial statements and related notes included in this Annual Report. This discussion and analysis of our financial condition and results of operations also contains forward-looking statements that involve risks, uncertainties, and assumptions. Our actual results may differ materially from those anticipated in these forward-looking statements because of a variety of factors, including those set forth under Item 1A. “Risk Factors” of this Annual Report. We undertake no duty to update any such forward-looking statements to conform to actual results or changes in our expectations.
Overview
We are a leading global supplier of custom engineered solutions with sales, engineering and manufacturing locations in North America, Europe, Middle East and Asia. We design, engineer and produce mechatronic products for OEMs utilizing our broad range of technologies for user interface, LED lighting system, power distribution and sensor applications.
Our solutions are found in the end markets of transportation (including automotive, commercial vehicle, e-bike, aerospace, bus and rail), cloud computing infrastructure, construction equipment, consumer appliance and medical devices. Our business is managed on a segment basis, with our four segments being Automotive, Industrial, Interface and Medical. For more information regarding the business and products of these segments, see Item 1. “Business” of this Annual Report.
Impacts of Macroeconomic and Geopolitical Conditions
Adverse macroeconomic conditions, including but not limited to inflation, slower growth or recession, changes to fiscal and monetary policy, higher interest rates, wage and commodity inflation, currency fluctuations and new or increased tariffs, could adversely affect demand for our products. In addition, the Russia/Ukraine conflict has resulted in, among other things, economic sanctions imposed by the international community which have impacted the global economy and given rise to potential global security issues that may adversely affect international business and economic conditions. Although we have no operations in Russia or Ukraine, certain of our customers and suppliers have been negatively impacted by these events, which in turn has impacted markets where we do business, including Europe and Asia. The economic sanctions imposed on Russia have further increased existing global supply chain, logistics, and inflationary challenges.
Update on the Impact of COVID-19
COVID-19 has continued to evolve since it was declared a global pandemic by the World Health Organization in March 2020. We continue to evaluate the nature and extent of the ongoing impacts of COVID-19 on our business, operations, and financial results. Beginning late in the fourth quarter of fiscal 2022 and continuing into fiscal 2023, various regions in China, including regions where we and our customers have operations, were subjected to lockdowns imposed by governmental authorities to mitigate the spread of COVID-19 in those areas. The resulting industry-wide production interruptions adversely impacted our results of operations in fiscal 2023.
Global Supply Chain Disruptions
Certain direct and indirect adverse impacts of the COVID-19 pandemic have continued to date and are expected to continue in fiscal 2024, including the worldwide semiconductor supply shortage and global supply chain disruptions. In addition, we have experienced, and may continue to experience, business interruptions, including customer shutdowns and increased material and logistics costs and labor shortages. The semiconductor supply shortage is due, in part, to increased demand across multiple industries, including the automotive industry, resulting in a slowdown in their production schedules. The semiconductor supply shortage is also impacting our supply chain and our ability to meet demand at some of our non-automotive customers. We expect this semiconductor shortage to have a continued impact on our operating results and financial condition in fiscal 2024.
Acquisition of Nordic Lights
As noted in Part I, Item 1 of this Annual Report, we acquired 92.2% of the outstanding shares of Nordic Lights on April 20, 2023. The results of operations of Nordic Lights are reported within the Industrial segment from the date of acquisition and were immaterial for fiscal 2023. See Note 3, “Acquisition” to our consolidated financial statements in this Annual Report for further information.
Restructuring Actions
In fiscal 2023, we incurred restructuring costs of $1.0 million primarily related to asset impairment charges and severance. In fiscal 2022, we initiated a restructuring plan to consolidate one of our operations within the Industrial segment in response to logistics issues and tariffs. This action resulted in a facility shutdown and consolidation of activities into an existing location and the recognition of $3.6 million of restructuring costs. We may take additional restructuring actions in future periods based upon market conditions and industry trends.
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Outlook
Our current expectations for fiscal 2024 are for net sales to be relatively flat compared to fiscal 2023 and lower net income. Fiscal 2024 sales estimates reflect the full-year inclusion of Nordic Lights and the roll-off of significant programs in the Automotive segment. We expect fiscal 2024 net income to be impacted by additional costs to support new program launches, market headwinds in the higher-margin Industrial segment, higher interest expense and less government assistance.
Consolidated Results of Operations
A detailed comparison of our results of operations between fiscal 2022 and fiscal 2021 can be found in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our fiscal 2022 Annual Report on Form 10-K filed with the SEC on June 23, 2022.
The table below compares our results of operations between fiscal 2023 and fiscal 2022:
| Fiscal Year Ended | ||||||||
|---|---|---|---|---|---|---|---|---|
| (in millions) | April 29, 2023 | April 30, 2022 | ||||||
| Net sales | $ | 1,179.6 | $ | 1,163.6 | ||||
| Cost of products sold | 915.5 | 898.7 | ||||||
| Gross profit | 264.1 | 264.9 | ||||||
| Selling and administrative expenses | 154.9 | 134.1 | ||||||
| Amortization of intangibles | 18.8 | 19.1 | ||||||
| Interest expense, net | 2.7 | 3.5 | ||||||
| Other income, net | (2.4 | ) | (10.3 | ) | ||||
| Income tax expense | 13.0 | 16.3 | ||||||
| Net income | $ | 77.1 | $ | 102.2 |
Net sales
Net sales increased $16.0 million, or 1.4%, to $1,179.6 million in fiscal 2023, compared to $1,163.6 million in fiscal 2022. The increase was primarily due to higher sales in the Industrial segment, partially offset by lower sales in the Automotive segment. Net sales were unfavorably impacted by foreign currency translation of $57.3 million, primarily due to the strengthening of the U.S. dollar relative to the euro and Chinese renminbi. Net sales included customer cost recoveries from spot buys of materials and premium freight costs of $20.9 million in fiscal 2023, compared to $22.1 million in in fiscal 2022. Excluding the impact of foreign currency translation and customer cost recoveries, net sales increased $74.5 million, or 6.5%.
Cost of products sold
Cost of products sold increased $16.8 million, or 1.9%, to $915.5 million (77.6% of net sales) in fiscal 2023, compared to $898.7 million (77.2% of net sales) in fiscal 2022. Excluding foreign currency translation, cost of products sold increased $59.4 million. The increase was primarily due to higher material costs, as a result of an increase in sales volumes and material cost inflation, and higher salary and operating expenses, partially offset by lower restructuring costs. Restructuring costs included within cost of products sold were $0.4 million in fiscal 2023, compared to $1.3 million in fiscal 2022.
Gross profit margin
Gross profit margin was 22.4% of net sales in fiscal 2023, compared to 22.8% of net sales in fiscal 2022. The decrease was due to inflationary pressures on material and other manufacturing costs, partially offset by higher sales volumes.
Selling and administrative expenses
Selling and administrative expenses increased $20.8 million, or 15.5%, to $154.9 million (13.1% of net sales) in fiscal 2023, compared to $134.1 million (11.5% of net sales) in fiscal 2022. Excluding foreign currency translation, selling and administrative expenses increased $24.6 million. The increase was primarily due to $6.8 million of acquisition costs related to Nordic Lights, higher compensation expense, professional fees and travel expense, partially offset by lower restructuring costs. Restructuring costs included within selling and administrative expenses were $0.5 million in fiscal 2023, compared to $2.3 million in fiscal 2022.
Amortization of intangibles
Amortization of intangibles decreased $0.3 million, or 1.6%, to $18.8 million in fiscal 2023, compared to $19.1 million in fiscal 2022.
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Interest expense, net
Interest expense, net was $2.7 million in fiscal 2023, compared to $3.5 million in fiscal 2022. The decrease was due to higher interest income of $3.2 million, partially offset by higher interest expense of $2.4 million. Interest income and interest expense increased due to higher interest rates.
Other income, net
Other income, net decreased $7.9 million to $2.4 million in fiscal 2023, compared to $10.3 million in fiscal 2022. Net foreign exchange losses were $7.1 million in fiscal 2023, compared to $1.9 million in fiscal 2022. Net foreign exchange losses were higher in fiscal 2023 due to lower efficiency in our foreign currency balance sheet remeasurement hedging program. In addition, net foreign exchange loss in fiscal 2023 included the recognition of $2.1 million of foreign exchange loss reclassified from accumulated other comprehensive income as the result of a reorganization of a foreign owned subsidiary.
In fiscal 2023, we received $9.7 million of government grants at certain of our international locations, compared to $11.1 million in fiscal 2022. Fiscal 2023 government grants include $6.3 million related to the COVID-19 pandemic and $3.4 million related to maintaining certain employment levels. Fiscal 2022 government grants primarily related to COVID-19 assistance.
Income tax expense
Income tax expense decreased $3.3 million, or 20.2%, to $13.0 million in fiscal 2023, compared to $16.3 million in fiscal 2022. Our effective tax rate increased to 14.4% in fiscal 2023, compared to 13.8% in fiscal 2022. In fiscal 2023, the effective income tax rate was favorably impacted by the amount of income earned in foreign jurisdictions with lower tax rates and a tax benefit of $7.3 million associated with the reorganization of a foreign owned subsidiary, partially offset by a reduction in foreign investment tax credits of $5.0 million and non-deductible acquisition costs of $1.4 million. In fiscal 2022, the effective income tax rate was favorably impacted by the amount of income earned in foreign jurisdictions with lower tax rates, the release of a valuation allowance of approximately $2.0 million due to a tax law change, and less U.S. tax on foreign income of $1.7 million attributable to lower earnings in non-U.S. jurisdictions, partially offset with non-deductible compensation of $2.1 million.
Net income
Net income decreased $25.1 million, or 24.6%, to $77.1 million in fiscal 2023, compared to $102.2 million in fiscal 2022. The impact of foreign currency translation decreased net income in fiscal 2023 by $10.3 million. Excluding foreign currency translation, net income decreased $14.8 million as a result of the reasons described above.
Operating Segments
Automotive
| Fiscal Year Ended | ||||||||
|---|---|---|---|---|---|---|---|---|
| (in millions) | April 29, 2023 | April 30, 2022 | ||||||
| Net sales | ||||||||
| North America | $ | 349.0 | $ | 400.9 | ||||
| Europe, the Middle East & Africa ("EMEA") | 231.2 | 216.5 | ||||||
| Asia | 156.0 | 164.1 | ||||||
| Net sales | 736.2 | 781.5 | ||||||
| Gross profit | $ | 126.2 | $ | 150.0 | ||||
| As a percent of net sales | 17.1 | % | 19.2 | % | ||||
| Income from operations | $ | 67.0 | $ | 92.6 | ||||
| As a percent of net sales | 9.1 | % | 11.8 | % | ||||
| Customer cost recoveries: | ||||||||
| North America | $ | 9.7 | $ | 10.1 | ||||
| EMEA | 3.7 | 2.6 | ||||||
| Asia | 0.6 | 0.5 | ||||||
| Total | $ | 14.0 | $ | 13.2 |
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Net sales
Automotive segment net sales decreased $45.3 million, or 5.8%, to $736.2 million in fiscal 2023, compared to $781.5 million in fiscal 2022. Net sales were unfavorably impacted by foreign currency translation of $35.4 million and the roll-off of a major program in North America. Excluding foreign currency translation and customer cost recoveries, net sales decreased $10.7 million, or 1.4%.
Net sales in North America decreased $51.9 million, or 12.9%, to $349.0 million in fiscal 2023, compared to $400.9 million in fiscal 2022. Excluding customer cost recoveries, net sales decreased $51.5 million primarily due to lower sales volumes from a major program roll-off. Net sales in EMEA increased $14.7 million, or 6.8%, to $231.2 million in fiscal 2023, compared to $216.5 million in fiscal 2022. The weaker euro, relative to the U.S. dollar, decreased net sales in EMEA by $23.3 million. Excluding foreign currency translation and customer cost recoveries, net sales in EMEA increased $36.9 million primarily due to higher sales volumes of user interface and switch products. Net sales in Asia decreased $8.1 million, or 4.9%, to $156.0 million in fiscal 2023, compared to $164.1 million in fiscal 2022. The weaker Chinese renminbi, relative to the U.S. dollar, decreased net sales in Asia by $12.1 million. Excluding foreign currency translation and customer cost recoveries, net sales in Asia increased $3.9 million primarily due to higher electric vehicle product sales volumes, partially offset by lower overhead console sales volumes.
Gross profit
Automotive segment gross profit decreased $23.8 million, or 15.9%, to $126.2 million in fiscal 2023, compared to $150.0 million in fiscal 2022. Excluding the impact of foreign currency translation, gross profit decreased $16.4 million. Gross profit margins decreased to 17.1% in fiscal 2023, from 19.2% in fiscal 2022. The decrease in gross profit margins was due to lower sales volumes and inflationary pressures on material and other manufacturing costs.
Income from operations
Automotive segment income from operations decreased $25.6 million, or 27.6%, to $67.0 million in fiscal 2023, compared to $92.6 million in fiscal 2022. Excluding the impact of foreign currency translation, income from operations decreased $21.2 million. The decrease was primarily due to lower gross profit and higher selling and administrative expenses. Selling and administrative expenses increased due to higher compensation expense, professional fees and travel expense.
Industrial
| Fiscal Year Ended | ||||||||
|---|---|---|---|---|---|---|---|---|
| (in millions) | April 29, 2023 | April 30, 2022 | ||||||
| Net sales | $ | 384.9 | $ | 318.1 | ||||
| Gross profit | $ | 127.8 | $ | 101.5 | ||||
| As a percent of net sales | 33.2 | % | 31.9 | % | ||||
| Income from operations | $ | 93.1 | $ | 67.1 | ||||
| As a percent of net sales | 24.2 | % | 21.1 | % | ||||
| Customer cost recoveries | $ | 4.7 | $ | 7.6 |
Net sales
Industrial segment net sales increased $66.8 million, or 21.0%, to $384.9 million in fiscal 2023, compared to $318.1 million in fiscal 2022. Net sales were unfavorably impacted by foreign currency translation of $21.9 million. Excluding the impact of foreign currency translation and customer cost recoveries, net sales increased $91.6 million, or 29.5%, primarily due to higher sales volumes of power distribution solutions for data centers and of commercial vehicle lighting solutions products.
Gross profit
Industrial segment gross profit increased $26.3 million, or 25.9%, to $127.8 million in fiscal 2023, compared to $101.5 million in fiscal 2022. Excluding the impact of foreign currency translation, gross profit increased $33.6 million. Gross profit margin increased to 33.2% in fiscal 2023, from 31.9% in fiscal 2022. The increase in gross profit margins was due to higher sales volumes and lower restructuring costs. Gross profit in fiscal 2022 included restructuring costs of $1.2 million, compared to $0.1 million in fiscal 2023.
Income from operations
Industrial segment income from operations increased $26.0 million, or 38.7%, to $93.1 million in fiscal 2023, compared to $67.1 million in fiscal 2022. Excluding the impact of foreign currency translation, income from operations increased $32.1 million. The increase was primarily due to higher gross profit, partially offset by an increase in selling and administrative expenses. Selling and administrative expenses in fiscal 2022 included restructuring costs of $2.2 million, compared to $0.4 million in fiscal 2023.
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Interface
| Fiscal Year Ended | ||||||||
|---|---|---|---|---|---|---|---|---|
| (in millions) | April 29, 2023 | April 30, 2022 | ||||||
| Net sales | $ | 54.9 | $ | 59.8 | ||||
| Gross profit | $ | 9.3 | $ | 12.6 | ||||
| As a percent of net sales | 16.9 | % | 21.1 | % | ||||
| Income from operations | $ | 5.5 | $ | 9.9 | ||||
| As a percent of net sales | 10.0 | % | 16.6 | % | ||||
| Customer cost recoveries | $ | 2.2 | $ | 1.3 |
Net sales
Interface segment net sales decreased $4.9 million, or 8.2%, to $54.9 million in fiscal 2023, compared to $59.8 million in fiscal 2022. Excluding customer cost recoveries, net sales decreased $5.8 million, or 9.9%. The decrease was primarily due to lower sales volumes of appliance products which were negatively impacted by consumer demand, partially offset by higher sales volumes of digital data products.
Gross profit
Interface segment gross profit decreased $3.3 million, or 26.2%, to $9.3 million in fiscal 2023, compared to $12.6 million in fiscal 2022. Gross profit margin decreased to 16.9% in fiscal 2023, from 21.1% in fiscal 2022. The decrease in gross profit margins was primarily due to lower sales volumes of appliance products.
Income from operations
Interface segment income from operations decreased $4.4 million, or 44.4%, to $5.5 million in fiscal 2023, compared to $9.9 million in fiscal 2022. The decrease was due to lower gross profit and higher selling and administrative expenses, primarily compensation expense and professional fees.
Medical
| Fiscal Year Ended | ||||||||
|---|---|---|---|---|---|---|---|---|
| (in millions) | April 29, 2023 | April 30, 2022 | ||||||
| Net sales | $ | 3.6 | $ | 4.2 | ||||
| Gross profit | $ | (0.5 | ) | $ | (0.4 | ) | ||
| Loss from operations | $ | (6.1 | ) | $ | (5.5 | ) |
Net sales
Medical segment net sales decreased $0.6 million, or 14.3%, to $3.6 million in fiscal 2023, compared to $4.2 million in fiscal 2022. The decrease was due to lower product demand.
Gross profit
Medical segment gross profit was a loss of $0.5 million in fiscal 2023, compared to a loss of $0.4 million in fiscal 2022. Gross profit decreased due to lower net sales.
Loss from operations
Medical segment loss from operations increased $0.6 million, or 10.9%, to $6.1 million in fiscal 2023, compared to $5.5 million in fiscal 2022. The increase in the loss was due to higher selling and administrative expenses, primarily higher marketing expenses.
Financial Condition, Liquidity and Capital Resources
Our liquidity requirements are primarily to fund our business operations, including capital expenditures and working capital requirements, as well as to fund debt service requirements, dividends and stock repurchases. Our primary sources of liquidity are cash flows from operations, existing cash balances and borrowings under our senior unsecured credit agreement. We believe our liquidity position will be sufficient to fund our existing operations and current commitments for at least the next twelve months. However, if economic conditions remain impacted for longer than we expect due to inflationary pressure, supply chain disruptions, the COVID-19 pandemic, or other geopolitical risks, including the Russia-Ukraine war, our liquidity position could be severely impacted.
At April 29, 2023, we had $157.0 million of cash and cash equivalents, of which $146.3 million was held in subsidiaries outside the U.S. Cash held by these subsidiaries is used to fund operational activities and can be repatriated, primarily through the payment of dividends and the repayment of intercompany loans, without creating material additional income tax expense.
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Share Buyback Program
On March 31, 2021, the Board of Directors authorized the purchase of up to $100.0 million of our common stock. On June 16, 2022, the Board of Directors authorized an increase in the existing share buyback program of an additional $100.0 million, and extended the expiration of the program to June 14, 2024. Purchases may be made on the open market, in private transactions or pursuant to purchase plans designed to comply with Rule 10b5-1 of the Securities Exchange Act of 1934. As of April 29, 2023, a total of 2,790,375 shares had been purchased at a total cost of $119.3 million since the commencement of the share buyback program. As of April 29, 2023, the dollar value of shares that remained available to be purchased under this share buyback program was approximately $80.7 million.
Credit Agreement
On October 31, 2022, we entered into a Second Amended and Restated Credit Agreement (the “Credit Agreement”) with Bank of America, N.A., as Administrative Agent, Swing Line Lender and L/C Issuer, and the Lenders and other parties named therein. The Credit Agreement amends and restates the Amended and Restated Credit Agreement, dated September 12, 2018 and as previously amended (the “Prior Credit Agreement”), with Bank of America, N.A., as Administrative Agent, Swing Line Lender, and L/C Issuer, Wells Fargo Bank, National Association, as L/C Issuer, and the Lenders named therein. Among other things, the Credit Agreement (i) increased the multicurrency revolving credit commitments under the Prior Credit Agreement to $750,000,000, (ii) refinanced in full and terminated the term loan facility under the Prior Credit Agreement, and (iii) made certain other changes to the covenants, terms, and conditions under the Prior Credit Agreement. In addition, the Credit Agreement permits us to increase the revolving commitments and/or add one or more tranches of term loans under the Credit Agreement from time to time by up to an amount equal to (i) $250,000,000 plus (ii) an additional amount so long as the leverage ratio would not exceed 3.00:1.00 on a pro forma basis, subject to, among other things, the receipt of additional commitments from existing and/or new lenders. The Credit Agreement matures on October 31, 2027.
As of April 29, 2023, $305.4 million was outstanding under the revolving credit facility. We were in compliance with all covenants under the Credit Agreement as of April 29, 2023. For further information, see Note 10, “Debt” to the consolidated financial statements included in this Annual Report.
Cash Flows
| Fiscal Year Ended | ||||||||
|---|---|---|---|---|---|---|---|---|
| (in millions) | April 29, 2023 | April 30, 2022 | ||||||
| Operating activities: | ||||||||
| Net income | $ | 77.1 | $ | 102.2 | ||||
| Non-cash items | 59.2 | 66.4 | ||||||
| Changes in operating assets and liabilities | (3.5 | ) | (69.8 | ) | ||||
| Net cash provided by operating activities | 132.8 | 98.8 | ||||||
| Net cash used in investing activities | (153.1 | ) | (37.4 | ) | ||||
| Net cash provided by (used in) financing activities | 3.2 | (114.6 | ) | |||||
| Effect of foreign currency exchange rate changes on cash and cash equivalents | 2.1 | (8.0 | ) | |||||
| Decrease in cash and cash equivalents | (15.0 | ) | (61.2 | ) | ||||
| Cash and cash equivalents at beginning of the period | 172.0 | 233.2 | ||||||
| Cash and cash equivalents at end of the period | $ | 157.0 | $ | 172.0 |
Operating activities
Net cash provided by operating activities increased $34.0 million to $132.8 million in fiscal 2023, compared to $98.8 million in fiscal 2022. The increase was due to lower cash outflows related to changes in operating assets and liabilities, partially offset by lower net income adjusted for non-cash items. The $3.5 million of cash outflows for operating assets and liabilities in fiscal 2023 was primarily due to higher accounts receivable, prepaid expenses and other assets, partially offset by lower inventory, and higher accounts payable and other liabilities.
Investing activities
Net cash used in investing activities was $153.1 million in fiscal 2023, compared to $37.4 million in fiscal 2022. In fiscal 2023, we paid $114.6 million of cash, net of cash acquired, for the acquisition of Nordic Lights. Capital expenditures in fiscal 2023 were $42.0 million, compared to $38.0 million in fiscal 2022. We received $3.5 million of cash from the sale of property, plant and equipment in fiscal 2023.
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Financing activities
Net cash provided by financing activities was $3.2 million in fiscal 2023, compared to net cash used in financing activities of $114.6 million in fiscal 2022. In fiscal 2023, we paid $48.1 million of cash for the repurchase of our shares under our share buyback program, compared to $64.5 million in fiscal 2022. We paid cash dividends of $19.8 million in fiscal 2023, compared to $20.4 million in fiscal 2022. In fiscal 2023, we had net borrowings of $73.7 million primarily to fund the acquisition of Nordic Lights. In fiscal 2022, we had net repayments on our borrowings of $29.2 million. In connection with our Credit Agreement, we paid debt issuance costs of $3.2 million.
Contractual Obligations
The following table summarizes our significant known contractual cash obligations and commercial commitments as of April 29, 2023:
| Payments Due By Period | |||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| (in millions) | Total | Less than 1 year | 1-3 years | 3-5 years | More than 5 years | ||||||||||||||
| Finance leases | $ | 0.6 | $ | 0.2 | $ | 0.3 | $ | 0.1 | $ | — | |||||||||
| Operating leases | 33.1 | 7.8 | 11.2 | 8.3 | 5.8 | ||||||||||||||
| Debt (1) | 310.1 | 3.2 | 0.4 | 305.8 | 0.7 | ||||||||||||||
| Estimated interest on debt (2) | 73.4 | 15.1 | 33.3 | 25.0 | — | ||||||||||||||
| Deferred compensation | 9.5 | 2.0 | 2.8 | 2.4 | 2.3 | ||||||||||||||
| Total | $ | 426.7 | $ | 28.3 | $ | 48.0 | $ | 341.6 | $ | 8.8 |
(1) Assumes the outstanding borrowings under the revolving credit facility will be repaid upon maturity of the credit agreement in October 2027.
(2) Based on interest rates in effect as of April 29, 2023 (including the impact of interest rate swaps).
Off-Balance Sheet Arrangements
We do not have any off-balance sheet arrangements as defined under SEC rules.
Legal Matters
For several years, Hetronic Germany-GmbH and Hydronic-Steuersysteme-GmbH (the “Fuchs companies”) served as our distributors for Germany, Austria and other central and eastern European countries pursuant to their respective intellectual property licenses and distribution and assembly agreements. We became aware that the Fuchs companies and their managing director, Albert Fuchs, had materially violated those agreements. As a result, we terminated all of our agreements with the Fuchs companies. On June 20, 2014, we filed a lawsuit against the Fuchs companies in the Federal District Court for the Western District of Oklahoma alleging material breaches of the distribution and assembly agreements and seeking damages, as well as various forms of injunctive relief. The defendants filed counterclaims alleging breach of contract, interference with business relations and business slander. On April 2, 2015, we amended our complaint against the Fuchs companies to add additional unfair competition and Lanham Act claims and to add additional affiliated parties.
A trial with respect to the matter began in February 2020. During the trial, the defendants dismissed their one remaining counterclaim with prejudice. On March 2, 2020, the jury returned a verdict in favor of the Company. The verdict included approximately $102 million in compensatory damages and $11 million in punitive damages. On April 22, 2020, the Court entered a permanent injunction barring defendants from selling infringing products and ordering them to return Hetronic’s confidential information. Defendants appealed entry of the permanent injunction. On May 29, 2020, the Court held defendants in contempt for violating the permanent injunction and entered the final judgment. Defendants appealed entry of the final monetary judgment as well. The appeal of the permanent injunction and the appeal of the final judgment were consolidated into a single appeal before the U.S. Court of Appeals for the Tenth Circuit. On August 24, 2021, the Tenth Circuit issued a decision affirming the lower court’s ruling with the exception that it instructed the District Court to modify the injunction from the entire world to all of the countries in which Hetronic sells its products. On April 20 and 21, 2022, the District Court held a hearing related to modifying the injunction pursuant to the Tenth Circuit’s opinion, and the parties have filed post-hearing briefs. The defendants also filed a petition for certiorari with the United States Supreme Court seeking to further appeal the extraterritorial application of the Lanham Act in this case. We opposed that petition. The Supreme Court requested the views of the Solicitor General on the petition for certiorari, and the Solicitor General recommended granting the petition. On November 4, 2022, the Supreme Court granted the petition. The Supreme Court heard arguments in this matter on March 21, 2023. At the conclusion of the hearing, the Supreme Court took the matter under advisement. Like any judgment, particularly a judgment involving defendants outside of the United States, there is no guarantee that we will be able to collect all or any portion of the judgment.
We incurred legal fees of $3.9 million, $3.3 million and $5.7 million in fiscal 2023, fiscal 2022 and fiscal 2021, respectively, related to the lawsuits. These amounts are included in the selling and administrative expenses and as part of the Industrial segment.
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Critical Accounting Policies and Estimates
The preparation of financial statements in conformity with GAAP requires that we make estimates and assumptions that can affect amounts reported in the consolidated financial statements and notes. In preparing our consolidated financial statements, we have made our best estimates and judgments of certain amounts included in the consolidated financial statements. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable. To the extent that there are differences between these estimates and actual results, our consolidated financial statements may be materially affected. Below are the estimates that we believe are critical to the understanding of our results of operations and financial condition. Other accounting policies are described in Note 1, “Description of Business and Summary of Significant Accounting Policies” to the consolidated financial statements included in this Annual Report.
Revenue recognition. Most of our revenue is recognized at a point in time. We have determined that the most definitive demonstration that control has transferred to a customer is physical shipment or delivery, depending on the contractual shipping terms, except for consignment transactions. Consignment transactions are arrangements where we transfer products to a customer location but retain ownership and control of such product until it is used by the customer. Revenue for consignment arrangements is recognized upon the customer’s usage.
Revenue associated with products which we believe have no alternative use, and where we have an enforceable right to payment, are recognized on an over time basis. Revenue is recognized based on progress to date, which is typically even over the production process through transfer of control to the customer.
In addition, from time to time, customers may negotiate annual price downs. Management has evaluated these price downs and determined that in some instances, these price downs give rise to a material right. In instances that a material right exists, a portion of the transaction price is allocated to the material right and recognized over the life of the contract.
Goodwill. Goodwill is not amortized but is tested for impairment on at least an annual basis. Goodwill is evaluated at the reporting unit level by comparing the fair value of the reporting unit to its carrying amount including goodwill. An impairment of goodwill exists if the carrying amount of the reporting unit exceeds its fair value. The impairment loss is the amount by which the carrying amount exceeds the reporting unit’s fair value, limited to the total amount of goodwill allocated to that reporting unit. In performing the goodwill impairment test, we have the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the estimated fair value of a reporting unit is less than its carrying amount.
Qualitative factors include, but are not limited to, the results of prior year fair value calculations, the movement of our share price and market capitalization, the reporting unit and overall financial performance, and macroeconomic and industry conditions. We consider the qualitative factors and weight of the evidence obtained to determine if it is more likely than not that a reporting unit’s fair value is less than the carrying amount. If, after assessing the qualitative factors, we were to determine that it is more likely than not that the fair value of a reporting unit is less than its carrying value, then a quantitative assessment is performed. We may also elect to proceed directly to the quantitative assessment without considering such qualitative factors.
For the quantitative assessment, we utilize either, or a combination of, the income approach and market approach to estimate the fair value of the reporting unit. The income approach uses a discounted cash flow method and the market approach uses appropriate valuation multiples observed for the reporting unit’s guideline public companies. The determination of discounted cash flows are based on management’s estimates of revenue growth rates and earnings before interest, taxes, depreciation and amortization (“EBITDA”) margins, taking into consideration business and market conditions for the countries and markets in which the reporting unit operates. We calculate the discount rate based on a market-participant, risk-adjusted weighted average cost of capital, which considers industry specific rates of return on debt and equity capital for a target industry capital structure, adjusted for risks associated with business size, geography and other factors specific to the reporting unit. Long-range forecasting involves uncertainty which increases with each successive period. Revenue growth rates and profitability assumptions, especially in the outer years, involve a greater degree of uncertainty.
Impairment of long-lived assets. We evaluate whether events and circumstances have occurred which indicate that the remaining estimated useful lives of our intangible assets, excluding goodwill, and other long-lived assets, may warrant revision or that the remaining balance of such assets may not be recoverable. If impairment indicators exist, we perform an impairment analysis by comparing the undiscounted cash flows resulting from the use of the asset group to the carrying amount. If the carrying amount exceeds the undiscounted cash flows, an impairment loss is recognized based on the excess of the asset’s carrying amount over its fair value.
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Income taxes. Our income tax expense and deferred tax assets and liabilities reflect management’s best assessment of estimated current and future taxes to be paid. We are subject to income taxes in the U.S. and numerous foreign jurisdictions. Significant judgments and estimates are required in determining the consolidated income tax provision and in evaluating income tax uncertainties.
The amount of income taxes we pay is subject to ongoing audits by federal, state and foreign tax authorities. Our estimate of the potential outcome of any uncertain tax issue is subject to management’s assessment of relevant risks, facts, and circumstances existing at that time. We use a more-likely-than-not threshold for financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. We record a liability for the difference between the benefit recognized and measured and tax position taken or expected to be taken on our tax return. To the extent that our assessment of such tax positions changes, the change in estimate is recorded in the period in which the determination is made. We report tax-related interest and penalties as a component of income tax expense.
Our deferred tax assets and liabilities reflect temporary differences between the amount of assets and liabilities for financial and tax reporting purposes. We adjust these amounts to reflect changes in tax rates expected to be in effect when the temporary differences reverse. We record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. We evaluate our ability to realize the tax benefits associated with deferred tax assets by assessing the adequacy of future expected taxable income, including the reversal of existing temporary differences, historical and projected operating results, and the availability of prudent and feasible tax planning strategies. The realization of tax benefits is evaluated by jurisdiction and the realizability of these assets can vary based on the character of the tax attribute and the carryforward periods specific to each jurisdiction. In the event we were to determine that we would be able to realize our deferred tax assets in the future in excess of its net recorded amount, an adjustment to the deferred tax asset would decrease income tax expense in the period a determination was made. Likewise, should we determine that we would not be able to realize all or part of our net deferred tax asset in the future, an adjustment to the deferred tax asset would be recorded to income tax expense in the period such determination was made.
We provide for taxes that may be payable if undistributed earnings of overseas subsidiaries were to be remitted to the U.S., except for those earnings that we consider to be permanently reinvested. Future sales of foreign subsidiaries are not exempt from capital gains tax in the U.S. We have no plans to dispose of any of our foreign subsidiaries and are not recording deferred taxes on outside basis differences in foreign subsidiaries for the sale of a foreign subsidiary.
Business combinations. We account for business combinations using the acquisition method of accounting whereby the identifiable assets and liabilities of the acquired business, as well as any noncontrolling interest in the acquired business, are recorded at their estimated fair values as of the date that we obtain control of the acquired business. Any purchase consideration in excess of the estimated fair values of the net assets acquired is recorded as goodwill. Acquisition-related expenses are expensed as incurred.
Determining the fair value of assets acquired and liabilities assumed requires management's judgment and often involves the use of significant estimates and assumptions, including assumptions with respect to future cash inflows and outflows, discount rates, and market multiples, among other items. We determine the fair values of intangible assets acquired generally in consultation with third-party valuation advisors. The valuation of assets acquired, and liabilities assumed requires a number of judgments and is subject to revision as additional information about the fair values becomes available. We recognize any adjustments to provisional amounts that are identified during the period not to exceed twelve months from the acquisition date in which the adjustments are determined. The results of operations of businesses acquired are included in the consolidated financial statements from their dates of acquisition.
Contingencies. We are subject to various investigations, claims and legal and administrative proceedings covering a wide range of matters that arise in the ordinary course of business activities. A significant amount of judgment and use of estimates is required to quantify our ultimate exposure in these matters. For those matters that we can estimate a range of loss, we have established reserves at levels within that range to provide for the most likely scenario based upon available information. The valuation of reserves for contingencies is reviewed on a quarterly basis to ensure that we are properly reserved. Reserve balances are adjusted to account for changes in circumstances for ongoing issues and the establishment of additional reserves for emerging issues. While we believe that the current level of reserves is adequate, changes in the future could impact these determinations.
New Accounting Pronouncements
For more information regarding new applicable accounting pronouncements, see Note 1, “Description of Business and Summary of Significant Accounting Policies” to the consolidated financial statements included in this Annual Report.
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