NOVANTA INC (NOVT) FY 2022 MD&A

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 (“MD&A”) should be read in conjunction with the Consolidated Financial Statements and Notes included in Item 8 of this Annual Report on Form 10-K. The MD&A contains certain forward looking statements within the meaning of the United States Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. In addition to historical financial information, the following discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. These forward-looking statements include, but are not limited to, anticipated impacts of the COVID-19 pandemic on our business, our financial results and our financial condition; our belief that the Purchasing Managers Index may provide an indication of the impact of general economic conditions on our sales into the advanced industrial end market; our strategy; anticipated financial performance; expected liquidity and capitalization; drivers of revenue growth and our growth expectations in various markets; management’s plans and objectives for future operations, expenditures and product development, and investments in research and development; business prospects; potential of future product releases and expansion of our product and service offerings; anticipated revenue performance; industry trends; market conditions; our competitive positions; changes in economic and political conditions, including supply chain disruptions and constraints and inflationary pressures; changes in accounting principles; changes in actual or assumed tax liabilities; expectations regarding tax exposures; anticipated reinvestment of future earnings and dividend policy; anticipated expenditures in regard to the Company’s benefit plans; future acquisitions and integration and anticipated benefits from acquisitions and dispositions; anticipated economic benefits and expected costs of restructuring programs; ability to repay our indebtedness; our intentions regarding the use of cash; expectations regarding legal and regulatory requirements, including environmental requirements, and our compliance thereto; and other statements that are not historical facts. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various important factors, including those set forth in Item 1A of this Annual Report on Form 10-K under the heading “Risk Factors.” The words “anticipates,” “believes,” “expects,” “intends,” “future,” “estimates,” “plans,” “could,” “would,” “should,” “potential,” “continues,” and similar words or expressions (as well as other words or expressions referencing future events, conditions or circumstances) identify forward looking statements. Readers should not place undue reliance on any such forward looking statements, which speak only as of the date they are made. Management and the Company disclaim any obligation to publicly update or revise any such statements to reflect any change in its expectations or in events, conditions, or circumstances on which any such statements may be based, or that may affect the likelihood that actual results will differ from those contained in the forward looking statements, except as required under applicable law.

Business Overview

Novanta Inc. and its subsidiaries (collectively referred to as, the “Company”, “Novanta”, “we”, “us”, “our”) is a leading global supplier of core technology solutions that give medical and advanced industrial original equipment manufacturers (“OEMs”) a competitive advantage. We combine deep proprietary technology expertise and competencies in photonics, vision and precision motion with a proven ability to solve complex technical challenges. This enables us to engineer core components and sub-systems that deliver extreme precision and performance, tailored to our customers' demanding applications.

End Markets

We primarily operate in two end markets: the medical market and the advanced industrial market.

Medical Market

For the year ended December 31, 2022, the medical market accounted for approximately 49% of our revenue. Revenue from our products sold to the medical market is generally affected by hospital and other healthcare provider capital spending, growth rates of surgical procedures, changes in regulatory requirements and laws, aggregation of purchasing by healthcare networks, changes in technology requirements, timing of OEM customers’ product development and new product launches, changes in customer or patient preferences, and general demographic trends.

Advanced Industrial Market

For the year ended December 31, 2022, the advanced industrial market accounted for approximately 51% of our revenue. Revenue from our products sold to the advanced industrial market is affected by a number of factors, including changing technology requirements and preferences of our customers, productivity or quality investments in a manufacturing environment, the financial condition of our customers, changes in regulatory requirements and laws, and general economic conditions. We believe that the Purchasing Managers Index on manufacturing activities specific to different regions around the world may provide an indication of the impact of general economic conditions on our sales into the advanced industrial market.

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Strategy

Our strategy is to drive sustainable, profitable growth through short-term and long-term initiatives, including:

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disciplined focus on our diversified business model of providing functionality to long life-cycle OEM customer platforms in attractive medical and advanced industrial niche markets;

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improving our business mix to increase medical sales as a percentage of total revenue by:

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introducing new products aimed at attractive medical applications, such as minimally invasive and robotic surgery, ophthalmology, patient monitoring, drug delivery, clinical laboratory testing and life science equipment;

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deepening our key account management relationships with and driving cross selling of our product offerings to leading medical equipment manufacturers; and

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pursuing complementary medical technology acquisitions;

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increasing our penetration of high growth advanced industrial applications, such as laser materials processing, intelligent end-of-arm robotic technology solutions, robotics, laser additive manufacturing, automation and metrology, by working closely with OEM customers to launch application specific products that closely match the requirements of each application;

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broadening our portfolio of enabling proprietary technologies and capabilities through increased investment in new product development, and investments in application development to further penetrate existing customers, while expanding the applicability of our solutions to new markets;

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broadening our product and service offerings through the acquisition of innovative and complementary technologies and solutions in medical and advanced industrial technology applications;

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expanding sales and marketing channels to reach new target customers;

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improving our existing operations to expand profit margins and improve customer satisfaction by implementing lean manufacturing principles, strategic sourcing across our major production sites, and optimizing and limiting the growth of our fixed cost base; and

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attracting, retaining, and developing world-class talented, diverse, and motivated employees.

Significant Events and Updates

Acquisition of MPH Medical Devices S.R.O.

On August 11, 2022, we acquired 100% of the outstanding shares of MPH Medical Devices S.R.O. ("MPH"), a Czech Republic- based manufacturer of medical consumables with plastics specialization in making disposable tube-set-like products, for a total purchase price of €21.8 million ($22.4 million), net of cash acquired. The acquisition was financed with borrowings under our revolving credit facility and cash available on hand. The addition of MPH has expanded the Company's manufacturing capacity and capabilities in medical disposable tube set products within the Vision reportable segment.

Business Environment

COVID-19 Pandemic

In response to the COVID-19 pandemic, we took proactive actions and incurred additional costs to protect the health and safety of our employees, including investments in technologies and monitoring equipment, testing employees for COVID-19 at certain locations and rearranging some of our facilities to accommodate social distancing and flexible post-pandemic work environment. These costs were not material in 2022.

Although COVID-19 restrictions have been relaxed in the U.S. and Europe, in response to outbreaks of infection in various locations within China, local governmental authorities continued to implement lockdown orders in some areas during 2022, significantly slowing economic and business activities. Our manufacturing and distribution operations in China have been impacted by these lockdowns.

There continue to be isolated COVID-19 outbreaks in certain regions of the world, but these outbreaks have not had a significant impact on our operations. The extent to which the COVID-19 pandemic will continue to impact our business, operations, financial condition, liquidity and results of operations in 2023 and beyond remains uncertain and unpredictable. For further discussion on the risks and uncertainties associated with the COVID-19 pandemic, refer to Part I, Item 1A. Risk Factors.

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Global Supply Chain Disruptions

Over the past three years, we experienced disruptions to our supply chain as a result of the COVID-19 pandemic and global electronics and other raw material shortages. While we regularly monitor the manufacturing output of companies in our supply chain, disruptions to our suppliers and/or sub-suppliers could further challenge our ability to manufacture our products, adversely affecting our operations and customer relationships. To mitigate the risk of supply chain interruptions, we are identifying alternative suppliers and distributors, sourcing raw materials from different supplier and distributor locations, modifying our product designs to allow for alternative components to be used without compromising quality and performance, in-sourcing production of parts where feasible, and taking other actions to ensure a sustainable supply of raw materials. Additionally, restrictions on or disruptions of transportation, such as reduced availability of air transports, port closures and backlogs and increased border controls or closures, have resulted in higher costs and delays for obtaining raw materials from suppliers. Our supply chain disruptions and customer orders to secure supply have caused significantly elevated customer order backlog levels. As of December 31, 2022, our backlog was almost double our average pre-COVID backlog levels due to longer customer lead times. We anticipate that our customers will gradually shorten their order lead times as supply chain disruptions ease over time in the near future.

Inflationary Pressures

The COVID-19 pandemic and the global supply chain disruptions have caused inflationary pressures on the market prices for raw materials and components as well increases in the costs of labor. Price increases were on average more than double the 2021 price increases for certain key raw materials and components. Similarly, the overall low unemployment rate and the competition for available talents resulted in average annual wage increases more than doubling 2021 average annual wage increases. We have generally been able to offset increases in these costs through various productivity cost reduction initiatives, as well as increasing our selling prices to pass through some of these higher costs to our customers. However, our ability to raise our selling prices depends on market conditions and competitive dynamics. Given the timing of our actions compared to the timing of these inflationary pressures, there may be periods during which we are unable to fully recover the increases in our costs. Additionally, the inflationary pressures have given rise to significant increases in interest rates as various governments used monetary policy to reduce inflation. As a result, our weighted average interest rate increased from approximately 2.3% as of December 31 2021 to approximately 5.1% as of December 31, 2022.

Russia Ukraine Conflict

In February 2022, Russian forces invaded Ukraine. In response, the U.S., the EU, and several other countries imposed economic and trade sanctions and other restrictions (collectively, “global sanctions”) targeting Russia and Belarus. Russia then imposed retaliatory economic measures against the U.S., the EU, and several other countries. Our sales to Russia have not been material. We also do not have any assets, employees or third-party contractors in Russia or Ukraine. The duration of the conflict and further sanctions could have further impact on the global economy and inflation. Due to the uncertainty around the duration of the conflict, these longer-term factors are unknown to our business.

Overview of Financial Results

Total revenue for 2022 was $860.9 million, an increase of $154.1 million, or 21.8%, versus 2021. This increase was primarily due to revenue from acquisitions in 2021 and 2022 and increased demand in the advanced industrial and medical markets. The effect of our acquisitions resulted in an increase in revenue of $93.3 million, or 13.2%. In addition, foreign exchange rates adversely impacted our revenue by $36.9 million, or 5.2%, in 2021.

Operating income for 2022 was $103.1 million, an increase of $39.0 million, or 60.9%, versus 2021. This increase was primarily attributable to an increase in gross profit of $78.1 million primarily attributable to higher revenue and a decrease in restructuring, acquisition and related charges of $13.6 million, partially offset by an increase in research and development and engineering (“R&D”) expenses of $13.2 million, selling, general and administrative (“SG&A”) expenses of $29.7 million and amortization expense of $9.8 million.

Basic earnings per common share (“basic EPS”) of $2.08 in 2022 increased $0.66 from the basic EPS of $1.42 in 2021. Diluted earnings per common share (“diluted EPS”) of $2.06 in 2022 increased $0.65 from the diluted EPS of $1.41 in 2021. The increases in basic EPS and diluted EPS were primarily attributable to the increase in operating income offset by the increase of income tax provision.

Specific components of our operating results for 2022 and 2021 are further discussed below.

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Results of Operations

Information pertaining to fiscal year 2020 results of operations, including a year-over-year comparison with fiscal year 2021, was included in our Annual Report on Form 10-K for the year ended December 31, 2021 under Part II, Item 7, “Management’s Discussion and Analysis of Financial Position and Results of Operations,” which was filed with the SEC on March 1, 2022.

The following table sets forth external revenue by reportable segment for 2022 and 2021 (dollars in thousands):

Photonics

Photonics segment revenue in 2022 increased by $42.2 million, or 18.2%, versus 2021, primarily due to increased demand in the advanced industrial and medical markets.

Vision

Vision segment revenue in 2022 increased by $15.9 million, or 6.1%%, versus 2021, primarily due to increased demand for minimally invasive surgery products, partially offset by production delays as a result of shortages of raw materials and other supply chain disruptions.

Precision Motion

Precision Motion segment revenue in 2022 increased by $96.0 million, or 45.2%, versus 2021, primarily due to $88.0 million of revenue contributions from 2021 acquisitions and increased demand in advanced industrial and medical markets, partially offset by a decline in microelectronics market.

Gross Profit

The following table sets forth the gross profit and gross profit margin for each of our reportable segments for 2022 and 2021 (dollars in thousands):

Gross profit and gross profit margin can be influenced by a number of factors, including product mix, pricing, volume, manufacturing efficiencies and utilization, costs for raw materials and outsourced manufacturing, headcount, inventory obsolescence and warranty expenses.

Photonics

Photonics segment gross profit for 2022 increased $21.2 million, or 19.6%, versus 2021, primarily due to an increase in both revenue and gross profit margin. Photonics segment gross profit margin was 47.0% for 2022, versus a gross profit margin of 46.5% for 2021. The increase in gross profit margin was primarily attributable to improved factory productivity and utilization, partially offset by supply chain disruptions and overall cost inflation.

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Vision

Vision segment gross profit for 2022 increased $7.8 million, or 7.8%, versus 2021, primarily due to an increase in both revenue and gross profit margin. Vision segment gross profit margin was 39.1% for 2022, compared with a gross profit margin of 38.5% for 2021. The increase in gross profit margin was primarily attributable to improved factory efficiency.

Precision Motion

Precision Motion segment gross profit for 2022 increased $46.8 million, or 47.1%, versus 2021, primarily due to an increase in both revenue and gross profit margin. Precision Motion segment gross profit margin was 47.4% for 2022, compared with a gross profit margin of 46.8% for 2021. The increase in gross profit margin was primarily attributable to improved factory utilization, partially offset by supply chain disruption and overall cost inflation.

Operating Expenses

The following table sets forth operating expenses for 2022 and 2021 (dollars in thousands):

Research and Development and Engineering Expenses

Research and development and engineering (“R&D”) expenses are primarily comprised of employee compensation and related expenses and cost of materials for R&D projects.

R&D expenses were $85.8 million, or 10.0% of revenue, in 2022, versus $72.5 million, or 10.3% of revenue, in 2021. R&D expenses increased in terms of total dollars primarily due to higher compensation related expense and R&D expenses from businesses acquired in 2021.

Selling, General and Administrative Expenses

Selling, general and administrative (“SG&A”) expenses include costs for sales and marketing, sales administration, finance, human resources, legal, information systems and executive management.

SG&A expenses were $158.9 million, or 18.5% of revenue, in 2022, versus $129.2 million, or 18.3% of revenue, in 2021. SG&A expenses increased in terms of total dollars and as a percentage of revenue primarily due to SG&A expenses from businesses acquired in 2021 and increases in variable compensation and discretionary spending.

Amortization of Purchased Intangible Assets

Amortization of purchased intangible assets is charged to our Photonics, Vision and Precision Motion segments. Amortization of developed technologies is included in cost of revenue in the consolidated statement of operations. Amortization of customer relationships, trademarks, trade names, backlog and other intangibles are included in operating expenses in the consolidated statement of operations.

Amortization of purchased intangible assets, excluding the amortization of developed technologies that is included in cost of revenue, was $26.3 million, or 3.1% of revenue, in 2022, versus $16.6 million, or 2.3% of revenue, in 2021. The increase, in terms of total dollars and as a percentage of revenue, was the result of more acquired intangible assets from the 2021 acquisitions.

Restructuring, Acquisition, and Related Costs

Restructuring, acquisition, and related charges primarily relate to our restructuring programs, acquisition related costs incurred for completed acquisitions, acquisition costs related to future potential acquisitions and failed acquisitions, and changes in fair value of contingent considerations.

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We recorded restructuring and acquisition related costs of $4.4 million in 2022, versus $18.0 million in 2021. The decrease in acquisition and related costs versus the prior year was primarily due to a $3.3 million reduction in earnout expenses related to prior year acquisitions, a $1.9 million reduction in legal fees and a $4.4 million reduction in other acquisition and related expenses. The restructuring costs also decreased $3.9 million related to decreased expenses for our restructuring plans.

Operating Income (Loss) by Segment

The following table sets forth operating income (loss) by segment for 2022 and 2021 (in thousands):

Photonics

Photonics segment operating income was $63.8 million, or 23.2% of revenue, in 2022, versus $46.8 million, or 20.1% of revenue, in 2021. The increase in operating income was primarily due to an increase in gross profit of $21.2 million, and a decrease in restructuring, acquisition and related costs of $1.6 million, partially offset by an increase in R&D spending of $2.9 million and an increase in SG&A expenses of $2.8 million.

Vision

Vision segment operating income was $28.2 million, or 10.2% of revenue, in 2022, versus $17.7 million, or 6.8% of revenue, in 2021. The increase in operating income was primarily due to an increase in gross profit of $7.8 million, a decrease in restructuring, acquisition and related costs of $3.1 million, and a decrease in amortization expenses of $1.6 million, partially offset by an increase in SG&A expenses of $1.9 million.

Precision Motion

Precision Motion segment operating income was $60.3 million, or 19.6% of revenue, in 2022, versus $52.7 million, or 24.8% of revenue, in 2021. The increase in operating income was primarily due to an increase in gross profit of $46.8 million, and a decrease in restructuring, acquisition and related costs of $4.2 million, partially offset by an increase in R&D spending of $10.3 million, an increase in SG&A expenses of $21.9 million and an increase in amortization of purchased intangible assets of $11.2 million.

Unallocated Corporate and Shared Services

Unallocated corporate and shared services costs primarily represent costs of corporate and shared SG&A functions and other public company costs that are not allocated to the operating segments, including certain restructuring and most acquisition related costs.

Unallocated corporate and shared services costs for 2022 decreased by $3.9 million, or 7.3%, from 2021, primarily due to a decrease in costs related to COVID-19 testing for employees of $3.3 million, and a decrease in restructuring, acquisition and related costs of $4.7 million, partially offset by an increase in SG&A expenses of $3.1 million.

Interest Income (Expense), Foreign Exchange Transaction Gains (Losses), and Other Income (Expense), Net

The following table sets forth interest income (expense), foreign exchange transaction gains (losses), and other income (expense) for 2022 and 2021(in thousands):

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Interest Income (Expense), Net

Net interest expense was $15.6 million in 2022 versus $7.4 million in 2021. The increase in net interest expense was primarily due to an increase in average debt levels and an increase in the weighted average interest rate on our senior credit facilities. The weighted average interest rate on our senior credit facilities was 3.24% and 2.16% during 2022 and 2021, respectively. Included in net interest expense was non-cash interest expense of approximately $1.2 million for both 2022 and 2021, related to the amortization of deferred financing costs on our debt.

Foreign Exchange Transaction Gains (Losses), Net

Foreign exchange transaction gains (losses) were nominal in both 2022 and 2021.

Other Income (Expense), Net

Net other expenses were nominal in both 2022 and 2021.

Income Tax Provision

We recorded a tax provision of $13.1 million in 2022, compared to a tax provision of $5.8 million in 2021. The effective tax rate for 2022 was 15% of income before income taxes, compared to an effective tax rate of 10.4% of income before income taxes for 2021. Our effective tax rate for 2022 differed from the Canadian statutory rate of 29.0% primarily due to the mix of income earned in jurisdictions with varying tax rates, $4.5 million benefit for foreign derived intangible income, $3.1 million benefit from U.K. patent box deductions, $2.3 million benefit from R&D and other tax credits, partially offset by $2.0 million increase in valuation allowances and a $2.1 million detriment related to disallowed compensation.

Our effective tax rate for 2021 differed from the Canadian statutory rate of 29.0% primarily due to the mix of income earned in jurisdictions with varying tax rates, $2.6 million benefit from U.K. patent box deductions, $5.1 million benefit from share-based compensation, $1.4 million benefit from R&D and other tax credits, and $1.2 million benefit for foreign derived intangible income, partially offset by $1.1 million detriment related to disallowed compensation, and a $0.9 million detriment on the establishment of a valuation allowance recorded on net operating losses and other timing items in certain tax jurisdictions.

On December 12, 2022, the EU member states agreed to implement the Organization for Economic Co-operation and Development’s (“OECD’) Pillar Two Model Rules to be effective as of January 2024. These rules will impose a global corporate minimum income tax rate of 15%. Other countries are also actively considering changes to their tax laws to adopt certain parts of the OECD’s proposals. The OECD continues to release additional guidance on these rules. The Company is analyzing the impact and will continue to monitor the related developments.

Net Income

The consolidated net income was $74.1 million for the year ended December 31, 2022, compared to $50.3 million for the year ended December 31, 2021, reflecting the impact of the factors described above.

Liquidity and Capital Resources

We assess our liquidity in terms of our ability to generate cash to fund our operating, investing, and financing activities. Our primary ongoing cash requirements are funding operations, capital expenditures, investments in businesses, and repayment of debt and related interest payments. Our primary sources of liquidity are cash flows from operations and borrowings under our revolving credit facility. We believe our future operating cash flows will be sufficient to meet our future operating and capital expenditure cash needs for the foreseeable future, including at least the next 12 months. The availability of borrowing capacity under our revolving credit facility provides another potential source of liquidity for any future capital expenditures and other liquidity needs. In addition, we have the ability to expand our borrowing capacity by up to $350.0 million by exercising the accordion feature under our revolving credit agreement. We may seek to raise additional capital, which could be in the form of bonds, convertible debt or preferred or common equity, to fund business development activities or other future investing cash requirements, subject to approval by the lenders in the Third Amended and Restated Credit Agreement. There is no assurance that such capital will be available on reasonable terms or at all.

Significant factors affecting the management of our ongoing cash requirements are the adequacy of available bank lines of credit and our ability to attract long term capital with satisfactory terms. The sources of our liquidity are subject to all of the risks of our business and could be adversely affected by, among other factors, risks associated with events outside of our control, such as economic consequences of global pandemics and geopolitical conflicts, worsening supply chain disruptions and electronics and other material shortages, a decrease in demand for our products, our ability to integrate current and future acquisitions, deterioration in

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certain financial ratios, availability of borrowings under our revolving credit facility, and market changes in general. See “Risks Relating to Our Common Shares and Our Capital Structure” included in Item 1A of this Annual Report on Form 10-K.

Our ability to make payments on our indebtedness and to fund our operations may be dependent upon the operating income and the distribution of funds from our subsidiaries. However, as local laws and regulations and/or the terms of our indebtedness restrict certain of our subsidiaries from paying dividends and transferring assets to us, there is no assurance that our subsidiaries will be permitted to provide us with sufficient dividends, distributions or loans when necessary.

As of December 31, 2022, $68.4 million of our $100.1 million of cash and cash equivalents was held by our subsidiaries outside of North America. Generally, our intent is to use cash held in these foreign subsidiaries to fund our local operations or acquisitions by those local subsidiaries and to pay down borrowings under our senior credit facilities. Approximately $150.3 million of our outstanding borrowings under our senior credit facilities were held in our subsidiaries outside of North America as of December 31, 2022. Additionally, we may use intercompany loans to address short-term cash flow needs from various subsidiaries.

We deferred $2.8 million of U.S. payroll tax payments in 2020 in accordance with relief provisions under the CARES Act. We paid $1.4 million of such deferred payroll tax payments during 2021. The remaining $1.4 million was paid during 2022.

In May 2021, our shareholders approved a special resolution to amend the Company’s articles to authorize up to 7.0 million preferred shares for future issuance. Our Board of Directors may designate and issue one or more series of preferred shares in order to raise additional capital, provided that no shares of any series may be entitled to more than one vote per share. As of December 31, 2022, no preferred shares were issued and outstanding.

Share Repurchase Plans

Our Board of Directors may approve share repurchase plans from time to time. Under these repurchase plans, shares may be repurchased at our discretion based on ongoing assessment of the capital needs of the business, the market price of our common shares, and general market conditions. Shares may also be repurchased through an accelerated share purchase agreement, on the open market or in privately negotiated transactions in accordance with applicable federal securities laws. Repurchases may be made under certain SEC regulations, which would permit common shares to be repurchased when we would otherwise be prohibited from doing so under insider trading laws. While the share repurchase plans are generally intended to offset dilution from equity awards granted to our employees and directors, the plans do not obligate us to acquire any particular amount of common shares. No time limit is typically set for the completion of the share repurchase plans, and the plans may be suspended or discontinued at any time. We expect to fund share repurchases through cash on hand and cash generated from operations.

In October 2018, our Board of Directors approved a share repurchase plan (the “2018 Repurchase Plan”) authorizing the repurchase of $25.0 million worth of common shares. Share repurchases have been made under the 2018 Repurchase Plan pursuant to Rule 10b-18 under the Securities Exchange Act of 1934. During the second quarter of 2022, we repurchased 80 thousand shares for an aggregate purchase price of $9.5 million at an average price of $118.97 per share under the 2018 Repurchase Plan. We have completed the 2018 Repurchase Plan and have repurchased a cumulative total of 264 thousand shares at an average price of $94.57 per share under the 2018 Repurchase Plan.

In February 2020, our Board of Directors approved a new share repurchase plan (the “2020 Repurchase Plan”) authorizing the repurchase of $50.0 million worth of common shares, effective after the 2018 Repurchase Plan is completed. Share repurchases have been made under the 2020 Repurchase Plan pursuant to Rule 10b-18 under the Securities Exchange Act of 1934. During the year ended December 31, 2022, we repurchased 4 thousand shares for an aggregate purchase price of $0.5 million at an average price of $116.95 per share under the 2020 Repurchase Plan. As of December 31, 2022, we had $49.5 million available for share repurchases under the 2020 Repurchase Plan.

Senior Credit Facilities

In December 2019, we entered into the Third Amended and Restated Credit Agreement, originally consisting of a $100.0 million U.S. dollar equivalent euro-denominated (approximately €90.2 million) 5-year term loan facility and a $350.0 million 5-year revolving credit facility (collectively, the “Senior Credit Facilities”). The term loan facility requires quarterly scheduled principal repayments of approximately €1.1 million that began in March 2020 with the remaining principal balance due upon maturity. We may make additional principal payments at any time, which will reduce the next quarterly installment payment due. We may pay down our revolving credit facility with cash on hand and cash generated from future operations at anytime until maturity.

On March 27, 2020, we entered into an amendment (the “First Amendment”) to the Third Amended and Restated Credit Agreement and exercised a portion of the uncommitted accordion feature. The First Amendment increased the revolving credit facility

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commitment under the Third Amended and Restated Credit Agreement by $145.0 million, from $350.0 million to $495.0 million, and reset the uncommitted accordion feature to $200.0 million for potential future expansion.

On June 2, 2020, we entered into an amendment (the “Second Amendment”) to the Third Amended and Restated Credit Agreement. The Second Amendment revised our consolidated leverage ratio definition (as defined in the Third Amended and Restated Credit Agreement) allowing for the use of up to $25 million unrestricted cash and cash equivalents as a reduction to consolidated funded indebtedness (as defined in the Third Amended and Restated Credit Agreement).

On October 5, 2021, we entered into an amendment (the “Fourth Amendment”) to the Third Amended and Restated Credit Agreement to exercise the accordion feature. The Fourth Amendment increased the revolving credit facility commitment under the Third Amended and Restated Credit Agreement by $200.0 million, from $495.0 million to $695.0 million, and reset the uncommitted accordion feature to $200.0 million for potential future expansion.

On March 10, 2022, the Company entered into an amendment (the “Fifth Amendment”) to the Third Amended and Restated Credit Agreement to extend the maturity date thereof from December 31, 2024 to March 10, 2027, update the pricing grid, replace LIBOR with SOFR as the reference rate for U.S. dollar borrowings, and increase the uncommitted accordion feature from $200.0 million to $350.0 million.

As of December 31, 2022, we had $81.9 (€76.6) million term loan and $358.4 million revolver borrowings outstanding under our Senior Credit Facilities. The borrowings outstanding under the Senior Credit Facilities bear interest at rates based on (a) the Base Rate, as defined in the Third Amended and Restated Credit Agreement, plus a margin ranging between 0.00% to 0.75% per annum, determined by reference to our consolidated leverage ratio, or (b) the Term SOFR Loans, Alternative Currency Loans, and Letters of Credit Rate, as defined in the Third Amended and Restated Credit Agreement, plus a margin ranging between 0.75% and 1.75% per annum, determined by reference to our consolidated leverage ratio. In addition, we are obligated to pay a commitment fee on the unused portion of the revolving credit facility, ranging between 0.20% and 0.30% per annum, determined by reference to our consolidated leverage ratio. As of December 31, 2022, we had outstanding borrowings under the Third Amended and Restated Credit Agreement denominated in Euro and U.S. Dollars of $150.3 million and $290.0 million, respectively.

The Third Amended and Restated Credit Agreement contains various covenants that, we believe, are usual and customary for this type of agreement, including a maximum allowed leverage ratio and a minimum required fixed charge coverage ratio (as defined in the Third Amended and Restated Credit Agreement). The following table summarizes these financial covenants and our compliance therewith as of December 31, 2022:

(1)
Maximum consolidated leverage ratio shall be increased to 4.00 for four consecutive quarters following a designated acquisition, as defined in the Fifth Amendment.

In addition, the Third Amended and Restated Credit Agreement contains various other customary representations, warranties and covenants applicable to the Company and its subsidiaries, including: (i) limitations on certain payments; (ii) limitations on fundamental changes involving the Company; (iii) limitations on the disposition of assets; and (iv) limitations on indebtedness, investments, and liens.

Cash Flows

Cash and cash equivalents totaled $100.1 million as of December 31, 2022, versus $117.4 million as of December 31, 2021. The net decrease in cash and cash equivalents is primarily attributable to $59.0 million of debt repayments, $46.3 million of contingent consideration payments related to acquisitions, $22.4 million of cash considerations paid for the MPH acquisition, $19.6 million of capital expenditures, $11.7 million of payroll tax payments upon vesting of share-based compensation awards, $10.0 million of repurchases of shares, and $2.5 million of debt issuance costs in connection with the Fifth Amendment, partially offset by $69.9 million of borrowings under our revolving credit facility used to fund the contingent consideration payment for the acquisition of ATI In4dustrial Automation Inc. (“ATI”) and the cash consideration for the MPH acquisition and cash provided by operating activities of $90.8 million.

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The following table summarizes our cash and cash equivalent balances, cash flows and unused borrowing capacity available under our revolving credit facility for the years indicated (in thousands):

Operating Cash Flows

Cash provided by operating activities was $90.8 million in 2022, versus $94.6 million in 2021. Cash provided by operating activities decreased from 2021 primarily due to a $48.6 million increase in inventories driven by increased customer demand and higher raw material purchases, and a bonus payout in 2022 of $8.4 million compared to no bonus payout in 2021 as a result of the elimination of our 2020 annual bonus plan, partially offset by an increase in operating profit as a result of higher revenue.

Beginning in January 2022, the Tax Cuts and Jobs Act of 2017 (“TCJA”) requires R&D expenditures be capitalized and amortized for income tax purposes over five years for domestic research and fifteen years for foreign research, rather than being deducted as incurred. This has the effect of increasing our cash taxes and deferred tax assets. As this provision under the TCJA was not deferred, modified, or repealed with retroactive effect going back to January 1, 2022 during 2022, our operating cash flows have decreased by approximately $11.3 million for the year ended December 31, 2022 as a direct result.

Investing Cash Flows

Cash used in investing activities was $42.5 million in 2022, primarily driven by the MPH acquisition. We paid cash consideration of $22.4 million, net of cash acquired. We also paid capital expenditures of $19.6 million and a contingent consideration payment of $1.5 million related to our 2016 asset acquisition of video signal processing and management technologies. We received $0.8 million net working capital adjustment in 2022 related to our ATI acquisition.

Cash used in investing activities was $306.7 million in 2021, primarily driven by the ATI and SEM acquisitions. In connection with these acquisitions, we paid cash considerations of $284.7 million (net of cash acquired of $14.6 million). We also paid capital expenditures of $20.0 million and a contingent consideration payment of $2.2 million related to our 2016 asset acquisition of video signal processing and management technologies.

We have no material commitments to purchase property, plant and equipment as of December 31, 2022. We expect to use approximately $25 million to $30 million in 2023 for capital expenditures related to investments in new property, plant and equipment for our existing businesses, which includes a significant one-time facility buildout project in the U.K. for our Solid State and Ultrafast Lasers products.

Financing Cash Flows

Cash used in financing activities was $60.2 million in 2022, primarily due to $59.0 million of term loan and revolving credit facility repayments, $46.3 million of contingent consideration payments related to prior year acquisitions, $11.7 million of payroll tax payments upon vesting of share-based compensation awards, $10.0 million of repurchases of common stock, and $2.5 million of debt issuance costs in connection with the Fifth Amendment, partially offset by $69.9 million of borrowings under our revolving credit facility used to fund the contingent consideration paid for the ATI acquisition and the cash consideration paid for the MPH acquisition.

Cash provided by financing activities was $204.8 million in 2021, primarily due to $280.0 million of borrowings under our revolving credit facility used to fund the cash considerations paid for the ATI and SEM acquisitions, partially offset by $32.4 million of term loan and revolving credit facility repayments, $30.8 million of payroll tax payments upon vesting of share-based compensation awards, $8.7 million of payment for the purchase of a building under a finance lease agreement, and $1.8 million of contingent consideration payments related to prior year acquisitions.

In 2023, we are contractually required to make $4.8 million in repayments under our term loan facility. In addition, we may make optional repayments under our revolving credit facility from time to time with available cash generated from future operating activities.

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Other Liquidity Matters

Pension Plans

We maintain a defined benefit pension plan (the “U.K. Plan”) in Novanta Technologies U.K. Limited, a wholly owned subsidiary of the Company. Our U.K. Plan was closed to new members in 1997 and stopped accruing additional pension benefits for existing members in 2003, thereby limiting our obligation to benefits earned through that date. Benefits under this plan were based on the participants’ years of service and compensation as of the date the plan was frozen, adjusted for inflation. On July 1, 2013, the Company provided a Guarantee (the “Guarantee”) in favor of the trustees of the U.K. Plan with respect to all present and future obligations and liabilities (whether actual or contingent and whether owed jointly or severally and in any capacity whatsoever) under the U.K. Plan.

Our funding policy is to fund the U.K. Plan based on actuarial methods as permitted by the Pensions Regulator in the U.K. The results of funding valuations depend on both the funding deficit and the assumptions used, such as asset returns, discount rates, mortality rates, retail price inflation and other market driven assumptions. Each assumption used represents one estimate of many possible future outcomes. The final cost to us will be determined by events as they actually become known, including actual return on plan assets and pension payments to plan participants. As of December 31, 2022, the fair value of plan assets exceeded the projected benefit obligation under the U.K. Plan by $2.0 million. Based on the results of the most recent funding valuation, our annual funding contributions are expected to be approximately $1.0 million in 2023 and will increase by 2.9% per year until the next statutory funding valuation date in 2024.

Material Cash Requirements

Senior Credit Facilities

As of December 31, 2022, we had $81.9 million (€76.6 million) term loan and $358.4 million revolving credit facility borrowings outstanding under the Senior Credit Facilities. The term loan is payable in quarterly installments of approximately €1.1 million ($1.2 million) with the final installment of €58.5 million ($62.6 million) due upon maturity in March 2027. Borrowings under the revolving credit facility are due at maturity in March 2027.

As of December 31, 2022, the future interest payments under our Senior Credit Facilities are expected to be approximately $96.5 million through maturity based on the current contractual term, with $23.4 million payable within the next twelve months. These estimates are based on current interest rates on floating rate obligations, as defined in the Third Amended and Restated Credit Agreement, for the remainder of the contractual life of both the term loan and outstanding borrowings under the revolving credit facility, and the current commitment fee rate was used for the unused commitments under the revolving credit facility as of December 31, 2022. These estimates also assume only quarterly term loan payments are made and outstanding revolving credit facility remains unchanged throughout the contractual term. The actual interest payments will vary due to changes in our debt level and interest rate. See Note 11, “Debt,” in the Consolidated Financial Statements for further details of our debt obligations and the timing of expected future payments.

Operating and Finance Leases

We have entered into various lease agreements for office and manufacturing facilities, vehicles, and equipment used in the normal course of business. Undiscounted operating and finance lease obligations were $66.5 million, with $10.3 million payable within the next twelve months. See Note 12, “Leases,” in the Consolidated Financial Statements for further details of our obligations and the timing of expected future payments.

Purchase Obligations

Purchase obligations represent an estimate of all open purchase orders and contractual obligations in the ordinary course of business for which we have not received the goods or services. As of December 31, 2022, we had $145.0 million of purchase obligations, with $142.7 million payable within the next twelve months.

Critical Accounting Policies and Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the U.S. requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the dates of the financial statements and the reported amounts of revenues and expenses for the reporting periods. On an ongoing basis, we evaluate our estimates, assumptions and judgments, including those related to revenue recognition, inventory valuation, impairment assessment and valuation of goodwill, intangible assets and tangible long-lived assets, valuation of contingent

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consideration obligations, accounting for income taxes, and accounting for loss contingencies. Actual results in the future could differ significantly from our estimates.

We believe that the following critical accounting policies and estimates most significantly affect the portrayal of our financial condition and results of operations and require the most difficult and subjective judgments.

Revenue Recognition. We recognize revenue in accordance with Accounting Standards Codification (“ASC”) 606, “Revenue from Contracts with Customers”. Under ASC 606, an entity recognizes revenue when its customer obtains control of promised goods or services, in an amount that reflects the consideration which the entity expects to receive in exchange for those goods or services. Revenue recognition for arrangements within the scope of ASC 606 includes the following five steps: (i) identifying the contract(s) with a customer; (ii) identifying the performance obligations in the contract; (iii) determining the transaction price; (iv) allocating the transaction price to the performance obligations in the contract; and (v) recognizing revenue when (or as) a performance obligation is satisfied.

We recognize revenue when control of promised goods or services is transferred to customers. This generally occurs upon shipment when the title and risk of loss pass to the customer. The vast majority of our revenue is generated from the sale of distinct products. Revenue is measured as the amount of consideration we expect to receive in exchange for such products, which is generally at contractually stated prices. Sales taxes and value added taxes collected concurrently with revenue generating activities are excluded from revenue.

Substantially all of our revenue is recognized at a point in time, upon shipment, rather than over time. At the request of our customers, we may perform professional services, generally for the maintenance and repair of products previously sold to those customers and for engineering services. Professional services are typically short in duration, mostly less than one month, and total less than 3% of our consolidated revenue. Revenue is typically recognized at a point in time when control transfers to the customer upon completion of professional services. These services generally involve a single distinct performance obligation. The consideration expected to be received in exchange for such services is normally the contractually stated amount.

We occasionally sell separately priced non-standard/extended warranty services or preventative maintenance plans with the sale of products. The transfer of control over the service plans is over time. We recognize the related revenue ratably over the terms of the service plans. The transaction price of a contract is allocated to each performance obligation based on its relative standalone selling price. Standalone selling prices are generally determined based on the prices charged to customers or using the expected cost plus a margin.

We account for shipping and handling activities that occur after the transfer of control over the related goods as fulfillment activities rather than performance obligations. The shipping and handling fees charged to customers are recognized as revenue and the related costs are recorded in cost of revenue at the time of transfer of control.

We generally provide warranties for our products. The standard warranty period is typically 12 months to 36 months. The standard warranty period for product sales is accounted for under the provisions of ASC 450, “Contingencies,” as we have the ability to ascertain the likelihood of the liability and can reasonably estimate the amount of the liability. A provision for the estimated cost related to warranty is recorded to cost of revenue at the time revenue is recognized. Our estimate of the costs to service warranty obligations is based on historical experience and expectations of future conditions. To the extent our experience in warranty claims or costs associated with servicing those claims differ from the original estimates, revisions to the estimated warranty liability are recorded at that time, with an offsetting entry recorded to cost of revenue.

We expense incremental direct costs of obtaining a contract when incurred if the expected amortization period is one year or less. These costs are recorded within selling, general and administrative expenses in the consolidated statement of operations. We do not adjust the promised amount of consideration for the effects of a financing component because the time period between the transfer of a promised good to a customer and the customer’s payment for that good is typically one year or less.

Inventories. Inventories, which include materials and conversion costs, are stated at the lower of cost or net realizable value, using the first-in, first-out method. Cost includes the cost of purchased materials, inbound freight charges, customs duties and trade tariffs on imported materials and components, external and internal processing and applicable labor and overhead costs. Net realizable value is the estimated selling price in the ordinary course of business, less reasonably predictable costs of completion, storage, disposal and transportation.

We regularly review inventory quantities on hand and, when necessary, record provisions for excess and obsolete inventory based on either our forecasted product demand and production requirements or trailing historical usage of the product. If our sales do not materialize as planned or at historical levels, we may have to increase our reserve for excess and obsolete inventory, which would reduce our operating income. If actual market conditions are more favorable than anticipated, inventory previously written down may be sold, resulting in lower cost of revenue and higher operating income than expected in that period.

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Share-Based Compensation. We record expenses associated with share-based compensation awards to employees and directors based on the fair value of awards as of the grant date. In addition to service-based awards granted to a wider employee base and stock options granted to certain members of the executive management team, we typically grant three types of performance-based awards to certain members of the executive management team: non-GAAP EPS performance-based restricted stock units (“EPS-PSUs”), operating cash flow performance-based restricted stock units (“OCF-PSUs”), and relative total shareholder return performance-based restricted stock units (“TSR-PSUs”). In January 2022, the Company granted Adjusted EBITDA performance-based restricted stock units to ATI employees (“ATI-PSUs”).

For share-based compensation awards that vest over time based on employment, the associated expenses are recognized in the consolidated statement of operations ratably over the vesting period of the awards, net of estimated forfeitures.

For stock options, share-based compensation expenses are recognized based on the fair value of the stock options, which is determined using Black-Scholes option pricing model as of the date of grant. Shared-based compensation expenses related to stock options are recognized on a straight-line basis ratably over the vesting period of the awards. Black-Scholes option pricing model includes various assumptions, including the expected term of the award, the expected volatility and the expected risk-free interest rate over the expected term of the award, expected dividend payments, and the fair value of the common stock underlying the awards.

For EPS-PSUs, OCF-PSUs and ATI-PSUs, share-based compensation expenses are recognized ratably over the vesting period when it is probable that specified performance targets are expected to be achieved based on management’s projections as of the end of each period. Management’s projections are revised, if necessary, in subsequent periods when underlying factors change the estimated probability of achieving the performance targets as well as the levels of achievement. When the estimated achievement levels are adjusted at a later date, a cumulative adjustment to the share-based compensation expense previously recognized would be required. Accordingly, share-based compensation expenses associated with EPS-PSUs, OCF-PSUs and ATI-PSUs may differ significantly from period to period based on changes to both the probability and the level of achievement against performance targets.

For TSR-PSUs, share-based compensation expenses are recognized based on the fair value of the TSR-PSUs, which is determined using the Monte-Carlo simulation valuation model as of the date of grant. Shared-based compensation expenses related to TSR-PSUs are recognized on a straight-line basis from the grant date to the end of the performance period, which is generally three years, regardless of whether the target relative total shareholder return is achieved. The Monte Carlo simulation model utilizes multiple input variables that determine the probability of satisfying the performance conditions stipulated in the grant agreement in a large number of simulated scenarios. Key assumptions for the Monte Carlo simulation model include risk-free interest rate and expected stock price volatility of both the Company’s common shares and the Russell 2000 index.

Valuation of Long-lived Assets. The purchase price we pay for acquired companies is allocated first to the identifiable assets acquired and liabilities assumed at their estimated fair value. Any excess purchase price is then allocated to goodwill. We make various assumptions and estimates in order to assign fair value to acquired tangible and intangible assets and liabilities. Key assumptions used to value identifiable intangible assets typically include revenue growth rates and projected cash flows, discount rates, royalty rates, technology obsolescence curves, and customer attrition rates, among others. Actual cash flows may vary from forecasts used to value these assets at the time of the business combination.

The estimated fair value of real estate assets acquired in a business combination is estimated based on comparable sales information and other market data, if available, as well as using an income or cost approach, specifically the direct capitalization and replacement value approaches. The direct capitalization and replacement value approaches use key assumptions such as market rent estimates, capitalization rates, local multipliers and remaining useful life of the real estate assets. Assumptions used are subject to management judgment and changes in those assumptions could impact the estimation of the fair value.

Our most significant identifiable intangible assets are customer relationships, acquired technologies, trademarks and trade names. In addition to our review of the carrying value of each asset, the estimated useful life assumptions for identifiable intangible assets, including the classification of certain intangible assets as “indefinite-lived,” are reviewed on a periodic basis to determine if changes in circumstances warrant revisions to them. All definite-lived intangible assets are amortized over the periods in which their economic benefits are expected to be realized.

Impairment analyses of goodwill and indefinite-lived intangible assets are conducted in accordance with ASC 350, “Intangibles—Goodwill and Other.” We test our goodwill balances annually as of the beginning of the second quarter or more frequently if indicators are present, or changes in circumstances suggest, that an impairment may exist. Should the fair value of our goodwill or indefinite-lived intangible assets decline because of reduced operating performance, market declines or other indicators of impairment, or as a result of changes in the discount rate, charges for impairment loss may be necessary.

We evaluate our goodwill, intangible assets and other long-lived assets for impairment at the reporting unit levels which is generally at least one level below our reportable segments. We have the option of first performing a qualitative assessment to determine whether it is necessary to perform the quantitative impairment test. In performing the qualitative assessment, we review

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factors both specific to the reporting unit and to the Company as a whole, such as financial performance, macroeconomic conditions, industry and market considerations, and the fair value of each reporting unit as of the last valuation date. If we elect this option and believe, as a result of the qualitative assessment, that it is more likely than not that the carrying value of goodwill is not recoverable, the quantitative impairment test is required; otherwise, no further testing is performed.

Alternatively, we may elect to bypass the qualitative assessment and perform the quantitative impairment test instead. This approach requires a comparison of the carrying value of each of our reporting units to the fair value of these reporting units. If the carrying value of a reporting unit exceeds its fair value, an impairment charge is recorded for the difference. The fair value of a reporting unit is estimated primarily using a discounted cash flow (“DCF”) method. The DCF method requires that we forecast future cash flows for each of the reporting units and discount the cash flow streams based on a weighted average cost of capital (“WACC”) that is derived, in part, from comparable companies within similar industries. The DCF calculations also include a terminal value calculation that is based upon an expected long-term growth rate for the applicable reporting unit. The carrying values of each reporting unit include assets and liabilities which relate to the reporting unit’s operations. Additionally, reporting units that benefit from corporate assets or liabilities are allocated a portion of those corporate assets and liabilities on a proportional basis.

We assess indefinite-lived intangible assets for impairment on an annual basis, and more frequently if impairment indicators are identified. We also periodically reassess their continuing classification as indefinite-lived intangible assets. Impairment exists if the fair value of the intangible asset is less than its carrying value. An impairment charge equal to the difference is recorded to reduce the carrying value to its fair value.

We evaluate amortizable intangible assets and other long-lived assets for impairment in accordance with ASC 360-10-35-15, “Impairment or Disposal of Long-Lived Assets,” whenever changes in events or circumstances indicate that the carrying values of the reporting units may exceed the undiscounted cash flow forecasts attributable to the reporting units. If undiscounted cash flow forecasts indicate that the carrying value of definite-lived intangible assets or other long-lived assets may not be recoverable, a fair value assessment is performed. For intangible assets, fair value estimates are derived from discounted cash flow forecasts. For other long-lived assets (primarily property, plant and equipment), fair value estimates are derived from the sources most appropriate for the particular asset and have historically included such approaches as sales comparison approach and replacement cost approach. If fair value is less than carrying value, an impairment charge equal to the difference is recorded. We also review the useful life and residual value assumptions for definite-lived intangible assets and other long-lived assets on a periodic basis to determine if changes in circumstances warrant revisions to them.

Factors which may trigger an impairment of our goodwill, intangible assets and other long-lived assets include the following:

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significant underperformance relative to historical or projected future operating results;

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changes in our use of the acquired assets or the strategy for our overall business;

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long-term negative industry or economic trends;

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technological changes or developments;

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changes in competition;

•
loss of key customers or personnel;

•
adverse judicial or legislative outcomes or political developments;

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significant declines in our stock price for a sustained period of time; and

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the decline of our market capitalization below net book value as of the end of any reporting period.

The occurrence of any of these events or any other unforeseeable events or circumstances that materially affect future operating results or cash flows may cause an impairment that is material to our results of operations or financial position in the reporting period in which it occurs or is identified.

The most recent annual goodwill and indefinite-lived intangible asset impairment test was performed as of the beginning of the second quarter of 2022, using a quantitative assessment, noting no impairment. As of December 31, 2022, there were no indicators of impairment of our long-lived assets.

Accounting for Income Taxes. As part of the process of preparing our consolidated financial statements, we are required to calculate our income tax provision (benefit) in each of the jurisdictions in which we operate. This process involves estimating our current income tax provision (benefit) together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are reported on our consolidated balance sheet.

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Judgment is required in determining our worldwide income tax provision. In the ordinary course of a global business, there are many transactions and calculations where the ultimate outcome is uncertain. Although we believe our estimates are reasonable, there is no assurance that the final outcome of these matters will not be different from that which is reflected in our historical income tax provisions and accruals. Such differences could have a material impact on our income tax provision and net income in the period in which such determination is made.

We record a valuation allowance on our deferred tax assets when it is more likely than not that they will not be realized. We have considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for a valuation allowance. In the event we determine that we are able to realize our deferred tax assets in the future in excess of their net recorded amounts, an adjustment to the valuation allowance for the deferred tax assets would be recorded and would increase our net income in the period in which such determination is made. Likewise, should we determine that we will not be able to realize all or part of our net deferred tax assets in the future, an adjustment to the valuation allowance for the deferred tax assets will be recorded and will reduce our net income in the period in which such determination is made.

In conjunction with our ongoing review of our actual results and anticipated future earnings, we continuously reassess the adequacy of the valuation allowance currently in place on our deferred tax assets. In 2022, we established a valuation allowance of $2.0 million recorded on state R&D credits, net operating losses and other timing items in certain tax jurisdictions. The factors used to assess the likelihood of realization of deferred tax assets are the forecast of future taxable income, available tax planning strategies that could be implemented to realize the net deferred tax assets, potential for carryback and future reversals of deferred tax liabilities.

The amount of income taxes we pay is subject to audits by federal, state and foreign tax authorities, which may result in proposed assessments. We believe that we have adequately provided for any reasonably foreseeable outcome related to these matters. However, our future results may include favorable or unfavorable adjustments to our tax liabilities in the period that the assessments are made or resolved, or when the statute of limitations for certain periods expires. As of December 31, 2022, the Company’s total amount of unrecognized tax benefits was $4.2 million, of which $3.7 million would favorably affect our effective tax rate, if recognized. Over the next twelve months, we may need to recognize up to $0.5 million of previously unrecognized tax benefits due to statute of limitations closures.

Income and foreign withholding taxes have not been recognized on the excess of the amount for financial reporting purposes over the tax basis of investments in foreign subsidiaries that are essentially permanent in nature. This amount becomes taxable upon a repatriation of assets from a subsidiary or a sale or liquidation of a subsidiary. The amount of undistributed earnings of foreign subsidiaries totaled $330.8 million as of December 31, 2022. The estimated unrecognized income and foreign withholding tax liabilities on these undistributed earnings is approximately $3.6 million.

Loss Contingencies. We are subject to legal proceedings, lawsuits and other claims relating to product quality, labor, service and other matters arising in the ordinary course of business. We review the status of each significant matter and assess our potential financial exposure on a quarterly basis. If the potential loss from any claim or legal proceeding is considered probable and the amount can be reasonably estimated, we accrue a liability for the estimated loss. Significant judgment is required in both the determination of probability and the determination as to whether an exposure is reasonably estimable. Because of uncertainties related to these matters, accruals are based only on the best information available as of the date of the financial statements. As additional information becomes available, we will reassess the potential liability related to our pending claims and litigation and may revise our estimates. Such revisions in the estimates of the potential liabilities could have a material impact on our results of operations and financial position. We expense legal fees as incurred.

Recent Accounting Pronouncements

See Note 2 to Consolidated Financial Statements for recent accounting pronouncements that could have a significant effect on us.

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