Latham Group, Inc. (SWIM) FY 2022 MD&A
This page reproduces the company's own Item 7 MD&A text from the linked SEC filing. It is filer text, not grepcent analysis, scoring, or investment advice.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with other sections of this Annual Report, including “Item 1. Business,” and our audited consolidated financial statements and related notes for the three years ended December 31, 2022, 2021 and 2020, included elsewhere in this Annual Report.
Overview
We are the largest designer, manufacturer, and marketer of in-ground residential swimming pools in North America, Australia, and New Zealand. We hold the #1 position in North America in every product category in which we compete. We believe that we are the most sought-after brand in the pool industry and the only pool company that has established a direct relationship with the homeowner. We are Latham, The Pool CompanyTM.
With an operating history that spans over 65 years, we offer the industry’s broadest portfolio of pools and related products, including in-ground swimming pools, pool liners, and pool covers.
We have a heritage of innovation. In an industry that has traditionally marketed on a business-to-business basis (pool manufacturer to dealer), we pioneered the first “direct-to-homeowner” digital and social marketing strategy that has transformed the homeowner’s purchase journey. Through this marketing strategy, we are able to create demand for our pools and to provide high quality, purchase-ready consumer leads to our dealer partners.
Partnership with our dealers is integral to our collective success, and we have enjoyed long-tenured relationships averaging over 14 years. We support our dealer network with business development tools, co-branded marketing programs, and in-house training, as well as an operations platform consisting of over 2,000 employees across over 30 locations.
The full resources of our company are dedicated to designing and manufacturing high-quality pool products, with the homeowner in mind, and positioning ourselves as a value-added partner to our dealers. As a result of this approach, 2022 marked our 13th consecutive year of net sales growth and Adjusted EBITDA growth. Net income does not adhere to this trend.
We conduct our business as one operating and reportable segment that designs, manufactures, and markets in-ground swimming pools, liners, and covers.
Recent Developments
Highlights for the year ended December 31, 2022
| Column 1 | Column 2 | Column 3 |
|---|---|---|
| ● | Increase in net sales of 10.4%, or $65.2 million, to $695.7 million for the year ended December 31, 2022, compared to $630.5 million for the year ended December 31, 2021. |
| Column 1 | Column 2 | Column 3 |
|---|---|---|
| ● | Decrease in net loss of $56.6 million, to $5.7 million for the year ended December 31, 2022, compared to a net loss of $62.3 million for the year ended December 31, 2021, representing a 0.8% net loss margin for the year ended December 31, 2022. |
| Column 1 | Column 2 | Column 3 |
|---|---|---|
| ● | Increase in Adjusted EBITDA (as defined below) of $3.5 million, to $143.3 million for the year ended December 31, 2022, compared to $139.8 million for the year ended December 31, 2021. |
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Business Update
Market conditions continue to evolve. Macroeconomic uncertainty is affecting consumer spending and softening demand for consumer durables, resulting in declines in U.S. new in-ground pool installations in 2022. We anticipate further net sales declines in our in-ground swimming pool product line in 2023. We continue to see destocking of packaged pool inventory at the wholesale distribution-level, and we expect normalization of inventory levels to remain a headwind. We believe continued progress on fiberglass conversion efforts, especially from concrete, will be a modest tailwind as we continue to work to drive homeowner and dealer awareness and adoption. We continue to take a disciplined approach to capital investments, with the focus on the completion of previously announced projects. This includes the completion of our Kingston, Ontario facility as well as our acquired fiberglass manufacturing assets in Seminole, Oklahoma. The Kingston and Seminole facilities for production will give us the opportunity to reduce freight costs, tighten our lead times, and tap into large markets with strong fiberglass conversion opportunities.
We have responded to economic uncertainty with immediate actions to reduce our costs. On November 8, 2022, we approved a cost reduction plan to optimize our production and shift schedules, implement a workforce reduction, and streamline our cover and liner manufacturing footprint with the closure of our Bossier City, Louisiana facility in the first quarter of 2023.
During the year ended December 31, 2022, we recognized costs related to the plan totaling $1.1 million, comprised primarily of $1.0 million for severance and related costs and $0.1 million of fixed asset and facility related expenses. The remaining costs under the plan of approximately $0.5 million are expected to be incurred and recognized in 2023. We expect to generate annual operating expense savings of approximately $12.0 million in fiscal 2023 as a result of our cost reduction plan.
Leadership Transition
On January 19, 2023, we announced that Robert L. Masson II will step down as our Chief Financial Officer for family reasons, effective March 17, 2023. J. Mark Borseth, who previously served as Latham’s Chief Financial Officer from February 2020 to July 2022, rejoined Latham as a strategic advisor effective February 13, 2023. On March 18, 2023, Mr. Borseth will become the Interim Chief Financial Officer. A search for a permanent Chief Financial Officer is underway.
Share Repurchase Program
On May 10, 2022, we approved a stock repurchase program (the “Repurchase Program”), which authorized us to repurchase up to $100 million of our shares of common stock over the next three years. We may effect these repurchases in open market transactions, privately negotiated purchases, or other acquisitions. We are not obligated to repurchase any of our outstanding shares under the Repurchase Program and the timing and amount of any repurchases will depend on market conditions, our stock price, alternative uses of capital, the terms of our debt instruments, and other factors. During the year ended December 31, 2022, we repurchased and concurrently retired 4,483,620 shares of our common stock for an aggregate amount of $23.0 million, pursuant to the Repurchase Program. As of December 31, 2022, approximately $77.0 million remained available for share repurchases pursuant to our Repurchase Program.
Key Factors Affecting our Performance
Our results of operations and financial condition are affected by the following factors, which reflect our operating philosophy and focus on designing, manufacturing, and marketing high quality and innovative pools and pool covers for the in-ground swimming pool market.
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Volume of Products Sold
Our net sales depend primarily on the volume of products we sell during any given period, and volume is affected by the following items, among others:
| Column 1 | Column 2 | Column 3 |
|---|---|---|
| ● | Sales, distribution, and marketing: While we have traditionally relied on our dealers and distributors to raise awareness of our products, we pioneered the first “direct-to-homeowner” digital and social marketing strategy that has transformed the homeowner’s purchase journey. Through this marketing strategy, we are able to create demand for our pools and generate and provide high quality, purchase-ready consumer leads to our dealer partners. |
In order to strengthen our relationship with our loyal dealer partners, we have implemented “Latham Grand,” a key dealer strategy whereby we have secured exclusivity from over 250 of our largest dealers in North America, which also includes the United States’ largest franchised dealer network, Premier Pools & Spas. We also have a strong distribution network as a result of over 450 distributor branch locations that represent our products. Through our significant investments in partnerships with dealers and distributors and our consumer-oriented marketing efforts, we have created both a “push and pull” demand dynamic for our products in the marketplace. We invest in our exclusive dealers through localized marketing spend, co-branding opportunities, tailored offerings, and priority lead generation. We also provide our dealers with enhanced product literature, in-store display samples, and other initiatives to drive sales. We have directed a significant portion of our advertising spend to digital channels, including social media and search advertising. Our improved digital marketing engine has the ability to strategically target market spend and to generate leads in territories where dealers have capacity to install more pools, markets where we are underpenetrated, or simply into the largest in-ground swimming pool markets. Our volume of product sales in a given period will be impacted by changes in our distribution platform and by our ability to generate leads for our dealers.
| Column 1 | Column 2 | Column 3 |
|---|---|---|
| ● | Material conversion: We have continued to increase sales of our products through our focused efforts to drive material conversion and market penetration of our products, specifically our fiberglass pools, which continue to take market share from traditional concrete pools and enable dramatically improved economics for consumers, dealers, and pool installers. We believe that this will be a long-term trend toward material conversion from traditional concrete pools. We believe that our fiberglass pools offer a compelling value proposition because of their lower up-front and lifecycle cost of ownership, less maintenance, higher quality, lower usage of harsh chemicals, quicker installation, and more convenient experience, compared to products manufactured from traditional materials. We anticipate that sales of our fiberglass pool products will continue to benefit from material conversion. The success of our efforts to drive conversion during any given period will impact the volume of our products sold during that period. |
| Column 1 | Column 2 | Column 3 |
|---|---|---|
| ● | Product Innovation: We continue to develop and introduce innovative products to accelerate material conversion and to expand our markets. The continuous evolution and expansion of our product portfolio is critical to our sales growth, expanding market share, and overall success. Our broad product offering allows dealers and distributors to offer consumers a wide variety of innovative pool shapes, depths, and lengths. Specifically, our innovative fiberglass pool offering employs the most durable components, consisting of a carbon fiber, Kevlar, and ceramic fiberglass build. Our use of innovative technology and premium materials result in long-lasting products that not only require lower up-front costs, but also save homeowners time and money from continuous maintenance throughout the product lifecycle. We believe that new products will enhance our ability to compete with traditional materials at a variety of price points, and we expect to continue to devote significant resources to developing innovative new products. The volume of our products sold during a given period will depend in part on our successfully introducing new products that generate additional demand, as well as the extent to which new products may impact our sales of existing products. |
| Column 1 | Column 2 | Column 3 |
|---|---|---|
| ● | Economic conditions: Demand for our products is affected by a number of economic factors impacting our customers and consumers. Customers typically pay for their new pools from assets on hand or from borrowing. A frequent source of borrowing is home equity financing, and accordingly, the level of equity in homes will affect consumers’ ability to obtain a home equity line of credit and to engage in backyard renovations that |
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| Column 1 | Column 2 | Column 3 |
|---|---|---|
| would result in purchases of our products. Demand for our products is also affected by the level of interest rates and the availability of credit, consumer confidence and spending, housing affordability, demographic trends, employment levels, and other macroeconomic factors that may influence the extent to which consumers engage in renovations to their backyard, including pool installation projects to enhance the outdoor living spaces of their homes. |
| Column 1 | Column 2 | Column 3 |
|---|---|---|
| ● | Seasonality and weather: Although we generally have demand for our products throughout the year, our business is seasonal, and weather is one of the principal external factors affecting the business. In general, net sales and net income are highest during spring and summer, representing the peak months of swimming pool use, pool installation and remodeling and repair activities. Severe weather also may play a role in affecting sales growth, as particularly rainy or cold years tend to slow the volume of sales, including as a result of complicating conditions for pool installations. Catastrophic events, such as hurricanes, tornadoes, and earthquakes can cause interruptions to our operations. These scenarios are partially mitigated by our geographic diversity, both across the United States and through international markets. |
Pricing
In general, our products are priced to be competitive in the in-ground swimming pool market, including the prices for concrete pools, and to keep in line with changes in our input costs.
Cost and Availability of Materials
Raw material costs, including costs of PVC, galvanized steel, fiberglass, aluminum, carbon fiber, Kevlar fiber, various resins, gelcoat, polypropylene fabric, ceramics, and roving, represent a majority of our cost of sales. Our supply agreements with key suppliers are typically negotiated on an annual basis. The cost of the raw materials used in our manufacturing processes is subject to volatility and has been affected by changes in supply and demand. We have minimal fixed-price contracts with our major vendors. We have not entered into hedges of our raw material costs at this time, but we may choose to enter into such hedges in the future.
Prices for spot market purchases are negotiated on a continuous basis in line with current market prices. Other than occasional strategic purchases of larger quantities of certain raw materials, we generally buy materials on an as-needed basis. Changes in prices of our raw materials have a direct impact on our cost of sales.
Acquisitions and Partnerships
On October 22, 2020, we acquired GLI, which specializes in manufacturing custom vinyl pool liners and safety covers. The acquisition expanded our liner and safety cover product offerings.
On November 24, 2021, we acquired Radiant Pools, a manufacturer of vinyl-lined and aluminum-walled swimming pools. The acquisition expands our product portfolio into vinyl-lined and aluminum-walled swimming pools.
On November 8, 2022, we acquired certain fiberglass pool manufacturing assets in Seminole, Oklahoma, that qualified as a business combination. This acquisition will replace lost fiberglass manufacturing capacity in Odessa, TX because of a plant fire and place our production closer to strong consumer markets in the region.
The consolidated financial statements include the results of operations of these acquisitions since their respective acquisition dates. The total purchase consideration was allocated to the assets acquired and liabilities assumed at their estimated fair values as of the date of acquisition, as determined by management. The excess of the purchase price over the amounts allocated to assets acquired and liabilities assumed has been recorded as goodwill.
On October 30, 2020, we entered into a long-term strategic partnership with and acquired a 28% equity interest in Premier Pools & Spas, a pool builder focusing on in-ground swimming pools. In August 2021, we sold a portion of our interest in Premier Pools & Spas, retaining a post-sale ownership interest of 20.1%. On December 17, 2021, Premier Pools & Spas issued additional non-voting common units. Our ownership interest in Premier Pools & Spas after the
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issuance of additional non-voting common units is 18.2% while our voting interest remains 20.1%. The purpose of this investment in Premier Pools & Spas is to help expand our sales and distribution channels. Products are sold directly to the franchisees, third parties independent of Premier Pools and Spas, and are therefore not considered related party transactions. Our investment in Premier Pools & Spas is reflected as an equity method investment on our consolidated balance sheet as of December 31, 2022, and our proportionate share of earnings or losses of Premier Pools & Spas is recognized in earnings (losses) from equity method investment in our consolidated statement of operations on a three-month lag.
Product Mix
We seek to continue to enhance our gross margins by improving the mix of products we sell, reducing fixed costs per unit, improving efficiency across our operations, including by investing in, and expanding, our digitally-enabled lead sourcing capabilities, expanding our specialized training opportunities such as “Latham University,” and sales support initiatives such as localized digital marketing spend, co-branding, enhanced product literature, in-store display samples, and social media initiatives.
Key Performance Indicators
Net Sales
We derive our revenue from the design, manufacture, and sale of in-ground swimming pools, pool covers, and liners. We sell fiberglass pools, which are one-piece manufactured fiberglass pools that are ready to be installed in a consumer’s backyard, and custom vinyl pools, which are manufactured pools that are made out of non-corrosive steel or composite polymer frame, on top of which a vinyl liner is installed. We sell liners for the interior surface of vinyl pools (including pools that were not manufactured by us). We also sell all-season covers, which are winterizing mesh or solid pool covers that protect pools against debris and cold or inclement weather, and automatic safety covers for pools that can be operated with a switch.
Our sales are made through one-step and two-step business-to-business distribution channels. In our one-step distribution channel, we sell our products directly to dealers who, in turn, sell our products to consumers. In our two-step distribution channel, we sell our products to distributors who warehouse our products and sell them on to dealers, who ultimately sell our products to consumers.
Each product shipped is considered to be one performance obligation. With the exception of our extended service warranties and our custom product contracts, we recognize our revenue when control of our promised goods is transferred to our customers (dealer in one-step distribution channel or distributor in two-step distribution channel), either upon shipment or arrival at our customer’s destination depending upon the terms of the purchase order. Sales are recognized net of any estimated rebates, returns, allowances, cash discounts or other sales incentives. Revenue that is derived from our extended service warranties, which are separately priced and sold, is recognized over the term of the contracts. Revenue from custom products is recognized over time utilizing an input method that compares the cost of cumulative work-in-process to date to the most current estimates for the entire cost of the performance obligation. See “— Critical Accounting Policies and Estimates — Revenue Recognition.”
Gross Margin
Gross margin is gross profit as a percentage of our net sales. Gross margin depends upon several factors, such as the prices we charge buyers, changes in prices of raw materials, the volume and relative sales mix among product lines, and plant performance, among other factors. Gross margin is also impacted by the costs of distribution and occupancy costs, which can vary.
Our gross profit is variable in nature and generally follows changes in net sales. The components of our cost of sales may not be comparable to the components of cost of sales or similar measures of other companies. As a result, our gross profit and gross margin may not be comparable to similar data made available by other companies.
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Adjusted EBITDA and Adjusted EBITDA Margin
We use Adjusted EBITDA and Adjusted EBITDA margin to supplement GAAP measures of performance to evaluate the effectiveness of our business strategies, to make budgeting decisions, to utilize as a significant performance metric in our annual management incentive bonus plan compensation and to compare our performance against that of other peer companies using similar measures. We define Adjusted EBITDA as net income (loss) plus (i) depreciation and amortization, (ii) interest expense, (iii) income tax (benefit) expense, (iv) loss (gain) on sale and disposal of property and equipment, (v) restructuring charges, (vi) stock-based compensation expense, (vii) unrealized (gains) losses on foreign currency transactions, (viii) strategic initiative costs, (ix) acquisition and integration related costs, (x) loss on extinguishment of debt, (xi) underwriting fees related to offering of common stock, (xii) the Odessa fire and other such unusual events, (xiii) IPO costs and (xiv) other. We believe excluding these items allows for better comparison of our financial results across reporting periods.
We define Adjusted EBITDA margin as Adjusted EBITDA divided by net sales. Our definitions of Adjusted EBITDA and Adjusted EBITDA margin may not be comparable to similarly titled measures of other companies.
We believe Adjusted EBITDA and Adjusted EBITDA margin are useful measurements for investors as they help identify underlying trends that could otherwise be masked by certain expenses that we do not consider indicative of our ongoing operating performance. We also use Adjusted EBITDA and Adjusted EBITDA margin for planning purposes, assessing our financial performance, and other strategic decisions. For a discussion of Adjusted EBITDA and Adjusted EBITDA margin and the limitations on their use, and the reconciliation of Adjusted EBITDA to net income (loss), the most directly comparable GAAP financial measure, and our calculation of Adjusted EBITDA margin see “— Non-GAAP Financial Measures” below.
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Results of Operations
Year ended December 31, 2022 Compared to Year ended December 31, 2021
The following table summarizes our results of operations for the years ended December 31, 2022 and 2021:
| | | | | | | | | | | | | | | | | |
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| | | Year Ended December 31, | ||||||||||||||
| | | | | | | | | | | | | | | | Change | |
| | | | | | % of | | | | | % of | | Change | | % of | | |
| | 2022 | Net Sales | 2021 | Net Sales | Amount | Net Sales | ||||||||||
| | | (dollars in thousands) | ||||||||||||||
| Net sales | | $ | 695,736 | | 100.0 | % | $ | 630,456 | | 100.0 | % | $ | 65,280 | | — | % |
| Cost of sales | | 479,267 | 68.9 | % | 426,294 | 67.6 | % | 52,973 | 1.3 | % | ||||||
| Gross profit | | 216,469 | 31.1 | % | 204,162 | 32.4 | % | 12,307 | (1.3) | % | ||||||
| Selling, general, and administrative expense | | 146,842 | 21.1 | % | 217,775 | 34.5 | % | (70,933) | (13.4) | % | ||||||
| Underwriting fees related to offering of common stock | | | 11,437 | | 1.6 | % | | — | | — | % | | 11,437 | 1.6 | % | |
| Amortization | | 28,180 | 4.1 | % | 22,566 | 3.6 | % | 5,614 | 0.5 | % | ||||||
| Income (loss) from operations | | 30,010 | 4.3 | % | (36,179) | (5.7) | % | 66,189 | 10.0 | % | ||||||
| Other expense (income): | | | | | | | | |||||||||
| Interest expense | | 15,753 | 2.3 | % | 24,433 | 3.9 | % | (8,680) | (1.6) | % | ||||||
| Loss on extinguishment of debt | | | 3,465 | | 0.5 | % | | — | | — | % | 3,465 | 0.5 | % | ||
| Other expense (income), net | | 1,301 | 0.1 | % | (4,860) | (0.8) | % | 6,161 | 0.9 | % | ||||||
| Total other expense (income), net | | 20,519 | 2.9 | % | 19,573 | 3.1 | % | 946 | (0.2) | % | ||||||
| Earnings from equity method investment | | | 4,230 | | 0.6 | % | | 2,222 | | 0.3 | % | | 2,008 | | 0.3 | % |
| Income (loss) before income taxes | | 13,721 | 2.0 | % | (53,530) | (8.5) | % | 67,251 | 10.5 | % | ||||||
| Income tax expense | | 19,415 | 2.8 | % | 8,818 | 1.4 | % | 10,597 | 1.4 | % | ||||||
| Net loss | | $ | (5,694) | (0.8) | % | $ | (62,348) | (9.9) | % | $ | 56,654 | 9.1 | % | |||
| Adjusted EBITDA | | $ | 143,252 | 20.6 | % | $ | 139,819 | 22.2 | % | $ | 3,433 | (1.6) | % |
Net Sales
Net sales was $695.7 million for the year ended December 31, 2022, compared to $630.5 million for the year ended December 31, 2021. The $65.2 million, or 10.4%, increase in net sales was driven by a $109.6 million increase from pricing, partially offset by a $44.4 million decrease from volume. The $109.6 million price increase reflects the impact of pricing actions to address inflation. The $44.4 million volume decrease was largely in packaged pools, driven by continued destocking of inventory in the wholesale distribution channel. The increase in total net sales across our product lines was $17.0 million for in-ground swimming pools, $26.3 million for covers and $21.9 million for liners.
Cost of Sales and Gross Margin
Cost of sales was $479.3 million for the year ended December 31, 2022, compared to $426.3 million for the year ended December 31, 2021, and increased as a percentage of net sales by 1.3%. Gross margin decreased by 1.3% to 31.1% for the year ended December 31, 2022, compared to 32.4% for the year ended December 31, 2021. The $53.0 million, or 12.4%, increase in cost of sales was primarily the result of cost inflation, partially offset by a $4.9 million decrease in non-cash stock-based compensation expense. The 1.3% decrease in gross margin was primarily driven by the impact of inflation and negative fixed cost leverage. Negative fixed cost leverage was driven by volume declines, primarily in packaged pools, driven by continued destocking of inventory in the wholesale distribution channel.
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Selling, General, and Administrative Expense
Selling, general, and administrative expense was $146.8 million for the year ended December 31, 2022, compared to $217.8 million for the year ended December 31, 2021, and decreased as a percentage of net sales by 13.4%. The $71.0 million, or 32.6% decrease in selling, general, and administrative expense was primarily driven by a $73.2 million decrease in non-cash stock-based compensation expense.
Amortization
Amortization was $28.2 million for the year ended December 31, 2022, compared to $22.6 million for the year ended December 31, 2021. The $5.6 million, or 24.9% increase in amortization was driven by the increase in definite-lived intangible assets resulting from our acquisition of Radiant in November 2021.
Interest Expense
Interest expense was $15.8 million for the year ended December 31, 2022, compared to $24.4 million for the year ended December 31, 2021. The $8.6 million, or 35.5% decrease in interest expense was primarily the result of lower amortization of deferred financing costs and debt discount and a lower average interest rate from the February 2022 debt refinancing, compared to the year ended December 31, 2021. In addition, interest expense for the year ended December 31, 2022 was partially offset by an unrealized gain of $3.0 million related to the change in fair value of our interest rate swap.
Other Expense (Income), Net
Other expense (income), net was $1.3 million for the year ended December 31, 2022, compared to ($4.9) million for the year ended December 31, 2021. The $6.2 million increase in other expense (income), net was primarily driven by a non-recurring $4.8 million gain related to the partial sale of our equity method investment during the year ended December 31, 2021 and a $1.3 million unfavorable change in net foreign currency transaction gains and losses associated with our international subsidiaries.
Earnings from Equity Method Investments
Earnings from equity method investment of Premier Pools & Spa was $4.2 million for the year ended December 31, 2022, compared to $2.2 million for the year ended December 31, 2021, primarily because of the financial performance of Premier Pools & Spa, partially offset by our reduced ownership interest during the year ended December 31, 2022 as compared to the year ended December 31, 2021.
Income Tax Expense
Income tax expense was $19.4 million for the year ended December 31, 2022, compared to $8.8 million for the year ended December 31, 2021. Our effective tax rate was 141.5% for the year ended December 31, 2022, compared to (16.5)% for the year ended December 31, 2021. The income tax expense of $19.4 million for the year ended December 31, 2022 was primarily because of a $9.2 million expense related to non-deductible stock compensation. For the year ended December 31, 2021, the effective tax rate differed from the statutory tax rate primarily because of nondeductible stock compensation of $25.7 million, partially offset by $12.7 million benefit related to the release of the valuation allowance on Canadian deferred tax assets.
Net Loss
Net loss was $5.7 million for the year ended December 31, 2022, compared to $62.3 million of net loss for the year ended December 31, 2021. The $56.6 million, or 90.9% decrease in net loss was primarily driven by the factors described above.
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Net Loss Margin
Net loss margin was 0.8% for the year ended December 31, 2022, compared to net loss margin of 9.9% for the year ended December 31, 2021. The 9.1% decrease in net loss margin was driven by a $56.6 million decrease in net loss and a $65.2 million increase in net sales, compared to the year ended December 31, 2021 because of the factors described above.
Adjusted EBITDA
Adjusted EBITDA was $143.3 million for the year ended December 31, 2022, compared to $139.8 million for the year ended December 31, 2021. The $3.5 million, or 2.5% increase in Adjusted EBITDA was primarily because of the increase in net sales. For a discussion of Adjusted EBITDA and Adjusted EBITDA margin and the limitations on their use, and the reconciliation of Adjusted EBITDA to net income (loss), the most directly comparable GAAP financial measure, and our calculation of Adjusted EBITDA margin see “— Non-GAAP Financial Measures” below.
Adjusted EBITDA Margin
Adjusted EBITDA margin was 20.6% for the year ended December 31, 2022, compared to 22.2% for the year ended December 31, 2021. The 1.6% decrease in Adjusted EBITDA margin was primarily because of a $3.5 million increase in Adjusted EBITDA and an $65.2 million increase in net sales, compared to the year ended December 31, 2021, driven by the factors detailed above.
Year ended December 31, 2021 Compared to Year ended December 31, 2020
| | | | | | | | | | | | | | | | | |
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| | | Year Ended December 31, | ||||||||||||||
| | | | | | | | | | | | | | | | Change | |
| | | | | | % of | | | | | % of | | Change | | % of | | |
| | 2021 | Net Sales | 2020 | Net Sales | Amount | Net Sales | ||||||||||
| | | (dollars in thousands) | ||||||||||||||
| Net sales | | $ | 630,456 | | 100.0 | % | $ | 403,389 | | 100.0 | % | $ | 227,067 | | — | % |
| Cost of sales | | 426,294 | 67.6 | % | 260,616 | 64.6 | % | 165,678 | 3.0 | % | ||||||
| Gross profit | | 204,162 | 32.4 | % | 142,773 | 35.4 | % | 61,389 | (3.0) | % | ||||||
| Selling, general, and administrative expense | | 217,775 | 34.5 | % | 85,527 | 21.2 | % | 132,248 | 13.3 | % | ||||||
| Amortization | | 22,566 | 3.6 | % | 17,347 | 4.3 | % | 5,219 | (0.7) | % | ||||||
| (Loss) income from operations | | (36,179) | (5.7) | % | 39,899 | 9.9 | % | (76,078) | (15.6) | % | ||||||
| Other expense (income): | | | | | | | | | ||||||||
| Interest expense | | 24,433 | 3.9 | % | 18,251 | 4.5 | % | 6,182 | (0.6) | % | ||||||
| Other (income) expense, net | | (4,860) | (0.8) | % | (1,111) | (0.3) | % | (3,749) | (0.5) | % | ||||||
| Total other expense (income), net | | 19,573 | 3.1 | % | 17,140 | 4.2 | % | 2,433 | (1.1) | % | ||||||
| Earnings from equity method investment | | | 2,222 | | 0.3 | % | | — | | — | % | | 2,222 | 0.3 | % | |
| (Loss) income before income taxes | | (53,530) | (8.5) | % | 22,759 | 5.7 | % | (76,289) | (14.2) | % | ||||||
| Income tax expense | | 8,818 | 1.4 | % | 6,776 | 1.7 | % | 2,042 | (0.3) | % | ||||||
| Net (loss) income | | $ | (62,348) | (9.9) | % | $ | 15,983 | 4.0 | % | $ | (78,331) | (13.9) | % | |||
| Adjusted EBITDA | | $ | 139,819 | 22.2 | % | $ | 83,836 | 20.8 | % | $ | 55,983 | 1.4 | % |
For discussion on comparison of the fiscal years ended December 31, 2021 and 2020, see the Results of Operations section disclosed in Part II, Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of our Annual Report on Form 10-K for the fiscal year ended December 31, 2021, which was filed with the SEC on March 10, 2022.
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Non-GAAP Financial Measures
We track our non-GAAP financial measures to monitor and manage our underlying financial performance. The following discussion includes the presentation of Adjusted EBITDA and Adjusted EBITDA margin, which are non-GAAP financial measures that exclude the impact of certain costs, losses and gains that are required to be included in our profit and loss measures under GAAP. Although we believe these measures are useful to investors and analysts for the same reasons it is useful to management, as discussed below, these measures are neither a substitute for, nor superior to, U.S. GAAP financial measures or disclosures. Other companies may calculate similarly-titled non-GAAP measures differently, limiting their usefulness as comparative measures. To address these limitations, we have reconciled Adjusted EBITDA to the applicable most comparable GAAP measure, net income (loss), throughout this Annual Report.
Adjusted EBITDA and Adjusted EBITDA Margin
Adjusted EBITDA and Adjusted EBITDA margin are key metrics used by management and our board of directors to assess our financial performance. Adjusted EBITDA and Adjusted EBITDA margin are also frequently used by analysts, investors, and other interested parties to evaluate companies in our industry, when considered alongside other GAAP measures. We use Adjusted EBITDA and Adjusted EBITDA margin to supplement GAAP measures of performance to evaluate the effectiveness of our business strategies, to make budgeting decisions, to utilize as a significant performance metric in our annual management incentive bonus plan compensation, and to compare our performance against that of other companies using similar measures. We have presented Adjusted EBITDA and Adjusted EBITDA margin solely as supplemental disclosures because we believe they allow for a more complete analysis of results of operations and assist investors and analysts in comparing our operating performance across reporting periods on a consistent basis by excluding items that we do not believe are indicative of our core operating performance, such as (i) depreciation and amortization, (ii) interest expense, (iii) income tax (benefit) expense, (iv) loss (gain) on sale and disposal of property and equipment, (v) restructuring charges, (vi) stock-based compensation expense, (vii) unrealized (gains) losses on foreign currency transactions, (viii) strategic initiative costs, (ix) acquisition and integration related costs, (x) loss on extinguishment of debt, (xi) underwriting fees related to offering of common stock, (xii) the Odessa fire and other such unusual events, (xiii) IPO costs and (xiv) other.
Adjusted EBITDA and Adjusted EBITDA margin are non-GAAP financial measures and should not be considered as alternatives to net income as a measure of financial performance or any other performance measure derived in accordance with GAAP, and they should not be construed as an inference that our future results will be unaffected by unusual or non-recurring items. You are encouraged to evaluate these adjustments and the reasons we consider them appropriate for supplemental analysis. In evaluating Adjusted EBITDA and Adjusted EBITDA margin, you should be aware that in the future we may incur expenses that are the same as or similar to some of the adjustments in this presentation. There can be no assurance that we will not modify the presentation of Adjusted EBITDA and Adjusted EBITDA margin in the future, and any such modification may be material. Our presentation of Adjusted EBITDA and Adjusted EBITDA margin should not be construed to imply that our future results will be unaffected by any such adjustments. In addition, other companies, including companies in our industry, may not calculate Adjusted EBITDA and Adjusted EBITDA margin at all or may calculate Adjusted EBITDA and Adjusted EBITDA margin differently and accordingly, are not necessarily comparable to similarly entitled measures of other companies, which reduces the usefulness of Adjusted EBITDA and Adjusted EBITDA margin as tools for comparison.
Adjusted EBITDA and Adjusted EBITDA margin have their limitations as analytical tools, and you should not consider them in isolation or as a substitute for analysis of our results as reported under GAAP. Some of these limitations are that Adjusted EBITDA and Adjusted EBITDA margin:
| Column 1 | Column 2 | Column 3 |
|---|---|---|
| ● | do not reflect every expenditure, future requirements for capital expenditures or contractual commitments; |
| Column 1 | Column 2 | Column 3 |
|---|---|---|
| ● | do not reflect changes in our working capital needs; |
| Column 1 | Column 2 | Column 3 |
|---|---|---|
| ● | do not reflect the interest expense, or the amounts necessary to service interest or principal payments, on our outstanding debt; |
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| Column 1 | Column 2 | Column 3 |
|---|---|---|
| ● | do not reflect income tax (benefit) expense, and because the payment of taxes is part of our operations, tax expense is a necessary element of our costs and ability to operate; |
| Column 1 | Column 2 | Column 3 |
|---|---|---|
| ● | do not reflect non-cash stock-based compensation, which will remain a key element of our overall compensation package; and |
| Column 1 | Column 2 | Column 3 |
|---|---|---|
| ● | do not reflect the impact of earnings or charges resulting from matters we consider not to be indicative of our ongoing operations. |
Although depreciation and amortization are eliminated in the calculation of Adjusted EBITDA and Adjusted EBITDA margin, the assets being depreciated and amortized will often have to be replaced in the future, and Adjusted EBITDA and Adjusted EBITDA margin do not reflect any costs of such replacements.
Management compensates for these limitations by primarily relying on our GAAP results, while using Adjusted EBITDA and Adjusted EBITDA margin as supplements to the corresponding GAAP financial measures.
The following table provides a reconciliation of our net income (loss) to Adjusted EBITDA for the periods presented and the calculation of Adjusted EBITDA margin:
| | | | | | | | | | | |
|---|---|---|---|---|---|---|---|---|---|---|
| | | Year Ended December 31, | ||||||||
| | 2022 | 2021 | 2020 | |||||||
| | | (in thousands) | ||||||||
| Net (loss) income | | $ | (5,694) | | $ | (62,348) | | $ | 15,983 | |
| Depreciation and amortization | | 38,175 | | 32,230 | | 25,365 | | |||
| Interest expense | | 15,753 | | 24,433 | | 18,251 | | |||
| Income tax expense | | 19,415 | | 8,818 | | 6,776 | | |||
| Loss on sale and disposal of property and equipment | | 193 | | 275 | | 332 | | |||
| Restructuring charges(a) | | 1,607 | | 906 | | 1,265 | | |||
| Stock-based compensation expense | | 50,634 | | 128,775 | | 1,827 | | |||
| Unrealized losses (gains) on foreign currency transactions(b) | | 2,534 | | 1,151 | | (1,111) | | |||
| Strategic initiative costs(c) | | 3,948 | | 2,531 | | 6,264 | | |||
| Acquisition and integration related costs(d) | | 326 | | 3,576 | | 5,497 | | |||
| Loss on extinguishment of debt(e) | | | 3,465 | | | — | | | — | |
| Underwriting fees related to offering of common stock(f) | | | 11,437 | | | — | | | — | |
| Odessa fire(g) | | | 869 | | | — | | | — | |
| IPO costs(h) | | — | | 3,956 | | 1,731 | | |||
| Other(i) | | | 590 | | (4,484) | | 1,656 | | ||
| Adjusted EBITDA | | $ | 143,252 | | $ | 139,819 | | $ | 83,836 | |
| Net sales | | $ | 695,736 | | $ | 630,456 | | $ | 403,389 | |
| Net (loss) income margin | | (0.8) | % | (9.9) | % | 4.0 | % | |||
| Adjusted EBITDA margin | | 20.6 | % | 22.2 | % | 20.8 | % |
| Column 1 | Column 2 |
|---|---|
| (a) | Represents costs related to a cost reduction plan announced in 2022 to optimize production and shift schedules, implement a workforce reduction, and to shut down our Bossier City, Louisiana facility. Also includes severance and other costs for our executive management changes. |
| Column 1 | Column 2 |
|---|---|
| (b) | Represents foreign currency transaction (gains) and losses associated with our international subsidiaries and changes in the fair value of the contingent consideration recorded in connection with the acquisition of Narellan, which was settled in September 2020. |
| Column 1 | Column 2 |
|---|---|
| (c) | Represents expenses for our strategic initiatives, including our rebranding initiative and fees paid to external consultants. |
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| Column 1 | Column 2 |
|---|---|
| (d) | Represents acquisition and integration costs primarily related to the acquisitions of GLI and Radiant, the equity investment in Premier Pools & Spas, as well as other costs related to potential transactions. |
| Column 1 | Column 2 |
|---|---|
| (e) | Represents the loss on extinguishment of debt in connection with our debt refinancing on February 23, 2022. |
| Column 1 | Column 2 |
|---|---|
| (f) | Represents underwriting fees related to our offering of common stock that was completed in January 2022. |
| Column 1 | Column 2 |
|---|---|
| (g) | Represents costs incurred and insurance recoveries related to a production facility fire in Odessa, Texas. |
| Column 1 | Column 2 |
|---|---|
| (h) | These expenses are primarily composed of legal, accounting, and professional fees incurred in connection with our initial public offering that are not capitalizable, and that are included within selling, general, and administrative expense. |
| Column 1 | Column 2 |
|---|---|
| (i) | Other costs consist of other discrete items as determined by management, primarily including: (i) fees paid to external advisors for various matters, (ii) the cost incurred and insurance proceeds related to our production facility fire in Picton, Australia in 2020, (iii) non-cash adjustments to record the step-up in the fair value of inventory related to the acquisitions of GLI and Radiant, which were amortized through cost of sales in the consolidated statements of operations, (iv) gain on sale of portion of equity method investment, and (v) other items. |
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Liquidity and Capital Resources
Overview
Our primary sources of liquidity are net cash provided by operating activities and availability under our New Revolving Credit Facility. Historically, we have funded working capital requirements, capital expenditures, payments related to acquisitions, and debt service requirements with internally generated cash on hand, through borrowings under our credit facilities, and through the issuance of shares of our common stock. Our primary cash needs are to fund working capital, capital expenditures, debt service requirements, and any acquisitions or investments we may undertake. As of December 31, 2022, we had $32.6 million of cash, $312.9 million of outstanding borrowings, and an additional $75.0 million of availability under our New Revolving Credit Facility.
Our primary working capital requirements are for the purchase of inventory, payroll, rent, facility costs and other selling, general, and administrative costs. Our working capital requirements fluctuate during the year, driven primarily by seasonality and the timing of raw material purchases. Our capital expenditures are primarily related to growth, including production capacity, storage, and delivery equipment. We are in the midst of a multi-year capital plan to invest in our facilities, technology, and systems, including investments to expand our fiberglass manufacturing capacity. We expect to fund these capital expenditures from net cash provided by operating activities.
We believe our existing cash, cash generated from operations and availability under our New Revolving Credit Facility, will be adequate to fund our operating expenses and capital expenditure requirements over the next 12 months, as well as our longer-term liquidity needs. We have based this estimate on assumptions that may prove to be wrong, and we could utilize our available capital resources sooner than we expect. We may issue debt or equity securities, which may provide an additional source of liquidity. However, there can be no assurance equity or debt financing will be available to us when we need it or, if available, the terms will be satisfactory to us and not dilutive to our then-current stockholders.
Our Indebtedness
On February 23, 2022, Latham Pool Products, Inc. (“Latham Pool Products”), our wholly owned subsidiary, entered into the New Credit Agreement with Barclays Bank PLC, which provides a senior secured multicurrency revolving line of credit (the “New Revolving Credit Facility”) in an initial principal amount of $75.0 million and a U.S. Dollar senior secured term loan (the “New Term Loan”) in an initial principal amount of $325.0 million. On the closing date, proceeds under the agreement were used to repay and replace $294.0 million under, and terminate, the Credit Agreement (as defined below) and for general corporate purposes.
New Revolving Credit Facility
The New Revolving Credit Facility may be utilized to finance ongoing general corporate and working capital needs and permits Latham Pools Products to borrow loans in U.S. Dollars, Canadian Dollars, Euros and Australian Dollars. The New Revolving Credit Facility matures on February 23, 2027. Loans outstanding under the New Revolving Credit Facility denominated in U.S. Dollars and Canadian Dollars bear interest, at the borrower’s option, at a rate per annum based on Term SOFR or CDO (each, as defined in the New Credit Agreement), as applicable, plus a margin of 3.50%, or at a rate per annum based on the Base Rate or the Canadian Prime Rate (each, as defined in the New Credit Agreement), plus a margin of 2.50%. Loans outstanding under the New Revolving Credit Facility denominated in Euros or Australian Dollars bear interest based on EURIBOR or the AUD Rate (each, as defined in the New Credit Agreement), respectively, plus a margin of 3.50%. A commitment fee accrues on any unused portion of the commitments under the New Revolving Credit Facility. The commitment fee is due and payable quarterly in arrears and is, initially, 0.375% per annum and will, thereafter, accrue at a rate per annum ranging from 0.25% to 0.50%, depending on the First Lien Net Leverage Ratio. The New Revolving Credit Facility is not subject to amortization.
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New Term Loan
The New Term Loan matures on February 23, 2029. Loans outstanding under the New Term Loan bear interest, at the borrower’s option, at a rate per annum based on Term SOFR (as defined in the New Credit Agreement), plus a margin ranging from 3.75% to 4.00%, depending on the First Lien Net Leverage Ratio (as defined in the New Credit Agreement, the “First Lien Net Leverage Ratio”), or based on the Base Rate (as defined in the New Credit Agreement), plus a margin ranging from 2.75% to 3.00%, depending on the First Lien Net Leverage Ratio. Loans under the New Term Loan are subject to scheduled quarterly amortization payments equal to 0.25% of the initial principal amount of the New Term Loan.
Prior Revolving Credit Facility
On December 18, 2018, Latham Pool Products entered into an agreement (the “Credit Agreement”) with Nomura Corporate Funding Americas, LLC (“Nomura”) that included a revolving line of credit (the “Revolver”) and letters of credit (“Letters of Credit” or collectively with the Revolver, the “Prior Revolving Credit Facility”), as well as the Prior Term Loan (as described and defined below). The Prior Revolving Credit Facility was utilized to finance ongoing general corporate and working capital needs with the Revolver of up to $30.0 million. The Prior Revolving Credit Facility was terminated in connection with the debt refinancing on February 23, 2022.
Prior Term Loan
Pursuant to the Credit Agreement, Latham Pool Products also borrowed $215.0 million in term loans (the “Prior Term Loan”). The Prior Term Loan was amended on May 29, 2019, to provide additional borrowings of $23.0 million, which was accounted for as a modification to the Prior Term Loan, to fund our acquisition of Narellan (the “First Amendment”). On October 14, 2020, we amended the First Amendment to provide additional borrowings of $20.0 million, which was accounted for as new debt (the “Second Amendment”). The Second Amendment was further amended on January 25, 2021, to provide an additional incremental term loan of $175.0 million (the “Third Amendment”). On January 25, 2021, Latham Pool Products borrowed the incremental term loan, and the proceeds were used on February 2, 2021 to purchase and retire equity interests and to pay a distribution. On March 31, 2021, we amended our Term Loan to revise the applicable reporting requirements (the “Fourth Amendment”). On November 24, 2021, we amended the Prior Term Loan to provide additional borrowings of $50 million (the “Fifth Amendment”). The proceeds from this incremental term loan were used to finance the Radiant Acquisition in part. The Prior Term Loan, collectively with the First Amendment, Second Amendment, Third Amendment, the Fourth Amendment, and the Fifth Amendment, is referred to as the “Amended Prior Term Loan.” As of December 31, 2021, we were in compliance with all covenants under the Prior Revolving Credit Facility and the Amended Prior Term Loan.
The Amended Prior Term Loan was terminated in connection with the debt refinancing on February 23, 2022.
Cash Flows
The following table summarizes our sources and uses of cash for each of the periods presented:
| | | | | | | | | | |
|---|---|---|---|---|---|---|---|---|---|
| | | Year Ended December 31, | |||||||
| | 2022 | 2021 | 2020 | ||||||
| | | (in thousands) | |||||||
| Net cash provided by operating activities | | $ | 32,309 | | $ | 33,690 | | $ | 63,160 |
| Net cash used in investing activities | | (45,018) | | (108,205) | | (115,805) | |||
| Net cash provided by financing activities | | 3,775 | | 60,018 | | 54,303 | |||
| Effect of exchange rate changes on cash | | (2,392) | | (861) | | 997 | |||
| Net (decrease) increase in cash | | $ | (11,326) | | $ | (15,358) | | $ | 2,655 |
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Operating Activities
During the year ended December 31, 2022, operating activities provided $32.3 million of cash. Net income (loss), after adjustments for non-cash items, provided cash of $105.9 million. Cash provided by operating activities was further driven by changes in our operating assets and liabilities, which used $73.6 million. Net cash used in changes in our operating assets and liabilities for the year ended December 31, 2022 consisted primarily of a $57.0 million increase in inventories, a $0.5 million increase in other assets, a $19.4 million decrease in accrued expenses and other current liabilities, and a $12.4 million decrease in accounts payable, partially offset by a $9.0 million decrease in trade receivables, a $4.7 million decrease in prepaid expenses and other current assets, a $1.7 million decrease in income tax receivable, and a $0.2 million increase in other long-term liabilities. The change in trade receivables was primarily driven by the timing of net sales, and the increase in inventories was primarily driven by a business decision to carry more inventory, as well as higher costs. The changes in accrued expenses and other current liabilities, and accounts payable were primarily because of volume of purchases and timing of payments.
During the year ended December 31, 2021, operating activities provided $33.7 million of cash. Net income (loss), after adjustments for non-cash items, provided cash of $88.5 million. Cash provided by operating activities was further driven by changes in our operating assets and liabilities, which used $54.8 million. Net cash used in changes in our operating assets and liabilities for the year ended December 31, 2021 consisted primarily of a $26.0 million increase in trade receivables, a $39.7 million increase in inventories, a $4.5 million increase in prepaid expenses and other current assets, and a $1.2 million decrease in other long-term liabilities, partially offset by a $10.7 million increase in accounts payable, a $4.7 million increase in accrued expenses and other current liabilities, a $0.8 million decrease in other assets, and a $0.3 million decrease in income tax receivable. The change in trade receivables was primarily driven by the timing of and increase in net sales, and the increase in inventories was primarily driven by increased production and cost inflation. The changes in accrued expenses and other current liabilities, and accounts payable were primarily because of volume of purchases and timing of payments.
Investing Activities
During the year ended December 31, 2022, investing activities used $45.0 million of cash, primarily consisting of the purchase of property and equipment for $39.7 million and acquisitions of businesses of $5.4 million. The purchase of property and equipment was primarily to expand capacity for production, especially for fiberglass pools.
During the year ended December 31, 2021, investing activities used $108.2 million of cash, primarily consisting of the acquisition of Radiant of $90.5 million, and the purchase of property and equipment for $25.0 million, partially offset by proceeds from the sale of equity method investment of $6.8 million and return of equity method investment of $0.4 million. The purchase of property and equipment was primarily to expand capacity for inventory production in order to meet increasing customer demand.
Financing Activities
During the year ended December 31, 2022, financing activities provided $3.8 million of cash, primarily consisting of proceeds from long-term debt borrowings in connection with the debt refinancing of $320.1 million, proceeds from the sale of common stock of $257.7 million and borrowings on revolving credit facilities of $25.0 million, partially offset by repayments on long-term debt borrowings of $286.5 million, the repurchase and retirement of common stock of $280.7 million, repayments on revolving credit facility borrowings of $25.0 million, and deferred financing fees paid of $6.9 million.
During the year ended December 31, 2021, financing activities provided $60.0 million of cash, primarily consisting of proceeds from our IPO, net of underwriting discounts, commissions, and offering costs of $399.3 million, proceeds from borrowings on the Amended Prior Term Loan of $222.8 million and borrowings on the Prior Revolving Credit Facility of $16.0 million, partially offset by the repurchase of common stock of $281.6 million, payments on long-term debt borrowings of $169.1 million, dividends to Class A unitholders of $110.0 million, and payments on Revolving Credit Facility borrowings of $16.0 million.
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For discussion on operating, investing, and financing activities of the fiscal year ended December 31, 2020, see the Liquidity and Capital Resources section disclosed in Part II, Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of our Annual Report on Form 10-K for the fiscal year ended December 31, 2021, which was filed with the SEC on March 10, 2022.
Inflation
We experience inflation and deflation related to our purchase of certain products. This price volatility could potentially have a material impact on our financial condition and/or our results of operations. In order to mitigate price volatility, we monitor price fluctuations and may adjust our selling prices accordingly, however, our ability to recover higher costs through increased pricing may be limited by the competitive environment in which we operate.
Contractual Obligations
Our largest contractual obligations as of December 31, 2022 consisted of principal payments related to our long-term indebtedness that are included in our consolidated balance sheet and the related periodic interest payments, and non-cancelable operating leases. For a description of our contractual obligations and commitments, see Notes 9 “Long-Term Debt” and 13 “Leases” to our Consolidated Financial Statements included elsewhere in this Annual Report.
Critical Accounting Policies and Estimates
Our consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United States. Throughout the preparation of these financial statements, we have made estimates and assumptions that impact the reported amounts of assets, liabilities, and the disclosure of contingent liabilities at the date of the financial statements and revenues and expenses during the reporting period. These estimates are based on historical results, trends, and other assumptions we believe to be reasonable. We evaluate these estimates on an ongoing basis. Actual results may differ from estimates.
Our significant accounting policies are presented in Note 2 of our consolidated financial statements. We believe that the following critical accounting policies affect the most significant estimates and management judgments used in preparation of the consolidated financial statements.
Revenue Recognition
With the exception of our extended service warranties and our custom product contracts, we recognize our revenue at a point in time when control of the promised goods is transferred to our customers, and in an amount that reflects the consideration we expect to be entitled to in exchange for those goods. Control of the goods is considered to have been transferred upon shipping or upon arrival at the customer’s destination, depending on the terms of the purchase order. Revenue that is derived from our extended service warranties, which are separately priced and sold, is recognized over the term of the contract. Revenue from custom products is recognized over time utilizing an input method that compares the cost of cumulative work-in-process to date to the most current estimates for the entire cost of the performance obligation. Custom products are generally delivered to the customer within three days of receipt of the purchase order. Each product shipped is considered to be one performance obligation. For each product shipped, the transaction price by product is specified in the purchase order.
We recognize revenue on the transaction price less any estimated rebates, returns, allowances, cash discounts, or other sales incentives. Customer rebates, returns, allowances, cash discounts, and other sales incentives are estimated by applying the portfolio approach using the most-likely-amount method and are recorded as a reduction to revenue.
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Customer Rebates and Cash Discounts
We offer rebates to our customers based on factors such as the total amount of the customer’s purchase and expected sales for a particular customer during the year. Rebates are estimated by applying the portfolio approach using the most-likely-amount method and are deducted from revenue at the time of sale. Estimates are updated each reporting period and are allocated accordingly to the performance obligations of the contract (the individual products).
Business Combinations
We account for business combinations that are deemed to be businesses under the acquisition method of accounting. Application of this method of accounting requires that the identifiable assets acquired (including identifiable intangible assets) and liabilities assumed generally be measured and recognized at fair value as of the acquisition date. Any contingent assets acquired and contingent liabilities assumed are also recognized at fair value if we can reasonably estimate fair value during the measurement period. We remeasure any contingent liabilities at fair value in each subsequent reporting period. The excess of the purchase price over the fair value of net assets acquired is recorded as goodwill. Determining the fair value of assets acquired and liabilities assumed requires management’s judgment, based on available information at the time of acquisition and subsequently obtained during a measurement period up to one year following the date of acquisition, relating to events or circumstances that existed at the acquisition date. Management’s judgment relies upon estimates and assumptions related to future cash flows, discount rates, useful lives of assets, market conditions, and other items. The fair value of intangible assets other than goodwill acquired in a business combination are estimated in accordance with the policy described below.
The fair value of intangible assets other than goodwill acquired in a business combination is recorded at fair value at the date of acquisition. Management values dealer relationships and franchise relationships using the multi-period excess earnings method. Under this method, the value of an intangible asset is equal to the present value of the after-tax cash flows attributable solely to the intangible asset, after making adjustments for the required return on and of the other associated assets. We value trade names, trademarks, and proprietary pool designs using the relief from royalty method. The relief-from-royalty method determines the present value of the economic royalty savings associated with the ownership or possession of the trade name, trademark, or proprietary pool design based on an estimated royalty rate applied to the cash flows to be generated by the business. The estimated royalty rate is determined based on the assessment of a reasonable royalty rate that a third party would negotiate in an arm’s-length license agreement for the use of the trade name, trademark, or proprietary pool design.
Impairment of Goodwill
We evaluate goodwill for impairment at least annually, or more frequently when events or changes in circumstances indicate that the carrying value may not be recoverable. We have selected the first day of the fourth fiscal quarter to perform our annual goodwill impairment testing.
We may assess our goodwill for impairment initially using a qualitative approach, or step zero, to determine whether conditions exist to indicate that it is more likely than not that the fair value of the reporting unit is less than its carrying value. The qualitative assessment requires significant judgments by management about economic conditions including the entity’s operating environment, its industry and other market considerations, entity-specific events related to financial performance or loss of key personnel, and other events that could impact the reporting unit. If management concludes, based on assessment of relevant events, facts, and circumstances, that it is more likely than not that the reporting unit’s fair value is greater than its carrying value, no further impairment testing is required.
If our assessment of qualitative factors indicates that it is more likely than not that the fair value of the reporting unit is less than its carrying value, then a quantitative assessment is performed. We may also elect to initially perform a quantitative analysis instead of starting with step zero. The quantitative analysis requires comparing the carrying value of the reporting unit, including goodwill, to its fair value. If the fair value of the reporting unit exceeds its carrying amount, goodwill is not considered to be impaired and no further testing is required. If the carrying amount of the reporting unit exceeds its fair value, there is an impairment of goodwill and an impairment loss is recorded. We calculate the
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impairment loss by comparing the fair value of the reporting unit less the carrying value, including goodwill. The goodwill impairment is limited to the carrying value of the goodwill.
Based on the results of the qualitative assessments performed for our one reporting unit, we determined that goodwill was not impaired at October 2, 2022 or October 3, 2021. However, if factors exist that could indicate an impairment in the future, including a sustained decrease in our stock price, we may be required to record impairment charges in future periods.
The qualitative factors we assessed included economic conditions, industry and market considerations, cost factors, overall financial performance, and other entity specific events. In addition, we considered our market capitalization based on quoted market prices of our securities on the Nasdaq Global Select Market, adjusted for the effect of a control premium as contemplated by ASC 350.
Stock-Based Compensation
Stock-based compensation is measured and recognized based on the grant date fair value of the awards. The fair value of our common stock is determined based on the quoted market price of our common stock for purposes of computing stock-based compensation expense. For stock options, we use a Black-Scholes model for estimating the grant date fair value. The Black-Scholes pricing model requires critical assumptions including risk-free rate, volatility, expected term and expected dividend yield. The expected term is computed using the simplified method. We use the simplified method to calculate expected term of the stock options since we do not have sufficient historical exercise data to provide a reasonable basis upon which to estimate expected term. The risk-free interest rate is based on the yield available on U.S. Treasury zero-coupon issues similar in duration to the expected term of the stock-based award. We consider the historical volatility of our stock price, as well as implied volatility. We utilized a dividend yield of zero, as we have no history or plan of declaring dividends on our common stock. The assumptions underlying these valuations represented our best estimate, which involved inherent uncertainties and the application of judgment. As a result, if we had used significantly different assumptions or estimates, the fair value of our stock-based compensation expense could have been materially different.
For stock options, restricted stock awards, and restricted stock units, stock-based compensation is recognized using a graded vesting method over the requisite service period in which employees earn the awards. We account for forfeitures of stock-based awards as they occur rather than applying an estimated forfeiture rate to stock-based compensation expense.
Contemporaneously with the pricing of our IPO, on April 22, 2021, we effected the Omnibus Incentive Plan in which we granted to certain of our employees restricted stock awards, restricted stock units, and option awards inclusive of the as converted Class B units as a result of the Reorganization.
Income Taxes
Deferred tax assets and liabilities are determined based on temporary differences resulting from the different treatment of items for tax and financial reporting purposes. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to reverse. We reduce deferred taxes by a valuation allowance when we conclude such deferred taxes are not more than likely to be realized. The determination of whether a deferred tax asset will be realized is made on both a jurisdictional basis and the use of our estimate of the recoverability of the deferred tax asset. In evaluating whether a valuation allowance is required under such rules, we consider all available positive and negative evidence, including our prior operating results, the nature and reason for any losses, our forecast of future taxable income in each respective tax jurisdiction and the dates on which any deferred tax assets are expected to expire. These assumptions require a significant amount of judgment, including estimates of future taxable income. As of both December 31, 2022 and 2021, our valuation allowance was $0.0 million. We continue to assess whether any significant changes in circumstances or assumptions have occurred that could materially affect our ability to realize deferred tax assets. We released the valuation allowance in 2021 since we believe we have sufficient positive evidence, including, but not limited to, three years’ of cumulative pre-tax book
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income, including permanent adjustments and recent profits within taxing jurisdictions, to overcome any negative evidence related to loss utilization expiration periods.
We record liabilities for uncertain income tax positions based on a two-step process. The first step is recognition, where an individual tax position is evaluated as to whether it has a likelihood of greater than 50% of being sustained upon examination based on the technical merits of the position, including resolution of any related appeals or litigation processes. The amount of the benefit that may be recognized is the largest amount that has a greater than 50% likelihood of being realized on ultimate settlement. The actual benefits ultimately realized may differ from the estimates. We classify interest and penalties related to unrecognized tax benefits as a component of income tax (benefit) expense within the consolidated statements of operations.
Although we believe that we have adequately reserved for our uncertain tax positions, we can provide no assurance that the final tax outcome of these matters will not be materially different. In future periods, changes in facts, circumstances, and new information may require us to change the recognition and measurement estimates with regard to individual tax positions. Our liabilities for uncertain tax positions were $7.1 million and $5.7 million for the years ended December 31, 2022 and 2021, respectively. Changes in recognition and measurement estimates are recorded in income tax (benefit) expense and liability in the period in which such changes occur.
Emerging Growth Company Status
The JOBS Act permits an “emerging growth company” such as us to take advantage of an extended transition period to comply with new or revised accounting standards applicable to public companies until those standards would otherwise apply to private companies. We have elected not to “opt out” of such extended transition period, which means that when a standard is issued or revised and it has different application dates for public or private companies, we will adopt the new or revised standard at the time private companies adopt the new or revised standard and will do so until such time that we either (i) irrevocably elect to “opt out” of such extended transition period or (ii) no longer qualify as an emerging growth company. We may choose to early adopt any new or revised accounting standards whenever such early adoption is permitted for private companies.
Recently Issued and Adopted Accounting Pronouncements
A description of recently issued accounting pronouncements that may potentially impact our financial position, results of operations, or cash flows is disclosed in Note 2 to our consolidated financial statements included elsewhere in this Annual Report.