TENNANT CO (TNC) FY 2021 MD&A

ITEM 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations

Overview

Tennant Company is a world leader in designing, manufacturing and marketing solutions that empower customers to achieve quality cleaning performance, reduce environmental impact and help create a cleaner, safer, healthier world. The Company is committed to creating and commercializing breakthrough, sustainable cleaning innovations to enhance its broad suite of products, including floor maintenance and cleaning equipment, detergent-free and other sustainable cleaning technologies, aftermarket parts and consumables, equipment maintenance and repair service, and asset management solutions. Our products are used in many types of environments, including retail establishments, distribution centers, factories and warehouses, public venues such as arenas and stadiums, office buildings, schools and universities, hospitals and clinics, and more. Customers include contract cleaners to whom organizations outsource facilities maintenance as well as businesses that perform facilities maintenance themselves. The Company reaches these customers through the industry's largest direct sales and service organization and through a strong and well-supported network of authorized distributors worldwide.

The year-over-year comparisons in this Management's Discussion and Analysis of Financial Condition and Results of Operations are as of and for the years ended December 31, 2021 and December 31, 2020, unless stated otherwise. The discussion of 2019 results and related year-over-year comparisons as of and for the years ended December 31, 2020 and December 31, 2019 are found in Part II, Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations," of our Form 10-K for the year ended December 31, 2020.

Impact of COVID-19

We continue to actively manage our business to respond to the COVID-19 pandemic and related impacts.

Throughout 2021 and into 2022, we have experienced disruption in the supply of raw materials and component parts, as well as raw material price inflation and inefficiencies as a result of supply chain issues. Although we regularly monitor the financial health and operations of companies in our supply chain, financial hardship or government restrictions on our suppliers or sub-suppliers caused by the COVID-19 pandemic could cause a disruption in our ability to obtain raw materials or component parts required to manufacture our products and adversely affect our operations. We have established frequent communications with suppliers to review, track and prioritize high-risk components. We have also identified and activated alternative suppliers, materials and components as needed. The Company continues work to minimize the impact of price inflation in inputs and market supply challenges by employing local-for-local and region-for-region manufacturing and sourcing to allow us to manufacture our products closer to our customers. At the same time, our engineering teams are evaluating platform design to allow for available parts and to increase our sourcing flexibility. Regarding transportation, we have set up tracking, reporting and communication channels with carriers to understand their risks and to evaluate available options where necessary. We expect the supply chain challenges and inflationary trends to continue into 2022.

We maintain our commitment to protect the health and safety of our employees and customers. We have continued our enhanced safety protocols for those on-site at our manufacturing facilities, and we have implemented work-from home processes for much of our workforce which partially remain in effect. We continue to monitor the evolving situation and guidance from local authorities.

All indications are that 2022 will require us to be agile as we manage through the year. However, as many governments shift their COVID-19 governance strategies from pandemic to endemic, and demand for our products remains strong, we remain confident in the long-term growth trends for all our products and locations.

For more information regarding factors and events that may impact our business, results of operations and financial condition as a result of the COVID-19 pandemic, see Item 1A. Risk Factors

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Historical Results

The following table compares the historical results of operations for the years ended December 31, 2021, 2020 and 2019 in dollars and as a percentage of Net Sales (in millions, except per share amounts and percentages):

Net Sales

Consolidated net sales in 2021 totaled $1,090.8 million, a 9.0% increase as compared to consolidated net sales of $1,001.0 million in 2020.

The 9.0% increase in consolidated net sales for 2021 as compared to 2020 was driven by:

The following table sets forth annual net sales by geographic area and the related percentage change from the prior year (in millions, except percentages):

Americas

Net sales in the Americas were $658.3 million in 2021, an increase of 4.3% from 2020. Organic sales growth in the Americas favorably impacted net sales by approximately 7.4% due to volume growth in most business units and product categories compared to 2020, which was more impacted by COVID-19. Price increases also contributed to organic sales growth. Foreign currency exchange within the Americas favorably impacted net sales by approximately 0.2% in 2021. The growth was partly offset by declines in the Company's AMR business, due to the lapping of a large order in North America in the prior year. At the same time, the business unit was directly impacted by global supply chain and labor constraints, which resulted in lower revenue than expected and increased backlog levels. The divestiture of the Coatings business resulted in a decline in net sales of approximately 3.3% in 2021.

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Europe, Middle East and Africa ("EMEA")

EMEA net sales were $331.9 million in 2021, an increase of 19.3% from 2020. Organic sales growth in EMEA favorably impacted net sales by approximately 14.2% in 2021 primarily due to market growth across the business unit and product categories compared to 2020, which was more impacted by COVID-19. Foreign currency exchange within EMEA favorably impacted net sales by approximately 5.1% in 2021.

Asia Pacific ("APAC")

APAC net sales were $100.6 million in 2021, an increase of 9.6% from 2020. Organic sales growth in APAC favorably impacted net sales by approximately 5.6% in 2021 primarily due to growth in Korea and Australia, partly offset by supply chain and labor challenges in our North American plants that supply APAC. Foreign currency exchange within APAC favorably impacted net sales by approximately 4.0% in 2021.

Gross Profit

Gross profit margin of 40.2% was 50 basis points lower in 2021 compared to 2020. The margin rate decrease was primarily driven by significant raw material and component parts inflation and higher freight costs, partly offset by higher selling prices.

Operating Expenses

Selling and Administrative Expense

Selling and Administrative ("S&A") expense was $321.9 million in 2021, an increase of $7.9 million compared to 2020. As a percentage of net sales, S&A expense in 2021 decreased 190 basis points to 29.5% from 31.4% in 2020. The S&A increase in 2021 was primarily driven by more normalized spending as profitability improved compared to 2020, when the Company took cost containment actions, including employee furloughs, reduction in travel spending, and temporary pay reductions, as well as benefits from government programs received related to COVID-19. The benefits represented wage subsidies received from various European and Canadian authorities that are not required to be repaid.

Research and Development Expense

Research and Development ("R&D") expense was $32.2 million, or 3% of net sales, in 2021, nearly flat as a percentage of net sales compared to 2020.

We believe that our research and development efforts have been, and continue to be, key drivers of our success in the marketplace.

Gain on Sale of Business

Gain on sale of business was $9.8 million in 2021 as a result of the sale of the Coatings business that occurred in the first quarter of 2021.

Total Other Expense, Net

Interest Expense, Net

Interest expense, net was $7.3 million of net expense in 2021, compared to $17.4 million in 2020, respectively. The decrease in 2021 was due to the restructuring of debt in the second quarter of 2021, which resulted in lower interest expense from more favorable interest rates and a lower amount of outstanding debt.

Net Foreign Currency Transaction Loss

Net foreign currency transaction loss was $0.7 million in 2021, compared to $5.3 million in 2020. The unfavorable impact from foreign currency transactions in 2021 and 2020 was primarily due to strengthening of the U.S. dollar relative to the Brazilian real. The reduction of losses recognized in 2021 compared to 2020 is driven by stabilization in the currency markets in the current year versus the previous year.

Loss on Extinguishment of Debt

Loss on extinguishment of debt was $11.3 million in 2021 due to the restructuring of debt that occurred in the second quarter of 2021.

Income Taxes

The effective tax rate for 2021 was 12.5% compared to 17.9% in 2020. The effective tax rate in 2021 decreased primarily due to a tax benefit resulting from an election to step-up the tax basis of certain assets for Italian tax purposes, as well as the release of certain valuation allowances related to net operating loss carryovers.

In general, it is our practice and intention to permanently reinvest the earnings of our foreign subsidiaries and repatriate earnings only when the tax impact is zero or immaterial. No deferred taxes have been provided for withholding taxes or other taxes that would result upon repatriation of our foreign investments to the U.S.

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Backlog

Backlog is one of the many indicators of business conditions in the Company's markets.  Our order backlog at December 31, 2021 was approximately 3x - 5x larger compared to previous years.  The increase in our order backlog year over year was primarily due to higher order rates coupled with persistent supply chain challenges and labor constraints. We expect this level of backlog to continue in 2022. Backlog includes orders that can be cancelled or postponed at the option of the customer at any time without penalty.

Liquidity and Capital Resources

Liquidity

Our primary liquidity needs are to fund working capital, fund investments, service our debt, maintain cash reserves and capital expenditures. Our sources of liquidity include cash generated from operations, borrowings under our revolving credit facility and from time to time, debt and equity offerings. We believe our current resources are sufficient to meet our working capital requirements for our current business for at least the next 12 months and thereafter for the foreseeable future.

Cash, cash equivalents and restricted cash totaled $123.6 million at December 31, 2021, as compared to $141.0 million as of December 31, 2020. Wherever possible, cash management is centralized and intercompany financing is used to provide working capital to subsidiaries as needed. Our current ratio was 1.8 as of December 31, 2021 and 1.9 as of December 31, 2020, and our primary working capital, which is comprised of accounts receivable, inventories and accounts payable was $250.5 million and $221.3 million, respectively. Our debt-to-capital ratio was 38.1% as of December 31, 2021, compared to 43.2% as of December 31, 2020.

In the second quarter of 2021, we signed an agreement (the "2021 Credit Agreement") that restructured our previous credit agreement. The 2021 Credit Agreement provides greater flexibility with fewer restrictive covenants and more favorable interest rates than the previous arrangement, consisting of a term loan facility in an amount up to $100.0 million and a revolving facility in an amount up to $450.0 million with an option to expand the revolving facility by up to $275.0 million with the consent of the lenders willing to provide additional borrowings in the form of increases to their revolving facility commitment or funding of incremental term loans. As a result, we expect future interest expense to be lower by approximately $1.0 million per month as compared to periods prior to the debt restructuring. In the second quarter of 2021, we used the proceeds from the 2021 Credit Agreement to retire our 5.625% Senior Notes due 2025. As of December 31, 2021, we had outstanding borrowings of $98.8 million and $168.0 million under our term loan facility and revolving facility, respectively. As of December 31, 2021, we had letters of credit and bank guarantees outstanding in the amount of $2.9 million, leaving approximately $279.1 million of unused borrowing capacity on our revolving facility. See Note 9 to the consolidated financial statements for more detail on the 2021 Credit Agreement.

The Company's Board of Directors has authorized a quarterly cash dividend of $0.25 per share payable March 15, 2022, to shareholders of record on March 3, 2022.

Cash Flow from Operating Activities

Operating activities provided $69.4 million of cash in 2021. Cash provided by operating activities was driven primarily by inflows from a strong performance influencing net income, by adding back non-cash items of $52.9 million and an increase in accounts payable of $19.1 million offset by outflows from an increase in inventory of $56.0 million and an increase in receivables of $20.3 million.

Cash Flow from Investing Activities

Investing activities in 2021 provided $1.7 million, resulting from $24.7 million of proceeds from the sale of our Coatings business net of cash divested, partially offset by $19.4 million of capital expenditures and $3.7 million from investments in leased assets. Cash used for capital expenditures decreased from 2020 due to the investments in the new corporate headquarters that occurred in 2020.

Cash Flow from Financing Activities

Net cash used in financing activities was $84.5 million in 2021. Proceeds from borrowings of $315.8 million and issuance of common stock of $5.0 million were mainly offset by payments of debt of $362.0 million, dividend payments of $17.5 million, repurchases of common stock of $15.0 million, a debt extinguishment payment of $8.4 million, and a contingent consideration payment of $2.5 million.

Contractual Obligations

The company believes the liquidity available from the combination of expected cash generated by operating activities, existing cash and available credit under existing credit facilities will be sufficient to meet its short-term and long-term cash requirements. Significant contractual obligations include principal and interest payments on long-term debt (Note 9) and operating lease commitments (Note 15).  We also have contractual purchase obligations of $125.7 million for 2022.

Newly Issued Accounting Guidance

See Note 2 to the consolidated financial statements for information on new accounting pronouncements.

No other new accounting pronouncements issued but not yet effective have had, or are expected to have, a material impact on our results of operations or financial position.

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Critical Accounting Policies and Estimates

Our consolidated financial statements are based on the selection and application of accounting principles generally accepted in the United States of America, which require us to make estimates and assumptions about future events that affect the amounts reported in our consolidated financial statements and the accompanying notes. Our significant accounting policies are described in Note 1 to the consolidated financial statements. Future events and their effects cannot be determined with absolute certainty. Therefore, the determination of estimates requires the exercise of judgment. Actual results could differ from those estimates, and any such differences may be material to the consolidated financial statements. We believe that the following policies may involve a higher degree of judgment and complexity in their application and represent the critical accounting policies used in the preparation of our consolidated financial statements. If different assumptions or conditions were to prevail, the results could be materially different from our reported results.

Goodwill – Goodwill represents the excess of cost over the fair value of net assets of businesses acquired and is allocated to our reporting units at the time of the acquisition. We analyze goodwill on an annual basis and when an event occurs or circumstances change that may reduce the fair value of a reporting unit below its carrying amount. We have the option of first analyzing qualitative factors to determine whether it is more likely than not that the fair value of any reporting unit is less than its carrying amount. However, we may elect to perform a quantitative goodwill impairment test in lieu of the qualitative test. An entity must recognize an impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value. Subsequent reversal of goodwill impairment charges is not permitted.

When we perform a qualitative goodwill test, we analyze qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the quantitative goodwill impairment test. If the qualitative test indicates there may be an impairment, we perform the quantitative test, which measures the amount of the goodwill impairment, if any. To perform the quantitative test, we calculate the fair value of each reporting unit, primarily utilizing the income approach. The income approach is based on discounted cash flow models that use reporting unit estimates for forecasted future financial performance, including revenues, margins, operating expenses, capital expenditures, depreciation, amortization, tax and discount rates. These estimates are developed as part of our planning process based on assumed growth rates, along with historical data and various internal estimates. Projected future cash flows are then discounted to a present value employing a discount rate that properly accounts for the estimated risk-adjusted weighted-average cost of capital relevant to each reporting unit.

We perform our annual goodwill impairment analysis as of October 1 and when an event occurs or circumstances change that may reduce the fair value of a reporting unit below its carrying amount. In 2020, we changed the goodwill impairment assessment date from December 31 to October 1 to better align with the timing of our annual planning process. The change did not result in any adjustments to our consolidated financial statements.

In 2021, we performed the qualitative goodwill test on all reporting units except on Europe, Middle East and Africa (EMEA) for which we performed a quantitative goodwill test. Our tests indicated that there was no goodwill impairment in any of our reporting units as of our annual assessment date.

We had goodwill of $193.1 million and $207.8 million at December 31, 2021 and 2020, respectively.

Income Taxes – We are required to estimate our income taxes in each of the jurisdictions in which we operate. This process involves estimating our actual current tax obligations based on expected income, statutory tax rates and tax planning opportunities in the various jurisdictions. We also establish reserves for uncertain tax matters that are complex in nature and uncertain as to the ultimate outcome. Although we believe that our tax return positions are fully supportable, we consider our ability to ultimately prevail in defending these matters when establishing these reserves. We adjust our reserves in light of changing facts and circumstances, such as the closing of a tax audit. We believe that our current reserves are adequate. However, the ultimate outcome may differ from our estimates and assumptions and could impact the income tax expense reflected in our consolidated statements of income.

Tax law requires certain items to be included in our tax return at different times than the items are reflected in our results of operations. Some of these differences are permanent, such as expenses that are not deductible in our tax returns, and some differences will reverse over time, such as depreciation expense on property, plant and equipment. These temporary differences result in deferred tax assets and liabilities, which are included within our consolidated balance sheets. Deferred tax assets generally represent items that can be used as a tax deduction or credit in our tax returns in future years but have already been recorded as an expense in our consolidated statements of income. We assess the likelihood that our deferred tax assets will be recovered from future taxable income, and, based on management’s judgment, to the extent we believe that recovery is not more likely than not, we establish a valuation allowance against those deferred tax assets. The deferred tax asset valuation allowance could be materially different from actual results because of changes in the mix of future taxable income, the relationship between book and taxable income and our tax planning strategies. As of December 31, 2021, a valuation allowance of $4.8 million was recorded against foreign and state tax credit carryforwards.

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Cautionary Factors Relevant to Forward-Looking Information

This Annual Report on Form 10-K, including “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7, contains certain statements that are considered “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements generally can be identified by the use of forward-looking terminology such as “may,” “will,” “expect,” “intend,” “estimate,” “anticipate,” “believe,” “project,” or “continue” or similar words or the negative thereof. These statements do not relate to strictly historical or current facts and provide current expectations of forecasts of future events. Any such expectations or forecasts of future events are subject to a variety of factors. Particular risks and uncertainties presently facing us include:

We caution that forward-looking statements must be considered carefully and that actual results may differ in material ways due to risks and uncertainties both known and unknown. Information about factors that could materially affect our results can be found in Part I, Item 1A "Risk Factors" of this Form 10-K. Shareholders, potential investors and other readers are urged to consider these factors in evaluating forward-looking statements and are cautioned not to place undue reliance on such forward-looking statements.

We undertake no obligation to update or revise any forward-looking statement, whether as a result of new information, future events or otherwise, except as required by law. Investors are advised to consult any further disclosures by us in our filings with the SEC and in other written statements on related subjects. It is not possible to anticipate or foresee all risk factors, and investors should not consider any list of such factors to be an exhaustive or complete list of all risks or uncertainties.

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