Reclassifications out of accumulated other comprehensive (loss) income for the six month periods ended June 30, 2018 and 2017 are presented in the following table.
Note 11. Hedging Activities and Fair Value Measurements
The Company is exposed to certain market risks during the normal course of its business arising from adverse changes in interest rates and foreign currency exchange rates. The Company selectively uses derivative financial instruments (“derivatives”), including foreign currency forward contracts and interest rate swaps, to manage the risks from fluctuations in foreign currency exchange rates and interest rates, respectively. The Company does not purchase or hold derivatives for trading or speculative purposes. Fluctuations in interest rates and foreign currency exchange rates can be volatile, and the Company’s risk management activities do not totally eliminate these risks. Consequently, these fluctuations could have a significant effect on the Company’s financial results.
The Company’s exposure to interest rate risk results primarily from its variable-rate borrowings. The Company manages its debt centrally, considering tax consequences and its overall financing strategies. The Company manages its exposure to interest rate risk by maintaining a mixture of fixed and variable rate debt and, from time to time, using pay-fixed interest rate swaps as cash flow hedges of variable rate debt in order to adjust the relative fixed and variable proportions.
A substantial portion of the Company’s operations is conducted by its subsidiaries outside of the United States in currencies other than the USD. Almost all of the Company’s non-U.S. subsidiaries conduct their business primarily in their local currencies, which are also their functional currencies. Other than the USD, the EUR, GBP, and Chinese Yuan are the principal currencies in which the Company and its subsidiaries enter into transactions. The Company is exposed to the impacts of changes in foreign currency exchange rates on the translation of its non-U.S. subsidiaries’ assets, liabilities and earnings into USD. The Company has certain U.S. subsidiaries borrow in currencies other than the USD.
The Company and its subsidiaries are also subject to the risk that arises when they, from time to time, enter into transactions in currencies other than their functional currency. To mitigate this risk, the Company and its subsidiaries typically settle intercompany trading balances monthly. The Company also selectively uses forward currency contracts to manage this risk. These contracts for the sale or purchase of European and other currencies generally mature within one year.
The following table summarizes the notional amounts, fair values and classification of the Company’s outstanding derivatives by risk category and instrument type within the Condensed Consolidated Balance Sheets as of June 30, 2018 and December 31, 2017.
Gains and losses on derivatives designated as cash flow hedges included in the Condensed Consolidated Statements of Comprehensive (Loss) Income for the three and six month periods ended June 30, 2018 and 2017, are as presented in the table below. See Note 1 “Condensed Consolidated Financial Statements” for a discussion of the adoption of ASU 2017-12.
As of June 30, 2018, the Company is the fixed rate payor on 12 interest rate swap contracts that effectively fix the LIBOR-based index used to determine the interest rates charged on a total of $1,125.0 million of the Company’s LIBOR-based variable rate borrowings. These contracts carry fixed rates ranging from 2.7% to 4.3% and have expiration dates ranging from 2018 to 2020. These swap agreements qualify as hedging instruments and have been designated as cash flow hedges of forecasted LIBOR-based interest payments. Based on LIBOR-based swap yield curves as of June 30, 2018, the Company expects to reclassify losses of $13.1 million out of AOCI into earnings during the next 12 months. The Company’s LIBOR-based variable rate borrowings outstanding as of June 30, 2018 were $1,175.9 million and €610.4 million.
The Company had three foreign currency forward contracts outstanding as of June 30, 2018 with notional amounts ranging from $18.5 million to $93.5 million. These contracts are used to hedge the change in fair value of recognized foreign currency denominated assets or liabilities caused by changes in currency exchange rates. The changes in the fair value of these contracts generally offset the changes in the fair value of a corresponding amount of the hedged items, both of which are included in the “Other operating expense, net” line on the face of the Condensed Consolidated Statements of Operations. The Company’s foreign currency forward contracts are subject to master netting arrangements or agreements between the Company and each counterparty for the net settlement of all contracts through a single payment in a single currency in the event of default on or termination of any one contract with that certain counterparty. It is the Company’s practice to recognize the gross amounts in the Condensed Consolidated Balance Sheets. The amount available to be netted is not material.
The Company’s (losses) gains on derivative instruments not designated as accounting hedges and total net foreign currency (losses) gains for the three and six month periods ended June 30, 2018 and 2017 were as follows.
The Company has a significant investment in consolidated subsidiaries with functional currencies other than the USD, particularly the EUR. The Company designated its Original Euro Term Loan as a hedge of the Company’s net investment in subsidiaries with EUR functional currencies in 2017 until it was extinguished and replaced on August 17, 2017 by a €615.0 million Euro Term Loan, further described in Note 8 “Debt.” On August 17, 2017, the Company designated the €615.0 million Euro Term Loan as a hedge of the Company’s net investment in subsidiaries with EUR functional currencies. As of June 30, 2018, the Euro Term Loan of €610.4 million remained designated.
For the period from January 1, 2017 to August 16, 2017, the Company designated two cross currency interest rate swaps, each with a USD notional amount of $100.0 million as hedges of its net investment in EUR functional subsidiaries. Both cross currency interest rate swaps were terminated on August 16, 2017. The losses and gains from the change in the fair value of the designated net investment hedges were recorded through other comprehensive income. The recorded Accumulated Other Comprehensive (Loss) Income at the termination of the cross currency interest rate swaps will remain in Accumulated Other Comprehensive (Loss) Income until there is a substantial liquidation of the Company’s net investment in subsidiaries with EUR functional currencies.
The Company’s gains and (losses), net of income tax, associated with changes in the value of debt and designated cross currency interest rate swaps for the three and six month periods ended June 30, 2018 and 2017 and the net balance of such gains and (losses) included in accumulated other comprehensive (loss) income as of June 30, 2018 and 2017 were as follows.
For the periods presented, all cash flows associated with derivatives are classified as operating cash flows in the Condensed Consolidated Statements of Cash Flows.
A financial instrument is defined as cash or cash equivalents, evidence of an ownership interest in an entity, or a contract that creates a contractual obligation or right to deliver or receive cash or another financial instruments from another party. The Company’s financial instruments consist primarily of cash and cash equivalents, trade accounts receivables, trade accounts payables, deferred compensation assets and obligations, derivatives and debt instruments. The carrying values of cash and cash equivalents, trade accounts receivables, trade accounts payables, and variable rate debt instruments are a reasonable estimate of their respective fair values.
Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (exit price) in the principal or more advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Valuation techniques used to measure fair value must maximize the use of observable inputs and minimize the use of unobservable inputs. The fair value hierarchy is based on three levels of inputs, of which the first two are considered observable and the last unobservable, that may be used to measure the fair value as follows.
The following table summarizes the Company’s financial assets and liabilities measured at fair value on a recurring basis as of June 30, 2018.
Note 12. Revenue from Contracts with Customers
The Company adopted ASC 606 on January 1, 2018 using the modified retrospective method. See Note 1 “Condensed Consolidated Financial Systems” for further discussion of the adoption.
The Company recognizes revenue when control is transferred to the customer. The amount of revenue recognized includes adjustments for any variable consideration, such as rebates, sales discounts, liquidated damages, etc., which are included in the transaction price, and allocated to each performance obligation. The variable consideration is estimated throughout the course of the contract using the Company’s best estimates. Judgments impacting variable consideration related to material rebate and sales discount programs, and significant contracts containing liquidated damage clauses are governed by robust management review processes.
The majority of the Company’s revenues are derived from short duration contracts and revenue is recognized at a single point in time when control is transferred to the customer, generally at shipment or when delivery has occurred or services have been rendered.
The Company has certain long duration engineered to order (“ETO”) contracts that require highly engineered solutions designed to customer specific applications. For contracts where the contractual deliverables have no alternative use and the contract termination clauses provide for the recovery of cost plus a reasonable margin, revenue is recognized over time based on the Company’s progress in satisfying the contractual performance obligations, generally measured as the ratio of actual costs incurred to date to the estimated total costs to complete the contract. For contracts with termination provisions that do not provide for recovery of cost and a reasonable margin, revenue is recognized at a point in time, generally at shipment or delivery to the customer. Identification of performance obligations, determination of alternative use, assessment of contractual language regarding termination provisions, and estimation of total project costs are all significant judgments required in the application of ASC 606.
Contractual specifications and requirements may be modified. The Company considers contract modifications to exist when the modification either creates new or changes the existing enforceable rights and obligations. In the event a contract modification is for goods or services that are not distinct in the contract, and therefore, form part of a single performance obligation that is partially satisfied as of the modification date, the effect of the contract modification on the transaction price and the Company’s measure of progress for the performance obligation to which it relates, is recognized on a cumulative catch-up basis.
Taxes assessed by a government authority that are both imposed on and concurrent with a specific revenue-producing transaction, that are collected by the Company from a customer, are excluded from revenue. Sales commissions are due at the earlier of collection of payment from customers or recognition of revenue. Applying the practical expedient from ASC 340-40-25-4, the Company recognizes the incremental costs of obtaining contracts as an expense when incurred if the amortization period of the assets that the Company otherwise would have recognized is one year or less. These costs are included in the “Selling and administrative expenses” line of the Condensed Consolidated Statements of Operations.
The following table provides disaggregated revenue by reportable segment for the three month period ended June 30, 2018.
The following table provides disaggregated revenue by reportable segment for the six month period ended June 30, 2018.
The majority of the Company’s contracts have a single performance obligation as the promise to transfer goods and/or services. For contracts with multiple performance obligations, the Company utilizes observable prices to determine standalone selling price or cost plus margin if a standalone price is not available. The Company has elected to expense shipping and handling costs as incurred.
The Company’s primary performance obligations include delivering standard or configured to order (“CTO”) goods to customers, designing and manufacturing a broad range of equipment customized to a customer’s specifications in ETO arrangements, rendering of services (maintenance and repair contracts) and certain extended or service type warranties. For incidental items that are immaterial in the context of the contract, costs are expensed as incurred or accrued at delivery.
As of June 30, 2018, for contracts with an original duration greater than one year, the Company expects to recognize revenue in the future related to unsatisfied (or partially satisfied) performance obligations of $178.2 million in the next twelve months and $88.1 million in periods thereafter. The performance obligations that are unsatisfied (or partially satisfied) are primarily related to orders for goods or services that were placed prior to the end of the reporting period and have not been delivered to the customer, on-going work on ETO contracts where revenue is recognized over time, and service contracts with an original duration greater than one year.
Contract Balances
The following table provides the contract balances as of June 30, 2018 and December 31, 2017 presented in the Condensed Consolidated Balance Sheets.
| | | June 30, 2018 | | | December 31, 2017 | |
| Accounts receivable, net of allowance for doubtful accounts of $19.4 and $18.7, respectively | | $ | 495.5 | | | $ | 536.3 | |
| Contract assets | | | 8.1 | | | | - | |
| Contract liabilities | | | 80.7 | | | | 42.7 | |
Accounts receivable – Amounts due where the Company’s right to receive cash is unconditional.
Contract assets – The Company’s rights to consideration for the satisfaction of performance obligations subject to constraints apart from timing. Contract assets are transferred to receivables when the right to collect consideration becomes unconditional. Contract assets are presented net of progress billings and related advances from customers.
Contract liabilities – Advance payments received from customers for contracts for which revenue is not yet recognized. The increase in the contract liabilities account as of June 30, 2018 and December 31, 2017 was due primarily to the acquisition of Runtech of $25.6 million. The remaining change is due to the timing of milestone payments received related to projects for production later this year, partially offset by contract liability balances converted to revenue in the period. Contract liability balances are generally recognized in revenue within twelve months.
Contract assets and liabilities are reported on the Condensed Consolidated Balance Sheets on a contract-by-contract basis at the end of each reporting period. Contract assets and liabilities are presented net on a contract level, where required.
Payments from customer are generally due 30-60 days after invoicing. Invoicing for sales of standard products generally coincides with shipment or delivery of goods. Invoicing for CTO and ETO contracts typically follows a schedule for billing at contractual milestones. Payments milestones normally include down payments upon the contract signing, completion of product design, completion of customer’s preliminary inspection, shipment or delivery, completion of installation, and customer’s on-site inspection. The timing of revenue recognition, billings and cash collections results in billed accounts receivable, unbilled receivables (contract assets) and customer advances and deposits (contract liabilities) on the Condensed Consolidated Balance Sheets.
The Company has elected the practical expedient from ASC 606-10-32-18 and does not adjust the transaction price for the effects of a financing component if, at contract inception, the period between when the Company transfers a promised good or service to a customer and when the customer pays for that good or service will be one year or less.
Note 13. Income Taxes
On December 22, 2017, the U.S. government enacted comprehensive tax legislation commonly referred to as the Tax Cuts and Jobs Act (“Tax Act”). The Tax Act makes broad and complex changes to the U.S. tax code that affected 2017, including, but not limited to, (1) requiring a one-time transition tax on certain unrepatriated earnings of foreign subsidiaries that is payable over eight years and (2) bonus depreciation that will allow for full expensing of qualified property.
The Tax Act also establishes new tax laws that affected 2018, including, but not limited to (1) the reduction of the U.S. federal corporate tax rate from 35% to 21%; (2) the elimination of the corporate alternative minimum tax (“AMT”); (3) the creation of the base erosion anti-abuse tax (“BEAT”), a new minimum tax; (4) a general elimination of U.S. federal income taxes on dividends from foreign subsidiaries; (5) a new provision designed to tax global intangible low-taxed income (“GILTI”), which allows for the possibility of using foreign tax credits (“FTC”) and a deduction of up to 50% to offset the income tax liability (subject to some limitations); (6) a new limitation on deductible interest expense; (7) the repeal of the domestic production activity deduction; (8) limitations on the deductibility of certain executive compensation; (9) limitations on the use of FTCs to reduce the U.S. income tax liability; and (10) limitations on net operating losses (“NOL”) generated after December 31, 2017, to 80% of taxable income.
The SEC staff issued SAB 118, which provides guidance on accounting for the tax effects of the Tax Act. SAB 118 provides a measurement period that should not extend beyond one year from the Tax Act enactment date for companies to complete the accounting under ASC 740. In accordance with SAB 118, a company must reflect the income tax effects of those aspects of the Tax Act for which the accounting under ASC 740 is complete. To the extent that a company’s accounting for certain income tax effects of the Tax Act is incomplete but it is able to determine a reasonable estimate, a company must record a provisional estimate in the financial statements. If a company cannot determine a provisional estimate to be included in the financial statements, a company should continue to apply ASC 740 on the basis of the provisions of the tax laws that were in effect immediately before the enactment of the Tax Act.
The Company has not completed the accounting for the income tax effects of certain elements of the Tax Act. If the Company was able to make reasonable estimates of the effects of elements for which an analysis is not yet complete, the Company recorded provisional adjustments, as described above. If the Company was not yet able to make reasonable estimates of the impact of certain elements, the Company has not recorded any adjustments related to those elements and have continued accounting for them in accordance with ASC 740 on the basis of the tax laws in effect before the Tax Act. As the Company completes the accounting of the income tax effects of the Tax Act, the Company anticipates that additional charges or benefits may be recorded at such time as prescribed by ASC 740 and SAB 118, and as further information becomes available regarding the Tax Act, the Company may make further adjustments to the provisions that have been recorded in the financial statements. The Company also continues to examine the impact of this tax reform legislation.
The Tax Act reduces the corporate tax rate to 21%, effective January 1, 2018. While the Company was able to make a reasonable estimate of the impact of the reduction in corporate rate, that estimate may be affected by other analyses related to the Tax Act, including, but not limited to, a calculation of deemed repatriation of deferred foreign income and the state tax effect of adjustments made to federal temporary differences. In the six month period ended June 30, 2018, no changes were made to either the benefit recognized of $89.6 million in 2017 or the $69.0 million benefit relating to the reduction of the ASC 740-30 liability also due to the change of the ending deferred tax rate for 2017. This remained an estimate as of June 30, 2018.
The Deemed Repatriation Transition Tax (“Transition Tax”) is a tax on previously untaxed accumulated and current earnings and profits (“E&P”) of certain of the Company’s foreign subsidiaries. To determine the amount of the Transition Tax, we must determine, in addition to other factors, the amount of post-1986 E&P of the relevant subsidiaries, the amount of non-U.S. income taxes paid on such earnings, and the impact of the accumulated overall foreign source loss on the Company’s ability to utilize foreign tax credits. The Company was able to make a reasonable estimate at year end 2017 for the Transition Tax and recorded a provisional Transition Tax obligation of $63.3 million. As a result of further technical guidance, an adjustment of additional tax expense of $7.9 million was made in the three month period ended March 31, 2018 relating to the Transition Tax. This adjustment brings the total impact of Transition Tax to $71.3 million. No additional changes were made during the three month period ended June 30, 2018. The Company continues to gather additional information to more precisely compute the amount of the Transition Tax and therefore, this amount remained an estimate as of June 30, 2018.
The Company’s accounting for the following elements of the Tax Act is incomplete, and no provisional adjustments, other than the adjustment related to the effects of the transitional tax, were recorded related to ASC 740-30.
Due to complexities, the Company has not yet determined if a change to the policy concerning permanent reinvestment will be made as a result of the Tax Act. No additional adjustments relating to ASC 740-30 have been recorded in accordance with SAB 118.
For 2018, the Tax Act creates a new requirement that certain income (i.e., GILTI) earned by controlled foreign corporations (“CFC”) must be included currently in the gross income of the CFCs’ U.S. shareholder. GILTI is the excess of the shareholder’s “net CFC tested income” over the net deemed tangible income return, which is currently defined as the excess of (1) 10% of the aggregate of the U.S. shareholder’s pro rata share of the qualified business asset investment of each CFC with respect to which it is a U.S. shareholder over (2) the amount of certain interest expense taken into account in the determination of net CFC-tested income.
Under U.S. GAAP, the Company is allowed to make an accounting policy choice of either (1) treating taxes due on future U.S. inclusions in taxable income related to GILTI as a current-period expense when incurred (the “period cost method”) or (2) factoring such amounts into a company’s measurement of its deferred taxes (the “deferred method”). The Company has determined that it will follow the period costs method (option 1 above) going forward. The tax provision for the six month period ended June 30, 2018 reflects this decision. All of the additional calculations and rule changes found in the Tax Act have been considered in the tax provision for the three and six month periods ended June 30, 2018.
The following table summarizes the Company’s provision (benefit) for income taxes and effective income tax provision rate for the three and six month periods ended June 30, 2018 and 2017.
| | | For the Three Month Period Ended | | | For the Six Month Period Ended | |
| | | 2018 | | | 2017 | | | 2018 | | | 2017 | |
| Income (loss) before income taxes | | $ | 77.5 | | | $ | (190.2 | ) | | $ | 143.4 | | | $ | (198.8 | ) |
| Provision (benefit) for income taxes | | $ | 17.2 | | | $ | (43.9 | ) | | $ | 40.7 | | | $ | (45.6 | ) |
| Effective income tax rate | | | 22.2 | % | | | 23.1 | % | | | 28.4 | % | | | 22.9 | % |
The increase in the provision for income taxes for the three month period ended June 30, 2018 when compared to the same three month period in 2017 is primarily due to the overall increase in global earnings when compared to the prior year. The effective income tax provision rate was impacted by the increase in global earnings and reduced by the windfall tax benefit to result in an overall decrease in the rate for the three month period ended June 30, 2018 when compared to the same three month period of 2017.
The increase in the provision for income taxes and increase in the effective income tax provision rate for the six month period ended June 30, 2018 when compared to the same six month period of 2017 is primarily due to the overall increase in global earnings when compared to the prior year.
Note 14. Supplemental Information
The components of “Other operating expense, net” for the three month and six month periods ended June 30, 2018 and 2017 are as follows.
| | | For the Three Month Period Ended | | | For the Six Month Period Ended | |
| | | 2018 | | | 2017 | | | 2018 | | | 2017 | |
| Other Operating Expense, Net | | | | | | | | | | | | |
| Foreign currency transaction (gains) losses, net | | $ | (2.4 | ) | | $ | 4.0 | | | $ | 0.2 | | | $ | 4.7 | |
Restructuring charges, net (1) | | | - | | | | 0.4 | | | | - | | | | 2.1 | |
Environmental remediation expenses (2) | | | - | | | | (0.1 | ) | | | - | | | | 0.9 | |
Stock-based compensation expense (3) | | | (0.8 | ) | | | 156.2 | | | | 1.9 | | | | 156.2 | |
Shareholder litigation settlement recoveries(4) | | | - | | | | - | | | | (4.5 | ) | | | - | |
Acquisition related expenses and non-cash charges(5) | | | 2.9 | | | | 1.0 | | | | 5.9 | | | | 1.8 | |
| (Gains) losses on asset and business disposals | | | - | | | | (0.5 | ) | | | (1.2 | ) | | | 2.5 | |
| Other, net | | | 0.9 | | | | 0.4 | | | | 2.6 | | | | 1.1 | |
| Total other operating expense, net | | $ | 0.6 | | | $ | 161.4 | | | $ | 4.9 | | | $ | 169.3 | |
| (1) | See Note 3 “Restructuring.” |
| (2) | Estimated environmental remediation costs recorded on an undiscounted basis for a former production facility. |
| (3) | Represents stock-based compensation expense recognized for the three month and six month periods ended June 30, 2018 of $1.8 million and $5.2 million, respectively, reduced by a ($2.6 million) and ($3.3 million) decrease in the estimated accrual for employer taxes for the three month and six month periods ended June 30, 2018, respectively, as a result of the achievement of employer tax caps in countries outside of the United States. Represents stock-based compensation expense recognized for stock options outstanding of $61.4 million and DSUs granted to employees at the date of the initial public offering of $94.8 million under the 2013 Stock Incentive Plan for the three and six month periods ended June 30, 2017. |
| (4) | Represents an insurance recovery of the Company’s shareholder litigation settlement in 2014. |
| (5) | Represents costs associated with successful and/or abandoned acquisitions, including third-party expenses, post-closure integration costs and non-cash charges and credits arising from fair value purchase accounting adjustments. |
Note 15. Contingencies
The Company is a party to various legal proceedings, lawsuits and administrative actions, which are of an ordinary or routine nature for a company of its size and sector. The Company believes that such proceedings, lawsuits and administrative actions will not materially adversely affect its operations, financial condition, liquidity or competitive position. A more detailed discussion of certain of these proceedings, lawsuits and administrative actions is set forth below.
Asbestos and Silica Related Litigation
The Company has also been named as a defendant in a number of asbestos-related and silica-related personal injury lawsuits. The plaintiffs in these suits allege exposure to asbestos or silica from multiple sources and typically the Company is one of approximately 25 or more named defendants.
Predecessors to the Company sometimes manufactured, distributed and/or sold products allegedly at issue in the pending asbestos and silica-related lawsuits (the “Products”). However, neither the Company nor its predecessors ever mined, manufactured, mixed, produced or distributed asbestos fiber or silica sand, the materials that allegedly caused the injury underlying the lawsuits. Moreover, the asbestos-containing components of the Products, if any, were enclosed within the subject Products.
Although the Company has never mined, manufactured, mixed, produced or distributed asbestos fiber or silica sand nor sold products that could result in a direct asbestos or silica exposure, many of the companies that did engage in such activities or produced such products are no longer in operation. This has led to law firms seeking potential alternative companies to name in lawsuits where there has been an asbestos or silica related injury.
The Company believes that the pending and future asbestos and silica-related lawsuits are not likely to, in the aggregate, have a material adverse effect on its consolidated financial position, results of operations or liquidity, based on: the Company’s anticipated insurance and indemnification rights to address the risks of such matters; the limited potential asbestos exposure from the Products described above; the Company’s experience that the vast majority of plaintiffs are not impaired with a disease attributable to alleged exposure to asbestos or silica from or relating to the Products or for which the Company otherwise bears responsibility; various potential defenses available to the Company with respect to such matters; and the Company’s prior disposition of comparable matters. However, inherent uncertainties of litigation and future developments, including, without limitation, potential insolvencies of insurance companies or other defendants, an adverse determination in the Adams County Case (discussed below), or other inability to collect from the Company’s historical insurers or indemnitors, could cause a different outcome. While the outcome of legal proceedings is inherently uncertain, based on presently known facts, experience, and circumstances, the Company believes that the amounts accrued on its balance sheet are adequate and that the liabilities arising from the asbestos and silica-related personal injury lawsuits will not have a material adverse effect on the Company’s consolidated financial position, results of operations or liquidity. “Accrued liabilities” and “Other liabilities” on the Condensed Consolidated Balance Sheet include a total litigation reserve of $100.8 million and $105.6 million as of June 30, 2018 and December 31, 2017, with respect to potential liability arising from the Company’s asbestos-related litigation. Asbestos related defense costs are excluded from the asbestos claims liability and are recorded separately as services are incurred. In the event of unexpected future developments, it is possible that the ultimate resolution of these matters may be material to the Company’s consolidated financial position, results of operation or liquidity.
The Company has entered into a series of agreements with certain of its or its predecessors’ legacy insurers and certain potential indemnitors to secure insurance coverage and/or reimbursement for the costs associated with the asbestos and silica-related lawsuits filed against the Company. The Company has also pursued litigation against certain insurers or indemnitors, where necessary. The Company has an insurance recovery receivable for probable asbestos related recoveries of approximately $96.2 million and $100.4 million as of June 30, 2018 and December 31, 2017, respectively, which was included in “Other assets” on the Consolidated Balance Sheets. During the six month period ended June 30, 2018 the Company received asbestos related insurance recoveries of $9.6 million, of which $4.0 million related to the recovery of indemnity payments, and was recorded as a reduction of the insurance recovery receivable in “Other assets” on the Condensed Consolidated Balance Sheets, and $5.6 million related to reimbursement of previously expensed legal defense costs, and was recorded as a reduction of “Selling and administrative expenses” in the Condensed Consolidated Statements of Operations.
The largest such recent action, Gardner Denver, Inc. v. Certain Underwriters at Lloyd’s, London, et al., was filed on July 9, 2010, in the Eighth Judicial Circuit, Adams County, Illinois, as case number 10-L-48 (the “Adams County Case”). In the lawsuit, the Company seeks, among other things, to require certain excess insurer defendants to honor their insurance policy obligations to the Company, including payment in whole or in part of the costs associated with the asbestos-related lawsuits filed against the Company. In October 2011, the Company reached a settlement with one of the insurer defendants, which had issued both primary and excess policies, for approximately the amount of such defendant’s policies that were subject to the lawsuit. Since then, the case has been proceeding through the discovery and motions process with the remaining insurer defendants. On January 29, 2016, the Company prevailed on the first phase of that discovery and motions process (“Phase I”). Specifically, the Court in the Adams County Case ruled that the Company has rights under all of the policies in the case, subject to their terms and conditions, even though the policies were sold to the Company’s former owners rather than to the Company itself. On June 9, 2016, the Court denied a motion by several of the insurers who sought permission to appeal the Phase I ruling immediately rather than waiting until the end of the whole case as is normally required. The case is now proceeding through the discovery process regarding the remaining issues in dispute (“Phase II”).
A majority of the Company’s expected future recoveries of the costs associated with the asbestos-related lawsuits are the subject of the Adams County Case.
The amounts recorded by the Company for asbestos-related liabilities and insurance recoveries are based on currently available information and assumptions that the Company believes are reasonable based on an evaluation of relevant factors. The actual liabilities or insurance recoveries could be higher or lower than those recorded if actual results vary significantly from the assumptions. There are a number of key variables and assumptions including the number and type of new claims to be filed each year, the resolution or outcome of these claims, the average cost of resolution of each new claim, the amount of insurance available, allocation methodologies, the contractual terms with each insurer with whom the Company has reached settlements, the resolution of coverage issues with other excess insurance carriers with whom the Company has not yet achieved settlements, and the solvency risk with respect to the Company’s insurance carriers. Other factors that may affect the future liability include uncertainties surrounding the litigation process from jurisdiction to jurisdiction and from case to case, legal rulings that may be made by state and federal courts, and the passage of state or federal legislation. The Company makes the necessary adjustments for the asbestos liability and corresponding insurance recoveries on an annual basis unless facts or circumstances warrant assessment as of an interim date.
Environmental Matters
The Company has been identified as a potentially responsible party (“PRP”) with respect to several sites designated for cleanup under U.S. federal “Superfund” or similar state laws that impose liability for cleanup of certain waste sites and for related natural resource damages. Persons potentially liable for such costs and damages generally include the site owner or operator and persons that disposed or arranged for the disposal of hazardous substances found at those sites. Although these laws impose joint and several liability on PRPs, in application the PRPs typically allocate the investigation and cleanup costs based upon the volume of waste contributed by each PRP. Based on currently available information, the Company was only a small contributor to these waste sites, and the Company has, or is attempting to negotiate, de minimis settlements for their cleanup. The cleanup of the remaining sites is substantially complete and the Company’s future obligations entail a share of the sites’ ongoing operating and maintenance expense. The Company is also addressing four on-site cleanups for which it is the primary responsible party. Three of these cleanup sites are in the operation and maintenance stage and one is in the implementation stage.
The Company has undiscounted accrued liabilities of $7.1 million and $7.5 million as of June 30, 2018 and December 31, 2017, respectively, on its Condensed Consolidated Balance Sheet to the extent costs are known or can be reasonably estimated for its remaining financial obligations for the environmental matters discussed above and does not anticipate that any of these matters will result in material additional costs beyond amounts accrued. Based upon consideration of currently available information, the Company does not anticipate any material adverse effect on its results of operations, financial condition, liquidity or competitive position as a result of compliance with federal, state, local or foreign environmental laws or regulations, or cleanup costs relating to these matters.
Note 16. Segment Results
A description of the Company’s three reportable segments, including the specific products manufactured and sold follows below.
In the Industrials segment, the Company designs, manufactures, markets and services a broad range of air compression, vacuum and blower products across a wide array of technologies and applications. Almost every manufacturing and industrial facility, and many service and process industries, use air compression and vacuum products in a variety of applications such as operation of pneumatic air tools, vacuum packaging of food products and aeration of waste water. The Company maintains a leading position in its markets and serves customers globally. The Company offers comprehensive aftermarket parts and an experienced direct and distributor-based service network world-wide to complement all of its products.
In the Energy segment, the Company designs, manufactures, markets and services a diverse range of positive displacement pumps, liquid ring vacuum pumps and compressors, and engineered loading systems and fluid transfer equipment, consumables, and associated aftermarket parts and services. It serves customers in the upstream, midstream, and downstream oil and gas markets, and various other markets including petrochemical processing, power generation, transportation, and general industrial. The Company is one of the largest suppliers in these markets and has long-standing customer relationships. Its positive displacement pumps are used in the oilfield for drilling, hydraulic fracturing, completion and well servicing. Its liquid ring vacuum pumps and compressors are used in many power generation, mining, oil and gas refining and processing, chemical processing and general industrial applications including flare gas and vapor recovery, geothermal gas removal, vacuum de-aeration, enhanced oil recovery, water extraction in mining and paper and chlorine compression in petrochemical operations. Its engineered loading systems and fluid transfer equipment ensure the safe handling and transfer of crude oil, liquefied natural gas, compressed natural gas, chemicals, and bulk materials.
In the Medical segment, the Company designs, manufactures and markets a broad range of highly specialized gas, liquid and precision syringe pumps and compressors primarily for use in the medical, laboratory and biotechnology end markets. The Company’s customers are mainly medium and large durable medical equipment suppliers that integrate the Company’s products into their final equipment for use in applications such as oxygen therapy, blood dialysis, patient monitoring, wound treatment, and others. Further, with the recent acquisitions, the Company has expanded into liquid handling components and systems used in biotechnology applications including clinical analysis instrumentation. The Company also has a broad range of end use deep vacuum products for laboratory science applications.
The Chief Operating Decision Maker (“CODM”) evaluates the performance of the Company’s reportable segments based on, among other measures, Segment Adjusted EBITDA. Management closely monitors the Segment Adjusted EBITDA of each reportable segment to evaluate past performance and actions required to improve profitability. Inter-segment sales and transfers are not significant. Administrative expenses related to the Company’s corporate offices and shared service centers in the United States and Europe, which includes transaction processing, accounting and other business support functions, are allocated to the business segments. Certain administrative expenses, including senior management compensation, treasury, internal audit, tax compliance, certain information technology, and other corporate functions, are not allocated to the business segments.
The following table provides summarized information about the Company’s operations by reportable segment and reconciles Segment Adjusted EBITDA to Income (Loss) Before Income Taxes for the three month and six month periods ended June 30, 2018 and 2017.
| | For the Three Month Period Ended June 30, | | | For the Six Month Period Ended June 30, | |
| | | 2018 | | | 2017 | | | 2018 | | | 2017 | |
| Revenue | | | | | | | | | | | | |
| Industrials | | $ | 328.7 | | | $ | 282.8 | | | $ | 645.6 | | | $ | 530.8 | |
| Energy | | | 273.1 | | | | 239.5 | | | | 515.3 | | | | 417.7 | |
| Medical | | | 66.4 | | | | 56.8 | | | | 126.8 | | | | 112.3 | |
| Total Revenue | | $ | 668.2 | | | $ | 579.1 | | | $ | 1,287.7 | | | $ | 1,060.8 | |
| Segment Adjusted EBITDA | | | | | | | | | | | | | | | | |
| Industrials | | $ | 71.1 | | | $ | 63.4 | | | $ | 137.9 | | | $ | 110.6 | |
| Energy | | | 79.7 | | | | 62.2 | | | | 147.6 | | | | 100.6 | |
| Medical | | | 18.0 | | | | 15.4 | | | | 33.9 | | | | 30.1 | |
| Total Segment Adjusted EBITDA | | $ | 168.8 | | | $ | 141.0 | | | $ | 319.4 | | | $ | 241.3 | |
| Less items to reconcile Segment Adjusted EBITDA to | | | | | | | | | | | | | | | | |
Income (Loss) Before Income Taxes(1): | | | | | | | | | | | | | | | | |
Corporate expenses not allocated to segments(a) | | $ | 7.2 | | | $ | 8.9 | | | $ | 9.6 | | | $ | 17.1 | |
| Interest expense | | | 26.1 | | | | 39.5 | | | | 52.1 | | | | 85.3 | |
| Depreciation and amortization expense | | | 45.3 | | | | 43.8 | | | | 90.2 | | | | 83.5 | |
Sponsor fees and expenses(b) | | | - | | | | 16.2 | | | | - | | | | 17.3 | |
Restructuring and related business transformation costs(c) | | | 8.4 | | | | 5.6 | | | | 12.9 | | | | 14.2 | |
Acquisition related expenses and non-cash charges(d) | | | 5.7 | | | | 1.2 | | | | 10.3 | | | | 1.9 | |
Environmental remediation loss reserve(e) | | | - | | | | (0.1 | ) | | | - | | | | 0.9 | |
Expenses related to public stock offerings(f) | | | 0.5 | | | | 1.8 | | | | 1.9 | | | | 3.2 | |
Establish public company financial reporting compliance(g) | | | 1.1 | | | | 2.1 | | | | 1.9 | | | | 3.3 | |
Stock-based compensation(h) | | | (0.8 | ) | | | 156.2 | | | | 1.9 | | | | 156.2 | |
| Foreign currency transaction (gains) losses, net | | | (2.4 | ) | | | 4.0 | | | | 0.2 | | | | 4.7 | |
Loss on extinguishment of debt(i) | | | 0.2 | | | | 50.4 | | | | 0.2 | | | | 50.4 | |
Shareholder litigation settlement recoveries(j) | | | - | | | | - | | | | (4.5 | ) | | | - | |
Other adjustments(k) | | | - | | | | 1.6 | | | | (0.7 | ) | | | 2.1 | |
| Income (Loss) Before Income Taxes | | $ | 77.5 | | | $ | (190.2 | ) | | $ | 143.4 | | | $ | (198.8 | ) |
| (1) | The reconciling items for the three month and six month periods ended June 30, 2017 have been reclassified to conform to the methodology used in the three and six month periods ended June 30, 2018, and include the following. |
| (a) | Includes insurance recoveries of asbestos legal fees of $5.6 million in the six month period ended June 30, 2018. |
| (b) | Represents management fees and expenses paid to the Company’s Sponsor. |
| (c) | Restructuring and related business transformation costs consist of the following. |
| | For the Three Month Period Ended June 30, | | | For the Six Month Period Ended June 30, | |
| | | 2018 | | | 2017 | | | 2018 | | | 2017 | |
| Restructuring charges | | $ | - | | | $ | 0.4 | | | $ | - | | | $ | 2.1 | |
| Severance, sign-on, relocation and executive search costs | | | 1.9 | | | | 0.6 | | | | 3.9 | | | | 1.6 | |
| Facility reorganization, relocation and other costs | | | 0.7 | | | | 1.8 | | | | 1.3 | | | | 2.9 | |
| Information technology infrastructure transformation | | | 0.2 | | | | 2.0 | | | | 0.2 | | | | 2.7 | |
| (Gains) losses on asset and business disposals | | | - | | | | (0.5 | ) | | | (1.2 | ) | | | 2.5 | |
| Consultant and other advisor fees | | | 4.0 | | | | 0.8 | | | | 6.6 | | | | 1.2 | |
| Other, net | | | 1.6 | | | | 0.5 | | | | 2.1 | | | | 1.2 | |
| Total restructuring and related business transformation costs | | $ | 8.4 | | | $ | 5.6 | | | $ | 12.9 | | | $ | 14.2 | |
| (d) | Represents costs associated with successful and/or abandoned acquisitions, including third-party expenses, post-closure integration costs and non-cash charges and credits arising from fair value purchase accounting adjustments. |
| (e) | Represents estimated environmental remediation costs and losses relating to a former production facility. |
| (f) | Represents expenses related to the Company’s initial public offering and subsequent secondary offerings. |
| (g) | Represents third party expenses to comply with the requirements of Sarbanes-Oxley in 2018 and the accelerated adoption of the new revenue recognition standard (ASC 606 – Revenue from Contracts with Customers) in the first quarter of 2018, one year ahead of the required adoption date for a private company. These expenses were previously included in “Expenses related to initial stock offering” and prior periods have been restated to conform to current period presentation. |
| (h) | Represents stock-based compensation expense recognized for the three month and six month periods ended June 30, 2018 of $1.8 million and $5.2 million, respectively, reduced by a ($2.6 million) and ($3.3 million) decrease in the estimated accrual for employer taxes for the three month and six month periods ended June 30, 2018, respectively, as a result of the achievement of employer tax caps in countries outside of the United States. Represents stock-based compensation expense recognized for stock options outstanding of $61.4 million and DSUs granted to employees at the date of the initial public offering of $94.8 million under the 2013 Stock Incentive Plan for the three and six month periods ended June 30, 2017. |
| (i) | Represents losses on extinguishment of the senior notes and a portion of the U.S. term loan. |
| (j) | Represents an insurance recovery of the Company’s shareholder litigation settlement in 2014. |
| (k) | Includes (i) the effects of the amortization of prior service costs and the amortization of gains in pension and other postretirement benefits (OPEB) expense, (ii) certain legal and compliance costs and (iii) other miscellaneous adjustments. |
Note 17. Related Party Transactions
Affiliates of KKR participated as (i) a lender in the Company’s Senior Secured Credit Facilities discussed in Note 8, “Debt,” (ii) an underwriter in the Company’s initial public offering, and (iii) a provider of services for the fiscal year 2017 debt refinancing transaction. KKR held a position in the Euro Term Loan Facility of €49.6 million as of June 30, 2018.
The Company entered into a monitoring agreement, dated July 30, 2013, with KKR pursuant to which KKR will provide management, consulting and financial advisory services to the Company and its divisions, subsidiaries, parent entities and controlled affiliates. Under the terms of the monitoring agreement the Company was, among other things, obligated to pay KKR (or such affiliate(s) as KKR designates) an aggregate annual management fee in the initial annual amount of $3.5 million, payable in arrears at the end of each fiscal quarter, plus upon request all reasonable out of pocket expenses incurred in connection with the provision of services under the agreement. The management fee increases at a rate of 5% per year effective on January 1, 2014. In May 2017, in connection with the Company’s initial public offering, the monitoring agreement was terminated and the Company paid a termination fee of $16.2 million during the three month period ended June 30, 2017 which was included in the “Selling and administrative expenses” line of the Condensed Consolidated Statements of Operations. The Company incurred management fees to KKR of $1.1 million and no out of pocket expenses for the six month period ended June 30, 2017.
Note 18. Earnings (Loss) Per Share
The computations of basic and diluted loss per share are as follows.
| | | For the Three Month Period Ended June 30, | | | For the Six Month Period Ended June 30, | |
| | | 2018 | | | 2017 | | | 2018 | | | 2017 | |
| Net income (loss) | | $ | 60.3 | | | $ | (146.3 | ) | | $ | 102.7 | | | $ | (153.2 | ) |
| Less: Net income attributable to noncontrolling interests | | | - | | | | - | | | | - | | | | 0.1 | |
| Net income (loss) attributable to Gardner Denver Holdings, Inc. | | $ | 60.3 | | | $ | (146.3 | ) | | $ | 102.7 | | | $ | (153.3 | ) |
| Average shares outstanding: | | | | | | | | | | | | | | | | |
| Basic | | | 201.8 | | | | 176.9 | | | | 201.7 | | | | 162.8 | |
| Diluted | | | 209.6 | | | | 176.9 | | | | 209.8 | | | | 162.8 | |
| Income (loss) per share: | | | | | | | | | | | | | | | | |
| Basic | | $ | 0.30 | | | $ | (0.83 | ) | | $ | 0.51 | | | $ | (0.94 | ) |
| Diluted | | $ | 0.29 | | | $ | (0.83 | ) | | $ | 0.49 | | | $ | (0.94 | ) |
The DSUs described in Note 15, “Stock-Based Compensation” of the Consolidated Financial Statements in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2017 are considered outstanding shares for the purpose of computing basic earnings (loss) per share because they will become issued solely upon the passage of time.
As of June 30, 2018, there was 0.8 million anti-dilutive shares that were not included in the computation of diluted earnings per share. As of June 30, 2017, there was 12.2 million of potentially dilutive stock-based awards that were not included in the computation of diluted loss per share because their inclusion would be anti-dilutive.
| ITEM 2. | MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS |
The following discussion contains management’s discussion and analysis of our financial condition and result of operations and should be read together with the unaudited condensed consolidated financial statements and the related notes thereto included elsewhere in this Quarterly Report on Form 10-Q. This discussion contains forward-looking statements that reflect our plans, estimates and beliefs and involve numerous risks and uncertainties, including, but not limited to, those described in the “Risk Factors” section of our Annual Report on Form 10-K for the fiscal year ended December 31, 2017. Actual results may differ materially from those contained in any forward-looking statements. You should carefully read the “Special Note Regarding Forward-Looking Statements” in this Quarterly Report on Form 10-Q.
Overview
Our Company
We are a leading global provider of mission-critical flow control and compression equipment and associated aftermarket parts, consumables and services, which we sell across multiple attractive end-markets within the industrial, energy and medical industries. We manufacture one of the broadest and most complete ranges of compressor, pump, vacuum and blower products in our markets, which, combined with our global geographic footprint and application expertise, allows us to provide differentiated product and service offerings to our customers. Our products are sold under a collection of premier, market-leading brands, including Gardner Denver, CompAir, Nash, Emco Wheaton, Robuschi, Elmo Rietschle and Thomas, which we believe are globally recognized in their respective end-markets and known for product quality, reliability, efficiency and superior customer service.
Our Segments
We report our results of operations through three reportable segments: Industrials, Energy and Medical.
Industrials
We design, manufacture, market and service a broad range of air compression, vacuum and blower products, including associated aftermarket parts, consumables and services, across a wide array of technologies and applications for use in diverse end-markets. Compressors are used to increase the pressure of air or gas, vacuum products are used to remove air or gas in order to reduce the pressure below atmospheric levels and blower products are used to produce a high volume of air or gas at low pressure. We sell our Industrials products through an integrated network of direct sales representatives and independent distributors, which is strategically tailored to meet the dynamics of each target geography or end-market.
Energy
We design, manufacture, market and service a diverse range of positive displacement pumps, liquid ring vacuum pumps, compressors and integrated systems, engineered fluid loading and transfer equipment and associated aftermarket parts, consumables and services. The highly engineered products offered by our Energy segment serve customers across upstream, midstream and downstream energy markets, as well as petrochemical processing, transportation and general industrial sectors.
Medical
We design, manufacture and market a broad range of highly specialized gas, liquid and precision syringe pumps and compressors that are specified by medical and laboratory equipment suppliers and integrated into their final equipment for use in applications, such as oxygen therapy, blood dialysis, patient monitoring, laboratory sterilization and wound treatment, among others. We offer a comprehensive product portfolio across a breadth of pump technologies to address the medical and laboratory sciences pump and fluid handling industry, as well as a range of end-use vacuum products for laboratory science applications, and we recently expanded into liquid pumps and automated liquid handling components and systems.
Components of Our Revenue and Expenses
Revenues
We generate revenue from sales of our highly engineered, application-critical products and by providing associated aftermarket parts, consumables and services. We sell our products and deliver aftermarket services both directly to end-users and through independent distribution channels, depending on the product line and geography. Below is a description of our revenues by segment and factors impacting total revenues.
Industrials Revenue
Our Industrials Segment Revenues are generated primarily through sales of air compression, vacuum and blower products to customers in multiple industries and geographies. A significant portion of our sales in the Industrials segment are made to independent distributors. The majority of Industrials segment revenues are derived from short duration contracts and revenue is recognized at a single point in time when control is transferred to the customer, generally at shipment or when delivery has occurred or services have been rendered. Certain contracts may involve significant design engineering to customer specifications, and depending on the contractual terms, revenue is recognized either over the duration of the contract or at contract completion when equipment is delivered to the customer. Our large installed base of products in our Industrials segment drives demand for recurring aftermarket support services primarily composed of replacement part sales to our distribution partners and, to a lesser extent, by directly providing replacement parts and repair and maintenance services to end customers. Revenue for services is recognized when services are performed. Historically, our shipments and revenues have peaked during the fourth quarter as our customers seek to fully utilize annual capital spending budgets.
Energy Revenue
Our Energy Segment Revenues are generated primarily through sales of positive displacement pumps, liquid ring vacuum pumps, compressors and integrated systems and engineered fluid loading and transfer equipment and associated aftermarket parts, consumables and services for use primarily in upstream, midstream, downstream and petrochemical end-markets across multiple geographies. The majority of Energy segment revenues are derived from short duration contracts and revenue is recognized at a single point in time when control is transferred to the customer, generally at shipment or when delivery has occurred or services have been rendered. Certain contracts with customers in the mid- and downstream and petrochemical markets are higher sales value and often have longer lead times and involve more application specific engineering. Depending on the contractual terms, revenue is recognized either over the duration of the contract or at contract completion when equipment is delivered to the customer. Provisions for estimated losses on uncompleted contracts are recognized in the period in which such losses are determined to be probable. As a result, the timing of these contracts can result in significant variation in reported revenue from quarter to quarter. Our large installed base of products in our Energy segment drives demand for recurring aftermarket support services to customers, including replacement parts, consumables and repair and maintenance services. The mix of aftermarket to original equipment revenue within the Energy segment is impacted by trends in upstream energy activity in North America. Revenue for services is recognized when services are performed. In response to customer demand for faster access to aftermarket parts and repair services, we expanded our direct aftermarket service locations in our Energy segment, particularly in North American markets driven by upstream energy activity. Energy segment products and aftermarket parts, consumables and services are sold both directly to end customers and through independent distributors, depending on the product category and geography.
Medical Revenue
Our Medical Segment Revenues are generated primarily through sales of highly specialized gas, liquid and precision syringe pumps that are specified by medical and laboratory equipment suppliers for use in medical and laboratory applications. Our products are often subject to extensive collaborative design and specification requirements, as they are generally components specifically designed for, and integrated into, our customers’ products. Revenue is recognized when control is transferred to the customer, generally at shipment or when delivery has occurred. Our Medical segment has no substantive aftermarket revenues.
Expenses
Cost of Sales
Cost of sales includes the costs we incur, including purchased materials, labor and overhead related to manufactured products and aftermarket parts sold during a period. Depreciation related to manufacturing equipment and facilities is included in cost of sales. Purchased materials represent the majority of costs of sales, with steel, aluminum, copper and partially finished castings representing our most significant materials inputs. We have instituted a global sourcing strategy to take advantage of coordinated purchasing opportunities of key materials across our manufacturing plant locations.
Cost of sales for services includes the direct costs we incur, including direct labor, parts and other overhead costs including depreciation of equipment and facilities, to deliver repair, maintenance and other field services to our customers.
Selling and Administrative Expenses
Selling and administrative expenses consist of (i) salaries and other employee-related expenses for our selling and administrative functions and other activities not associated with the manufacture of products or delivery of services to customers; (ii) facility operating expenses for selling and administrative activities, including office rent, maintenance, depreciation and insurance; (iii) marketing and direct costs of selling products and services to customers including internal and external sales commissions; (iv) research and development expenditures; (v) professional and consultant fees; (vi) Sponsor fees and expenses; (vii) expenses related to our public stock offerings and to establish public company reporting compliance; and (viii) other miscellaneous expenses. Certain corporate expenses, including those related to our shared service centers in the United States and Europe, that directly benefit our businesses are allocated to our business segments. Certain corporate administrative expenses, including corporate executive compensation, treasury, certain information technology, internal audit and tax compliance, are not allocated to the business segments.
Amortization of Intangible Assets
Amortization of intangible assets includes the periodic amortization of intangible assets recognized when an affiliate of our Sponsor acquired us on July 30, 2013 and intangible assets recognized in connection with businesses we acquired since July 30, 2013, including customer relationships and trademarks.
Other Operating Expense, Net
Other operating expense, net includes foreign currency gains and losses, restructuring charges, certain litigation and contract settlement losses and recoveries, environmental remediation, stock-based compensation expense and other miscellaneous operating expenses.
Benefit or Provision for Income Taxes
The benefit or provision for income taxes includes U.S. federal, state and local income taxes and all non-U.S. income taxes. We are subject to income tax in approximately 33 jurisdictions outside of the United States. Because we conduct operations on a global basis, our effective tax rate depends, and will continue to depend, on the geographic distribution of our pre-tax earnings among several different taxing jurisdictions. Our effective tax rate can also vary based on changes in the tax rates of the different jurisdictions, the availability of tax credits and non-deductible items.
Items Affecting our Reported Results
General Economic Conditions and Capital Spending in the Industries We Serve
Our financial results closely follow changes in the industries and end-markets we serve. Demand for most of our products depends on the level of new capital investment and planned and unplanned maintenance expenditures by our customers. The level of capital expenditures depends, in turn, on the general economic conditions as well as access to capital at reasonable cost. In particular, demand for our Industrials products generally correlates with the rate of total industrial capacity utilization and the rate of change of industrial production. Capacity utilization rates above 80% have historically indicated a strong demand environment for industrial equipment. In our Energy segment, demand for our products that serve upstream energy end-markets are influenced heavily by energy prices and the expectation as to future trends in those prices. Energy prices have historically been cyclical in nature and are affected by a wide range of factors. As energy prices start improving from low levels observed in the first half of 2016, we have observed increases in drilled but uncompleted wells, global land rig count, wells and footage drilled as well as drilling and completion capital expenditures to positively impact our results of operations. In the midstream and downstream portions of our Energy segment, overall economic growth and industrial production, as well as secular trends, impact demand for our products. In our Medical segment we expect demand for our products to be driven by favorable trends, including the growth in healthcare spend and expansion of healthcare systems due to an aging population requiring medical care and increased investment in health solutions and safety infrastructures in emerging economies. Over longer time periods, we believe that demand for all of our products also tends to follow economic growth patterns indicated by the rates of change in the GDP around the world, as augmented by secular trends in each segment. Our ability to grow and our financial performance will also be affected by our ability to address a variety of challenges and opportunities that are a consequence of our global operations, including efficiently utilizing our global sales, manufacturing and distribution capabilities and engineering innovative new product applications for end-users in a variety of geographic markets.
Foreign Currency Fluctuations
A significant portion of our revenues, approximately 52% for the six month period ended June 30, 2018, was denominated in currencies other than the U.S. dollar. Because much of our manufacturing facilities and labor force costs are outside of the United States, a significant portion of our costs are also denominated in currencies other than the U.S. dollar. Changes in foreign exchange rates can therefore impact our results of operations and are quantified when significant to our discussion.
Seasonality
Historically, our shipments and revenues have peaked during the fourth quarter as our customers seek to fully utilize annual capital spending budgets. Also, our EMEA operations generally experience a slowdown during the July, August and December holiday seasons. General economic conditions may, however, impact future seasonal variations.
Factors Affecting the Comparability of our Results of Operations
As a result of a number of factors, our historical results of operations are not comparable from period to period and may not be comparable to our financial results of operations in future periods. Key factors affecting the comparability of our results of operations are summarized below.
Upstream Energy
We sell products and provide services to customers in upstream energy markets, primarily in the United States. For the upstream energy end-market, in our Energy segment we manufacture pumps and associated aftermarket products and services used in drilling, hydraulic fracturing and well service applications, while in our Industrials segment we sell dry bulk frac sand blowers, which are used in hydraulic fracturing operations. We refer to these products and services in the Energy and Industrial segments as “upstream energy.” Our Medical segment is not exposed to the upstream energy industry.
Our exposure to upstream energy production levels, coupled with reduced exploration activity and the deferral of maintenance and growth in capital expenditures by upstream energy companies, favorably impacted our financial results in the six month period ended June 30, 2018.
The average daily closing of West Texas Intermediate spot market crude oil prices for the six month period ended June 30, 2018 increased to $65.55 from $49.85 in the same period in 2017. As a result, there has been increased exploration activity and capital expenditures by upstream energy companies. According to Baker Hughes, Inc., the average weekly U.S. land rig count increased to 986 during the six month period ended June 30, 2018 from 798 in 2017, and, according to Spears & Associates, Inc., the annual average monthly new wells drilled in the United States increased to 1,967 for the six month period ended June 30, 2018 compared to 1,883 in the same period in 2017. We have experienced increased demand for our upstream energy products and services in the six month period ended June 30, 2018 compared to the same six months in 2017.
Restructuring and Other Business Transformation Initiatives
Our top priority since the completion of the KKR Transaction in 2013 has been the transformation of our business. In 2014, we commenced operational excellence initiatives to streamline our cost structure and support margin expansion, including through manufacturing footprint reduction, selling and administrative expense efficiency, and strategic sourcing in our Industrials, Energy and Medical segments.
A key element of our business transformation initiatives are restructuring programs within our Industrials, Energy, and Medical segments. Restructuring charges, program related facility reorganization, relocation and other costs, and related capital expenditures were impacted most significantly by these business transformation initiatives. Under these restructuring programs, we incurred restructuring charges of $0.0 million and $0.4 million in the three month periods ended June 30, 2018 and 2017, respectively, and $0.0 million and $2.1 million in the six month periods ended June 30, 2018 and 2017, respectively. These restructuring programs were completed in 2017. We generally expect that the savings associated with these restructuring programs will recover the associated costs within two to three years of such costs being incurred. In addition, we incurred program related facility reorganization, relocation and other costs of $8.4 million and $5.2 million in the three month periods ended June 30, 2018 and 2017, respectively, and $12.9 million and $12.1 million in the six month periods ended June 30, 2018 and 2017.
Acquisitions
Given our global reach, market leading position in our various product categories, strong channel access and aftermarket presence and operational excellence competency, we provide an attractive acquisition platform in the flow control and compression equipment sectors. Part of our strategy for growth is to acquire complementary flow control and compression equipment businesses, which provide access to new technologies or geographies or improve our aftermarket offerings.
In June 2017, within our Industrials segment, we acquired a leading North American manufacturer of gas compression equipment and solutions for vapor recovery, biogas and other process and industrial applications for approximately $20.4 million (inclusive of an indemnity holdback of $1.9 million recorded in “Accrued liabilities”). In February 2018, within our Industrials segment, we acquired a leading global manufacturer of turbo vacuum technology systems and optimization solutions for industrial applications for approximately $94.9 million, net of cash acquired. In May 2018, within our Energy segment, we acquired a manufacturer of plungers, pony rods and other well service pump components for approximately $21.0 million, net of cash acquired (inclusive of a $2.0 million promissory note and a $0.2 million holdback recorded in “Accrued liabilities”).
See Note 2 “Business Combinations” to our condensed consolidated financial statements included elsewhere in this Form 10-Q for the impact of the acquisitions on revenue and operating earnings from the date of acquisition.
Sponsor Management Fees and Expenses
Through the date of our initial public offering, our Sponsor charged an annual management fee, as well as fees and expenses for services provided. In May 2017, in connection with our initial public offering, the monitoring agreement was terminated in accordance with its terms and we paid a termination fee of approximately $16.2 million. Sponsor fees and expenses were $1.1 million for the six month period ended June 30, 2017.
Stock-Based Compensation Expense
Under the terms of the 2013 Stock Incentive Plan and the 2017 Omnibus Incentive Plans stock-based compensation expense of $1.8 million and $5.2 million was recognized for the three month and six month periods ended June 30, 2018.
Under the terms of the 2013 Plan, concurrent with the initial public offering, we recognized stock-based compensation expense of approximately $61.4 million related to time-based and performance-based stock options for the six month period ended June 30, 2017. We also recognized $94.8 million of compensation expense related to a grant of 5.5 million deferred stock units (“DSU”) to employees at the date of the initial public offering.
We expect to make stock-based awards to employees and recognize stock-based compensation expense in future periods. Prior to our initial public offering which occurred in May 2017, no stock-based compensation expense was recognized.
Income Taxes
On December 22, 2017, the U.S. government enacted comprehensive tax legislation commonly referred to as the Tax Cuts and Jobs Act (“Tax Act”). The Tax Act makes broad and complex changes to the U.S. tax code that impact the fourth quarter of 2017 and full year 2018.
See Note 13 “Income Taxes” to our condensed consolidated financial statements included elsewhere in this Form 10-Q.
Outlook
Industrials Segment
The mission-critical nature of our Industrials products across manufacturing processes drives a demand environment and outlook that are highly correlated with global and regional industrial production, capacity utilization and long-term GDP growth. In the United States and Europe, we are poised to continue benefiting from expected growth in real GDP, along with a continued rebound in industrial production activity in 2018. In APAC, despite the recent deceleration, GDP growth remains robust. In the second quarter of 2018, we had $336.2 million of orders in our Industrials segment, an increase of 19.5% over the second quarter of 2017, or a 14.8% increase on a constant currency basis.
Energy Segment
Our Energy segment has a diverse range of equipment and associated aftermarket parts, consumables and services for a number of market sectors with energy exposure, spanning upstream, midstream, downstream and petrochemical applications. Demand for certain of our Energy products has historically corresponded to the supply and demand dynamics related to oil and natural gas products, and has been influenced by oil and natural gas prices, the level and intensity of hydraulic fracturing activity, rig count, drilling activity and other economic factors. These factors have caused the level of demand for certain of our Energy products to change at times (both positively and negatively) and we expect these trends to continue in the future. In the second quarter of 2018, we had $303.7 million of orders in our Energy segment, an increase of 14.0% over the second quarter of 2017, or an 11.8% increase on a constant currency basis.
An increased number of drilling rigs have reentered the market as crude oil prices have improved from low points observed during the first half of 2016 and the number of drilled but uncompleted wells has grown 89% from December 2013 to June 2018. Land rig count in the United States has increased 168% from 384 rigs in May 2016 to 1,028 rigs in June 2018 compared to a relatively flat rig count growth in the rest of the world over this same time period. This trend is expected to continue, as Spears & Associates, Inc. projects the U.S. land rig count to grow 8% from the second quarter of 2018 to the fourth quarter of 2018, compared to 4% for the rest of the world (excluding Canada) over this same time period. We believe we are well positioned to benefit from the expected growth in drilling rigs and improvements in crude oil prices. In addition, secular industry trends that are driving increased demand of newer, fit-for-purpose equipment with innovations that increase productivity. As a result of our expanded direct aftermarket service locations, particularly within North America, we believe we are well positioned to benefit from both the increasing intensity of hydraulic fracturing activity and the increase in the backlog of drilled but uncompleted wells.
Our midstream and downstream products provide relatively stable demand with attractive, long-term growth trends related to an expected increase in the production and transportation of hydrocarbons. Demand for our petrochemical industry products correlates with growth in the development of new petrochemical plants as well as activity levels therein. Advancements in the development of unconventional natural gas resources in North America over the past decade have resulted in the abundant availability of locally sourced natural gas as feedstock for petrochemical plants in North America, supporting long-term growth.
Medical Segment
In 2018, we continue to see an uptick in demand for products and services in the Medical space driven by attractive secular growth trends in the aging population requiring medical care, emerging economies modernizing and expanding their healthcare systems and increased investment globally in health solutions. Our entry into Liquid diaphragm pumps and Liquid Handling Automation Systems is seeing favorable response from the market driven by the need for higher healthcare efficiency, requiring premium and high performance systems. In the second quarter of 2018, we had $72.5 million of orders in our Medical segment, an increase of 27.2% over the second quarter of 2017, or a 22.5% increase on a constant currency basis.
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How We Assess the Performance of Our Business
We manage operations through the three business segments described above. In addition to our consolidated GAAP financial measures, we review various non-GAAP financial measures, including Adjusted EBITDA, Adjusted Net Income and Free Cash Flow.
We believe Adjusted EBITDA and Adjusted Net Income are helpful supplemental measures to assist us and investors in evaluating our operating results as they exclude certain items whose fluctuation from period to period do not necessarily correspond to changes in the operations of our business. Adjusted EBITDA represents net loss before interest, taxes, depreciation, amortization and certain non-cash, non-recurring and other adjustment items. We believe that the adjustments applied in presenting Adjusted EBITDA are appropriate to provide additional information to investors about certain material non-cash items and about non-recurring items that we do not expect to continue at the same level in the future. Adjusted Net Income is defined as net loss including interest, depreciation and amortization of non-acquisition related intangible assets and excluding other items used to calculate Adjusted EBITDA and further adjusted for the tax effect of these exclusions.
We use Free Cash Flow to review the liquidity of our operations. We measure Free Cash Flow as cash flows from operating activities less capital expenditures. We believe Free Cash Flow is a useful supplemental financial measure for us and investors in assessing our ability to pursue business opportunities and investments and to service our debt. Free Cash Flow is not a measure of our liquidity under GAAP and should not be considered as an alternative to cash flows from operating activities.
Management and our board of directors regularly use these measures as tools in evaluating our operating and financial performance and in establishing discretionary annual compensation. Such measures are provided in addition to, and should not be considered to be a substitute for, or superior to, the comparable measures under GAAP. In addition, we believe that Adjusted EBITDA, Adjusted Net Income and Free Cash Flow are frequently used by investors and other interested parties in the evaluation of issuers, many of which also present Adjusted EBITDA, Adjusted Net Income and Free Cash Flow when reporting their results in an effort to facilitate an understanding of their operating and financial results and liquidity.
Adjusted EBITDA, Adjusted Net Income and Free Cash Flow should not be considered as alternatives to net income (loss) or any other performance measure derived in accordance with GAAP, or as alternatives to cash flow from operating activities as a measure of our liquidity. Adjusted EBITDA, Adjusted Net Income and Free Cash Flow have limitations as analytical tools, and you should not consider such measures either in isolation or as substitutes for analyzing our results as reported under GAAP.
Included in our discussion of our consolidated and segment results below are changes in revenues and Adjusted EBITDA on a Constant Currency basis. Constant Currency information compares results between periods as if exchange rates had remained constant period over period. We define Constant Currency revenues and Adjusted EBITDA as total revenues and Adjusted EBITDA excluding the impact of foreign exchange rate movements and use it to determine the Constant Currency revenue and Adjusted EBITDA growth on a year-over-year basis. Constant Currency revenues and Adjusted EBITDA are calculated by translating current period revenues and Adjusted EBITDA using corresponding prior period exchange rates. These results should be considered in addition to, not as a substitute for, results reported in accordance with GAAP. Results on a Constant Currency basis, as we present them, may not be comparable to similarly titled measures used by other companies and are not a measure of performance presented in accordance with GAAP.
See “Non-GAAP Financial Measures” below for reconciliation information.
Results of Operations
Consolidated results should be read in conjunction with the segment results section herein and Note 16 “Segment Results” of our unaudited Consolidated Financial Statements included elsewhere in this report, which provides more detailed discussions concerning certain components of our Condensed Consolidated Statements of Operations. All intercompany accounts and transactions have been eliminated within the consolidated results.
The following table presents selected Consolidated Results of Operations of our business for the three and six month periods ended June 30, 2018 and 2017.
| | | For the Three Month Period Ended June 30, | | | For the Six Month Period Ended June 30, | |
| | | 2018 | | | 2017 | | | 2018 | | | 2017 | |
| Condensed Consolidated Statement of Operations: | | | | | | | | | | | | | | |
| Revenues | | $ | 668.2 | | | $ | 579.1 | | | $ | 1,287.7 | | | $ | 1,060.8 | |
| Cost of sales | | | 418.9 | | | | 363.2 | | | | 806.6 | | | | 670.3 | |
| Gross profit | | | 249.3 | | | | 215.9 | | | | 481.1 | | | | 390.5 | |
| Selling and administrative expenses | | | 115.8 | | | | 125.6 | | | | 222.6 | | | | 228.0 | |
| Amortization of intangible assets | | | 31.5 | | | | 30.5 | | | | 62.4 | | | | 58.1 | |
| Other operating expense, net | | | 0.6 | | | | 161.4 | | | | 4.9 | | | | 169.3 | |
| Operating income (loss) | | | 101.4 | | | | (101.6 | ) | | | 191.2 | | | | (64.9 | ) |
| Interest expense | | | 26.1 | | | | 39.5 | | | | 52.1 | | | | 85.3 | |
| Loss on extinguishment of debt | | | 0.2 | | | | 50.4 | | | | 0.2 | | | | 50.4 | |
| Other income, net | | | (2.4 | ) | | | (1.3 | ) | | | (4.5 | ) | | | (1.8 | ) |
| Income (loss) before income taxes | | | 77.5 | | | | (190.2 | ) | | | 143.4 | | | | (198.8 | ) |
| Provision (benefit) for income taxes | | | 17.2 | | | | (43.9 | ) | | | 40.7 | | | | (45.6 | ) |
| Net income (loss) | | | 60.3 | | | | (146.3 | ) | | | 102.7 | | | | (153.2 | ) |
| Less: Net income attributable to noncontrolling interest | | | - | | | | - | | | | - | | | | 0.1 | |
| Net income (loss) attributable to Gardner Denver Holdings, Inc | | $ | 60.3 | | | $ | (146.3 | ) | | $ | 102.7 | | | $ | (153.3 | ) |
| | | | | | | | | | | | | | | | | |
| Percentage of Revenues: | | | | | | | | | | | | | | | | |
| Gross profit | | | 37.3 | % | | | 37.3 | % | | | 37.4 | % | | | 36.8 | % |
| Selling and administrative expenses | | | 17.3 | % | | | 21.7 | % | | | 17.3 | % | | | 21.5 | % |
| Operating income (loss) | | | 15.2 | % | | | (17.5 | %) | | | 14.8 | % | | | (6.1 | %) |
| Net income (loss) | | | 9.0 | % | | | (25.3 | %) | | | 8.0 | % | | | (14.4 | %) |
| Adjusted EBITDA | | | 24.2 | % | | | 22.8 | % | | | 24.1 | % | | | 21.1 | % |
| | | | | | | | | | | | | | | | | |
| Other Financial Data: | | | | | | | | | | | | | | | | |
Adjusted EBITDA(1) | | | 161.6 | | | | 132.1 | | | | 309.8 | | | | 224.2 | |
Adjusted Net Income (1) | | | 92.4 | | | | 43.7 | | | | 173.2 | | | | 63.9 | |
| Cash flows - operating activities | | | 134.3 | | | | 22.6 | | | | 194.5 | | | | 20.0 | |
| Cash flows - investing activities | | | (29.4 | ) | | | (24.1 | ) | | | (131.4 | ) | | | (40.6 | ) |
| Cash flows - financing activities | | | (106.3 | ) | | | 14.2 | | | | (114.5 | ) | | | 0.8 | |
Free Cash Flow (1) | | | 123.5 | | | | 12.2 | | | | 173.6 | | | | (6.8 | ) |
| (1) | See the “Non-GAAP Financial Measures” section included in this Quarterly Report for a reconciliation to the nearest GAAP measure. |
Revenues
Revenues for the three month period ended June 30, 2018 were $668.2 million, an increase of $89.1 million, or 15.4%, compared to $579.1 million for the same three month period in 2017. The increase in revenues was due primarily to higher revenues from upstream energy exposed markets in our Energy segment (4.1% or $23.6 million), higher volume in our Industrials segment including acquisitions as well as higher volume in the other markets in our Energy segment and our Medical segment (7.0% or $40.3 million), the favorable impact of foreign currencies (3.3% or $19.1 million) and improved pricing (1.1% or $6.1 million). The percentage of consolidated revenues derived from aftermarket parts and services was 38.9% in the three month period ended June 30, 2018 compared to 41.7% in the same three month period in 2017.
Revenues for the six month period ended June 30, 2018 were $1,287.7 million, an increase of $226.9 million, or 21.4% compared to $1,060.8 million for the same six month period in 2017. The increase in revenues was due primarily to higher revenues from upstream energy exposed markets in our Energy segment (7.5% or $79.8 million), the favorable impact of foreign currencies (4.8% or $51.4 million), higher volume in our Industrials segment including acquisitions as well as higher volume in the other markets in our Energy segment and our Medical segment (8.0% or $84.7 million) and improved pricing (1.0% or $11.0 million). The percentage of consolidated revenues derived from aftermarket parts and services was 39.9% in the six month period ended June 30, 2018 compared to 43.1%
Gross Profit
Gross profit for the three month period ended June 30, 2018 was $249.3 million, an increase of $33.4 million, or 15.5%, compared to $215.9 million for the same three month period in 2017, and as a percentage of revenues was 37.3% for the three month periods ended June 30, 2018, and 2017. The increase reflects higher revenues from upstream energy exposed markets in our Energy segment, higher volume in the other markets in our Energy segment as well as our Industrials and Medical segments, revenues from acquisitions in the second quarter of 2017 and first quarter of 2018 in our Industrials segment, and improved pricing.
Gross profit for the six month period ended June 30, 2018 was $481.1 million, an increase of $90.6 million, or 23.2% compared to $390.5 million in the same six month period in 2017, and as a percentage of revenues was 37.4% for the six month period ended June 30, 2018 and 36.8% for the same six month period in 2017. The increase reflects higher revenues from upstream energy exposed markets in our Energy segment, higher volume in the other markets in our Energy segment as well as our Industrials and Medical segments, revenues from acquisitions in the second quarter of 2017 and first quarter of 2018 in our Industrials segment, and improved pricing.
Selling and Administrative Expenses
Selling and administrative expenses were $115.8 million for the three month period ended June 30, 2018, a decrease of $9.8 million, or 7.8%, compared to $125.6 million for the same three month period in 2017. Selling and administrative expenses as a percentage of revenues decreased to 17.3% for the three month period ended June 30, 2018 from 21.7% in the same three month period in 2017. The decrease in selling and administrative expenses primarily reflects lower salaries and other employee related costs and lower sponsor fees, partially offset by higher professional and consulting fees, increased facility operating expenses, and increased sales commissions.
Selling and administrative expenses were $222.6 million for the six month period ended June 30, 2018, a decrease of $5.4 million, or 2.4%, compared to $228.0 million for the same six month period in 2017. Selling and administrative expenses as a percentage of revenues decreased to 17.3% for the six month period ended June 30, 2018 from 21.5% in the same six month period in 2017. The decrease in selling and administrative expenses primarily reflects lower sponsor fees, partially offset by higher salaries and other employee related costs, higher professional and consulting fees, increased facility operating expenses, and increased sales commissions.
Amortization of Intangible Assets
Amortization of intangible assets was $31.5 million for the three month period ended June 30, 2018, an increase of $1.0 million, compared to $30.5 million in the same three month period in 2017. The increase was primarily due to amortization of intangibles acquired in the second quarter of 2017 and the first and second quarters of 2018.
Amortization of intangible assets was $62.4 million for the six month period ended June 30, 2018, an increase of $4.3 million, compared to $58.1 million in the same six month period in 2017. The increase was primarily due to amortization of intangibles acquired in the second quarter of 2017 and the first and second quarters of 2018.
Other Operating Expense, Net
Other operating expense, net for the three month period ended June 30, 2018 was $0.6 million, a decrease of $160.8 million, compared to $161.4 million in the same three month period in 2017. The decrease was primarily due to lower stock-based compensation expense ($157.0 million), increased foreign currency transaction gains, net ($6.4 million, consisting of $2.4 million of gains in the three month period ended June 30, 2018 compared to losses of $4.0 million in the same period in 2017), and lower restructuring charges, net ($0.4 million), partially offset by increased acquisition related expenses and non-cash charges ($1.9 million), and lower gains on asset and business disposals ($0.6 million).
Other operating expense, net for the six month period ended June 30, 2018 was $4.9 million, a decrease of $164.4 million, compared to $169.3 million in the same six month period in 2017. The decrease was primarily due to lower stock-based compensation expense ($154.3 million), a shareholder litigation settlement recovery received in 2018 ($4.5 million), lower foreign currency transaction losses, net ($4.5 million), increased gains on asset and business disposals ($3.7 million, consisting of $1.2 million of gains in the six month period ended June 30, 2018 compared to losses of $2.5 million in the same period in 2017), lower restructuring charges, net ($2.1 million), and lower environmental remediation expenses ($0.9 million), and partially offset by increased acquisition related expenses and non-cash charges ($4.1 million).
Interest Expense
Interest expense for the three month period ended June 30, 2018 was $26.1 million, a decrease of $13.4 million, compared to $39.5 million in the same three month period in 2017. The decrease was primarily due to a lower weighted-average interest rate of approximately 5.2% for the three month period ended June 30, 2018 compared to 6.5% in the same three month period in 2017.
Interest expense for the six month period ended June 30, 2018 was $52.1 million, a decrease of $33.2 million, compared to $85.3 million in the same six month period in 2017. The decrease was primarily due to reduced debt as a result of repayments of debt with proceeds from our initial public offering in May 2017, and a lower weighted-average interest rate of approximately 5.1% in the six month period ended June 30, 2018 compared to 6.5% in the same six month period in 2017.
Other Income, Net
Other income, net was $2.4 million in the three month period ended June 30, 2018 and $1.3 million in the same three month period in 2017, consisting primarily of investment income and realized and unrealized gains and losses on investments.
Other income, net was $4.5 million in the six month period ended June 30, 2018 and $1.9 million in the same six month period in 2017, consisting primarily of investment income and realized and unrealized gains and losses on investments.
Provision (Benefit) for Income Taxes
The provision for income taxes was $17.2 million resulting in a 22.2% effective income tax provision rate for the three month period ended June 30, 2018, compared to a benefit for income taxes of ($43.9) million resulting in a 23.1% effective income tax benefit rate in the same three month period in 2017. The increase in the provision for income taxes for the three month period ended June 30, 2018 when compared to the same three month period of 2017 is primarily due to the overall increase in global earnings when compared to the prior year. The effective income tax provision rate was impacted by the increase in global earnings and reduced by the windfall tax benefit to result in an overall decrease in the rate for the three month period ended June 30, 2018 when compared to the same three month period of 2017.
The provision for income taxes was $40.7 million resulting in a 28.4% effective income tax provision rate for the six month period ended June 30 2018, compared to a benefit for income taxes of ($45.6) million resulting in a 22.9% effective income tax benefit rate in the same six month period in 2017. The increase in the provision for income taxes and increase in the effective income tax provision rate for the six month period ended June 30, 2018 when compared to the same six month period of 2017 is primarily due to the overall increase in global earnings when compared to the prior year.
Net Income (Loss)
Net income was $60.3 million for the three month period ended June 30, 2018 compared to a net loss of $146.3 million in the same three month period in 2017. The increase in net income was primarily due to higher gross profit on increased revenues, reduced interest expense, lower selling and administrative expenses, reduced loss on the extinguishment of debt, and lower other operating expenses, net, partially offset by an increased provision for income taxes and higher amortization expenses.
Net income was $102.7 million for the six month period ended June 30, 2018 compared to a net loss of $153.2 million in the same six month period in 2017. The increase in net income was primarily due to higher gross profit on increased revenues, reduced interest expense, lower selling and administrative expenses, reduced loss on the extinguishment of debt, and lower other operating expenses, net, partially offset by an increased provision for income taxes and higher amortization expenses.
Adjusted EBITDA
Adjusted EBITDA increased $29.5 million to $161.6 million for the three month period ended June 30, 2018 compared to $132.1 million in the same three month period in 2017. Adjusted EBITDA as a percentage of revenues increased 140 basis points to 24.2% for the three month period ended June 30, 2018 from 22.8% for the same three month period in 2017. The increase in Adjusted EBITDA was primarily due to higher volume including acquisitions in our Industrials segment as well as higher volume in the other markets in our Energy segment and our Medical segment ($15.2 million), increased revenues in upstream energy exposed markets in our Energy segment ($14.0 million), improved pricing ($6.1 million), the favorable impact of foreign currencies ($4.6 million) and lower selling and administrative expenses ($2.0 million), partially offset by a shift in Industrials segment revenue mix driven by strong original equipment sales and a decrease in aftermarket revenues as a percentage of total revenues for the three month period ended June 30, 2018 as compared to the same three month period in 2017 and continued investments in innovation, including research and development and in emerging markets.
Adjusted EBITDA increased $85.6 million to $309.8 million for the six month period ended June 30, 2018 compared to $224.2 million in the same six month period in 2017. Adjusted EBITDA as a percentage of revenues increased 300 basis points to 24.1% for the six month period ended June 30, 2018 from 21.1% for the same six month period in 2017. The increase in Adjusted EBITDA was primarily due to increased revenues in upstream energy exposed markets in our Energy segment ($44.0 million), higher volume including acquisitions in our Industrials segment as well as higher volume in the other markets in our Energy segment and our Medical segment ($33.0 million), the favorable impact of foreign currencies ($11.7 million), improved pricing ($11.0 million), and lower selling and administrative expenses ($7.3 million), partially offset by a shift in Industrials segment revenue mix driven by strong original equipment sales and a decrease in aftermarket revenues as a percentage of total revenues for the six month period ended June 30, 2018 as compared to the same six month period in 2017 and continued investments in innovation, including research and development and in emerging markets.
Adjusted Net Income
Adjusted Net Income increased $48.7 million to $92.4 million for the three month period ended June 30, 2018, compared to $43.7 million in the same three month period in 2017. The increase was due to increased Adjusted EBITDA and lower interest expense and a decreased income tax provision as adjusted, partially offset by increased depreciation expense, and amortization of non-acquisition related intangible assets.
Adjusted Net Income increased $109.3 million to $173.2 million for the six month period ended June 30, 2018 compared to $63.9 million in the same six month period in 2017. The increase was due to increased Adjusted EBITDA and lower interest expense, partially offset by an increase in the income tax provision, as adjusted, an increase in depreciation expense, and an increase in amortization of non-acquisition related intangible assets.
Non-GAAP Financial Measures
Set forth below are the reconciliations of Net Income (Loss) to Adjusted EBITDA and Adjusted Net Income and Cash Flows from Operating Activities to Free Cash Flow.
| | | For the Three Month Period Ended June 30, | | | For the Six Month Period Ended June 30, | |
| | | 2018 | | | 2017 | | | 2018 | | | 2017 | |
Net Income (Loss)(1) | | $ | 60.3 | | | $ | (146.3 | ) | | $ | 102.7 | | | $ | (153.2 | ) |
| Plus: | | | | | | | | | | | | | | | | |
| Interest expense | | | 26.1 | | | | 39.5 | | | | 52.1 | | | | 85.3 | |
| Provision (benefit) for income taxes | | | 17.2 | | | | (43.9 | ) | | | 40.7 | | | | (45.6 | ) |
| Depreciation expense | | | 13.8 | | | | 13.3 | | | | 27.8 | | | | 25.4 | |
Amortization expense(a) | | | 31.5 | | | | 30.5 | | | | 62.4 | | | | 58.1 | |
Sponsor fees and expenses(b) | | | - | | | | 16.2 | | | | - | | | | 17.3 | |
Restructuring and related business transformation costs(c) | | | 8.4 | | | | 5.6 | | | | 12.9 | | | | 14.2 | |
Acquisition related expenses and non-cash charges(d) | | | 5.7 | | | | 1.2 | | | | 10.3 | | | | 1.9 | |
Environmental remediation loss reserve(e) | | | - | | | | (0.1 | ) | | | - | | | | 0.9 | |
Expenses related to public stock offerings(f) | | | 0.5 | | | | 1.8 | | | | 1.9 | | | | 3.2 | |
Establish public company financial reporting compliance(g) | | | 1.1 | | | | 2.1 | | | | 1.9 | | | | 3.3 | |
Stock-based compensation(h) | | | (0.8 | ) | | | 156.2 | | | | 1.9 | | | | 156.2 | |
| Foreign currency transaction (gains) losses, net | | | (2.4 | ) | | | 4.0 | | | | 0.2 | | | | 4.7 | |
Loss on extinguishment of debt(i) | | | 0.2 | | | | 50.4 | | | | 0.2 | | | | 50.4 | |
Shareholder litigation settlement recoveries(j) | | | - | | | | - | | | | (4.5 | ) | | | - | |
Other adjustments(k) | | | - | | | | 1.6 | | | | (0.7 | ) | | | 2.1 | |
| Adjusted EBITDA | | $ | 161.6 | | | $ | 132.1 | | | $ | 309.8 | | | $ | 224.2 | |
| Minus: | | | | | | | | | | | | | | | | |
| Interest expense | | $ | 26.1 | | | $ | 39.5 | | | $ | 52.1 | | | $ | 85.3 | |
Income tax provision, as adjusted(l) | | | 25.4 | | | | 32.3 | | | | 49.9 | | | | 44.5 | |
| Depreciation expense | | | 13.8 | | | | 13.3 | | | | 27.8 | | | | 25.4 | |
| Amortization of non-acquisition related intangible assets | | | 3.9 | | | | 3.3 | | | | 6.8 | | | | 5.1 | |
| Adjusted Net Income | | $ | 92.4 | | | $ | 43.7 | | | $ | 173.2 | | | $ | 63.9 | |
| Free Cash Flow | | | | | | | | | | | | | | | | |
| Cash flows - operating activities | | $ | 134.3 | | | $ | 22.6 | | | $ | 194.5 | | | $ | 20.0 | |
| Minus: | | | | | | | | | | | | | | | | |
| Capital expenditures | | | 10.8 | | | | 10.4 | | | | 20.9 | | | | 26.8 | |
| Free Cash Flow | | $ | 123.5 | | | $ | 12.2 | | | $ | 173.6 | | | $ | (6.8 | ) |
| (1) | The reconciling items for the three and six month periods ended June 30, 2017 have been reclassified to conform to the methodology used in the three and six month periods ended June 30, 2018, and include the following. |
| (a) | Represents $27.6 million and $27.2 million of amortization of intangible assets arising from the KKR transaction and other acquisitions (customer relationships and trademarks) and $3.9 million and $3.3 million of amortization of non-acquisition related intangible assets, in each case for the three month periods ended June 30, 2018 and 2017, respectively. Represents $55.6 million and $53.0 million of amortization of intangible assets arising from the KKR transaction and other acquisitions (customer relationships and trademarks) and $6.8 million and $5.1 million of amortization of non-acquisition related intangible assets, in each case for the six month periods ended June 30, 2018 and 2017, respectively. |
| (b) | Represents management fees and expenses paid to our Sponsor. |
| (c) | Restructuring and related business transformation costs consisted of the following. |
| | | For the Three Month Period Ended June 30, | | | For the Six Month Period Ended June 30, | |
| | | 2018 | | | 2017 | | | 2018 | | | 2017 | |
| Restructuring charges | | $ | - | | | $ | 0.4 | | | $ | - | | | $ | 2.1 | |
| Severance, sign-on, relocation and executive search costs | | | 1.9 | | | | 0.6 | | | | 3.9 | | | | 1.6 | |
| Facility reorganization, relocation and other costs | | | 0.7 | | | | 1.8 | | | | 1.3 | | | | 2.9 | |
| Information technology infrastructure transformation | | | 0.2 | | | | 2.0 | | | | 0.2 | | | | 2.7 | |
| (Gains) losses on asset and business disposals | | | - | | | | (0.5 | ) | | | (1.2 | ) | | | 2.5 | |
| Consultant and other advisor fees | | | 4.0 | | | | 0.8 | | | | 6.6 | | | | 1.2 | |
| Other, net | | | 1.6 | | | | 0.5 | | | | 2.1 | | | | 1.2 | |
| Total restructuring and related business transformation costs | | $ | 8.4 | | | $ | 5.6 | | | $ | 12.9 | | | $ | 14.2 | |
| (d) | Represents costs associated with successful and/or abandoned acquisitions, including third-party expenses, post-closure integration costs and cash charges and credits arising from fair value purchase accounting adjustments. |
| (e) | Represents estimated environmental remediation costs and losses relating to a former production facility. |
| (f) | Represents certain expenses related to our initial public offering and subsequent secondary offerings. |
| (g) | Represents third party expenses to comply with the requirements of Sarbanes-Oxley in 2018 and the accelerated adoption of the new revenue recognition standard (ASC 606 – Revenue from Contracts with Customers) in the first quarter of 2018, one year ahead of the required adoption date for a private company. These expenses were previously included in “Expenses related to initial stock offering” and prior periods have been restated to conform to current period presentation. |
| (h) | Represents stock-based compensation expense recognized for the three month and six month periods ended June 30, 2018 of $1.8 million and $5.2 million, respectively, reduced by a ($2.6 million) and ($3.3 million) decrease in the estimated accrual for employer taxes for the three month and six month periods ended June 30, 2018, respectively, as a result of the achievement of employer tax caps in countries outside of the United States. Represents stock-based compensation expense recognized for stock options outstanding of $61.4 million and DSUs granted to employees at the date of the initial public offering of $94.8 million under the 2013 Stock Incentive Plan for the three and six month periods ended June 30, 2017. |
| (i) | Represents loss on extinguishment of the senior notes and a portion of the U.S. term loan. |
| (j) | Represents an insurance recovery of our shareholder litigation settlement in 2014. |
| (k) | Includes (i) effects of amortization of prior service costs and amortization of gains in pension and other postemployment (OPEB) expense, (ii) certain legal and compliance costs and (iii) other miscellaneous adjustments. |
| (l) | Represents our income tax provision adjusted for the tax effect of pre-tax items excluded from Adjusted Net Income and the removal of applicable discrete tax items. The tax effect of pre-tax items excluded from Adjusted Income is computed using the statutory tax rate related to the jurisdiction that was impacted by the adjustment after taking into account the impact of permanent differences and valuation allowances. Discrete tax items include changes in tax laws or rates, changes in uncertain tax positions relating to prior years and changes in valuation allowances. All impacts relating to the Tax Cuts and Jobs Act of 2017 have been included as adjustments on the “Tax law change” line of the table below. |
The income tax provision, as adjusted for each of the periods presented below consisted of the following.
| | | For the Three Month Period Ended June 30, | | | For the Six Month Period Ended June 30, | |
| | | 2018 | | | 2017 | | | 2018 | | | 2017 | |
| Provision (benefit) for income taxes | | $ | 17.2 | | | $ | (43.9 | ) | | $ | 40.7 | | | $ | (45.6 | ) |
| Tax impact of pre-tax income adjustments | | | 7.7 | | | | 76.0 | | | | 16.6 | | | | 88.8 | |
| Tax law change | | | - | | | | - | | | | (7.9 | ) | | | - | |
| Discrete tax items | | | 0.5 | | | | 0.2 | | | | 0.5 | | | | 1.3 | |
| Income tax provision, as adjusted | | $ | 25.4 | | | $ | 32.3 | | | $ | 49.9 | | | $ | 44.5 | |
Segment Results
We classify our businesses into three segments: Industrials, Energy and Medical. Our Corporate operations (as described below) are not discussed separately as any results that had a significant impact on operating results are included in the “Results of Operations” discussion above.
We evaluate the performance of our Segments based on Segment Revenues and Segment Adjusted EBITDA. Segment Adjusted EBITDA is indicative of operational performance and ongoing profitability. Our management closely monitors Segment Adjusted EBITDA to evaluate past performance and identify actions required to improve profitability.
The Segment measurements provided to and evaluated by the chief operating decision maker are described in Note 16 “Segment Results” in the “Notes to Consolidated Financial Statements” included in this Report.
Included in our discussion of our Segment results below are changes in Segment Revenues and Segment Adjusted EBITDA on a Constant Currency basis. Constant Currency information compares results between periods as if exchange rates had remained constant period over period. We define Constant Currency as changes in Segment Revenues and Segment Adjusted EBITDA excluding the impact of foreign exchange rate movements. We use these measures to determine the Constant Currency Segment Revenues and Segment Adjusted EBITDA growth on a year-on-year basis. Constant Currency Segment Revenues and Segment Adjusted EBITDA are calculated by translating current period Segment Revenues and Segment Adjusted EBITDA using prior period exchange rates. These results should be considered in addition to, not as a substitute for, results reported in accordance with GAAP. Results on a constant currency basis, as we present them, may not be comparable to similarly titled measures used by other companies and are not a measure of performance presented in accordance with GAAP.
Segment Results for the Three and Six Month Periods Ended June 30, 2018 and 2017
The following tables display Segment Revenues, Segment Adjusted EBITDA and Segment Adjusted EBITDA Margin (Segment Adjusted EBITDA as a percentage of Segment Revenues) for each of our Segments and illustrates, on a percentage basis, the impact of foreign currency fluctuations on Segment Revenues and Segment Adjusted EBITDA growth.
Industrials Segment Results
| | | For the Three Month Period Ended June 30, | | | Percent Change | | | Constant Currency Percent Change | |
| | | 2018 | | | 2017 | | | 2018 vs. 2017 | | | 2018 vs. 2017 | |
| Segment Revenues | | $ | 328.7 | | | $ | 282.8 | | | | 16.2 | % | | | 11.8 | % |
| Segment Adjusted EBITDA | | $ | 71.1 | | | $ | 63.4 | | | | 12.1 | % | | | 7.4 | % |
| Segment Margin | | | 21.6 | % | | | 22.4 | % | | | | | | | | |
Segment Revenues for the three month period ended June 30, 2018 were $328.7 million, an increase of $45.9 million, or 16.2%, compared to $282.8 million in the same three month period in 2017. The increase in Segment Revenues was due to higher volume including acquisitions (9.9% or $27.9 million), the favorable impact of foreign currencies (4.5% or $12.6 million) and improved pricing (1.9% or $5.4 million). The percentage of Segment Revenues derived from aftermarket parts and services was 31.4% in the three month period ended June 30, 2018 compared to 34.6% in the same three month period in 2017.
Segment Adjusted EBITDA for the three month period ended June 30, 2018 was $71.1 million, an increase of $7.7 million, or 12.1%, compared to $63.4 million in the same three month period in 2017. Segment Adjusted EBITDA Margin decreased 80 basis points to 21.6% from 22.4% in 2017. The increase in Segment Adjusted EBITDA was primarily due to higher volume including acquisitions ($8.3 million), improved pricing ($5.4 million), and the favorable impact of foreign currencies ($3.0 million), partially offset by a shift in Industrials segment revenue mix driven by strong original equipment sales and a decrease in aftermarket revenues as a percentage of total revenues for the three month period ended June 30, 2018 as compared to the same three month period in 2017 and continued investments in innovation, including research and development and in emerging markets.
| | | For the Six Month Period Ended June 30, | | | Percent Change | | | Constant Currency Percent Change | |
| | | 2018 | | | 2017 | | | 2018 vs. 2017 | | | 2018 vs. 2017 | |
| Segment Revenues | | $ | 645.6 | | | $ | 530.8 | | | | 21.6 | % | | | 14.9 | % |
| Segment Adjusted EBITDA | | $ | 137.9 | | | $ | 110.6 | | | | 24.7 | % | | | 17.0 | % |
| Segment Margin | | | 21.4 | % | | | 20.8 | % | | | | | | | | |
Segment Revenues for the six month period ended June 30, 2018 was $645.6 million an increase of $114.8 million, or 21.6%, compared to $530.8 million in the same six month period in 2017. The increase in Segment Revenues was due to higher volume including acquisitions (13.1% or $69.4 million), the favorable impact of foreign currencies (6.7% or $35.5 million) , and improved pricing (1.9% or $9.9 million). The percentage of Segment Revenues derived from aftermarket parts and service was 31.7% in the six month period ended June 30, 2018, compared to 35.3% in the same six month period in 2017.
Segment Adjusted EBITDA for the six month period ended June 30, 2018 was $137.9 million, an increase of $27.3 million, or 24.7%, compared to $110.6 million in the same six month period in 2017. Segment Adjusted EBITDA Margin increased 60 basis points to 21.4% from 20.8% in 2017. The increase in Segment Adjusted EBITDA was primarily due to higher volume including acquisitions ($24.4 million), improved pricing ($9.9 million), and the favorable impact of foreign currencies ($8.5 million), partially offset by a shift in Industrials segment revenue mix driven by strong original equipment sales and a decrease in aftermarket revenues as a percentage of total revenues for the six month period ended June 30, 2018 as compared to the same six month period in 2017 and continued investments in innovation, including research and development and in emerging markets.
Energy Segment Results
| | | For the Three Month Period Ended June 30, | | | Percent Change | | | Constant Currency Percent Change | |
| | | 2018 | | | 2017 | | | 2018 vs. 2017 | | | 2018 vs. 2017 | |
| Segment Revenues | | $ | 273.1 | | | $ | 239.5 | | | | 14.0 | % | | | 12.2 | % |
| Segment Adjusted EBITDA | | $ | 79.7 | | | $ | 62.2 | | | | 28.1 | % | | | 26.4 | % |
| Segment Margin | | | 29.2 | % | | | 26.0 | % | | | | | | | | |
Segment Revenues for the three month period ended June 30, 2018 were $273.1 million, an increase of $33.6 million, or 14.0%, compared to $239.5 million in the same three month period in 2017. The increase in Segment Revenues was due to higher revenues from upstream energy exposed markets (9.9% or $23.6 million), higher volume in other markets of our Energy Segment (2.5% or $6.0 million), and the favorable impact of foreign currencies (1.7% or $4.0 million). The percentage of Segment Revenues derived from aftermarket parts and services was 56.6% in the three month period ended June 30, 2018 compared to 58.1% in the same three month period in 2017.
Segment Adjusted EBITDA for the three month period ended June 30, 2018 was $79.7 million, an increase of $17.5 million, or 28.1% compared to $62.2 million in the same three month period in 2017. Segment Adjusted EBITDA Margin increased 320 basis points to 29.2% from 26.0% in 2017. The increase in Segment Adjusted EBITDA was primarily due to increased revenues from upstream energy exposed markets ($14.0 million), higher volume in other markets in our Energy segment ($3.6 million), and the favorable impacts of foreign currencies ($1.0 million).
| | | For the Six Month Period Ended June 30, | | | Percent Change | | | Constant Currency Percent Change | |
| | | 2018 | | | 2017 | | | 2018 vs. 2017 | | | 2018 vs. 2017 | |
| Segment Revenues | | $ | 515.3 | | | $ | 417.7 | | | | 23.4 | % | | | 20.9 | % |
| Segment Adjusted EBITDA | | $ | 147.6 | | | $ | 100.6 | | | | 46.7 | % | | | 44.9 | % |
| Segment Margin | | | 28.6 | % | | | 24.1 | % | | | | | | | | |
Segment Revenues for the six month period ended June 30, 2018 were $515.3 million, an increase of $97.6 million, or 23.4%, compared to $417.7 million in the same six month period in 2017. The increase in Segment Revenues was due to higher revenues from upstream energy exposed markets (19.1% or $79.8 million), the favorable impact of foreign currencies (2.2% or $9.1 million), and higher volume in other markets of our Energy Segment (2.1% or $8.8 million). The percentage of Segment Revenues derived from aftermarket parts and service was 59.2% in the six month period ended June 30, 2018 compared to 63.6% in the same six month period in 2017.
Segment Adjusted EBITDA for the six month period ended June 30, 2018 was $147.6 million, an increase of $47.0 million, or 46.7%, compared to $100.6 million in the same six month period in 2017. Segment Adjusted EBITDA Margin increased 450 basis points to 28.6% from 24.1% in 2017. The increase in Segment Adjusted EBITDA was primarily due to increased revenues from upstream energy exposed markets ($44.0 million), higher volume in other markets in our Energy segment ($5.3 million), and the favorable impacts of foreign currencies ($1.7 million).
Medical Segment Results
| | | For the Three Month Period Ended June 30, | | | Percent Change | | | Constant Currency Percent Change | |
| | | 2018 | | | 2017 | | | 2018 vs. 2017 | | | 2018 vs. 2017 | |
| Segment Revenues | | $ | 66.4 | | | $ | 56.8 | | | | 16.9 | % | | | 12.3 | % |
| Segment Adjusted EBITDA | | $ | 18.0 | | | $ | 15.4 | | | | 16.9 | % | | | 11.0 | % |
| Segment Margin | | | 27.1 | % | | | 27.1 | % | | | | | | | | |
Segment Revenues for the three month period ended June 30, 2018 were $66.4 million, an increase of $9.6 million, or 16.9%, compared to $56.8 million in the same three month period in 2017. The increase in Segment Revenues was due to higher volume (11.7% or $6.7 million) and, the favorable impact of foreign currencies (4.5% or $2.5 million). The percentage of Segment Revenues derived from aftermarket parts and services was 3.3% in the three month period ended June 30, 2018 compared to 8.1% in the same three month period in 2017.
Segment Adjusted EBITDA for the three month period ended June 30, 2018 was $18.0 million, an increase of $2.6 million, or 16.9%, compared to $15.4 million in the same three month period in 2017. Segment Adjusted EBITDA Margin was 27.1% in both periods. The increase in Segment Adjusted EBITDA was primarily due to higher volume ($3.6 million) and, the favorable impact of foreign currencies ($0.9 million).
| | | For the Six Month Period Ended June 30, | | | Percent Change | | | Constant Currency Percent Change | |
| | | 2018 | | | 2017 | | | 2018 vs. 2017 | | | 2018 vs. 2017 | |
| Segment Revenues | | $ | 126.8 | | | $ | 112.3 | | | | 12.9 | % | | | 6.9 | % |
| Segment Adjusted EBITDA | | $ | 33.9 | | | $ | 30.1 | | | | 12.6 | % | | | 5.3 | % |
| Segment Margin | | | 26.7 | % | | | 26.8 | % | | | | | | | | |
Segment Revenues for the six month period ended June 30, 2018 were $126.8 million, an increase of $14.5 million, or 12.9%, compared to $112.3 million in the same six month period in 2017. The increase in Segment Revenues was due to higher volume (6.4% or $7.2 million) and, the favorable impact of foreign currencies (6.1% or $6.8 million. The percentage of Segment Revenues derived from aftermarket parts and service was 3.6% in the six month period ended June 30, 2018 compared to 4.1% in the same six month period in 2017.
Segment Adjusted EBITDA for the six month period ended June 30, 2018 was $33.9 million, an increase of $3.8 million, or 12.6% compared to $30.1 million in the same six month period in 2017. The increase in Segment Adjusted EBITDA was primarily due to higher volume ($3.9 million) and the favorable impact of foreign currencies ($2.2 million).
Liquidity and Capital Resources
Our investment resources include cash generated from operations and borrowings under our Revolving Credit Facility and the Receivables Financing Agreement.
As of June 30, 2018, we had $7.0 million of outstanding letters of credit written against the Revolving Credit Facility and $353.0 million of unused availability. We also had $32.1 million of letters of credit outstanding against the Receivables Financing Agreement and $82.2 million of unused availability.
See the description of these line-of-credit resources as well as our outstanding debt obligations in Note 8 “Debt” to the Condensed Consolidated Financial Statements.
As of June 30, 2018 and 2017, we were in compliance with all of our debt covenants and no event of default had occurred or was ongoing.
Liquidity
A substantial portion of our liquidity needs arise from debt service requirements, and from the ongoing cost of operations, working capital and capital expenditures.
| | | June 30, 2018 | | | December 31, 2017 | |
| Cash and cash equivalents | | $ | 337.8 | | | $ | 393.3 | |
| Short-term borrowings and current maturities of long-term debt | | | 7.9 | | | | 20.9 | |
| Long-term debt | | | 1,903.5 | | | | 2,019.3 | |
| Total debt | | $ | 1,911.4 | | | $ | 2,040.2 | |
We can increase the borrowing availability under the Senior Secured Credit Facilities by up to $250.0 million in the form of additional commitments under the Revolving Credit Facility and/or incremental term loans plus an additional amount so long as we do not exceed a specified senior secured leverage ratio. We can incur additional secured indebtedness under the Term Loan Facilities if certain specified conditions are met under the credit agreement governing the Senior Secured Credit Facilities. Our liquidity requirements are significant primarily due to debt service requirements. See Note 8 “Debt” to our condensed consolidated financial statements included elsewhere in this Form 10-Q.
Our principal sources of liquidity have been existing cash and cash equivalents, cash generated from operations and borrowings under the Senior Secured Credit Facilities and the Receivables Financing Agreement. Our principal uses of cash will be to provide working capital, meet debt service requirements, fund capital expenditures and finance strategic plans, including possible acquisitions. Additionally, on August 1, 2018 our Board of Directors authorized a share repurchase program pursuant to which we may repurchase up to $250 million of our common stock over the next two years. The share repurchase program does not obligate us to acquire any particular amount of common stock, and it may be suspended or terminated at any time at our discretion. We may also seek to finance capital expenditures under capital leases or other debt arrangements that provide liquidity or favorable borrowing terms. We continue to consider acquisition opportunities, but the size and timing of any future acquisitions and the related potential capital requirements cannot be predicted. In the event that suitable businesses are available for acquisition upon acceptable terms, we may obtain all or a portion of the necessary financing through the incurrence of additional long-term borrowings. As market conditions warrant, we and our major equity holders, including our Sponsor and its affiliates, may from time to time, seek to repurchase debt securities that we have issued or loans that we have borrowed, including the borrowings under the Senior Secured Credit Facilities, in privately negotiated or open market transactions, by tender offer or otherwise. Based on our current level of operations and available cash, we believe our cash flow from operations, together with availability under the Revolving Credit Facility and the Receivables Financing Agreement, will provide sufficient liquidity to fund our current obligations, projected working capital requirements, debt service requirements and capital spending requirements for the foreseeable future. Our business may not generate sufficient cash flows from operations or future borrowings may not be available to us under our Revolving Credit Facility or the Receivables Financing Agreement in an amount sufficient to enable us to pay our indebtedness, or to fund our other liquidity needs. Our ability to do so depends on, among other factors, prevailing economic conditions, many of which are beyond our control. In addition, upon the occurrence of certain events, such as a change in control, we could be required to repay or refinance our indebtedness. We may not be able to refinance any of our indebtedness, including the Senior Secured Credit Facilities, on commercially reasonable terms or at all. Any future acquisitions, joint ventures or other similar transactions may require additional capital and there can be no assurance that any such capital will be available to us on acceptable terms or at all.
The majority of our cash is in jurisdictions outside of the United States. However, we believe our U.S. operations will generate sufficient cash flows from operations along with our availability under the Revolving Credit Facility and the Receivables Financing Agreement to satisfy our cash needs in the United States. As a result of the KKR transaction and the significant increase in our long-term debt balance as of July 30, 2013, at the acquisition date, we modified our assertion concerning the permanent reinvestment of undistributed earnings for non-U.S. subsidiaries in these foreign operations. We intend to repatriate certain foreign earnings for the purpose of servicing our Senior Secured Credit Facilities, which will result in net U.S. tax liabilities as these foreign earnings are distributed. We have previously asserted that we intend to repatriate about $200.0 million of accumulated earnings and while we currently have sufficient cash flows in the U.S. as of June 30, 2018 we are maintaining that assertion. We are still evaluating our position from a business perspective in light of the Tax Cuts and Jobs Act and have only adjusted our deferred liability for the impacts of the transitional tax. Our deferred income tax liability related to unremitted earnings as of June 30, 2018 is $9.1 million which consists mainly of withholding taxes. No additional adjustments relating to taxation and unremitted earnings have been recorded in accordance with SAB 118, as we are not currently able to reasonably estimate the impact as of the filing of the June 30, 2018 financial statements.
Working Capital
| | | June 30, 2018 | | | December 31, 2017 | |
| Net Working Capital: | | | | | | |
| Current assets | | $ | 1,445.6 | | | $ | 1,463.6 | |
| Less: Current liabilities | | | 571.4 | | | | 561.8 | |
| Net working capital | | $ | 874.2 | | | $ | 901.8 | |
| | | | | | | | | |
| Operating Working Capital: | | | | | | | | |
| Accounts receivable and contract assets | | $ | 503.6 | | | $ | 536.3 | |
| Plus: Inventories (excluding LIFO) | | | 542.2 | | | | 481.1 | |
| Less: Accounts payable | | | 310.9 | | | | 269.7 | |
| Less: Contract liabilities | | | 80.7 | | | | 42.7 | |
| Operating working capital | | $ | 654.2 | | | $ | 705.0 | |
Net working capital decreased $27.6 million to $874.2 million as of June 30, 2018 from $901.8 million as of December 31, 2017. Operating working capital decreased $50.8 million to $654.2 million as of June 30, 2018 from $705.0 million as of December 31, 2017 due to lower accounts receivable and contract assets, higher accounts payable and higher contract liabilities, partially offset by higher inventories. During 2018, management has proactively focused on improving working capital performance, specifically for accounts receivable and accounts payable, through the enhancement of centralized processes designed to improve the timing of customer cash collections and to standardize and extend vendor payment terms and pay practices. These efforts resulted in a decrease in accounts receivable and an increase in accounts payable at the quarter ended June 30, 2018 as compared to December 31, 2017, partially offset by increases from acquisitions in 2018. The increase in contract assets resulted from the adoption of ASC 606 in the first quarter of 2018. The increase in inventories was primarily due to additions to inventory in anticipation of increased demand for certain products, higher inventory costs related to projects expected to ship later in the year and increases from acquisitions in 2018. The increase in contract liabilities was primarily due to an acquisition in the first quarter of 2018 and the timing of customer milestone payments for in-process engineered to order contracts at the end of the second quarter 2018 compared to the end of the fourth quarter of 2017.
Cash Flows
The following table reflects the major categories of cash flows for the six month periods ended June 30, 2018 and 2017, respectively.
| | For the Six Month Periods Ended June 30, | |
| | 2018 | | | 2017 | |
| Cash flows - operating activities | | $ | 194.5 | | | $ | 20.0 | |
| Cash flows - investing activities | | | (131.4 | ) | | | (40.6 | ) |
| Cash flows - financing activities | | | (114.5 | ) | | | 0.8 | |
Free cash flow (1) | | | 173.6 | | | | (6.8 | ) |
| (1) | See the “Non-GAAP Financial Measures” section included in this Quarterly Report for a reconciliation to the nearest GAAP measure. |
Operating Activities
Cash provided by operating activities increased $174.5 million to $194.5 million for the six month period ended June 30, 2018 from a generation of cash of $20.0 million in the same six month period in 2017, primarily due to higher net income (excluding non-cash charges for stock-based compensation, depreciation and amortization, foreign currency transaction losses, and deferred income taxes and certain insurance recoveries) and increased cash provided by operating working capital.
Operating working capital generated cash of $47.7 million in the six month period ended June 30, 2018 compared to using cash of $3.2 million in the same six month period in 2017. Changes in accounts receivable generated cash of $34.7 million in the six month period ended June 30, 2018 compared to using cash of $16.0 million in the same six month period in 2017. Changes in inventory used cash of $46.8 million in the six month period ended June 30, 2018 compared to using cash of $21.4 million in the six month period in 2017. Changes in accounts payable generated cash of $45.3 million in the six month period ended June 30, 2018 compared to generating cash of $21.8 million in the same six month period in 2017. Changes in contract liabilities generated cash of $14.5 million in the six month period ended June 30, 2018 compared to generating cash of $12.4 million in the same six month period in 2017.
Investing Activities
Cash used in investing activities included capital expenditures of $20.9 million and $26.8 million for the six month periods ended June 30, 2018 and 2017, respectively. We currently expect capital expenditures to total approximately $60.0 million to $70.0 million for the full year in 2018. Cash paid in business combinations for the six month periods ended June 30, 2018 and 2017 were $113.6 million and $18.8 million, respectively. Net proceeds from the disposals of property, plant and equipment were $3.1 million and $5.0 million for the six month periods ended June 30, 2018 and 2017, respectively.
Financing Activities
Cash used in financing activities of $114.5 million for the six month period ended June 30, 2018 reflects principal payments of long-term borrowings of $110.5 million and purchases of treasury stock of $9.2 million, partially offset by proceeds from stock option exercises of $5.2 million. Cash provided by financing activities of $0.8 million for the six month period ended June 30, 2017 reflects proceeds from the issuance of common stock, net of share issuance costs of $897.3 million, partially offset by principal payments of long-term borrowings of $859.4 million, a premium paid on the extinguishment of senior notes of $29.7 million, purchases of treasury stock of $2.6 million, purchases of shares from noncontrolling interests of $4.7 million and the payment of debt issuance costs of $0.3 million.
Free Cash Flow
Free cash flow increased $180.4 million to a free cash inflow of $173.6 million in the six month period ended June 30, 2018 from a free cash outflow of $6.8 million in the same six month period in 2017 due to increased cash provided by operating activities of $174.5 million and a decrease in capital expenditures of $5.9 million.
Off-Balance Sheet Arrangements
We have no off-balance sheet arrangements that have or are materially likely to have a current or future material effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.
Critical Accounting Estimates
Management has evaluated the accounting estimates used in the preparation of the Company’s condensed consolidated financial statements and related notes and believe those estimates to be reasonable and appropriate. Certain of these accounting estimates require the application of significant judgment by management in selecting appropriate assumptions for calculating financial estimates. By their nature, these judgments are subject to an inherent degree of uncertainty. These judgments are based on historical experience, trends in the industry, information provided by customers and information available from other outside sources, as appropriate. Besides the critical accounting estimates related to ASC 606 documented herein, the most significant areas involving management judgments and estimates may be found in the section “Critical Accounting Estimates” of “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” and in Note 1 “Summary of Significant Accounting Policies” of “Item 8. Financial Statements and Supplementary Data” included in our annual report on Form 10-K for the fiscal year ended December 31, 2017.
Revenue Recognition (ASC 606)
Accounting for long-term ETO contracts which require revenue recognition over time involves the use of various techniques to estimate total contract revenue and costs. For long-term contracts, we estimate the profit on a contract as the difference between the total estimated revenue and total expected costs to complete a contract and that profit is recognized over the life of the contract. Such estimates are governed by a robust management review process.
Contract estimates are based on various assumptions to project the outcome of future events that may extend for more than a year. These assumptions include labor productivity and availability, the complexity of the work to be performed, estimated cost, availability of materials, and the performance of subcontractors.
As a significant change in one or more of these estimates could affect the profitability of our contracts, we review and update our contract-related estimates regularly. We recognize adjustments resulting from changes in estimated profits on contracts under the cumulative catch-up method. Under this method, the impact of an adjustment to the amount of profit recognized to date is recorded in the period that adjustment is identified. Revenues and profit in future periods of contract performance is recognized using the adjusted estimate. Provisions for estimated losses on uncompleted contracts are recognized in the period in which such losses are determined to be probable.
Environmental Matters
Information with respect to the effect of compliance with environmental protection requirements and resolution of environmental claims on us and our manufacturing operations is contained in Note 18 “Contingencies” of the Consolidated Financial Statements in our annual report on Form 10-K for the fiscal year ended December 31, 2017. We believe that as of June 30, 2018, there have been no material changes to this information.
Recent Accounting Pronouncements
The information set forth in Note 1 “Condensed Consolidated Financial Statements” to our Condensed Consolidated Financial Statements under Part I, Item 1, “Financial Statements” under the heading “Recently Issued Accounting Pronouncements” is incorporated herein by reference.
| ITEM 3. | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK |
We are exposed to interest rate risk as a result of our variable-rate borrowings. We manage our exposure to interest rate risk by maintaining a mixture of fixed and variable debt, and from time to time, use pay-fixed interest rate swaps as cash flow hedges of our variable rate debt in order to adjust the relative fixed and variable portions.
In addition, we are exposed to foreign currency risks that arise from our global business operations. Changes in foreign currency exchange rates affect the translation of local currency balances of foreign subsidiaries, transaction gains and losses associated with intercompany loans with foreign subsidiaries and transactions denominated in currencies other than a subsidiary’s functional currency. While future changes in foreign currency exchange rates are difficult to predict, our revenues and earnings may be adversely affected if the U.S. dollar further strengthens.
We seek to minimize our exposure to foreign currency risks through a combination of normal operating activities, including by conducting our international business operations primarily in their functional currencies to match expenses with revenues and the use of foreign currency forward exchange contracts and debt denominated in currencies other than the U.S. dollar. In addition, to mitigate the risk arising from entering into transactions in currencies other than our functional currencies, we typically settle intercompany trading balances monthly.
As of June 30, 2018, there have been no material changes to our market risk assessment previously disclosed in the annual report on Form 10-K for the fiscal year ended December 31, 2017.
| ITEM 4. | CONTROLS AND PROCEDURES |
Disclosure Controls and Procedures
The Company maintains a set of disclosure controls and procedures as that term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), that are designed to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act, is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission (“SEC”) rules and forms, and that such information is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosures. The design of any disclosure controls and procedures is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Any controls and procedures, no matter how well designed and operated, can provide only reasonable, not absolute, assurance of achieving the desired control objectives. In accordance with Rule 13a-15(b) of the Exchange Act, as of the end of the period covered by this Quarterly Report on Form 10-Q, an evaluation was carried out under the supervision and with the participation of the Company’s management, including its Chief Executive Officer and Chief Financial Officer, of the effectiveness of its disclosure controls and procedures. Based on that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures, as of the end of the period covered by this Quarterly Report on Form 10-Q, were effective to provide reasonable assurance that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms and is accumulated and communicated to the Company’s management, including the Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.
Internal Control over Financial Reporting
There has not been any change in our internal control over financial reporting (as such term is defined in Rule 13a-15(f) under the Exchange Act) during the fiscal quarter to which this report relates that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
PART II. OTHER INFORMAITON
The information set forth in Note 14 “Contingencies” to our Condensed Consolidated Financial Statements under Part I Item 1 “Financial Statements,” is incorporated herein by reference.
As of June 30, 2018, there have been no material changes to our risk factors in our annual report on Form 10-K for the fiscal year ended December 31, 2017.
| ITEM 2. | UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS |
None.
| ITEM 3. | DEFAULTS UPON SENIOR SECURITIES |
None.
Not applicable.
None.
The following is a list of all exhibits filed or furnished as part of this report.
The agreements and other documents filed as exhibits to this report are not intended to provide factual information or other disclosures other than with respect to the terms of the agreements or other documents themselves, and you should not rely on them for that purpose. In particular, any representations and warranties made by us in these agreements or other documents were made solely within the specific context of the relevant agreement or document and may not describe the actual statement of affairs as of the date they were made or at any other time.
Exhibit No. | Description |
| | |
| Certification of Periodic Report by Chief Executive Officer under Section 302 of the Sarbanes-Oxley Act of 2002 (furnished herewith) |
| | |
| Certification of Periodic Report by Chief Financial Officer under Section 302 of the Sarbanes-Oxley Act of 2002 (furnished herewith) |
| | |
| Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (furnished herewith) |
| | |
| Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (furnished herewith) |
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
| Date: August 3, 2018 | GARDNER DENVER HOLDINGS, INC. |
| | |
| | By: | /s/ Mark R. Sweeney | |
| | Name: Mark R. Sweeney |
| | Vice President and Chief Accounting Officer |
| | (Principal Accounting Officer) |
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