Research and development (R&D) expenses in the third quarter of 2007 increased 6.8% to $5.9 million from $5.5 million in 2006. R&D expenses as a percentage of net sales were 3.7% for the third quarter of 2007 compared to 3.8% in the comparable quarter last year.
R&D expenses for the nine months ended September 30, 2007 were $17.4 million, up 7.8% from $16.2 million in 2006. R&D expenses as a percentage of net sales were 3.6% for the first nine months compared to 3.7% in the same period last year, which is in line with our target of investing 3% to 4% of net sales annually on R&D.
Selling and administrative (S&A) expenses in the third quarter of 2007 increased 12.6% to $50.9 million from $45.2 million in 2006. S&A expenses for the third quarter included a $1.7 million charge for a restructuring action approved by management during the quarter as discussed in Note 2 to the Condensed Consolidated Financial Statements. The charge consists primarily of severance and outplacement benefits. The remaining 8.8% increase in expenses in the third quarter of 2007 was due to general inflationary cost increases, the inclusion of expenses related to acquired operations and costs to support international market coverage and other strategic initiatives. In addition, an increase in bad debt expense also contributed to the increase between periods. Unfavorable direct foreign currency exchange added approximately $1.3 million to the increase in S&A expense for the third quarter of 2007.
For the nine months ended September 30, 2007, S&A expenses increased 8.6% to $149.8 million from $137.9 million in the comparable period last year. The increase in S&A expenses, in addition to the restructuring charge discussed above, was due to general inflationary cost increases, the inclusion of expenses related to acquired operations and costs to support international market coverage and growth initiatives. In addition, an increase in bad debt expenses also contributed to the increase between periods. Unfavorable direct foreign currency exchange added approximately $3.5 million to the increase in S&A expense for the nine months ended September 30, 2007. Offsetting these increases was a decrease in performance-based compensation expense.
S&A expenses as a percentage of net sales were 31.6% for the third quarter of 2007, up from 31.0% in the comparable quarter last year. The increase in S&A expenses as a percentage of net sales in the third quarter of 2007 is primarily attributable to the charge recognized for the restructuring action during the quarter.
S&A expenses as a percentage of net sales for the nine months ended September 30, 2007 were 31.1% down from the 31.9% in the comparable period last year. The decrease as a percent of net sales for the nine months is primarily due to sales growing at a faster rate than expenses, despite investments to support our growth initiatives.
Interest income, net was flat between the third quarter of 2007 and 2006, but declined by $0.7 million for the nine month period ended September 30, 2007, as compared to the same period in 2006. The unfavorable comparison between the first nine months of 2007 and 2006 primarily reflects a decrease in interest income as a result of lower average levels of cash, cash equivalents and short-term investments during the first nine months of 2007 compared to 2006. In addition, we received interest income related to a state tax refund in the second quarter of 2006.
Other income, net remained essentially unchanged between the third quarter of 2007 and 2006. Foreign currency translation gains were lower in the third quarter of 2007 when compared to the same period in 2006. This decline was offset, in part, by an increase in ESOP income due to a higher average stock price. The Company benefits from ESOP income when the shares held by the Company’s ESOP Plan are utilized and the basis of those shares is lower than the current average stock price. In addition, we incurred expenses in the third quarter of 2006 associated with a potential acquisition that we did not complete. A similar expense was not incurred during the third quarter of 2007.
For the nine month period ended September 30, 2007, other income, net increased by $0.7 million. The increase in total other income, net for the first nine months of 2007 when compared to the same period in 2006 was primarily driven by an increase in ESOP income of $1.1 million due to a higher average stock price. Partially offsetting this increase was $0.5 million in discretionary contributions to Tennant’s charitable foundation during 2007. Similar contributions were not made during 2006.
Income Taxes
The effective tax rate in the third quarter of 2007 was 2.5% compared to the effective tax rate in the third quarter of the prior year of 28.6%. The third quarter of 2007 included net favorable discrete items of $4.1 million primarily related to the reversal of a German valuation allowance, net of the impact of tax rate changes in foreign jurisdictions on deferred taxes. During the third quarter of 2007 it was determined that it was now more likely than not that tax net operating loss carryforwards in Germany would be utilized in the future and accordingly the valuation allowance on the related deferred tax asset was reduced to zero.
The year-to-date 2007 effective tax rate was 25.9% compared to the year-to-date effective tax rate last year of 32.2%.
We expect our 2007 full year base tax rate will be approximately 36% before the impact of one-time items, resulting in an effective tax rate of between 29% and 31%. Our estimate of the full year effective tax rate is subject to change and may be impacted by changes in our forecasts of operating profit in total or by taxing jurisdiction, or to changes in the tax laws and regulations.
Liquidity and Capital Resources
On June 19, 2007, we entered into a credit agreement (the “Credit Agreement”) with JPMorgan Chase Bank, National Association, as administrative agent, Bank of America, N.A., as syndication agent, BMO Capital Markets Financing, Inc. and U.S. Bank National Association, as Co-Documentation Agents and the Lenders from time to time party thereto. The Credit Agreement provides us and certain of our foreign subsidiaries access to a $125.0 million senior unsecured revolving credit facility until June 19, 2012. Borrowings may be denominated in U.S. Dollars or certain other currencies. The Credit Agreement contains a $75.0 million sublimit on foreign currency borrowings and a $50.0 million sublimit on borrowings by the foreign subsidiaries. The facility is available for general corporate purposes, working capital needs, share repurchases and acquisitions.
The fee for committed funds under the Credit Agreement ranges from an annual rate of 0.08% to 0.225%, depending on our leverage ratio. Borrowings under the Credit Agreement generally bear interest at an annual rate of, at our option, either (i) between LIBOR plus 0.32% to LIBOR plus 1.025%, depending on our leverage ratio, or (ii) the higher of (A) the prime rate or (B) the federal funds rate plus 0.50%.
The Credit Agreement contains customary representations, warranties and covenants, including but not limited to covenants restricting our ability to incur indebtedness and liens and to merge or consolidate with another entity. Further, the Credit Agreement contains a covenant requiring us to maintain an indebtedness to EBITDA ratio as of the end of each quarter of not greater than 3.5 to 1, and to maintain an EBITDA to interest expense ratio of no less than 3.5 to 1. The Credit Agreement also restricts us from paying dividends or repurchasing stock in an amount that exceeds $50.0 million during any fiscal year if, after giving effect to such payments, our leverage ratio would exceed 2.5 to 1.
On August 23, 2007, we entered into an unsecured revolving credit facility (the “Credit Facility”) with Bank of America, National Association which expires on August 23, 2008. This Credit Facility is denominated in Renminbi in the amount of 14.6 million RMB, or approximately $1.9 million U.S. Dollars, and is available for general corporate purposes, including working capital needs of our China location. The interest rate on borrowed funds is equal to the People’s Bank of China’s base rate. This facility also allows for the issuance of standby letters of credit, performance bonds and other similar instruments over the term of the facility for a fee of 0.95% of the amount issued.
Our debt-to-total-capitalization ratio was 1.6% at September 30, 2007 and December 31, 2006. Cash, cash equivalents and short-term investments totaled $31.9 million at September 30, 2007, compared to $45.3 million at December 31, 2006. We believe that the combination of cash, cash equivalents and short-term investments on hand, as well as internally generated funds and amounts available under the Credit Agreement and Credit Facility are more than sufficient to meet our cash requirements for the next year.
OPERATING ACTIVITIES — Operating activities provided $31.4 million of cash for the nine months ended September 30, 2007. Cash provided by operating activities was driven primarily by strong net earnings, partially offset by a decrease in employee compensation and benefits and other accrued expenses and accounts payable. The decrease in employee compensation and benefits and other accrued expenses was primarily a result of payments of prior fiscal year performance awards, annual rebates, incentives and profit sharing. Timing of payments was the primary reason for the decrease in accounts payable.
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In the comparable 2006 period, operating activities provided $27.7 million of cash, which was primarily driven by year-to-date net earnings, a decrease in receivables and a reduction in accounts payable and employee compensation and benefits and other accrued expenses. The decrease in receivables was due to seasonality of sales volumes. The reduction in accounts payable and employee compensation and benefits and other accrued expenses was due to payments of 2005 performance-based incentives, annual rebates, sales incentives and profit sharing as well as timing of accounts payable payments. An increase in inventory levels due to a buildup of inventory to support new products launched and to support the fourth quarter 2006 expected shipments also impacted operating activities and days inventory on hand for the nine months ended September 30, 2006.
Management evaluates how effectively we utilize two of our key operating assets, receivables and inventories, using accounts receivable “Days Sales Outstanding” (DSO) and “Days Inventory on Hand” (DIOH), on a FIFO basis. These metrics are as follows (in days):
| | | | | | | | | | |
| | September 30, 2007 | | December 31, 2006 | | September 30, 2006 | |
| | | | | | | |
DSO | | | 65 | | | 61 | | | 64 | |
DIOH | | | 89 | | | 82 | | | 91 | |
For the period ended September 30, 2007, DSO increased one day compared to the same period last year, primarily due to a higher mix of international receivables which have longer payment terms. In comparison to December 31, 2006, DSO increased four days as a result of a higher mix of international account receivables as well as a higher mix of domestic national account receivables both of which have longer payment terms.
During the third quarter of 2007, DIOH decreased two days compared to the same period last year and increased seven days compared to December 31, 2006. The decrease was primarily due to fluctuations in foreign currency rates and the increase as compared to year end is due to higher inventory levels at our foreign locations due to longer lead times and pipeline fill for new products.
INVESTING ACTIVITIES — Investing activities during the nine months ended September 30, 2007 used $19.8 million in cash. The primary use was capital expenditures, which totaled $23.8 million during the nine months ended September 30, 2007 and included investments in support of our footprint consolidation, global expansion initiatives and new product development. Other significant uses of cash during the first nine months of 2007 included the acquisition of Floorep Limited, a distributor of cleaning equipment based in Scotland. Floorep was purchased for $2.6 million, net of cash acquired. These uses were offset by net sales activity of short-term investments, which generated $6.3 million in cash during the nine month period.
We currently anticipate full-year capital spending to be in the range of approximately $26 to $28 million.
During the nine month period ended September 30, 2006, investing activities used $31.0 million of cash. Uses of cash included $13.2 million for capital expenditures, purchases of short-term investments of $10.0 million and $8.5 million for the acquisition of Hofmans Machinefabriek.
FINANCING ACTIVITIES — Net cash used by financing activities was $19.0 million during the first nine months of 2007. Significant uses of cash included $20.5 million for repurchases of common stock under our share repurchase program and $6.8 million in dividend payments. Proceeds from issuance of common stock generated $7.7 million of cash in the first nine months of 2007, primarily driven by employee stock option exercises.
During the first nine months of 2006, net cash used by financing activities was $3.0 million. Significant uses of cash included $6.3 million in dividend payments as well as repurchases of common stock under our share repurchase program of $2.8 million. Proceeds from issuance of common stock driven by employee stock option exercises of $6.7 million were a significant source of cash during this period.
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Item 3. Quantitative and Qualitative Disclosures About Market Risk
Foreign Currency Risk
Due to the global nature of our operations, we are subject to exposures resulting from foreign currency exchange fluctuations in the normal course of business. Our primary exchange rate exposure is with the Euro, the Canadian dollar, the Australian dollar, the British pound, the Chinese yuan and the Japanese yen against the U.S. dollar. The direct financial impact of foreign currency exchange includes the effect of translating profits from local currencies to U.S. Dollars, the impact of currency fluctuations on the transfer of goods between Tennant operations in the United States and abroad and transaction gains and losses. In addition to the direct financial impact, foreign currency exchange has an indirect financial impact on our results, including the effect on sales volumes within local economies and the impact of pricing actions taken as a result of foreign exchange rate fluctuations. We could experience favorable or unfavorable foreign exchange effects for the remainder of 2007, compared with prior year results.
Because our products are currently manufactured or sourced primarily from the United States, a stronger dollar generally has a negative impact on results from operations outside the United States while a weaker dollar generally has a positive effect. Our objective in managing the exposure to foreign currency fluctuations is to minimize the earnings effects associated with foreign exchange rate changes on certain of our foreign currency-denominated assets and liabilities. We periodically enter into various contracts, principally forward exchange contracts, to protect the value of certain of our foreign currency-denominated assets and liabilities. The gains and losses on these contracts generally approximate changes in the value of the related assets and liabilities.
Commodity Risk
We are subject to exposures resulting from potential cost increases related to our purchases of raw materials or other product components. We do not use derivative commodity instruments to manage our exposures to changes in commodity prices such as steel, oil, gas, lead and other commodities.
Various factors beyond our control affect the price of oil and gas, including but not limited to worldwide and domestic supplies of oil and gas, political instability or armed conflict in oil-producing regions, the price and level of foreign imports, the level of consumer demand, the price and availability of alternative fuels, domestic and foreign governmental regulation, weather-related factors and the overall economic environment. We purchase petroleum-related component parts for use in our manufacturing operations. In addition, our freight costs associated with shipping and receiving product and sales and service vehicle fuel costs are impacted by fluctuations in the cost of oil and gas. If the price of oil and gas continue to increase, our results could be unfavorably impacted in 2007.
Increases in worldwide demand and other factors affect the price for steel and related products. We do not maintain an inventory of raw or fabricated steel in excess of near-term production requirements. As a result, increases in the price of steel can significantly increase the cost of our steel-based raw materials and component parts if we are not able to fully mitigate with price increases or cost-reduction actions.
During 2006 and through the period ended September 30, 2007, our raw materials and other purchased component costs, such as batteries, were unfavorably impacted by commodity prices and we were not able to fully mitigate these higher costs with selling price increases and cost-reduction actions. We will continue to focus on mitigating the risk of continued future raw material or other product component cost increases through product pricing, negotiations with our vendors and cost-reduction actions. The success of these efforts will depend upon our ability to increase our selling prices in a competitive market and our ability to achieve cost savings. If the commodity prices remain at their current levels or continue to increase, our results may continue to be unfavorably impacted in 2007.
Other Matters
Management regularly reviews our business operations, processes and overall organizational structure with the objective of improving financial performance and maximizing our return on investment. As a result of this ongoing process to improve financial performance, we may incur restructuring charges in the future which, if taken, could be material to our financial results.
Additional information on market risk is included in the Management’s Discussion and Analysis section of our 2006 Annual Report on Form 10-K.
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Cautionary Statement Relevant to Forward-Looking Information
Certain statements contained in this document as well as other written and oral statements made by us from time to time are considered “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act. These statements do not relate to strictly historical or current facts and provide current expectations or forecasts of future events. Any such expectations or forecasts of future events are subject to a variety of factors. These include factors that affect all businesses operating in a global market as well as matters specific to us and the markets we serve. Particular risks and uncertainties presently facing us include:
| |
• | Geopolitical and economic uncertainty throughout the world. |
| |
• | Changes in laws, including changes in accounting standards and taxation changes. |
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• | Inflationary pressures. |
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• | Potential for increased competition in our business. |
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• | Relative strength of the U.S. dollar, which affects the cost of our materials and products bought and sold internationally. |
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• | Fluctuations in the cost or availability of raw materials and purchased components. |
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• | Success and timing of new products. |
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• | Ability to achieve projections of future financial and operating results. |
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• | Successful integration of acquisitions, including recoverability of acquired goodwill and intangible assets. |
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• | Ability to achieve operational efficiencies, including synergistic and other benefits of acquisitions. |
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• | Ability to achieve anticipated global sourcing cost reductions. |
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• | Unforeseen product quality problems. |
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• | Ability to acquire, retain and protect proprietary intellectual property rights. |
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• | Effects of litigation, including threatened or pending litigation. |
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• | Price and timing of the sale of our Maple Grove, Minnesota manufacturing facility. |
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• | Ability to benefit from production reallocation plans, including benefits from our expansion into China. |
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• | Ability to achieve growth plans. |
We caution that forward-looking statements must be considered carefully and that actual results may differ in material ways due to risks and uncertainties both known and unknown. Shareholders, potential investors and other readers are urged to consider these factors in evaluating forward-looking statements and are cautioned not to place undue reliance on such forward-looking statements. For additional information about factors that could materially affect Tennant’s results, please see our other Securities and Exchange Commission filings, including the “Risk Factors” section of our 2006 Annual Report on Form 10-K.
We do not undertake to update any forward-looking statement, and investors are advised to consult any further disclosures by us on this matter in our filings with the Securities and Exchange Commission and in other written statements we make from time to time. It is not possible to anticipate or foresee all risk factors, and investors should not consider any list of such factors to be an exhaustive or complete list of all risks or uncertainties.
Item 4. Controls and Procedures
(a)Evaluation of disclosure controls and procedures. Based on their evaluation as of the end of the period covered by this report, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)) are effective to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.
(b)Changes in internal controls. There were no changes in our internal controls over financial reporting during the most recently completed fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
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PART II – OTHER INFORMATION
Item 1A. Risk Factors
There have been no material changes in our risk factors from those disclosed in our 2006 Annual Report on Form 10-K.
Item 2. Unrestricted Sales of Equity Securities and Use of Proceeds
In November 2004, Tennant Company’s Board of Directors authorized the repurchase of 400,000 shares of our common stock under the share repurchase program approved by the Board of Directors in May 2001. In August 2006, the Board of Directors approved the adjustment of the number of shares then available for repurchase to reflect the impact of the two-for-one stock split in July 2006. On May 3, 2007, the Board of Directors authorized the repurchase of 1,000,000 additional shares of our common stock. Share repurchases are made from time to time in the open market or through privately negotiated transactions, primarily to offset the dilutive effect of shares issued through our stock-based compensation programs.
| | | | | | | | | | | | | |
For the Quarter
Ended 9/30/2007 | | Total Number
of Shares
Purchased (1) | | Average Price
Paid Per Share | | Total Number of
Shares Purchased as
Part of Publicly
Announced Plans or
Programs | | Maximum Number of
Shares that May Yet
Be Purchased | |
| | | | | | | | | | |
July 1 – 31, 2007 | | | 10,100 | | | 37.51 | | | 10,100 | | | 1,192,774 | |
August 1 – 31, 2007 | | | 151,700 | | | 41.93 | | | 151,700 | | | 1,041,074 | |
September 1 – 30, 2007 | | | 116,988 | | | 43.94 | | | 116,900 | | | 924,174 | |
| | | | | | | | | |
Total | | | 278,788 | | | 42.61 | | | 278,700 | | | 924,174 | |
| | | | | | | | | |
| |
(1) | Includes 88 shares delivered or attested to in satisfaction of the exercise price and/or withholding obligations by employees who exercised stock options or restricted stock under employee compensation plans. |
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Item 6. Exhibits
Exhibits
| | | | |
Item # | | Description | | Method of Filing |
| | | | | |
3i | | Restated Articles of Incorporation | | Incorporated by reference to Exhibit 3i to the Company’s report on Form 10 Q for the quarterly period ended June 30, 2006. |
| | | | |
3ii | | Certificate of Designation | | Incorporated by reference to Exhibit 3.1 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2006. |
| | | | |
3iii | | Amended and Restated By-Laws | | Incorporated by reference to Exhibit 3ii to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 1999. |
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31.1 | | Rule 13a-14(a)/15d-14(a) Certification of CEO | | Filed herewith electronically. |
| | | | |
31.2 | | Rule 13a-14(a)/15d-14(a) Certification of CFO | | Filed herewith electronically. |
| | | | |
32 | | Section 1350 Certifications | | Filed herewith electronically. |
SIGNATURES
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.
| | | |
| | | TENNANT COMPANY |
| | | |
Date: | November 2, 2007 | | /s/ H. Chris Killingstad |
| | | |
| | | H. Chris Killingstad |
| | | President and Chief Executive Officer |
|
Date: | November 2, 2007 | | /s/ Thomas Paulson |
| | | |
| | | Thomas Paulson |
| | | Vice President and Chief Financial Officer |
| | | (Principal Financial and Accounting Officer) |
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