Item 7. Management’s Discussion and Analysis
Item 7. Management’s Discussion and Analysis of Financial Condition
and Results of Operations
Outlook
This re port contains forward-looking statements that are based on Alamo Group’s current expectations. Actual results in future periods may differ materially from those expressed or implied because of a number of risks and uncertainties which are discussed below and in the Forward-Looking Information section beginning on page 13.
In 2020, the COVID-19 pandemic triggered a worldwide recession that caused a significant downturn in our markets globally and negatively affected our expected results. These unfavorable market conditions continued throughout much of 2020 and could continue for an extended period of time. In an effort to contain the spread of COVID-19, maintain the health and safety of our employees, meet reduced demand from our customers, and in accordance with governmental requirements, we closed or partially shut down certain office and manufacturing facilities around the world at different times in early 2020. Although most of our facilities re-opened in the second quarter of 2020, some operated at reduced capacities depending on fluctuations in customer demand and measures taken at our facilities to protect employees which included quarantining of personnel as needed.
Despite some of our markets showing signs of recovery in the second half of 2020, the ongoing spread of the virus presents several risks to our business, especially for the first half of 2021. In the fourth quarter of 2020 we experienced some operational and supply chain disruptions caused by the pandemic. We continue to experience varying levels of disruption, particularly in our supply chain, and it is hard to predict the extent to which these disruptions may continue. COVID-19 vaccines are currently being administered around the world with the hope that the majority of the population will have access to the vaccine by the second half of 2021. If vaccine effectiveness is consistent with current government and health organization estimates, we believe the vaccine will mitigate the spread of the virus and allow a return to more normal operations in the second half of the year. However, we recognize that case surges or new strains of the virus or other unanticipated events could lead to new restrictions or lockdowns, which may limit our operational capabilities and/or lead to a renewed softening of customer demand. All of this is dependent on future developments relating to the pandemic, which are highly uncertain and unpredictable at this time. In addition, certain i nput costs, most notably steel, have recently increased, while international trade disputes, shipping delays, a changing political landscape in the U.S., and a continuing tight labor market are also of concern. Given the current level of business uncertainty, we remain cautious in terms of our outlook for the year. Despite the challenges faced in 2020, we will continue our focus on ongoing operational improvement initiatives and, as we did in 2020, will monitor capital expenditures in 2021 in line with depreciation levels of the last several years. Of course, we may also be negatively affected by several other unanticipated factors, such as a weakness in the overall economy; significant changes in currency exchange rates; further changes in trade or tax policy; Brexit integration impacts; increased levels of government regulation; weakness in the agricultural sector; acquisition integration issues; budget constraints or revenue shortfalls in governmental entities; and other risks and uncertainties as described in “Risk Factors.”
2020 Performance
In 2020, the Company's net sales increased by 4.0%, but net income decreased by 10.0% compared to 2019. The increase in net sales was due to the acquisitions of Morbark and Dutch Power in 2019 which was offset by market declines due to COVID-19. The decrease in net income was attributable to the COVID-19 pandemic which began to materially affect our operations in March 2020 and continued to negatively impact the Company's overall financial performance during the year.
The Company's Industrial Division experienced a 5.6% increase in sales for 2020 compared to 2019 due to the acquisitions of Morbark and Dutch Power . Without factoring in contributions from Morbark and Dutch Power , sales across all legacy Industrial product groups (with the exception of vegetation control, which was up) were down in 2020 compared to 2019, mostly attributable to the adverse impacts of the COVID-19 pandemic which included temporary plant closures in the U.S., France, and Canada during the second quarter of 2020, as well as other operational disruptions across the Industrial Division and softness in customer demand which occurred over the course of the year. The Division's new orders showed signs of improvement, though not evenly across product lines. Some areas, such as forestry, increased above historical average while others, such as excavators and vacuum trucks continued to be soft.
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The Company's Agricultural Division sales were up less than 1% in 2020 compared to 2019 but were negatively affected by the COVID-19 pandemic, and to a lesser extent ongoing global trade tensions, which began to hurt Agricultural sales as well as operations in late March of this year. During the second quarter of 2020 however, North American sales and profitability in the Agricultural Division showed some improvement and continued to show signs of recovery for the remainder of 2020. Likewise, soft market conditions in the Agricultural Division's operations in the U.K. and France during the first half of 2020 as well as experiencing temporary plant closures and operational disruptions during the months of March and April due to COVID-19, also showed signs of improvement during the second half of 2020.
Consolidated income from operations was $93.2 million in 2020, which included $4.8 million of non-cash inventory step-up expense related to the Morbark acquisition and redundancy costs in the amount of $2.7 million related to the Company's plan to close the Dutch Power facility located in Enschede, in The Netherlands. Without these one-time charges, consolidated income from operations was $100.7 million, an increase of 6.4% when compared to 2019, mainly the result of contributions to operating income from the Morbark and Dutch Power acquisitions. The Company's backlog increased 35.6% to $354.1 million at the end of 2020 versus the backlog of $261.0 million at the end of 2019. The increase in the Company's backlog was primarily attributable to improved market conditions in the second half of 2020, specifically in the Agricultural Division, offset by adverse effects from the COVID-19 pandemic, which has hurt the Company's overall sales and profitability.
The following discussion should be read in conjunction with the consolidated financial statements of the Company and the notes thereto included elsewhere in this Annual Report on Form 10-K.
The following tables set forth, for the periods indicated, certain financial data:
Fiscal Year Ended December 31,
Net sales (data in thousands): 2020 2019 2018
Industrial $ 811,161 $ 768,454 $ 638,198
Agricultural 352,305 350,684 370,624
Total net sales $ 1,163,466 $ 1,119,138 $ 1,008,822
Cost and profit margins, as percentages of net sales:
Cost of sales 74.9 % 75.6 % 74.6 %
Gross profit 25.1 % 24.4 % 25.4 %
Selling, general, administrative, and amortization expenses 17.1 % 16.0 % 15.4 %
Income from operations 8.0 % 8.5 % 10.0 %
Income before income taxes 6.7 % 7.5 % 9.4 %
Net income 4.9 % 5.6 % 7.3 %
Results of Operations
Fiscal 2020 compared to Fiscal 2019
The Company’s net sales in the fiscal year ended December 31, 2020 (“2020”) were $1,163.5 million, an increase of $44.4 million or 4.0% compared to $1,119.1 million for the fiscal year ended December 31, 2019 (“2019”). The increase was attributable to the acquisitions of Morbark and Dutch Power, which year over year contributed net sales of $160.5 million. Negatively affecting sales in 2020, was the outbreak of the COVID-19 pandemic which began to affect the Company's operations late in the first quarter of 2020.
Net Industrial sales were $811.2 million in 2020 compared to $768.5 million in 2019, an increase of $42.7 million or 5.6%, coming from the acquisitions of Dutch Power and Morbark mentioned above, which were offset by the impacts from the COVID-19 pandemic that began to materially affect the Division late in the first quarter of 2020. This included temporary plant closures in the U.S., France and Canada along with other operational disruptions throughout our global markets resulting from health concerns and
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governmental directives, reduced governmental spending, and customer delivery restrictions, among other things.
Net Agricultural sales were $352.3 million in 2020 compared to $350.7 million in 2019, representing an increase of $1.6 million or 0.5%. Despite the COVID-19 pandemic, agricultural market conditions began to improve during the second quarter of 2020 as demand for our products continued to outpace last year. Sales in this Division's North American operations did reasonably well and benefited from the contributions of Dixie Chopper but the ongoing pandemic affected supply chain and logistics across the entire Division as well as sales and operations, particularly in our U.K. and French Agricultural businesses, as they experienced temporary plant closures and soft markets.
Gross profit for 2020 was $292.1 million (25.1% of net sales) compared to $273.2 million (24.4% of net sales) in 2019, an increase of $18.9 million. The increase in gross profit mainly came from the acquisitions of Dutch Power and Morbark. Gross margin percentage improved year over year primarily due to a favorable mix of parts sales and pricing actions which more than offset the negative impact of higher steel prices and lower factory utilization. Also, negatively affecting the gross margin and gross margin percentage during the first nine months of 2020 were $4.8 million of charges on sales of inventory that had been previously stepped-up related to the Morbark acquisition.
Selling, general and administrative expenses (“SG&A”) were $184.2 million (15.8% of net sales) in 2020 compared to $172.9 million (15.5% of net sales) in 2019, an increase of $11.3 million. Morbark and Dutch Power accounted for $23.6 million of net additional SG&A expense in 2020 offset by $12.3 million in expense savings related to the COVID-19 pandemic. 2019 included $1.9 million of acquisition expenses related to the Morbark and Dutch Power . Amortization expense in 2020 was $14.7 million compared to $5.7 million in 2019, an increase of $9.0 million. The increased amortization expense in 2020 was primarily from the acquisitions of Morbark and Dutch Power.
Interest expense for 2020 was $15.8 million compared to $10.7 million in 2019, an increase of $5.1 million or 47.4%. The increase in interest expense in 2020 came from increased borrowings due to the Morbark acquisition in 2019 offset by a decrease in interest rates.
Other income (expense), net was expense of $0.6 million during 2020 compared to expense of $0.8 million in 2019. The expense in 2020 and the expense in 2019 were primarily the result of changes in exchange rates.
Provision for income taxes was $21.5 million (27.5% of income before income taxes) for 2020 compared to $21.4 million (25.4% of income before income taxes) in 2019. The increase in the tax rate for 2020 was due to the reversal of a FIN 48 benefit recognized in 2019 partially offset by the benefit of the final GILTI regulations issued in July of 2020.
Net income for 2020 was $56.6 million compared to $62.9 million in 2019, due to the factors described above.
Fiscal 2019 compared to Fiscal 2018
The Company’s net sales in the fiscal year ended December 31, 2019 (“2019”) were $1,119.1 million, an increase of $110.3 million or 10.9% compared to $1,008.8 million for the fiscal year ended December 31, 2018 (“2018”). The increase in net sales was mainly due to the acquisition of Dutch Power, which contributed $36.4 million in net sales and the Morbark acquisition, which added $35.1 million in net sales. Also contributing to the increase in sales for 2019 was relatively strong demand for our products in the Company's Industrial Division. These positive net sales impacts more than offset lower sales in our Agricultural Division due to weak market conditions as well as unfavorable currency translation effects in our European operations.
Net Industrial sales were $768.5 million in 2019 compared to $638.2 million in 2018, an increase of $130.3 million or 20.4%, primarily resulting from the acquisitions of Dutch Power and Morbark which together accounted for $71.5 million of the increase in net sales. Also contributing to the increase were higher sales of vacuum trucks, sweepers, excavators and snow equipment. To a lesser extent, negatively affecting sales in this division were lower mowing equipment sales.
Net Agricultural sales were $350.7 million in 2019 compared to $370.6 million in 2018, representing a decrease of $19.9 million or 5.4%. Negatively affecting sales in the Agricultural Division were weak market conditions and lower farm incomes, which have been impacted by lower commodity prices as well as on
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going trade disputes. A first quarter 2019 shutdown in this Division's largest manufacturing facility to install an upgrade to its paint system in addition to heavy rains and flooding throughout the mid-west part of the U.S. during the second quarter of 2019 also negatively hampered sales. Also negatively affecting sales were weak agricultural conditions in the U.K. during the second half of 2019.
Gross profit for 2019 was $273.2 million (24.4% of net sales) compared to $256.1 million (25.4% of net sales) in 2018, an increase of $17.1 million. The increase in gross profit for 2019 came from the acquisitions of Dutch Power and Morbark and higher equipment sales in the Company's Industrial Division. Negatively affecting the gross margin and margin percentage for 2019 as compared to 2018 were the step-up inventory charge of $3.3 million at Morbark due to the acquisition, the effects of lower production in our Agricultural Division and unfavorable product mix, partially offset by lower material costs and improvements in the Rivard vacuum truck business.
Selling, general and administrative expenses (“SG&A”) were $172.9 million (15.5% of net sales) in 2019 compared to $151.5 million (15.0% of net sales) in 2018, an increase of $21.4 million. To a large extent, the increase in SG&A was a result of the acquisitions of Dutch Power and Morbark which accounted for $12.5 million of the increase. Also contributing to the higher SG&A costs were increased spending in research and development projects, higher commissions and other selling expenses as well as acquisition expenses, in the amount of $1.9 million. Amortization expense in 2019 was $5.7 million compared to $3.5 million in 2018, an increase of $2.2 million. The increased amortization expense in 2019 was primarily from the acquisitions of Dutch Power and Morbark.
Interest expense for 2019 was $10.7 million compared to $5.5 million in 2018, an increase of $5.2 million or 95.6%. The increase in interest expense in 2019 came from increased borrowings due to the Dutch Power and Morbark acquisitions.
Other income (expense), net was expense of $0.8 million during 2019 compared to expense of $1.5 million in 2018. The expense in 2019 and the expense in 2018 were primarily the result of changes in exchange rates.
Provision for income taxes was $21.4 million (25.4% of income before income taxes) for 2019 compared to $21.0 million (22.3% of income before income taxes) in 2018. The lower effective tax rate in 2018 as compared to 2019 was a result of the Company recording a net benefit to income taxes of $3.3 million in 2018 relating to the adjustment in the provisional amounts recorded in the fourth quarter of 2017 upon enactment of Tax Cuts and Jobs Act ("TCJA"), as more fully described in Note 14 of the Notes to the Consolidated Financial Statements. This factor reduced the Company's effective income tax rate for 2018 to 22.3%.
Net income for 2019 was $62.9 million compared to $73.5 million in 2018, due to the factors described above.
Liquidity and Capital Resources
In addition to normal operating expenses, the Company has ongoing cash requirements which are necessary to conduct the Company’s business, including inventory purchases and capital expenditures. The Company’s accounts receivable, inventory and accounts payable levels, particularly in its Agricultural Division, build in the first quarter and early spring and, to a lesser extent, in the fourth quarter in anticipation of the spring and fall selling seasons. Accounts receivable historically build in the first and fourth quarters of each year as a result of pre-season sales and year-round sales programs. These sales, primarily in the Agricultural Division, help balance the Company’s production during the first and fourth quarters.
As of December 31, 2020, the Company had working capital of $345.7 million, which represents a decrease of $62.3 million from working capital of $408.0 million as of December 31, 2019. The decrease in working capital was primarily due to reductions of accounts receivable and inventory levels which created excess cash used to reduce debt levels. This was done in response to the COVID-19 pandemic.
Capital expenditures were $17.9 million for 2020, compared to $31.3 million for 2019. The decrease was related to the COVID-19 pandemic. In the first quarter of 2020, we began to limit new capital expenditures; however, any previously approved projects and related spending carried over. The Company will fund any future expenditure from operating cash flows or through our revolving credit facility, described below.
Net cash provided by operating activities was $184.3 million for 2020, compared to $88.8 million for 2019. The increase of cash from operating activities came primarily from working capital due to reductions in accounts
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receivable and inventory levels as well as a decreased in the Company's investment in rental equipment in the Industrial Division .
Net cash used in investing activities was $14.2 million for 2020, compared to $429.9 million for 2019. The decrease in cash used in investing activities was primarily due to repayment of debt related to the acquisitions in 2019 of Morbark , Dutch Power and to a lesser extent Dixie Chopper .
Net cash used by financing activities was $164.2 million for 2020, compared to $349.2 million of net cash provided for 2019. The majority of the net cash provided by financing activities in 2019 was due to borrowings to finance the acquisitions of Morbark , Dutch Power , and to a lesser extent Dixie Chopper .
The Company had $44.7 million in cash and cash equivalents held by its foreign subsidiaries as of December 31, 2020. The majority of these funds are at our European and Canadian facilities. The Company will continue to repatriate European and Canadian cash and cash equivalents in excess of amounts needed to fund operating and investing activities, but will need to monitor exchange rates to determine the appropriate timing of such repatriation given the current relative strength of the U.S. dollar. Repatriated funds will initially be used to reduce funded debt levels under the Company's current credit facility and subsequently used to fund working capital, capital investments and acquisitions company-wide.
On October 24, 2019, the Company, as Borrower, and each of its domestic subsidiaries as guarantors, entered into a Second Amended and Restated Credit Agreement (the Credit Agreement ) with Bank of America, N.A., as Administrative Agent. The Credit Agreement provides the Company with the ability to request loans and other financial obligations in an aggregate amount of up to $650.0 million and, subject to certain conditions, the Company has the option to request an increase in aggregate commitments of up to an additional $200.0 million. Pursuant to the Credit Agreement, the Company has borrowed $300.0 million pursuant to a Term Facility repayable with interest quarterly at a percentage of the initial principal amount of the Term Facility of 5.0% per year with the remaining principal due in 5 years. Up to $350.0 million is available under the Credit Agreement pursuant to a Revolver Facility which terminates in 5 years. The Agreement requires the Company to maintain two financial covenants, a maximum leverage ratio and a minimum asset coverage ratio. The Agreement also contains various covenants relating to limitations on indebtedness, limitations on investments and acquisitions, limitations on sale of properties and limitations on liens and capital expenditures. The Agreement also contains other customary covenants, representations and events of defaults. The expiration date of the Term Facility and the Revolver Facility is October 24, 2024. As of December 31, 2020, $285.2 million was outstanding under the Credit Agreement, $280.2 million on the Term Facility and $5.0 million on the Revolver Facility. On December 31, 2020, $2.2 million of the revolver capacity was committed to irrevocable standby letters of credit issued in the ordinary course of business as required by vendors' contracts resulting in $176.7 million in available borrowings. The Company is in compliance with the covenants under the Agreement.
Management believes the Agreement and the Company’s ability to internally generate funds from operations should be sufficient to meet the Company’s cash requirements for the foreseeable future. However, future challenges affecting the banking industry and credit markets in general could potentially cause changes to credit availability, which creates a level of uncertainty.
Inflation
The Company believes that inflation generally has not had a material impact on its operations or liquidity. The Company is exposed to the risk that the price of energy, steel and other purchased components may increase and the Company may not be able to increase the price of its products correspondingly. If this occurs, the Company’s results of operations would be adversely impacted.
New Accounting Pronouncements
As discussed in Note 2 of Notes to Consolidated Financial Statements, certain new financial accounting pronouncements became effective January 1, 2020, or will become effective in the future. The effect on our financial statements upon adoption of these pronouncements is discussed in the above- referenced note.
Off-Balance Sheet Arrangements
There are currently no off-balance sheet arrangements that have or are currently likely to have a current or future material effect on our financial condition.
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Contractual and Other Obligations
The following table shows the Company’s approximate obligations and commitments to make future payments under contractual obligations as of December 31, 2020:
Payment due by period
(in thousands) Less than 1-3 3-5 More than
Contractual Obligations Total 1 Year Years Years 5 Years
Long-term debt obligations $ 285,233 $ 15,000 $ 30,000 $ 240,233 $ —
Capital lease obligations 153 66 55 32 —
Interest obligations 21 6 11 4 —
Operating lease obligations 15,555 4,072 5,152 2,709 3,622
Purchase obligations 158,880 158,880 — — —
Total $ 459,842 $ 178,024 $ 35,218 $ 242,978 $ 3,622
Definitions:
A. Long-term debt obligation means a principal payment obligation under long-term borrowings.
B. Capital lease obligation means a principal payment obligation under a lease classified as a capital lease.
C. Interest obligation represents interest due on long-term debt and capital lease obligations. Interest on long-term debt assumes all floating rates of interest remain the same as those in effect at December 31, 2020.
D. Operating lease obligation means a payment obligation under a lease classified as an operating lease.
E. Purchase obligation means an agreement to purchase goods or services that is enforceable and legally binding on the registrant that specifies all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transactions.
Critical Accounting Estimates
Management’s Discussion and Analysis of Financial Condition and Results of Operations are based upon our Consolidated Financial Statements, which have been prepared in accordance with U.S. Generally Accepted Accounting Principles (“GAAP”). The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. Management bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
Critical Accounting Policies
An accounting policy is deemed to be critical if it requires an accounting estimate to be made based on assumptions about matters that are highly uncertain at the time the estimate is made, and if different estimates that reasonably could have been used, or changes in the accounting estimates that are reasonably likely to occur periodically, could materially impact the financial statements. Management believes the following critical accounting policies reflect its more significant estimates and assumptions used in the preparation of the Consolidated Financial Statements. For further information on the critical accounting policies, see Note 1 of our Notes to Consolidated Financial Statements.
Business Combinations
We account for the acquisition of a business in accordance with the accounting standards codification guidance for business combinations, whereby the total consideration transferred is allocated to the assets acquired and liabilities assumed, including amounts attributable to intangible assets based on their respective estimated fair values as of the date of acquisition. Goodwill represents the excess of consideration transferred over the estimated fair value of the net assets acquired in a business combination.
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Assigning estimated fair values to the assets acquired and liabilities assumed requires the use of significant estimates, judgments, inputs, and assumptions regarding the fair value of intangibles assets that are separately identifiable from goodwill, inventory step-up, and property, plant, and equipment and are based on available historical information, future expectations, and assumptions determined to be reasonable but are inherently uncertain with respect to future events, including economic conditions, competition, the useful life of the acquired assets and other factors. Such significant estimates, judgments, inputs, and assumptions include, when applicable, the selection of an appropriate valuation method depending on the nature of the respective asset, such as the income approach, the market or sales comparison approach, or the cost approach; estimating future cash flows based on projected revenues and/or margins that we expect to generate subsequent to an acquisition; applying an appropriate discount rate to estimate the present value of those projected cash flows we expect to generate subsequent to an acquisition; selecting an appropriate royalty rate or estimating a customer attrition or technological obsolescence factor where necessary and appropriate given the nature of the respective asset; assigning the appropriate contributory asset charge where needed; determining an appropriate useful life and the related depreciation or amortization method for the respective asset; and assessing the accuracy and completeness of other historical financial metrics of the acquiree used as standalone inputs or as the basis for determining estimated projected inputs such as margins, customer attrition, and costs to hold and sell product.
In determining the estimated fair value of intangible assets that are separately identifiable from goodwill, we typically utilize the income approach, which discounts the projected future cash flows using an appropriate discount rate that reflects the risks associated with the projected cash flows. However, in certain instances, particularly in relation to developed technology or patents, we may utilize the cost approach depending on the nature of the respective intangible asset and the recency of the development or procurement of such technology. In determining the estimated fair value of acquired inventory, we typically utilize the cost approach for raw materials and the sales comparison approach for finished goods, work in process and component parts. In determining the estimated fair value of acquired property, plant, and equipment, we typically utilize the sales comparison approach or the cost approach depending on the nature of the respective asset and the recency of the construction or procurement of such asset.
We may refine the estimated fair values of assets acquired and liabilities assumed, if necessary, over a period not to exceed one year from the date of acquisition by taking into consideration new information that, if known at the date of acquisition, would have affected the estimated fair values ascribed to the assets acquired and liabilities assumed. The judgments made in determining the estimated fair value assigned to assets acquired and liabilities assumed, as well as the estimated useful life and depreciation or amortization method of each asset, can materially impact the net earnings of the periods subsequent to an acquisition through depreciation and amortization, and in certain instances through impairment charges, if the asset becomes impaired in the future. During the measurement period, any purchase price allocation changes that impact the carrying value of goodwill will affect any measurement of goodwill impairment taken during the measurement period, if applicable.