ALAMO GROUP INC 10-K

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Executive Summary and 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 14. We experienced strong demand for our products in 2022 which led to record net sales for the full year. Our markets continue to exhibit strength and we currently see do not anticipate a significant reduction in customer demand, at least in the near term. However, many of the same adverse operating conditions that we experienced in 2022 including, among other things, supply chain disruptions, input cost inflation, and labor shortages continue to present challenges to our business. Supply chain and labor issues have led to disruptions in our manufacturing facilities which constrain our operating efficiencies and negatively impact our overall profitability. These challenges are also partially responsible for our record high backlog levels, as we have struggled to fully complete and ship products in a timely manner. While our supply chain appears to be gradually improving, we expect that some or all of these adverse operating conditions will persist for at least a portion of 2023. 2022 Performance In 2022, the Company's net sales increased by 13% and net income increased by 27% compared to 2021. The increase in both net sales and net income was primarily due to a strong demand for our products. Margins improved due to the increase in demand along with pricing actions we began in 2021 which helped mitigate inflation cost pressures. However, our results were constrained by higher input costs, ongoing supply chain disruptions, and skilled labor shortages. The Company's Vegetation Management Division experienced a 15% increase in net sales for the full year of 2022 compared to the full year of 2021. The increase in net sales was primarily due to continued strong customer demand for our products and positive pricing actions. The division's income from operations for 2022 was up 37% versus the full year of 2021, due to improved sales and positive pricing actions but offset by higher input costs and operational inefficiencies due to supply chain disruptions and labor constraints. The Company's Industrial Equipment Division net sales were up 11% for the full year of 2022 compared to the full year of 2021. The division's net sales were strong in the excavator and vacuum truck product lines and were also supported by moderate sales increases in our street sweeper, debris collector and snow removal equipment lines. Negatively impacting this division were higher input costs and supply chain disruptions including, most significantly, a shortage of truck chassis. These adverse conditions had a negative impact on the division's income from operations, which for the full year of 2022 was up only 5% compared to the full year of 2021. Consolidated income from operations was $148.6 million for the full year of 2022 compared to $116.9 million in 2021, an increase of 27%. The Company's backlog increased 26% to $1.0 billion at the end of 2022 versus the backlog of $800.8 million at the end of 2021. The increase in the Company's backlog was primarily attributable to continued strong customer demand for our products in both of the Company's divisions as outlined above. Inflationary Impacts In 2022, the cost of commodities, components, parts, and accessories was significantly higher compared to the cost of those items purchased in 2021, mainly as a result of ongoing upward inflationary pressure. In 2023, we anticipate that the average cost of commodities, components, parts, and accessories will be slightly higher than the average costs experienced during 2022 but the rate of inflation appears to be moderating. Any material worsening of the current inflationary environment could lead to higher input costs which is likely to have a material adverse effect on our business and financial results. 30 Impact of the War in Ukraine In 2022, we discontinued sales into the Russian and Belarusian markets as a response to the war in Ukraine. Our sales in those markets represented an insignificant share of our overall international business and, accordingly, this decision did not have a material impact on our 2022 results nor do we expect it to have a material impact on our future financial results. The war has disrupted parts of our supply chain and has created additional inflationary pressure on some of the items we purchase for our end-products, but we do not believe these effects are material to our business. However, any significant change in or escalation of the war in Ukraine could result in unanticipated effects which may adversely impact our business. 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): 2022 2021 2020 Vegetation Management $ 937,065 $ 812,676 $ 654,630 Industrial Equipment 576,551 521,547 508,836 Total net sales $ 1,513,616 $ 1,334,223 $ 1,163,466 Cost and profit margins, as percentages of net sales: Cost of sales 75.1 % 74.9 % 74.8 % Gross profit 24.9 % 25.1 % 25.2 % Selling, general, administrative, and amortization expenses 15.1 % 16.3 % 17.1 % Income from operations 9.8 % 8.8 % 8.1 % Income before income taxes 8.9 % 8.2 % 6.9 % Net income 6.7 % 6.0 % 5.0 % Results of Operations Fiscal 2022 compared to Fiscal 2021 The Company’s net sales in the fiscal year ended December 31, 2022 (“2022”) were $1,513.6 million, an increase of $179.4 million or 13.4% compared to $1,334.2 million for the fiscal year ended December 31, 2021 (“2021”). The increase in sales was attributable to continued strong customer demand for our products in both the Vegetation Management and Industrial Equipment Divisions and improved pricing. Negatively impacting net sales were higher costs for materials and inbound freight, supply chain disruptions and a shortage of skilled labor. Also, currency translation negatively affected sales as the U.S. dollar strengthened against the currencies of international countries where we operate. Net Vegetation Management sales were $937.1 million in 2022 compared to $812.7 million in 2021, an increase of $124.4 million or 15.3%, coming from a strong performance in all product lines, particularly forestry and tree care and agricultural and governmental mowing equipment in both North America and Europe. Supply chain disruptions, labor constraints and unfavorable input cost changes constrained this Division during 2022. Currency translation effects also negatively impacted net sales in this division. Net Industrial Equipment sales were $576.6 million in 2022 compared to $521.5 million in 2021, representing an increase of $55.1 million or 10.5%. The increase was mainly due to continued solid results in our excavator and vacuum truck product lines with modest support from other product lines. This division was also negatively impacted by ongoing supply chain disruptions and logistics issues in 2022, including delays in receiving truck chassis and component parts from supply chain partners. 31 Gross profit for 2022 was $376.5 million (24.9% of net sales) compared to $334.5 million (25.1% of net sales) in 2021, an increase of $42.0 million. The increase in gross profit was mainly attributable to higher sales volume during 2022 compared to 2021 as well as improved pricing. Profitability was negatively impacted by supply chain disruptions, shortages of component parts, along with higher costs of materials and inbound freight. These factors led to lower profitability as a percentage of sales in 2022 as compared to the same period in 2021. Selling, general and administrative expenses (“SG&A”) were $212.6 million (14.0% of net sales) in 2022 compared to $202.9 million (15.2% of net sales) in 2021, an increase of $9.7 million. The increase in SG&A expenses in 2022 was attributable to higher administrative, marketing and engineering expenses as the Company returned to pre-pandemic expense levels. Amortization expense in 2022 was $15.3 million compared to $14.6 million in 2021, an increase of $0.7 million. Interest expense for 2022 was $14.4 million compared to $10.5 million in 2021, an increase of $3.9 million or 36.3%. The increase in interest expense in 2022 primarily came from higher interest rates and increased borrowing levels. Borrowing levels rose in 2022 primarily because of the need for the Company to increase its inventory levels to accommodate stronger market demand and to mitigate supply chain challenges. We anticipate borrowing levels will continue to be pressured by higher inventory requirements unless and until the supply chain situation improves. Other income (expense), net was expense of $0.7 million during 2022 compared to income of $1.9 million in 2021. The expense in 2022 was primarily the result of an excise tax audit and to a lesser extent, changes in exchange rates. The income in 2021 was primarily due to changes in exchange rates and the sale of a facility in the Netherlands for $3.4 million. Provision for income taxes was $32.4 million (24.1% of income before income taxes) for 2022 compared to $29.3 million (26.7% of income before income taxes) in 2021. Net income for 2022 was $101.9 million compared to $80.2 million in 2021, with the increase in 2022 net income resulting from the factors described above. Fiscal 2021 compared to Fiscal 2020 The Company’s net sales in the fiscal year ended 2021 were $1,334.2 million, an increase of $170.7 million or 14.7% compared to $1,163.5 million for the fiscal year ended December 31, 2020 (“2020”). The increase in sales was attributable to the continued strong recovery in customer demand for our products in both the Vegetation Management and the Industrial Equipment Divisions. Negatively affecting sales in 2020 was the onset of the COVID-19 pandemic which materially impacted global demand for the Company's products and overall Company financial performance. Net Vegetation Management sales were $812.7 million in 2021 compared to $654.6 million in 2020, an increase of $158.1 million or 24.1%, coming from improved sales in the forestry/tree care and agricultural mowing units along with solid contributions from the U.K., Europe, Brazil and Australia operations. Sales in this Division were negatively impacted by operational and supply chain disruptions and logistics issues due to the pandemic. Net Industrial Equipment sales were $521.5 million in 2021 compared to $508.8 million in 2020, representing an increase of $12.7 million or 2.5%. The increase primarily resulted from higher customer demand for excavation/vacuum truck products and to a lesser extent the sweeper/debris collection products, offset by softer demand for snow removal equipment. Negatively affecting this Division were delays in truck chassis deliveries due to ongoing computer chip shortages as well as other supply chain constraints and operational disruptions due to the pandemic. Gross profit for 2021 was $334.5 million (25.1% of net sales) compared to $293.7 million (25.2% of net sales) in 2020, an increase of $40.8 million. The increase in gross profit was primarily attributable to higher sales volume in 2021 as well as pricing increases that were implemented over the course of the year. This was offset by inflationary pressures, mainly from steel, along with higher costs relating to delivery of component parts, such as airfreighting charges to meet customer deliveries, which also had a negative effect on gross margin percentage for the full year of 2021. Negatively affecting the gross margin and gross margin percentage during for the full year of 2020 was a $4.8 million charge on sales of inventory that had been previously stepped-up related to the Morbark acquisition. 32 Selling, general and administrative expenses (“SG&A”) were $202.9 million (15.2% of net sales) in 2021 compared to $184.2 million (15.8% of net sales) in 2020, an increase of $18.7 million. The full year of 2021 included higher administrative and marketing expenses as the Company returned to pre-pandemic expense levels. Amortization expense in 2021 was $14.6 million compared to $14.7 million in 2020, a decrease of $0.1 million. Interest expense for 2021 was $10.5 million compared to $15.8 million in 2020, a decrease of $5.3 million or 33.5%. The decrease in interest expense in 2021 primarily came from a decrease in interest rates, and to a lesser extent, reduced borrowing levels. Other income (expense), net was income of $1.9 million during 2021 compared to expense of $0.6 million in 2020. The income in 2021 was primarily from changes in exchange rates and the sale of a facility in the Netherlands and the expense in 2020 was primarily the result of changes in exchange rates offset by the gain on the sale of two properties, one in the U.S. and one in Canada. Provision for income taxes was $29.3 million (26.7% of income before income taxes) for 2021 compared to $22.0 million (27.5% of income before income taxes) in 2020. Net income for 2021 was $80.2 million compared to $57.8 million in 2020, with the increase in 2021 net income resulting from 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 Vegetation Management 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 Vegetation Management Division, help balance the Company’s production during the first and fourth quarters. As of December 31, 2022, the Company had working capital of $536.7 million, which represents a increase of $117.1 million from working capital of $419.6 million as of December 31, 2021. The increase in working capital was primarily a result of volume-driven and inflation-driven increases in accounts receivable as well as an increase in inventory to support the Company's higher backlog levels. Capital expenditures were $31.1 million for 2022, compared to $25.3 million for 2021. The Company will fund any future expenditures from operating cash flows or through our revolving credit facility, described below. Net cash provided by operating activities was $14.5 million for 2022, compared to $49.7 million for 2021. The decrease of cash from operating activities is primarily the result of increased borrowings on the Company's revolving credit facility used for increased working capital needs in support of elevated backlog levels. Net cash used in investing activities was $31.7 million for 2022, compared to $33.4 million for 2021. Net cash provided by financing activities was $24.5 million for 2022, compared to net cash used of $23.0 million for 2021. The Company had $42.9 million in cash and cash equivalents held by its foreign subsidiaries as of December 31, 2022. The majority of these funds are held 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 28, 2022, the Company, as the borrower, and each of its domestic subsidiaries as guarantors, entered into a Third Amended and Restated Credit Agreement (the “2022 Credit Agreement”) with Bank of America, N.A., as Administrative Agent. The 2022 Credit Agreement provides the Company with the ability to request loans and other financial obligations in an aggregate amount of up to $655.0 million. Under the 2022 Credit Agreement, the Company has borrowed $255.0 million pursuant to a Term Facility, while up to $400.0 million is available to the Company pursuant to a Revolver Facility which terminates in five years. The Term Facility requires the Company to 33 make equal quarterly principal payments of $3.75 million over the term of the loan, with the final payment of any outstanding principal amount, plus interest, due at the end of the five year term. Borrowings under the 2022 Credit Agreement bear interest, at the Company’s option, at a Term Secured Overnight Financing Rate (“SOFR”) or a Base Rate (each as defined in the 2022 Credit Agreement), plus, in each case, an applicable margin. The applicable margin ranges from 1.25% to 2.50% for Term SOFR borrowings and from .25% to 1.50% for Base Rate borrowings with the margin percentage based upon the Company's consolidated leverage ratio. The Company must also pay a commitment fee to the lenders ranging between 0.15% to 0.30% on any unused portion of the $400.0 million Revolver Facility. The 2022 Credit Agreement requires the Company to maintain two financial covenants, namely, a maximum consolidated leverage ratio and a minimum consolidated fixed charge coverage ratio. The Agreement also contains various covenants relating to limitations on indebtedness, limitations on investments and acquisitions, limitations on the 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 2022 Credit Agreement, including the Term Facility and the Revolver Facility, is October 28, 2027. As of December 31, 2022, $301.9 million was outstanding under the Credit Agreement, $249.9 million on the Term Facility and $52.0 million on the Revolver Facility. On December 31, 2022, $2.8 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 $295.2 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 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. In 2022, the Company was materially impacted by inflationary pressures that significantly increased the price of steel as well as the price of many other purchased components. In 2022, we worked to mitigate some of the effects of cost increases through aggressive pricing actions but cost inflation is an ongoing challenge that could have a material impact on the Company's business and financial results, particularly if the current inflationary environment materially worsens. New Accounting Pronouncements As discussed in Note 2 of Notes to Consolidated Financial Statements, certain new financial accounting pronouncements became effective January 1, 2021, 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. Payment due by period 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. 34 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 policy 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. 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 intangible 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. 35