Item 7. Management’s Discussion and Analysis
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
Overview
We are a leading integrated and innovative global provider of advanced materials, specialty catalysts and services. We believe that our products and services contribute to improving the sustainability of the environment.
We conduct operations through two repor ting segments: (1) Ecoservices and (2) Advanced Materials & Catalysts (including our 50% interest in the Zeolyst Joint Venture).
Ecoservices: We are a leading provider of sulfuric acid recycling to the North American refining industry for the production of alkylate, an essential gasoline component for lowering vapor pressure and increasing octane to meet stringent gasoline specifications and fuel efficiency standards. We are also a leading North American producer of high quality and high strength virgin sulfuric acid for industrial and mining applications. We also provide chemical waste handling and treatment services, as well as ex-situ catalyst activation services for the refining and petrochemical industry.
Advanced Materials & Catalysts : We are a global supplier of finished silica catalyst, catalyst supports and functionalized silicas necessary to produce high performing plastics and to enable sustainable chemistry. This segment includes our 50% interest in the Zeolyst Joint Venture, where we are a leading global supplier of zeolites used for catalysts that support the production of sustainable fuels, remove nitrogen oxides from diesel engine emissions and are broadly applied in refining and petrochemical processes.
Effective November 28, 2023, the Company renamed the Catalyst Technologies segment to Advanced Materials & Catalysts. Beginning with the year ended December 31, 2023, the segment results and disclosures included in the Company’s consolidated financial statements reflect the new segment name for all periods presented. This change to the Company’s segment name does not change the Company’s consolidated balance sheets, statements of income or cash flows for the prior periods or the way the Company’s chief operating decision maker (“CODM”) evaluated the business.
In 2023, we served global customers across many end uses and, as of December 31, 2023, operated out of ten strategically located manufacturing facilities.
On December 14, 2020, we completed the sale of our Performance Materials business to Potters Buyer, LLC, an affiliate of The Jordan Company, L.P. Effective on August 1, 2021, we completed the sale of our Performance Chemicals business to Sparta Aggregator L.P., a partnership with Koch Minerals & Trading, LLC and Cerberus Capital Management, L.P. The results of operations, financial condition, and cash flows for the Performance Materials and Performance Chemicals businesses are presented herein as discontinued operations for the 2022 and 2021 periods presented. Refer to Note 4 of our consolidated financial statements for additional information.
Economic Effects on our Business and Results
We continue to monitor the developments in Russia and Ukraine, as well as the related economic sanctions and export controls imposed on certain industry sectors. Although the current conflict has created global economic and political uncertainties and affected certain supply chain disruptions, we do not believe we have significant exposure in those countries. We have no operations in Russia or Ukraine. We had no sales to customers in Ukraine and Russia in December 31, 2023 and our sales to a customer in Russia were immaterial for the year ended December 31, 2022 and 2% for the year ended December 31, 2021. We also did not make any purchases from suppliers in Russia or Ukraine. As Russia’s invasion of Ukraine continues to unfold, we will continue to monitor compliance with sanctions imposed by the U.S. government and other countries.
We continue to monitor the developments in the Middle East. Although the Company experienced shipment delays, the impact remained immaterial on our business.
43
2022 Stock Repurchase Program
On April 27, 2022, the Board approved a stock repurchase program that authorized the Company to purchase up to $450 million of the Company’s common stock over the four-year period from the date of approval. During the year-ended December 31, 2023, the Company repurchased 541,494 shares on the open market at an average price of $9.85 per share, for a total of $5.3 million, excluding brokerage commissions and accrued excise tax. Additionally, in connection with secondary offerings of the Company’s common stock in March and May 2023, the Company repurchased 7,000,000 shares of its common stock sold in the offerings from the underwriters at a weighted average price of $10.48 per share concurrently with the closing of the offerings, for a total of $73.4 million, excluding accrued excise tax.
As of December 31, 2023, $234.6 million was available for additional share repurchases under the program.
During the year-ended December 31, 2022, the Company repurchased 1,970,763 shares on the open market at an average price of $9.82 per share, for a total of $19.4 million, excluding brokerage commissions. Additionally, in connection with secondary offerings of the Company’s common stock in August and November 2022, the Company repurchased 14,500,000 shares of its common stock sold in the offerings from the underwriters at a weighted average price of $8.09 per share concurrently with the closing of the offerings, for a total of $117.3 million.
Basis of Presentation
Our zeolite catalysts product group operates through the Zeolyst Joint Venture, which we account for as an equity method investment in accordance with accounting principles generally accepted in the United States (“GAAP”). We do not record sales by the Zeolyst Joint Venture as revenue and such sales are not consolidated within our results of operations. However, net income and Adjusted EBITDA reflects our share of the earnings of the Zeolyst Joint Venture that have been recorded as equity in net income from affiliated companies in our consolidated statements of income and includes Zeolyst Joint Venture adjustments on a proportionate basis based on our 50% ownership interest.
Key Performance Indicators
Adjusted EBITDA and Adjusted Net Income
Adjusted EBITDA and adjusted net income are financial measures that are not prepared in accordance with GAAP and that we use to evaluate our operating performance, for business planning purposes and to measure our performance relative to that of our competitors. Adjusted EBITDA and adjusted net income are presented as key performance indicators as we believe these financial measures will enhance a prospective investor’s understanding of our results of operations and financial condition. EBITDA consists of net income (loss) attributable t o continuing operations b efore interest, taxes, depreciation and amortization. Adjusted EBITDA consists of EBITDA adjusted for (i) non-operating income or expense, (ii) the impact of certain non-cash, nonrecurring or other items included in net income (loss) and EBITDA that we do not consider indicative of our ongoing operating performance, and (iii) depreciation, amortization and interest of our 50% share of the Zeolyst Joint Venture. Adjusted net income consists of net income (loss) adjusted for (i) non-operating income or expense and (ii) the impact of certain non-cash, nonrecurring or other items included in net income (loss) that we do not consider indicative of our ongoing operating performance. We believe that these non-GAAP financial measures provide investors with useful financial metrics to assess our operating performance from period-to-period by excluding certain items that we believe are not representative of our core business.
You should not consider Adjusted EBITDA or adjusted net income in isolation or as alternatives to the presentation of our financial results in accordance with GAAP. The presentation of Adjusted EBITDA and adjusted net income financial measures may differ from similar measures reported by other companies and may not be comparable to other similarly titled measures. In evaluating Adjusted EBITDA and adjusted net income, you should be aware that we are likely to incur expenses similar to those eliminated in this presentation in the future and that certain of these items could be considered recurring in nature. Our presentation of Adjusted EBITDA and adjusted net income should not be construed as an inference that our future results will be unaffected by unusual or nonrecurring items. Reconciliations of Adjusted EBITDA and adjusted net income to GAAP net income (loss) are included in the results of operations discussion that follows for each of the respective periods.
44
Key Factors and Trends Affecting Operating Results and Financial Condition
Sales
Overall, our Ecoservices and Advanced Materials & Catalysts segments continued to benefit from demand trends for our products and services in the industries we serve. While sales of our virgin sulfuric acid into the production of nylon intermediates and sales of polyethylene catalysts weakened in the second half of 2023, demand across the balance of product categories, end-uses and customers throughout 2023 remained positive. Contractual pass-through mechanisms and targeted price increases have served to mitigate the adverse impacts of inflationary pressures in 2023, including higher variable costs on our businesses and supply chain constraints, including limited availability and higher costs for energy, logistics, and other raw materials.
Cost of Goods Sold
Cost of goods sold consists of variable product costs, fixed manufacturing expenses, depreciation expense and freight expenses. Variable product costs include all raw materials, energy and packaging costs that are directly related to the manufacturing process. Fixed manufacturing expenses include all plant employment costs, manufacturing overhead and periodic maintenance costs.
The primary raw materials for our Ecoservices segment include spent sulfuric acid, sulfur, acids, bases (including sodium hydroxide, or “caustic soda”), and certain metals. Spent sulfuric acid for our Ecoservices segment is supplied by customers for a nominal charge as part of their contracts. The primary raw materials used in the manufacture of products in our Advanced Materials & Catalysts segment include sodium silicate and cesium hydroxide. During the second quarter of 2023, inflationary pressures began to ease, which reduced the cost of goods for sulfur, energy, logistics and other raw materials.
Most of our Ecoservices contracts feature take-or-pay volume protection and/or quarterly price adjustments for commodity inputs, labor, the Chemical Engineering Index (U.S. chemical plant construction cost index) and natural gas. Over 80% of our Ecoservices segment sales for the year ended December 31, 2023 were under contracts featuring quarterly price adjustments. The price adjustments generally reflect actual costs for producing acid and tend to protect us from volatility in labor, fixed costs and raw material pricing. The take-or-pay volume protection allows us to cover fixed costs through intermittent, temporary production issues at customer refineries.
While natural gas is not a direct feedstock for any product, natural gas powered machinery and equipment are used to heat raw materials and create the chemical reactions necessary to produce end-products. We maintain multiple suppliers wherever possible and structure our customer contracts when possible to allow for the pass-through of raw material, labor and natural gas costs.
Joint Ventures
We account for our investments in our equity joint ventures under the equity method. Our joint venture, the Zeolyst Joint Venture, manufactures high performance, specialty, zeolite-based catalysts, used in emission control, refining and petrochemical industry applications and by the broader chemicals industry. Demand for the Zeolyst Joint Venture products fluctuates based upon the timing of our customer’s fixed bed catalyst replacements. We share proportionally in the management of our joint venture with the other parties to such joint venture.
Seasonality
Our regeneration services product group, which is a part of our Ecoservices segment, typically experiences seasonal fluctuations as a result of higher demand for gasoline products in the summer months and lower demand in the winter months. These demand fluctuations results in higher sales and working capital requirements in the second and third quarters.
45
Foreign Currency
As a global business, we are subject to the impact of gains and losses on currency translations, which occur when the financial stat ements of foreign operations are translated into U.S. dollars. We operate in various geographies with approximately 6% of our sales for the years ended December 31, 2023 and 2022 in currencies other than the U.S. dollar. Because our consolidated financial results are reported in U.S. dollars, sales or earnings generated in currencies other tha n the U.S. dollar can result in a significant increase or decrease in the amount of those sales and earnings when translated to U.S. dollars. The foreign currency to which we have the most significant exchange rate exposure is the British Pound.
Results of Operations
Year Ended December 31, 2023 Compared to the Year Ended December 31, 2022
Highlights
The following is a summary of our financial performance for the year ended December 31, 2023 compared with the year ended December 31, 2022.
Sales
Sales decreased $129.1 million to $691.1 million. The decrease in sales was primarily due to lower sales volume and the pass-through of lower sulfur costs, offset by higher average selling prices, after adjusting for impact of the pass-through of lower sulfur costs.
Gross Profit
Gross profit decreased $26.8 million to $197.9 million. The decrease in gross profit was primarily due to lower sales volume.
Operating Income
Operating income decreased $7.7 million to $96.7 million. The decrease in operating income was primarily due to the decrease in gross profit, offset by l ower selling, general and administrative expenses and other operating expenses .
Equity in Net Income from Affiliated Companies
Equity in net income of affiliated companies increased $2.9 million to $30.6 million. The increase was primarily due to higher sales within the Zeolyst Joint Venture partially offset by the impact of unfavorable fixed cost absorption.
46
The following is our consolidated statement of income and a summary of financial results for the years ended December 31, 2023 and 2022.
Years ended
December 31, Change
2023 2022 $ %
(in millions, except percentages)
Sales $ 691.1 $ 820.2 $ (129.1) (15.7) %
Cost of goods sold 493.2 595.5 (102.3) (17.2) %
Gross profit 197.9 224.7 (26.8) (11.9) %
Gross profit margin 28.6 % 27.4 %
Selling, general and administrative expenses 79.2 85.3 (6.1) (7.2) %
Other operating expense, net 22.0 35.0 (13.0) (37.1) %
Operating income 96.7 104.4 (7.7) (7.4) %
Operating income margin 14.0 % 12.7 %
Equity in net income from affiliated companies (30.6) (27.7) (2.9) 10.5 %
Interest expense, net 44.7 37.2 7.5 20.2 %
Other expense, net 0.6 0.2 0.4 200.0 %
Income from continuing operations before income taxes 82.0 94.7 (12.7) (13.4) %
Provision for income taxes 10.8 24.9 (14.1) (56.6) %
Effective tax rate 13.2 % 26.3 %
Net income from continuing operations 71.2 69.8 1.4 2.0 %
Net income from discontinued operations, net of tax — 3.9 (3.9) (100.0) %
Net income $ 71.2 $ 73.7 $ (2.5) (3.4) %
Sales
Years ended
December 31, Change
2023 2022 $ %
(in millions, except percentages)
Sales:
Ecoservices $ 584.8 $ 702.5 $ (117.7) (16.8) %
Advanced Materials & Catalysts 106.3 117.7 (11.4) (9.7) %
Total sales $ 691.1 $ 820.2 $ (129.1) (15.7) %
Ecoservices : Sales in Ecoservices for the year ended December 31, 2023 were $584.8 million, a decrease of $117.7 million, or 16.8%, compared with sales of $702.5 million for the year ended December 31, 2022. The decrease in sales reflects lower sales volume of $52.1 million and the negative impact associated with the pass-through of lower sulfur costs of approximately $86 million, offset by higher average selling pricing of $20.4 million , after adjusting for the impact of the pass-through of lower sulfur costs.
Sales volume was lower primarily due to lower virgin sulfuric acid sales associated with the adverse impact of Winter Storm Elliott earlier in the year, extended maintenance turnaround activity at our facilities and lower end use demand of virgin sulfuric acid, primarily in the production of nylon intermediates. Favorable pricing continued to benefit Ecoservices, driven by higher contractual and index pricing within regeneration services, as well as the pass-through of higher freight costs.
47
Advanced Materials & Catalysts : Sales in Advanced Materials & Catalysts for the year ended December 31, 2023 were $106.3 million, a decrease of $11.4 million, or 9.7%, compared with sales of $117.7 million for the year ended December 31, 2022. The decrease in sales was primarily due to lower sales volume of $24.2 million, partially offset by higher average selling prices of $12.4 million and the effects of foreign currency translation of $0.4 million.
The decrease in sales volume was primarily driven by lower end use demand for polyethylene catalysts and niche custom catalysts during the year ended December 31, 2023. The higher average selling prices were primarily driven by implemented price increases.
Gross Profit
Gross profit for the year ended December 31, 2023 was $197.9 million, a decrease of $26.8 million, or 11.9%, compared with $224.7 million for the year ended December 31, 2022. The decrease in gross profit is primarily driven by lower sales volume of $30.1 million as well as unfavorable manufacturing costs of $29.5 million, partially offset by favorable average selling prices of $32.8 million, exclusive of the pass-through of sulfur costs.
Sales volume was lower primarily due to lower virgin sulfuric acid sales and lower polyethylene catalysts sales. The unfavorable manufacturing costs was primarily driven by costs related to the extended maintenance turnaround activity, planned turnaround activity, and higher unplanned repair and maintenance costs.
Selling, General and Administrative Expenses
Selling, general and administrative expenses for the year ended December 31, 2023 were $79.2 million, a decrease of $6.1 million compared with $85.3 million for the year ended December 31, 2022. The decrease in selling, general and administrative expenses was mainly due to a decrease in compensation related costs of $6.3 million and a decrease in stock-based compensation expense of $4.6 million driven by fewer overall awards granted and outstanding for the year ended December 31, 2023. This was partly offset by an increase in professional fees of $3.4 million primarily related to consulting and recruiting charges.
Other Operating Expense, Net
Other operating expense, net for the year ended December 31, 2023 was $22.0 million, a decrease of $13.0 million, or 37.1%, compared with $35.0 million for the year ended December 31, 2022. The decrease in other operating expense, net was mainly driven by severance charges incurred in the prior period from contracts associated with fo rmer executives and residual costs from the sale of the Performance Chemicals business and other transactions costs for the year ended December 31, 2022 .
Equity in Net Income from Affiliated Companies
Equity in net income from affiliated companies for the year ended December 31, 2023 was $30.6 million, an increase of $2.9 million or 10.5%, compared with $27.7 million for the year ended December 31, 2022. The increase was primarily due to higher sales for hydrocracking, sustainable fuels and emission control catalysts within the Zeolyst Joint Venture partially offset by the impact of unfavorable fixed cost absorption during the year ended December 31, 2023 as compared to the year ended December 31, 2022.
Interest Expense, Net
Interest expense, net for the year ended December 31, 2023 was $44.7 million, an increase of $7.5 million, as compared with $37.2 million for the year ended December 31, 2022. The increase in interest expense was due to year over year increase in variable rates, which was partially offset by lower outstanding debt for the year ended December 31, 2023 , as compared to the year ended December 31, 2022. This was offset by the benefits associated with our interest rate caps, which included an adjustment related to prior year interest rate amortization.
Other Expense, Net
Other expense, net was $0.6 million for the year ended December 31, 2023, an increase of $0.4 million, compared with $0.2 million for the year ended December 31, 2022. The change primarily related to a $1.6 million change in net gains in foreign currency translation in the current year and a change of $1.1 million in pension plan costs.
48
Provision for Income Taxes
The provision for income taxes for the year ended December 31, 2023 was $10.8 million compared with $24.9 million for the year ended December 31, 2022. The effective income tax rate for the year ended December 31, 2023 was 13.2% compared to 26.3% for the year ended December 31, 2022. The difference between the U.S. federal statutory income tax rate and our effective income tax rate for the year ended December 31, 2023 was mainly due to the impact of a valuation allowance release connected to our state investment tax credit carryovers, foreign tax credit benefit, the Section 162(m) deduction limitation for “covered” employees with compensation in excess of $1 million, along with the tax deductibility of stock compensation. The difference between the U.S. federal statutory income tax rate and our effective income tax rate for the year ended December 31, 2022 was mainly due the impact of the Section 162(m) deduction limitation for “covered” employees with compensation in excess of $1 million, along with the tax deductibility of stock compensation.
Net Income
For the foregoing reasons, net income was $71.2 million for the year ended December 31, 2023 as compared to $73.7 million for the year ended December 31, 2022.
Adjusted EBITDA
Summarized EBITDA and Adjusted EBITDA information is shown below in the following table:
Years ended
December 31, Change
2023 2022 $ %
(in millions, except percentages)
Adjusted EBITDA (1) :
Ecoservices $ 200.0 $ 227.8 $ (27.8) (12.2) %
Advanced Materials & Catalysts (2)
81.9 78.0 3.9 5.0 %
Unallocated corporate expenses (22.0) (29.0) 7.0 (24.1) %
Total $ 259.9 $ 276.8 $ (16.9) (6.1) %
(1) We define Adjusted EBITDA as EBITDA adjusted for certain items as noted in the reconciliation below. Our management evaluates the performance of our segments and allocates resources based primarily on Adjusted EBITDA. Adjusted EBITDA does not represent cash flow for periods presented and should not be considered as an alternative to net income as an indicator of our operating performance or as an alternative to cash flows as a source of liquidity. Adjusted EBITDA may not be comparable with EBITDA or Adjusted EBITDA as defined by other companies.
(2) The Adjusted EBITDA from the Zeolyst Joint Venture included in the Advanced Materials & Catalysts segment was $50.5 million for the year ended December 31, 2023, which includes $30.7 million of equity in net income, excluding $6.4 million of amortization of investment in affiliate step-up plus $13.4 million of joint venture depreciation, amortization and interest. The Adjusted EBITDA from the Zeolyst Joint Venture included in the Advanced Materials & Catalysts segment was $50.3 million for the year ended December 31, 2022, which includes $27.9 million of equity in net income, excluding $6.4 million of amortization of investment in affiliate step-up plus $16.0 million of joint venture depreciation, amortization and interest.
Ecoservices : Adjusted EBITDA for the year ended December 31, 2023 was $200.0 million, a decrease of $27.8 million, or 12.2%, compared to $227.8 million for the year ended December 31, 2022. The decrease in Ecoservices’ Adjusted EBITDA was the result of lower sales volumes for virgin sulfuric acid, as well as higher unplanned repair and maintenance costs associated with production downtime at several of our manufacturing sites and the associated impact from Winter Storm Elliott, partially offset by higher average selling prices, excluding the pass-through of lower sulfur costs .
Favorable pricing continued to benefit Ecoservices driven by higher contractual pricing and index pricing within regeneration services as well as the pass through of higher freight costs. The Winter Storm Elliott and unplanned production downtime drove both lower sales of virgin sulfuric acid as well as higher maintenance costs during the year.
49
In addition, the lower volume was driven by a decrease in demand for virgin sulfuric acid used in the production of nylon intermediates.
Advanced Materials & Catalysts: Adjusted EBITDA for the year ended December 31, 2023 was $81.9 million, an increase of $3.9 million, or 5.0%, compared with $78.0 million for the year ended December 31, 2022. Adjusted EBITDA increased due higher average selling prices from implemented price increases, partially offset by lower volume from decreased demand for polyethylene catalysts and the timing of niche custom catalyst sales. In addition, within the Zeolyst Joint Venture, strong pricing and higher sales of hydrocracking catalyst, emission control catalyst and catalyst used in the production of sustainable fuels was offset by higher manufacturing costs and the year-over-year impact of prior year unfavorable fixed cost absorption.
A reconciliation of net income attributable to Ecovyst Inc. to Adjusted EBITDA is as follows:
Years ended
December 31,
2023 2022
(in millions)
Reconciliation of net income to Adjusted EBITDA
Net income from continuing operations $ 71.2 $ 69.8
Provision for income taxes 10.8 24.9
Interest expense, net 44.7 37.2
Depreciation and amortization 84.6 79.2
EBITDA 211.3 211.1
Joint venture depreciation, amortization and interest (a)
13.4 16.0
Amortization of investment in affiliate step-up (b)
6.4 6.4
Net loss on asset disposals (c)
4.1 3.6
Foreign currency exchange (gain) loss (d)
(1.3) 1.4
LIFO expense (benefit) (e)
3.5 (0.2)
Transaction and other related costs (f)
3.0 7.0
Equity-based compensation 16.0 20.6
Restructuring, integration and business optimization expenses (g)
2.7 11.6
Other (h)
0.8 (0.7)
Adjusted EBITDA $ 259.9 $ 276.8
(a) We use Adjusted EBITDA as a performance measure to evaluate our financial results. Because our Advanced Materials & Catalysts segment includes our 50% interest in the Zeolyst Joint Venture, we include an adjustment for our 50% proportionate share of depreciation, amortization and interest expense of the Zeolyst Joint Venture.
(b) Represents the amortization of the fair value adjustments associated with the equity affiliate investment in the Zeolyst Joint Venture as a result of the combination of the businesses of PQ Holdings Inc. and Eco Services Operations LLC in May 2016. We determined the fair value of the equity affiliate investment and the fair value step-up was then attributed to the underlying assets of the Zeolyst Joint Venture. Amortization is primarily related to the fair value adjustments associated with intangible assets, including customer relationships and technical know-how.
(c) When asset disposals occur, we remove the impact of net gain/loss of the disposed asset because such impact primarily reflects the non-cash write-off of long-lived assets no longer in use.
(d) Reflects the exclusion of the foreign currency transaction gains and losses in the statements of income related to the non-permanent intercompany debt denominated in local currency translated to U.S. dollars.
(e) Represents non-cash adjustments to the Company’s LIFO reserves for certain inventories in the U.S. that are valued using the LIFO method, effectively reflecting the results as if these inventories were valued using the FIFO
50
method, which we believe provides a means of comparison to other companies that may not use the same basis of accounting for inventories.
(f) Relates to certain transaction costs, including debt financing, due diligence and other costs related to transactions that are completed, pending or abandoned, that we believe are not representative of our ongoing business operations.
(g) Includes the impact of restructuring, integration and business optimization expenses, which are incremental costs that are not representative of our ongoing business operations.
(h) Other consists of adjustments for items that are not core to our ongoing business operations. These adjustments include environmental remediation and other legal costs, expenses for capital and franchise taxes, and defined benefit pension and postretirement plan (benefits) costs, for which our obligations are under plans that are frozen. Also included in this amount are adjustments to eliminate the benefit realized in cost of goods sold of the allocation of a portion of the contract manufacturing payments under the five-year agreement with the buyer of the Performance Chemicals business to the financing obligation under the failed sale-leaseback. Included in this line-item are rounding discrepancies that may arise from rounding from dollars (in thousands) to dollars (in millions).
Adjusted Net Income
Summarized adjusted net income information is shown below in the following table:
Years ended December 31,
2023 2022
Pre-tax Tax expense (benefit) After-tax Pre-tax Tax expense (benefit) After-tax
(in millions)
Reconciliation of net income to Adjusted Net Income (1)(2)
Net income from continuing operations $ 82.0 $ 10.8 $ 71.2 $ 94.7 $ 24.9 $ 69.8
Amortization of investment in affiliate step-up (b)
6.4 1.6 4.8 6.4 1.5 4.9
Net loss on asset disposals (c)
4.1 1.0 3.1 3.6 0.9 2.7
Foreign currency exchange (gain) loss (d)
(1.3) (0.3) (1.0) 1.4 0.4 1.0
LIFO expense (benefit) (e)
3.5 0.9 2.6 (0.2) (0.1) (0.1)
Transaction and other related costs (f)
3.0 0.8 2.2 7.0 1.1 5.9
Equity-based compensation 16.0 1.5 14.5 20.6 (0.1) 20.7
Restructuring, integration and business optimization expenses (g)
2.7 0.7 2.0 11.6 2.8 8.8
Other (h)
0.8 0.2 0.6 (0.7) (0.2) (0.5)
Adjusted Net Income, including Impact valuation allowance release 117.2 17.2 100.0 144.4 31.2 113.2
Impact of valuation allowance release (3)
— 10.2 (10.2) — — —
Adjusted Net Income $ 117.2 $ 27.4 $ 89.8 $ 144.4 $ 31.2 $ 113.2
(1) We define adjusted net inco me as net income attributable to Ecovyst Inc. adjusted for non-operating income or expense and the impact of certain non-cash or other items that are included in net income that we do not consider indicative of our ongoing operating performance. Adjusted net income is presented as a key performance indicator as we believe it will enhance a prospective investor’s understanding of our results of operations and financial
51
condition. Adjusted net income may not be comparable with net income or adjusted net income as defined by other companies.
(2) Ref er to the Adjusted EBITDA notes above for more information with respect to each adjustment.
(3) Represents the tax impact of the state tax credit valuation allowance release. Item is not expected to be recurring.
The adjustments to net income attributable to Ecovyst Inc. are shown net of each applicable statutory tax rates of 25.4% and 23.9% for the year ended December 31, 2023 and 2022, respectively, except for equity-based compensation. The tax effect on equity-based compensation is derived by removing the tax effect of any equity-based compensation expense disallowed as a result of its inclusion within IRC Sec. 162(m), and adding the tax effect of equity-based stock compensation shortfall recorded as a discrete item.
Results of Operations
Year Ended December 31, 2022 Compared to the Year Ended December 31, 2021
A discussion of our performance for the year ended December 31, 2022 compared to the year ended December 31, 2021 is set forth in Part II, Item 7 of our Form 10-K for the year ended December 31, 2022 under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
Financial Condition, Liquidity and Capital Resources
Our primary sources of liquidity consist of cash flows from operations, existing cash balances as well as funds available under our asset based lending revolving credit facility (“ABL Facility”). We expect that ongoing requirements for debt service and capital expenditures will be funded from these sources of funds. Our primary liquidity requirements include funding working capital requirements (primarily inventory and accounts receivable, net of accounts payable and other accrued liabilities), debt service requirements and capital expenditures. Our capital expenditures include both maintenance of business, which include spending on maintenance and HSE initiatives as well as growth, which includes spending to drive organic sales growth and cost savings initiatives.
We believe that our existing cash, cash equivalents and cash flows from operations, combined with availability under our ABL Facility, will be sufficient to meet our presently anticipated future cash needs for at least the next twelve months. We may also pursue strategic acquisition or divestiture opportunities, which may impact our future cash requirements. We may, from time to time, increase borrowings under our ABL Facility to meet our future cash needs. As of December 31, 2023, we had cash and cash equivalents of $88.4 million and availability of $63.8 million under our ABL Facility, after giving effect to $4.0 million of outstanding letters of credit, for a total available liquidity of $152.2 million. As of December 31, 2023, we did not have any revolving credit facility borrowings and were in compliance with all covenants under our debt agreements.
Our ABL Facility has one financial covenant with two ratios to maintain. The first ratio compares the total ABL availability against a threshold: the greater of 10% of the line cap (which is defined as the lesser of our revolving loan commitments and the value of our assets) or $20.0 million. The greater of this threshold cannot be greater than the total availability of the ABL Facility. The second ratio compares the ABL Facility availability of the U.S. revolving credit facility against a $15.0 million threshold. As of December 31, 2023, we were in compliance with the financial covenant under the ABL Facility.
The 2021 Term Loan Facility and the ABL Facility contain various restrictive covenants. Each limits the ability of the Company and its restricted subsidiaries to incur certain indebtedness or liens, merge, consolidate or liquidate, dispose of certain property, make investments or declare or pay dividends, make optional payments, modify certain debt instruments, enter into certain transactions with affiliates, enter into certain sales and leasebacks, and certain other non-financial restrictive covenants. The ABL Facility also contains one financial covenant which applies when minimum availability under the ABL Facility exceeds a certain threshold. During such time, the Company is required to maintain a fixed-charge coverage ratio of at least 1.0 to 1.0. The Company was in compliance with all debt covenants under the 2021 Term Loan Facility and the ABL Facility as of December 31, 2023 and 2022, respectively.
Included in our cash and cash equivalents balance as of December 31, 2023 was $10.7 million of cash and cash equivalents in foreign jurisdictions. Depending on foreign cash balances, we have certain flexibility to repatriate funds should the need arise. Should the need arise, we would repatriate the funds in the most tax efficient manner from those subsidiaries. Repatriation of foreign cash is generally not subject to U.S. federal income taxes at the time of cash
52
distribution. However, foreign earnings may still be taxed for state income tax purposes, as well as subject to certain foreign withholding tax obligations, when cash amounts are distributed back to the U.S.
Over the course of the next twelve months and beyond, we anticipate making significant cash payments for known contractual and other obligations, including:
Principal and interest on long-term debt
As of December 31, 2023, our total indebtedness was $877.5 million, with up to $63.8 million of available borrowings under our ABL. Our liquidity requirements are significant, primarily due to debt service requirements. As reported, our cash interest expense for the years ended December 31, 2023, 2022 and 2021 was approximately $42.1 million, $35.4 million and $59.0 million, respectively. Before any impact of hedges, a one percent change in assumed interest rates for our variable interest credit facilities would have an annual impact of approximately $8.8 million on interest expense. The principal balance due in the next twelve months is $9.0 million.
Interest payments due within the next twelve months are $70.7 million using the interest rate effective as of December 31, 2023 on our variable interest credit facilities. Interest on long-term debt excludes amortization of deferred financing fees and original issue discount. The actual interest payments may differ materially based on actual amounts of long-term debt outstanding and actual interest rates in future periods, as well as the hedging impact from our interest rate cap agreements.
Subject to approval by our board of directors, we may raise additional capital or borrowings from time to time or seek to refinance our existing debt. There can be no assurances that future capital or borrowings will be available to us, and the cost and availability of new capital or borrowings could be materially impacted by market conditions. Further, the decision to refinance our existing debt is based on a number of factors, including general market conditions and our ability to refinance on attractive terms at any given point in time. Any attempts to raise additional capital or borrowings or refinance our existing debt could cause us to incur significant charges. Such charges could have a material impact on our financial position, results of operations, or cash flows.
Lease obligations
The Company has operating and finance lease agreements for land, buildings, railcars, vehicles, manufacturing equipment and general office equipment, as well as a financing obligation in connection with a failed-sale-leaseback. We utilize an incremental borrowing rate over the relevant operating and finance lease terms, which is the rate of interest that it would have to pay to borrow on a collateralized basis over a similar term an amount equal to the lease payments in a similar economic environment. We utilize a fixed borrowing rate for the financing obligation.
As of December 31, 2023, our total operating lease liabilities was $24.2 million, with $10.8 million of principal and interest payments made during the year. Operating lease payments due within the next twelve months is $9.5 million.
As of December 31, 2023, our total finance lease liabilities was $0.1 million as of December 31, 2023, with $0.1 million of principal and interest payments made during the year. Finance lease payments due withing the next twelve months is $0.1 million.
As of December 31, 2023, our total finance obligation was $7.9 million as of December 31, 2023, with $3.1 million of principal and interest payments made during the year. Finance obligation due withing the next twelve months is $3.2 million.
53
Cash Flow
Years ended
December 31,
2023 2022 2021
(in millions)
Continuing Operations
Net cash provided by (used in)
Operating activities $ 137.6 $ 180.4 $ 137.3
Investing activities (65.3) (63.0) 875.7
Financing activities (93.5) (148.1) (963.1)
Discontinued Operations
Net cash provided by (used in)
Operating activities — 6.3 (7.4)
Investing activities — — (40.0)
Financing activities — — (1.1)
Effect of exchange rate changes on cash and cash equivalents (1.3) (5.5) 2.3
Net change in cash and cash equivalents (22.5) (29.9) 3.7
Cash and cash equivalents at beginning of period 110.9 140.9 137.2
Cash and cash equivalents at end of period $ 88.4 $ 111.0 $ 140.9
Years ended
December 31,
2023 2022 2021
(in millions)
Continuing Operations
Net income $ 71.2 $ 69.8 $ 1.8
Non-cash and non-working capital related activities (1)
86.6 114.3 156.6
Changes in working capital (20.8) (2.2) (18.1)
Other operating activities 0.6 (1.5) (3.0)
Net cash provided by operating activities, continuing operations $ 137.6 $ 180.4 $ 137.3
(1) Includes depreciation, amortization, amortization of deferred financing costs and original issue discount, debt extinguishment costs, foreign currency exchange (gain) loss, pension and postretirement healthcare (benefit) expense, deferred income tax provision (benefit), net (gain) loss on asset disposals, stock compensation expense, equity in net income and dividends received from affiliated companies.
54
Years ended
December 31,
2023 2022 2021
(in millions)
Continuing Operations
Working capital changes that provided (used) cash:
Receivables $ (6.1) $ 5.4 $ (33.5)
Inventories (1.4) 9.9 0.6
Prepaids and other current assets (1.1) — (7.8)
Accounts payable 2.4 (10.1) 10.0
Accrued liabilities (14.6) (7.4) 12.6
$ (20.8) $ (2.2) $ (18.1)
Years ended
December 31,
2023 2022 2021
(in millions)
Continuing Operations
Purchases of property, plant and equipment $ (65.3) $ (58.9) $ (60.0)
Proceeds from business divestitures, net of cash — — 978.4
Payments for business divestiture, net of cash — (3.7) —
Business combinations, net of cash acquired — (0.5) (42.6)
Other, net — 0.1 (0.1)
Net cash (used in) provided by investing activities, continuing operations $ (65.3) $ (63.0) $ 875.7
Years ended
December 31,
2023 2022 2021
(in millions)
Continuing Operations
Cash repayments on debt obligations $ (9.0) $ (9.0) $ (542.9)
Dividends paid to stockholders — — (435.6)
Repurchases of common shares (78.7) (136.7) —
Tax withholdings on equity award vesting (3.4) (0.3) —
Repayment of financing obligation (2.8) (2.7) —
Other financing activities 0.4 0.6 15.4
Net cash used in financing activities, continuing operations $ (93.5) $ (148.1) $ (963.1)
The following discussions related to our cash flows are presented on a continuing operations basis, which excludes the cash flows from our former Performance Chemicals and Performance Materials businesses, which are accounted for as discontinued operations.
55
Year Ended December 31, 2023 Compared to the Year Ended December 31, 2022
Net cash provided by operating activities was $137.6 million for the year ended December 31, 2023, compared with $180.4 million provided for the year ended December 31, 2022. Cash generated by operating activities, other than changes in working capital was lower by $24.1 million during the year ended December 31, 2023, as compared to the prior year was primarily driven by lower earnings, lower dividends from affiliates, higher cash taxes and cash interest, and unfavorable change in working capital . The decrease in cash from working capital during the year ended December 31, 2023 of $18.6 million was unfavorable compared to the year ended December 31, 2022 primarily due to unfavorable changes in receivables, inventories, prepaids and other current assets and accrued liabilities, which were offset by favorable change in accounts payable.
The unfavorable change in receivables was driven by the timing of sales orders and collections. The unfavorable change in inventory was primarily due to the timing of sales orders and inventory build. The unfavorable change in prepaid and other current assets primarily relates to the timing of interest receivable and non-trade receivables from related parties. The unfavorable change in accrued liabilities primarily relates to changes in payments for other compensation-related liabilities in the current period. The favorable change in accounts payable is due to the timing of vendor payments.
Net cash used in investing activities was $65.3 million for the year ended December 31, 2023, compared to net cash used of $63.0 million during the year ended December 31, 2022. Cash used in investing activities consisted of $65.3 million and $58.9 million to fund capital expenditures during the years ended December 31, 2023 and 2022, respectively. During the year ended December 31, 2022, we made an additional payment of $3.7 million related to our divestiture of our Performance Chemicals business representing the final adjustments to the sale price.
Net cash used in financing activities was $93.5 million for the year ended December 31, 2023, compared with $148.1 million used during the year ended December 31, 2022. Net cash used in financing activities was driven by fewer repurchases of common stock of $58.0 million in December 31, 2023 compared to December 31, 2022.
Year Ended December 31, 2022 Compared to the Year Ended December 31, 2021
A discussion of our cash flows for the year ended December 31, 2022 compared to the year ended December 31, 2021 is set forth in Part II, Item 7 of our Form 10-K for the year ended December 31, 2022 under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
Debt
December 31,
2023 2022
(in millions)
Senior Secured Term Loan Facility due June 2028 $ 877.5 $ 886.5
ABL Facility — —
Total debt 877.5 886.5
Original issue discount (6.2) (7.5)
Deferred financing costs (3.4) (4.1)
Total debt, net of original issue discount and deferred financing costs 867.9 874.9
Less: current portion (9.0) (9.0)
Total long-term debt, excluding current portion $ 858.9 $ 865.9
As of December 31, 2023 our total debt was $877.5 million excluding the original issue discount of $6.2 million and deferred financing fees of $3.4 million for our senior secured credit facilities. Our net debt was $789.1 million, including cash and cash equivalents of $88.4 million. Our total available liquidity as of December 31, 2023 was $152.2 million, which represents our cash on hand of $88.4 million plus our excess availability under our ABL of $63.8 million, after giving effect to $4.0 million of outstanding letters of credit and no revolving credit facility borrowings. We may seek, subject to market conditions and other factors, opportunities to repurchase, refinance or otherwise reprice our debt.
56
ABL Facility
On May 4, 2016, we entered a $200.0 million senior secured ABL facility, which provided for $200.0 million in revolving credit commitments.
On March 20, 2020, we amended the ABL Facility to increase the aggregate amount of the revolving loan commitments available by $50.0 million to $250.0 million, consisting of up to $195.0 million in U.S. commitments, up to $15.0 million in Canadian commitments and up to $40.0 million in European commitments. The maturity of the facility was extended to March 20, 2025. In addition, there was an annual commitment fee equal to 0.375%, with a step-down to 0.25% based on average usage of the revolving credit borrowings available.
Following the amendment, the borrowings under the amended ABL Facility bore interest at a rate equal to the LIBOR rate or the base rate plus a margin of between 1.25% to 1.75% or 0.25% to 0.75%, respectively.
On June 9, 2021, we amended the ABL Facility a third time to decrease the aggregate amount of revolving loan commitments available to $100.0 million, consisting of $90.0 million in U.S. commitments and $10.0 million in European commitments and extended the maturity date to August 2, 2026.
On February 17, 2023, we amended the ABL Facility to replace LIBOR with a secured overnight financing rate (“SOFR”) as the benchmark interest rate with respect to U.S. dollar-denominated borrowings. Following this amendment, U.S. dollar-denominated borrowings under the ABL Facility bear interest at a rate equal to an adjusted SOFR rate or the base rate plus a margin of between 1.25% and 1.75% or 0.25% to 0.75%, respectively.
As of December 31, 2023, there were no revolving credit borrowings under the ABL Facility. Revolving credit borrowings are payable at our option throughout the term of the ABL Facility with the balance due August 2, 2026. We have the availability to request letters of credit under the ABL Facility. We had $4.0 million of letters of credit outstanding as of December 31, 2023, which reduce available borrowings under the ABL Facility by such amounts.
We were in compliance with all debt covenants as of December 31, 2023 and 2022, respectively.
2021 Term Loan Facility
On June 9, 2021, we entered into an agreement for a senior secured term loan facility (the “2021 Term Loan Facility”) in an aggregate principal amount of $900.0 million, with an original issue discount of 0.25% and interest at a floating rate of LIBOR (with a 0.50% minimum LIBOR floor) plus 2.75% per annum (or, depending on the Borrower’s first lien net leverage ratio, 2.50%), with a maturity date of June 9, 2028. The 2021 Term Loan Facility requires scheduled quarterly amortization payments, each equal to 0.25% of the original principal amount of the loans under the 2021 Term Loan Facility. The proceeds from the 2021 Term Loan Facility were used to repay the 2020 Term Loan Facility in full and partially repay the 2018 Term Loan Facility.
On February 9, 2023, we amended the 2021 Term Loan Facility to replace LIBOR with SOFR as the benchmark interest rate. Following this amendment, the 2021 Term Loan Facility bears interest at an adjusted SOFR rate (with a 0.50% minimum floor) plus 2.75% per annum (or, depending on the first lien net leverage ratio, 2.50%).
Capital Expenditures
Maintenance capital expenditures include spending on maintenance of business, health, safety and environmental initiatives. Growth capital expenditures include spending to drive organic sales growth and cost savings initiatives. These capital expenditures represent our “book” capital expenditures for which the company has recorded, but not necessarily paid for the capital expenditures.
Years ended
December 31,
2023 2022 2021
(in millions)
Maintenance capital expenditures $ 54.1 $ 46.9 $ 42.8
Growth capital expenditures 8.1 9.0 19.6
Total capital expenditures $ 62.2 $ 55.9 $ 62.4
57
Capital expenditures remained at a level sufficient for required maintenance and certain expansion growth initiatives during these periods. Maintenance capital expenditures were higher in the year ended December 31, 2023 as compared to December 31, 2022 due to extended turnaround activities and additional expenditures incurred related to Winter Storm Elliott impacting our manufacturing facilities earlier in the year. Growth capital expenditures are slightly lower in the year ended December 31, 2023 as compared to December 31, 2022 due to the completion of several expansion projects in 2022.
Pension Funding
We paid an immaterial amount in cash contributions into our defined benefit pension plans and other postretirement plans in December 31, 2023, 2022, and 2021. The net periodic pension and postretirement expense (benefit) was $0.1 million, $(1.0) million, and $(0.3) million for those same periods, respectively.
As of December 31, 2023 and 2022, our pension plans and other post-retirement benefit plans were underfunded by $5.4 million and $6.7 million, respectively.
Off-Balance Sheet Arrangements
We had $4.0 million of outstanding letters of credit on our revolver facility as of December 31, 2023 and 2022, respectively.
Critical Accounting Policies and Estimates
We prepare our consolidated financial statements in conformity with GAAP and our significant accounting policies are described in Note 2 to our consolidated financial statements. The preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions that affect reported amounts and related disclosures. We base our estimates and judgments on historical experience and other relevant factors that we believe 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. We review these matters and reflect changes in estimates as appropriate. We have identified below the accounting policies, estimates and critical judgment areas that we believe could have a material effect on our financial position, liquidity or results of operations.
Revenue Recognition
In determining the appropriate amount of revenue to be recognized as we fulfill our obligations under our agreements, we perform the following steps: (i) identify the contract with the customer; (ii) determine whether the promised goods or services are performance obligations, including whether they are distinct in the context of the contract; (iii) measure the transaction price; (iv) allocate the transaction price to the performance obligations based on estimated selling prices; and (v) recognize revenue when (or as) we satisfy each performance obligation.
We identify a contract when an agreement with a customer creates legally enforceable rights and obligations, which occurs when a contract has been approved by both parties, the parties are committed to perform their respective obligations, each party’s rights and payment terms are clearly identified, commercial substance exists and it is probable that we will collect the consideration to which we are entitled.
Evidence of a contract with a customer may take the form of a master service agreement (“MSA”), a MSA in combination with an underlying purchase order, a combination of a pricing quote with an underlying purchase order or an individual purchase order received from a customer. Certain of our customers enter into MSAs that establish the terms, including prices, under which orders to purchase goods may be placed. In cases where the MSA contains a distinct order for goods or contains an enforceable minimum quantity to be purchased by the customer, we consider the MSA to be evidence of a contract with a customer as the MSA creates enforceable rights and obligations. In cases where the MSA does not contain a distinct order for goods, evidence of a contract with a customer is the purchase order issued under the MSA. Our customers may also negotiate orders via pricing quotes, which typically detail product pricing, delivery terms and payment information. When a customer procures goods under this method, we consider the combination of the pricing quote and the purchase order to create enforceable rights and obligations. Absent either a MSA or pricing quote, we consider an individual purchase order to create enforceable rights and obligations.
58
We identify a performance obligation in a contract for each promised good that is separately identifiable from other promises in the contract and for which the customer can benefit from the good. The majority of our contracts have a single performance obligation, which is the promise to transfer individual goods to the customer. Certain of our contracts include multiple performance obligations under which the purchase price for each distinct performance obligation is defined in the contract. These distinct performance obligations may include stand-ready provisions, which are arrangements to provide a customer assurance that they will have access to output from our manufacturing facilities, or monthly reservations of capacity fees. We consider stand-ready provisions and reservation of capacity fees to be performance obligations satisfied over time. Revenues related to stand-ready provisions and reservation of capacity fees are recognized on a ratable basis throughout the contract term and billed to the customer on a monthly basis.
As described above, our MSAs with our customers may outline prices for individual products or contract provisions. MSAs in the our Ecoservices segment may contain provisions whereby raw materials costs are passed-through to the customer per the terms of their contract. Our exposure to fluctuations in raw materials prices is limited, as the majority of pass-through contract provisions reset based on fluctuations in the underlying raw material price. MSAs in our Ecoservices segment also contain take-or-pay arrangements, whereby the customer would incur a penalty in the form of a shortfall volume fee. Currently there is no history in which customers fail to meet the contractual minimum. Revenue from product sales are recorded at the sales price, which includes estimates of variable consideration for which reserves are established and which result from discounts, returns or other allowances that are offered within contracts with our customers.
We recognize revenues when performance obligations under the terms of a contract with our customer are satisfied, which generally occurs at a point in time by transferring control of a product to the customer. We determine the point in time when a customer obtains control of a product and we satisfy the performance obligation by considering factors including when we have a right to payment for the product, the customer has legal title to the product, we have transferred possession of the product, the customer has assumed the risks and rewards of ownership of the product and the customer has accepted the product. Revenue is measured as the amount of consideration we expect to receive in exchange for transferring goods. We do not have any significant payment terms as payment is received at, or shortly after, the point of sale.
Goodwill and Intangible Assets
Assets and liabilities of acquired businesses are measured at their estimated fair values at the dates of acquisition. The excess of the purchase price over the estimated fair value of the net assets acquired, including identified intangibles, is recorded as goodwill. The determination and allocation of fair value to the assets acquired and liabilities assumed is based on various assumptions and valuation methodologies requiring considerable management judgment, including estimates based on historical information, current market data and future expectations.
Goodwill and intangible assets with indefinite lives are not amortized, but are tested for impairment annually or more frequently if events or circumstances exist that would more likely than not reduce the fair value of the reporting unit below its carrying amount.
Goodwill is tested for impairment at the reporting unit level. In performing tests for goodwill impairment, we are able to use our discretion to first perform an optional qualitative assessment about the likelihood of the carrying value of a reporting unit exceeding its fair value. The qualitative assessment need not be applied to all reporting units. If we determine that it is more likely than not that the fair value of a reporting unit is less than its carrying amount based on the qualitative assessment, we perform a quantitative goodwill impairment test to identify the potential goodwill impairment and measure the amount of the goodwill impairment loss, if any, to be recognized for that reporting unit. For the annual assessments in 2023 and 2022, we bypassed the option to perform the qualitative assessment and proceeded directly to performing the quantitative goodwill impairment test for each of our reporting units. The quantitative test identifies both the potential existence of impairment and the amount of impairment loss.
In applying the quantitative test, the Company calculates and compares the reporting unit’s estimated fair value to its carrying value, including goodwill. If the fair value of a reporting unit exceeds its carrying value, goodwill is not impaired. If the carrying value of a reporting unit exceeds its fair value, an impairment loss is recognized for the amount by which the carrying value exceeds the reporting unit’s fair value. An impairment loss cannot exceed the carrying value of goodwill assigned to a reporting unit and the loss establishes a new basis in the goodwill. Subsequent reversal of an impairment loss is not permitted.
59
For the purposes of the quantitative goodwill impairment test, we determine the fair value of our reporting units using a combination of a market approach and an income, or discounted cash flow, approach. Estimating the fair value of a reporting unit requires various assumptions including the use of projections of future cash flows and discount rates that reflect the risks associated with achieving those cash flows. The key assumptions used in estimating the fair value are operating margin growth rates, revenue growth rates, the weighted average cost of capital, the perpetual growth rate, and the estimated earnings market multiples of each reporting unit. The market value is estimated using publicly traded comparable company values by applying their most recent annual Adjusted EBITDA multiples to the reporting unit’s Adjusted EBITDA for the trailing twelve months. The income approach value is estimated using a discounted cash flow approach. The assumptions about future cash flows and growth rates are based on our assessment of a number of factors including the reporting unit’s recent performance against budget as well as management’s ability to execute planned future strategic initiatives. Discount rate assumptions are based on an assessment of the risk inherent in those future cash flows.
For intangible assets other than goodwill, definite-lived intangible assets are amortized over their respective estimated useful lives. Intangible assets with indefinite lives are not amortized, but rather are tested for impairment at least annually or more frequently if events occur or circumstances change that would more likely than not reduce the fair value of the intangible asset below its carrying amount. Our indefinite-lived intangible assets include trade names and certain trademarks. Similar to the goodwill impairment test, we may first assess qualitative factors to determine whether it is necessary to perform a quantitative impairment test. If we choose to bypass the qualitative assessment, or if the qualitative assessment indicates that the indefinite-lived intangible asset is more likely than not impaired, a quantitative impairment test must be performed. The quantitative test for indefinite-lived intangible assets is a one-step test comparing the fair value of the asset to its carrying amount. If the fair value of the indefinite-lived intangible asset is less than the carrying amount, an impairment loss is recognized in an amount equal to the difference.
The unit of accounting used to test our indefinite-lived intangible assets for impairment is at the reporting unit level. The fair values of our indefinite-lived trade names and trademarks are determined for impairment testing purposes based on an income approach using a discounted cash flow valuation model under a relief from royalty methodology. Significant assumptions under the relief from royalty method include the royalty rate a market participant may assume, projected sales and the discount rate applied to the estimated cash flows.
For definite-lived intangible assets, we amortize technical know-how over periods that range from fourteen to twenty years, customer relationships over periods that range from seven to fifteen years, trademarks over a fifteen year period, contracts over periods that range from two to sixteen years, and permits over five years. We perform an impairment review of definite-lived intangible assets when facts and circumstances indicate that the carrying value of an asset may not be recoverable from its undiscounted future cash flows. The impairment test for definite-lived intangible assets is consistent with the test applied to property, plant and equipment as described in our policy.
Assessment of the potential impairment of goodwill and intangible assets is an integral part of our normal ongoing review of operations. Testing for potential impairment of these assets is significantly dependent on numerous assumptions and reflects management's best estimates at a particular point in time. Estimates based on these assumptions may differ significantly from actual results. Changes in factors and assumptions used in assessing potential impairments can have a significant impact on the existence and magnitude of impairments, as well as the time in which such impairments are recognized.
In addition, we continually review our diverse portfolio of assets to ensure they are achieving their greatest potential and are aligned with our growth strategy. Strategic decisions involving a particular group of assets may trigger an assessment of the recoverability of the related assets. Such an assessment could result in impairment losses.
For further information, see Note 14 to these consolidated financial statements.
60
Income Taxes
We operate within multiple taxing jurisdictions and are subject to tax filing requirements and potential audits within these jurisdictions. Our operations and the global complexity of tax regulations require assessments of uncertainties and judgments in estimating taxes we will ultimately pay. The final taxes paid are dependent upon many factors, including negotiations with taxing authorities in various jurisdictions, outcomes of tax litigation and resolution of disputes arising from federal, state and international tax audits in the normal course of business. The resolution of these uncertainties may result in adjustments to our tax assets and tax liabilities. We use the asset and liability method in accounting for income taxes. Deferred tax assets and liabilities are recorded for temporary differences between the tax basis of assets and liabilities and their reported amounts in the financial statements, using statutory tax rates in effect for the year in which the differences are expected to reverse. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the results of operations in the period that includes the enactment date. We evaluate our deferred tax assets each period to ensure that estimated future taxable income will be sufficient in character (e.g., capital gain versus ordinary income treatment), amount and timing, to result in their realizability. A valuation allowance is recorded to reduce the carrying amounts of deferred tax assets, unless it is more likely than not that those assets will be realized. Considerable judgments are required in establishing deferred tax valuation allowances. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences and carryforward deferred tax assets become deductible or utilized. We consider the scheduled reversal of taxable temporary differences, projected future taxable income and tax-planning strategies in making this assessment. As events and circumstances change, valuation allowances are adjusted within results from operations when applicable.
Generally, APB 23 of ASC Topic 740, Income Taxes (“ASC 740”), provides guidance with respect to establishing deferred income taxes on earnings from foreign subsidiaries, to the extent that these earnings are considered to be available for repatriation. Further, ASC 740-30 requires that deferred taxes be established with respect to the earnings of a foreign subsidiary, unless existing tax law provides a means by which the investment in a subsidiary can be recovered tax-free. We have determined that we are able repatriate the non-permanently reinvested earnings of our foreign subsidiaries in a tax-free manner. As such, we are able to assert for purposes of ASC 740-30 that no deferred income taxes are needed with respect to earnings from foreign subsidiaries.
We recognize net tax benefits under the recognition and measurement criteria of ASC 740, which prescribes requirements and other guidance for financial statement recognition and measurement of positions taken or expected to be taken on tax returns. We recognize a financial statement benefit for positions taken for tax return purposes when it will be more likely than not (i.e. greater than 50%) that the positions will be sustained upon tax examination, based solely on the technical merits of the tax positions. Otherwise, no tax benefit is recognized. The tax benefits recognized are measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. We recognize potential accrued interest and penalties related to unrecognized tax benefits as a component of income tax expense. Tax examinations are often complex as tax authorities may disagree with the treatment of items reported by us and may require several years to resolve. These accrued liabilities represent a provision for taxes that are reasonably expected to be incurred on the basis of available information but which are not certain.
Stock-Based Compensation
We grant stock-based compensation awards in connection with our stock incentive plans. Under the terms of the incentive plans, we are authorized to issue equity awards to our employees, directors and affiliates. The grants have taken the form of restricted stock awards, restricted stock units, performance stock units and stock options. Restricted stock awards provide the recipient with shares of our stock subject to certain vesting requirements. Restricted stock units and performance stock units provide the recipient with the right to receive shares of our stock at a future date if certain vesting conditions are met. Stock option awards provide the recipient the ability to purchase shares of our stock at a given strike price upon the satisfaction of certain vesting requirements.
The vesting requirements associated with the awards include a mix of both service and/or performance conditions. Depending on the award and recipient, the service condition may reflect a cliff vesting provision (e.g., 100% vested upon four years of service) or a graded vesting provision (e.g., 33.3% vested each year over a period of three years). Prior to the Company’s IPO, the Company issued restricted stock awards and stock options with performance conditions that were based on the occurrence of a defined liquidity event upon which certain investment funds affiliated with CCMP receive proceeds exceeding defined thresholds. Although achievement of the performance condition is subject to continued service with us, the terms of awards issued with performance conditions stipulate that the performance vesting
61
condition can be attained for a period of six months following separation from service under certain circumstances, depending on the means of separation from the Company and subject to other factors such as individual separation agreements. The same performance vesting condition for our restricted stock awards also governs the achievement of the performance vesting condition for our stock options. The value of the restricted stock awards granted was based on the average of the high and low trading prices of our common stock on the NYSE on the preceding trading day, in accordance with our policy for valuing such awards.
In addition to restricted stock awards, we have granted restricted stock units and performance stock units as part of our equity incentive compensation program. Each restricted stock unit provides the recipient with the right to receive a share of common stock subject to graded vesting terms based on service, which generally requires one year of service for members of our board of directors and three years of service for employees. Performance stock units vest upon the achievement of Company-specific financial performance targets and the provision of service through the vesting date.
We recognize compensation expense related to our equity awards with service conditions on a straight-line basis over the stated vesting period for each award. Expense related to our equity awards with performance conditions is recognized in the period in which it becomes probable that the performance target will be achieved. No compensation expense has been recognized to-date on any of our restricted stock awards and stock options subject to vesting based on performance conditions, since a liquidity event triggering vesting of the awards has not occurred, nor is it considered probable.
The grant date fair value of restricted stock awards, restricted stock units and performance stock units is based on the value of our common stock as traded on the New York Stock Exchange. The grant date fair value of stock option awards is estimated using a Black-Scholes option pricing model. Determining the fair value of stock option awards at the grant date requires judgment, including estimates of the average risk-free interest rate, dividend yield, volatility and expected term. Since we have limited experience with respect to historical exercise and forfeiture rates or patterns, we have estimated certain assumptions using acceptable simplified methods and through benchmarking to our peer group of companies.
Recently Issued Accounting Standards
See Note 3 to our consolidated financial statements for a discussion of recently issued accounting standards and their effect on us.