Item 7. Management’s Discussion and Analysis
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Background
The Company has one reportable segment, Industrial Tools & Service ("IT&S"). This segment is primarily engaged in the design, manufacture and distribution of branded hydraulic and mechanical tools, as well as providing services and tool rental to the industrial, maintenance, infrastructure, oil & gas, energy and other markets. Financial information related to the Company's reportable segment is included in Note 15, "Business Segment, Geographic and Customer Information" in the notes to the consolidated financial statements.
Business Update
Our businesses provide an array of products and services across multiple markets and geographies which results in significant diversification. The IT&S segment continues to have exposure within thirteen vertical markets. We continue to execute our strategy to drive best in class returns for our shareholders, demonstrated by our acquisition of HTL Group in January 2020, our focus on improving commercial effectiveness, optimizing our global facility footprint and our heavy emphasis on new product development.
We remain focused on our long-term strategy of pursuing both organic and acquisition-related growth opportunities aligned with our strategic objectives. This includes the advancement of our commercial effectiveness initiatives along with new product development efforts. We also remain focused on our safety, quality, cost and delivery metrics across our manufacturing, assembly and service operations. Our IT&S segment is focused on accelerating global sales growth through new product introductions, a continued emphasis on sales effectiveness and more focused retail and wholesale marketing efforts. In addition, we remain focused on reducing our concentration in the oil & gas vertical markets by growing sales of critical products, rentals, and services with new and existing customers in other attractive vertical markets including power generation, non-commercial aerospace (military), rail and mining.
COVID-19 Update
Over the past two quarters of fiscal 2020, our business, like many others around the world, has experienced the significant negative financial impacts of the COVID-19 pandemic. Our key manufacturing facilities globally continued to operate with additional precautions in place to ensure the safety of our employees, and we have continued to supply our customers with the products and services they require. However, demand for our products has been significantly impacted, and we expect it will continue to be impacted to some extent for the remainder of the pandemic, as levels of uncertainty exist within our customers and our markets. In order to help mitigate the negative financial impact caused by the pandemic, we have executed, and continue to execute, a number of temporary cash and cost-savings measures including the cancellation of our fiscal 2020 bonus plan, employee furloughs, reduction of capital expenditures, suspension of employee benefit programs such as the 401(k) match, applications for governmental assistance programs, utilization of governmental regulations allowing for the deferral of certain tax payments and cuts to discretionary spend. In addition, we proactively amended our interest coverage ratio covenant in our Senior Credit Facility to mitigate the risk of non-compliance with said covenant should the pandemic have a longer duration. We will continue to evaluate and implement (if deemed necessary) cash and cost-savings measures in the near term in order to reduce the impact of the pandemic on our financial results. While we believe that the essential products we provide, along with our current strong balance sheet, will allow us to be well positioned for long-term growth after the pandemic, we cannot reasonably estimate the duration and severity of the COVID-19 pandemic, and accordingly, the ultimate impact it will have on our business, results of operations, and financial condition.
General Business Update
On October 31, 2019, the Company completed the previously announced sale of its former EC&S segment to wholly owned subsidiaries of BRWS Parent LLC, a Delaware limited liability company and affiliate of One Rock Capital Partners II, LP, for a purchase price of approximately $216 million (inclusive of final working capital adjustments).
On March 21, 2019, the Company announced a restructuring plan focused on i) the integration of the Enerpac and Hydratight businesses (IT&S segment), ii) the strategic exit of certain commodity type services in our North America Services operation (IT&S segment), and iii) driving efficiencies within the overall corporate structure. In the third quarter of fiscal 2020, the Company announced the expansion and revision of this plan, which further simplifies and flattens the corporate structure through elimination of redundancies between the segment and corporate functions, while enhancing our commercial and marketing processes to become even closer to our customers. Total restructuring charges associated with this restructuring plan were $7 million for the year ended August 31, 2020, r elated primarily to headcount reductions and facility consolidations. We anticipate achieving annual savings of $12 million to $15 million from the first phase of the plan and anticipate an additional annual savings of $12 million to $15 million from the expansion and revision of the plan. The annual benefit of these gross cost savings may be impacted by a number of factors, including annual incentive compensation differentials.
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The Company also incurred approximately $2 million of restructuring costs within the Other operating segment in the year ended August 31, 2020, associated with a facilities consolid ation. We anticipate realizing approximately $3 million to $5 million of annual savings associated with the actions and have started realizing these savings in fiscal 2020.
Historical Financial Data (in millions)
Year Ended August 31,
2020 2019 2018
Statements of Earnings Data: (1)
Net sales $ 493 100 % $ 655 100 % $ 641 100 %
Cost of products sold 276 56 % 362 55 % 358 56 %
Gross profit 217 44 % 293 45 % 283 44 %
Selling, administrative and engineering expenses 181 37 % 209 32 % 210 33 %
Amortization of intangible assets 8 2 % 9 1 % 9 1 %
Restructuring charges 7 1 % 4 1 % 11 2 %
Impairment & divestiture (benefit) charges (3) (1) % 23 4 % 3 0 %
Operating profit 24 5 % 48 7 % 50 8 %
Financing costs, net 19 4 % 28 4 % 31 5 %
Other (income) expense, net (3) (1) % 1 — % — 0 %
Earnings before income tax expense 8 2 % 19 3 % 19 3 %
Income tax expense 2 — % 11 2 % 14 2 %
Net earnings $ 6 1 % $ 8 1 % $ 5 1 %
Other Financial Data: (1)
Depreciation $ 12 $ 11 $ 11
Capital expenditures 12 15 11
(1) Results are from continuing operations and exclude the financial results of businesses classified as "Assets from discontinued operations" and "Liabilities from discontinued operations" on the Consolidated Balance Sheets and of previously divested businesses reported as discontinued operations.
Fiscal 2020 compared to Fiscal 2019
Consolidated sales from continuing operations in fiscal 2020 were $493 million, 25% lower than the prior-year sales of $655 million. Core s ales decreased $117 million (20%) while strategic exits and divestitures of non-core product lines, net of current year acquisitions, accounted for a $38 million (6%) decrease in net sales. Changes in foreign currency exchange rates favorably impacted sales comparisons by 1%. The 20% decrease in core sales predominantly was a result of the significant declines in volume in the third and fourth quarter due to impacts of the COVID-19 pandemic and volatile oil prices. In addition, global economic uncertainty, predominantly in North America, caused slight year-over-year declines from volume in the first half of the fiscal year, and there were lower year-over-year service sales in the fiscal year as large projects in the Middle East and Asia in fiscal 2019 did not repeat in fiscal 2020. Gross profit margins remained relatively consistent year-over-year despite the substantial volume decrease as we benefited from the strategic exit of certain low-profit product and service lines in fiscal 2020, executed certain temporary cost-reduction actions such as furloughs and other temporary wage reduction measures, and we saw a greater impact from COVID-19 to our service revenue stream, which generally has lower gross profit margins than our product sales. O perating profit was $24 million lower in fiscal 2020 as compared to fiscal 2019 as a result of the $76 million decrease in gross profit driven by the decline in net sales volume, offset by cost reduction actions to reduce selling, administrative, and engineering expenses ("SAE"), and impairment & divestiture benefits in the current year as opposed to charges in the prior year. SAE decreased $28 million, predominantly due to the benefit from restructuring actions and a decrease in commissions expense as a result of the reduction in sales volumes, as well as temporary cost reduction measures in response to the COVID-19 pandemic including the termination of our fiscal 2020 bonus plan, furloughs and other temporary wage reduction programs, and other discretionary spending initiatives. In addition, we received approximately $1.1 million of COVID-19 relief governmental support in certain foreign jurisdictions. With respect to impairment and divestiture charges, in fiscal 2020, we incurred a net benefit of $3 million due to the benefit from the divestitures of our Connectors and UNI-LIFT product lines, partially offset by the impairment and divestiture charges associated with the divestiture of our Milwaukee Cylinder business. In fiscal 2019 , we incurred $14 million of goodwill impairment charges associated with triggering events impacting Cortland U.S., $6 million of impairment & divestiture charges associated with the impairment of a customer
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relationship intangible in connection with the strategic exit of certain North America service offerings and $3 million of trade name impairment & divestiture charges associated with a re-branding strategy which will ultimately eliminate the use of certain secondary brands within the IT&S segment that were previously determined to be indefinite-lived. Financing costs also decreased in fiscal 2020 as we utilized the proceeds from the sale of EC&S in the first quarter of the fiscal year to pay off the remaining $175 million principal on our term loan and in the fourth quarter of fiscal 2020 , we redeemed our 5.625% senior notes by drawing on our revolving credit facility which provided modest interest savings during our fourth quarter and will provide over $10 million of annual savings at current interest rates. These savings were partially offset as we expensed $2 million of capitalized debt issuance costs associated with the accelerated repayment of our term loan and redemption of our senior notes. Our income tax expense decreased for reasons discussed in the Income Tax Expense section below.
Fiscal 2019 compared to Fiscal 2018
Consolidated sales from continuing operations in fiscal 2019 were $655 million, 2% higher than the prior year sales of $641 million. Core sales were up $26 million (4%), as a result of a 5% core sales increase in the IT&S segment. Changes in foreign currency exchange rates unfavorably impacted sales comparisons by 2%. Gross profit margins remained relatively consistent year-over-year. We benefited from our strategic exit of highly customized heavy lifting projects which historically provided lower gross profit margins, offset by higher service & rental sales which provide lower gross profit margins. Operating profit was lower in fiscal 2019 as compared to fiscal 2018 as a result of increased impairment and divestiture charges. In fiscal 2019 , we incurred $14 million of goodwill impairment charges associated with triggering events impacting Cortland U.S., $6 million of impairment & divestiture charges associated with the impairment of a customer relationship intangible asset in connection with the strategic exit of certain North America service offerings and $3 million of trade name impairment & divestiture charges associated with a re-branding strategy which will ultimately eliminate the use of certain secondary brands within the IT&S segment that were previously determined to be indefinite-lived. In fiscal 2018, we incurred $3 million of impairment & divestiture charges associated with the divestiture of our Viking business. Financing costs also decreased in fiscal 2019 as a result of the execution of our capital allocation strategy to utilize cash to reduce our debt by $73 million over the course of fiscal 2019 in addition to reduced interest costs on our new Senior Credit Facility. Our income tax expense also decreased in fiscal 2019 as discussed in further detail within the Income Tax Expense section below.
Segment Results
Industrial Tools & Services Segment
The IT&S segment is a global supplier of branded hydraulic and mechanical tools and services to a broad array of end markets, including industrial, energy, mining and production automation markets. Its primary products include branded tools, cylinders, hydraulic torque wrenches and highly engineered heavy lifting technology solutions (Product product line). On the services side, we provide energy maintenance and manpower services to meet customer-specific needs and rental capabilities for certain of our products (Service & Rental product line). The following table sets forth the results of operations for the IT&S segment (in millions):
Year Ended August 31,
2020 2019 2018
Net Sales $ 455 $ 610 $ 591
Operating Profit 66 101 99
Operating Profit % 14.4 % 16.6 % 16.8 %
Fiscal 2020 compared to Fiscal 2019
Fiscal 2020 IT&S segment net sales decreased by $155 million (25%) from fiscal 2019 to $455 million. Core sales decreased $110 million (20%) year-over-year while strat egic exits and divestitures of non-core product lines, net of current-year acquisitions, accounted for $38 million (6%) of the decrease. Changes in foreign currency exchange rates favorably impacted sales comparisons by 1%. The 20% decrease in core sales predominantly was a result of the significant declines in volume in the third and fourth quarter due to impacts of the COVID-19 pandemic and volatile oil prices. In addition, global economic uncertainty, predominantly in North America, caused slight year-over-year declines from volume in the first half of the fiscal year, and there were lower year-over-year service sales in the fiscal year as large projects in the Middle East and Asia in fiscal 2019 did not repeat in fiscal 2020.
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Fiscal 2020 operating profit decreased $35 million (35%) from the prior year. The operating profit decrease was a result of the $72 million decrease in gross profit as a result of the sales volume decline, partially offset by a $23 million decrease in selling, administrative, and engineering costs and a $12 million decrease in impairment and divestiture charges. The $23 million decrease in SAE was predominantly due to the benefit from restructuring actions and a decrease in commissions expense as a result of the reduction in sales volumes, in addition to cost-reduction measures in response to the COVID-19 pandemic including the termination of our fiscal 2020 bonus plan, furloughs and other temporary wage reduction programs, and other discretionary spending initiatives. We also received approximately $1.1 million of COVID-19 relief governmental support in certain foreign jurisdictions. With respect to impairment and divestiture charges, in fiscal 2020 , we incurred a net benefit of $3 million due to the benefit from the divestitures of our Connectors and UNI-LIFT product lines, partially offset by the impairment and divestiture charges associated with the divestiture of our Milwaukee Cylinder business. In fiscal 2019 , we incurred $6 million of impairment & divestiture charges associated with the impairment of a customer relationship intangible in connection with the strategic exit of certain North America service offerings and $3 million of trade name impairment & divestiture charges associated with a re-branding strategy which will ultimately eliminate the use of certain secondary brands within the IT&S segment that were previously determined to be indefinite lived.
Fiscal 2019 compared to Fiscal 2018
Fiscal 2019 IT&S segment net sales increased by $19 million (3%) from fiscal 2018 to $610 million. Changes in foreign currency exchange rates unfavorably impacted sales comparisons by 3%, while the Mirage and Equalizer acquisitions increased net sales by 1%. The IT&S segment core sales increased $28 million (5%) on a year-over-year basis. Flat core sales for the Product product line reflected changing macroeconomic environments over the course of our fiscal year as strong growth in our core sales over the first three quarters of the fiscal year outweighed the strategic focus to exit heavy lifting technology projects which historically were at low margins, whereas the fourth quarter saw decelerating demand globally which was most reflected in our European operations. The core sales increase of 19% in the Service & Rental product line was the result of higher global maintenance activity levels as compared to the prior year, predominantly in our Middle East operations. Operating profit margins decreased from 16.8% in fiscal 2018 to 16.6% in fiscal 2019 primarily due to additional impairment & divestiture charges in fiscal 2019 as compared to fiscal 2018 (impairment & divestiture charges of $9 million related to tradename and customer relationship intangible impairments in fiscal 2019 with no impairment & divestiture charges in fiscal 2018 ) and sales mix, specifically the increased revenues from Middle East service & rental which have lower gross profit margins than our product sales, partially offset by increased margins in our product sales as a result of our strategic focus to exit heavy lifting technology projects which historically were at low margins. Restructuring charges were $4 million in both fiscal 2019 and 2018 .
Corporate
Corporate consists of selling and administrative costs and expenses, including executive, legal, finance, and technology, that are not allocated to the segments based on their nature, as well as corporate costs previously allocated to the EC&S segment that must be excluded from discontinued operations based on their nature. Corporate expenses were $38 million in fiscal 2020 compared to $42 million in fiscal 2019. The decrease of $4 million is a result of the benefit of restructuring actions, positive experience in medical claims, and temporary cost-reduction actions in response to COVID-19 including the termination of our fiscal 2020 bonus plan, furloughs and other temporary wage reduction programs, and restrictions on travel and other discretionary spend. These were partially offset by $2 million of restructuring expenses associated with our strategic efforts to drive efficiency in the overall corporate structure (there were no restructuring charges in fiscal 2019) and an increase in business development costs, specifically costs associated with the acquisition of HTL Group.
Corporate expenses were $42 million in fiscal 2019 as compared to $44 million in fiscal 2018. A decrease in annual incentive amounts, as well as restructuring charges of $5 million in fiscal 2018 (no restructuring costs in fiscal 2019), partially offset by increased outsourced consulting fees resulted in a $2 million year-over-year cost reduction.
Net financing costs were $19 million, $28 million and $31 million in fiscal 2020, 2019 and 2018, respectively. Fiscal 2020 financing costs decreased as a result of the repayment in the first quarter of the remaining $175 million principal balance on our term loan with the proceeds from the EC&S divestiture, as well as the redemption of our 5.625% senior notes in the fourth quarter, funded by drawing on the revolving credit facility, which reduced interest rate expense due to the difference in interest rates. These actions were partially offset due to $2 million of additional interest expense recorded due to the accelerated write off of the remaining capitalized debt issuance costs associated with the early payoff of the term loan and redemption of the senior notes. Fiscal 2019 net financing costs decreased from fiscal 2018 primarily as a result of the $73 million of term loan principal payments made throughout fiscal 2019 and lower interest rates resulting from our March 2019 Senior Credit Facility refinancing.
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Income Tax Expense
The Company's income tax expense or benefit is impacted by a number of factors, including, among others, the amount of taxable earnings generated in foreign jurisdictions with tax rates that are different than the U.S. federal statutory rate, permanent items, state tax rates, changes in tax laws, acquisitions and divestitures and the ability to utilize various tax credits and net operating loss carryforwards. The Company's global operations, acquisition activity and specific tax attributes provide opportunities for continuous global tax planning initiatives to maximize tax credits and deductions. Income tax expense also includes the impact of provision to tax return adjustments, changes in valuation allowances and reserve requirements for unrecognized tax benefits. Pre-tax earnings, income tax expense and effective income tax rate from continuing operations for the past three years were as follows (in thousands):
Year Ended August 31,
2020 2019 2018
Earnings before income tax expense $ 7,849 $ 18,724 $ 19,196
Income tax expense 2,292 10,657 14,450
Effective income tax rate 29.2 % 56.9 % 75.3 %
The comparability of pre-tax earnings, income tax expense and the related effective income tax rates are impacted by impairment and other divestiture charges (benefits) as well as the Tax Cuts and Jobs Act (the “Act”), which was enacted on December 22, 2017. Fiscal 2020 results included $3 million of impairment and divestiture benefits, while fiscal 2019 and 2018 results included $23 million and $3 million of charges, respectively. A substantial portion of these charges (benefits) do not result in tax benefits. The fiscal 2020 tax provision included a tax benefit of $3 million related to legislative changes and additional guidance related to the Act as compared to a tax benefit of $2 million in fiscal 2019 and a tax charge of $6 million in fiscal 2018 .
Both the fiscal 2020 and prior-year income tax provisions were impacted by the mix of earnings in foreign jurisdictions with income tax rates different than the U.S. federal income tax rate and income tax benefits from global tax planning initiatives. The Company’s earnings before income taxes from continuing operations, excluding impairment and other divestiture charges, had over 75% of earnings from foreign jurisdictions for fiscal 2020, 2019 and 2018, which results in an effective tax rate that is higher than the current U.S. statutory tax rate of 21%. Excluding the impairment and divestiture charges (benefits), the fiscal 2020 effective tax rate was 32.5%, which is comparable to the fiscal 2019 effective tax rate of 30.2%. In general, the increase in the fiscal 2020 effective tax rate from the statutory 21% is largely driven by taxable earnings in jurisdictions with higher tax rates and non-creditable withholding tax.
Items Impacting Comparability
On December 1, 2017, the Company completed the sale of the Viking business, which had net sales from continuing operations of $3 million for the year ended August 31, 2018.
In fiscal 2018, the Company acquired the stock and certain assets of Mirage Machines, Ltd. ("Mirage") and the stock of Equalizer International, Limited ("Equalizer"). The acquired businesses generated combined net sales of $5 million, $14 million and $9 million for the years ended August 31, 2020, 2019 and 2018, respectively.
On January 7, 2020, the Company acquired the stock of HTL Group ("HTL"), a provider of controlled bolting products, calibration and repair services, and tool rental services, which contributed net sales of $6 million in fiscal 2020. During fiscal 2020, the Company completed the sale of the UNI-LIFT and Connectors product lines, as well as the Milwaukee Cylinder business, which contributed combined net sales of $3 million, $18 million and $11 million for the years ended August 31, 2020, 2019 and 2018, respectively.
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Liquidity and Capital Resources
At August 31, 2020, cash and cash equivalents were $152 million, comprised of $130 million of cash held by foreign subsidiaries and $22 million held domestically. The following table summarizes the cash flow attributable to operating, investing and financing activities (in millions):
Year Ended August 31,
2020 2019 2018
Net cash (used in) provided by operating activities $ (3) $ 54 $ 106
Net cash provided by (used in) investing activities 176 11 (63)
Net cash used in financing activities (239) (100) (18)
Effect of exchange rate changes on cash 7 (5) (4)
Net (decrease) increase in cash and cash equivalents $ (59) $ (40) $ 21
Cash flow provided by operations was a use of $3 million in fiscal 2020 , a decrease of $57 million from the prior year due to a $34 million decrease in cash flows from discontinued operations driven by the timing of the divestiture of the EC&S segment in the first quarter and a decrease in net earnings from continuing operations, exclusive of the impacts of impairment & divestiture (benefit) charges, of $26 million year-over-year. W e generated $176 million of cash from investing activities in the current year from the divestiture of the EC&S business ($211 million, net, comprised of the sales price of $216 million, less closing costs of $3 million and $2 million of capital expenditures in fiscal 2020 prior to the divestiture date) and the divestiture of other non-core product lines ($10 million), offset by the HTL Group acquisition ($33 million) and capital expenditures ($12 million). We utilized the funds from the sale of EC&S to repay the remaining $175 million of outstanding principal on our term loan and utilized free cash flow and excess cash on hand to reduce the outstanding principal on our remaining debt by a net $33 million, in addition to repurchasing approximately 1 million shares of our outstanding common stock for $28 million.
Cash flow provided by operations was $54 million in fiscal 2019, a decrease of $52 million from the prior year due primarily to higher cash taxes paid, higher incentive compensation payouts in fiscal 2019, a change in the timing of our 401(k) plan Company match funding and additional cash usage associated with divestiture costs. We utilized the cash flow from operations, along with $36 million of cash from the sale of our PHI and Cortland Fibron businesses and excess cash on hand, for $73 million of principal payments on our then outstanding term loan ($43 million more than our required commitment as of August 31, 2018), $27 million of capital expenditures and to repurchase approximately 1 million shares of our outstanding common stock for approximately $22 million.
The Company's Senior Credit Facility is comprised of a $400 million revolving line of credit and provided for a $200 million term loan both scheduled to mature in March 2024 (see Note 7 , "Debt" in the notes to the consolidated financial statements for further details of the Senior Credit Facility). As previously noted, the Company paid off the outstanding principal balance on the term loan in November 2019. Further, as noted in Note 7 , "Debt", on June 15, 2020, the Company borrowed $295 million under the Senior Credit Facility revolving line of credit to fund the redemption of all of the outstanding Senior Notes at par, plus the remaining accrued and unpaid interest, in order to reduce interest costs in the current interest rate environment. The unused credit line and amount available for borrowing under the revolving line of credit was $140 million at August 31, 2020 .
We believe that the revolver, combined with our existing cash on hand and anticipated operating cash flows, will be adequate to meet operating, debt service, acquisition and capital expenditure funding requirements for the foreseeable future.
Primary Working Capital Management
We use primary working capital as a percentage of sales as a key metric for working capital efficiency. We define this metric as the sum of net accounts receivable and net inventory less accounts payable, divided by the past three months' sales annualized. The following table shows the components of our primary working capital (in millions):
August 31, 2020 August 31, 2019
$ PWC % $ PWC %
Accounts receivable, net $ 84 19 % $ 126 20 %
Inventory, net 69 16 % 77 12 %
Accounts payable (45) (10) % (77) (12) %
Net primary working capital $ 108 25 % $ 126 20 %
Total primary working capital was $108 million at August 31, 2020, which decreased from $126 million at August 31, 2019. The primary working capital decrease related to decreased accounts receivable as a result of the substantial decrease in net sales in the third and fourth quarter of fiscal 2020 as a result of the COVID-19 pandemic, decreased inventory levels as part of the Company-wide initiative to reduce inventory levels to meet demand levels in the current COVID-19 environment, and a
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decrease in accounts payable as a result of the decrease in volume of inventory purchases and other expenditures in the fourth quarter of fiscal 2020 in response to the economic environment created by the COVID-19 pandemic.
Our accounts receivable are derived from a diverse customer base spread across a number of industries, with our largest single customer generating approximately 3% of fiscal 2020 net sales from continuing operations.
Capital Expenditures
The majority of our manufacturing activities consist of assembly operations. We believe that our capital expenditure requirements are not as extensive as other industrial companies given the nature of our operations. Capital expenditures associated with continuing operations were $12 million, $15 million and $11 million in fiscal 2020, 2019 and 2018, respectively. Capital expenditures for fiscal 2021 are expected to be $10-$15 million, but could vary depending on business performance, changes in foreign currency exchange rates, the timing and extent of the impact from the COVID-19 pandemic and the amount of assets leased instead of purchased.
Commitments and Contingencies
Given our desire to allocate cash flow and revolver availability to fund growth initiatives, we have historically leased most of our facilities and some operating equipment. We lease certain facilities, computers, equipment and vehicles under various operating lease agreements, generally over periods ranging from one to twenty years. Under most arrangements, we pay the property taxes, insurance, maintenance and expenses related to the leased property. Many of our leases include provisions that enable us to renew the leases at contractually agreed rates or, less commonly, based upon market rental rates on the date of expiration of the initial leases.
We are contingently liable for certain lease payments under leases within businesses we previously divested or spun-off. If any of these businesses do not fulfill their future lease payment obligations under a lease, we could be liable for such obligations, however, the Company does not believe it is probable that it will be required to satisfy these obligations. Future minimum lease payments for these leases at August 31, 2020 were $7 million with monthly payments extending to fiscal 2025.
We had outstanding letters of credit totaling $12 million and $18 million at August 31, 2020 and 2019, respectively, the majority of which relate to commercial contracts and self-insured workers' compensation programs.
Contractual Obligations
The timing of payments due under our contractual commitments is as follows (in millions):
Payments Due
2021 2022 2023 2024 2025 Thereafter Total
Debt (short-term and long-term) $ — $ — $ — $ 255 $ — $ — $ 255
Interest on long-term debt 4 4 4 2 — — 14
Operating leases* 12 8 7 5 4 14 50
$ 16 $ 12 $ 11 $ 262 $ 4 $ 14 $ 319
*Operating lease contractual obligations amounts do not include $1.6 million in minimum lease payments for a real estate lease signed, but not yet commenced as of August 31, 2020.
Interest on long-term debt assumes the current interest rate environment and revolving credit facility borrowings consistent with the August 31, 2020 debt level.
Our contractual obligations generally relate to amounts due under contracts with third-party service providers. These contracts are primarily for real estate leases, vehicle leases, IT and manufacturing leases, information technology services and telecommunications services. Only those obligations that are not cancellable are included in the table.
As part of our global sourcing strategy, we have entered into agreements with certain suppliers that require the supplier to maintain minimum levels of inventory to support certain products for which we require a short lead time to fulfill customer orders. We have the ability to notify the supplier that they no longer need to maintain the minimum level of inventory should we discontinue manufacture of a product during the contract period, however, we must purchase the remaining minimum inventory levels the supplier was required to maintain within a defined period of time. As these contracts allow for us to terminate with appropriate notice so long as we utilize the remaining inventory on hand at the supplier and there are no overall minimum volumes in these contracts other than what the supplier is required to maintain on hand at any given point in time, these contracts are excluded from the table above.
We have long-term obligations related to our deferred compensation, pension and postretirement plans that are excluded from this table and summarized in Note 11, “Employee Benefit Plans” in the notes to the consolidated financial statements.
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Our liability for unrecognized tax benefit s was $23 million at August 31, 2020, but is not included in the table of contractual obligations because the timing of the potential settlements of these uncertain tax positions cannot be reasonably estimated.
Critical Accounting Estimates
We prepare our consolidated financial statements in conformity with GAAP. This requires management to make estimates and assumptions that affect reported amounts and related disclosures. Actual results could differ from those estimates. The following estimates are considered by management to be the most critical in understanding judgments involved in the preparation of our consolidated financial statements and uncertainties that could impact our results of operations, financial position and cash flow.
Inventories: Inventory cost is determined using the last-in, first-out (“LIFO”) method for a portion of U.S. owned inventory (approximately 44% and 48% of total inventories at August 31, 2020 and 2019, respectively). If the LIFO method were not used, inventory balances would be higher than amounts presented in the consolidated balance sheet by $10 million at both August 31, 2020 and 2019. We perform an analysis on historical sales usage of individual inventory items on hand and record a reserve to adjust inventory cost to market value. The inventory valuation assumptions used are based on historical experience. We believe that such estimates are made based on consistent and appropriate methods; however, actual results may differ from these estimates under different assumptions or conditions.
Goodwill and Long-lived Assets:
Goodwill Impairment Review and Estimates: A considerable amount of management judgment is required in performing the impairment tests, principally in determining the fair value of each reporting unit and the indefinite-lived intangible assets. While we believe our judgments and assumptions are reasonable, different assumptions could change the estimated fair values and, therefore, impairment charges could be required. Significant negative industry or economic trends, disruptions to the Company's business, loss of significant customers, inability to effectively integrate acquired businesses, unexpected significant changes or planned changes in use of the assets or in entity structure and divestitures may adversely impact the assumptions used in the valuations and ultimately result in future impairment charges.
In estimating the fair value of a reporting unit, we generally use a discounted cash flow model, which calculates fair value as the sum of the projected discounted cash flows over a discrete seven-year period plus an estimated terminal value. Significant assumptions include forecasted revenues, operating profit margins, and discount rates applied to the future cash flows based on the respective reporting unit's estimated weighted average cost of capital. In certain circumstances, we also review a market approach in which a trading multiple is applied to either forecasted EBITDA (earnings before interest, income taxes, depreciation and amortization) or anticipated proceeds of the reporting unit to arrive at the estimated fair value. If the fair value of a reporting unit is less than its carrying value, an impairment loss is recorded. The estimated fair value represents the amount we believe a reporting unit could be bought or sold for in a current transaction between willing parties on an arms-length basis.
The fiscal 2020 annual review of the reporting units performed in the fourth quarter did not result in any reporting units having an estimated fair value that exceeded the carrying value (expressed as a percentage of the carrying value) by less than 30%.
Fiscal 2019 Impairment Charges : As a result of a triggering event in fiscal 2019, we recorded a $14 million goodwill impairment charge associated with the Cortland U.S. reporting unit. See Note 6, "Goodwill, Intangible Assets, and Long-Lived Assets" in the notes to the consolidated financial statements for further discussion.
In addition, as a result of the EC&S reporting unit being held for sale as of August 31, 2019, we recorded a $210 million impairment charge representing the excess of the net book value of the net assets of the reporting unit as compared to the anticipated proceeds less costs to sell which is recorded within "(Loss) earnings from discontinued operations" within the Consolidated Statements of Operations.
Fiscal 2018 Impairment Charges: Our fourth quarter fiscal 2018 impairment review resulted in a review of the recoverability of the goodwill and long-lived assets of two reporting units (Cortland and PHI) for which the results of those assessments below are included in the results of discontinued operations.
Cortland Reporting Unit: The Cortland reporting unit recognized impairment charges in conjunction with Cortland Fibron’s held for sale classification, resulting in a $10 million impairment charge representing the excess of net book value of assets held for sale over anticipated proceeds. This impairment charge included $4 million related to goodwill. The impairment charge is recorded within "(Loss) earnings from discontinued operations" within the Consolidated Statements of Operations. See Note 5, “Discontinued Operations and Other Divestiture Activities” in the notes to the consolidated financial statements for further discussion.
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PHI Reporting Unit: The PHI business primarily designs, manufactures and distributes concrete tensioning products. Changes in certain assumptions used in our annual goodwill impairment analysis, which are linked, in part, to recent market share losses, resulted in a fair value estimate of the reporting unit lower than its carrying value. As a result, we recognized a $17 million impairment charge related to the goodwill of the PHI business, which represented the entire goodwill balance of the reporting unit. The impairment charge is recorded within "(Loss) earnings from discontinued operations" within the Consolidated Statements of Operations. See Note 5, “Discontinued Operations and Other Divestiture Activities” in the notes to the consolidated financial statements for further discussion.
Indefinite-lived intangibles (tradenames): Indefinite-lived intangible assets are also subject to annual impairment testing. On an annual basis or more frequently if a triggering event occurs, the fair value of indefinite-lived intangible assets, based on a relief of royalty valuation approach, are evaluated to determine if an impairment charge is required.
The fiscal 2020 annual impairment review of indefinite-lived intangible assets resulted in one impairment charge associated with an indefinite-lived intangible asset for less than $0.1 million. For the remaining indefinite-lived intangibles, the annual assessment did not result in any indefinite-lived asset having an estimated fair value that exceeded the carrying value (expressed as a percentage of the carrying value) by less than 10%.
We recognized an impairment charge of $3 million in the fourth quarter of fiscal 2019 as a result of our determination that two secondary tradenames which were previously assumed to have an indefinite life would be phased out over the next 12-15 months and be re-branded with the Enerpac tradename.
We recognized impairment charges during the fourth quarter of fiscal 2018 to write-down the value of tradenames by $7 million in relation to the Cortland Fibron held-for-sale treatment (impairment charge recorded as a component of "(Loss) earnings from discontinued operations" within the Consolidated Statements of Operations).
A considerable amount of management judgment is required in performing impairment tests, principally in determining the fair value of each reporting unit and the indefinite-lived intangible assets. While we believe our judgments and assumptions are reasonable, different assumptions, including the duration and severity of the impacts from the COVID-19 pandemic, could change the estimated fair values and, therefore, future additional impairment charges could be required. Prolonged weakening industry or economic trends, disruptions to our business, loss of significant customers, inability to effectively integrate acquired businesses, unexpected significant changes or planned changes in the use of the assets or in entity structure and divestitures may adversely impact the assumptions used in the valuations and ultimately result in future impairment charges.
Long-lived assets (fixed assets and amortizable intangible assets): We also review long-lived assets for impairment when events or changes in business circumstances indicate that the carrying amount of the assets may not be fully recoverable. If such indicators are present, we perform undiscounted operating cash flow analyses to determine if impairment exists. If impairment is determined to exist, any related impairment loss is calculated based on fair value.
In the first quarter of fiscal 2020, in connection with the held-for sale-treatment of the Milwaukee Cylinder business, we recognized a $3 million impairment charge, representing the excess of the net book value of assets held for sale over anticipated proceeds. See Note 5, "Discontinued Operations and Other Divestiture Activities" in the notes to the consolidated financial statements for further discussion.
In the fourth quarter of fiscal 2019, in connection with our North America service restructuring within the IT&S segment, we identified one customer relationship intangible asset associated with the component of the service business we intended to exit. As a result of our assessment, for which the primary assumption is the anticipated revenues associated with those customers, we determined that the fair value of the intangible asset was less than its carrying value, and therefore, recorded a $6 million impairment charge. See Note 6, "Goodwill, Intangible Assets, and Long-Lived Assets" in the notes to the consolidated financial statements for further discussion.
Also in the fourth quarter of fiscal 2019, in connection with the held-for-sale treatment of the remaining businesses within the EC&S segment, we recognized a $54 million impairment charge related to the recognition in earnings of the cumulative effect of foreign currency rate changes since acquisition of those businesses which is recorded in "(Loss) earnings from discontinued operations" within the Consolidated Statements of Operations. See Note 5, "Discontinued Operations and Other Divestiture Activities" in the notes to the consolidated financial statements for further discussion.
In the fourth quarter of fiscal 2018, related to the held-for-sale treatment of our Cortland Fibron business, we recognized a $46 million long-lived asset impairment, representing the excess of net book value of assets held for sale over anticipated proceeds which consisted of i) $35 million related to the recognition in earnings of the cumulative effect of foreign currency rate changes since acquisition; ii) $10 million representing the excess of the net book value of assets held for sale to the anticipated proceeds and iii) $1 million of other divestiture charges. These charges are recorded as a component of "(Loss) earnings from discontinued operations" within the Consolidated Statements of Operations. See Note 5, "Discontinued Operations and Divestiture Activities" in the notes to the consolidated financial statements for further discussion.
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During the fourth quarter of fiscal 2018, the undiscounted operating cash flows of our PHI business did not exceed the carrying value of the net assets of the business, resulting in a long-lived asset impairment charge of $6 million (recorded as a component of "(Loss) earnings from discontinued operations" on the Consolidated Statements of Operations), consisting of charges of $5 million and $1 million on amortizable intangible assets and fixed assets (primarily machinery and equipment), respectively. See Note 5, "Discontinued Operations and Divestiture Activities" in the notes to the consolidated financial statements for further discussion.
Significant management judgment is required in performing impairment tests, principally in determining the fair value of long-lived assets. While we believe our judgments and assumptions are reasonable, different assumptions could change the estimated fair values and, therefore, future additional impairment charges could be required. Prolonged weakening industry or economic trends, disruptions to our business, loss of significant customers, inability to effectively integrate acquired businesses, unexpected significant changes or planned changes in the use of the assets or in entity structure and divestitures may adversely impact the assumptions used in the valuations and ultimately result in future impairment charges.
Business Combinations and Purchase Accounting: Business combinations are accounted for using the acquisition method of accounting, and accordingly, the assets and liabilities of the acquired business are recorded at their respective fair values. The excess of the purchase price over the estimated fair value is recorded as goodwill. Assigning fair market values to the assets acquired and liabilities assumed at the date of an acquisition requires knowledge of current market values and the values of assets in use, and often requires the application of judgment regarding estimates and assumptions. While the ultimate responsibility resides with management, for certain acquisitions we retain the services of certified valuation specialists to assist with assigning estimated values to certain acquired assets and assumed liabilities, including intangible assets and tangible long-lived assets. Acquired intangible assets, excluding goodwill, are valued using discounted cash flow methodology based on future cash flows specific to the type of intangible asset purchased. This methodology incorporates various estimates and assumptions, the most significant being projected revenue growth rates, profit margins and forecasted cash flows based on discount rates and terminal growth rates.
Employee Benefit Plans: We provide a variety of benefits to employees and former employees including, in some cases, pensions and postretirement health care. Plan assets and obligations are recorded based on an August 31 measurement date utilizing various actuarial assumptions such as discount rates, assumed rates of return on plan assets and health care cost trend rates. We determine the discount rate assumptions by referencing high-quality, long-term bond rates that are matched to the duration of our benefit obligations, with appropriate consideration of local market factors, participant demographics and benefit payment forecasts. At August 31, 2020 and 2019, the discount rates on domestic benefit plans were 2.40% and 2.90%, respectively. In estimating the expected return on plan assets, we consider historical returns, forward-looking considerations, inflation assumptions and the asset-allocation strategy in investing such assets. Domestic benefit plan assets consist primarily of participating units in mutual funds with equity based strategies, mutual funds with fixed income based strategies, and U.S treasury securities. The expected return on domestic benefit plan assets was 4.60% and 5.75% for the fiscal years ended August 31, 2020 and 2019, respectively. A 25 basis point change in the assumptions for the discount rate or expected return on plan assets would not have materially changed the fiscal 2020 domestic benefit plan expense.
We review actuarial assumptions on an annual basis and make modifications based on current rates and trends, when appropriate. As required by GAAP, the effects of any modifications are recorded currently or amortized over future periods. Based on information provided by independent actuaries and other relevant sources, we believe that the assumptions used are reasonable; however, changes in these assumptions could impact our financial position, results of operations or cash flow. See Note 11, “Employee Benefit Plans” in the notes to the consolidated financial statements for further discussion.
Income Taxes: Judgment is required to determine the annual effective income tax rate, deferred tax assets and liabilities, reserves for unrecognized tax benefits and any valuation allowances recorded against net deferred tax assets. Our effective income tax rate is based on annual income, statutory tax rates, tax planning opportunities available in the various jurisdictions in which we operate and other adjustments. Our annual effective income tax rate includes the impact of discrete income tax matters including adjustments to reserves for uncertain tax positions and the benefits of various income tax planning activities. Tax regulations require items to be included in our tax returns at different times than these same items are reflected in our consolidated financial statements. As a result, the effective income tax rate in our consolidated financial statements differs from that reported in our tax returns. Some of these differences are permanent, such as expenses that are not tax deductible, while others are temporary differences, such as amortization and depreciation expenses.
Temporary differences create deferred tax assets and liabilities, which are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. We establish valuation allowances for our deferred tax assets when the amount of expected future taxable income is not large enough to utilize the entire deduction or credit. Relevant factors in determining the realizability of deferred tax assets include future taxable income, the expected timing of the reversal of temporary differences, tax planning strategies and the expiration dates of the various tax attributes.
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