Item 7. Management’s Discussion and Analysis
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following Management’s Discussion and Analysis is intended to assist the reader in understandin g our results of operations and financial condition. Management’s Discussion and Analysis is provided as a supplement to, and should be read in conjunction with, our audited consolidated financial statements that are included in Item 8. "Financial Statements and Supplementary Data ".
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, alternative energy and other markets. Financial information related to the Company's reportable segment is included in Note 16, "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 and the Company are well-positioned to drive shareholder value through a sustainable business strategy built on well-established brands, broad global distribution and end markets, clear focus on the core tools and services business and disciplined capital deployment.
Our Business Model
Our long-term goal is to create shareholder value and best in class returns through growth of our core businesses, driving efficiency and profitability, generating strong cash flow, and being disciplined in the deployment of our capital. We intend to leverage our strong brand, market positions, and dealer and distribution networks to generate organic core sales growth that exceeds end-market growth rates. our plan is to accomplish organic growth through a combination of market-share capture and product innovation, as well as market expansion into new vertical markets, emerging industries and new geographic regions. In addition to organic growth, we also focus on profit margin expansion by utilizing continuous improvement techniques to drive productivity and lower costs and by enacting routine pricing initiatives to generate price realization and offset cost increases, such as commodity and tariff increases and general inflation. Finally, cash flow generation is critical to achieving our financial and long-term strategic objectives. We expect to achieve strong cash flow generation by maximizing returns on assets and minimizing primary working capital needs. The cash flow that results from efficient asset management and improved profitability is used to fund internal growth opportunities, pay down of debt, opportunistic returns for shareholders, and strategic acquisitions.
General Business Update
In March 2022, the Company announced the start of its ASCEND transformation program (“ASCEND”). ASCEND’s key initiatives include accelerating organic growth go-to-market strategies, improving operational excellence and production efficiency by utilizing a Lean approach, and driving greater efficiency and productivity in selling, general and administrative expense by better leveraging resources to create a more efficient and agile organization. The program is expected to be executed over roughly 24 to 36 months. The Company expects that it will deliver an incremental $40-$50 million of annual operating profit from the execution of ASCEND, with the full run rate of operating profit expected to be reflected in its results as it exits fiscal 2024 and fully incorporated into its fiscal 2025 projections. Enerpac anticipates investing approximately $60-$65 million over the life of the program to support the ASCEND initiatives. Such investment is expected to include consulting costs to aid in the development and execution of the program, capital expenditures and restructuring costs.
In June 2022, the Company approved a restructuring plan in connection with the initiatives identified as part of the ASCEND transformation program (see Note 3, “ASCEND Transformation Program” in the notes to the consolidated financial statements) to drive greater efficiency and productivity in global selling, general and administrative resources. The total costs of this plan were then estimated at $6 to $10 million, constituting predominately severance and other employee-related costs to be incurred as cash expenditures and impacting both IT&S and Corporate. On September 23, 2022, the Company approved an updated restructuring plan. The costs of this updated plan (which includes the amounts for the plan approved in June) are estimated at $10 to $15 million. These costs are expected to be incurred over the expected duration of the transformation program, ending in the fourth quarter of fiscal year 2024.
Commencing in February 2022, in response to the armed conflict in Ukraine, many countries, including the member countries of NATO initiated a variety of sanctions and export controls targeting Russia and associated entities. Approximately 1% of our historical annual sales are to customers and distributors associated with Russia and we had approximately $0.5
17
million of receivables associated with those customers and distributors as of February 28, 2022. The sanctions currently in place limit our ability to provide goods to those customers and distributors and banking sanctions effectively negate our ability to collect those receivables; as such, we recorded a full allowance for doubtful accounts against those receivables as of February 28, 2022 and indefinitely suspended doing business in Russia. We will continue to monitor the situation with Russia to assess when and if we are able to resume business with those customers and distributors, including collection of the outstanding receivables. We also continue to monitor and manage the ancillary impact of the Russia crisis on our business, which is primarily related to supply chain, increased commodity and energy costs, foreign exchange rate volatility and dealer confidence particularly in Europe.
During the year ended August 31, 2022, the Company recorded through bad debt expense (included in "Selling, general and administrative expenses" in the Condensed Consolidated Statements of Earnings) a reserve of $13.2 million to fully reserve for the outstanding accounts receivable balance for an agent in our Middle East/North Africa/Caspian ("MENAC") region. The allowance for doubtful accounts for this particular agent as of August 31, 2022 represents management's best estimate of the probable amount of collection and considers various factors with respect to this matter, including, but not limited to, (i) the lack of payment by the agent since the fiscal quarter ended February 28, 2021, (ii) our due diligence on balances due to the agent from its end customers related to sales of our services and products and the known markup on those sales from the agent to end customers, (iii) the status of ongoing negotiations with the agent to secure payments and (iv) legal recourse available to us to secure payment. Actual collections from the agent may differ from the Company's estimate. We have completely ceased our relationship with this agent and have transitioned to serving our regional customers through recently created direct operations within the region.
During largely the second half of fiscal 2020 and through the first three quarters of fiscal 2021, our business, like many others around the world, experienced significant negative financial impacts from the COVID-19 pandemic. Beginning in the third quarter of fiscal 2021, we returned to year-over-year core growth in all regions. Throughout fiscal 2022, we experienced strong growth in most regions that we operate, however, there were still regions that were impacted by the lingering effects of the pandemic, most notably on our European service business and Chinese operations in the second quarter and third quarter of fiscal 2022, respectively. Our key manufacturing facilities continue to operate with additional precautions in place to ensure the safety of our employees and prevent production disruptions. Increased demand due to global economies returning to more normalized levels and pandemic-related factors significantly stressed the global supply chain and created challenges in freight lines and the overall logistics environment. This led to increased raw material, components and logistics costs, as well as longer lead times on orders. We continue to closely monitor our supply chain in order to ensure we can maintain competitive lead times and deliver products to customers timely.
On October 31, 2019, the Com pany 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), with approximately $3 million which was due in four equal quarterly installments, the last of which was received in the first quarter of 2021. The EC&S segment is treated as discontinued operations in our financial statements for all periods.
Despite pandemic-related demand challenges, the supply chain and logistics challenges we are currently experiencing, and the impact of the Ukraine conflict and the associated sanctions on Russia, our balance sheet remains strong and the Company continues to focus on the execution of our strategic growth initiatives in the markets we serve. We remain focused on new product development, driving organic growth and pursuing disciplined acquisition opportunities.
18
Historical Financial Data (dollars in millions)
Year Ended August 31,
2022 2021 2020
Statements of Earnings Data: (1)
Net sales $ 571 100 % $ 529 100 % $ 493 100 %
Cost of products sold 306 54 % 286 54 % 276 56 %
Gross profit 265 46 % 243 46 % 217 44 %
Selling, general and administrative expenses 217 38 % 175 33 % 181 37 %
Amortization of intangible assets 7 1 % 8 2 % 8 2 %
Restructuring charges 8 1 % 3 1 % 7 1 %
Impairment & divestiture charges (benefit) 2 0 % 6 1 % (3) (1) %
Operating profit 31 5 % 51 10 % 24 5 %
Financing costs, net 4 1 % 5 1 % 19 4 %
Other expense (income), net 2 0 % 2 0 % (3) (1) %
Earnings before income tax expense 24 4 % 44 8 % 8 2 %
Income tax expense 4 1 % 4 1 % 2 0 %
Net earnings $ 20 3 % $ 40 8 % $ 6 1 %
Other Financial Data: (1)
Depreciation $ 12 $ 13 $ 12
Capital expenditures 8 12 12
(1) Results are from continuing operations and exclude the financial results of previously divested businesses reported as discontinued operations. E xcept per share amounts, the summation of the individual components may not equal the total due to rounding.
Fiscal 2022 compared to Fiscal 2021
Consolidated net sales from continuing operations in fiscal 2022 were $571 million, 8% higher than the prior-year sales of $529 million with the impact from foreign currency rates unfavorably impacting sales by roughly $15 million or 3%. "Core sales," which excludes the impact of foreign currency changes and the impact from recent acquisitions and divestitures to net sales, increased $57 million or 11%. The product pricing actions that the Company took beginning in late fiscal 2021 and during fiscal 2022 in response to significant inflationary pressures on commodities, freight and energy costs coupled with year-over-year product volume growth largely in the first half of fiscal 2022, as prior year fiscal 2021 first half sales were still impacted by the COVID-19 pandemic, were the primary drivers of the increase in net sales. Gross profit as a percentage of net sales in fiscal 2022 of 46% remained relatively flat with fiscal 2021, with improved gross profit margins on product primarily due to the aforementioned pricing actions outweighing the impact of inflation and improved productivity in our manufacturing facilities being offset by lower service gross profit margins due to lower service utilization as a result of the Russia-Ukraine conflict and the mix of service work performed year over year.
Operating profit was $20 million lower in fiscal 2022 as compared to fiscal 2021 predominantly due to $42 million of incremental selling, general and administrative ("SG&A") expenses offset by a $22 million increase in gross profit, as described above. The increase in SG&A is due to ASCEND transformation program charges of $14 million related primarily to the use of external services for the support in the design, development and execution of the program; discrete bad debt charges of approximately $14 million associated with the significant delinquency in payments from a MENAC region agent and for Russian customers and distributors; incremental leadership transition & board search charges of $8 million; charges of $3 million related to external support for the deep-dive holistic business review prior to the launch of the ASCEND program; and roughly $3 million of higher travel and entertainment costs tied to more commercial and leadership travel as we exited the COVID-19 pandemic. Restructuring charges increased $6 million as compared to the prior period as a result of charges to streamline and flatten the organizational structure ($3 million), as well as ASCEND-related restructuring expenses ($3 million).
19
Fiscal 2021 compared to Fiscal 2020
Consolidated net sales from continuing operations in fiscal 2021 were $529 million, 7% higher than the prior-year sales of $493 million. Core sales increased $27 million (5%) and divested product lines and the strategic exits of certain service offerings, net of sales from acquisitions, decreased net sales $2 million (1%), while the impact from foreign currency rates favorably impacted sales by 2%. The COVID-19 pandemic had a detrimental impact on our core sales in the third and fourth quarter of fiscal 2020. Sales in the first and second quarter of fiscal 2021 still were COVID-19 impacted, however, not to the same extent as we saw in the third and fourth quarters of fiscal 2020. The third and fourth quarter of fiscal 2021 saw more of a return to normalcy in our core product sales, driving the overall increase in core sales from fiscal 2020 to fiscal 2021. Gross profit margins increased 2% year over year as a result of the increase in volumes, leading to greater absorption of overhead, and a strong mix of product and service sales. Operating profit was $27 million higher in fiscal 2021 as compared to fiscal 2020 predominantly as a resul t of the $26 million increase in gross profit. SG&A also decreased approximately $6 million, leading to the increase in operating profit, as a result of the recognition of a gain on the sale of a manufacturing facility in China. Restructuring savings realized in fiscal 2021 were able to offset the short-term cost reduction actions taken in the third and fourth quarter of fiscal 2020 in response to the COVID-19 pandemic (i.e., termination of our fiscal 2020 bonus program and furloughs and other temporary wage reduction programs.) The savings in SG&A were nearly offset by an increase in impairment and divestiture charges recorded in fiscal 2021, specifically the $6 million goodwill impairment charge associated with the Cortland Industrial reporting unit (Other Segment). Financing costs also decreased in fiscal 2021 due to continued benefit from the cash pay off of our outstanding term loan in fiscal 2020, the rate benefit from the retirement of our senior notes in the fourth quarter of fiscal 2020 through drawing on our revolving credit facility, and the paydown of $56 million of principal on our outstanding credit facility in fiscal 2021 through utilization of cash from operations.
Segment Results
IT&S 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 infrastructure, industrial maintenance, repair, and operations, oil & gas, mining, alternative and renewable energy, and civil construction markets. Its primary products include branded tools, cylinders, pumps, hydraulic torque wrenches, highly engineered heavy lifting technology solutions and other tools (Product product line). On the service and rental side, the segment provides 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 (dollars in millions):
Year Ended August 31,
2022 2021 2020
Net Sales $ 527 $ 493 $ 455
Operating Profit 79 82 66
Operating Profit % 14.9 % 16.6 % 14.4 %
Fiscal 2022 compared to Fiscal 2021
Fiscal 2022 IT&S segment net sales increased by $34 million (7%) from fiscal 2021 to $527 million, which included a $15 million or 3% unfavorable impact on sales due to changes in foreign currency exchange rates. Core sales increased $49 million (10%) year-over-year. The increase in core sales was predominantly attributable to the continued global market recovery from the COVID-19 pandemic resulting in incremental product volume growth largely in the first half of the fiscal year coupled with the impact from pricing actions taken in late fiscal 2021 and during fiscal 2022 due to the significant inflation affecting commodity, freight and energy costs.
Fiscal 2022 operating profit decreased $3 million (4%) from the prior year. The operating profit decrease was a result of a $14 million increase in SG&A primarily due to discrete bad debt charges of approximately $14 million associated with the significant delinquency in payments from a MENAC region agent and for Russian customers and distributors offset by a $15 million increase in gross profit due to pricing actions outweighing the impact of inflation and improved productivity in our manufacturing facilities being offset by lower service gross profit margins due to lower service utilization as a result of the Russia-Ukraine conflict and the mix of service work performed year over year.
Fiscal 2021 compared to Fiscal 2020
Fiscal 2021 IT&S segment net sales increased by $38 million (8%) from fiscal 2020 to $493 million. Core sales increased $29 million (7%) year-over-year. The net sales increase included a $2 million (1%) decrease from strategic exits and divestitures of non-core product lines, acquisitions in fiscal 2021, and a 2% favorable impact on sales due to changes in foreign currency exchange rates. The 10% increase in core sales was predominantly a result of broad-based market recovery, as our largest regions of the world returned to more normalized levels of activity in the second half of fiscal 2021.
20
Fiscal 2021 operating profit increased $16 million ( 25% ) from the prior year. The operating profit increase was a result of a $24 million increase in gross profit as a result of the increased sales volumes, offset by the $8 million increase in SG&A expenses. The increase in SG&A expenses resulted from increased sales commissions, the cost of our fiscal 2021 bonus plan (the fiscal 2020 bonus plan was eliminated in response to the COVID-19 pandemic) and other discretionary spending cuts and government subsidy programs that provided a benefit in fiscal 2020, partially offset by the benefit of the restructuring plan first announced in March 2019 and expanded in fiscal 2020.
Corporate
Corporate consists of selling, general and administrative costs and expenses, including executive, legal, finance, human resources, and information technology, that are not allocated to the segments based on their nature. Corporate expenses were $49 million in fiscal 2022 compared to $20 million in fiscal 2021. The increase of $29 million is a result of th e ASCEND transformation program charges ( $13 million ), business review charges related to external support for the deep dive-holistic business review prior to the launch of ASCEND ( $3 million ), leadership transition & board search charges ( $8 million ) and an increase in restructuring charges to streamline and flatten the corporate structure ($1 million), as well as ASCEND-related restructuring expenses ($1 million).
Corporate expenses were $20 million in fiscal 2021 as compared to $38 million in fiscal 2020. The decrease of $18 million is a result of the realization of savings from restructuring actions, the elimination of costs retained after the EC&S divestiture that were required to support the transition services agreement entered into as part of that sale, the reduction in business development costs and the gain, net of transaction costs and value-added taxes, resulting from the sale of our facility in China.
Net financing costs were $4 million, $5 million and $19 million in fiscal 2022, 2021 and 2020, respectively. The decrease in net financing costs in fiscal 2022 as compared to fiscal 2021 was due to the year-over-year increase in interest income due to greater short-term investment of excess cash in fiscal 2022. Fiscal 2021 net financing costs decreased as a result of the cash pay off of our outstanding term loan in November 2019, the retirement of the 5.625% senior notes in June 2020 through drawing on our revolving line of credit, resulting in a lower interest rate on our outstanding long-term debt, and the reduction of the principal on our outstanding credit facility by $56 million in fiscal 2021 through utilization of cash from operations.
Income Tax Expense
The Company's income tax expense 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. 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 fiscal years were as follows (dollars in thousands):
Year Ended August 31,
2022 2021 2020
Earnings before income tax expense $ 23,992 $ 43,975 $ 7,849
Income tax expense 4,401 3,763 2,292
Effective income tax rate 18.3 % 8.6 % 29.2 %
The comparability of pre-tax earnings, income tax expense and the related effective income tax rates are impacted by impairment and other divestiture charges and benefits as well as the Coronavirus Aid, Relief and Economic Security Act (“CARES Act”), which was enacted on March 27, 2020. Fiscal 2022 and 2021 results included $2 million and $6 million of impairment and divestiture charges, respectively, and a $3 million impairment and divestiture benefit in fiscal 2020. A substantial portion of these charges (benefits) do not result in a tax expense or benefit. The fiscal 2022 tax provision included a tax benefit of $3 million related global tax planning initiatives resulting from certain prior-year business losses for which no benefits were previously recognized. The fiscal 2021 tax provision included a tax benefit of $8 million related to the lapse of statute of limitations on uncertain tax positions and a $4 million tax benefit related to the net operating loss carryback provision of the CARES Act as compared to a $3 million tax benefit in fiscal 2020 driven by legislative changes.
Both the fiscal 2022 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 fiscal 2022 effective tax rate was 18.3%, which is significantly higher than the fiscal 2021 effective tax rate of 8.6%. The fiscal 2022 effective tax rate was lower than the statutory 21% primarily as a result of the one-time tax benefits related to global tax planning initiatives that will not repeat in future periods due to certain tax attributes that are no longer available.
21
Items Impacting Comparability
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 $11 million, $14 million and $6 million in fiscal 2022, 2021 and 2020, respectively. 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 for the year ended August 31, 2020.
Liquidity and Capital Resources
At August 31, 2022, cash and cash equivalents were $121 million, comprised of $119 million of cash held by foreign subsidiaries and $2 million held domestically. The following table summarizes the cash flow attributable to operating, investing and financing activities (in millions):
Year Ended August 31,
2022 2021 2020
Net cash provided by (used in) operating activities $ 52 $ 54 $ (3)
Net cash (used in) provided by investing activities (7) 13 176
Net cash used in financing activities (52) (82) (239)
Effect of exchange rate changes on cash (12) 2 7
Net decrease in cash and cash equivalents $ (20) $ (12) $ (59)
Cash flow provided by operations was $52 million and $54 million in fiscal 2022 and 2021, respectively. The decrease of $2 million in cash flow provided by operations was the result of $19 million lower net earnings from continuing operations offset by approximately $14 million of incremental receivable reserves to reconcile net earnings from continuing operations to net cash provided by operating activities. We used $7 million of cash in investing activities in the current year as compared to $13 million cash provided by investing activities in the prior-year period. The cash used in fiscal 2022 was primarily used for capital expenditures. The cash provided by investing activities in fiscal 2021 was largely generated due to the receipt of proceeds from the sale of our manufacturing facility in China ($22 million) and the death benefit for life insurance on legacy officers of the Company ($3 million), offset by approximately $12 million of capital expenditures. In fiscal 2022, our cash used in financing activities was primarily from the purchase of treasury shares of $75 million and the paydown of principal on our revolving credit facility of $60 million partially offset by the borrowing on the revolving credit facility of $85 million. The cash used in financing activities in fiscal 2021 was primarily for the paydown of $90 million of principal on our outstanding credit facility with cash provided by operating activites and excess cash on hand.
Cash flow provided by operations was $54 million in fiscal 2021, an increase of $57 million from the prior year due to a
$20 million increase in cash flows from discontinued operations driven by the timing of the divestiture of the EC&S segment in
fiscal 2020 and an increase in net earnings from continuing operations of $35 million year over year. We generated $13 million
of cash from investing activities in the current year as compared to $176 million in the prior-year period. The cash provided in
fiscal 2020 was primarily generated from the sale of our EC&S segment as well as our Connectors and UNI-LIFT product lines,
slightly offset by cash used for capital expenditures. In fiscal 2021, we sold our manufacturing facility in China for
approximately $22 million and received approximately $3 million in proceeds associated with the death benefit for life
insurance on legacy officers of the Company, which was offset by approximately $12 million of capital expenditures in the
fiscal year. In fiscal 2021, our cash used in financing activities was primarily from the paydown of $80 million of principal on
our outstanding credit facility with cash from operations and excess cash on hand.
The Company's senior credit facility is comprised of a $400 million revolving line of credit and a $200 million term loan which were scheduled to mature in March 2024 (see Note 8, "Debt" in the notes to the consolidated financial statements for further details of the senior credit facility). The Company paid off the outstanding principal balance on the term loan in November 2019. In June 2020, the Company borrowed $295 million under the senior credit facility revolving line of credit to fund the redemption of all of its then outstanding Senior Notes at par, plus the remaining accrued and unpaid interest, to reduce interest costs. Outstanding borrowings under the senior credit facility revolving line of credit were $200 million as of August 31, 2022. The unused credit line and amount available for borrowing under the revolving line of credit was $191 million at August 31, 2022.
On September 9, 2022, the Company refinanced its credit facility resulting in a new $600 million senior credit facility, comprised of a $400 million revolving line of credit and a $200 million term loan, which will mature in September 2027. See N ote 18, " Subsequent Event " in the notes to the consolidated financial statements for further details.
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.
22
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 (dollars in millions):
August 31, 2022 August 31, 2021
$ PWC % $ PWC %
Accounts receivable, net $ 107 18 % $ 103 18 %
Inventory, net 84 14 % 75 13 %
Accounts payable (73) (12) % (62) (11) %
Net primary working capital $ 118 20 % $ 116 20 %
Total primary working capital was $118 million at August 31, 2022, which increased from $116 million at August 31, 2021. The primary working capital increase related to increased accounts receivable as a result of higher sales in the fourth quarter of fiscal 2022 compared to the fourth quarter of fiscal 2021 and due to $9 million of higher inventory as we continue to work through supply chain issues. Higher inventory levels, specifically the purchase of inventory, was the driver of the $11 million of incremental accounts payable as of August 31, 2022 compared to August 31, 2021.
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 $8 million for 2022 and $12 million in both fiscal 2021 and 2020.
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, 2022 were $4 million with monthly payments extending to fiscal 2025.
We had outstanding letters of credit totaling $11 million and $12 million at August 31, 2022 and 2021, respectively, the majority of which relate to commercial contracts and self-insured workers' compensation programs.
Additional detail regarding contingencies is included in Note 17, "Commit ments and Contingencies " in the notes to the consolidated financial statements, which is incorporated by reference.
Contractual Obligations
Our predominant sources of contractual obligations include the payment of interest and principal on our outstanding line of credit, our operating lease portfolio, certain employee-related benefit plans and agreements with certain suppliers related to the procurement of inventory.
The timing of principal payments associated with our revolving line of credit are disclosed in Note 8, "Debt " in the notes to the consolidated financial statements. We pay interest monthly based on prevailing interest rates at the time and the balance outstanding on our revolving line of credit.
Our lease contracts are primarily for real estate leases, vehicle leases, IT and manufacturing leases, information technology services and telecommunications services. See Note 11, "Leases" in the notes to the consolidated financial statements for future minimum lease payments associated with our lease portfolio.
We have long-term obligations related to our deferred compensation, pension and postretirement plans that are summarized in Note 12, “Employee Benefit Plans” in the notes to the consolidated financial statements.
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
23
we discontinue manufacturing 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. 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.
Critical Accounting Estimates
We prepare our consolidated financial statements in conformity with US 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.
Accounts receivable, net: Accounts receivable, net is recorded based on the contractual value of our accounts receivable, net of an estimated allowance for doubtful accounts representing management’s best estimate of the amount of receivables that are not probable of collection. Accounts receivable, net was $107 million as of August 31, 2022 , which is net of a $18 million allowance for doubtful accounts. Our customer base generally consists of financially reputable distributors, agents, OEMs, and other customers with whom we have long standing relationships, and historically we have not experienced significant write off of accounts receivables as a percentage of our annual net sales (accounts receivable written off as a percentage of net sales was 0.1% for each the years ended August 31, 2022 , 2021 , and 2020, respectively). As of August 31, 2022, the Company was exposed to a concentration of credit risk with an agent as a result of its continued payment delinquency. During the year ended August 31, 2022, the Company recorded through bad debt expense (included in SG&A in the Condensed Consolidated Statements of Earnings) a reserve of $13 million for this agent based on the consideration of the factors listed below, which fully reserves for this agent's outstanding account receivable balance. The allowance for doubtful accounts for this particular agent as of August 31, 2022 represents management's best estimate of the amount probable of collection and considers various factors with respect to this matter, including, but not limited to, (i) the lack of payment by the agent since the fiscal quarter ended February 28, 2021, (ii) our due diligence on balances due to the agent from its end customers related to sales of our services and products and the known markup on those sales from the agent to end customer, (iii) the status of ongoing negotiations with the agent to secure payments and (iv) legal recourse available to secure payment. Actual collections from the agent may differ from the Company's estimate.
Inventories: Inventory cost is determined using the last-in, first-out (“LIFO”) method for a portion of U.S. owned inventory (approximately 52% and 48% of total inventories at August 31, 2022 and 2021, respectively). If the LIFO method were not used, inventory balances would be higher than amounts presented in the Consolidated Balance Sheet by $19 million and $16 million at August 31, 2022 and 2021, respectively. We perform an analysis on historical sales usage of individual inventory items on hand and record a reserve to adjust inventory cost to net realizable 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.
Fiscal 2022 Impairment Charges: In the fourth quarter of fiscal 2022, in conjunction with our annual goodwill impairment assessment, we recorded a $1 million goodwill impairment charge associated with the Cortland Industrial reporting unit. See Note 7, "Goodwill, Intangible Assets, and Long-Lived Assets" in the notes to the consolidated financial statements for further discussion. In addition, the annual goodwill impairment assessment resulted in two reporting units having an estimated fair
24
value that exceeded the carrying value by less than 110%. The combined goodwill for these reporting units as of August 31, 2022, was approximately $140 million.
Fiscal 2021 Impairment Charges : In the fourth quarter of fiscal 2021, the Cortland Industrial business lagged behind our IT&S segment with respect to recovery in demand from the COVID-19 pandemic. Further, though volumes did increase from previous quarters, it became clear that we were not on track to realize the annual savings from our footprint optimization actions at the pace initially projected. Therefore, in conjunction with our annual goodwill impairment assessment, we recorded a $6 million goodwill impairment charge associated with the Cortland Industrial reporting unit. See Note 7, "Goodwill, Intangible Assets, and Long-Lived Assets" in the notes to the consolidated financial statements for further discussion. The fiscal 2021 annual review of other 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 100%.
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.
No material impairments were recorded in fiscal 2022 or fiscal 2021 as a result of triggering events or the annual impairment review of indefinite-lived intangible assets.
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, 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.
No long-lived asset impairment charges were recorded in fiscal 2022 or fiscal 2021. In both fiscal 2022 and 2021, the fact that the fair value of the Cortland Industrial reporting unit was less than its net book value was considered a triggering event, however, no impairments were recorded on the long-lived assets based on the results of the undiscounted cash flow analyses performed.
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, 2022 and 2021, the discount rates on domestic benefit plans were 4.8% and 2.6%, respectively. In estimating the expected return on plan assets, we consider historical returns, forward-looking considerations,
25
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 5.5% and 4.2% for the fiscal years ended August 31, 2022 and 2021, 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 2022 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 US 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 12, “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.