Item 7. Management’s Discussion and Analysis
Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations
This MD&A contains forward-looking statements that involve risks and uncertainties. Please see “Forward-Looking Statements” in Item 1- Business and Item 1A- Risk Factors in this Form 10-K for a discussion of the uncertainties, risks and assumptions associated with these statements. This discussion should be read in conjunction with our historical financial statements and related notes thereto and the other disclosures contained elsewhere in this Form 10-K. The results of operations for the periods reflected herein are not necessarily indicative of results that may be expected for future periods, and our actual results may differ materially from those discussed in the forward-looking statements as a result of various factors, including but not limited to those listed under Item 1A- Risk Factors and included elsewhere in this Form 10-K.
This MD&A is a supplement to our financial statements and notes thereto included elsewhere in this 10-K and is provided to enhance your understanding of our results of operations and financial condition. Our discussion of results of operations is presented in millions throughout the MD&A and due to rounding may not sum or calculate precisely to the totals and percentages provided in the tables. Our MD&A is organized as follows:
• Company Overview. This section provides a general description of our Company and reportable segments, business and industry trends, our key business strategies and background information on other matters discussed in this MD&A.
• Consolidated Results of Operations and Operating Results by Business Segment. This section provides our analysis and outlook for the significant line items on our consolidated statements of operations, as well as other information that we deem meaningful to an understanding of our results of operations on both a consolidated basis and a business segment basis.
• Liquidity and Capital Resources. This section contains an overview of our financing arrangements and provides an analysis of trends and uncertainties affecting liquidity, cash requirements for our business, and sources and uses of our cash.
• Critical Accounting Policies and Estimates. This section discusses the accounting policies that we consider important to the evaluation and reporting of our financial condition and results of operations, and whose application requires significant judgments or a complex estimation process.
Company Overview
We are a leading global provider of windows, doors, wall systems, and other building products. We design, produce, and distribute an extensive range of interior and exterior doors, wood, vinyl, and aluminum windows, and related products for use in the new construction, R&R of residential homes, and, to a lesser extent, non-residential buildings.
We operate manufacturing and distribution facilities in 19 countries, located primarily in North America, Europe, and Australia. For many product lines, our manufacturing processes are vertically integrated, enhancing our range of capabilities, our ability to innovate, and our quality control as well as providing supply chain, transportation, and working capital savings.
Business Segments
Our business is organized in geographic regions to ensure integration across operations serving common end markets and customers. We have three reportable segments: North America, Europe, and Australasia. Financial information related to our business segments can be found in Note 14 - Segment Information of our financial statements included elsewhere in this 10-K.
Acquisitions and Divestitures
During 2021, the Company ceased the appeal process for its litigation with Steves & Sons, Inc. (“Steves”). As a result, we are required to divest the Company’s Towanda, PA operations (“Towanda”). Assuming customary closing conditions are met and subject to court approval, we believe the divestiture will occur within the next twelve months and qualifies for held for sale accounting and we have reclassified certain assets and liabilities to assets held for sale in the accompanying financial statements. The results of Towanda will continue to be reported within our North America operations until the divestiture is finalized.
For additional information on the Steves litigation and divestiture, see Note 24 - Commitments and Contingencies of our financial statements included elsewhere in this 10-K.
In March 2019, we acquired VPI Quality Windows, Inc., a leading manufacturer of vinyl windows, specializing in customized solutions for mid-rise multi-family, industrial, hospitality and commercial projects. VPI, headquartered in Spokane, Washington, with operations in Spokane, Washington and Statesville, North Carolina, is part of our North America segment and was acquired for $57.8 million in cash, net of cash acquired.
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Factors and Trends Affecting Our Business
Components of Net Revenues
The key components of our net revenues include core net revenues (which we define to include the impact of pricing and volume/mix, as discussed further under the heading, “Product Pricing and Volume/Mix” below), contribution from acquisitions made within the prior twelve months, and the impact of foreign exchange. Core net revenues reported in our financial statements are impacted by the fluctuating currency values in the geographies in which we operate, which we refer to as the impact from foreign exchange. Throughout this “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, percentage changes in pricing are based on management schedules and are not derived directly from our accounting records.
Product Demand
General business, financial market, and economic conditions globally and in the regions where we operate influence overall demand in our end markets and for our products. In particular, the following factors may have a direct impact on demand for our products in the countries and regions where our products are marketed and sold:
• the strength of the economy;
• employment rates and consumer confidence and spending rates;
• the availability and cost of credit;
• the amount and type of residential and non-residential construction;
• housing sales and home values;
• the age of existing home stock, home vacancy rates, and foreclosures;
• interest rate fluctuations for our customers and consumers;
• volatility in both debt and equity capital markets;
• increases in the cost of raw materials or any shortage in supplies or labor, including as a result of tariffs or other trade restrictions;
• the effects of governmental regulation and initiatives to manage economic conditions;
• geographical shifts in population and other changes in demographics; and
• changes in weather patterns.
In addition, we seek to drive demand for our products through the implementation of various strategies and initiatives. We believe we can enhance demand for our new and existing products by:
• innovating and developing new products and technologies;
• investing in branding and marketing strategies, including marketing campaigns in both print and social media, as well as our investments in training centers and mobile training facilities; and
• implementing channel initiatives to enhance our relationships with key channel partners and customers, including optimizing growth through rebate programs in North America.
Product Pricing and Volume/Mix
The price and mix of products that we sell are important drivers of our net revenues and net income. Under the heading “Results of Operations,” references to (i) “pricing” refer to the impact of price increases or decreases, as applicable, for particular products between periods based on demand and (ii) “volume/mix” refer to the combined impact of both the number of products we sell in a particular period and the types of products sold, in each case, on net revenues. While we operate in competitive markets, the demand for our innovative products allows us to exercise pricing discipline, which is an important element of our strategy to achieve profitable growth through improved margins. Our strategy also includes incentivizing our channel partners to sell our higher margin products, and we believe a renewed focus on innovation and the development of new technologies will increase our sales volumes and the overall profitability of our product mix.
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Cost Reduction Initiatives
Prior to the ongoing operational transformation being executed by our senior executive team, our operations were managed in a decentralized manner with varying degrees of emphasis on cost efficiency and limited focus on continuous improvement or strategic sourcing. Our senior management team has a proven track record of implementing operational excellence programs at some of the world’s leading industrial manufacturing businesses, and we believe the same successes can be realized at JELD-WEN. Key areas of focus of our operational excellence and footprint rationalization programs include:
• reducing labor, overtime, and waste costs by reducing facility count while optimizing manufacturing capacity and improving planning and manufacturing processes;
• reducing or minimizing increases in material costs through strategic global sourcing and value-added re-engineering of components, in part by leveraging our significant spend and the global nature of our purchases;
• reducing warranty costs by improving quality; and
• a JEM-enabled facility rationalization and modernization initiative that will reduce overhead costs and complexity, while increasing our overall capacity and improving our service levels.
We continue to implement our strategic initiatives under JEM to develop the culture and processes of operational excellence and continuous improvement. These cost reduction initiatives, which include plant closures and consolidations, headcount reductions, and other various initiatives aimed at lowering production and overhead costs, may not produce the intended results within the intended timeframe.
Raw Material Costs
Commodities such as vinyl extrusions, glass, aluminum, wood, steel, plastics, fiberglass, and other composites are major components in the production of our products. Changes in the underlying prices of these commodities have a direct impact on the cost of goods sold. While we attempt to pass on a substantial portion of such cost increases to our customers, we may not be successful in doing so. In addition, our results of operations for individual quarters may be negatively impacted by a delay between the time of raw material cost increases and a corresponding price increase. Conversely, our results of operations for individual quarters may be positively impacted by a delay between the time of a raw material price decrease and a corresponding competitive pricing decrease.
Freight Costs
We incur substantial freight and duty costs to third party logistics providers and port authorities to transport raw materials and work-in-process inventory to our manufacturing facilities and to deliver finished goods to our customers. Changes in freight and duty rates as well as the availability of freight services can have a significant impact on our cost of goods sold. Freight and duty costs have risen significantly due to a number of factors that have affected the supply and demand of trucking and port services, including increased regulation, such as data logging of miles, increases in general economic activity, labor shortages, and an aging workforce. We attempt to mitigate some of these cost increases through various internal initiatives and to pass a substantial portion of these increases to our customers; however, we may not realize the intended results within the intended timeframe.
Working Capital and Seasonality
Working capital, which is defined as accounts receivable plus inventory less accounts payable, fluctuates throughout the year and is affected by seasonality of sales of our products and of customer payment patterns. The peak season for home construction and remodeling in our North America and Europe segments, which represent the substantial majority of our revenues, generally corresponds with the second and third calendar quarters, and therefore our sales volume is usually higher during those quarters. Typically, working capital increases at the end of the first quarter and beginning of the second quarter in conjunction with, and in preparation for, our peak season, and working capital decreases starting in the third quarter as inventory levels and accounts receivable decline. Inventories fluctuate as we manage availability in our supply chain due to COVID-19 impacts and for some raw materials with long delivery lead times, such as steel, as we work through prior shipments and take delivery of new orders. Our working capital balances have been impacted by inflation in the current year due to rising costs in raw materials impacting both inventory and accounts payable as well as higher accounts receivable usages as a result of price realization across our product portfolio.
Foreign Currency Exchange Rates
We report our consolidated financial results in U.S. dollars. Due to our international operations, the weakening or strengthening of foreign currencies against the U.S. dollar can affect our reported operating results and our cash flows as we translate our foreign subsidiaries’ financial statements from their reporting currencies into U.S. dollars. The exchange rates used to translate our foreign subsidiaries’ financial results for the year ended December 31, 2021 compared to the year ended December 31, 2020 reflected, on average, the U.S. dollar weakened against the Australian dollar, Canadian dollar, and Euro by 9%, 7% and 4%, respectively. See Item 1A- Risk Factors - Risks Relating to Our Business and Industry, Item 1A- Risk Factors - Exchange rate fluctuations may impact
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our business, financial condition, and results of operations, and Item 7A- Quantitative and Qualitative Disclosures About Market Risk- Exchange Rate Risk.
Components of our Operating Results
Net Revenues
Our net revenues are a function of sales volumes and selling prices, each of which is a function of product mix, and consist primarily of:
• sales of a wide variety of interior and exterior doors, including patio doors, for use in residential and non-residential applications, with and without frames, to a broad group of wholesale and retail customers in all of our geographic markets;
• sales of a wide variety of windows for both residential and certain non-residential uses, to a broad group of wholesale and retail customers primarily in North America, Australia, and the U.K.; and
• other sales, including sales of moldings, trim board, cut-stock, glass, stairs, hardware and locks, door skins, shower enclosures, wardrobes, window screens, and miscellaneous installation and other services revenue.
Net revenues do not include internal transfers of products between our component manufacturing, product manufacturing and assembly, and distribution facilities.
Cost of Sales
Cost of sales consists primarily of material costs, direct labor and benefit costs, including payroll taxes, repair and maintenance, depreciation, utility, rent and warranty expenses, outbound freight, insurance and benefits, supervision and tax expenses.
Material Costs. The single largest component of cost of sales is material costs, which include raw materials, components, and finished goods purchased for use in manufacturing our products or for resale. Our most significant material costs include glass, wood, wood components, doors, door facings, door parts, hardware, vinyl extrusions, steel, fiberglass, packaging materials, adhesives, resins and other chemicals, core material, and aluminum extrusions. The cost of each of these items is impacted by global supply and demand trends, both within and outside our industry, as well as commodity price fluctuations, conversion costs, energy costs, and transportation costs. We have and may continue to experience inflation in our material costs, including increased costs for inbound freight, due to supply chain challenges as a result of COVID-19. The imposition of new tariffs on imports, new trade restrictions, or changes in tariff rates or trade restrictions may further impact material costs. See Item 7A- Quantitative and Qualitative Disclosures About Market Risk- Raw Materials Risk.
Direct Labor and Benefit Costs. Direct labor and benefit costs reflect a combination of production hours, average headcount, general wage levels, payroll taxes, and benefits provided to employees. Direct labor and benefit costs include wages, overtime, payroll taxes, and benefits paid to hourly employees at our facilities that are involved in the production and/or distribution of our products. These costs are generally managed by each facility and headcount is adjusted according to overall and seasonal production demand. We run multi-shift operations in many of our facilities to maximize return on assets and utilization. Direct labor and benefit costs fluctuate with headcount, but generally tend to increase with inflation due to increases in wages and health benefit costs.
Repair and Maintenance, Depreciation, Utility, Rent, and Warranty Expenses.
• Repairs and maintenance costs consist of equipment and facility maintenance expenses, purchases of maintenance supplies, and the labor costs involved in performing maintenance on our equipment and facilities.
• Depreciation includes depreciation expense associated with our production assets and plants.
• Rent is predominantly comprised of lease costs for facilities we do not own as well as vehicle fleet and equipment lease costs. Facility leases are typically multi-year and may include increases tied to certain measures of inflation.
• Warranty expenses represent all costs related to servicing warranty claims and product issues and are mostly related to our window and door products sold in the U.S. and Canada.
Outbound Freight. Outbound freight includes payments to third-party carriers for shipments of orders to our customers, as well as driver, vehicle, and fuel expenses when we deliver orders to customers. The majority of our products are shipped by third-party carriers.
Insurance and Benefits, Supervision, and Tax Expenses.
• Insurance and benefit costs are the expenses relating to our insurance programs, health benefits, retirement benefit programs (including the pension plan), and other benefits that are not included in direct labor and benefits costs.
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• Supervision costs are the wages and bonus expenses related to plant managers. Both insurance and benefits and supervision expenses tend to be influenced by headcount and wage levels.
• Tax costs are mostly payroll taxes for employees not included in direct labor and benefit costs, and property taxes. Tax expenses are impacted by changes in tax rates, headcount and wage levels, and the number and value of properties owned.
In addition, an appropriate portion of each of the insurance and benefits, supervision and tax expenses are allocated to SG&A expenses.
Selling, general, and administrative expenses
SG&A expenses consist primarily of research and development, sales and marketing, and general and administrative expenses.
Research and Development . Research and development expenses consist primarily of personnel expenses related to research and development, consulting and contractor expenses, tooling and prototype materials, and overhead costs allocated to such expenses. Substantially all of our research and development expenses are related to developing new products and services and improving our existing products and services. To date, research and development expenses have been expensed as incurred, because the period between achieving technological feasibility and the release of products and services for sale has been short and development costs qualifying for capitalization have been insignificant.
We expect our research and development expenses to increase in absolute dollars as we continue to make significant investments in developing new products and enhancing existing products as part of our growth strategy.
Sales and Marketing. Sales and marketing expenses consist primarily of advertising and marketing promotions of our products and services and related personnel expenses, as well as sales incentives, trade show and event costs, sponsorship costs, consulting and contractor expenses, travel, display expenses, and related amortization. Sales and marketing expenses are generally variable expenses. We expect our sales and marketing expenses to increase in absolute dollars as we continue to actively promote our products and services.
General and Administrative . General and administrative expenses consist of personnel expenses for our finance, legal, human resources, and administrative personnel, as well as the costs of professional services, any allocated overhead, information technology, amortization of intangible assets acquired, and other administrative expenses. We expect our general and administrative expenses to increase in absolute dollars to support future growth and the related infrastructure of our business.
Impairment and Restructuring Costs
Impairment and restructuring costs consist primarily of all salary-related severance benefits that are accrued and expensed when a restructuring plan has been put into place, the plan has received approval from the appropriate level of management and the benefit is probable and reasonably estimable. In addition to salary-related costs, we incur other restructuring costs when facilities are closed or capacity is realigned within the organization. Upon termination of an employment or commercial contract we record liabilities and expenses pursuant to the terms of the relevant agreement. For non-contractual restructuring activities, liabilities and expenses are measured and recorded at fair value in the period in which they are incurred.
Interest Expense, Net
Interest expense, net, relates primarily to interest payments on our credit facilities and debt securities, as well as commitment fees and amortization of any original issue discount or debt issuance costs. Debt issuance costs are included as an offset to long-term debt in the accompanying consolidated balance sheets and are amortized to interest expense over the life of the applicable facility using the effective interest method. For additional details, see Note 11 - Long-Term Debt in our financial statements for the year ended December 31, 2021 included elsewhere in this 10-K .
Other Income, Net
Other income, net, includes profit and losses related to various miscellaneous non-operating expenses primarily relating to pension benefit income and expenses, governmental pandemic assistance reimbursements relating to COVID-19, legal settlement income, insurance reimbursements, loss on extinguishment of debt, gains and losses on sale of business units, property, and equipment, and certain foreign currency related gains and losses, including from our hedging activities used to mitigate foreign exchange impacts.
Income Taxes
Income taxes are recorded using the asset and liability method of accounting for income taxes. Under this method, deferred tax assets and liabilities are recognized for the deferred tax consequences attributable to differences between the financial statement
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carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities 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. The effect on deferred tax assets and liabilities due to a change in tax rates is recognized in income in the period that includes the date of enactment. We recognize the effect of income tax positions only if those positions are more likely than not of being sustained. Recognized income tax positions are measured at the largest amount that is greater than 50% likely of being realized. Changes in recognition or measurement are reflected in the period in which the change in judgment occurs. We record interest related to unrecognized tax benefits in income tax expense. As of December 31, 2021, our U.S. federal, state, and foreign net operating loss (“NOL”) carryforwards were $1,560.6 million in the aggregate and $96.4 million of such NOL carryforwards do not expire. For additional details, see Note 13 - Income Taxes in our financial statements for the year ended December 31, 2021 included elsewhere in this 10-K.
Significant Developments
In March 2020, the World Health Organization declared the outbreak of COVID-19 a global pandemic. In the following weeks, global restrictions, including stay at home and similar orders, were implemented in a significant number of countries in which we operate. We made, and continue to make, changes to our operations to ensure proper measures are in place for the health and safety of our employees and to satisfy the needs of our customers. We continue to experience intermittent closures and reduced operating capacity of certain manufacturing facilities, primarily due to local and governmental mandates.
During 2021, we continued to experience increased demand for our products in both residential and remodel channels due to the low residential housing supply, low interest rates, and consumers’ focus on their homes. In addition, we have and may continue to experience challenges throughout our operations relating to COVID-19, including increased inflation in our supply chain, as well as in raw materials, labor, and freight charges. We have experienced delays of inbound and outbound deliveries and labor availability issues due to quarantines, site access, and employee absences.
The scope and nature of impacts from COVID-19, most of which are beyond our control, continue to evolve, and the outcome is uncertain. The ultimate effects of the COVID-19 pandemic on us and the end markets we service, is highly uncertain and will depend on future developments. Such effects could exist for an extended period even after the pandemic ends.
Results of Operations
The tables in this section summarize key components of our results of operations for the periods indicated, both in U.S. dollars and as a percentage of our net revenues. Certain percentages presented in this section have been rounded to the nearest whole number. Accordingly, totals may not equal the sum of the line items in the tables below. We define core revenues as revenue excluding the impact of foreign exchange and acquisitions completed in the last twelve months.
Comparison of the Year Ended December 31, 2021 to the Year Ended December 31, 2020
December 31, 2021 December 31, 2020
(amounts in thousands) % of Net
Revenues % of Net
Revenues
Net revenues $ 4,771,719 100.0 % $ 4,235,677 100.0 %
Cost of sales 3,796,452 79.6 % 3,333,770 78.7 %
Gross margin 975,267 20.4 % 901,907 21.3 %
Selling, general and administrative 704,892 14.8 % 702,715 16.6 %
Impairment and restructuring charges 2,950 0.1 % 10,469 0.2 %
Operating income 267,425 5.6 % 188,723 4.5 %
Interest expense, net 77,566 1.6 % 74,800 1.8 %
Other income (14,503) (0.3) % (2,752) (0.1) %
Income before taxes
204,362 4.3 % 116,675 2.8 %
Income tax expense 35,540 0.7 % 25,089 0.6 %
Net income $ 168,822 3.5 % $ 91,586 2.2 %
Consolidated Results
Net Revenues – Net revenues increased $536.0 million, or 12.7%, to $4,771.7 million in the year ended December 31, 2021 from $4,235.7 million in the year ended December 31, 2020. The increase was due to an improvement in core revenues of 10% and a positive impact from foreign exchange of 3%. Core revenues increased due to a 7% benefit from pricing and favorable volume/mix of 3%.
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Gross Margin – Gross margin increased $73.4 million, or 8.1%, to $975.3 million in the year ended December 31, 2021 from $901.9 million in the year ended December 31, 2020. Gross margin as a percentage of net revenues was 20.4% in the year ended December 31, 2021 and 21.3% in the year ended December 31, 2020. The decrease in gross margin percentage was primarily due to the impact of inflation on material costs, freight, and labor compensation in the current period, partially offset by improved pricing, positive manufacturing variances, and favorable volume/mix.
SG&A Expense – SG&A expense increased $2.2 million, or 0.3%, to $704.9 million in the year ended December 31, 2021 from $702.7 million in the year ended December 31, 2020. The increase in SG&A expense was primarily due to the non-recurrence of certain savings from cost reduction measures implemented in 2020 in response to COVID-19, primarily related to salary and benefits, and the impact of inflation on compensation in the current period, partially offset by reduced variable compensation and litigation related expenses.
Impairment and Restructuring Charges – Impairment and restructuring charges decreased $7.5 million, or 71.8%, to $3.0 million in the year ended December 31, 2021 from $10.5 million in the year ended December 31, 2020. Charges incurred in 2021 primarily relate to ongoing restructuring projects within our Europe segment and asset impairment charges in North America. Charges incurred in 2020 primarily related to severance charges for ongoing restructuring projects across all segments as well as impairment charges primarily related to capitalized costs of certain ERP modules due to delays in implementation and uncertainty of their future use. For more information, refer to Note 19 - Impairment and Restructuring Charges to our consolidated financial statements included in this 10-K.
Interest Expense, Net – Interest expense, net, increased $2.8 million, or 3.7%, to $77.6 million in the year ended December 31, 2021 from $74.8 million in the year ended December 31, 2020. The increase was primarily due to interest on our Senior Secured Notes issued in May 2020, partially offset by lower interest rates throughout 2021.
Other Income – Other income increased $11.8 million, or 427.0%, to $14.5 million in the year ended December 31, 2021 from $2.8 million in the year ended December 31, 2020. Other income in the year ended December 31, 2021 primarily consisted of foreign currency gains of $9.9 million and reimbursements from governmental pandemic assistance relating to COVID-19 and insurance and of $3.2 million, partially offset by a loss on sale or disposal of property and equipment of $2.0 million and a loss on extinguishment of debt of $1.3 million. Other income in the year ended December 31, 2020 primarily consisted of foreign currency losses of $11.9 million and pension expense of $1.6 million, offset by reimbursements from governmental pandemic assistance relating to COVID-19 of $7.4 million, a gain on sale of property and equipment of $4.1 million, and insurance reimbursements of $1.4 million.
Income Taxes – Income tax expense increased $10.5 million, or 41.7%, to $35.5 million in the year ended December 31, 2021 from $25.1 million in the year ended December 31, 2020. The effective tax rate in the year ended December 31, 2021 was 17.4% compared to 21.5% in the year ended December 31, 2020. The increase in income tax expense in the year ended December 31, 2021 was primarily due to an increase in income before taxes of $87.7 million, partially offset by a tax benefit from tax credits and GILTI HTE as well as a partial release of U.S. state valuation allowances. For more information, refer to Note 13 – Income Taxes to our consolidated financial statements included in this 10-K.
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Comparison of the Year Ended December 31, 2020 to the Year Ended December 31, 2019
December 31, 2020 December 31, 2019
(dollars in thousands) % of Net
Revenues % of Net
Revenues
Net revenues $ 4,235,677 100.0 % $ 4,289,761 100.0 %
Cost of sales 3,333,770 78.7 % 3,417,222 79.7 %
Gross margin 901,907 21.3 % 872,539 20.3 %
Selling, general and administrative 702,715 16.6 % 660,574 15.4 %
Impairment and restructuring charges 10,469 0.2 % 21,551 0.5 %
Operating income 188,723 4.5 % 190,414 4.4 %
Interest expense, net 74,800 1.8 % 71,778 1.7 %
Other income (2,752) (0.1) % (1,409) — %
Income before taxes 116,675 2.8 % 120,045 2.8 %
Income tax expense 25,089 0.6 % 57,074 1.3 %
Net income $ 91,586 2.2 % $ 62,971 1.5 %
Consolidated Results
Net Revenues – Net revenues decreased $54.1 million, or 1.3%, to $4,235.7 million in the year ended December 31, 2020 from $4,289.8 million in the year ended December 31, 2019. The decrease was driven by a decline in core revenue of 2% consisting of a 5% decline in volume/mix, partially offset by a 3% pricing benefit.
Gross Margin – Gross margin increased $29.4 million, or 3.4%, to $901.9 million in the year ended December 31, 2020 from $872.5 million in the year ended December 31, 2019. Gross margin as a percentage of net revenues was 21.3% in the year ended December 31, 2020 and 20.3% in the year ended December 31, 2019. Gross margins increased due to positive manufacturing variances and improved pricing, partially offset by unfavorable volume/mix and the effect of inflation on labor compensation.
SG&A Expense – SG&A expense increased $42.1 million, or 6.4%, to $702.7 million in the year ended December 31, 2020 from $660.6 million in the year ended December 31, 2019. The increase in SG&A expense was primarily due to increased legal expenses, primarily relating to litigation and environmental accruals and fees, and estimated variable compensation, partially offset by reductions in spending relating to sales, marketing, and travel as a result of cost saving measures implemented in response to COVID-19, and the non-recurrence of acquisition costs recorded in 2019.
Impairment and Restructuring Charges – Impairment and restructuring charges decreased $11.1 million, or 51.4%, to $10.5 million in the year ended December 31, 2020 from $21.6 million in the year ended December 31, 2019. Charges incurred in 2020 primarily related to severance charges for ongoing restructuring projects across all segments as well as impairment charges primarily related to capitalized costs of certain ERP modules due to delays in implementation and uncertainty of their future use. Charges incurred in 2019 primarily related to plant consolidations in our North America and Australasia segments resulting in impairments of ROU assets and property and equipment as well as severance costs across all segments and corporate. For more information, refer to Note 19 - Impairment and Restructuring Charges to our consolidated financial statements included in this 10-K.
Interest Expense, Net – Interest expense, net, increased $3.0 million, or 4.2%, to $74.8 million in the year ended December 31, 2020 from $71.8 million in the year ended December 31, 2019. The increase was primarily due to interest on our Senior Secured Notes issued in May 2020, partially offset by reduced borrowings and interest rates under our revolving credit facilities and a lower cost of borrowing on our Term Loan Facility.
Other Income – Other income increased $1.3 million, or 95.3%, to $2.8 million in the year ended December 31, 2020 from $1.4 million in the year ended December 31, 2019. The other income in the year ended December 31, 2020 primarily consisted of foreign currency losses of $11.9 million and pension expense of $1.6 million, offset by reimbursements from governmental pandemic assistance relating to COVID-19 of $7.4 million, a gain on sale or disposal of property and equipment of $4.1 million, and an insurance reimbursement of $1.4 million. Other income in the year ended December 31, 2019 was primarily due to foreign currency gains of $7.4 million, a gain on the sale or disposal of business units, property and equipment of $1.5 million, and legal settlement income of $1.2 million, partially offset by pension expense of $10.7 million.
Income Taxes – Income tax expense decreased $32.0 million, or 56.0%, to $25.1 million in the year ended December 31, 2020 from $57.1 million in the year ended December 31, 2019. The effective tax rate in the year ended December 31, 2020 was 21.5% compared to 47.5% in the year ended December 31, 2019. The decrease in income tax expense in 2020 was primarily due to a tax
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benefit recorded in 2020 as a result of the HTE election and related planning, which resulted in a decrease in the U.S. valuation allowance, partially offset by tax expense related to a reduction in U.S. foreign tax credit carryforwards and additional state tax expense related expenses. For more information, refer to Note 13 - Income Taxes to our consolidated financial statements included in this 10-K.
Segment Results
We report our segment information in the same way management internally organizes the business in assessing performance and making decisions regarding allocation of resources in accordance with ASC 280-10 - Segment Reporting . We have determined that we have three reportable segments, organized and managed principally by geographic region. Our reportable segments are North America, Europe, and Australasia. We report all other business activities in Corporate and unallocated costs. We define Adjusted EBITDA as net income (loss), adjusted for the following items: loss from discontinued operations, net of tax; equity earnings of non-consolidated entities; income tax (benefit) expense; depreciation and amortization; interest expense, net; impairment and restructuring charges; gain on previously held shares of equity investment; (gain) loss on sale of property and equipment; share-based compensation expense; non-cash foreign exchange transaction/translation (income) loss; other non-cash items; other items; and costs related to debt restructuring and debt refinancing. For additional information on segment Adjusted EBITDA, see Note 14 - Segment Information to our consolidated financial statements included in this 10-K.
Comparison of the Year Ended December 31, 2021 to the Year Ended December 31, 2020
Year Ended
(amounts in thousands) December 31, 2021 December 31, 2020
Net revenues from external customers % Variance
North America $ 2,829,240 $ 2,528,993 11.9 %
Europe 1,352,450 1,187,777 13.9 %
Australasia 590,029 518,907 13.7 %
Total Consolidated $ 4,771,719 $ 4,235,677 12.7 %
Percentage of total consolidated net revenues
North America 59.3 % 59.7 %
Europe 28.3 % 28.0 %
Australasia 12.4 % 12.3 %
Total Consolidated 100.0 % 100.0 %
Adjusted EBITDA (1)
North America $ 352,881 $ 315,952 11.7 %
Europe 127,292 136,363 (6.7) %
Australasia 71,448 62,449 14.4 %
Corporate and unallocated costs (86,542) (68,350) 26.6 %
Total Consolidated $ 465,079 $ 446,414 4.2 %
Adjusted EBITDA as a percentage of segment net revenues
North America 12.5 % 12.5 %
Europe 9.4 % 11.5 %
Australasia 12.1 % 12.0 %
Total Consolidated 9.7 % 10.5 %
(1) Adjusted EBITDA is a financial measure that is not calculated in accordance with GAAP. For a discussion of our presentation of Adjusted EBITDA, see Note 14 - Segment Information in our consolidated financial statements.
North America
Net revenues in North America increased $300.2 million, or 11.9%, to $2,829.2 million in the year ended December 31, 2021 from $2,529.0 million in the year ended December 31, 2020. The increase was primarily due to an increase in core revenues of 12%. Core revenues increased due to an 10% benefit from pricing and favorable volume/mix of 2%.
Adjusted EBITDA in North America increased $36.9 million, or 11.7%, to $352.9 million in the year ended December 31, 2021 from $316.0 million in the year ended December 31, 2020. The increase was due to favorable pricing, volume growth, and positive manufacturing variances, partially offset by the impact of inflation on material costs, freight, and labor compensation.
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Europe
Net revenues in Europe increased $164.7 million, or 13.9%, to $1,352.5 million in the year ended December 31, 2021 from $1,187.8 million in the year ended December 31, 2020. The increase was primarily due to an increase in core revenue of 9% and a positive impact from foreign exchange of 5%. Core revenues increased due a 5% benefit from pricing and favorable volume/mix of 4%.
Adjusted EBITDA in Europe decreased $9.1 million, or 6.7%, to $127.3 million in the year ended December 31, 2021 from $136.4 million in the year ended December 31, 2020. The decrease was primarily due to the impact of inflation on material costs, freight, and labor compensation in the current period, partially offset by favorable pricing and positive manufacturing variances.
Australasia
Net revenues in Australasia increased $71.1 million, or 13.7%, to $590.0 million in the year ended December 31, 2021 from $518.9 million in the year ended December 31, 2020. The increase was primarily due to a positive impact from foreign exchange of 9% and an increase in core revenues of 5%. Core revenues increased due to favorable volume/mix of 3% and a 2% benefit from pricing.
Adjusted EBITDA in Australasia increased $9.0 million, or 14.4%, to $71.4 million in the year ended December 31, 2021 from $62.4 million in the year ended December 31, 2020. The increase was primarily due to improved volume/mix and positive manufacturing variances, partially offset by the impact of inflation on material costs.
Corporate and unallocated costs
Corporate and unallocated costs increased in the year ended December 31, 2021 compared to the year ended December 31, 2020 primarily due to the non-recurrence of certain savings from cost reduction measures implemented in 2020 in response to COVID-19, primarily related to salary and benefits, and the impact of inflation as well as increased health benefit costs and software related expenditures, partially offset by reduced variable compensation expenses resulting in a decrease to Adjusted EBITDA of $18.2 million, or 26.6%.
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Comparison of the Year Ended December 31, 2020 to the Year Ended December 31, 2019
Year Ended
(dollars in thousands) December 31, 2020 December 31, 2019
Net revenues from external customers % Variance
North America $ 2,528,993 $ 2,534,336 (0.2) %
Europe 1,187,777 1,178,441 0.8 %
Australasia 518,907 576,984 (10.1) %
Total Consolidated $ 4,235,677 $ 4,289,761 (1.3) %
Percentage of total consolidated net revenues
North America 59.7 % 59.1 %
Europe 28.0 % 27.5 %
Australasia 12.3 % 13.4 %
Total Consolidated 100.0 % 100.0 %
Adjusted EBITDA (1)
North America $ 315,952 $ 267,335 18.2 %
Europe 136,363 116,193 17.4 %
Australasia 62,449 74,484 (16.2) %
Corporate and Unallocated costs (68,350) (42,974) 59.0 %
Total Consolidated $ 446,414 $ 415,038 7.6 %
Adjusted EBITDA as a percentage of segment net revenues
North America 12.5 % 10.5 %
Europe 11.5 % 9.9 %
Australasia 12.0 % 12.9 %
Total Consolidated 10.5 % 9.7 %
(1) Adjusted EBITDA is a financial measure that is not calculated in accordance with GAAP. For a discussion of our presentation of Adjusted EBITDA, see Note 14 - Segment Information in our consolidated financial statements.
North America
Net revenues in North America decreased $5.3 million, or 0.2%, to $2,529.0 million in the year ended December 31, 2020 from $2,534.3 million in the year ended December 31, 2019. The decrease was primarily due to a decline in core revenues of 1% offset by a 1% increase attributable to the contribution from the acquisition of VPI. Core revenues decreased due to unfavorable volume/mix of 6%, partially offset by a 5% benefit from pricing.
Adjusted EBITDA in North America increased $48.6 million, or 18.2%, to $316.0 million in the year ended December 31, 2020 from $267.3 million in the year ended December 31, 2019. The increase was due to favorable pricing, positive manufacturing variances, reduced marketing and travel expenses, and contributions from our VPI acquisition, partially offset by unfavorable revenue mix and the effect of inflation on labor compensation.
Europe
Net revenues in Europe increased $9.3 million, or 0.8%, to $1,187.8 million in the year ended December 31, 2020 from $1,178.4 million in the year ended December 31, 2019. The increase was primarily due to a favorable impact from foreign exchange of 2%, partially offset by a decline in core revenue of 1%. Core revenues decreased due to unfavorable volume/mix of 2%, partially offset by a 1% benefit from pricing.
Adjusted EBITDA in Europe increased $20.2 million, or 17.4%, to $136.4 million in the year ended December 31, 2020 from $116.2 million in the year ended December 31, 2019. The increase was primarily due to positive manufacturing variances and favorable pricing, partially offset by unfavorable revenue mix and the effect of inflation on labor compensation.
Australasia
Net revenues in Australasia decreased $58.1 million, or 10.1%, to $518.9 million in the year ended December 31, 2020 from $577.0 million in the year ended December 31, 2019. The decrease was primarily due to a reduction in core revenues of 9% and unfavorable impacts from foreign exchange of 1%. Core revenues decreased due to unfavorable volume/mix of 8% and reduced pricing of 1%.
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Adjusted EBITDA in Australasia decreased $12.0 million, or 16.2%, to $62.4 million in the year ended December 31, 2020 from $74.5 million in the year ended December 31, 2019. The decrease was primarily due to lower volumes from market headwinds and adverse pricing, partially offset by positive manufacturing variances and reductions in spending relating to sales, marketing, travel, and salaries as a result of cost saving measures implemented in response to COVID-19.
Corporate and unallocated costs
Corporate and unallocated costs increased in the year ended December 31, 2020 compared to the year ended December 31, 2019 primarily due to increased variable compensation and the impact of foreign exchange hedges, resulting in a decrease to Adjusted EBITDA of $25.4 million, or 59.0%.
Liquidity and Capital Resources
Overview
We have historically funded our operations through a combination of cash from operations, draws on our revolving credit facilities, and the issuance of non-revolving debt such as our Term Loan Facility, Senior Notes, and Senior Secured Notes. Working capital, which we define as accounts receivable plus inventory less accounts payable, fluctuates throughout the year and is affected by the seasonality of sales of our products, customer payment patterns, and the translation of the balance sheets of our foreign operations into the U.S. dollar. Typically, working capital increases at the end of the first quarter and beginning of the second quarter in conjunction with, and in preparation for, the peak season for home construction and remodeling in our North America and Europe segments, which represent the substantial majority of our revenues, and decreases starting in the fourth quarter as inventory levels and accounts receivable decline. Inventories fluctuate for raw materials with long delivery lead times, such as steel, as we work through prior shipments and take delivery of new orders.
As of December 31, 2021, we had total liquidity (a non-GAAP measure) of $837.8 million, consisting of $395.6 million in unrestricted cash, $425.8 million available for borrowing under the ABL Facility, and AUD 22.6 million ($16.4 million) available for borrowing under the Australia Senior Secured Credit Facility (See Note 11 – Long-Term Debt to our consolidated financial statements for additional details regarding amendments made to the ABL Facility in July 2021), compared to total liquidity of $1,121.5 million as of December 31, 2020. The decrease in total liquidity was primarily due to cash utilized for share repurchases, higher working capital investment, capital expenditures, and repayments of long-term debt and legal settlements, partially offset by the increase in earnings.
As of December 31, 2021, our cash balances, including $1.3 million of restricted cash, consisted of $46.3 million in the U.S. and $350.6 million in non-U.S. subsidiaries. Based on our current level of operations, the seasonality of our business and anticipated growth, we believe that cash provided by operations and other sources of liquidity, including cash, cash equivalents and availability under our revolving credit facilities, will provide adequate liquidity for ongoing operations, planned capital expenditures and other investments, and debt service requirements for at least the next twelve months.
We may, from time to time, refinance, reprice, extend, retire or otherwise modify our outstanding debt to lower our interest payments, reduce our debt, or otherwise improve our financial position. These actions may include repricing amendments, extensions, and/or opportunistic refinancing of debt. The amount of debt that may be refinanced, repriced, extended, retired, or otherwise modified, if any, will depend on market conditions, trading levels of our debt, our cash position, compliance with debt covenants, and other considerations.
Based on hypothetical variable rate debt that would have resulted from drawing each revolving credit facility up to the full commitment amount, a 1.0% decrease in interest rates would have reduced our interest expense by $1.2 million in the year ended December 31, 2021. A 1.0% increase in interest rates would have increased our interest expense by $7.5 million in the same period. The impact of a hypothetical decrease would have been partially mitigated by interest rate floors that apply to certain of our debt agreements.
Contractual Obligations
In addition to our discussion and analysis surrounding our liquidity and capital resources, we have significant contractual obligations and commitments as of December 31, 2021 relating to the following:
• Long-term debt and interest obligations – As of December 31, 2021 our outstanding debt balance was $1,720.9 million. See Note 11 - Long-Term Debt to our consolidated financial statements for additional details regarding the timing of expected future principal payments. Interest on long-term debt is calculated based on debt outstanding and interest rates in effect on December 31, 2021, taking into account scheduled maturities and amortization payments. As of December 31, 2021, we estimate interest payments of $70.3 million due in 2022 and $270.2 million due in 2023 and thereafter.
• Finance and operating lease obligations – As of December 31, 2021, our remaining contractual commitments for finance and operating leases was $250.2 million. See Note 7 - Leases to our consolidated financial statements for additional details regarding the timing of expected future payments
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• Purchase obligations – As of December 31, 2021, we have purchase obligations of $20.8 million due in 2022 and $27.6 million due in 2023 and thereafter. These purchase obligations are primarily relating to software hosting services and capital expenditures. Purchase obligations are defined as purchase agreements that are enforceable and legally binding and that specify all significant terms, including quantity, price, and the approximate timing of the transaction.
Borrowings and Refinancings
In December 2021, we amended our Australia Senior Secured Credit Facility resulting in reduced borrowing fees and reinstated maintenance financial covenant ratios to pre-pandemic thresholds.
In July 2021, we refinanced our existing Term Loan Facility and ABL Facility by issuing replacement loans that aggregated to $550.0 million in principal amount under the Term Loan Facility and added $100.0 million in potential additional revolving loan capacity to our ABL Facility.
In the fourth quarter of 2020, we began to include the eligible accounts receivable and inventory balances of certain recently acquired U.S. businesses in determining our borrowing base on our U.S. ABL Facility, which increased our availability.
In May 2020, we issued $250.0 million of Senior Secured Notes, the proceeds of which were used to repay the outstanding balance under our ABL Facility with the remainder to be used for general corporate purposes. In addition, we amended our Australia Senior Credit Facility to add AUD 30.0 million of additional revolving loan capacity. This supplemental facility matured on June 30, 2021 and was not renewed.
In December 2019, we amended our ABL facility to reflect current banking regulatory requirements, which did not have a financial impact.
In September 2019, we amended the Term Loan Facility to provide for an incremental aggregate principal amount of $125.0 million and used the proceeds to repay $115.0 million of outstanding borrowings under the ABL Facility.
In June 2019, we reallocated AUD 5.0 million from the term loan commitment to the interchangeable commitment of the Australia Senior Secured Credit Facility.
As of December 31, 2021, we were in compliance with the terms of all of our Credit Facilities and the indentures governing the Senior Notes and Senior Secured Notes.
Our results have been and will continue to be impacted by substantial changes in our net interest expense throughout the periods presented and into the future. See Note 11 - Long-Term Debt to our consolidated financial statements for additional details.
Cash Flows
The following table summarizes the changes to our cash flows for the periods presented:
Year Ended
(amounts in thousands) December 31, 2021 December 31, 2020 December 31, 2019
Cash provided by (used in):
Operating activities $ 175,666 $ 355,655 $ 302,709
Investing activities (92,361) (82,003) (184,948)
Financing activities (401,209) 207,909 (6,411)
Effect of changes in exchange rates on cash and cash equivalents
(21,800) 25,157 903
Net change in cash and cash equivalents $ (339,704) $ 506,718 $ 112,253
Cash Flow from Operations
Net cash provided by operating activities decreased $180.0 million to $175.7 million in the year ended December 31, 2021 from $355.7 million in the year ended December 31, 2020. The decrease in cash provided by operating activities was due primarily to increased inventory costs, increased accounts receivable, cash paid for legal settlements, and increased cash taxes, partially offset by increased earnings.
Net cash provided by operating activities increased $52.9 million to $355.7 million in the year ended December 31, 2020 from $302.7 million in the year ended December 31, 2019. The increase in cash provided by operating activities was due primarily to increases in accruals for the deferral of payroll taxes, including $20.9 million as a result of the CARES Act, which will be paid equally in 2022 and 2023, legal and environmental matters, and estimated variable compensation.
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Cash Flow from Investing Activities
Net cash used in investing activities increased $10.4 million to $92.4 million in the year ended December 31, 2021 from $82.0 million in the year ended December 31, 2020 primarily due to a decrease in cash received from the sale of property, plant and equipment.
Net cash used in investing activities decreased $102.9 million to $82.0 million in the year ended December 31, 2020 from $184.9 million in the year ended December 31, 2019 primarily due to a decrease in cash used for acquisitions and a reduction in capital expenditures.
Cash Flow from Financing Activities
Net cash used in financing activities was $401.2 million in the year ended December 31, 2021 and consisted primarily of repurchases of our Common Stock of $323.7 million and net debt repayments of $86.1 million.
Net cash provided by financing activities was $207.9 million in the year ended December 31, 2020 and consisted primarily of net borrowings of $210.9 million, partially offset by repurchases of our Common Stock of $5.0 million.
Net cash used in financing activities was $6.4 million in the year ended December 31, 2019 and was comprised primarily of repurchases of our Common Stock of $20.0 million, partially offset by increased borrowings of $13.1 million.
Holding Company Status
We are a holding company that conducts all of our operations through subsidiaries, and we rely on dividends or advances from our subsidiaries to fund the holding company. The majority of our operating income is derived from JWI, our main operating subsidiary. The ability of our subsidiaries to pay dividends to us is subject to applicable local law and may be limited due to the terms of other contractual arrangements, including our Credit Facilities, Senior Notes, and Senior Secured Notes.
The Australia Senior Secured Credit Facility also contains restrictions on dividends that limit the amount of cash that the obligors under these facilities can distribute to JWI. Obligors under the Australia Senior Secured Credit Facility may pay dividends only to the extent they do not exceed 80% of after tax net profits (with a one-year carryforward of unused amounts) and only while no default is continuing under such agreement. For further information regarding the Australia Senior Secured Credit Facility, see Note 11 - Long-Term Debt in our consolidated financial statements.
The amount of our consolidated net assets that were available to be distributed under our credit facilities as of December 31, 2021 was $777.0 million.
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Critical Accounting Policies and Estimates
The following disclosure is provided to supplement the description of our accounting policies contained in Note 1 - Description of Company and Summary of Significant Accounting Policies in our consolidated financial statements. Our MD&A is based upon our consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which may differ from these estimates. The following discussion highlights the estimates we believe are critical and should be read in conjunction with the consolidated financial statements included in Part II, Item 8 of this Form 10-K.
Acquisitions
We allocate the fair value of purchase consideration to the tangible assets acquired, liabilities assumed, and intangible assets acquired based on their acquisition date fair values. Goodwill as of the acquisition date is measured as the excess of consideration transferred over the net of the acquisition date fair values of the assets acquired and the liabilities assumed. If the fair value of the acquired assets exceeds the purchase price the difference is recorded as a bargain purchase in other (income) expense. Such valuations require us to make significant estimates and assumptions, especially with respect to intangible assets. As a result, during the measurement period, which may be up to one year from the acquisition date, material adjustments must be reflected in the comparative consolidated financial statements in the period in which the adjustment amount will be determined. Upon the conclusion of the measurement period or final determination of the values of assets acquired or liabilities assumed, whichever comes first, any subsequent adjustments are recorded to our consolidated statements of operations. Newly acquired entities are included in our results from the date of their respective acquisitions.
Recoverability of Long-Lived and Intangible Assets
Long-lived assets, other than goodwill, are reviewed for impairment whenever events or changes in circumstances indicate the carrying amount of such asset groups may not be recoverable. Such events or circumstances include, but are not limited to, a significant decrease in the fair value of the underlying business or a change in utilization of property and equipment.
We group assets to test for impairment at the lowest level for which identifiable cash flows are largely independent of the cash flows of other groups of assets and liabilities. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the assets.
When evaluating long-lived assets and definite lived intangible assets for potential impairment, if a triggering event is identified, we perform an impairment test by reviewing the expected undiscounted cash flows generated from the anticipated use and eventual disposition of the asset group compared to the carrying value of the asset group. If the expected undiscounted cash flows are less than the carrying value of the asset group, then an impairment charge is required to reduce the carrying value of the asset group to fair value. If we recognize an impairment loss, the carrying amount of the asset is adjusted to fair value based on the discounted estimated future net cash flows. For a depreciable long-lived assets, the new cost basis will be depreciated over the remaining useful life of that asset. For an amortizable intangible asset, the new cost basis will be amortized over the remaining useful life of the asset. Our impairment loss calculations require management to apply judgments in estimating future cash flows to determine asset fair values, including forecasting useful lives of the assets.
Goodwill
Goodwill is tested for impairment on an annual basis during the fourth quarter and between annual tests if indicators of potential impairment exist, using a fair-value-based approach. Current accounting guidance provides an entity the option to perform a qualitative assessment to determine whether it is more-likely-than-not that the fair value of a reporting unit is impaired. If we do not perform a qualitative assessment, or if we determine that it is more likely than not that the fair value of the reporting unit exceeds its carrying amount, we calculate the estimated fair value of the reporting unit.
We estimated the fair value of our reporting units using a discounted cash flow model (implied fair value measured on a non-recurring basis using level 3 inputs). Inherent in the development of the discounted cash flow projections are assumptions and estimates derived from a review of our expected revenue and terminal growth rates, EBITDA margins, and cost of capital. Changes in assumptions or estimates used in our goodwill impairment testing could materially affect the determination of the fair value of a reporting unit, and therefore, could eliminate the excess of fair value over carrying value of a reporting unit and, in some cases, could result in impairment. Such changes in assumptions could be caused by items such as a loss of one or more significant customers, decline in the demand for our products due to changing economic conditions, or failure to control cost increases above what can be recouped in sale price increases. These types of changes would negatively affect our profits, revenues, and growth over the long term
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and such a decline could significantly affect the fair value assessment of our reporting units and cause our goodwill to become impaired.
As of December 31, 2021, the fair value of our North America, Europe, and Australasia reporting units would have to decline by approximately 32%, 37%, and 12%, respectively, to be considered for potential impairment. Keeping all other assumptions consistent, an increase in the discount rate of 1% would result in the fair value of a reporting unit over its carrying value of 26%, 31%, and 4% for the North America, Europe, and Australasia reporting units, respectively.
A material change in the fair value or carrying value of our Australasia reporting unit would put the reporting unit at risk of goodwill impairment. For example, our ability to increase revenue and improve EBITDA margins are key assumptions in our projections of revenue, earnings and cash flows. If our actual experience in future years falls significantly below our current projections, the fair value of the reporting unit could be negatively impacted. Similarly, an increase in interest rates would lower our discounted cash flows and negatively impact the fair value of the reporting unit. We believe our projections and assumptions are reasonable, but it is possible they could change, impacting our fair value estimate, or the carrying value could change.
Income Taxes
Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities 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. The effect on the deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. We evaluate both the positive and negative evidence that is relevant in assessing whether we will realize the deferred tax assets. A valuation allowance is recorded when it is more likely than not that some of the deferred tax assets will not be realized. This projected realization is directly related to our future projections of the performance of our business and management’s planning initiatives at any point in time. As a result, valuation allowances are subject to change as proven business trends and planning initiatives develop.
The tax effects from an uncertain tax position can be recognized in the consolidated financial statements only if the position is more likely than not to be sustained, based on the technical merits of the position and the jurisdiction. We recognize the financial statement benefit of a tax position only after determining that the relevant tax authority would more likely than not sustain the position following an audit and the tax related to the position would be due to the entity and not the owners. For tax positions meeting the more likely than not threshold, the amount recognized in the consolidated financial statements is the largest benefit that has a greater than 50 percent likelihood of being realized, upon ultimate settlement with the relevant tax authority. We apply this accounting standard to all tax positions for which the statute of limitations remains open. Changes in recognition or measurement are reflected in the period in which the change in judgment occurs.
We file a consolidated federal income tax return in the U.S. and various states. For financial statement purposes, we calculate the provision for federal income taxes using the separate return method. Certain subsidiaries file separate tax returns in certain countries and states. Any U.S. federal, state and foreign income taxes refundable and payable are reported in other current assets and other current liabilities in the consolidated balance sheets as of December 31, 2021 and December 31, 2020. We record interest and penalties on amounts due to tax authorities as a component of income tax expense in the consolidated statements of operations. We have elected to account for the impact of GILTI in the period in which it is incurred.
Contingent Liabilities
Contingent liabilities require significant judgment in estimating potential losses for legal and environmental claims. Each quarter, we review significant new claims and litigation for the probability of an adverse outcome. Estimates are recorded as liabilities when it is probable that a liability has been incurred and the amount of the loss is reasonably estimable. Disclosure is required when there is a reasonable possibility that the ultimate loss will materially exceed the recorded provision. Contingent liabilities are often resolved over long time periods. Estimating probable losses requires analysis of multiple forecasts that often depend on judgments about potential actions by third parties such as regulators, and the estimated loss can change materially as individual claims develop.
Share-based Compensation Plan
We have share-based compensation plans that provide for compensation to employees through various grants of share-based instruments. We apply the fair value method of accounting using the Black-Scholes option-pricing model to determine the compensation expense for stock options. The compensation expense for RSUs awarded is based on the fair value of the RSU at the date of grant. Compensation expense is recorded in the consolidated statements of operations and is recognized over the requisite service period. The determination of obligations and compensation expense requires the use of several mathematical and judgmental factors, including stock price, expected volatility, the anticipated life of the option, estimated risk-free rate, and the number of shares
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or share options expected to vest. Any difference in the number of shares or share options that actually vest can affect future compensation expense. Other assumptions are not revised after the original estimate.
The Black-Scholes option-pricing model requires the use of weighted average assumptions for estimated expected volatility, estimated expected term of stock options, risk-free rate, estimated expected dividend yield, and the fair value of the underlying common stock at the date of grant. We estimate the expected term of all stock options based on previous history of exercises. The risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant for the expected term of the stock option. The expected dividend yield rate is 0% which is consistent with the expected dividends to be paid on common stock. For stock options granted, we prepare the valuations with the assistance of a third-party valuation firm, utilizing approaches and methodologies consistent with the AICPA Practice Aid.
For PSUs issued prior to 2021, the number of PSUs that vest is determined by a payout factor consisting of equally weighted performance measures of Adjusted EBITDA and free cash flow, each as reported over the applicable three year performance period and is adjusted based upon a market condition measured by our relative total shareholder return (“TSR”) over the applicable three year performance period as compared to the TSR of the Russell 3000 index. For PSUs issued in 2021, the number of PSUs that vest is determined by a payout factor consisting of equally weighted pre-set three year performance targets on return on invested capital (“ROIC”) and TSR. The fair value of the award is estimated using a Monte Carlo simulation approach in a risk-neutral framework to model future stock price movements based on historical volatility, risk free rates of return, and correlation matrix.
We estimate forfeitures based on our historical analysis of actual stock option forfeitures. Actual forfeitures are recorded when incurred and estimated forfeitures are reviewed and adjusted at least annually.
Employee Retirement and Pension Benefits
The obligations under our defined benefit pension plans are calculated using actuarial models and methods. The most critical assumption and estimate used in the actuarial calculations is the discount rate for determining the current value of benefit obligations. Other assumptions and estimates used in determining benefit obligations and plan expenses include expected return on plan assets, inflation rates, and demographic factors such as retirement age, mortality, and turnover. These assumptions and estimates are evaluated periodically and are updated accordingly to reflect our actual experience and expectations.
The discount rate used to determine the benefit obligations was computed through a projected benefit cash flow model. This approach determines the discount rate as the rate that equates the present value of the cash flows (determined using that single rate) to the present value of the cash flows where each cash flows' present value is determined using the spot rates from the Willis Towers Watson RATE: Link 10:90 Yield Curve.
The discount rate utilized to calculate the projected benefit obligation at the measurement date for our U.S. pension plan increased to 2.88% at December 31, 2021 from 2.55% at December 31, 2020. As the discount rate is reduced or increased, the pension and post retirement obligation would increase or decrease, respectively, and future pension and post-retirement expense would increase or decrease, respectively. Lowering the discount rate by 0.25% would increase the U.S. pension and post-retirement obligation at December 31, 2021 by approximately $14.9 million and would decrease estimated fiscal year 2022 pension income by approximately $1.7 million. Increasing the discount rate by 0.25% would decrease the U.S. pension and post-retirement obligation at December 31, 2021 by approximately $14.2 million and would increase estimated fiscal year 2022 pension income by approximately $0.7 million.
We determine the expected long-term rate of return on plan assets based on the plan assets’ historical long-term investment performance, current asset allocation, and estimates of future long-term returns by asset class. Holding all other assumptions constant, a 1% increase or decrease in the assumed rate of return on plan assets would decrease or increase, respectively, 2022 net periodic pension expense by approximately $4.1 million.
The actuarial assumptions we use in determining our pension benefits may differ materially from actual results because of changing market and economic conditions, higher or lower withdrawal rates, or longer or shorter life spans of participants. While we believe that the assumptions used are appropriate, differences in actual experience or changes in assumptions might materially affect our financial position or results of operations.
Capital Expenditures
We expect that the majority of our capital expenditures will be focused on supporting our cost reduction and efficiency improvement projects, certain growth initiatives, and to a lesser extent, on sustaining our current manufacturing operations. We are subject to health, safety, and environmental regulations that may require us to make capital expenditures to ensure our facilities are compliant with those various regulations .
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