KADANT INC 10-Q

Item 2 – Management's Discussion and Analysis of Financial Condition and Results of Operations When we use the terms "we," "us," "our," and the "Company," we mean Kadant Inc., a Delaware corporation, and its consolidated subsidiaries, taken as a whole, unless the context otherwise indicates. This Quarterly Report on Form 10-Q and the documents we incorporate by reference in this report include forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended (Exchange Act), and Section 27A of the Securities Act of 1933, as amended. These forward-looking statements are not statements of historical fact and may include statements regarding possible or assumed future results of operations. Forward-looking statements are subject to risks and uncertainties and are based on the beliefs and assumptions of our management, using information currently available to our management. When we use words such as "believes," "expects," "anticipates," "intends," "plans," "estimates," "seeks," "should," "likely," "will," "would," "may," "continue," "could," or similar expressions, we are making forward-looking statements. Forward-looking statements are not guarantees of performance. They involve risks, uncertainties, and assumptions. Our future results of operations may differ materially from those expressed in the forward-looking statements. Many of the important factors that will determine these results and values are beyond our ability to control or predict. You should not put undue reliance on any forward-looking statements. We undertake no obligation to publicly update any forward-looking statement, whether as a result of new information, future events, or otherwise. For a discussion of important factors that may cause our actual results to differ materially from those suggested by the forward-looking statements, you should read carefully Risk Factors included in Part II, Item 1A , of this report and Part I, Item 1A, of our Annual Report on Form 10-K for the fiscal year ended January 1, 2022 (the Annual Report) and as may be further amended and/or restated in subsequent filings with the SEC. Overview Company Background We are a global supplier of technologies and engineered systems that drive Sustainable Industrial Processing. Our products and services play an integral role in enhancing efficiency, optimizing energy utilization, and maximizing productivity in process industries while helping our customers advance their sustainability initiatives with products that reduce waste or generate more yield with fewer inputs, particularly fiber, energy, and water. Producing more while consuming less is a core aspect of Sustainable Industrial Processing and a major element of the strategic focus of our operating segments. Our financial results are reported in three reportable operating segments: Flow Control, Industrial Processing, and Material Handling. The Flow Control segment consists of our fluid-handling and doctoring, cleaning, & filtration product lines; the Industrial Processing segment consists of our wood processing and stock-preparation product lines; and the Material Handling segment consists of our conveying and vibratory, baling, and fiber-based product lines. A description of each segment is as follows: • Flow Control – Custom-engineered products, systems, and technologies that control the flow of fluids used in industrial and commercial applications to keep critical processes running efficiently in the packaging, tissue, food, metals, and other industrial sectors. Our primary products include rotary sealing devices, steam systems, expansion joints, doctor systems, roll and fabric cleaning devices, and filtration and fiber recovery systems. • Industrial Processing – Equipment, machinery, and technologies used to recycle paper and paperboard and process timber for use in the packaging, tissue, wood products, and alternative fuel industries, among others. Our primary products include stock-preparation systems and recycling equipment, chemical pulping equipment, debarkers, stranders, chippers, and logging machinery. In addition, we provide industrial automation and digitization solutions to process industries. • Material Handling – Products and engineered systems used to handle bulk and discrete materials for secondary processing or transport in the aggregates, mining, food, and waste management industries, among others. Our primary products include conveying and vibratory equipment and balers. In addition, we manufacture and sell biodegradable, absorbent granules used as carriers in agricultural applications and for oil and grease absorption. Industry and Business Overview We had consolidated bookings of $210.9 million in the third quarter of 2022, down from the robust bookings experienced in the first and second quarters of 2022 of $266.1 million and $265.9 million, respectively, and $244.7 million in the third quarter of 2021, as industrial demand has moderated. Demand for our capital equipment products was down 39% sequentially primarily from our Industrial Processing segment where demand has slowed following major capacity additions over the past several years. We continue to see strong demand for our parts and consumables, down slightly from record 22 Table of Contents KADANT INC. demand in the first half of 2022. We expect a lower level of bookings in the last quarter of 2022 compared to previous quarters as end-market demand slows in response to actions taken by the central banks in several countries to control inflation. We ended the third quarter of 2022 with consolidated backlog of $350.3 million. An overview of our business by segment is as follows: • Flow Control – Our Flow Control segment had its third highest bookings quarter, following record bookings in the first half of 2022, increasing 11% compared to the third quarter of 2021. This increase included an 8% decrease from the unfavorable effect of foreign currency translation. Orders for both parts and consumables products and capital equipment continue to be strong due in part to high energy prices as customers seek to optimize energy utilization. We expect bookings to moderate in the last quarter of 2022 compared with the record booking performance achieved during the first nine months of 2022 due to growing uncertainty in the macroeconomic environment. • Industrial Processing – Our Industrial Processing segment bookings decreased 34% compared to record bookings in the third quarter of 2021, and 29% sequentially after several quarters of growth, in part due to lower demand for capital equipment at our wood processing business. This decrease was largely due to a reversion to more typical demand after a period of high activity. In addition, capital bookings decreased at our stock-preparation business compared to strong bookings in the third quarter of 2021. We expect sequentially higher capital bookings in our Industrial Processing segment in the last quarter of 2022, but lower than the first and second quarters of 2022, as demand for capital equipment returns to more typical levels . Orders for parts and consumables products at our Industrial Processing segment increased sequentially and over the third quarter of 2021, however, we anticipate lower bookings in the last quarter of 2022 compared to the robust demand we experienced in prior quarters of 2022. • Material Handling – Our Material Handling segment bookings decreased 2% compared to the third quarter of 2021, including a 5% decrease from the unfavorable effect of foreign currency translation. We expect demand for our material handling products to continue to moderate in the last quarter of 2022 compared with the record levels experienced in the first half of the year. Many of our operations continue to be impacted by labor availability and supply chain constraints, the latter of which resulted in inflationary pressure on material costs, longer lead times, and increased freight costs. Our businesses are alleviating supply chain constraints through various measures, including advance purchases of raw materials to prevent potential manufacturing disruptions and mitigating increased material and freight costs through price adjustments, when possible. We believe that the fundamentals of our business will remain positive, particularly given our high backlog and ongoing strength in the markets we serve. Despite this optimism, we expect our operating environment to continue to be challenging as a result of the factors impacting our business discussed above and the uncertainties and risks surrounding the COVID-19 pandemic, including China's zero-COVID policy. For more information related to these challenges, and other factors impacting our business, including recent geopolitical tensions, please see Risk Factors included in Part II, Item 1A , of this report, and Part I, Item 1A, of our Annual Report and subsequent filings with the SEC. International Sales Slightly more than half of our sales are to customers outside the United States, mainly in Europe, Asia, and Canada. As a result, our financial performance can be materially affected by currency exchange rate fluctuations between the U.S. dollar and foreign currencies. In the first nine months of 2022, we experienced a significant unfavorable foreign currency translation effect on our results of operations compared to 2021 due to the strengthening of the U.S. dollar against foreign currencies in countries in which we operate, especially the euro. We expect this trend to continue throughout the remainder of the year. We currently do not use derivative instruments to hedge our exposure to exchange rate fluctuations created by the translation into the U.S. dollar of our foreign subsidiaries' results that are in functional currencies other than the U.S. dollar. To mitigate the impact of foreign currency transaction fluctuations, we generally seek to charge our customers in the same currency in which our operating costs are incurred. Additionally, we may enter into forward currency exchange contracts to hedge certain firm purchase and sale commitments denominated in currencies other than our subsidiaries' functional currencies. Global Trade The United States imposes tariffs on certain imports from China, which has and will continue to increase the cost of some of the equipment that we import. Although we have worked to mitigate the impact of tariffs through pricing and sourcing strategies, we cannot be sure these strategies will effectively mitigate the impact of these costs. For more information on risks associated with our global operations, including tariffs, please see Risk Factors, included in Part II, Item 1A , of this report, and Part I, Item 1A, of our Annual Report and subsequent filings with the SEC. 23 Table of Contents KADANT INC. Acquisitions We expect that a significant driver of our growth over the next several years will be the acquisition of businesses and technologies that complement or augment our existing products and services or may involve entry into a new process industry. We continue to pursue acquisition opportunities. In the third quarter of 2021, we acquired The Clouth Group of Companies (Clouth) for $92.9 million, net of cash acquired plus debt assumed. Clouth, which is included in our Flow Control segment, is a leading manufacturer of doctor blades and related equipment used in the production of paper, packaging, and tissue. We expect several synergies in connection with this acquisition, including deepening our presence in the growing ceramic blade market and expansion of product sales at our existing businesses by leveraging Clouth's complementary global geographic footprint. Clouth has three manufacturing facilities in Germany and one in Poland. In the third quarter of 2021, we also acquired East Chicago Machine Tool Corporation (Balemaster) for $53.5 million, net of cash acquired. Balemaster, which is included in our Material Handling segment, is a leading U.S. manufacturer of horizontal balers and related equipment used primarily for recycling packaging waste at corrugated box plants and large retail and distribution centers. We expect several synergies in connection with this acquisition, including expanding our presence in the secondary material processing sector and creating new opportunities for leveraging our high-performance balers produced in Europe. In the fourth quarter of 2021, we acquired the assets of a business in India for $2.9 million, which is included in our Industrial Processing segment. Results of Operations Third Quarter 2022 Compared With Third Quarter 2021 Revenue The following table presents the change in revenue by segment between the third quarters of 2022 and 2021, and those changes excluding the effect of foreign currency translation and acquisitions which we refer to as change in organic revenue. Organic revenue excludes the effect of acquisitions for the four quarterly reporting periods following the date of the acquisition. The presentation of the change in organic revenue is a non-GAAP measure. We believe this non-GAAP measure helps investors gain an understanding of our underlying operations consistent with how management measures and forecasts its performance, especially when comparing such results to prior periods. This non-GAAP measure should not be considered superior to or a substitute for the corresponding U.S. generally accepted accounting principles (GAAP) measure. Revenue by segment in the third quarters of 2022 and 2021 was as follows: (Non-GAAP) Three Months Ended Currency Translation Acquisition Change in Organic Revenue (In thousands, except percentages) October 1, 2022 October 2, 2021 Total Increase % Change Increase % Change Flow Control $ 86,880 $ 76,253 $ 10,627 14 % $ (6,286) $ — $ 16,913 22 % Industrial Processing 86,085 81,620 4,465 5 % (4,868) 154 9,179 11 % Material Handling 51,545 41,916 9,629 23 % (2,864) — 12,493 30 % Consolidated Revenue $ 224,510 $ 199,789 $ 24,721 12 % $ (14,018) $ 154 $ 38,585 19 % Consolidated revenue increased 12% in the third quarter of 2022, including a 7% decrease from the unfavorable effect of foreign currency translation. Organic revenue increased 19% due to higher demand for capital equipment across all segments and parts and consumables products, principally at our Flow Control and Material Handling segments as described below. Revenue at our Flow Control segment increased 14% in the third quarter of 2022, while organic revenue increased 22%. The increase in organic revenue was due to higher demand for both parts and consumables products and capital equipment resulting in part from high energy prices as customers seek to optimize energy utiliz ation. Parts and consumables revenue was particularly strong in Europe and North America due to improved market conditions and pri ce increases. Increased demand for capital equipment was driven primarily by our Chinese operations due to several large projects. Revenue at our Industrial Processing segment increased 5% in the third quarter of 2022, while organic revenue increased 11%. Organic revenue increased principally due to higher demand for capital equipment at our wood processing businesses in North America and parts and consumables products throughout our Industrial Processing segment. These 24 Table of Contents KADANT INC. increases were partially offset by a decrease in demand for capital equipment at our stock-preparation businesses as mills focus on installing and optimizing capital equipment purchased in prior periods. Revenue at our Material Handling segment increased 23% in the third quarter of 2022, while organic revenue increased 30%, due to higher demand for both capital equipment and parts and consumables products. Increased demand at our conveying and vibratory equipment business was driven by several large capital equipment orders in North America, as well as price increases to offset higher input costs. At our baling business, increased demand for our cap ital equipment in both North America and Europe was offset in part by a decrease in parts and consumables revenue in Europe partially due to shipment delays. Gross Profit Margin Gross profit margin by segment in the third quarters of 2022 and 2021 was as follows: Three Months Ended Basis Point Change October 1, 2022 October 2, 2021 Flow Control 51.6% 49.7% 190 bps Industrial Processing 39.3% 39.7% (40) bps Material Handling 32.3% 31.9% 40 bps Consolidated Gross Profit Margin 42.5% 41.9% 60 bps Consolidated gross profit margin increased to 42.5% in the third quarter of 2022 compared with 41.9% in the third quarter of 2021, which included $2.2 million of amortization of acquired profit in inventory that lowered gross profit margin in the 2021 period by 1.1 percentage points. Within our operating segments, gross profit margin: • Increased to 51.6% at our Flow Control segment from 49.7% in the 2021 period, which included $1.8 million of amortization of acquired profit in inventory that lowered gross profit margin in the 2021 period by 2.4 percentage points. • Decreased to 39.3% from 39.7% at our Industrial Processing se gment due to the impact of lower-margin capital equipment revenue at our wood processing businesses. • Increased to 32.3% at our Material Handling segment from 31.9% in the 2021 period, which included $0.4 million of amortization of acquired profit in inventory that lowered gross profit margin in the 2021 period by 0.9 percentage points. Selling, General, and Administrative Expenses Selling, general, and administrative (SG&A) expenses by segment in the third quarters of 2022 and 2021 were as follows: Three Months Ended (In thousands, except percentages) October 1, 2022 % of Revenue October 2, 2021 % of Revenue Increase (Decrease) % Change Flow Control $ 20,717 24 % $ 19,658 26 % $ 1,059 5 % Industrial Processing 14,660 17 % 15,229 19 % (569) (4) % Material Handling 9,321 18 % 9,465 23 % (144) (2) % Corporate 8,455 N/A 7,964 N/A 491 6 % Consolidated SG&A Expenses $ 53,153 24 % $ 52,316 26 % $ 837 2 % Consolidated SG&A expenses as a percentage of revenue decreased to 24% in the third quarter of 2022 compared with 26% in the third quarter of 2021 principally due to a 12% increase in revenue. Consolidated SG&A expenses increased $0.8 million due to increased compensation expense associated with existing and new personnel and increased selling-related costs. These increases were largely offset by a $3.4 million favorable effect of foreign currency translation and a decrease of $0.9 million in incremental acquisition-related costs. 25 Table of Contents KADANT INC. Within our operating segments, SG&A expenses: • Increased $1.1 million at our Flow Control segment principally due to increased compensation expense associated with existing and new personnel and increased travel costs. These increases were partially offset by a $1.9 million favorable effect of foreign currency translation and a decrease of $0.5 million in acquisition-related costs. • Decreased $0.6 million at our Industrial Processing segment principally due to a $0.9 million favorable effect of foreign currency translation . This decrease was offset in part by in creased compensation expense and selling-related costs. • Decreased $0.1 million at our Material Handling segment principally due a $0.5 million favorable effect of foreign currency translation and a $0.4 million decrease in acquisition-related costs. These decreases were largely offset by increased compensation expense. • Increased $0.5 million at Corporate primarily due to increased incentive compensation and travel costs. Gain on Sale and Other Costs, Net During the third quarter of 2022, we recorded restructuring costs within our Flow Control segment of $0.1 million, which consisted of severance costs related to the termination of two employees. This restructuring plan was initiated in the fourth quarter of 2021 to eliminate a redundant ceramic blade manufacturing operation that resulted from our acquisition of Clouth. Interest Expense Interest expense increased to $1.7 million in the third quarter of 2022 from $1.3 million in the third quarter of 2021 due to a higher weighted-average interest rate, partially offset by lower average debt outstanding in the third quarter of 2022 compared to the third quarter of 2021. Provision for Income Taxes Provision for income taxes increased to $9.7 million in the third quarter of 2022 from $6.7 million in the third quarter of 2021. The effective tax rate of 26% in the third quarter of 2022 was higher than our statutory rate of 21% primarily due to the distribution of our worldwide earnings, nondeductible expenses, and state taxes. The effective tax rate of 25% in the third quarter of 2021 was higher than our statutory rate of 21% primarily due to nondeductible expenses, the distribution of our worldwide earnings, state taxes, and tax expense associated with Global Intangible Low-Taxed Income (GILTI) provisions. These increases in tax expense in the third quarter of 2021 were offset in part by a decrease in tax expense related to the net excess income tax benefits from stock-based compensation arrangements. Net Income Net income increased to $27.7 million in the third quarter of 2022 from $20.7 million in the third quarter of 2021 primarily due to a $10.2 million increase in operating income, offset in part by a $3.0 million increase in provision for income taxes (see discussions above for further details). First Nine Months 2022 Compared With First Nine Months 2021 Revenue The following table presents changes in revenue and organic revenue by segment between the first nine months of 2022 and 2021. Organic revenue is a non-GAAP measure as defined above in the results of operations for the third quarter of 2022 compared with the third quarter of 2021. 26 Table of Contents KADANT INC. Revenue by segment in the first nine months of 2022 and 2021 was as follows: (Non-GAAP) Nine Months Ended Currency Translation Acquisitions Change in Organic Revenue (In thousands, except percentages) October 1, 2022 October 2, 2021 Total Increase % Change Increase % Change Flow Control $ 257,926 $ 210,769 $ 47,157 22 % $ (10,663) $ 24,222 $ 33,598 16 % Industrial Processing 263,572 233,455 30,117 13 % (9,940) 473 39,584 17 % Material Handling 151,141 123,839 27,302 22 % (6,358) 15,371 18,289 15 % Consolidated Revenue $ 672,639 $ 568,063 $ 104,576 18 % $ (26,961) $ 40,066 $ 91,471 16 % Consolidated revenue in the first nine months of 2022 increased 18%, including a 7% increase from acquisitions and a 5% decrease from the unfavorable effect of foreign currency translation. Organic revenue increased 16%, principally driven by higher demand for capital equipment led by our Industrial Processing segment and parts and consumables at our Flow Control segment and, to a lesser extent, Industrial Processing segment, as described below. Revenue at our Flow Control segment increased 22% in the first nine months of 2022, while organic revenue increased 16%. Organic revenue increased due to higher demand for our parts and consumables products in North America and Europe due to improved market conditions, especially compared to the first half of 2021. Also contributing to the organic revenue increase was higher demand for capital equipment in China and Europe primarily for our doctoring, cleaning, and filtration systems. Re venue at our Industrial Processing segment increased 13% in the first nine months of 2022, while organic revenue increased 17%, due to higher demand for capital equipment, principally in Europe and North America and, to a lesser extent, a higher demand for parts and consumables, primarily in North America. Increased demand for our wood processing business products, for both capital and parts and consumables products, principally in North America, was driven by high mill activity, which resulted in increased capital investment and higher parts consumption. In addition, increased demand for capital equipment at our stock-preparation businesses, primarily at our European and Chinese operations, due to improved market conditions compared to early 2021. Revenue at our Material Handling segment increased 22% in the first nine months of 2022, while organic revenue increased 15%, due to higher demand for capital equipment at our European baling operations driven by improved business conditions, and parts and consumables at our vibratory and conveying business in North America resulting from strong demand in the aggregate and food and packaging industries. Gross Profit Margin Gross profit margin by segment in the first nine months of 2022 and 2021 was as follows: Nine Months Ended Basis Point Change October 1, 2022 October 2, 2021 Flow Control 52.3% 51.8% 50 bps Industrial Processing 38.8% 40.1% (130) bps Material Handling 34.8% 33.8% 100 bps Consolidated Gross Profit Margin 43.1% 43.1% 0 bps Consolidated gross profit margin remained flat at 43.1% in the first nine months of 2022 compared with the first nine months of 2021. The consolidated gross profit margin in 2021 was impacted by $2.2 million of amortization of acquired profit in inventory, which lowered gross profit margin in the 2021 period by 0.4 percentage points, partially offset by the benefits received from government employee retention assistance programs of $0.9 million in the 2021 period, which increased gross profit margin by 0.2 percentage points. Within our operating segments, gross profit margin: • Increased to 52.3% at our Flow Control segment from 51.8% in the 2021 period, which included $1.8 million of amortization of acquired profit in inventory that lowered gross profit margin in the 2021 period by 0.9 percentage points. • Decreased to 38.8% from 40.1% at our Industrial Processing segment due to the impact of lower-margin capital equipment revenue at our wood processing businesses and at our Chinese stock-preparation business in the 2022 27 Table of Contents KADANT INC. period, and the inclusion of $0.7 million for benefits received from government employee retention assistance programs, which increased gross profit margin in the 2021 period by 0.3 percentage points. • Increased to 34.8% from 33.8% at our Material Handling segment primarily due to a higher gross profit margin profile from our Balemaster business acquired in 2021 and the inclusion of $0.4 million of amortization of acquired profit in inventory, which lowered gross profit margin in the 2021 period by 0.3 percentage points. Selling, General, and Administrative Expenses SG&A expenses by segment in the first nine months of 2022 and 2021 were as follows: Nine Months Ended (In thousands, except percentages) October 1, 2022 % of Revenue October 2, 2021 % of Revenue Increase % Change Flow Control $ 63,770 25 % $ 54,226 26 % $ 9,544 18 % Industrial Processing 46,643 18 % 45,339 19 % 1,304 3 % Material Handling 29,823 20 % 27,518 22 % 2,305 8 % Corporate 27,404 N/A 23,931 N/A 3,473 15 % Consolidated SG&A Expenses $ 167,640 25 % $ 151,014 27 % $ 16,626 11 % Consolidated SG&A expenses as a percentage of revenue decreased to 25% in the first nine months of 2022 compared with 27% in the first nine months of 2021 principally due to an 18% increase in revenue. Consolidated SG&A expenses increased $16.6 million due to the inclusion of $11.3 million of SG&A expenses from acquisitions, increased compensation expense associated with existing and new personnel, increased selling-related costs associated with improved business conditions, and the inclusion of benefits received from government employee retention assistance programs of $1.4 million in the first nine months of 2021. These increases were offset in part by a $6.5 million favorable effect of foreign currency translation and a decrease of $2.1 million in incremental acquisition-related costs. Within our operating segments, SG&A expenses: • Increased $9.5 million at our Flow Control segment principally due to the inclusion of $7.8 million of SG&A expenses from Clouth, increased compensation and travel costs, and the inclusion of benefits received from government employee retention assistance programs of $0.8 million in the first nine months of 2021. These increases were partially offset by a $3.2 million favorable effect of foreign currency translation and a decrease of $1.6 million in incremental acquisition-related costs. • Increased $1.3 million at our Industrial Processing segment due to increased compensation and selling-related costs, a $0.6 million reversal of an indemnification asset related to the release of tax reserves, and the inclusion of benefits received from government employee retention assistance programs of $0.5 million in the first nine months of 2021. These increases were partially offset by a $2.2 million favorable effect of foreign currency translation and a decrease of $0.2 million in incremental acquisition-related costs. • Increased $2.3 million at our Material Handling segment principally due to the inclusion of $3.1 million of SG&A expenses from Balemaster, increased travel costs, and the inclusion of benefits received from government employee retention assistance programs of $0.2 million in the first nine months of 2021. These increases were partially offset by a $1.2 million favorable effect of foreign currency translation and a decrease of $0.3 million in incremental acquisition-related costs. • Increased $3.5 million at Corporate primarily due to increased compensation expense for existing and new personnel. Gain on Sale and Other Costs, Net Gain on Sale of Assets We entered into several agreements with the local government in China to sell the existing manufacturing building and land use rights at one of our subsidiaries in China for $25.2 million. The agreements became effective in the first quarter of 2022 after a 31% down payment was received, including 25% in 2021 and 6% in the first quarter of 2022, and a land use right in a new location was secured. As a result, we recognized a gain on the sale of these assets of $20.2 million, or $15.1 million, net of deferred taxes of $5.1 million, in the first quarter of 2022. A receivable of $16.1 million was recognized for the present value of the remaining amount of the sale proceeds, which is due the earlier of when the government sells the property or within two years from the effective date of the agreements. The receivable outstanding at October 1, 2022 was $14.6 million. Our 28 Table of Contents KADANT INC. subsidiary, which is part of our Industrial Processing segment, will continue to occupy its current facility until construction of its new facility is complete. Other Costs During the first quarter of 2022, we recognized an impairment charge of $0.2 million related to the write-down of certain fixed assets that will not be moved to the new manufacturing facility in China, as discussed above. During the third quarter of 2022, we recorded restructuring costs within our Flow Control segment of $0.1 million which consisted of severance costs related to the termination of two employees. This restructuring plan was initiated in the fourth quarter of 2021 to eliminate a redundant ceramic blade manufacturing operation that resulted from our acquisition of Clouth. Interest Expense Interest expense increased to $4.3 million in the first nine months of 2022 from $3.5 million in the first nine months of 2021 due to a higher weighted-average interest rate, partially offset by lower average debt outstanding in the first nine months of 2022 compared to the first nine months of 2021. Provision for Income Taxes Provision for income taxes increased to $33.1 million in the first nine months of 2022 from $21.3 million in the first nine months of 2021. The effective tax rate of 26% in the first nine months of 2022 was higher than our statutory rate of 21% primarily due to the distribution of our worldwide earnings, nondeductible expenses, and state taxes. The effective tax rate of 26% in the first nine months of 2021 was higher than our statutory rate of 21% primarily due to the distribution of our worldwide earnings, nondeductible expenses, state taxes, and tax expense associated with GILTI. These increases in tax expense in the first nine months of 2021 were offset in part by a decrease in tax expense related to the net excess income tax benefits from stock-based compensation arrangements. Net Income Net income increased to $95.5 million in the first nine months of 2022 from $60.5 million in the first nine months of 2021 primarily due to a $47.2 million increase in operating income, offset in part by a $11.8 million increase in provision for income taxes (see discussions above for further details). Non-GAAP Key Performance Indicators In addition to the financial measures prepared in accordance with GAAP, we use certain non-GAAP financial measures, including organic revenue (defined as revenue excluding the effect of foreign currency translation and acquisitions), adjusted operating income, earnings before interest, taxes, depreciation, and amortization (EBITDA), adjusted EBITDA, adjusted EBITDA margin (defined as adjusted EBITDA divided by revenue), and free cash flow (defined as cash flow provided by operations less capital expenditures). We use organic revenue in order to understand our trends and to forecast and evaluate our financial performance and compare revenue to prior periods (see discussion in Revenue above). Adjusted operating income, adjusted EBITDA, and adjusted EBITDA margin exclude impairment and restructuring costs, acquisition costs, amortization expense related to acquired profit in inventory and backlog, and certain gains or losses. These items are excluded as they are not indicative of our core operating results and are not comparable to other periods, which have differing levels of incremental costs, expenditures or income, or none at all. Additionally, we use free cash flow in order to provide insight on our ability to generate cash for acquisitions and debt repayments, as well as for other investing and financing activities. We believe these non-GAAP financial measures, when taken together with the corresponding GAAP financial measures, provide meaningful supplemental information regarding our performance by excluding certain items that may not be indicative of our core business, operating results, or future outlook. We believe that the inclusion of such measures helps investors gain an understanding of our underlying operating performance and future prospects, consistent with how management measures and forecasts our performance, especially when comparing such results to previous periods or forecasts and to the performance of our competitors. Such measures are also used by us in our financial and operating decision-making and for compensation purposes. We also believe this information is responsive to investors' requests and gives them an additional measure of our performance. 29 Table of Contents KADANT INC. Our non-GAAP financial measures are not meant to be considered superior to or a substitute for the results of operations or cash flow prepared in accordance with GAAP. In addition, our non-GAAP financial measures have limitations associated with their use as compared to the most directly comparable GAAP measures, in that they may be different from, and therefore not comparable to, similar measures used by other companies. A reconciliation of adjusted operating income, adjusted EBITDA, and adjusted EBITDA margin is as follows: Three Months Ended Nine Months Ended (In thousands, except percentages) October 1, 2022 October 2, 2021 October 1, 2022 October 2, 2021 Net Income Attributable to Kadant $ 27,487 $ 20,461 $ 94,849 $ 59,886 Net Income Attributable to Noncontrolling Interest 184 237 672 635 Provision for Income Taxes 9,746 6,742 33,075 21,252 Interest Expense, Net 1,450 1,265 3,671 3,321 Other Expense, Net 19 23 60 71 Operating Income 38,886 28,728 132,327 85,165 Gain on Sale (a) — — (20,190) — Acquisition Costs 410 718 486 2,619 Indemnification Asset Reversal (b) — — 575 — Impairment and Restructuring Costs 72 — 254 — Acquired Backlog Amortization (c) — 604 703 691 Acquired Profit in Inventory Amortization (d) — 2,216 (218) 2,216 Adjusted Operating Income (non-GAAP measure) 39,368 32,266 113,937 90,691 Depreciation and Amortization 8,456 8,591 25,684 23,906 Adjusted EBITDA (non-GAAP measure) $ 47,824 $ 40,857 $ 139,621 $ 114,597 Adjusted EBITDA Margin (non-GAAP measure) 21.3% 20.5% 20.8% 20.2% A reconciliation of free cash flow from cash flow provided by operating activities is as follows: Three Months Ended Nine Months Ended (In thousands) October 1, 2022 October 2, 2021 October 1, 2022 October 2, 2021 Cash Provided by Operating Activities $ 24,897 $ 37,932 $ 67,462 $ 101,410 Less: Capital Expenditures (e) (6,376) (3,370) (16,191) (7,688) Free Cash Flow (non-GAAP measure) $ 18,521 $ 34,562 $ 51,271 $ 93,722 (a) Consists of a $20.2 million gain on the sale of a Chinese facility in our Industrial Processing segment pursuant to a relocation plan (as discussed above). (b) Represents an indemnification asset reversal related to the release of tax reserves associated with uncertain tax positions. (c) Represents intangible amortization expense associated with acquired backlog. (d) Represents expense (income) within the cost of revenue associated with amortization of acquired profit in inventory. (e) Includes capital expenditures of $2.2 million and $5.4 million in the three and nine months ended October 1, 2022, respectively, associated with the construction of a new manufacturing facility in China (as discussed below). Liquidity and Capital Resources Consolidated working capital was $188.0 million at October 1, 2022, compared with $162.4 million at January 1, 2022. Cash and cash equivalents were $72.9 million at October 1, 2022, compared with $91.2 million at January 1, 2022, which included cash and cash equivalents held by our foreign subsidiaries o f $70.7 million at October 1, 2022 and $83.8 million at January 1, 2022. 30 Table of Contents KADANT INC. Cash Flows Cash flow information in the first nine months of 2022 and 2021 was as follows: Nine Months Ended (In thousands) October 1, 2022 October 2, 2021 Net Cash Provided by Operating Activities $ 67,462 $ 101,410 Net Cash Used in Investing Activities (13,923) (148,587) Net Cash (Used in) Provided by Financing Activities (62,112) 66,714 Exchange Rate Effect on Cash, Cash Equivalents, and Restricted Cash (10,474) (2,513) (Decrease) Increase in Cash, Cash Equivalents, and Restricted Cash $ (19,047) $ 17,024 Operating Activities Cash provided by operating activities decreased to $67.5 million in the first nine months of 2022 from $101.4 million in the first nine months of 2021 due to the timing of investments in working capital. Our operating cash flows are primarily generated from cash received from customers, offset by cash payments for items such as inventory, employee compensation, operating leases, income taxes and interest payments on outstanding debt obligations. Cash provided by net income in the first nine months of 2022 was offset in part by investments in working capital. Increases in inventory and accounts receivable used cash of $54.5 million, including $33.8 million for inventory primarily related to capital equipment orders that will ship in the fourth quarter of 2022 and first half of 2023. These uses of cash were offset in part by $16.2 million of cash provided by customer deposits. Cash provided by operating activities in the first nine months of 2021 was due to cash provided by net income and working capital. Cash provided by working capital in 2021 included $19.8 million from accounts payable related to inventory purchases for increased order activity and $19.6 million in customer deposits for capital equipment orders. These sources of cash were offset in part by cash used of $32.9 million for accounts receivable and inventory as a result of revenue growth and to support increased demand. Investing Activities Cash used in investing activities was $13.9 million in the first nine months of 2022, compared with $148.6 million in the first nine months of 2021. Cash used in investing activities in the first nine months of 2022 included capital expenditures of $16.2 million, which included $5.4 million for expenditures associated with the construction of a new manufacturing facility in China. This use of cash was partially offset by proceeds received from the sale of assets of $2.1 million. Cash used in investing activities in the first nine months of 2021 included $141.5 million for acquisitions and $7.7 million for capital expenditures. Financing Activities Cash used in financing activities was $62.1 million in the first nine months of 2022, compared with cash provided by financing activities of $66.7 million in the first nine months of 2021. Repayment of short- and long-term obligations was $69.5 million in the first nine months of 2022, partially offset by borrowings under our revolving credit facility of $21.6 million compared to borrowings under our revolving credit facility of $151.9 million in the first nine months of 2021, partially offset by repayment of short- and long-term obligations of $72.7 million. Cash dividends paid to stockholders were $9.0 million in the first nine months of 2022 and $8.6 million in the first nine months of 2021. In addition, taxes paid related to the vesting of equity awards was $4.6 million in the first nine months of 2022 compared to $3.4 million in the first nine months of 2021. Exchange Rate Effect on Cash, Cash Equivalents, and Restricted Cash The exchange rate effect on cash, cash equivalents, and restricted cash represents the impact of translation of cash balances at our foreign subsidiaries. The $10.5 million reduction in cash, cash equivalents, and restricted cash in the first nine months of 2022 was primarily attributable to the strengthening of the U.S. dollar against the euro and Chinese renminbi and, to a lesser extent, the British pound sterling. Borrowing Capacity and Debt Obligations We entered into an unsecured multi-currency revolving credit facility, dated as of March 1, 2017 (as amended and restated to date, the Credit Agreement). As of October 1, 2022, the outstanding balance under the Credit Agreement was $195.0 million, which included $71.0 million of euro-denominated borrowings. As of October 1, 2022, we have a borrowing capacity 31 Table of Contents KADANT INC. available under the Credit Agreement of $206.3 million in addition to a $150.0 million uncommitted, unsecured incremental borrowing facility. Under our debt agreements, our leverage ratio must be less than 3.75, or, if we elect, for the quarter during which a material acquisition occurs and for the three fiscal quarters thereafter, must be less than 4.00. As of October 1, 2022, our leverage ratio was 0.94 and we were in compliance with our debt covenants. We expect to renew our Credit Agreement prior to its maturity date of December 14, 2023. See Note 5 , Short- and Long-Term Obligations, in the accompanying condensed consolidated financial statements for additional information regarding our debt obligations. Additional Liquidity and Capital Resources On May 19, 2022, our board of directors approved the repurchase of up to $50 million of our equity securities during the period from May 19, 2022 to May 19, 2023. We have not repurchased any shares of our common stock under this authorization or under our previous $20 million authorization, which expired on May 20, 2022. We paid cash dividends of $9.0 million in the first nine months of 2022. On September 8, 2022, we declared a quarterly cash dividend of $0.26 per share totaling $3.0 million that will be paid on November 10, 2022. Future declarations of dividends are subject to our board of directors' approval and may be adjusted as business needs or market conditions change. The declaration of cash dividends is subject to our compliance with the covenant in our Credit Agreement related to our consolidated leverage ratio. We plan to make expenditures of approximately $11 to $13 million during the remainder of 2022 for property, plant, and equipment, including $6 million for a new manufacturing facility. One of our Chinese subsidiaries is building a new manufacturing facility and relocating over the next two years. Capital expenditures for the new facility are estimated to be approximately $20 million, including $11 million in 2022. The cost of the new facility will be offset by the proceeds received from the sale of our existing facility. See Note 2 , Gain on Sale and Other Costs, Net, in the accompanying condensed consolidated financial statements for additional information regarding the relocation of our Chinese manufacturing facility. As of October 1, 2022, we had approximately $219.8 million of total unremitted foreign earnings. It is our intent to indefinitely reinvest $198.2 million of these earnings to support the current and future capital needs of our foreign operations, including debt repayments, if any. In the first nine months of 2022, we recorded withholding taxes on the earnings in certain foreign subsidiaries that we plan to repatriate in the foreseeable future. The foreign withholding taxes that would be required if we were to remit the indefinitely-reinvested foreign earnings to the United States would be approximately $3.5 million . In the future, our liquidity position will be affected by cash flows from operations, cash paid to service our debt obligations, acquisitions, capital projects, dividends, and stock repurchases. We believe that existing cash and cash equivalents, along with cash generated from operations, our existing borrowing capacity and continued access to debt markets, will be sufficient to meet the capital requirements of our operations for the next 12 months and foreseeable future. Contractual Obligations and Other Commercial Commitments There have been no material changes to our contractual obligations and other commercial commitments during the first nine months of 2022 compared with those disclosed in Management's Discussion and Analysis of Financial Condition and Results of Operations, set forth in Part II, Item 7, of our Annual Report. Application of Critical Accounting Policies and Estimates Management's discussion and analysis of financial condition and results of operations is based upon our condensed consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent liabilities, and the reported amounts of revenue and expenses during the reporting period. Our critical accounting policies are defined as those that entail significant judgments and uncertainties, and could potentially result in materially different results under different assumptions and conditions. Management evaluates its estimates on an ongoing basis based on historical experience, current economic and market conditions, and other assumptions management believes are reasonable. We believe that our most critical accounting policies which are significant to our consolidated financial statements, and which involve the most complex or subjective decisions or assessments, are those described in "Management's Discussion and Analysis of Financial Condition and Results of Operations" under the section captioned "Application of Critical Accounting Estimates" in Part II, Item 7, of our Annual Report. There have been no material changes to these critical accounting policies since the end of fiscal 2021 that warrant disclosure. Recent Accounting Pronouncements See Note 1 , under the headings Recent Accounting Pronouncements Not Yet Adopted , in the accompanying condensed consolidated financial statements for details. 32 Table of Contents KADANT INC. Item 3 – Quantitative and Qualitative Disclosures About Market Risk Our exposure to market risk from changes in interest rates and foreign currency exchange rates has not changed materially from our exposure as disclosed in Part II, Item 7A, of our Annual Report.