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 I, Item 1A, of our Annual Report on Form 10-K for the fiscal year ended December 31, 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 business. 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 Our consolidated bookings were $215.2 million in the second quarter of 2023, decreasing 22% sequentially from record bookings in the first quarter of 2023, which included several large orders in our Material Handling and Flow Control segments. Our bookings returned to a more typical level in the second quarter following a general slowdown in industrial activity, and we expect bookings for the remainder of the year to be consistent with the second quarter of 2023. We ended the second quarter with a strong backlog of $362.8 million, more than half of which was attributable to our Industrial Processing segment. An overview of our business by segment is as follows: 21 Table of Contents KADANT INC. • Flow Control – Our Flow Control segment bookings decreased 16% sequentially compared to record bookings in the first quarter of 2023 led by weaker demand in Europe where inflationary pressures resulted in constrained spending. We expect a slight decrease in demand in this segment for the remainder of the year compared to the second quarter of 2023 reflecting the overall softening in industrial production, but expect our end markets to remain healthy. • Industrial Processing – Our Industrial Processing segment bookings decreased 18% sequentially from the first quarter of 2023 driven by weaker demand for our capital equipment products. D emand for our wood processing capital equipment returned to more typical levels in the second quarter of 2023 after the record-setting pace experienced over the last two years, which was fueled by a robust U.S. housing market. Demand for our wood processing parts and consumable products declined sequentially in the second quarter of 2023 but remained strong. Orders for our stock-preparation capital equipment products declined sequentially in the second quarter of 2023, especially in Europe and China, while demand for our parts and consumables products remained stable during the same period. We expect steady demand in the Industrial Processing segment for the remainder of the year, but remain cautious as to how governmental efforts to control inflation may impact this segment's end markets. • Material Handling – Our Material Handling segment bookings decreased 35% sequentially compared to the record bookings in the first quarter of 2023. Our vibratory and conveying business led the sequential decline primarily due to a large capital equipment order valued at approximately $12 million booked in the first quarter for the longest conveying line in North America. Demand in our baling business also declined sequentially in both the U.S. and Europe due in part to the delay of capital equipment projects given the increased uncertainty in the economy. We expect demand in the Material Handling segment for the second half of 2023 to be steady and consistent with the second quarter of 2023. Our global operations have been and continue to be impacted by complex market conditions fueled by inflationary pressures, geopolitical tensions, and labor availability. While the U.S economy has proven more resilient, growth in the European economy has slowed due to high energy prices and surging inflation, and China's manufacturing activity has contracted. We expect our operating environment to continue to be challenging as central banks work to address inflationary pressures, which creates continued uncertainty for the remainder of 2023. However, we believe that the fundamentals of our business remain strong, particularly given our high backlog levels, solid global operations teams, and ongoing strength in the markets we serve. For more information related to these challenges, and other factors impacting our business, please see Risk Factors included in 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. 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. 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. 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 I, Item 1A, of our Annual Report and subsequent filings with the SEC. 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. In recent years, we have acquired several businesses and continue to pursue acquisition opportunities. 22 Table of Contents KADANT INC. Results of Operations Second Quarter 2023 Compared With Second Quarter 2022 Revenue The following table presents the change in revenue by segment between the second quarters of 2023 and 2022, 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 second quarters of 2023 and 2022 is as follows: (Non-GAAP) Three Months Ended Increase Currency Translation Change in Organic Revenue (In thousands, except percentages) July 1, 2023 July 2, 2022 % Change Increase % Change Flow Control $ 95,729 $ 85,220 $ 10,509 12% $ (247) $ 10,756 13% Industrial Processing 89,967 84,402 5,565 7% (2,323) 7,888 9% Material Handling 59,357 52,027 7,330 14% 238 7,092 14% Consolidated $ 245,053 $ 221,649 $ 23,404 11% $ (2,332) $ 25,736 12% Consolidated revenue increased 11% in the second quarter of 2023, including a 1% decrease from the unfavorable effect of foreign currency translation. All our operating segments contributed to the 12% increase in organic revenue led by our Flow Control segment. The majority of the organic revenue increase was due to higher demand for our capital equipment, especially at our Industrial Processing segment's wood processing businesses and, to a lesser extent, our Flow Control segment. In addition, we experienced increased demand for our parts and consumables products at our Material Handling segment's vibratory and conveying business and at our Flow Control segment. Revenue at our Flow Control segment increased 12% in the second quarter of 2023 primarily due to higher demand for capital equipment, especially in North America and, to a lesser extent, for our parts and consumables products. The higher demand for parts and consumables occurred in all regions and was driven by the strength in the underlying packaging industry primarily in North America, and from our customers, primarily in Europe, seeking to mitigate high energy prices with our products that optimize energy utilization. Revenue at our Industrial Processing segment increased 7% in the second quarter of 2023, while organic revenue increased 9%. The increase in organic revenue was primarily driven by higher demand for capital equipment at our wood processing businesses due to several large projects in North America. This increase was offset in part by softening demand at our stock-preparation businesses in China as manufacturing activity has contracted and mills focus on installing and optimizing capital equipment purchased in prior periods. Revenue at our Material Handling segment increased 14% in the second quarter of 2023 primarily from our parts and consumables products at our vibratory and conveying business in North America partially due to the fulfillment of orders from our backlog, which led to record parts and consumables revenue in this segment in the second quarter of 2023. Revenue also increased, but to a lesser extent, at our baling business in North America driven by the sale of our capital equipment products used to recycle packaging materials. 23 Table of Contents KADANT INC. Gross Profit Margin Gross profit margin by segment in the second quarters of 2023 and 2022 is as follows: Three Months Ended Basis Point Change July 1, 2023 July 2, 2022 Flow Control 51.4% 52.8% (140) bps Industrial Processing 39.5% 38.4% 110 bps Material Handling 36.8% 35.9% 90 bps Consolidated 43.5% 43.3% 20 bps Consolidated gross profit margin increased to 43.5% in the second quarter of 2023 compared with 43.3%`in the second quarter of 2022 due to higher margins achieved on our capital equipment products, especially in our Industrial Processing segment, partially offset by a decrease in the proportion of higher-margin parts and consumables revenue, which decreased to 62% compared to 66% in the prior year period. Within our operating segments, gross profit margin: • Decreased to 51.4% at our Flow Control segment from 52.8% in the 2022 period due to a lower percentage of parts and consumables revenue compared to the prior year period and lower margins achieved on our parts and consumables products. • Increased to 39.5% at our Industrial Processing segment from 38.4% in the 2022 period due to higher margins achieved on wood processing capital equipment products, partially offset by a decrease in the proportion of higher-margin parts and consumables revenue. • Increased to 36.8% at our Material Handling segment from 35.9% in the 2022 period due to a greater proportion of higher-margin parts and consumables revenue compared to the prior year period, and higher margins achieved on our capital equipment products. Selling, General, and Administrative Expenses Selling, general, and administrative (SG&A) expenses by segment in the second quarters of 2023 and 2022 are as follows: Three Months Ended (In thousands, except percentages) July 1, 2023 July 2, 2022 Increase % Change Flow Control $ 22,200 $ 20,969 $ 1,231 6% Industrial Processing 16,677 15,614 1,063 7% Material Handling 11,019 9,498 1,521 16% Corporate 10,094 9,238 856 9% Consolidated $ 59,990 $ 55,319 $ 4,671 8% Consolidated as a Percentage of Revenue 24% 25% Consolidated SG&A expenses as a percentage of revenue decreased to 24% in the second quarter of 2023 compared with 25% in the second quarter of 2022 principally due to the increase in revenue . Consolidated SG&A expenses were higher in the second quarter of 2023 due to increased compensation expense, trade show and travel-related costs, and professional service fees. Within our operating segments, SG&A expenses: • Increased $1.2 million at our Flow Control segment principally due t o increased compensation expense, travel costs, and professional service fees. • Increased $1.1 million at our Industrial Processing segment due to increased compensation expense associated with existing and new personnel and incremental trade show and travel-related costs . These increases were offset in part by a $0.4 million favorable effect of foreign currency translation. 24 Table of Contents KADANT INC. • Increased $1.5 million at our Material Handling segment principally due to increased compensation expense associated with existing and new personnel and a $0.2 million indemnification asset reversal related to the release of tax reserves. • Increased $0.9 million at Corporate due to increased professional service fees and compensation expense associated with existing and new personnel . Other Costs Other costs of $0.1 million in the second quarter of 2023 within our Industrial Processing segment associated with the China Transaction (as defined below in the results of operations for the first six months of 2023 compared with the first six months of 2022) included a write-down of certain fixed assets that will not be moved to the new manufacturing facility in China and facility moving costs. Interest Expense Interest expense increased to $2.2 million in the second quarter of 2023 from $1.4 million in the second quarter of 2022 due to a higher weighted-average interest rate, partially offset by lower average debt outstanding in the second quarter of 2023 compared to the second quarter of 2022. Provision for Income Taxes Provision for income taxes increased to $11.2 million in the second quarter of 2023 from $10.0 million in the second quarter of 2022. The effective tax rate of 27% in the second quarter of 2023 was higher than our statutory rate of 21% primarily due to the distribution of our worldwide earnings, state taxes, nondeductible expenses, and tax expense associated with Global Intangible Low-Taxed Income provisions. The effective tax rate of 27% in the second quarter of 2022 was higher than our statutory rate of 21% primarily due to the distribution of our worldwide earnings, state taxes, nondeductible expenses, and the cost of repatriating the earnings of certain foreign subsidiaries. Net Income Net income increased to $29.9 million in the second quarter of 2023 from $26.4 million in the second quarter of 2022 primarily due to a $5.6 million increase in operating income, offset in part by a $0.9 million increase in interest expense and a $1.2 million increase in provision for income taxes (see discussions above for further details). First Six Months 2023 Compared With First Six Months 2022 Revenue The following table presents changes in revenue and organic revenue by segment between the first six months of 2023 and 2022. Organic revenue is a non-GAAP measure as defined above in the results of operations for the second quarter of 2023 compared with the second quarter of 2022. Revenue by segment in the first six months of 2023 and 2022 is as follows: (Non-GAAP) Six Months Ended Currency Translation Change in Organic Revenue (In thousands, except percentages) July 1, 2023 July 2, 2022 Increase (Decrease) % Change Increase % Change Flow Control $ 185,250 $ 171,046 $ 14,204 8% $ (2,802) $ 17,006 10% Industrial Processing 173,509 177,487 (3,978) (2)% (6,146) 2,168 1% Material Handling 116,052 99,596 16,456 17% (776) 17,232 17% Consolidated $ 474,811 $ 448,129 $ 26,682 6% $ (9,724) $ 36,406 8% Consolidated revenue in the first six months of 2023 increased 6%, including a 2% decrease from the unfavorable effect of foreign currency translation. The organic revenue increase of 8% was led by our Material Handling and Flow Control segments due to higher demand for both our parts and consumables and capital equipment products. Revenue at our Flow Control segment increased 8% in the first six months of 2023, while organic revenue increased 10% with relatively equal contributions from our fluid-handling and doctoring, cleaning, & filtration product lines. The increase 25 Table of Contents KADANT INC. in organic revenue was primarily due to higher demand for parts and consumables and capital equipment products in North America driven by strength in the underlying packaging industry and, to a lesser extent, demand from our customers, primarily in Europe, seeking to mitigate high energy prices with our products that optimize energy utilization. We are more cautious about the outlook for the remainder of the year as mills take downtime and reduce maintenance spending and customers in Europe face challenging market conditions. Revenue at our Industrial Processing segment decreased 2% in the first six months of 2023, while organic revenue increased 1%. Organic revenue increased primarily due to higher demand for our capital equipment products at both our stock-preparation and wood processing businesses in North America where the U.S. economy and housing market continued to demonstrate resiliency against inflationary pressures. This increase was largely offset by softening demand at our stock-preparation businesses in China as manufacturing activity has contracted and mills focus on installing and optimizing capital equipment purchased in prior periods. Revenue at our Material Handling segment increased 17% in the first six months of 2023 led by our vibratory and conveying business in North America. Expansion projects related to the mining of minerals led to increased demand for our aboveground and underground conveying systems. In addition, parts and consumables revenue at our vibratory and conveying business increased over 25% from the prior year period partially due to the fulfillment of orders from our backlog. Revenue also increased, but to a lesser extent, at our baling business in North America driven by the sale of our capital equipment products used to recycle packaging materials. Gross Profit Margin Gross profit margin by segment in the first six months of 2023 and 2022 is as follows: Six Months Ended Basis Point Change July 1, 2023 July 2, 2022 Flow Control 52.3% 52.6% (30) bps Industrial Processing 40.0% 38.5% 150 bps Material Handling 36.4% 36.1% 30 bps Consolidated 43.9% 43.3% 60 bps Consolidated gross profit margin increased to 43.9% in the first six months of 2023 compared with 43.3% in the first six months of 2022 due to higher margins achieved on capital equipment products, partially offset by a lower proportion of parts and consumables revenue, which decreased to 64% compared to 65% in the prior year period. Within our operating segments, gross profit margin: • Decreased to 52.3% at our Flow Control segment from 52.6% in the 2022 period primarily due to a lower proportion of parts and consumables revenue. • Increased to 40.0% at our Industrial Processing segment from 38.5% in the 2022 period primarily due to higher margins achieved on our stock-preparation capital equipment products. • Increased to 36.4% at our Material Handling segment from 36.1% in the 2022 period principally due to higher margins achieved on our parts and consumables products. Selling, General, and Administrative Expenses SG&A expenses by segment in the first six months of 2023 and 2022 were as follows: Six Months Ended (In thousands, except percentages) July 1, 2023 July 2, 2022 Increase % Change Flow Control $ 44,417 $ 43,053 $ 1,364 3% Industrial Processing 32,975 31,983 992 3% Material Handling 21,738 20,502 1,236 6% Corporate 19,422 18,949 473 2% Consolidated $ 118,552 $ 114,487 $ 4,065 4% Consolidated as a Percentage of Revenue 25% 26% Consolidated SG&A expenses as a percentage of revenue decreased to 25% in the first six months of 2023 compared with 26% in the first six months of 2022 principally due to the increase in revenue . Consolidated SG&A expenses in the first 26 Table of Contents KADANT INC. six months of 2023 included a $2.1 million favorable effect of foreign currency, a decrease of $0.8 million in acquisition-related costs, and a decrease of $0.4 million in indemnification asset reversals related to the release of tax reserves. Excluding these favorable items, consolidated SG&A expenses increased $7.4 million, or 6%, primarily due to increased compensation expense and travel-related costs. Within our operating segments, SG&A expenses: • Increased $1.4 million at our Flow Control segment primarily due t o increased compensation expense and travel costs. These increases were partially offset by a $0.6 million favorable effect of foreign currency translation and a decrease in bad debt expense. • Increased $1.0 million at our Industrial Processing segment principally due to increased compensation expense associated with existing and new personnel and incremental trade show and travel-related cost s . These increases were partially offset by a $1.3 million favorable effect of foreign currency translation and the inclusion of an indemnification asset reversal related to the release of tax reserves of $0.6 million in 2022. • Increased $1.2 million at our Material Handling segment due to increased compensation expense associated with existing and new personnel and, to a lesser extent, the inclusion of an indemnification asset reversal related to the release of tax reserves of $0.2 million. These increases were partially offset by a decrease of $0.7 million in acquisition-related costs and a $0.2 million favorable effect of foreign currency translation. • Increased $0.5 million at Corporate due to increased professional service fees and compensation expense associated with existing and new personnel , partially offset by a decrease in incentive compensation. 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 of one of our subsidiaries in China for $25.2 million and relocate to a new facility (the China Transaction). 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 China Transaction of $20.2 million, or $15.1 million, net of deferred taxes of $5.0 million, in the first quarter of 2022. Our subsidiary, which is part of the Industrial Processing segment, will continue to occupy its current facility until construction of its new facility is complete, which is expected during the second half of 2023. See Note 2 , Gain on Sale and Other Costs, Net, in the accompanying condensed consolidated financial statements for further details. Other Costs Other costs of $0.1 million in the first six months of 2023 and $0.2 million in the first six months of 2022 within our Industrial Processing segment associated with the China Transaction included a write-down of certain fixed assets that will not be moved to the new manufacturing facility in China and facility moving costs. Interest Expense Interest expense increased to $4.6 million in the first six months of 2023 from $2.6 million in the first six months of 2022 due to a higher weighted-average interest rate, partially offset by lower average debt outstanding in the first six months of 2023 compared to the first six months of 2022. Provision for Income Taxes Provision for income taxes decreased to $20.9 million in the first six months of 2023 from $23.3 million in the first six months of 2022. The effective tax rate of 26% in the first six months of 2023 was higher than our statutory rate of 21% primarily due to the distribution of our worldwide earnings, state taxes, and nondeductible expenses. The effective tax rate of 26% in the first six 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. These increases in ta x expense in the first six months of 2022 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 decreased to $58.2 million in the first six months of 2023 from $67.9 million in the first six months of 2022 primarily due to a decrease in operating income $10.2 million and a $2.0 million increase in interest expense, offset in part by a $2.4 million decrease in provision for income taxes. Net income in the first six months of 2022 included a $15.1 million after-tax gain on the sale of a building related to the China Transaction (see discussions above for further details). 27 Table of Contents KADANT INC. 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 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. 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 Six Months Ended (In thousands, except percentages) July 1, 2023 July 2, 2022 July 1, 2023 July 2, 2022 Net Income Attributable to Kadant $ 29,734 $ 26,170 $ 57,809 $ 67,362 Net Income Attributable to Noncontrolling Interest 212 239 396 488 Provision for Income Taxes 11,182 9,951 20,945 23,329 Interest Expense, Net 1,929 1,089 4,000 2,221 Other Expense, Net 21 19 42 41 Operating Income 43,078 37,468 83,192 93,441 Gain on Sale (a) — — — (20,190) Acquisition Costs — — — 76 Indemnification Asset Reversals (b) 177 — 177 575 Other Costs 74 — 74 182 Acquired Backlog Amortization (c) — — — 703 Acquired Profit in Inventory Amortization (d) — — — (218) Adjusted Operating Income (non-GAAP measure) 43,329 37,468 83,443 74,569 Depreciation and Amortization 8,237 8,486 16,683 17,228 Adjusted EBITDA (non-GAAP measure) $ 51,566 $ 45,954 $ 100,126 $ 91,797 Adjusted EBITDA Margin (non-GAAP measure) 21.0% 20.7% 21.1% 20.5% (a) Represents a $20.2 million pre-tax gain on the China Transaction in our Industrial Processing segment. (b) Represents indemnification asset reversals related to the release of tax reserves associated with uncertain tax positions. (c) Represents intangible amortization expense associated with acquired backlog. (d) Represents income within cost of revenue associated with amortization of acquired profit in inventory. 28 Table of Contents KADANT INC. A reconciliation of free cash flow from cash flow provided by operating activities is as follows: Three Months Ended Six Months Ended (In thousands) July 1, 2023 July 2, 2022 July 1, 2023 July 2, 2022 Cash Provided by Operating Activities $ 22,478 $ 18,797 $ 59,344 $ 42,565 Less: Capital Expenditures (a) (8,777) (6,947) (13,246) (9,815) Free Cash Flow (non-GAAP measure) $ 13,701 $ 11,850 $ 46,098 $ 32,750 (a) Includes $3.1 million and $3.3 million in the three and six months ended July 1, 2023, respectively, and $3.1 million and $3.2 million in the three and six months ended July 2, 2022, respectively, related to the China Transaction. Liquidity and Capital Resources Consolidated working capital was $222.4 million at July 1, 2023, compared with $201.9 million at December 31, 2022. Cash and cash equivalents were $66.7 million at July 1, 2023, compared with $76.4 million at December 31, 2022, which included cash and cash equivalents held by our foreign subsidiaries o f $62.0 million at July 1, 2023 and $75.8 million at December 31, 2022. Cash Flows Cash flow information in the first six months of 2023 and 2022 is as follows: Six Months Ended (In thousands) July 1, 2023 July 2, 2022 Net Cash Provided by Operating Activities $ 59,344 $ 42,565 Net Cash Used in Investing Activities (12,902) (7,894) Net Cash Used in Financing Activities (56,551) (45,388) Exchange Rate Effect on Cash, Cash Equivalents, and Restricted Cash 579 (5,418) Decrease in Cash, Cash Equivalents, and Restricted Cash $ (9,530) $ (16,135) Operating Activities Cash provided by operating activities increased to $59.3 million in the first six months of 2023 from $42.6 million in the first six months of 2022 primarily due to a reduction in cash used for 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. During the first six months of 2023, cash provided by income was offset in part by investments in working capital. Increases in inventory used cash of $10.8 million primarily related to capital equipment orders that will ship in 2023 and early 2024. Decreases in accounts payable used cash of $9.4 million primarily due to the timing of payments. In addition, an increase in accounts receivable used cash of $4.0 million mainly due to our revenue growth and the timing of shipments. During the first six months of 2022, cash provided by income was offset in part by investments in working capital. Increases in inventory used cash of $26.8 million primarily related to capital equipment orders that shipped in 2022 and early 2023. In addition, an increase in accounts receivable associated with our revenue growth used cash of $12.3 million. These uses of cash were offset in part by $9.3 million of cash received from customer deposits. Investing Activities Cash used in investing activities was $12.9 million in the first six months of 2023, compared with $7.9 million in the first six months of 2022. Capital expenditures were $13.2 million in the first six months of 2023 and $9.8 million in the first six months of 2022, including capital expenditures associated with the construction of our new manufacturing facility in China of $3.3 million in the first six months of 2023 and $3.2 million in the first six months of 2022. In addition, we received $1.9 million of cash from the sale of assets in the first six months of 2022. 29 Table of Contents KADANT INC. Financing Activities Cash used in financing activities was $56.6 million in the first six months of 2023, compared with $45.4 million in the first six months of 2022. Repayments of short- and long-term obligations were $46.1 million in the first six months of 2023 compared to repayments of short- and long-term obligations of $51.4 million, partially offset by borrowings under our revolving credit facility of $16.5 million in the first six months of 2022. Cash dividends paid to stockholders were $6.4 million in the first six months of 2023 and $5.9 million in the first six months of 2022. In addition, taxes paid related to the vesting of equity awards was $3.9 million in the first six months of 2023 compared to $4.6 million in the first six months of 2022. 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 $0.6 million increase in cash, cash equivalents, and restricted cash in the first six months of 2023 was primarily attributable to the weakening of the U.S. dollar against the euro, and to a lesser extent, the Mexican peso, and Brazilian real, partially offset by the strengthening of the U.S. dollar against the Chinese renminbi. Borrowing Capacity and Debt Obligations Our unsecured multi-currency revolving credit facility originally entered into on March 1, 2017 (as amended and restated to date, the Credit Agreement) matures on November 30, 2027 and has a total borrowing capacity of $400 million. At July 1, 2023, we had $257.3 million of borrowing capacity available under our Credit Agreement, in addition to a $200 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 4.25. As of July 1, 2023, our leverage ratio was 0.51 and we were in compliance with our debt covenants. 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 18, 2023, our board of directors approved the repurchase of up to $50 million of our equity securities during the period from May 18, 2023 to May 18, 2024. We have not repurchased any shares of our common stock under this authorization or under our previous $50 million authorization that expired on May 19, 2023. We paid cash dividends of $6.4 million in the first six months of 2023. On May 18, 2023, we declared a quarterly cash dividend of $0.29 per share totaling $3.4 million that will be paid on August 10, 2023. 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 $25 to $27 million during the remainder of 2023 for property, plant, and equipment, including $5 million for our new manufacturing facility in China. As of July 1, 2023, we had approximately $269.9 million of total unremitted foreign earnings. It is our intent to indefinitely reinvest $223.8 million of these earnings to support the current and future capital needs of our foreign operations, including debt repayments, if any. In the first six months of 2023, 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 $3.7 million. 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 six months of 2023 compared with those disclosed in Management's Discussion and Analysis of Financial Condition and Results of Operations under the heading Liquidity and Capital Resources 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, 30 Table of Contents KADANT INC. 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 heading 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 2022 that warrant disclosure. 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.