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 (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 and chippers. 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 $209.6 million in the third quarter of 2023, decreasing 3% sequentially and 1% compared to the third quarter of 2022. Our bookings declined in the second and third quarters of 2023 after the record bookings in the first quarter of 2023 following a general slowdown in industrial activity. We expect our bookings in the fourth quarter of 2023 to be consistent with the prior quarter as our customers assess and respond to the impact of differing market conditions around the world. We ended the third quarter with a strong backlog of $323.5 million, more than half of which was attributable to our Industrial Processing segment. 23 Table of Contents KADANT INC. An overview of our business by segment is as follows: • Flow Control – Our Flow Control segment bookings decreased 2% compared to the third quarter of 2022 led by a decline in capital bookings. In North America, there was constrained capital spending as mills took downtime and paper and containerboard producers consolidated or moved locations to align capacity with demand. In Europe, there was continued uncertainty in the end markets we serve primarily due to elevated inflation and high interest rates. In addition, there has been a reduction in demand for paper across Europe as the supply chain focuses on reducing the volume of packaging materials used in shipments. However, many of the end markets in our Flow Control segment remain strong despite the general sluggishness in the manufacturing sector, and we expect bookings in the fourth quarter of 2023 to remain stable. • Industrial Processing – Our Industrial Processing segment bookings decreased 10% compared to the third quarter of 2022 driven by weaker demand for our parts and consumables products. Demand for our wood processing products declined 12% compared to the third quarter of 2022 largely driven by a decrease in new construction activity. While there is still a healthy level of quote activity, there has been an increase in the quote to order times. In our stock-preparation business in the U.S., market-related downtime at our customers contributed to weaker demand for our parts and consumables products. This was offset in part by increased demand for our capital equipment as mills focused on replacement and refurbishment projects critical to keeping the mills operational. In China, there was an increase in stock-preparation capital equipment bookings driven by a large greenfield project, however, overall market conditions are sluggish as mills focus on bringing capacity online. Given the recent and anticipated capital project activity, we expect sequentially higher bookings in our Industrial Processing segment in the fourth quarter of 2023. • Material Handling – Our Material Handling segment bookings increased 17% compared to the third quarter of 2022 led by our baling business. The growing need for efficient waste handling and packaging solutions across various industries has resulted in increased demand for our baling products. As more countries and industries prioritize waste reduction and recycling, the demand for baling equipment is expected to rise. Increased demand led by our parts and consumables products at our conveying and vibratory business in the third quarter of 2023 was due in part to new government legislation, which has positively impacted the aggregates industry. While we expect demand in our Material Handling segment to moderate in the near term, we continue to see growing project activity, particularly in North America. Our global operations have been and continue to be impacted by complex market conditions fueled by inflationary pressures, geopolitical tensions, and softening markets. While the U.S economy has proven more resilient, growth in the European economy has slowed due to high interest rates and elevated 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 and into 2024. However, we believe that the fundamentals of our business remain strong, particularly given our high backlog levels, solid global operations teams, and long-term strength of our end markets. 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. 24 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. In recent years, we have acquired several businesses and continue to pursue acquisition opportunities. Results of Operations Third Quarter 2023 Compared With Third Quarter 2022 Revenue The following table presents the change in revenue by segment between the third 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 third quarters of 2023 and 2022 is as follows: Three Months Ended Increase Currency Translation (Non-GAAP) Change in Organic Revenue (In thousands, except percentages) September 30, 2023 October 1, 2022 % Change Increase % Change Flow Control $ 90,798 $ 86,880 $ 3,918 5% $ 2,743 $ 1,175 1% Industrial Processing 94,220 86,085 8,135 9% (10) 8,145 9% Material Handling 59,164 51,545 7,619 15% 1,217 6,402 12% Consolidated $ 244,182 $ 224,510 $ 19,672 9% $ 3,950 $ 15,722 7% Consolidated revenue increased 9% in the third quarter of 2023, including a 2% increase from the favorable effect of foreign currency translation. All our operating segments contributed to the 7% increase in organic revenue. The majority of the organic revenue increase was due to higher demand for our capital equipment at our Material Handling and Industrial Processing segments and, to a lesser extent, increased demand for our parts and consumables products at our Industrial Processing segment. Revenue at our Flow Control segment increased 5% in the third quarter of 2023, while organic revenue increased 1%, with offsetting geographic impacts. Increased demand for our parts and consumables products in North America as mills took downtime and focused on maintenance spending was partially offset by softening demand in Europe due to more challenging market conditions. Higher demand for our capital equipment in Europe, especially from our customers seeking to mitigate high energy prices, were mostly offset by weaker demand in China due to depressed market conditions resulting in longer quote to order times. Revenue at our Industrial Processing segment increased 9% in the third quarter of 2023 driven by increased demand for both our capital equipment and parts and consumable products. The higher demand for capital equipment occurred primarily in our stock-preparation business due to several large projects in Europe. Additionally, there was increased demand for parts and consumables products in our stock-preparation and wood processing businesses, primarily in North America, due to maintenance requirements at many of our customers. Revenue at our Material Handling segment increased 15% in the third quarter of 2023, while organic revenue increased 12%. The increase in organic revenue was led by capital project activity at our conveying and vibratory business due to higher production rates. In addition, our baling business had increased demand for parts and consumables as more industries focus on waste reduction and recycling. 25 Table of Contents KADANT INC. Gross Profit Margin Gross profit margin by segment in the third quarters of 2023 and 2022 is as follows: Three Months Ended Basis Point Change September 30, 2023 October 1, 2022 Flow Control 52.2% 51.6% 60 bps Industrial Processing 39.5% 39.3% 20 bps Material Handling 35.7% 32.3% 340 bps Consolidated 43.3% 42.5% 80 bps Consolidated gross profit margin increased to 43.3% in the third quarter of 2023 compared with 42.5%`in the third quarter of 2022 due to higher margins achieved on our parts and consumables products, especially in our Material Handling segment. This increase was partially offset by a decrease in the proportion of higher-margin parts and consumables revenue, which decreased to 61% compared to 63% in the prior year period. Within our operating segments, gross profit margin: • Increased to 52.2% at our Flow Control segment from 51.6% in the 2022 period primarily due to higher margins achieved on our capital equipment partially offset by a decrease in margins for our parts and consumables products. • Increased to 39.5% at our Industrial Processing segment from 39.3% in the 2022 period due to higher margins achieved on parts and consumable products partially offset by a decrease in margins achieved on our wood processing capital equipment products. • Increased to 35.7% at our Material Handling segment from 32.3% in the 2022 period due to increased margins on our conveying and vibratory parts and consumable products partially offset by a decrease in margins achieved on our capital equipment products. Selling, General, and Administrative Expenses Selling, general, and administrative (SG&A) expenses by segment in the third quarters of 2023 and 2022 are as follows: Three Months Ended (In thousands, except percentages) September 30, 2023 October 1, 2022 Increase % Change Flow Control $ 21,538 $ 20,717 $ 821 4% Industrial Processing 15,968 14,660 1,308 9% Material Handling 10,332 9,321 1,011 11% Corporate 10,051 8,455 1,596 19% Consolidated $ 57,889 $ 53,153 $ 4,736 9% Consolidated as a Percentage of Revenue 24% 24% Consolidated SG&A expenses as a percentage of revenue was 24% in both the third quarters of 2023 and 20 22. Consolidated SG&A expenses increased $4.7 million in the third quarter of 2023 compared to the third quarter of 2022, including a $1.1 million unfavorable effect of foreign currency translation and increased compensation expense, professional service fees, and travel-related costs. Within our operating segments, SG&A expenses: • Increased $0.8 million at our Flow Control segment principally due to a $0.7 million unfavorable effect of foreign currency translation, foreign currency transaction losses, and increased travel costs. These increases were partially offset by a decrease in acquisition costs of $0.4 million. • Increase d $1.3 million at our Industrial Processing segment due to increased compensation expense associated with existing and new personnel and higher trade show costs. • Increased $1.0 million at our Material Handling segment principally due to increased compensation expense associated with existing and new personnel and a $0.2 million unfavorable effect of foreign currency translation. • Increased $1.6 million at Corporate due to higher professional service fees and compensation expense. 26 Table of Contents KADANT INC. Other Costs Other Costs were $1.0 million in the third quarter of 2023 and $0.1 million in the third quarter of 2022 and included the following: • Costs of $0.5 million in the third quarter of 2023 within our Industrial Processing segment were associated with the China Transaction (as defined below in the results of operations for the first nine months of 2023 compared with the first nine months of 2022) and related to the relocation of machinery and equipment and administrative offices to the new manufacturing facility. • Restructuring and impairment costs of $0.4 million in the third quarter of 2023 within our Flow Control segment related to the consolidation of a small manufacturing operation into a larger facility in Germany (2023 Restructuring Plan). This charge consisted of severance costs for the termination of 10 employees, asset-write downs, and facility and other closure costs. We expect annualized savings of approximately $0.7 million, primarily in cost of sales, from these restructuring actions. • Restructuring costs of $0.1 million in the third quarter of 2022 within our Flow Control segment related to a restructuring plan we initiated in the fourth quarter of 2021 to eliminate a redundant ceramic blade manufacturing operation in France (2021 Restructuring Plan). This charge consisted of severance costs associated with the termination of two employees. Interest Expense Interest expense increased to $2.1 million in the third quarter of 2023 from $1.7 million in the third quarter of 2022 due to a higher weighted-average interest rate, partially offset by lower average debt outstanding in the third quarter of 2023 compared to the third quarter of 2022. Provision for Income Taxes Provision for income taxes increased to $10.8 million in the third quarter of 2023 from $9.7 million in the third quarter of 2022. The effective tax rate of 26% in the third quarter of 2023 was higher than our statutory rate of 21% primarily due to the distribution of our worldwide earnings and state taxes. 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. Net Income Net income increased to $31.0 million in the third quarter of 2023 from $27.7 million in the third quarter of 2022 primarily due to a $4.7 million increase in operating income, offset in part by a $0.4 million increase in interest expense and a $1.1 million increase in provision for income taxes (see discussions above for further details). First Nine Months 2023 Compared With First Nine Months 2022 Revenue The following table presents changes in revenue and organic revenue by segment between the first nine months of 2023 and 2022. Organic revenue is a non-GAAP measure as defined above in the results of operations for the third quarter of 2023 compared with the third quarter of 2022. Revenue by segment in the first nine months of 2023 and 2022 is as follows: Nine Months Ended Currency Translation (Non-GAAP) Change in Organic Revenue (In thousands, except percentages) September 30, 2023 October 1, 2022 Increase % Change Increase % Change Flow Control $ 276,048 $ 257,926 $ 18,122 7% $ (59) $ 18,181 7% Industrial Processing 267,729 263,572 4,157 2% (6,156) 10,313 4% Material Handling 175,216 151,141 24,075 16% 441 23,634 16% Consolidated $ 718,993 $ 672,639 $ 46,354 7% $ (5,774) $ 52,128 8% 27 Table of Contents KADANT INC. Consolidated revenue in the first nine months of 2023 increased 7%, including a 1% decrease from the unfavorable effect of foreign currency translation. All our operating segments contributed to the 8% increase in organic revenue with relatively equal contributions from sales of our capital equipment and parts and consumables products. The majority of the organic revenue increase was driven by higher demand in North America. In addition, modestly higher demand in Europe was offset by softening demand in China. Revenue at our Flow Control segment increased 7% in the first nine months of 2023 primarily due to higher demand for parts and consumables and capital equipment products in North America driven by continued strength in the U.S. economy and underlying packaging industry. While there was increased demand for our capital equipment in Europe from customers seeking to mitigate high energy prices, demand for our parts and consumables products was modestly higher than the 2022 period reflecting the challenging market conditions. In China, there was softening demand for our capital equipment as manufacturing activity has slowed. Revenue at our Industrial Processing segment increased 2% in the first nine months of 2023, while organic revenue increased 4%. Organic revenue increased primarily due to higher demand for our capital equipment products at our wood processing and stock-preparation 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. Additionally, there was increased demand for parts and consumable products in our stock-preparation business in Europe and, to a lesser extent, North America due to maintenance requirements at many of our customers. Revenue at our Material Handling segment increased 16% in the first nine months of 2023 due to higher demand for both capital equipment and parts and consumables products at our conveying and vibratory business in North America. This was due in part to expansion projects related to the mining of minerals that led to increased demand for our conveying systems. Revenue also increased, but to a lesser extent, at our baling business due to higher demand for our products as more industries focus on waste reduction and recycling. Gross Profit Margin Gross profit margin by segment in the first nine months of 2023 and 2022 is as follows: Nine Months Ended Basis Point Change September 30, 2023 October 1, 2022 Flow Control 52.3% 52.3% 0 bps Industrial Processing 39.8% 38.8% 100 bps Material Handling 36.2% 34.8% 140 bps Consolidated 43.7% 43.1% 60 bps Consolidated gross profit margin increased to 43.7% in the first nine months of 2023 compared with 43.1% in the first nine months of 2022 due to higher margins achieved on both capital equipment and parts and consumable products, partially offset by a lower proportion of parts and consumables revenue, which decreased to 63% compared to 64% in the prior year period. Within our operating segments, gross profit margin: • Increased to 39.8% at our Industrial Processing segment from 38.8% in the 2022 period primarily due to higher margins achieved on our stock-preparation capital equipment and parts and consumable products, partially offset by a decrease in proportion of higher-margin parts and consumables revenue. • Increased to 36.2% at our Material Handling segment from 34.8% in the 2022 period principally due to higher margins achieved for our parts and consumables products. This increase was partially offset by lower margins achieved on our capital equipment products and, to a lesser extent, a decrease in proportion of higher-margin parts and consumables revenue. 28 Table of Contents KADANT INC. Selling, General, and Administrative Expenses SG&A expenses by segment in the first nine months of 2023 and 2022 were as follows: Nine Months Ended (In thousands, except percentages) September 30, 2023 October 1, 2022 Increase % Change Flow Control $ 65,955 $ 63,770 $ 2,185 3% Industrial Processing 48,943 46,643 2,300 5% Material Handling 32,070 29,823 2,247 8% Corporate 29,473 27,404 2,069 8% Consolidated $ 176,441 $ 167,640 $ 8,801 5% Consolidated as a Percentage of Revenue 25% 25% Consolidated SG&A expenses as a percentage of revenue was 25% in both the first nine months of 2023 and 2022 . Consolidated SG&A expenses increased $8.8 million in the first nine months of 2023 compared to the first nine months of 2022 and included a decrease of $1.2 million in acquisition-related costs, a $1.0 million favorable effect of foreign currency, 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 $11.4 million, or 7%, primarily due to increased compensation expense and travel-related costs. Within our operating segments, SG&A expenses: • Increased $2.2 million at our Flow Control segment primarily due to increased compensation expense, travel costs, and foreign currency transaction losses. These increases were partially offset by a decrease in bad debt expense and acquisition costs. • Increased $2.3 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 costs. These increases were partially offset by a $1.2 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 $2.2 million at our Material Handling segment d ue 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. • Increased $2.1 million at Corporate d ue to increased compensation expense and professional service fees. 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 (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, relocated to its new facility during the third quarter 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 were $1.0 million in the first nine months of 2023 and $0.3 million in the first nine months of 2022 and included the following: • Costs of $0.6 million in the first nine months of 2023 within our Industrial Processing segment were associated with the China Transaction and related to the relocation of machinery and equipment and administrative offices to the new manufacturing facility. • Restructuring and impairment costs of $0.4 million in the first nine months of 2023 within our Flow Control segment related to the 2023 Restructuring Plan, which consisted of severance costs for the termination of 10 employees, asset-write downs, and facility and other closure costs. 29 Table of Contents KADANT INC. • Impairment costs of $0.2 million in the first nine months of 2022 within our Industrial Processing segment were associated with the China Transaction and related to the write-down of certain fixed assets that were not moved to the new manufacturing facility. Restructuring costs of $0.1 million in the first nine months of 2022 within our Flow Control segment under the 2021 Restructuring Plan consisted of severance costs for the termination of two employees. Interest Expense Interest expense increased to $6.7 million in the first nine months of 2023 from $4.3 million in the first nine months of 2022 due to a higher weighted-average interest rate, partially offset by lower average debt outstanding in the first nine months of 2023 compared to the first nine months of 2022. Provision for Income Taxes Provision for income taxes decreased to $31.8 million in the first nine months of 2023 from $33.1 million in the first nine months of 2022. The effective tax rate of 26% in the first nine months of 2023 and 2022 was higher than our statutory rate of 21% primarily due to the distribution of our worldwide earnings, state taxes, and nondeductible expenses. Net Income Net income decreased to $89.2 million in the first nine months of 2023 from $95.5 million in the first nine months of 2022 primarily due to a decrease in operating income of $5.6 million and a $2.4 million increase in interest expense, offset in part by a $1.3 million decrease in provision for income taxes. Net income in the first nine 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). 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 relocation costs, restructuring and impairment costs, acquisition costs, amortization expense related to acquired profit in inventory and backlog, and other income or expense, as indicated. 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. 30 Table of Contents KADANT INC. 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) September 30, 2023 October 1, 2022 September 30, 2023 October 1, 2022 Net Income Attributable to Kadant $ 30,864 $ 27,487 $ 88,673 $ 94,849 Net Income Attributable to Noncontrolling Interest 175 184 571 672 Provision for Income Taxes 10,816 9,746 31,761 33,075 Interest Expense, Net 1,669 1,450 5,669 3,671 Other Expense, Net 20 19 62 60 Operating Income 43,544 38,886 126,736 132,327 Gain on Sale (a) — — — (20,190) Acquisition Costs — 410 — 486 Indemnification Asset (Provision) Reversals (b) (50) — 127 575 Relocation Costs 535 — 609 — Restructuring and Impairment Costs 434 72 434 254 Acquired Backlog Amortization (c) — — — 703 Acquired Profit in Inventory Amortization (d) — — — (218) Adjusted Operating Income (non-GAAP measure) 44,463 39,368 127,906 113,937 Depreciation and Amortization 8,234 8,456 24,917 25,684 Adjusted EBITDA (non-GAAP measure) $ 52,697 $ 47,824 $ 152,823 $ 139,621 Adjusted EBITDA Margin (non-GAAP measure) 21.6% 21.3% 21.3% 20.8% (a) Represents a $20.2 million pre-tax gain on the China Transaction in our Industrial Processing segment. (b) Represents the provision for or reversal of indemnification assets related to the establishment or 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. A reconciliation of free cash flow from cash flow provided by operating activities is as follows: Three Months Ended Nine Months Ended (In thousands) September 30, 2023 October 1, 2022 September 30, 2023 October 1, 2022 Cash Provided by Operating Activities $ 46,967 $ 24,897 $ 106,311 $ 67,462 Less: Capital Expenditures (a) (8,848) (6,376) (22,094) (16,191) Free Cash Flow (non-GAAP measure) $ 38,119 $ 18,521 $ 84,217 $ 51,271 (a) Includes $2.5 million and $5.8 million in the three and nine months ended September 30, 2023, respectively, and $2.2 million and $5.4 million in the three and nine months ended October 1, 2022, respectively, related to the China Transaction. Liquidity and Capital Resources Consolidated working capital was $222.6 million at September 30, 2023, compared with $201.9 million at December 31, 2022. Cash and cash equivalents were $76.8 million at September 30, 2023, compared with $76.4 million at December 31, 2022, which included cash and cash equivalents held by our foreign subsidiaries o f $73.0 million at September 30, 2023 and $75.8 million at December 31, 2022. 31 Table of Contents KADANT INC. Cash Flows Cash flow information in the first nine months of 2023 and 2022 is as follows: Nine Months Ended (In thousands) September 30, 2023 October 1, 2022 Net Cash Provided by Operating Activities $ 106,311 $ 67,462 Net Cash Used in Investing Activities (20,060) (13,923) Net Cash Used in Financing Activities (85,671) (62,112) Exchange Rate Effect on Cash, Cash Equivalents, and Restricted Cash (1,252) (10,474) Decrease in Cash, Cash Equivalents, and Restricted Cash $ (672) $ (19,047) Operating Activities Cash provided by operating activities increased to $106.3 million in the first nine months of 2023 from $67.5 million in the first nine 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 nine months of 2023, significant cash outflows associated with working capital related to accounts payable and accounts receivable. Decreases in accounts payable used cash of $12.9 million primarily due to the timing of payments. An increase in accounts receivable used cash of $10.7 million mainly due to our revenue growth and the timing of shipments. In addition, an increase in other liabilities provided cash of $5.9 million due in part to work performed by subcontractors and outside vendors. During the first nine months of 2022, significant cash outflows associated with working capital related to inventory and accounts receivable. 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 shipped in 2022 and the first half of 2023. These uses of cash were offset in part by $16.2 million of cash received from customer deposits. Investing Activities Cash used in investing activities was $20.1 million in the first nine months of 2023, compared with $13.9 million in the first nine months of 2022. Capital expenditures were $22.1 million in the first nine months of 2023 and $16.2 million in the first nine months of 2022, including capital expenditures associated with the construction of our new manufacturing facility in China of $5.8 million in the first nine months of 2023 and $5.4 million in the first nine months of 2022. Financing Activities Cash used in financing activities was $85.7 million in the first nine months of 2023, compared with $62.1 million in the first nine months of 2022. Repayments of short- and long-term obligations were $71.9 million in the first nine months of 2023 compared to repayments of short- and long-term obligations of $69.5 million, partially offset by borrowings under our revolving credit facility of $21.6 million in the first nine months of 2022. Cash dividends paid to stockholders were $9.8 million in the first nine months of 2023 and $9.0 million in the first nine months of 2022. In addition, taxes paid related to the vesting of equity awards was $3.9 million in the first nine months of 2023 compared to $4.6 million in the first nine 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 $1.3 million decrease in cash, cash equivalents, and restricted cash in the first nine months of 2023 was primarily attributable to the strengthening of the U.S. dollar against the Chinese renminbi, and to a lesser extent, the Euro and Swedish Krona. 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 September 30, 2023, we had $284.9 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, 32 Table of Contents KADANT INC. must be less than 4.25. As of September 30, 2023, our leverage ratio was 0.38 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 $9.8 million in the first nine months of 2023. On September 7, 2023, we declared a quarterly cash dividend of $0.29 per share totaling $3.4 million that will be paid on November 9, 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 $16 to $18 million during the remainder of 2023 for property, plant, and equipment, including $2 to $3 million for our new manufacturing facility in China. As of September 30, 2023, we had approximately $265.6 million of total unremitted foreign earnings. It is our intent to indefinitely reinvest $224.8 million of these earnings to support the current and future capital needs of our foreign operations, including debt repayments, if any. In the first nine 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 $4.2 million. We believe that existing cash and cash equivalents, along with future 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 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 condensed 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 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. Recent Accounting Pronouncements See Note 1 , under the heading Recent Accounting Pronouncements Not Yet Adopted, in the accompanying condensed consolidated financial statements for details. 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. 33 Table of Contents KADANT INC.