MIMEDX GROUP, INC. 10-K

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Executive Summary During 2023, the Company delivered 20.0% growth in net sales, with broad-based contributions by customer type. This growth was driven by a combination of commercial execution, favorable end market demand and contributions from newer products to our portfolio. Operating and financial highlights during the year include: • Fourth quarter and full year 2023 net sales of $86.8 million and $321.5 million, respectively, reflecting 16.7% and 20.0% growth over the fourth quarter and full year 2022, respectively. • Net income from continuing operations for the fourth quarter and full year 2023 of $51.3 million and $67.4 million, respectively. • Announced strategic realignment of the Company, increasing focus on Wound & Surgical business and significantly improving profitability; disbanded the Regenerative Medicine business unit and suspended knee osteoarthritis clinical trial program. • Launched EPIEFFECT, the latest addition to the Company’s broad portfolio of Advanced Wound Care products. • Announced conversion of outstanding Series B convertible preferred stock to common stock. • Appointed new members to the Company’s Executive Leadership Team, including a new CEO, CFO and Chief Operating Officer. Overview MIMEDX is a pioneer and leader in placental biologics focused on delivering innovative solutions to patients and the healthcare professionals who treat them. With more than a decade of experience helping clinicians manage acute and chronic wounds, MIMEDX has been dedicated to providing a leading portfolio of products for applications in the wound care, burn, and surgical sectors of healthcare. All of our products sold in the United States are regulated by the U.S. Food & Drug Administration ( “FDA” ). We apply Current Good Tissue Practices ( “CGTP” ) and other applicable quality standards in addition to terminal sterilization to produce our allografts. Our Products Our product portfolio is divided into two categories (1) Wound Care Products and (2) Surgical and Other Products. Our Wound Care Products include EPIFIX, EPICORD and EPIEFFECT, which are all marketed for external use, such as in Advanced Wound Care applications. Within Surgical and Other, our product offering includes AMNIOFIX, AMNIOCORD and AMNIOEFFECT, which are positioned for use in a variety of applications and surgical settings, including lower extremity repair, plastic surgery, vascular surgery and multiple orthopedic repairs and reconstructions. Our AXIOFILL product has also seen the most uptake by clinicians for surgical applications. By specific source material, our primary platform technologies include tissue allografts derived from human placental membrane (EPIFIX, AMNIOFIX, EPIEFFECT, and AMNIOEFFECT), tissue allografts derived from human umbilical cord (EPICORD and AMNIOCORD), and a particulate extracellular matrix derived from human placental disc (AXIOFILL). This discussion, which presents our results for the fiscal years ended December 31, 2023 and 2022, should be read in conjunction with our Consolidated Financial Statements and the accompanying notes. Also, please refer to Part I, Item 1, Business , and Part I, Item 1A, Risk Factors , which include detailed discussions of various items impacting our business, results of operations and financial condition. We intend for this discussion to provide the reader with information that will assist in understanding our financial statements, the changes in certain key items in those financial statements from period to period and the primary factors that accounted for those changes. We also discuss certain performance metrics that management uses to assess the Company's performance. Our Annual Report for the year ended December 31, 2022 (the “ 2022 Annual Report ”) includes a discussion and analysis of our total company financial condition and results of operations for 2022 compared to 2021 in Part II, Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations . Please note that, subsequent to the publication of our 2022 Annual Report, we announced our plan to disband our Regenerative Medicine business unit, the results of which we believe are not material to an understanding of our financial condition, changes in financial condition and results of operation, is now classified as discontinued operations. For further details, please see Note 13, Discontinued Operations , to our consolidated financial statements included in Part II, Item 8 of this Annual Report. 40 Components of and Key Factors Influencing Our Results of Continuing Operations In assessing the performance of our business, we consider a variety of performance and financial measures. We believe the items discussed below provide insight into the factors that affect these key measures. Net sales Our net sales are derived from selling to a wide range of customers, including hospitals, wound care centers and private physician offices that have clinicians using our suite of products to aid in the management of patients with chronic or hard-to-heal wounds. These customers choose products like ours based upon a variety of factors, including clinical efficacy, availability, handling characteristics, and reimbursement coverage and payer sources. Net sales is recognized based on the consideration we expect to receive from the sale at the point in time when control of the goods is transferred to the customer, which generally occurs upon our delivery to a third-party carrier or implantation for consignment arrangements. Net sales consists of the gross selling price of the product, less any discounts, rebates, fees paid to GPOs, and returns. Cost of goods sold and gross profit Cost of goods sold includes product testing costs, quality assurance costs, personnel costs, manufacturing costs, raw materials and product costs, depreciation and facility costs associated with our manufacturing and warehouse facilities. Fluctuations in our cost of goods sold correspond with the fluctuations in these costs as well as sales volume. Gross profit is calculated as net sales less cost of goods sold. Gross margin is calculated as gross profit divided by net sales. Our gross margin is affected by product and geographic sales mix, realized pricing of our products, the efficiency of our manufacturing operations and the costs of materials used to make our products. Regulatory actions, including with respect to reimbursement for our products, may require costly expenditures or result in pricing pressure, and may decrease our gross profit and gross margin. Selling, general and administrative expense Selling, general and administrative (“ SG&A ”) expense includes costs to execute our sales strategy. These include personnel costs pertaining to our sales force and sales support functions, including salaries, commissions and other incentive compensation, commissions to sales agents, customer support, travel expenses, and bad debt expense. SG&A expense also includes costs related to functions which support our business, such as legal, finance, human resources, and other such functions that include costs such as personnel costs, insurance, and certain professional fees. We expect our SG&A expense to fluctuate based on revenue fluctuations, geographic changes, and any changes to the size of our headcount, particularly that of our sales and marketing forces. Certain of these costs scale with sales, but can fluctuate depending on sales mix. For example, we pay sales agents a greater commission than our internal sales force, meaning that we could incur greater commission expenses if a greater proportion of our sales are through sales agents. Research and development expense Research and development expense relates to our investments to expand our product pipeline and platforms, including historically through clinical trials, as well as expenditures in improvements to our manufacturing process and the enhancement of existing products. Our research and development costs also include expenses such as salaries and benefits related to our research department, consulting costs and advisory costs, and regulatory costs. We expense research and development costs as incurred. Fluctuations in research and development expenses can be impacted by the timing and cadence of our clinical trials. Investigation, restatement and related expense Investigation, restatement and related expense primarily relates to legal fees advanced to certain former officers and directors of the Company under certain indemnification agreements and our liability from legal proceedings taken against us. The timing and extent of these expenses depend on the stage and status of legal proceedings. Other activity includes amounts received from certain director and officer insurance providers. Interest expense We incur interest expense primarily through stated interest on our outstanding term and revolving loans. The interest on our term and revolving loans are currently tied to applicable Secured Overnight Financing Rates (“ SOFR ”). Increases in SOFR 41 could cause our interest expense to increase. Other activity influencing interest expense relates to the amortization of deferred financing costs and original issue discount associated with credit facilities outstanding. Income Taxes We generate tax liability primarily in the United States and have net operating losses, research and development tax credit carryforwards, and other deferred tax assets which defray our liability. Large fluctuations are generally due to changes in our expectations of the realizability of our deferred tax assets. See “ Critical Accounting Estimates ” for further details. Results of Continuing Operations for 2023 Compared to 2022 Year Ended December 31, (in thousands) 2023 2022 $ Change % Change Net sales $ 321,477 $ 267,841 $ 53,636 20.0 % Cost of sales 54,634 48,316 6,318 13.1 % Gross profit 266,843 219,525 47,318 21.6 % Selling, general and administrative 211,124 208,673 2,451 1.2 % Research and development 12,665 12,701 (36) (0.3) % Investigation, restatement and related 5,176 12,177 (7,001) (57.5) % Amortization of intangible assets 762 701 61 8.7 % Interest expense, net (6,457) (5,016) (1,441) 28.7 % Other expense, net (26) (4) (22) nm Income tax provision benefit (expense) 36,806 (206) 37,012 nm Net income (loss) from continuing operations $ 67,439 $ (19,953) $ 87,392 nm Net Sales We recorded net sales for the year ended December 31, 2023 of $321.5 million, an increase of $53.6 million, or 20.0%, over the year ended December 31, 2022 net sales of $267.8 million. Our sales by care setting were as follows (amounts in thousands): Year Ended December 31, Change 2023 2022 $ % Hospital $ 187,000 $ 163,206 $ 23,794 14.6 % Private Office 95,789 77,158 $ 18,631 24.1 % Other 38,688 27,477 $ 11,211 40.8 % Total $ 321,477 $ 267,841 $ 53,636 20.0 % Net sales in the Hospital setting were $187.0 million for the year ended December 31, 2023, a $23.8 million, or 14.6% increase, compared to $163.2 million for the year ended December 31, 2022. The increase was primarily driven by sales of our new products introduced since the third quarter of 2022, particularly AMNIOEFFECT. Net sales in the Private Office setting grew by $18.6 million, or 24.1%, to $95.8 million for the year ended December 31, 2023, compared to $77.2 million for the year ended December 31, 2022. The increase reflects general increases in sales volume, driven by strong commercial execution, an evolving Medicare reimbursement landscape in this site of service and sales of our new products introduced since the fourth quarter of 2023. Net sales in Other care settings increased by $11.2 million, or 40.8%, to $38.7 million for the year ended December 31, 2023 compared to $27.5 million for the year ended December 31, 2022. The increase was primarily driven by the addition of new customers in certain other sites of service and, to a lesser extent, initial contributions related to our commercial efforts in Japan. 42 Gross Margin and Cost of Sales Gross margin in 2023 was 83.0%, compared to 82.0% in 2022. The increase in margin was driven by a higher proportion of sales with lower manufacturing costs as well as increased throughput efficiencies compared to 2022. Cost of sales for the year ended December 31, 2023 was $54.6 million, an increase of $6.3 million, or 13.1%, compared to $48.3 million for the year ended December 31, 2022. The increase in cost of sales was driven by the increase in sales volume and the changes in margins noted above. Selling, General and Administrative Expense SG&A expense increased $2.5 million, or 1.2%, to $211.1 million for December 31, 2023, compared to $208.7 million for December 31, 2022. The increase was driven by higher levels of sales commissions due to higher sales volumes, as well as increases in stock-based compensation in 2023. These increases were partially offset by a decrease in certain administrative expenses, including severance expenses associated with the departure of our former CEO in 2022. Research and Development Expense Our research and development (“ R&D ”) expense remained essentially flat at $12.7 million for the years ended December 31, 2023 and December 31, 2022. Our R&D expenses in 2022 and 2023 were primarily driven by the development and launches of our newest products in the portfolio, AMNIOEFFECT, AXIOFILL and EPIEFFECT, along with additional early-stage Wound & Surgical products in development. Investigation, Restatement and Related Expense Investigation, restatement, and related expenses decreased $7.0 million to $5.2 million for the year ended December 31, 2023, compared to $12.2 million for the year ended December 31, 2022. The decrease was related to negotiated reductions in legal fees previously incurred under indemnification agreements with certain former members of management year-over-year. In addition, following the end of a legal proceeding, expenses under our last material indemnification agreement substantially ceased in 2023. Prior to this, the Company had incurred significant expenses in fulfilling its obligations under indemnification agreements by advancing and reimbursing legal fees of certain former officers and directors of the Company. Amortization of Intangible Assets Amortization expense related to intangible assets increased $0.1 million from $0.7 million for the year ended December 31, 2022 to $0.8 million for the year ended December 31, 2023. Interest Expense, Net Interest expense increased $1.4 million to $6.5 million for the year ended December 31, 2023 from $5.0 million for the year ended December 31, 2022. The increase was the result of year-over-year increases in the reference market interest rates on our outstanding debt. We expect interest expense to decrease in future quarters as a result of our debt refinancing transactions completed on January 2024. Income Tax Provision The effective tax rate for 2023 and 2022 was (120.2)% and (1.0)%, respectively, on pre-tax book income from continuing operations of $30.6 million for 2023 and pre-tax book loss from continuing operations of $19.7 million for 2022. Our effective tax rate for the year ended December 31, 2023 was significantly influenced by the reversal of a valuation allowance, reflecting a change in the determination of the likelihood of the realizability of certain of the Company’s deferred tax assets as of that date. This re-evaluation occurred as a result of the conclusion that the disbanding of our Regenerative Medicine segment qualified as a discontinued operation, in concert with the Company’s operating results. Net operating losses incurred during 2022 were offset by a full valuation allowance. Liquidity and Capital Resources We require capital for our operating activities, including costs associated with the sale of product through direct and indirect sales channels, research and development activities, compliance costs, costs to sell and market our products, regulatory fees, and legal and consulting fees in connection with ongoing litigation and other matters. We generally fund our operating capital requirements through our operating activities and cash reserves. We expect to use capital to invest in the broadening of our 43 product portfolio, including through potential acquisitions, licensing agreements or other arrangements, the international expansion of our business and certain capital projects. As of December 31, 2023, we had $82.0 million of cash and cash equivalents. Our net working capital at December 31, 2023 was $118.3 million, an increase of $27.6 million from $90.6 million at December 31, 2022. Our current ratio was 3.6 to 1 as of December 31, 2023 and 3.1 to 1 as of December 31, 2022. The Company is currently paying its obligations in the ordinary course of business. We believe that our anticipated cash from operating activities, existing cash and cash equivalents, and available credit under the Citizens Credit Agreement, as defined below, will enable us to meet our operational liquidity needs for the twelve months following the filing date of this Annual Report. Contractual Obligations Contractual obligations associated with ongoing business activities are expected to result in cash payments in future periods. See Item 8, Note 16, Commitments and Contingencies , in the Consolidated Financial Statements for more information regarding our contractual commitments. Citizens Loan Facilities On January 19, 2024, we entered into a Credit Agreement (the “ Citizens Credit Agreement ”) with a syndicate of banks comprised of Citizens Bank, N.A. as administrative agent (the “ Agent ”), and Bank of America, N.A. The Citizens Credit Agreement was designed to simultaneously improve our capital structure, providing the ability to refinance the $50 million Hayfin Term Loan at lower interest rates and have access to additional borrowing capacity that could be deployed in the future in support of our organic and potential inorganic growth objectives. The Citizens Credit Agreement provides for senior secured credit facilities in an aggregate principal amount of up to $95.0 million consisting of: (i) a $75.0 million senior secured revolving credit facility (the “ Revolving Credit Facility ”) with a $10.0 million letter of credit sublimit and a $10.0 million swingline loan sublimit, and (ii) a $20.0 million senior secured term loan facility (the “ Term Loan Facility ” and, together with the Revolving Credit Facility, the “ Credit Facilities ”). All obligations are required to be paid in full on January 19, 2029 (the “ Maturity Date ”), and are guaranteed by certain of the Company’s subsidiaries, and secured by substantially all of the assets of the Company and the guarantors pursuant to a customary security agreement. Subject to the terms of the Citizens Credit Agreement, the Company has the option to obtain one or more incremental term loan facilities and/or increase the commitments under the Revolving Credit Facility in an aggregate principal amount equal to the greater of (i) $50.0 million and (ii) 1.00 times the Company’s Consolidated EBITDA as defined therein, each subject to the existing or any new lenders’ election to extend additional term loans or revolving commitments. At our option, borrowings under the Citizens Credit Agreement (other than any swingline loan) will bear interest at a rate per annum equal to (i) the Alternate Base Rate, as defined therein, or (ii) a Term SOFR as defined therein, in each case plus an applicable margin ranging from 1.25% and 2.50% with respect to Alternate Base Rate borrowings and 2.25% and 3.50% for Term SOFR borrowings. Swingline loans will bear interest at a rate per annum equal to one-month Term SOFR plus the applicable margin. The applicable margin will be determined based on the Company’s consolidated total net leverage ratio. The Company is required to pay a quarterly commitment fee on any unused portion of the Revolving Credit Facility, letter of credit fees, and other customary fees to the Agent and the Lenders. The Term Loan Facility will amortize on a quarterly basis at 1.25% (for year one and two), 1.875% (for year three and four), and 2.5% (for year five) based on the aggregate principal amount outstanding under the Term Loan Facility, with the remainder due on the Maturity Date. The Company must make mandatory prepayments in connection with certain asset dispositions and casualty events, subject in each case to customary reinvestment rights. The Company may prepay borrowings under the Credit Facilities at any time, without premium or penalty, and may, at its option, reduce the aggregate unused commitments under the Revolving Credit Facility in whole or in part, in each case subject to the terms of the Credit Agreement. The Company must also comply with certain financial covenants, including a maximum total net leverage ratio and a minimum consolidated fixed charge coverage ratio, as well as other customary restrictive covenants. 44 In addition, on January 19, 2024, we borrowed $30.0 million under the Revolving Credit Facility and $20.0 million under the Term Loan Facility. Proceeds from the initial drawings under the Credit Facilities, together with cash on hand, were used to repay in full the $50.0 million principal amount and other obligations under that certain Loan Agreement, dated as of June 30, 2020 (as amended from time to time), by and among the Company, the guarantors party thereto, the lenders party thereto and Hayfin Services LLP, as administrative and collateral agent (as amended from time to time, the “ Hayfin Loan Agreement ”) and to pay related fees, premiums, costs and expenses (collectively with the entry into the Citizens Credit Agreement and the initial borrowings thereunder, the “ Debt Refinancing Transactions ”). On February 27, 2024, we repaid the initial $30.0 million drawing under the Revolving Credit Facility. Hayfin Term Loan In June 2020, we entered into the Hayfin Loan Agreement, under which Hayfin provided us with a senior secured term loan of $50 million (the “ Hayfin Term Loan ”). The Hayfin Term Loan was to mature on June 30, 2025 (the “ Maturity Date ”). Interest on any borrowings was based on SOFR, plus a fallback provision of 0.15%, subject to a floor of 1.5%, plus a margin of 6.75%. As of December 31, 2023, the Hayfin Term Loan carried an interest rate of 12.3%. As noted above, in January 2024, we repaid in full the Hayfin Term Loan as part of the Debt Refinancing Transactions and terminated the Hayfin Loan Agreement. Separation Agreement In 2022, the Company entered into a Separation Agreement and General Release with Timothy R. Wright, the former Chief Executive Officer of the Company (the “ Separation Agreement ”). Pursuant to the terms of the Separation Agreement and Mr. Wright’s general release of all claims against the Company, the Company will pay Mr. Wright a total of $3.1 million in cash in a series of installments through September 2024. Of this amount, $1.2 million is reflected in accrued compensation in the consolidated balance sheet as of December 31, 2023. Discussion of Cash Flows for 2023 Compared to 2022 Operating Activities from Continuing Operations During the year ended December 31, 2023, net cash provided by operating activities of continuing operations increased $42.9 million to $34.9 million compared to cash used of $8.0 million for the year ended December 31, 2022. The increase in cash provided by operating activities was primarily as a result of year-over-year increases in net sales, which drove increases in collections from customers, as well as year-over-year decreases in operating expenses during the year ended December 31, 2023. Investing Activities During the year ended December 31, 2023, net cash used in investing activities was $2.2 million, a decrease of $0.5 million, compared to $2.7 million for the year ended December 31, 2022. The primary reason for the decrease was a $0.5 million increase in capital expenditures, year-over-year, offset by $1.0 million of payments made pursuant to a licensing agreement in 2022. Financing Activities During the year ended December 31, 2023, net cash used in financing activities was $8.6 million, an increase of $8.0 million compared to cash used in financing activities of $0.6 million for the year ended December 31, 2022. During 2023, we repurchased 5,000 shares of our Series B Preferred Stock for $9.5 million. The repurchase was offset by increases in proceeds from option exercises ($0.3 million) and decreases in stock repurchases for tax withholdings ($1.2 million). Critical Accounting Estimates This Management’s Discussion and Analysis of Financial Condition and Results of Operations discusses our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America (“ GAAP ”). The preparation of these financial statements requires that we make judgments and estimates which may affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. We derive these judgments and estimates on historical experience and other relevant factors which we believe to be reasonable. Actual results may differ from these estimates. Share-Based Compensation 45 Description We measure the fair value of stock options and other stock-based awards granted to employees on the grant date and recognize the assessed fair value as share-based compensation expense, straight-line, over the requisite service period to achieve the award based on the vesting requirements, to the extent that the achievement of performance conditions associated with such awards, as applicable, are determined to be “probable.” Judgments and Uncertainties Share-based payment arrangements are measured at fair value on the grant date. The fair value of equity incentive awards, which are usually shares of our common stock, are generally measured at the last trading price on the grant date. The fair value of stock options is calculated using an appropriate valuation technique. The valuation technique generally requires us to make certain assumptions, including (1) the fair value of the common stock, (2) the expected volatility of our stock price, (3) the expected term of the award, (4) the risk-free interest rate, and (5) expected dividends. Our expectation for volatility is generally based on historical daily share price movements, with certain adjustments for abnormal share price activity associated with events which are not expected to recur during the expected term. The expected term of the award requires us to make assumptions regarding the post-vesting behavior of the recipients, which is based off available evidence. Our assumption for the risk-free rate is derived from prevailing U.S. Treasuries with similar terms to the award on the grant date. Our assumption for dividends is derived from our own dividend history. To the extent that any such awards are subject to a market condition, the resolution of the market condition is reflected in the fair value of the grant date. Further, the requisite service period associated with an award containing a market condition must derive the service period over which the market condition is expected to be met. Fair value and derived service periods are generally determined using a Monte Carlo simulation. Subsequent to the determination of fair value, we recognize expense to the extent we evaluate that performance conditions associated with share-based payment arrangements are probable of occurring. In certain cases where the extent of vesting is based on the extent of achievement, we are required to determine the extent to which achievement is probable. We determine probable performance based on actual performance to date, internally-developed budgets and forecasts for periods covered by the relevant performance condition, and other evidence deemed relevant to this determination. We re-evaluate our probability assessments at least quarterly, with any revisions reflected as a cumulative adjustment to expense. Because of the cumulative nature of adjustments, during any period in which we re-evaluate probability, the adjustments could significantly impact our results of operations. Sensitivity of Estimate to Change For the year ended December 31, 2023, we granted stock options with a fair value on the grant date of $7.0 million. This estimate was determined using a Monte Carlo simulation using the following inputs: Assumption Stock price on grant date $ 3.70 Exercise price $ 3.70 Risk-free interest rate 3.58 % Expected volatility (annualized) 75.00 % Dividend yield — % Weighted average grant date fair value $ 1.93 The granted stock options reflected an expected term based on our expectations for exercise activity. Changes in any of these assumptions could result in a revised estimate of fair value of the granted stock options, which would impact the amount of expense recognized over the requisite service period, and could materially affect the total fair value or the amount of expense recognized in a particular period. In addition, cumulative expense recognized for unvested performance stock unit awards was $1.7 million for the year ended December 31, 2023. This is based on determinations regarding probable resolution or the extent of probable resolution of relevant performance conditions to earn such awards. If it is subsequently determined that the performance conditions associated with these awards are no longer probable of being met, or performance conditions which were determined to be probable of occurring do not actually occur, we could reverse up to this amount of expense in the period such determination is made. Furthermore, if probable levels of achievement are later determined to be greater, or actual achievement exceeds the level 46 of achievement assessed as probable, we could record increases to expense to reflect this level of achievement. The amount of any incremental expense recognition or reversal will depend on the magnitude and timing of such change in estimate. Net Sales Description We record estimates for returns and allowances as a reduction to net sales based on our expectation for such returns. Judgments and Uncertainties We sell our products to individual customer and independent distributors (collectively referred to as “ customers ”). Customers obtain and use products either through ship and bill sales or consignment arrangements. We recognize revenue as performance obligations are fulfilled, which generally occurs upon the shipment of product to customers for ship and bill sales or upon implantation for consignment sales. We recognize revenue based on consideration we expect to receive from the sale. This consists of the gross selling price of the product, less any discounts, rebates, fees paid to GPOs, and an expectation for sales returns. We maintain a return policy that allows our customers to return product for any reason within 30 days of sale, and to return product that is damaged or non-conforming, ordered in error, or due to recall at any time. We anticipate increases in sales returns in light of potential or actual regulatory actions. We derive an expectation for product returns based on historical return patterns and other factors, including shifts in our regulatory environment and product recalls. Determinations involving other factors are based on our estimates for product at customer sites that are eligible for return. Additions or reversals to our return allowance, as determined necessary, are accounted for prospectively and recorded as a decrease or increase to net sales, respectively. Actual returns are recorded against the recorded accrual. Sensitivity of Estimate to Change We have accrued $1.1 million for sales returns as of December 31, 2023. Changes in return patterns or unforeseen changes in regulations or identified product recalls could cause returns significantly in excess of this estimate. Income Taxes Description We record a valuation allowance to offset our net deferred tax asset to the extent that realization is not likely. Judgments and Uncertainties Deferred income taxes arise from temporary differences between the tax basis of assets and liabilities and their reported amounts in the financial statements. Transactions which result in lower taxable income in the future give rise to deferred tax assets. We evaluate our ability to recover deferred tax assets based on projected future taxable income, scheduled reversals of deferred tax liabilities, tax planning strategies, and our recent operating results. Judgment is required to determine whether the totality of this evidence suggests that we can recover our deferred tax assets in the future. Sensitivity of Estimate to Change As of December 31, 2023, we had $0.9 million in valuation allowances recorded against our deferred tax assets balance of $41.7 million. The amount and extent of the valuation allowance necessary to reflect the extent of realization of these deferred tax assets being more likely than not may change due to changes in tax law, a revision to our expectation regarding taxable income in the future, taxable income generated in a period in which we had not previously anticipated taxable income, a change in scheduled reversals of deferred tax liabilities, and other changes. If the weight of available evidence suggests that some or all of this amount is more likely than not to be realized, we will change the valuation allowance with a corresponding adjustment to income tax provision (benefit) expense to the extent that the underlying deferred tax asset is more likely than not to be realized. 47 Recently Adopted Accounting Pronouncements See Item 8, Note 2, Significant Accounting Policies , in the Consolidated Financial Statements for recently adopted accounting pronouncements.