MSA Safety Inc 10-Q

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis should be read in conjunction with the historical financial statements and other financial information included elsewhere in this quarterly report on Form 10-Q. This discussion may contain forward-looking statements that involve risks and uncertainties. The forward-looking statements are not historical facts, but rather are based on current expectations, estimates, assumptions and projections about our industry, business and future financial results. Our actual results could differ materially from the results contemplated by these forward-looking statements due to a number of factors, including those discussed in the sections of our annual report entitled “Forward-Looking Statements” and “Risk Factors,” and those discussed in our Form 10-Q quarterly reports filed after such annual report (such as in Part II, Item 1A, “Risk Factors.”) BUSINESS OVERVIEW MSA is a global leader in the development, manufacture and supply of safety products that protect people and facility infrastructures. Recognized for their market leading innovation, many MSA products integrate a combination of electronics, mechanical systems and advanced materials to protect users against hazardous or life-threatening situations. The Company's comprehensive product line, which is governed by rigorous safety standards across highly regulated industries, is used by workers around the world in a broad range of markets, including fire service, oil, gas and petrochemical industry, construction, industrial manufacturing applications, utilities, mining and the military. MSA's core products include breathing apparatus, fixed gas and flame detection systems, portable gas detection instruments, industrial head protection products, firefighter helmets and protective apparel, and fall protection devices. We are committed to providing our customers with service unmatched in the safety industry and, in the process, enhancing our ability to provide a growing line of safety solutions for customers in key global markets. On January 5, 2023, the Company divested Mine Safety Appliances LLC ("MSA LLC"), a wholly owned subsidiary that holds legacy product liability claims relating to coal dust, asbestos, silica, and other exposures, to Sag Main Holdings, LLC, a joint venture between R&Q Insurance Holdings Ltd. (“R&Q"”) and Obra Capital, Inc. (“Obra”). In connection with the closing, MSA contributed $341.2 million in cash and cash equivalents, while R&Q and Obra contributed an additional $35.0 million. As a result of the transaction, MSA derecognized all legacy cumulative trauma product liability reserves, related insurance assets, and associated deferred tax assets of the divested subsidiary from its balance sheet in the first quarter of 2023. R&Q and Obra have assumed management of the divested subsidiary, including the management of its claims. Refer to Note 17—Contingencies to the unaudited condensed consolidated financial statements in Part I Item 1 of this Form 10-Q for further information. We tailor our product offerings and distribution strategy to satisfy distinct customer preferences that vary across geographic regions. To best serve these customer preferences, we have organized our business into four geographical operating segments that are aggregated into three reportable geographic segments: Americas, International and Corporate. Americas. Our largest manufacturing and research and development facilities are located in the United States. We serve our markets across the Americas with manufacturing facilities in the U.S., Mexico and Brazil. Operations in the other countries within the Americas segment focus primarily on sales and distribution in their respective home country markets. International. Our International segment includes companies in Europe, the Middle East and Africa ("EMEA") and the Asia Pacific region. In our largest International subsidiaries (in Germany, France, U.K., Ireland and China), we develop, manufacture and sell a wide variety of products. In China, the products manufactured are sold primarily in China as well as in regional markets. Operations in other International segment countries focus primarily on sales and distribution in their respective home country markets. Although some of these companies may perform limited production, most of their sales are of products manufactured in our plants in Germany, France, the U.S., U.K., Ireland and China or are purchased from third-party vendors. Corporate. The Corporate segment primarily consists of general and administrative expenses incurred in our corporate headquarters, costs associated with corporate development initiatives, legal expense, interest expense, foreign exchange gains or losses and other centrally-managed costs. Corporate general and administrative costs comprise the majority of the expense in the Corporate segment. -23- Table of Contents PRINCIPAL PRODUCTS The following is a brief description of each of our principal product categories: MSA's corporate strategy includes a focus on driving sales of core products, where we have leading market positions and a distinct competitive advantage. Core products, as mentioned above, include breathing apparatus where self-contained breathing apparatus is the principal product, fixed gas and flame detection systems, portable gas detection instruments, industrial head protection products, firefighter helmets and protective apparel, and fall protection devices. Core products comprised approximately 91% of sales for both the three months ended March 31, 2023 and 2022. MSA also maintains a portfolio of non-core products. Non-core products reinforce and extend the core offerings, drawing upon our customer relationships, distribution channels, geographical presence and technical experience. These products are complementary to the core offerings and sometimes reflect more episodic or contract-driven growth patterns. Key non-core products include air-purifying respirators, eye and face protection, ballistic helmets and gas masks. MSA maintains a diversified portfolio of safety products that protect workers and facility infrastructure across a broad array of end markets. While the company sells its products through distribution, which can limit end-user visibility, the Company provides estimated ranges of end market exposure to facilitate understanding of its growth drivers. The Company estimates that approximately 35%-40% of its overall revenue is derived from the fire service market and approximately 25%-30% of its revenue is derived from the energy market. The remaining revenue is split among construction, utilities, general industrial applications, military and mining. A detailed listing of our significant product offerings in the aforementioned product groups above is included in MSA's Annual Report on Form 10-K for the year ended December 31, 2022. RESULTS OF OPERATIONS Three Months Ended March 31, 2023, Compared to Three Months Ended March 31, 2022 Net Sales. Net sales for the three months ended March 31, 2023, were $398.3 million, an increase of $67.6 million, or 20.4%, compared to $330.7 million in the same period last year, driven by pricing actions to keep pace with inflation and volume growth. We saw healthy growth across product categories. Please refer to the Net Sales table for a reconciliation of the quarter over quarter sales change. Net Sales Three Months Ended March 31, Dollar Increase Percent Increase (In millions) 2023 2022 Consolidated $398.3 $330.7 $67.6 20.4% Americas 280.3 225.7 54.6 24.2% International 118.0 105.0 13.0 12.4% Net Sales Three Months Ended March 31, 2023 versus March 31, 2022 (Percent Change) Americas International Consolidated GAAP reported sales change 24.2% 12.4% 20.4% Currency translation effects (0.5)% 5.6% 1.6% Constant currency sales change 23.7% 18.0% 22.0% Note: Constant currency sales change is a non-GAAP financial measure provided by the Company to give a better understanding of the Company's underlying business performance. Constant currency sales change is calculated by deducting the percentage impact from currency translation effects from the overall percentage change in net sales. Net sales for the Americas segment were $280.3 million in the first quarter of 2023, an increase of $54.6 million, or 24.2%, compared to $225.7 million in the first quarter of 2022. Constant currency sales in the Americas segment increased 23.7%. This growth was driven by increases in all products, particularly portable gas detection and firefighter helmets and protective apparel, primarily turnout gear, associated with strong demand and improved output. -24- Table of Contents Net sales for the International segment were $118.0 million in the first quarter of 2023, an increase of $13.0 million, or 12.4%, compared to $105.0 million for the first quarter of 2022. Constant currency sales in the International segment increased 18.0% during the quarter. This growth was driven by strength across most core products, partially offset by a decrease in firefighter helmets and protection apparel. Healthy order growth in the quarter drove an increase in backlog when compared against year-end 2022. Backlog increased across substantially all products. Looking ahead, we continue to operate in a very dynamic environment. There are a number of other evolving factors that will continue to influence our revenue and earnings outlook. These factors include, among other things, supply chain constraints, raw material or semiconductor availability, industrial employment rates, interest rate changes, military conflict, currency exchange volatility, the pace of economic recovery, as well as geopolitical risk, particularly as it relates to energy uncertainty which could affect operations and suppliers based in Germany and broader Europe. These or other conditions could impact our future results and growth expectations throughout 2023. Refer to Note 8—Segment Information to the unaudited condensed consolidated financial statements in Part I Item 1 of this Form 10-Q, for information regarding sales by product group. Gross profit . Gross profit for the first quarter of 2023 was $181.4 million, an increase of $38.6 million or 27.0%, compared to $142.8 million for the first quarter of 2022. The ratio of gross profit to net sales was 45.5% in the first quarter of 2023 compared to 43.2% in the same quarter last year. Volume leverage, pricing and productivity efforts kept pace with inflation and we will continue to manage this price/cost dynamic throughout 2023. Selling, general and administrative expenses. Selling, general and administrative ("SG&A") expenses were $91.1 million during the first quarter of 2023, an increase of $12.5 million or 16.0%, compared to $78.6 million for the same period a year ago. Overall, SG&A expenses were 22.9% of net sales during the first quarter of 2023, compared to 23.8% of net sales during the same period in 2022. Constant currency SG&A increased by approximately $13.7 million or 17.9%, demonstrating strong leverage on revenue growth. The increase in SG&A is directly attributable to the 20% sales growth in the quarter. The increase was driven by higher variable compensation associated with sales performance as well as additional travel and advertising costs to support the higher business activity. Please refer to the SG&A expenses table for a reconciliation of the quarter over quarter expense change. Selling, general, and administrative expenses Three Months Ended March 31, 2023 versus March 31, 2022 (Percent Change) Consolidated GAAP reported change 16.0% Currency translation effects 1.9% Constant currency change 17.9% Research and development expense . Research and development expense was $15.2 million during the first quarter of 2023, an increase of $1.9 million, compared to $13.3 million during the first quarter of 2022. Research and development expense was 3.8% of net sales in the first quarter of 2023 compared to 4.0% in the same period of 2022. During the first quarter of 2023 and 2022, we capitalized $3.0 million and $2.2 million of software development costs, respectively. Depreciation expense for capitalized software development cost of $2.3 million and $1.7 million during the first quarter of 2023 and 2022, respectively, was recorded in costs of products sold on the unaudited Condensed Consolidated Statements of Operations. MSA remains committed to dedicating significant resources to research and development activities, including the development of technology-based safety solutions. As we continue to invest a significant portion of our new product development into technology-based safety solutions, we anticipate that the historical relationship of research and development expense to net sales will continue to evolve; however, we do not anticipate reductions in the relative level of total spend on research and development activities on an annual basis. Total spend on both software development and research and development activities was $18.2 million and $15.5 million during the quarters ended March 31, 2023 and 2022, respectively. Restructuring charges . Restructuring charges of $1.7 million during the first quarter of 2023 were primarily related to manufacturing footprint optimization activities. This compared to restructuring charges of $2.2 million during the first quarter of 2022 which were primarily related to the expansion of our European Shared Service Center in Warsaw, Poland. We remain focused on executing programs to further optimize our cost structure. -25- Table of Contents Currency exchange . Currency exchange losses were $4.2 million in the first quarter of 2023 compared to $3.3 million in the first quarter of 2022. The currency exchange losses for both periods related primarily to foreign currency exposure on unsettled inter-company balances. Refer to Note 15—Derivative Financial Instruments to the unaudited condensed consolidated financial statements in Part I Item 1 of this Form 10-Q, for information regarding our currency exchange rate risk management strategy. Product liability expense. Product liability expense for the first quarter of 2023 was minimal due to our divestiture of MSA LLC, as discussed further in Note 17—Contingencies to the unaudited condensed consolidated financial statements in Part I Item 1 of this Form 10-Q. This compared to $2.8 million in the first quarter of 2022 which related primarily to defense costs incurred for cumulative trauma product liability claims. Loss on divestiture of MSA LLC. The $129.2 million pre-tax loss on divestiture of MSA LLC for the first quarter of 2023 relates to the derecognition of all legacy cumulative trauma product liability reserves and related insurance assets of the divested subsidiary during the first quarter of 2023. The loss also includes a $341.2 million contribution of cash and cash equivalents, as well as transaction related costs of $5.6 million. Refer to Note 17—Contingencies to the unaudited condensed consolidated financial statements in Part I Item 1 of this Form 10-Q for further information. GAAP operating income. Consolidated operating loss for the first quarter of 2023 was $60.1 million compared to operating income of $42.7 million in the same period last year. The decrease in operating results was primarily driven by the loss on divestiture of MSA LLC partially offset by higher sales and gross margin. Adjusted operating income. Americas adjusted operating income for the first quarter of 2023 was $71.7 million, an increase of $19.3 million or 36.7% compared to $52.4 million in the prior year first quarter. The increase in adjusted operating income is primarily attributable to higher sales and gross margin. International adjusted operating income for the first quarter of 2023 was $15.8 million, an increase of $6.8 million, or 74.9%, compared to $9.0 million in the prior year first quarter. The increase in adjusted operating income is primarily attributable to higher sales and gross margin. Corporate segment adjusted operating loss for the first quarter of 2023 was $10.1 million, an increase of $2.5 million in comparison to an adjusted operating loss of $7.6 million in the first quarter of 2022, driven by higher compensation expense, primarily performance based compensation which was impacted by the sales growth and improved results from prior year. The following tables represent a reconciliation from GAAP operating income to adjusted operating income (loss) and adjusted EBITDA. Adjusted operating margin % is calculated as adjusted operating income (loss) divided by net sales and adjusted EBITDA margin % is calculated as adjusted EBITDA divided by net sales. Adjusted operating income (loss) Three Months Ended March 31, 2023 (In thousands) Americas International Corporate Consolidated Net sales $ 280,267 $ 117,995 $ — $ 398,262 GAAP operating loss (60,061) Restructuring charges (Note 3) 1,747 Currency exchange losses, net 4,175 Loss on divestiture of MSA LLC (Note 17) 129,211 Product liability expense (Note 17) 3 Amortization of acquisition-related intangible assets 2,305 Adjusted operating income (loss) 71,694 15,779 (10,093) 77,380 Adjusted operating margin % 25.6 % 13.4 % Depreciation and amortization 12,267 Adjusted EBITDA 80,494 19,058 (9,905) 89,647 Adjusted EBITDA margin % 28.7 % 16.2 % -26- Table of Contents Adjusted operating income (loss) Three Months Ended March 31, 2022 (In thousands) Americas International Corporate Consolidated Net sales $ 225,648 $ 105,044 $ — $ 330,692 GAAP operating income 42,668 Restructuring charges (Note 3) 2,189 Currency exchange losses, net 3,271 Product liability expense (Note 17) 2,772 Amortization of acquisition-related intangible assets 2,336 Transaction costs (a) 607 Adjusted operating income (loss) 52,435 9,024 (7,616) 53,843 Adjusted operating margin % 23.2 % 8.6 % Depreciation and amortization 11,829 Adjusted EBITDA 60,796 12,362 (7,486) 65,672 Adjusted EBITDA margin % 26.9 % 11.8 % (a) Transaction costs include advisory, legal, accounting, valuation, and other professional or consulting fees incurred during acquisitions and divestitures. These costs are included in selling, general and administrative expense in the unaudited Condensed Consolidated Statements of Operations. Note: Adjusted operating income (loss) and adjusted EBITDA are non-GAAP financial measures. Adjusted operating income (loss) is reconciled above to the nearest GAAP financial measure, Operating income (loss), and excludes restructuring, currency exchange, product liability expense, loss on divestiture of MSA LLC, transaction costs and acquisition-related amortization. Adjusted EBITDA is reconciled above to the nearest GAAP financial measure, Operating income (loss) and excludes depreciation and amortization expense. Total other expense (income), net. Total other expense, net, for the first quarter of 2023 was $7.7 million, compared to total other income, net, of $2.7 million for the same period in 2022 driven primarily by higher interest expense related to higher interest rates, increased debt balances and decreased pension income driven by a lower expected rate of return. Income taxes. The reported effective tax rate for the first quarter of 2023 was (121.7)% compared to 21.7% for the first quarter of 2022. This significant variance from the prior year is primarily due to the divestiture of MSA LLC and the non-deductible loss recorded on the derecognition of the product liability reserves and related assets. Refer to Note 17—Contingencies to the unaudited condensed consolidated financial statements in Part I Item 1 of this Form 10-Q for further information on this transaction. We are subject to regular review and audit by both foreign and domestic tax authorities. While we believe our tax positions will be sustained, the final outcome of tax audits and related litigation may differ materially from the tax amounts recorded in our unaudited condensed consolidated financial statements. Net (loss) income . Net loss was $150.2 million for the first quarter of 2023, or $(3.83) per diluted share compared to net income of $35.5 million, or $0.90 per diluted share, for the same period last year. -27- Table of Contents LIQUIDITY AND CAPITAL RESOURCES Our main source of liquidity is operating cash flows, supplemented by borrowings. Our principal liquidity requirements are for working capital, capital expenditures, principal and interest payments on debt, declared dividend payments and acquisitions. At March 31, 2023, approximately 30% of our long-term debt is at fixed interest rates with repayment schedules through 2036. The remainder of our long-term debt is at variable rates on an unsecured revolving credit facility and a term loan, both due in 2026. At March 31, 2023, approximately 89% of our borrowings are denominated in U.S. dollars, which limits our exposure to currency exchange rate fluctuations. At March 31, 2023, the Company had cash and cash equivalents totaling $138.9 million and access to sufficient capital, providing ample liquidity and flexibility to continue to maintain our balanced capital allocation strategy that prioritizes growth investments, funding our dividends and servicing debt obligations. Cash, cash equivalents and restricted cash decreased $23.8 million during the first quarter of 2023 primarily as a result of the MSA LLC divestiture as discussed below, compared to increasing $6.3 million during the same period in 2022. We believe MSA's healthy balance sheet and access to significant capital at March 31, 2023, positions us well to navigate through challenging business conditions and supply chain constraints or other unexpected events. Operating activities. Operating activities used cash of $285.9 million during the first quarter of 2023, compared to providing $24.5 million during the same period in 2022. The decreased operating cash flow as compared to the same period in 2022 was primarily related to the contribution of $341.2 million in the divestiture of MSA LLC. Refer to Note 17—Contingencies to the unaudited condensed consolidated financial statements in Part I Item 1 of this Form 10-Q for further information. This decrease was partially offset by working capital improvements, notably for trade receivables. Investing activities. Investing activities used cash of $8.4 million during the first quarter of 2023, compared to providing $1.1 million during the same period in 2022. The increase in cash used in investing activities as compared to the same period in 2022 was primarily related to the absence of short-term investment activity. Our investments in available-for-sale marketable securities, primarily fixed income, were transferred to Sag Main Holdings, LLC, as part of our MSA LLC divestiture as described in Note 17—Contingencies to the unaudited condensed consolidated financial statements in Part I Item 1 of this Form 10-Q. We remain committed to evaluating additional acquisition opportunities that will allow us to continue to grow in key end markets and geographies. Financing activities. Financing activities provided cash of $272.8 million during the first quarter of 2023 compared to using cash of $15.9 million during the same period in 2022. During the first quarter of 2023, we had net proceeds from long-term debt of $295.4 million to fund the MSA LLC divestiture as compared to net proceeds from long-term debt of $5.0 million during the same period in 2022. We paid cash dividends of $18.0 million during the first quarter of 2023, compared to $17.3 million in the same period in 2022. We also used cash of $3.7 million during both the three months ended March 31, 2023, and 2022, to repurchase shares related to employee stock compensation transactions. CUMULATIVE TRANSLATION ADJUSTMENTS The position of the U.S. dollar relative to international currencies, primarily the euro and British pound, at March 31, 2023, resulted in a translation gain of $11.2 million being recorded to the cumulative translation adjustments shareholders' equity account during the first quarter of 2023, compared to a $5.9 million translation gain being recorded to the cumulative translation adjustments shareholders' equity account during the same period in 2022. COMMITMENTS AND CONTINGENCIES We made contributions of $2.0 million to our pension plans during the first quarter of 2023. We expect to make total contributions of approximately $8.2 million to our pension plans in 2023 primarily associated with statutorily required plans in the International segment. The Company had outstanding bank guarantees and standby letters of credit with banks as of March 31, 2023, totaling $9.7 million, of which $1.5 million relate to the senior revolving credit facility. These letters of credit serve to cover customer requirements in connection with certain sales orders and insurance companies. The Company is also required to provide cash collateral in connection with certain arrangements. At March 31, 2023, the Company has $1.7 million of restricted cash in support of these arrangements. We have purchase commitments for materials, supplies, services, and property, plant and equipment as part of our ordinary conduct of business. Please refer to Note 17—Contingencies to the unaudited condensed consolidated financial statements in Part I Item 1 of this Form 10-Q for further discussion on the Company's single incident and cumulative trauma product liabilities. -28- Table of Contents CRITICAL ACCOUNTING POLICIES AND ESTIMATES We prepare our unaudited condensed consolidated financial statements in accordance with accounting principles generally accepted in the United States of America ("U.S. GAAP"). The preparation of these unaudited condensed consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and the related disclosures. We evaluate these estimates and judgments on an on-going basis based on historical experience and various assumptions that we believe to be reasonable under the circumstances. However, different amounts could be reported if we had used different assumptions and in light of different facts and circumstances. Actual amounts could differ from the estimates and judgments reflected in our unaudited condensed consolidated financial statements. The more critical judgments and estimates used in the preparation of our unaudited condensed consolidated financial statements are discussed in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended December 31, 2022. RECENTLY ADOPTED AND RECENTLY ISSUED ACCOUNTING STANDARDS None. -29- Table of Contents