Item 7. Management’s Discussion and Analysis
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis summarize the significant factors affecting our results of operations and financial condition during the years ended December 31, 2021, 2020 and 2019 and should be read in conjunction with the information included under Item 1. Business and Item 8. Financial Statements and Supplementary Data included elsewhere in this Annual Report. We prepare our financial statements in accordance with accounting principles generally accepted in the United States (“GAAP” or “U.S. GAAP”) and in U.S. Dollars.
This section discusses year-to-year comparisons between 2021 and 2020. For discussions on year-to-year comparison between 2020 and 2019, refer to Part II, Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report in Form 10-K, which was filed with the United States Securities and Exchange Commission (“SEC”) on February 18, 2021.
Overview
In 2021, our net sales was $1,546.8 million, sales volumes was 964.3 kmt, net income was $134.7 million, and Adjusted EBITDA was $268.4 million.
• Specialty Carbon Black Segment —Adjusted EBITDA was $148.4 million, and the Adjusted EBITDA Margin was 24.8%. This segment accounted for 38.7% of our total revenue, 55.3% of total Adjusted EBITDA and 27.3% of our total volume in kmt in 2021.
• Rubber Carbon Black Segment —Adjusted EBITDA was $120.0 million, and Adjusted EBITDA Margin was 12.7%. This segment accounted for 61.3% of our total revenue, 44.7% of total Adjusted EBITDA and 72.7% of our total volume in kmt in 2021.
Key Factors Affecting Our Results of Operations
We believe that certain factors have had, and will continue to have, a material effect on our results of operations and financial condition. As many of these factors are beyond our control and certain of these factors have historically been volatile, past performance will not necessarily be indicative of future performance and it is difficult to predict future performance with any degree of certainty. In addition, important factors that could cause our actual results of operations or financial conditions to differ materially from those expressed or implied below, include, but are not limited to, factors indicated under “ Item 1A. Risk Factors ”, and “ Cautionary Statement for the Purposes of the “Safe Harbor” Provisions of the Private Securities Litigation Reform Act of 1995 ” elsewhere in this Annual Report.
Recent Developments and Certain Known Trends
General Economic Conditions, Cyclicality and Seasonality
In 2021, our business saw a strong rebound in operations compared to fiscal 2020 which was adversely affected by the COVID-19 pandemic. Despite demand improvement for our products during 2021, COVID-19 pandemic infection rate remains high in many parts of the world, which could impact demand. Other factors impacting us are high raw material costs, and availability and costs of global transportation.
Reconciliation of Non-GAAP Financial Measures
We present certain financial measures that are not prepared in accordance with GAAP or the accounting standards of any other jurisdiction and may not be comparable to other similarly titled measures of other companies. For a reconciliation of these non-GAAP financial measures to the most directly comparable GAAP measures, see section Reconciliation of Non-GAAP Financial Measures below.
These non-GAAP measures are, but are not limited to, Contribution Margin, Contribution Margin per metric ton (collectively, “Contribution Margins”), Adjusted EBITDA, Net Working Capital and Capital Expenditures. We define Contribution Margin as revenue less variable costs (such as raw materials, packaging, utilities and distribution costs). We define Contribution Margin per Metric Ton as Contribution Margin divided by volume measured in metric tons. We define Adjusted EBITDA as income from operations before depreciation and amortization, restructuring expenses, consulting fees related to Company strategy, gain related to legal settlement, and includes equity earnings (loss) in affiliated companies, net of tax. Adjusted EBITDA is used by our management to evaluate our operating performance and make decisions regarding allocation of capital because it excludes the effects of items that have less bearing on the performance of our underlying core business. We define Net Working Capital as inventories plus current trade receivables minus trade payables. We define Capital Expenditures as cash paid for the acquisition of intangible assets and property, plant and equipment as shown in the Consolidated Financial Statements.
We also use Segment Adjusted EBITDA Margin, which we define as Adjusted EBITDA for the relevant segment divided by the revenue for that segment.
We use Adjusted EBITDA as internal measures of performance to benchmark and compare performance among our own operations. We use these measures, together with other measures of performance under GAAP, to compare the relative performance of operations in planning, budgeting and reviewing the performance of our business. We believe these measures are useful measures of financial performance in addition to consolidated net income for the period, income from operations and other profitability measures under GAAP because they facilitate operating performance comparisons from period to period and company to company and, with respect to Contribution Margin, eliminate volatility in feedstock prices. By eliminating potential differences in results of operations between periods or companies caused by factors such as depreciation and amortization methods, historic cost and age of assets, financing and capital structures and taxation positions or regimes, we believe that Adjusted EBITDA can provide a useful additional basis for comparing the current performance of the underlying
23
Orion Engineered Carbons S.A
operations being evaluated. For these reasons, we believe EBITDA-based measures are often used by the investment community as a means of comparison of companies in our industry. By deducting variable costs (such as raw materials, packaging, utilities and distribution costs) from revenue, we believe that Contribution Margins can provide a useful basis for comparing the current performance of the underlying operations being evaluated by indicating the portion of revenue that is not consumed by these variable costs and therefore contributes to the coverage of all costs and profits.
Different companies and analysts may calculate measures based on EBITDA, contribution margins and working capital differently, so making comparisons among companies on this basis should be done carefully. Adjusted EBITDA, Contribution Margins and Net Working Capital are not measures of performance under GAAP and should not be considered in isolation or construed as substitutes for revenue, consolidated net income for the period, income from operations, gross profit and other GAAP measures as an indicator of our operations in accordance with GAAP.
Reconciliation of Non-GAAP Financial Measures
Contribution Margin and Contribution Margin per Metric Ton (A Non-GAAP Financial Measures)
Reconciliation of Contribution Margin and Contribution Margin per Metric Ton to gross profit is as follows:
Year Ended December 31,
2021 2020
(In millions, except per ton data)
Revenue
$ 1,546.8 $ 1,136.4
Variable costs
(979.9) (672.5)
Contribution margin 566.9 463.9
Freight 92.9 68.8
Fixed Costs
(273.2) (240.4)
Gross profit $ 386.6 $ 292.3
Volume (in kmt) 964.3 866.8
Contribution margin per metric ton $ 587.9 $ 535.2
Gross profit per metric ton 400.9 337.2
Reconciliation of Adjusted EBITDA to consolidated net income is as follows:
Year Ended December 31,
2021 2020
(In millions)
Net income $ 134.7 $ 18.2
Add back income tax expense 51.7 8.1
Add back earnings in affiliated companies, net of tax (0.7) (0.5)
Income before earnings in affiliated companies and income taxes 185.7 25.8
Add back interest and other financial expense, net 38.0 38.7
Add back reclassification of actuarial losses from AOCI 4.8 9.9
Income from operations 228.5 74.4
Add back depreciation and amortization of intangible assets, right of use assets, and property, plant and equipment 104.1 96.6
EBITDA 332.6 171.0
Earnings in affiliated companies, net of tax 0.7 0.5
Extraordinary expense items related to COVID-19 — 3.9
Evonik legal settlement:
Cash settlement (79.5) —
Release of legal reserve, net (3.4) —
Long term incentive plan 5.2 4.4
EPA-related expenses 2.3 5.2
Environmental reserve accrual 7.2 —
Other adjustments 3.3 15.0
Adjusted EBITDA $ 268.4 $ 200.0
Adjusted EBITDA Specialty Carbon Black
$ 148.4 $ 110.0
Adjusted EBITDA Rubber Carbon Black
120.0 90.0
24
Orion Engineered Carbons S.A
Operating Result s
2021 Compared to 2020
Operating results for the periods discussed are as follows:
Year Ended December 31, Year-Over-Year
2021 2020 Delta
(In millions) %
Net sales $ 1,546.8 $ 1,136.4 $ 410.4 36.1
Cost of sales 1,160.2 844.1 316.1 37.4
Gross profit 386.6 292.3 94.3 32.3
Selling, general and administrative expenses 210.4 176.1 34.3 19.5
Research and development costs 22.0 20.2 1.8 8.9
Gain related to litigation settlement (82.9) — (82.9) —
Other expenses, net 8.6 21.6 (13.0) (60.2)
Income from operations 228.5 74.4 154.1 207.1
Interest and other financial expense, net 38.0 38.7 (0.7) (1.8)
Reclassification of actuarial losses from AOCI 4.8 9.9 (5.1) (51.5)
Income before earnings in affiliated companies and income taxes 185.7 25.8 159.9 619.8
Income tax expense 51.7 8.1 43.6 538.3
Earnings in affiliated companies, net of tax 0.7 0.5 0.2 40.0
Net income $ 134.7 $ 18.2 $ 116.5 640.1
Net sales
Net sales increased overall by $410.4 million, or 36.1%, from $1,136.4 million in 2020 to $1,546.8 million in 2021, driven primarily by the impact of passing through of higher feedstock costs, higher sales volume across all regions and segments, favorable impact of foreign currency translation, and favorable product mix.
Volumes increased by 97.5 kmt, or 11.2%, to 964.3 kmt, year-over-year, primarily driven by higher demand in both segments, across all application and geographies, driven by a sharp global economic recovery from the COVID-19 induced economic downturn in 2020.
Cost of sales
Cost of sales increased by $316.1 million, or 37.4%, from $844.1 million in 2020 to $1,160.2 million in 2021, primarily driven by higher production and associated costs. Fluctuations in our cost of sales are generally driven by changes in feedstock and energy costs.
Selling, general and administrative expenses
Selling, general and administrative expenses increased by $34.3 million, or 19.5%, from $176.1 million in 2020 to $210.4 million in 2021 driven primarily by higher freight costs associated with increase in sales volumes and higher incentive compensation.
Gain related to litigation settlement
During the second quarter of 2021, Evonik agreed to make a one-time cash payment of €66.55 million ($79.5 million) to settle dispute which originated from the acquisition of the carbon black business line from Evonik, completed on July 29, 2011 by Rhône Capital and Triton Partners. The Acquisition agreement provided for a partial indemnity from Evonik against various exposures, including capital investments, fines and costs arising in connection with U.S. Clean Air Act violations that occurred prior to the closing of the Acquisition (i.e., under Evonik’s control). In addition, we released $3.4 million of legal reserves, net, related to this dispute.
Other expenses, net
Other expenses, net which comprises other operating income and other operating expenses, decreased to $8.6 million in 2021 from $21.6 million in 2020.
The 2020 fiscal year included additional $3.9 million expenses incurred due to COVID-19, which was not repeated in 2021 and higher restructuring cost compared to 2021, partially offset by higher long-term incentive compensation costs and reserves for environmental remediation costs.
25
Orion Engineered Carbons S.A
Income from operations
Income from operations increased by $154.1 million to $228.5 million compared to 2020. The increase was primarily driven by passing through of higher feedstock costs, higher sales volume due to sharp global recovery from COVID-19 across all regions, favorable product mix and the Evonik legal settlement related gain, partially offset by higher selling, general and administrative costs.
Interest and other financial expense, net
Interest and other financial expense, net is comprised of interest and other financial income and interest and other financial expenses. Interest and other financial expense, net amounted to $38.0 million in 2021 compared to $38.7 million in 2020. The decrease of $0.7 million was primarily due to lower foreign currency transactions, partially offset by costs associated with refinancing of our Term-Loan during the third quarter of 2021.
Income tax expense
Income tax expense amounted to $51.7 million in 2021 compared to $8.1 million in 2020, as a result of increased income before taxes.
In 2021, the effective tax rate was in line with the expected Company rate. Unfavorable impacts from non-deductible business expenses and valuation allowance adjustments of deferred tax assets were offset by the benefit from the reduction in the valuation allowance related tax loss carryforwards in Brazil, interest carryforwards in Germany and a favorable pre-tax earnings mix by jurisdiction. For details regarding this deviation, see Item 8. Financial Statements and Supplementary Data and Note P. Income Taxes to the audited Consolidated Financial Statements.
In 2020, the effective tax rate was in line with the expected Company rate. Unfavorable impacts from non-deductible business expenses, pre-tax earnings mix by jurisdiction and valuation adjustments of deferred tax assets primarily associated with the economic downturn related to COVID-19 were offset by the benefit from the reduction in the valuation allowance related to U.S. tax credits of $3.6 million. For details regarding this deviation, see Item 8. Financial Statements and Supplementary Data and Note P. Income Taxes to the audited Consolidated Financial Statements.
Contribution margin and Contribution margin per metric ton (A Non-GAAP Financial Measures)
Contribution margin increased by $103.0 million, or 22.2%, from $463.9 million in 2020 to $566.9 million in 2021. Contribution margin per metric ton increased slightly by 9.8%, from $535.2 per metric ton in 2020 to $587.9 per metric ton in 2021.
The increase was primarily driven by passing through of higher feedstock costs, higher sales volume due to sharp global recovery from COVID-19 across all regions and segments, favorable product mix and higher energy sales, favorable impact of foreign currency translation, partially offset by higher selling, general and administrative costs.
Adjusted EBITDA (A Non-GAAP Financial Measure)
Adjusted EBITDA increased by $68.4 million, or 34.2%, from $200.0 million in 2020 to $268.4 million in 2021, primarily driven by passing through of higher feedstock costs, higher sales volume due to sharp global recovery from COVID-19 across all regions, and impact of favorable product mix, partially offset by higher selling, general and administrative costs.
26
Orion Engineered Carbons S.A
Segment Discussion
Our business operations are divided into two operating segments—the Specialty Carbon Black and Rubber Carbon Black. We use Segment Adjusted EBITDA as measures of segment performance and profitability. The table below presents our segment results derived from our audited Consolidated Financial Statements for 2021, and 2020.
Year Ended December 31, Year-Over-Year
2021 2020 Delta
(In millions, unless otherwise indicated) %
Specialty Carbon Black
Net sales $ 598.2 $ 445.2 $ 153.0 34.4
Cost of sales (400.6) (296.5) (104.1) 35.1
Gross profit $ 197.6 $ 148.7 $ 48.9 32.9
Volume (kmt) (1)
263.2 231.9 31.3 13.5
Adjusted EBITDA $ 148.4 $ 110.0 $ 38.4 34.9
Adjusted EBITDA Margin (%) 24.8 24.7 0.1 0.4
Rubber Carbon Black
Net sales $ 948.6 $ 691.2 $ 257.4 37.2
Cost of sales (759.6) (547.6) (212.0) 38.7
Gross profit $ 189.0 $ 143.6 $ 45.4 31.6
Volume (kmt) 701.1 634.9 66.2 10.4
Adjusted EBITDA $ 120.0 $ 90.0 $ 30.0 33.3
Adjusted EBITDA Margin (%) 12.7 13.0 (0.3) (2.3)
Specialty Carbon Black
2021 Compared to 2020
Net sales of the Specialty Carbon Black segment increased by $153.0 million, or 34.4%, from $445.2 million in 2020 to $598.2 million in 2021, primarily driven by passing through of higher feedstock costs, higher sales volumes due to sharp global recovery from COVID-19 induced economic downturn reflecting a broad-based demand increase across nearly all applications, favorable product mix and favorable impact of foreign currency translation.
Volume of the Specialty Carbon Black segment increased by 31.3 kmt, or 13.5%, from 231.9 kmt in 2020 to 263.2 kmt in 2021, driven primarily by sharp global recovery from COVID-19 induced economic downturn reflecting a broad-based demand increase across nearly all applications.
Gross profit of the Specialty Carbon Black segment increased by $48.9 million, or 32.9%, from $148.7 million in 2020 to $197.6 million in 2021, primarily driven by passing through of higher feedstock costs, higher sales volume due to global recovery from COVID-19 induced economic downturn reflecting a broad-based demand increase across nearly all applications, and favorable product mix.
Adjusted EBITDA of the Specialty Carbon Black segment increased by $38.4 million, or 34.9%, from $110.0 million in 2020 to $148.4 million in 2021, primarily driven by passing through of higher feedstock costs, higher sales volume due to global recovery from COVID-19 induced economic downturn reflecting a broad-based demand increase across nearly all applications, passing through of higher feedstock costs, and favorable product mix.
Rubber Carbon Black
2021 Compared to 2020
Net sales of the Rubber Carbon Black segment increased by $257.4 million, or 37.2%, from $691.2 million in 2020 to $948.6 million in 2021, primarily driven by passing through of higher feedstock costs, higher sales volume due to sharp global recovery from COVID-19 induced economic downturn and favorable impact of foreign currency translation.
Volume of the Rubber Carbon Black segment increased by 66.2 kmt, or 10.4%, from 634.9 kmt in 2020 to 701.1 kmt in 2021, reflecting higher demand.
Gross profit of the Rubber Carbon Black segment increased by $45.4 million, or 31.6%, from $143.6 million in 2020 to $189.0 million in 2021, primarily driven by passing through of higher feedstock costs, and higher sales volume due to global recovery from COVID-19 induced economic downturn reflecting a broad-based demand increase across nearly all applications.
27
Orion Engineered Carbons S.A
Adjusted EBITDA of the Rubber Carbon Black segment increased by $30.0 million, or 33.3%, from $90.0 million in 2020 to $120.0 million in 2021, primarily due to passing through of higher feedstock costs, favorable operating leverage associated with substantially higher sales volume, partially offset by higher general and administrative expenses.
Liquidity and Capital Resources
Historical Cash Flows
The table below presents cash flows derived from our Consolidated Financial Statements.
Year Ended December 31,
2021 2020
(In millions)
Net cash provided by operating activities $ 145.2 $ 125.3
Net cash used in investing activities (214.7) (144.9)
Net cash provided by financing activities 73.3 13.5
2021
Net cash provided by operating activities in 2021 amounted to $145.2 million. The cash provided by operating activities primarily reflected our net income, adjusted for non-cash items and changes in working capital and $82.9 million related to Evonik legal settlement gain. See “ Note Q. Commitments and Contingencies ” for further discussion on Evonik legal settlement.
Net cash used in investing activities in 2021 was $214.7 million. Approximately $119.8 million related to capital expenditures comprised of a combination of safety, sustainability and growth investments. Additionally, approximately $94.9 million was associated with our ongoing efforts to install emissions reduction technology to meet the Environmental Protection Agency (“EPA”) requirements.
Net cash provided by financing activities in 2021 were $73.3 million comprised primarily of net borrowings under our revolving credit facility of $75.8 million for our working capital. Our financing activity included refinancing of our Term-loan and associated costs. See Note J. Debt and Other Obligations for further discussion on our Term-loan refinancing.
2020
Net cash provided by operating activities in 2020 amounted to $125.3 million and consisted of a consolidated profit for the period of $18.2 million, adjustments primarily for depreciation of $96.6 million and changes in working capital.
Net cash used in investing activities in 2020 amounted to $144.9 million. These expenditures were comprised of a combination of safety, sustainability and growth investments as well as expenditures associated with our ongoing efforts to install emissions reduction technology to meet EPA requirements in the U.S.
Net cash provided by financing activities in 2020 amounted to $13.5 million, primarily reflecting the company drawing under its revolver to bolster its cash position and enhance financial flexibility to successfully manage through the pandemic.
Sources of Liquidity
Our principal sources of liquidity are the net cash generated (i) from operating activities, primarily driven by our operating results and changes in working capital requirements and (ii) from financing activities, primarily driven by borrowing amounts available under our committed multicurrency, senior secured RCF and related ancillary facilities, various uncommitted local credit lines and, from time to time, term loan borrowings.
We believe our anticipated future operating cash flow, capacity under our existing credit facilities and uncommitted bilateral lines of credit, along with access to surety bonds will be sufficient to finance our planned capital expenditures, settle our commitments and contingencies and address our normal anticipated working capital needs for the foreseeable future.
As of December 31, 2021, the company had estimated liquidity of $241.6 million, including cash and equivalents of $65.7 million, $166.7 million in availability remaining under our revolving credit facility, including ancillary lines, and $9.2 million under other available credit lines.
28
Orion Engineered Carbons S.A
Net Working Capital (Non-GAAP Financial Measure)
We define Net Working Capital as the total of inventories and current trade receivables, less trade payables. Net Working Capital is a non-GAAP financial measure, and other companies may use a similarly titled financial measure that is calculated differently from the way we calculate Net Working Capital. The following table set forth the principal components of our Net Working Capital as of the dates indicated.
Year Ended December 31,
2021 2020
(In millions)
Inventories $ 229.8 $ 141.5
Trade receivables 288.9 234.8
Trade payables (195.1) (131.2)
Net working capital $ 323.6 $ 245.1
Our Net Working Capital position can vary significantly from month to month, mainly due to fluctuations in oil prices and receipts of carbon black oil shipments. In general, increases in the cost of raw materials lead to an increase in our Net Working Capital requirements, as our inventories and trade receivables increase as a result of higher carbon black oil prices and related sales levels. These increases are partially offset by related increases in trade payables. Due to the quantity of carbon black oil that we typically keep in stock, such increases in Net Working Capital occur gradually over a period of two to three months. Conversely, decreases in the cost of raw materials lead to a decrease in our Net Working Capital requirements over the same period of time.
Our Net Working Capital increased to $323.6 million as of December 31, 2021 compared to $245.1 million as of December 31, 2020. The components of working capital that used or provided cash were:
• Inventories —higher oil prices and an increase in production to meet forecasted demand resulted in increased raw material and finished goods inventory; and
• Trade receivables —increase was driven by higher sales due to higher product demand and passing through of higher feedstock costs.
Trade receivables include a long-term steam supply contract between one of our wholly-owned subsidiaries and the city of Hürth, Germany (Stadtwerke Hürth/Hürth municipal utilities). The municipality financed certain turbines and infrastructure which are operated by us under a finance lease agreement. In addition, the city of Hürth entered into a long-term supply agreement for heat delivered to the city. Since the fourth quarter of 2020, the city of Hürth has not fully honored the contractually-stipulated calculation for heat deliveries, amongst other stipulations. As a result, Orion has open receivables from the city of Hürth totaling $5.5 million as of December 31, 2021 while the city of Hürth argues open claims of approximately $3.3 million related to lease payments. Orion is in negotiations with the city but is prepared to pursue its rights vigorously through legal enforcement if necessary.
Those increases were partially offset by:
• Accounts payable —higher production and higher oil prices resulted in increased accounts payable.
Capital Requirements
Capital Expenditure —We define Capital Expenditures as cash paid for the acquisition of intangible assets and property, plant and equipment as shown in the Consolidated Financial Statements. We plan to finance our Capital Expenditures, including EPA related expenditures, with cash generated by our operating activities. To finance construction of the Mintaka facility in China we plan to borrow up to $80 million. Other than EPA spending, we currently do not have any material commitments to make Capital Expenditures and do not plan to make Capital Expenditures outside the ordinary course of our business. See “ Note Q. Commitments and Contingencies ” for further details regarding the EPA settlement in Notes to Consolidated Financial Statements included in Item 8 of Part II of this Annual Report..
Debt and Other Obligations —Our gross debt balance as of December 31, 2021 was $788.5 million, an increase of $44.9 million compared to December 31, 2020. Maturities of $3.0 million of debt, due in 2022, excluding net unamortized premiums and discounts, will be paid from current cash balances and cash generated by operations. For more information on Debt, refer to Note J. Debt and Other Obligations , in Notes to Consolidated Financial Statements included in Item 8 of Part II of this Annual Report.
Contractual Obligations —For more information on Contractual obligations, refer to “ Note Q. Commitments and Contingencies ” in Notes to Consolidated Financial Statements included in Item 8 of Part II of this Annual Report.
Leases —For operating and finance leases, refer to Note G. Leases in Notes to Consolidated Financial Statements included in Item 8 of Part II of this Annual Report.
29
Orion Engineered Carbons S.A
Trend Information
See Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations — Recent Developments and Certain Known Trends.
Critical Accounting Policies and Estimates
The preparation of our financial statements in conformity with accounting principles generally accepted in the United States (“GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosure of contingent assets and liabilities. The policies and estimates discussed below are considered by our management to be critical to an understanding of the Consolidated Financial Statements because their application requires the most significant judgments from management in estimating matters for financial reporting that are inherently uncertain. This discussion should be read in conjunction with our Consolidated Financial Statements and related notes included in this Annual Report in Form 10-K.
Use of Estimates —We consider an accounting estimate to be critical to the financial statements if (i) the estimate is complex in nature or requires a high degree of judgment and (ii) if different estimates and assumptions were used, the results could have a material impact on the Consolidated Financial Statements. Estimates and assumptions are based on information available at the time such estimates and assumptions are made. Adjustments made with respect to the use of these estimates and assumptions often relate to information not previously available. Uncertainties with respect to such estimates and assumptions are inherent in the preparation of Consolidated Financial Statements. We evaluate our estimates and application of our policies on an ongoing basis. Actual results may differ from these estimates under different assumptions or conditions.
Inventories —W e account for our raw materials, work-in-progress and finished goods inventories using average cost method of accounting. The cost of raw materials, which represents a substantial portion of our operating expenses, and energy costs generally follow price trends for crude oil and/or natural gas.
We periodically review inventory for both potential obsolescence and potential declines in anticipated selling prices. Due to natural inventory composition changes, variation in pricing from period to period does not necessarily result in a linear lower of cost or market (“LCM”) impact. Fluctuation in the prices from period to period may result in the recognition of charges to adjust the value of inventory to the lower of cost or market in periods of falling prices and the reversal of those charges in subsequent interim periods as market prices recover. We write down the value of our inventories by an amount equal to the difference between the cost of the inventory and its estimated net realizable value. Historically, such write-downs have not been material. However, if actual market conditions are less favorable than those projected by management at the time of the assessment, additional inventory write-downs may be required, which could reduce our gross profit and our earnings.
Goodwill Impairment —We record goodwill for the excess of the cost of an acquisition over the fair value of the net assets of the acquired business. Goodwill is reviewed for impairment at least annually or more frequently if an event or change in circumstance indicates that an impairment may have occurred.
We also have the option to proceed directly to the quantitative impairment test. Under the quantitative impairment test, the fair value of each reporting unit, calculated using a discounted cash flow model, is compared to its carrying value, including goodwill. The discounted cash flow model inherently utilizes a significant number of estimates and assumptions including operating margins, tax rates, discount rates, capital expenditures and working capital changes. If the carrying value of the reporting unit including goodwill exceeds its fair value, an impairment charge equal to the excess would be recognized, up to a maximum amount of goodwill allocated to that reporting unit.
For 2021 we performed a qualitative impairment assessment and for 2020 we performed a quantitative impairment assessment of our reporting units. Both periods indicated the fair value of our reporting units was greater than their carrying value including goodwill. Accordingly, a quantitative goodwill impairment test was not required in 2021. No goodwill impairment was recognized in 2021 or 2020.
Loss Contingencies —We record liabilities for loss contingencies when it is probable that a liability has been incurred and the amount of loss is reasonably estimable. We provide disclosure when there is a reasonable possibility that the ultimate loss will exceed the recorded provision by a material amount or if the loss is not reasonably estimable but is expected to be material to our financial results. We are currently involved in litigation and other proceedings, as discussed in Note Q. Commitments and Contingencies to the accompanying Consolidated Financial Statements. We have accrued our estimates of the probable losses associated with these matters and associated legal costs are generally recognized as incurred. However, our losses are typically resolved over long periods of time and are often difficult to estimate due to various factors including the possibility of multiple actions by third parties. Therefore, it is possible future earnings could be affected by changes in our estimates related to these matters.
Accruals for Taxes Based on Income —The determination of our provision for income taxes and the calculation of our tax benefits and liabilities is subject to management’s estimates and judgments due to the complexity of the tax laws and regulations in the tax jurisdictions in which we operate. Uncertainties exist with respect to interpretation of these complex laws and regulations.
Deferred tax assets and liabilities are determined based on temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis, and are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to reverse.
30
Orion Engineered Carbons S.A
We recognize future tax benefits to the extent that the realization of these benefits is more likely than not. Our current provision for income taxes is impacted by the recognition and release of valuation allowances related to net deferred tax assets in certain jurisdictions. Further changes to these valuation allowances may impact our future provision for income taxes, which will include no tax benefit with respect to losses incurred and no tax expense with respect to income generated in these countries until the respective valuation allowance is eliminated.
We recognize the financial statement benefits with respect to an uncertain income tax position that we have taken or may take on an income tax return when we believe it is more likely than not that the position will be sustained with the tax authorities.
ACCOUNTING AND REPORTING CHANGES
For a discussion of the potential impact of new accounting pronouncements on our Consolidated Financial Statements, see Note B. Recent Accounting Pronouncements to the Consolidated Financial Statements.