Item 7. Management’s Discussion and Analysis
ITEM 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) provides a comparison of the Company's results of operations, as well as liquidity and capital resources for the years ended December 31, 2022 and 2021. The MD&A should be read in conjunction with the Company's consolidated financial statements and notes included in Item 8 of this Annual Report. Throughout this MD&A, the Company refers to measures used by management to evaluate performance, including financial measures that are not defined under generally accepted accounting principles (GAAP) in the U.S. Net sales excluding foreign currency translation (i.e. organic sales) is not a measure of financial performance under GAAP; however, the Company believes it is useful in understanding its financial results and provides comparable measures for understanding the operating results of the Company between different periods.
The year-over-year comparisons in this MD&A are as of and for the years ended December 31, 2022 and December 31, 2021, unless stated otherwise. The discussion of 2020 results and related year-over-year comparisons as of and for the years ended December 31, 2021 and December 31, 2020 are found in Part II, Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations," of our Form 10-K for the year ended December 31, 2021.
Overview
Tennant Company is a world leader in designing, manufacturing and marketing solutions that empower customers to achieve quality cleaning performance, reduce environmental impact and help create a cleaner, safer, healthier world. The Company is committed to creating and commercializing breakthrough, sustainable cleaning innovations to enhance its broad suite of products, including floor maintenance and cleaning equipment, detergent-free and other sustainable cleaning technologies, aftermarket parts and consumables, equipment maintenance and repair service, and asset management solutions. Our products are used in many types of environments, including factories and warehouses, distribution centers, office buildings, public venues such as arenas and stadiums, schools and universities, hospitals and clinics, and more. Customers include contract cleaners to whom organizations outsource facilities maintenance as well as businesses that perform facilities maintenance themselves. The Company reaches these customers through the industry's largest direct sales and service organization and through a strong and well-supported network of authorized distributors worldwide.
Macroeconomic Events
We continue to actively manage our business to respond to the COVID-19 pandemic and related impacts. Governments across the world have taken actions, including stay-at-home orders, to limit the spread of COVID-19. These actions, specifically in China, have and may continue to reduce operating activities and negatively impact financial results.
We continue to experience disruption in the supply of key component parts, as well as inflation and inefficiencies as a result of supply chain issues. We have established frequent communications with suppliers to review, track and prioritize high-risk components. We have also identified and activated alternative suppliers, materials and components as needed. We continue to work closely with our suppliers to achieve a deeper integration into our suppliers' supply chains, including the procurement of sub-component parts. The Company continues work to minimize the impact of inflation on inputs and market supply challenges by employing local-for-local and region-for-region manufacturing and sourcing to allow us to manufacture our products closer to our customers. At the same time, our engineering teams are evaluating platform design to increase our sourcing flexibility.
In February 2022, the United States announced targeted economic sanctions on Russia in response to the military conflict in Ukraine. While we do not have any direct operations or employees in Russia or Ukraine and have suspended sales to Russia and Belarus, our operating results have been and may continue to be negatively impacted by supply chain constraints and inflationary pressures stemming from this conflict. In addition to fully adhering to all sanctions, we will continue to monitor developments in the region, including the impact of rising commodity and energy prices.
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Due to the global nature of our operations, we are subject to exposures resulting from foreign currency exchange fluctuations in the normal course of business. The direct financial impact of foreign currency exchange includes the effect of translating profits from local currencies to U.S. dollars, the impact of currency fluctuations on the transfer of goods between our operations in the United States and our international operations and transaction gains and losses. Volatility in the foreign exchange market has and may continue to negatively impact the financial results of our international operations.
As described in Part I, Item 1A - Risk Factors, we may encounter financial difficulties if the United States or other global economies experience an additional or continued long-term economic downturn as our product sales are sensitive to declines in capital spending by our customers. Any sustained adverse impacts to our business, the industries in which we operate, market demand for our products, and/or certain suppliers or customers may also affect our future results of operations, financial position, or cash flows. We are actively monitoring the macroeconomic environment, especially the potential impact of global supply chain constraints on cost inflation, and the potential decreased demand for our products.
Outlook
Global economic conditions continue to be highly volatile and uncertainty remains regarding the timing of a full recovery from supply chain challenges and inflationary trends. We continue to monitor costs in the current inflationary environment and will take pricing actions and manage costs accordingly. We anticipate that we will need to remain agile as we continue to manage evolving challenges. We remain confident in the long-term growth trends for all our products and services in the markets we serve.
Historical Results
The following table compares the historical results of operations for the years ended December 31, 2022, and 2021 in dollars and as a percentage of net sales (in millions, except per share amounts and percentages):
2022 % 2021 %
Net sales $ 1,092.2 100.0 $ 1,090.8 100.0
Cost of sales 671.3 61.5 652.8 59.8
Gross profit 420.9 38.5 438.0 40.2
Selling and administrative expense 306.3 28.0 321.9 29.5
Research and development expense 31.1 2.8 32.2 3.0
Gain on sale of assets (3.7) (0.3) (9.8) (0.9)
Operating income 87.2 8.0 93.7 8.6
Interest expense, net (7.1) (0.7) (7.3) (0.7)
Net foreign currency transaction loss (1.2) (0.1) (0.7) (0.1)
Loss on extinguishment of debt — — (11.3) (1.0)
Other income (expense), net 0.6 0.1 (0.3) —
Income before income taxes 79.5 7.3 74.1 6.8
Income tax expense 13.2 1.2 9.2 0.8
Net income 66.3 6.1 64.9 5.9
Net income per share - diluted $ 3.55 $ 3.44
Net Sales
Consolidated net sales in 2022 totaled $1,092.2 million, a 0.1% increase as compared to consolidated net sales of $1,090.8 million in 2021.
The 0.1% increase in consolidated net sales was driven by:
• Organic sales increase of approximately 4.2% primarily due to the impact of higher selling prices across all regions partially offset by volume declines due mostly to supply chain constraints impacting the availability of key component parts;
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• A net unfavorable impact from foreign currency exchange across all business units of approximately 4.0%; and
• An unfavorable impact from the divestiture of our Coatings business in 2021 of 0.1%.
The following table sets forth annual net sales by geographic area and the related percentage change from the prior year (in millions, except percentages):
2022 % 2021
Americas $ 705.9 7.2 $ 658.3
Europe, Middle East and Africa (EMEA) 301.6 (9.1) 331.9
Asia Pacific (APAC) 84.7 (15.8) 100.6
Total $ 1,092.2 0.1 $ 1,090.8
Americas
Net sales in the Americas were $705.9 million in 2022, an increase of 7.2% from 2021. Organic sales grew 7.4%, mainly due to higher selling prices in all categories across the region and volume increases in Latin America. Diminished parts availability on certain component parts due to supply chain constraints limited the Company’s ability to increase production and address elevated backlog levels in the region. The divestiture of the Coatings business resulted in a decline in net sales of approximately 0.2% in 2022.
Europe, Middle East and Africa ("EMEA")
EMEA net sales were $301.6 million in 2022, a decrease of 9.1% from 2021. Foreign currency exchange within EMEA unfavorably impacted net sales by approximately 11.6%. Organic sales grew 2.5% in EMEA, primarily driven by higher selling prices in equipment and parts and consumables across the region, partially offset by volume declines due to supply chain constraints and softening demand in the region.
Asia Pacific ("APAC")
APAC net sales were $84.7 million in 2022, a decrease of 15.8% from 2021. Organic sales declined 11.4% in APAC, primarily due to volume declines in China as government shutdowns related to COVID-19 unfavorably impacted demand. This was partly offset by volume growth in Australian markets. Foreign currency exchange within APAC unfavorably impacted net sales by approximately 4.4% in 2022.
Gross Profit
Gross profit margin of 38.5% was 170 basis points lower in 2022 compared to 2021. The margin rate decrease was primarily attributable to the broad effects of inflation on materials, labor, and freight costs, partly offset by higher selling prices and favorable sales mix.
Operating Expenses
Selling and Administrative Expense
Selling and Administrative expense ("S&A expense") was $306.3 million in 2022, a decrease of $15.6 million compared to 2021. As a percentage of net sales, S&A expense in 2022 decreased 150 basis points to 28.0% from 29.5% in 2021. The S&A expense decrease was driven by lower variable employee compensation expenses partially offset by increased costs related to incremental consulting costs to address parts shortages.
Research and Development Expense
Research and Development ("R&D") expense was $31.1 million, or 2.8% of net sales, in 2022, nearly flat as a percentage of net sales compared to 2021.
We conduct research and development activities to develop new products and to enhance the functionality, effectiveness, ease of use and reliability of our existing products. We believe that our research and development efforts have been, and continue to be, key drivers of our success in the marketplace.
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Total Other Expense, Net
Interest Expense, Net
Interest expense, net was $7.1 million in 2022, a decrease of $0.2 million compared to 2021. The decrease reflected lower average outstanding debt in 2022, partially offset by higher interest rates.
Our debt portfolio as of December 31, 2022 was comprised of debt predominately in U.S. dollars. The Company manages its floating rate debt exposure using fixed rate interest rate swaps to reduce the Company's risk of the possibility of increased interest costs. On December 1, 2022, the Company entered into an aggregate $120 million notional amount of interest rate swaps that exchange a variable rate of interest for a fixed rate of interest of 4.076% over the term of the agreements.
Foreign Currency Transaction Loss
Net foreign currency transaction loss was $1.2 million in 2022, compared to $0.7 million in 2021. The unfavorable impact was primarily due to strengthening of the U.S. dollar relative to the Brazilian real on foreign denominated liabilities.
Income Taxes
The effective tax rate for 2022 was 16.6% compared to 12.5% in 2021. The increase in the effective tax rate was primarily driven by certain nonrecurring tax items. The 2022 tax rate includes benefits related to a reduction to a deferred tax liability on undistributed foreign earnings. The 2021 tax rate included benefits from a foreign tax basis step-up election and a valuation allowance related to net operating loss carryovers. These nonrecurring events had a one-time impact of (7.2%) in 2022 and (11.5%) in 2021.
In general, it is our practice and intention to permanently reinvest the earnings of our foreign subsidiaries and repatriate earnings only when the tax impact is zero or immaterial. No deferred taxes have been provided for withholding taxes or other taxes that would result in repatriation of our foreign investments to the U.S.
Backlog
Backlog is one of the many indicators of business conditions in the Company's markets. Our order backlog was approximately $326.4 million at December 31, 2022 compared to $169.7 million at December 31, 2021. The increase in our order backlog is primarily due to higher order rates coupled with persistent supply chain challenges that impacted our ability to obtain key component parts and increase production. We expect this level of backlog to continue in 2023. Backlog includes orders that can be cancelled or postponed at the option of the customer at any time without penalty.
Liquidity and Capital Resources
Liquidity
Our primary liquidity needs are to fund working capital, fund investments, service our debt, maintain cash reserves and invest in capital expenditures. Our sources of liquidity include cash generated from operations, borrowings under our revolving credit facility and from time to time, debt and equity offerings. We believe our current resources are sufficient to meet our working capital requirements for our current business for at least the next 12 months and thereafter for the foreseeable future.
Cash, cash equivalents and restricted cash totaled $77.4 million at December 31, 2022, as compared to $123.6 million as of December 31, 2021. Wherever possible, cash management is centralized and intercompany financing is used to provide working capital to subsidiaries as needed. Our current ratio was 2.2 as of December 31, 2022 and 1.8 as of December 31, 2021. Our primary working capital, which is comprised of accounts receivable, inventories and accounts payable was $332.0 million as of December 31, 2022 and $250.5 million as of December 31, 2021. Our debt-to-capital ratio was 40.9% as of December 31, 2022, compared to 38.1% as of December 31, 2021.
The Company's Board of Directors authorized a quarterly cash dividend of $0.265 per share payable on March 15, 2023, to shareholders of record at the close of business on March 3, 2023.
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Cash Flow from Operating Activities
Net cash used in operating activities in 2022 was $25.1 million compared to net cash provided by operating activities of $69.4 million in 2021. The increase in cash used was primarily driven by an increase in working capital attributable to investments in inventory required to support an anticipated ramp in production; higher accounts receivables due to increased sales to customers with extended payment terms; and increased cash payments for employee compensation and benefits and income taxes.
Cash Flow from Investing Activities
Net cash used in investing activities in 2022 was $24.5 million compared to net cash provided by investing activities of $1.7 million in 2021. In 2022, we used $25.0 million for capital expenditures compared to $19.4 million in 2021. The prior year period included $24.7 million of cash proceeds from sale of assets, net of cash divested in 2021 compared to $4.1 million of cash proceeds from sale of asset, net of cash divested in 2022.
Cash Flow from Financing Activities
Net cash provided by financing activities in 2022 was $8.1 million compared to net cash used in financing activities of $84.5 million in 2021. The increase in cash provided was primarily due to a decrease in repayments of borrowing and share repurchases in 2022, partly offset by increased dividend payments.
Cash Requirements
The company believes the liquidity available from the combination of expected cash generated by operating activities, existing cash and available credit under existing credit facilities will be sufficient to meet its short-term and long-term cash requirements. Significant contractual obligations include principal and interest payments on long-term debt (Note 9) and operating lease commitments (Note 15). We also have contractual purchase obligations of approximately $113 million for 2023.
Newly Issued Accounting Guidance
See Note 2 to the consolidated financial statements for information on new accounting pronouncements.
No other new accounting pronouncements issued but not yet effective have had, or are expected to have, a material impact on our results of operations or financial position.
Critical Accounting Policies and Estimates
Our consolidated financial statements are based on the selection and application of accounting principles generally accepted in the United States of America, which require us to make estimates and assumptions about future events that affect the amounts reported in our consolidated financial statements and the accompanying notes. Our significant accounting policies are described in Note 1 to the consolidated financial statements. Future events and their effects cannot be determined with absolute certainty. Therefore, the determination of estimates requires the exercise of judgment. Actual results could differ from those estimates, and any such differences may be material to the consolidated financial statements. We believe that the following policies may involve a higher degree of judgment and complexity in their application and represent the critical accounting policies used in the preparation of our consolidated financial statements. If different assumptions or conditions were to prevail, the results could be materially different from our reported results.
Goodwill – Goodwill represents the excess of cost over the fair value of net assets of businesses acquired and is allocated to our reporting units at the time of the acquisition. We analyze goodwill on an annual basis and when an event occurs or circumstances change that may reduce the fair value of a reporting unit below its carrying amount. We have the option of first analyzing qualitative factors to determine whether it is more likely than not that the fair value of any reporting unit is less than its carrying amount. However, we may elect to perform a quantitative goodwill impairment test in lieu of the qualitative test. An entity must recognize an impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value. Subsequent reversal of goodwill impairment charges is not permitted.
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When we perform a qualitative goodwill test, we analyze qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the quantitative goodwill impairment test. If the qualitative test indicates there may be an impairment, we perform the quantitative test, which measures the amount of the goodwill impairment, if any. To perform the quantitative test, we calculate the fair value of each reporting unit, primarily utilizing the income approach. The income approach is based on discounted cash flow models that use reporting unit estimates for forecasted future financial performance, including revenues, margins, operating expenses, capital expenditures, depreciation, amortization, tax and discount rates. These estimates are developed as part of our planning process based on assumed growth rates, along with historical data and various internal estimates. Projected future cash flows are then discounted to a present value employing a discount rate that properly accounts for the estimated risk-adjusted weighted-average cost of capital relevant to each reporting unit.
We perform our annual goodwill impairment analysis as of October 1 and when an event occurs or circumstances change that may reduce the fair value of a reporting unit below its carrying amount. In 2020, we changed the goodwill impairment assessment date from December 31 to October 1 to better align with the timing of our annual planning process. The change did not result in any adjustments to our consolidated financial statements.
In 2022, we elected to perform the quantitative goodwill test in lieu of the qualitative test on all reporting units. Our tests indicated the fair value in each reporting unit was substantially in excess of its carrying value. There was no goodwill impairment in any of our reporting units as of our annual assessment date.
We had goodwill of $182.0 million and $193.1 million at December 31, 2022 and 2021, respectively.
Income Taxes – We are required to estimate our income taxes in each of the jurisdictions in which we operate. This process involves estimating our actual current tax obligations based on expected income, statutory tax rates and tax planning opportunities in the various jurisdictions. We also establish reserves for uncertain tax matters that are complex in nature and uncertain as to the ultimate outcome. Although we believe that our tax return positions are fully supportable, we consider our ability to ultimately prevail in defending these matters when establishing these reserves. We adjust our reserves in light of changing facts and circumstances, such as the closing of a tax audit. We believe that our current reserves are adequate. However, the ultimate outcome may differ from our estimates and assumptions and could impact the income tax expense reflected in our consolidated statements of income.
Tax law requires certain items to be included in our tax return at different times than the items are reflected in our results of operations. Some of these differences are permanent, such as expenses that are not deductible in our tax returns, and some differences will reverse over time, such as depreciation expense on property, plant and equipment. These temporary differences result in deferred tax assets and liabilities, which are included within our consolidated balance sheets. Deferred tax assets generally represent items that can be used as a tax deduction or credit in our tax returns in future years but have already been recorded as an expense in our consolidated statements of income. We assess the likelihood that our deferred tax assets will be recovered from future taxable income, and, based on management’s judgment, to the extent we believe that recovery is not more likely than not, we establish a valuation allowance against those deferred tax assets. The deferred tax asset valuation allowance could be materially different from actual results because of changes in the mix of future taxable income, the relationship between book and taxable income and our tax planning strategies. As of December 31, 2022, a valuation allowance of $3.3 million was recorded against foreign and state tax credit carryforwards.
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Cautionary Factors Relevant to Forward-Looking Information
This Annual Report on Form 10-K, including “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7, contains certain statements that are considered “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements generally can be identified by the use of forward-looking terminology such as “may,” “will,” “expect,” “intend,” “estimate,” “anticipate,” “believe,” “project,” or “continue” or similar words or the negative thereof. These statements do not relate to strictly historical or current facts and provide current expectations of forecasts of future events. Any such expectations or forecasts of future events are subject to a variety of factors. Particular risks and uncertainties presently facing us include:
• Geopolitical and economic uncertainty throughout the world.
• Uncertainty surrounding the COVID-19 pandemic.
• Ability to comply with global laws and regulations.
• Ability to adapt to price sensitivity.
• Competition in our business.
• Fluctuations in the cost, quality or availability of raw materials and purchased components.
• Ability to adjust pricing to respond to cost pressures.
• Unforeseen product liability claims or product quality issues.
• Ability to attract, retain and develop key personnel and create effective succession planning strategies.
• Ability to effectively manage strategic plan or growth processes.
• Ability to successfully upgrade and evolve our information technology systems.
• Ability to successfully protect our information technology systems from cybersecurity risks.
• Occurrence of a significant business interruption.
• Ability to maintain the health and safety of our workforce.
• Ability to complete and integrate acquisitions.
• Ability to develop and commercialize new innovative products and services.
We caution that forward-looking statements must be considered carefully and that actual results may differ in material ways due to risks and uncertainties both known and unknown. Information about factors that could materially affect our results can be found in Part I, Item 1A "Risk Factors" of this Form 10-K. Shareholders, potential investors and other readers are urged to consider these factors in evaluating forward-looking statements and are cautioned not to place undue reliance on such forward-looking statements.
We undertake no obligation to update or revise any forward-looking statement, whether as a result of new information, future events or otherwise, except as required by law. Investors are advised to consult any further disclosures by us in our filings with the SEC and in other written statements on related subjects. It is not possible to anticipate or foresee all risk factors, and investors should not consider any list of such factors to be an exhaustive or complete list of all risks or uncertainties.
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