filings.toolsItem 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion of our financial condition and results of operations should be read in conjunction with the selected financial data and the consolidated financial statements and related notes contained in Item 6. Selected Financial Data and Item 8. Financial Statements and Supplementary Data of this annual report on Form 10-K, respectively. See “Risk Factors” contained in Item 1A. Risk Factors of this annual report on Form 10-K and “Cautionary Statement” contained in Item 1. Business of this annual report on Form 10-K for a discussion of the uncertainties, risks and assumptions associated with these statements.
OVERVIEW
We are a leading supplier of building materials, manufactured components and construction services to professional contractors, sub-contractors, and consumers. The Company operates 402 locations in 40 states across the United States. Given the span and depth of our geographical reach, our locations are organized into nine geographical regions (Regions 1 through 9), which are also our operating segments, and these are further aggregated into four reportable segments: Northeast, Southeast, South and West. All of our segments have similar customers, products and services, and distribution methods. Our financial statements contain additional information regarding segment performance which is discussed in Note 14 to the consolidated financial statements included in Item 8 of this annual report on Form 10-K.
We offer an integrated solution to our customers providing manufacturing, supply and installation of a full range of structural and related building products. Our manufactured products include our factory-built roof and floor trusses, wall panels and stairs, vinyl windows, custom millwork and trim, as well as engineered wood that we design, cut, and assemble for each home. We also assemble interior and exterior doors into pre-hung units. Additionally, we supply our customers with a broad offering of professional grade building products not manufactured by us, such as dimensional lumber and lumber sheet goods and various window, door and millwork lines. Our full range of construction-related services includes professional installation, turn-key framing and shell construction, and spans all our product categories.
We group our building products into six product categories:
| • | Lumber & Lumber Sheet Goods. Lumber & lumber sheet goods include dimensional lumber, plywood, and OSB products used in on-site house framing. |
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| • | Manufactured Products. Manufactured products consist of wood floor and roof trusses, steel roof trusses, wall panels, stairs, and engineered wood. |
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| • | Windows, Door & Millwork. Windows & doors are comprised of the manufacturing, assembly, and distribution of windows and the assembly and distribution of interior and exterior door units. Millwork includes interior trim and custom features that we manufacture under the Synboard ® brand name. |
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| • | Gypsum, Roofing & Insulation. Gypsum, roofing, & insulation include wallboard, ceilings, joint treatment and finishes. |
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| • | Siding, metal, and concrete. Siding, metal, and concrete includes vinyl, composite, and wood siding, exterior trim, other exteriors, metal studs and cement. |
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| • | Other Building Products & Services. Other building products & services are comprised of products such as cabinets and hardware as well as services such as turn-key framing, shell construction, design assistance, and professional installation spanning the majority of our product categories. |
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Our operating results are dependent on the following trends, events and uncertainties, some of which are beyond our control:
| • | Homebuilding Industry. Our business is driven primarily by the residential new construction market and the residential repair and remodel market, which are in turn dependent upon a number of factors, including demographic trends, interest rates, consumer confidence, employment rates, foreclosure rates, the availability of skilled construction labor, and the health of the economy and mortgage markets. According to the U.S. Census Bureau, annual U.S. total and single-family housing starts were 1,202,900 and 848,900, respectively, in 2017. However, both total and single-family housing starts remain well below the normalized historical averages (from 1959 through 2017) of 1.5 million and 1.1 million, respectively. We believe the housing industry is currently experiencing a shortage of skilled construction labor, which is constraining housing activity. Due to the lower levels in housing starts and increased competition for homebuilder business, we have seen and may continue to experience downward competitive pressure on our gross margins. In addition to these factors, there has been a trend of consolidation within the building products supply industry. However, our industry remains highly fragmented and competitive and we will continue to face significant competition from local and regional suppliers. We still believe there are several meaningful trends that indicate U.S. housing demand will recover to the historical average in the long term and that the downturn in the housing industry was a trough in the cyclical nature of the residential construction industry. These trends include relatively low interest rates, the aging of housing stock, and normal population growth due to immigration and birthrate exceeding death rate. Industry forecasters, including the |
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| National Association of Homebuilders (“NAHB”), expect to see continued improvement in housing demand over the next few years. |
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| • | Targeting Large Production Homebuilders. Over the past ten years, the homebuilding industry has undergone consolidation, and the larger homebuilders have increased their market share. We expect that trend to continue as larger homebuilders have better liquidity and land positions relative to the smaller, less capitalized homebuilders. Our focus is on maintaining relationships and market share with these customers while balancing the competitive pressures we are facing in servicing large homebuilders with certain profitability expectations. We expect that our ability to maintain strong relationships with the largest builders will be vital to our ability to expand into new markets as well as grow our market share. Additionally, we have been successful in expanding our custom homebuilder base while maintaining acceptable credit standards. |
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| • | Repair and remodel end market. Although the repair and remodel end market is influenced by housing starts to a lesser degree than the homebuilding market, the repair and remodel end market is still dependent upon some of the same factors as the homebuilding market, including demographic trends, interest rates, consumer confidence, employment rates, foreclosure rates, and the health of the economy and home financing markets. We expect that our ability to remain competitive in this space as well as grow our market share will depend on our continued ability to provide a high level of customer service coupled with a broad product offering. |
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| • | Use of Prefabricated Components. Homebuilders are increasingly using prefabricated components in order to realize increased efficiency and improved quality. Shortening cycle time from start to completion is a key imperative of the homebuilders during periods of strong consumer demand. While the conversion of customers to this product offering slowed during the downturn, we see the demand for prefabricated components increasing as the residential new construction market continues to strengthen and the availability of skilled construction labor remains limited. |
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| • | Economic Conditions. Economic changes both nationally and locally in our markets impact our financial performance. The building products supply industry is highly dependent upon new home construction and subject to cyclical market changes. Our operations are subject to fluctuations arising from changes in supply and demand, national and local economic conditions, labor costs and availability, competition, government regulation, trade policies and other factors that affect the homebuilding industry such as demographic trends, interest rates, housing starts, the availability of suitable building lots, employment levels, consumer confidence, and the availability of credit to homebuilders, contractors, and homeowners. |
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| • | Cost of Materials. Prices of wood products, which are subject to cyclical market fluctuations, may adversely impact operating income when prices rapidly rise or fall within a relatively short period of time. We purchase certain materials, including lumber products, which are then sold to customers as well as used as direct production inputs for our manufactured and prefabricated products. Short-term changes in the cost of these materials, some of which are subject to significant fluctuations, are sometimes passed on to our customers, but our pricing quotation periods may limit our ability to pass on such price changes. We may also be limited in our ability to pass on increases on in-bound freight costs on our products. Our inability to pass on material price increases to our customers could adversely impact our operating results. |
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| • | Controlling Expenses. Another important aspect of our strategy is controlling costs and striving to be the low-cost building materials supplier in the markets we serve. We pay close attention to managing our working capital and operating expenses. Further, we pay careful attention to our logistics function and its effect on our shipping and handling costs. |
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| • | Multi-Family and Light Commercial Business. Our primary focus has been, and continues to be, on single-family residential new construction and the repair and remodel end market. However, we will continue to identify opportunities for profitable growth in the multi-family and light commercial markets. |
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| • | Reduction of Debt: As a result of our historical growth through acquisitions, we have substantial indebtedness. Debt reduction will continue to be a key area of focus for the Company. |
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RECENT DEVELOPMENTS
During the year ended December 31, 2017, the Company executed three debt transactions which are described in Note 8 to the consolidated financial statements included in Item 8 of this annual report on Form 10-K. These transactions further extended our debt maturity profile and reduced our annual cash interest on a go forward basis.
On December 22, 2017, the 2017 Tax Act became enacted law. The effects of the 2017 Tax Act on our financial statements for the year ended December 31, 2017 are discussed in more detail below as well as in Note 11 to the consolidated financial statements included in Item 8 of this annual report on Form 10-K. The 2017 Tax Act, among several other substantial changes, reduces the statutory federal income tax rate from 35% to 21% for periods beginning after December 31, 2017. We generally expect the 2017 Tax Act to have a positive impact on our business due to the anticipated reduction in federal cash tax payments.
CURRENT OPERATING CONDITIONS AND OUTLOOK
Though the level of housing starts remains below the historical average, the homebuilding industry has shown improvement since 2011. According to the U.S. Census Bureau, actual U.S. total housing starts for 2017 were 1,202,900, an increase of 2.5% compared to 2016. Actual U.S. single-family housing starts for 2017 were 848,900, an increase of 8.6% compared to 2016. While the housing industry has strengthened over the past few years, the limited availability of credit to smaller homebuilders and potential homebuyers, as well as the high demand for a limited supply of skilled construction labor, among other factors, have hampered a stronger recovery. A composite of third party sources, including the NAHB, are forecasting 1,292,000 U.S. total housing starts and 921,000 U.S. single-family housing starts for 2018, which are increases of 7.4% and 8.5%, respectively, from 2017. In addition, the Home Improvement Research Institute (“HIRI”) is forecasting sales in the professional repair and remodel end market to increase approximately 2.5% in 2018 compared to 2017.
Our net sales for the year ended December 31, 2017 were up 10.5% over the same period last year. We estimate that our sales volume increased 4.3%, while commodity price inflation resulted in an additional 6.2% increase in sales in 2017 compared to 2016. For the year ended December 31, 2017 sales volume growth in single-family and the repair and remodel end market were partially offset by declines in multi-family. Our gross margin percentage decreased by 0.5% during the year ended December 31, 2017 compared to the year ended December 31, 2016. Our gross margin percentage decreased primarily due to gross profit margin compression on commodity products resulting from inflation in the lumber and lumber sheet goods markets during most of 2017. We continue to invest in our business to improve our operating efficiency, which has allowed us to better leverage our operating costs against changes in net sales. Our selling, general and administrative expenses, as a percentage of net sales, were 20.5% for the year ended December 31, 2017, a 0.9% decrease from 21.4% in 2016. The decrease in selling, general and administrative expenses, as a percentage of net sales, was due to cost leverage as well as the decline in depreciation and amortization on acquired ProBuild assets, partially offset by investments the Company made towards growth initiatives, including additional sales associates and new locations.
We believe the long-term outlook for the housing industry is positive due to growth in the underlying demographics. We feel we are well-positioned to take advantage of the construction activity in our markets and to increase our market share, which may include strategic acquisitions. We will continue to focus on working capital by closely monitoring the credit exposure of our customers and by working with our vendors to improve our payment terms and pricing on our products. We strive to achieve the appropriate balance of short-term expense control while maintaining the expertise and capacity to grow the business as market conditions improve. In addition, debt reduction will continue to be a key area of focus for the Company.
RESULTS OF OPERATIONS
The following table sets forth the percentage relationship to sales of certain costs, expenses and income items for the years ended December 31:
| 2017 | 2016 | 2015 | ||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Sales | 100.0 | % | 100.0 | % | 100.0 | % | ||||||
| Cost of sales | 75.4 | % | 74.9 | % | 74.7 | % | ||||||
| Gross margin | 24.6 | % | 25.1 | % | 25.3 | % | ||||||
| Selling, general and administrative expenses | 20.5 | % | 21.4 | % | 22.7 | % | ||||||
| Income from operations | 4.1 | % | 3.7 | % | 2.6 | % | ||||||
| Interest expense, net | 2.7 | % | 3.3 | % | 3.1 | % | ||||||
| Income tax expense (benefit) | 0.8 | % | (1.9 | )% | 0.1 | % | ||||||
| Net income (loss) | 0.6 | % | 2.3 | % | (0.6 | )% |
2017 Compared with 2016
Sales. Sales for the year ended December 31, 2017 were $7,034.2 million, a 10.5% increase from sales of $6,367.3 million for 2016. We estimate that our sales volume increased 4.3%, while commodity price inflation resulted in an additional 6.2% increase in sales in 2017 compared to 2016. For the year ended December 31, 2017, sales volume growth in single-family and the repair and remodel end market were partially offset by declines in multi-family.
The following table shows sales classified by major product category (dollars in millions):
| 2017 | 2016 | |||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Sales | % of Sales | Sales | % of Sales | % Change | ||||||||||||||||
| Lumber & lumber sheet goods | $ | 2,510.9 | 35.7 | % | $ | 2,131.4 | 33.5 | % | 17.8 | % | ||||||||||
| Manufactured products | 1,208.5 | 17.2 | % | 1,097.7 | 17.2 | % | 10.1 | % | ||||||||||||
| Windows, doors & millwork | 1,360.6 | 19.4 | % | 1,286.2 | 20.2 | % | 5.8 | % | ||||||||||||
| Gypsum, roofing & insulation | 538.4 | 7.6 | % | 520.0 | 8.2 | % | 3.5 | % | ||||||||||||
| Siding, metal & concrete products | 655.9 | 9.3 | % | 622.3 | 9.8 | % | 5.4 | % | ||||||||||||
| Other building products & services | 759.9 | 10.8 | % | 709.7 | 11.1 | % | 7.1 | % | ||||||||||||
| Total sales | $ | 7,034.2 | 100.0 | % | $ | 6,367.3 | 100.0 | % | 10.5 | % |
We achieved increased net sales across all of our product categories. The impact of commodity price inflation in 2017 resulted in the sales growth of our lumber and lumber sheet goods category exceeding the sales growth of our other product categories.
Gross Margin. Gross margin increased $130.6 million to $1,727.4 million. Our gross margin percentage decreased to 24.6% in 2017 from 25.1% in 2016, a 0.5% decrease. Our gross margin percentage decreased primarily due to gross profit margin compression on commodity products resulting from inflation in the lumber and lumber sheet goods markets during most of 2017.
Selling, General and Administrative Expenses. Selling, general and administrative expenses increased $81.9 million, or 6.0%. Our salaries and benefits expense was $935.5 million, an increase of $41.1 million from 2016, and stock compensation increased $3.0 million. Office general and administrative increased $13.9 million, delivery expense increased $10.1 million and occupancy expense increased $5.9 million. In addition, we recognized a $4.2 million loss on the disposal of assets during the year ended December 31, 2017 compared to a gain of $5.0 million during the year ended December 31, 2016.
As a percentage of net sales, selling, general and administrative expenses decreased from 21.4% in 2016 to 20.5% in 2017 due to cost leverage as well as the decline in depreciation and amortization on acquired ProBuild assets, partially offset by investments the Company made towards growth initiatives, including additional sales associates and new locations.
Interest Expense, net. Interest expense was $193.2 million in 2017, a decrease of $21.5 million from 2016. This decrease was largely attributable to the positive results of our debt transactions executed in fiscal years 2016 and 2017. Interest expense for the years ended December 31, 2017 and 2016 included one-time charges related to the debt financing transactions of $58.7 million and $57.0 million, respectively.
Income Tax Expense. We recorded income tax expense of $53.1 million during the year ended December 31, 2017 compared to an income tax benefit of $122.7 million during the year ended December 31, 2016. Due to the enactment of the 2017 Tax Act, we recorded income tax expense of $29.0 million for the year ended December 31, 2017 related to the revaluation of our net deferred tax assets. We recorded reductions of $2.8 million and $131.7 million in the after tax non-cash valuation allowance on our net deferred tax assets for the years ended December 31, 2017 and 2016, respectively. For the year ended December 31, 2017, our effective tax rate was 57.8% largely due to the impact of the additional income tax expense recognized in connection with the enactment of the 2017 Tax Act. Our effective rate for the year ended December 31, 2016 was (566.1%) primarily due to the release of the valuation allowance against our net federal and some state deferred tax assets in that period. Absent the effect of the 2017 Tax Act and the changes to our valuation allowance, our effective rate would have been 29.4% and 41.8% for the years ended December 31, 2017 and 2016, respectively.
2016 Compared with 2015
Sales. Sales for the year ended December 31, 2016 were $6,367.3 million, a 78.6% increase from sales of $3,564.4 million for 2015. Net sales increased $2,659.1 million, or approximately 75%, due to the ProBuild acquisition. Excluding the impact of the ProBuild acquisition, we estimate net sales increased $143.8 million, or approximately 4% due to increased volume.
The following table shows sales classified by major product category (dollars in millions):
| 2016 | 2015 | |||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Sales | % of Sales | Sales | % of Sales | % Change | ||||||||||||||||
| Lumber & lumber sheet goods | $ | 2,131.4 | 33.5 | % | $ | 1,129.7 | 31.7 | % | 88.7 | % | ||||||||||
| Manufactured products | 1,097.7 | 17.2 | % | 635.3 | 17.8 | % | 72.8 | % | ||||||||||||
| Windows, doors & millwork | 1,286.2 | 20.2 | % | 818.1 | 23.0 | % | 57.2 | % | ||||||||||||
| Gypsum, roofing & insulation | 520.0 | 8.2 | % | 264.9 | 7.4 | % | 96.3 | % | ||||||||||||
| Siding, metal & concrete products | 622.3 | 9.8 | % | 319.6 | 9.0 | % | 94.7 | % | ||||||||||||
| Other building products & services | 709.7 | 11.1 | % | 396.8 | 11.1 | % | 78.9 | % | ||||||||||||
| Total sales | $ | 6,367.3 | 100.0 | % | $ | 3,564.4 | 100.0 | % | 78.6 | % |
Due to the ProBuild acquisition, we achieved increased net sales across all product categories. Our sales classification by product categories has shifted as we diversified our product offerings to support a broader customer base across 40 states through the ProBuild acquisition.
Gross Margin. Gross margin increased $695.3 million to $1,596.7 million. Of this increase, $656.8 million is due to the ProBuild acquisition. Our gross margin percentage decreased to 25.1% in 2016 from 25.3% in 2015, a 0.2% decrease. Our gross margin percentage decreased primarily due to the impact of commodity price inflation relative to our short-term customer pricing commitments during the year ended December 31, 2016. However, this decrease was mostly offset by an increase in our gross margin percentage largely attributable to the ProBuild acquisition, the result of ProBuild’s higher mix of higher margin repair & remodel and retail sales.
Selling, General and Administrative Expenses. Selling, general and administrative expenses increased $549.7 million, or 67.8%, largely due to the ProBuild acquisition. Our salaries and benefits expense was $894.3 million, an increase of $383.7 million from 2015, largely due to increased full-time equivalent employees following the ProBuild acquisition. Delivery expense increased $65.9 million, office general and administrative expense increased $46.5 million, occupancy expense increased $45.9 million and intangible asset amortization increased $10.7 million. These increases were primarily a result of the ProBuild acquisition, the related integration activities and increased sales volume. These increases were partially offset by a $4.2 million decrease in facility closure costs.
As a percentage of net sales, selling, general and administrative expenses decreased from 22.7% in 2015 to 21.4% in 2016 largely due to the benefit of synergy cost savings. Synergy cost savings were primarily attributable to reduced payroll and benefits expense, as well as decreased delivery costs and location consolidations.
Interest Expense, net. Interest expense was $214.7 million in 2016, an increase of $105.5 million from 2015. Of the $105.5 million increase, $49.6 million was attributable to increased interest expense associated with our increased debt balances following the ProBuild acquisition financing and subsequent refinancing transactions, $28.1 million was attributable to losses on debt extinguishment largely due to the payment of redemption premiums on our 2021 and 2023 notes, $17.6 million was related to increased amortization and write-off of debt discount and debt issuance costs largely due to our debt transactions during the year ended December 31, 2016, and $14.2 million was due to interest expense primarily related to lease obligations assumed in the ProBuild acquisition. These increases were partially offset by a $4.6 million decrease in interest expense due to non-cash fair value adjustments related to the exercise of all remaining stock warrants in 2015.
Income Tax Expense. We recorded an income tax benefit of $122.7 million during the year ended December 31, 2016 compared to income tax expense of $4.4 million during the year ended December 31, 2015. In the third quarter of 2016, we released the valuation allowance against our net federal and some state deferred tax assets. We recorded a reduction of the after-tax, non-cash valuation allowance on our net deferred tax assets of $131.7 million during the year ended December 31, 2016 compared to an increase of $9.7 million during the year ended December 31, 2015. Absent the valuation allowance our effective tax rate would have been 41.8% and 28.5% for the years ended December 31, 2016 and 2015, respectively.
Results by Reportable Segment
The following tables show net sales and income before income taxes by reportable segment excluding the “All Other” caption as shown in Note 14 to the consolidated financial statements included in Item 8 of this annual report on Form 10-K (dollars in thousands):
| Year ended December 31, | ||||||||||||||||||||||||||||||||||||||||
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| Net sales | Income before income taxes | |||||||||||||||||||||||||||||||||||||||
| % of net | % of net | % of net | % of net | |||||||||||||||||||||||||||||||||||||
| 2017 | sales | 2016 | sales | % change | 2017 | sales | 2016 | sales | % change | |||||||||||||||||||||||||||||||
| Northeast | $ | 1,285,286 | 18.7 | % | $ | 1,204,100 | 19.4 | % | 6.7 | % | $ | 40,359 | 3.1 | % | $ | 35,347 | 2.9 | % | 14.2 | % | ||||||||||||||||||||
| Southeast | 1,542,330 | 22.4 | % | 1,362,259 | 22.0 | % | 13.2 | % | 49,735 | 3.2 | % | 40,261 | 3.0 | % | 23.5 | % | ||||||||||||||||||||||||
| South | 1,855,425 | 27.0 | % | 1,699,371 | 27.4 | % | 9.2 | % | 90,551 | 4.9 | % | 72,183 | 4.2 | % | 25.4 | % | ||||||||||||||||||||||||
| West | 2,188,696 | 31.9 | % | 1,939,206 | 31.2 | % | 12.9 | % | 85,628 | 3.9 | % | 72,745 | 3.8 | % | 17.7 | % | ||||||||||||||||||||||||
| $ | 6,871,737 | 100.0 | % | $ | 6,204,936 | 100.0 | % | $ | 266,273 | 3.9 | % | $ | 220,536 | 3.6 | % |
| Year ended December 31, | ||||||||||||||||||||||||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Net sales | Income before income taxes | |||||||||||||||||||||||||||||||||||||||
| % of net | % of net | % of net | % of net | |||||||||||||||||||||||||||||||||||||
| 2016 | sales | 2015 | sales | % change | 2016 | sales | 2015 | sales | % change | |||||||||||||||||||||||||||||||
| Northeast | $ | 1,204,100 | 19.4 | % | $ | 626,985 | 18.9 | % | 92.0 | % | $ | 35,347 | 2.9 | % | $ | 28,843 | 4.6 | % | 22.5 | % | ||||||||||||||||||||
| Southeast | 1,362,259 | 22.0 | % | 890,164 | 26.8 | % | 53.0 | % | 40,261 | 3.0 | % | 17,193 | 1.9 | % | 134.2 | % | ||||||||||||||||||||||||
| South | 1,699,371 | 27.4 | % | 1,015,556 | 30.6 | % | 67.3 | % | 72,183 | 4.2 | % | 53,435 | 5.3 | % | 35.1 | % | ||||||||||||||||||||||||
| West | 1,939,206 | 31.2 | % | 785,370 | 23.7 | % | 146.9 | % | 72,745 | 3.8 | % | 35,230 | 4.5 | % | 106.5 | % | ||||||||||||||||||||||||
| $ | 6,204,936 | 100.0 | % | $ | 3,318,075 | 100.0 | % | $ | 220,536 | 3.6 | % | $ | 134,701 | 4.1 | % |
We have four reportable segments based on an aggregation of the geographic regions in which we operate. While there is some geographic similarity between our reportable segments and the regions as defined by the U.S. Census Bureau, our reportable segments do not necessarily fully align with any single U.S. Census Bureau region.
According to the U.S. Census Bureau, actual single-family housing starts during the year ended December 31, 2017 increased 3.2%, 7.7%, 7.6% and 13.6% in the Northeast region, Midwest region, South region and West region, respectively. For the year ended December 31, 2017, we achieved increased net sales and profitability compared to 2016 across all of our reportable segments, due to the impact of commodity price inflation as well as an increase in sales volume.
According to the U.S. Census Bureau, actual single-family housing starts during the year ended December 31, 2016 increased 8.8%, 9.5%, 8.7% and 12.8% in the South region, Northeast region, West region and Midwest region, respectively. For the year ended December 31, 2016, we achieved increased net sales and profitability compared to 2015 across all our reportable segments, primarily due to the ProBuild acquisition and sales volume increases.
LIQUIDITY AND CAPITAL RESOURCES
Our primary capital requirements are to fund working capital needs and operating expenses, meet required interest and principal payments, and to fund capital expenditures and potential future acquisitions. Our capital resources at December 31, 2017 consist of cash on hand and borrowing availability under our 2022 facility.
Our 2022 facility will be primarily used for working capital, general corporate purposes, and funding acquisitions. In addition, we may use the 2022 facility to facilitate debt repayment and consolidation. Availability under the 2022 facility is determined by a borrowing base. Our borrowing base consists of trade accounts receivable, inventory, other receivables, including progress billings and credit card receivables, and qualified cash that all meet specific criteria contained within the credit agreement, minus agent specified reserves. Net excess borrowing availability is equal to the maximum borrowing amount minus outstanding borrowings and letters of credit.
The following table shows our borrowing base and excess availability as of December 31, 2017 and 2016 (in millions):
| As of | |||||||
|---|---|---|---|---|---|---|---|
| December 31, 2017 | December 31, 2016 | ||||||
| Accounts Receivable Availability | $ | 437.2 | $ | 403.5 | |||
| Inventory Availability | 380.8 | 332.0 | |||||
| Other Receivables Availability | 39.2 | 27.9 | |||||
| Gross Availability | 857.2 | 763.4 | |||||
| Less: | |||||||
| Agent Reserves | (24.9 | ) | (26.9 | ) | |||
| Plus: | |||||||
| Cash in Qualified Accounts | 39.4 | 15.5 | |||||
| Borrowing Base | 871.7 | 752.0 | |||||
| Aggregate Revolving Commitments | 900.0 | 800.0 | |||||
| Maximum Borrowing Amount (lesser of Borrowing Base and Aggregate Revolving Commitments) | 871.7 | 752.0 | |||||
| Less: | |||||||
| Outstanding Borrowings | (350.0 | ) | — | ||||
| Letters of Credit | (84.9 | ) | (84.8 | ) | |||
| Net Excess Borrowing Availability on Revolving Facility | $ | 436.8 | $ | 667.2 |
As of December 31, 2017, we had $350.0 million in outstanding borrowings under our 2022 facility and our net excess borrowing availability was $436.8 million after being reduced by outstanding letters of credit of approximately $84.9 million. We are required to meet a fixed charge coverage ratio of 1:00 to 1:00 if our excess availability falls below the greater of $80.0 million or 10% of the maximum borrowing amount, which was $87.2 million as of December 31, 2017. We were not in violation of any covenants or restrictions imposed by any of our debt agreements at December 31, 2017.
Liquidity
Our liquidity at December 31, 2017 was $494.3 million, which consists of net borrowing availability under the 2022 facility and cash on hand. We are expecting continued improvement in the housing industry in 2018. Beyond 2018, it is difficult for us to predict what will happen as our industry is dependent on a number of factors, including national economic conditions, employment levels, the availability of credit for homebuilders and potential home buyers, the level of foreclosures, existing home inventory, and interest rates.
We have substantial indebtedness following our recent acquisitions, which increased our interest expense and could have the effect of, among other things, reducing our flexibility to respond to changing business and economic conditions. From time to time, based on market conditions and other factors and subject to compliance with applicable laws and regulations, the Company may repurchase or call the 2024 notes, repay debt, or otherwise enter into transactions regarding its capital structure.
Should the current industry conditions deteriorate or we pursue additional acquisitions, we may be required to raise additional funds through the sale of capital stock or debt in the public capital markets or in privately negotiated transactions. There can be no assurance that any of these financing options would be available on favorable terms, if at all. Alternatives to help supplement our liquidity position could include, but are not limited to, idling or permanently closing additional facilities, adjusting our headcount in response to current business conditions, attempts to renegotiate leases, managing our working capital and/or divesting of non-core businesses. There are no assurances that these steps would prove successful or materially improve our liquidity position.
Consolidated Cash Flows
Cash provided by operating activities was $178.5 million and $158.2 million in 2017 and 2016, respectively. The increase in cash provided by operations is due to increased sales and profitability during the year ended December 31, 2017. However, this increase in cash provided by operating activities was mostly offset by the working capital increase of $94.1 million for 2017 exceeding the working capital increase of $43.9 million in 2016. This increased investment in working capital is primarily related to accounts receivable and inventory during the year ended December 31, 2017 compared to the prior year due to a $666.9 million increase in sales over the same period. In addition, the larger increase in working capital for 2017 was also due to a decrease in accrued liabilities in the current year compared to an increase in accrued liabilities in 2016. The decrease in accrued liabilities in 2017 is primarily due to a decrease in accrued interest attributable to the redemption of the 2023 notes in December 2017. These increases were partially offset by the increase in accounts payable for 2017 exceeding the increase in 2016 primarily due to increased purchases in the current year.
Cash provided by operating activities was $158.2 million and $177.0 million in 2016 and 2015, respectively. Our working capital increased $43.9 million in 2016 compared to a decrease of $99.0 million in 2015. The change in working capital is largely due to the ProBuild acquisition, as well as increases in receivables and inventory and increased customer demand. These increases were partially offset by increases in accounts payable and accrued liabilities largely due to increased purchases and increased accounts payable days. Cash interest payments increased $99.5 million in 2016 compared to 2015. The remaining change is due to an increase in cash provided by operations primarily related to increased sales and profitability during the year ended December 31, 2016 as a result of the ProBuild acquisition and higher sales volume.
Cash used in investing activities was $59.4 million and $38.3 million in 2017 and 2016, respectively. The increase in cash used in investing activities is largely due to a $19.7 million increase in capital expenditures in 2017 compared to 2016. The increase in capital expenditures in 2017 largely relates to facility improvements and the purchase of machinery and equipment to support sales growth.
Cash used in investing activities was $38.3 million and $1,508.0 million in 2016 and 2015, respectively. The change is primarily due to $1,462.7 million in cash used for the ProBuild acquisition in 2015. The remaining change is largely due to an increase in proceeds from the sale of property, plant and equipment and a decrease in capital expenditures in 2016 compared to 2015.
Cash used in financing activities was $76.0 million and $170.5 million for the years ended December 31, 2017 and 2016, respectively. Cash used in financing activities in 2017 was primarily attributable to the $379.9 million in payments of long-term debt, largely due to the extinguishment of our 2023 notes. In connection with the extinguishment of the 2023 notes we paid $48.7 million in debt extinguishment costs. These payments were largely offset by $350.0 million in net borrowings under the 2022 facility. Cash used in financing activities in 2016 largely relates to the debt transactions executed in that period which are described below.
Cash used in financing activities was $170.5 million in 2016 compared to cash provided by financing activities of $1,378.3 million in 2015. Cash used in financing activities in 2016 was primarily attributable to $807.5 million in payments of long-term debt, largely due to the extinguishment of our 2021 notes, the partial pay down of the 2015 term loan and 2023 notes. In addition, we repaid $60.0 million, net, under the 2015 facility, paid $42.9 million of debt extinguishment costs and $15.7 million in debt issuance costs. These payments were partially offset by $750.0 million in proceeds from the 2024 notes issuance. Cash provided by financing activities for 2015 is attributable to the financing activities executed in connection with the ProBuild acquisition.
Capital Expenditures
Capital expenditures vary depending on prevailing business factors, including current and anticipated market conditions. Historically, capital expenditures have for the most part remained at relatively low levels in comparison to the operating cash flows generated during the corresponding periods. We expect our 2018 capital expenditures to be in the range of approximately $120 million to $130 million primarily related to rolling stock, equipment and facility improvements to support our operations.
DISCLOSURES OF CONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTS
The following summarizes our contractual obligations as of December 31, 2017 (in thousands):
| Payments Due by Period | ||||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Contractual obligations | Total | Less than 1 year | 1-3 years | 3-5 years | More than 5 years | |||||||||||||||
| Long-term debt | $ | 1,562,950 | $ | 4,700 | $ | 9,400 | $ | 359,400 | $ | 1,189,450 | ||||||||||
| Interest on long-term debt(1) | 477,674 | 79,441 | 158,287 | 145,405 | 94,541 | |||||||||||||||
| Lease finance obligations(2) | 328,961 | 18,418 | 36,871 | 35,362 | 238,310 | |||||||||||||||
| Capital lease obligations(2) | 16,591 | 6,689 | 9,902 | — | — | |||||||||||||||
| Operating leases | 319,867 | 76,565 | 114,578 | 67,797 | 60,927 | |||||||||||||||
| Total contractual cash obligations | $ | 2,706,043 | $ | 185,813 | $ | 329,038 | $ | 607,964 | $ | 1,583,228 |
| (1) | We had $350.0 million in outstanding borrowings under the 2022 facility as of December 31, 2017. Borrowings under the 2022 facility bear interest at a variable rate. Therefore, actual interest may differ from the amounts presented above due to interest rate changes or any future borrowing activity under the 2022 facility. The 2024 term loan also bears interest at a variable rate, therefore actual interest may differ from the amounts presented above due to interest rate changes. |
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| (2) | Future minimum commitments for lease finance obligations and capital lease obligations. |
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The amounts reflected in the table above for operating leases represent future minimum lease payments under non-cancelable operating leases with an initial or remaining term in excess of one year at December 31, 2017. Purchase orders entered into in the ordinary course of business are excluded from the above table because they are payable within one year. Amounts for which we are
liable under purchase orders are reflected on our consolidated balance sheet as accounts payable and accrued liabilities. Where it makes economic sense to do so, we plan to lease certain equipment during 2018 to support anticipated sales growth. These operating leases are not included in the table above.
OTHER CASH OBLIGATIONS NOT REFLECTED IN THE BALANCE SHEET
In accordance with accounting principles generally accepted in the United States, commonly referred to as GAAP, our operating leases are not recorded in our balance sheet. In addition to the lease obligations included in the above table, we have residual value guarantees on certain equipment leases. Under these leases we have the option of (1) purchasing the equipment at the end of the lease term, (2) arranging for the sale of the equipment to a third party, or (3) returning the equipment to the lessor to sell the equipment. If the sales proceeds in either case are less than the residual value, then we are required to reimburse the lessor for the deficiency up to a specified level as stated in each lease agreement. The guarantees under these leases for the residual values of equipment at the end of the respective operating lease periods approximated $5.6 million as of December 31, 2017.
Based upon the expectation that none of these leased assets will have a residual value at the end of the lease term that is materially less than the value specified in the related operating lease agreement or that we will purchase the equipment at the end of the lease term, we do not believe it is probable that we will be required to fund any amounts under the terms of these guarantee arrangements. Accordingly, no accruals have been recognized for these guarantees.
In addition, the Company is party to certain agreements related to its lease finance obligations which commit the Company to perform certain repairs and maintenance obligations under the leases in a specified manner and timeframe that generally will occur throughout the next year.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Critical accounting policies are those that both are important to the accurate portrayal of a company’s financial condition and results, and require subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain.
In order to prepare financial statements that conform to GAAP, we make estimates and assumptions that affect the amounts reported in our financial statements and accompanying notes. Certain estimates are particularly sensitive due to their significance to the financial statements and the possibility that future events may be significantly different from our expectations.
We have identified the following accounting policy that requires us to make the most subjective or complex judgments in order to fairly present our consolidated financial position and results of operations.
Goodwill. Goodwill represents the excess of the amount we paid to acquire businesses over the estimated fair value of tangible assets and identifiable intangible assets acquired, less liabilities assumed. At December 31, 2017, our goodwill balance was $740.4 million, representing 24.6% of our total assets.
We test goodwill for impairment in the fourth quarter of each year or at any other time when impairment indicators exist by comparing the estimated implied value of a reporting units’ goodwill to its book value. Examples of such indicators that could cause us to test goodwill for impairment between annual tests include a significant change in the business climate, unexpected competition or a significant deterioration in market share. We may also consider market capitalization relative to our net assets. Housing starts are a significant sales driver for us. If there is a significant decline or an expected decline in housing starts, this could adversely affect our expectations for a reporting unit and the value of that reporting unit.
In connection with our annual goodwill impairment test in the fourth quarter of 2017 we elected to adopt updated guidance which simplifies the accounting for goodwill impairment. This updated guidance is described in Note 2 to the consolidated financial statements included in Item 8 of this annual report on Form 10-K.
The process of evaluating goodwill for impairment involves the determination of the fair value of our reporting units. Our reporting units are aligned with our nine geographic regions which are also determined to be our operating segments. In evaluating goodwill for impairment, the Company first assesses qualitative factors to determine whether it is more likely than not that the fair value of the reporting unit is less than its carrying value. If it is concluded that it is not more likely than not that the fair value of the reporting unit is less than its carrying value, then no further testing of the goodwill is required.
However, if we determine that it is more likely than not that the fair value of the reporting unit is less than its carrying amount, we perform a quantitative goodwill impairment test. This test identifies both the existence of and the amount of goodwill impairment
by comparing the fair value of a reporting unit to its carrying amount, including goodwill. If the fair value of a reporting unit exceeds its carrying amount goodwill is not impaired. If the carrying amount of a reporting unit exceeds its fair value an impairment loss is recognized in amount equal to that excess, limited to the amount of goodwill allocated to that reporting unit.
In performing our annual impairment tests at December 31, 2017, we developed a range of fair values for our reporting units using a five-year discounted cash flow methodology. Inherent in such fair value determinations are estimates relating to future cash flows, including revenue growth, gross margins, operating expenses and long-term growth rates, and our interpretation of current economic indicators and market conditions and their impact on our strategic plans and operations. Due to the uncertainties associated with such estimates, interpretations and assumptions, actual results could differ from projected results, which could result in impairment of goodwill could be recorded.
Significant information and assumptions utilized in estimating future cash flows for our reporting units includes projections of market share gains as well as publicly available industry information on projected single-family housing starts and lumber commodity prices which are used to project revenue. Projected gross margins and operating expenses reflect current headcount levels and cost structure and are flexed in future years based upon historical trends at various revenue levels. Long-term growth was based upon terminal value earnings before interest, taxes, depreciation and amortization (“EBITDA”) multiples of 5.0x for all reporting units to reflect the relevant expected acquisition price. A discount rate of 12.5% was used for all reporting units and is intended to reflect the weighted average cost of capital for a potential market participant and includes all risks of ownership and the associated risks of realizing the stream of projected future cash flows. Decreasing the long-term growth to an EBITDA multiple of 4.0x, or increasing the discount rate by 1.0% to 13.5%, would not have changed the results of our impairment testing.
At December 31, 2017, the fair values of each of our reporting units were substantially in excess of their respective carrying amounts. The excess (or “cushion”) of the fair values over the carrying amounts of our nine reporting units ranged from $122 million to $315 million. Factors that could negatively impact the estimated fair value of our reporting units and potentially trigger additional impairment include, but are not limited to, unexpected competition, lower than expected housing starts, an increase in market participant weighted average cost of capital, increases in material or labor cost, and significant declines in our market capitalization. Future impairment of goodwill would have the effect of decreasing our earnings or increasing our losses in such period, but would not impact our current outstanding debt obligations or compliance with covenants contained in the related debt agreements. We did not have any goodwill impairments in 2017, 2016 or 2015.
RECENTLY ISSUED ACCOUNTING STANDARDS
Information regarding recent accounting pronouncements is discussed in Note 2 to the consolidated financial statements included in Item 8 of this annual report on Form 10-K.
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