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 and analysis of our financial condition and results of operations should be read together with “Item 6 - Selected Financial Data” and the consolidated financial statements and the related notes included in Item 8 of this Annual Report on Form 10-K. This discussion contains forward-looking statements, based on current expectations and related to future events and our future financial performance, that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of many factors, including those set forth under “Item 1A - Risk Factors.”
Overview
We are a leading designer and manufacturer of a wide range of power generation equipment and other engine powered products serving the residential, light commercial, industrial and construction markets. Unlike our primary competitors in the generator market, power generation is our main focus. As the only significant market participant focused predominantly on these products, we have one of the leading market positions in the power equipment market in North America and an expanding presence internationally. We believe we have one of the widest range of products in the marketplace, including residential, commercial and industrial standby generators, as well as portable and mobile generators used in a variety of applications. Other engine powered products that we design and manufacture include light towers which provide temporary lighting for various end markets and a broad product line of power washers for residential and commercial use.
Business drivers and operational factors
In operating our business and monitoring its performance, we pay attention to a number of business drivers and trends as well as operational factors. The statements in this section are based on our current expectations.
Business drivers and trends
Our performance is affected by the demand for reliable power solutions by our customer base. This demand is influenced by several important drivers and trends affecting our industry, including the following:
Increasing penetration opportunity. Many potential customers are not aware of the costs and benefits of automatic backup power solutions. We estimate that penetration rates for home standby generators are only approximately 3.0% of U.S. single-family detached, owner-occupied households with a home value of over $100,000, as defined by the U.S. Census Bureau's 2011 American Housing Survey for the United States. The decision to purchase backup power for many light-commercial buildings such as convenience stores, restaurants and gas stations are more return-on-investment (ROI) driven and as a result these applications have relatively lower penetration rates as compared to buildings used in more code-driven or mission critical applications such as hospitals, wastewater treatment facilities, 911 call centers, data centers and certain industrial locations. In addition, the emergence of lower cost, cleaner burning natural gas fueled generators has helped to accelerate the penetration of standby generators in the light-commercial market. Also, the importance of backup power for telecommunications infrastructure is increasing due to the growing importance for uninterrupted voice and data services. We believe by expanding our distribution network, continuing to develop our product line, and targeting our marketing efforts, we can continue to build awareness and increase penetration for our standby generators.
Effect of large scale power disruptions. Power disruptions are an important driver of customer awareness and have historically influenced demand for generators. Increased frequency and duration of major power outage events caused by the aging U.S. power grid increases product awareness and may drive consumers to accelerate their purchase of a standby or portable generator during the immediate and subsequent period, which we believe may last for six to twelve months for standby generators. For example, the multiple major outage events that occurred during the second half of both 2011 and 2012 drove strong demand for portable and home standby generators, and the increased awareness of these products contributed to substantial organic revenue growth in 2012 with strong growth continuing during 2013. While there are localized power outages that occur practically every day across the U.S., major outage activity is unpredictable by nature and, as a result, our sales levels and profitability may fluctuate from period to period.
Impact of residential investment cycle. The market for residential generators is also affected by the residential investment cycle and overall consumer confidence and sentiment. When homeowners are confident of their household income, the value of their home and overall net worth, they are more likely to invest in their home. These trends can have an impact on demand for residential generators. Trends in the new housing market highlighted by residential housing starts can also impact demand for our residential products.
Impact of business capital investment cycle. The market for our commercial and industrial products is affected by the overall capital investment cycle, including non-residential building construction, durable goods and infrastructure spending as well as investments in the exploration and production of oil & gas, as businesses or organizations either add new locations or make investments to upgrade existing locations or equipment. These trends can have a material impact on demand for these products. The capital investment cycle may differ for the various commercial and industrial end markets that we serve including light commercial, retail, telecommunications, industrial, data centers, healthcare, construction, oil & gas and municipal infrastructure, among others. The market for these products is also affected by general economic conditions and credit availability in the geographic regions that we serve. In addition, we believe demand for our mobile power products will continue to benefit from a secular shift towards renting versus buying this type of equipment.
Factors affecting results of operations
We are subject to various factors that can affect our results of operations, which we attempt to mitigate through factors we can control, including continued product development, expanded distribution, pricing and cost control. Certain operational and other factors that affect our business include the following:
Effect of commodity, currency and component price fluctuations. Industry-wide price fluctuations of key commodities, such as steel, copper and aluminum and other components we use in our products, together with foreign currency fluctuations, can have a material impact on our results of operations. We have historically attempted to mitigate the impact of rising commodity, currency and component prices through improved product design and sourcing, manufacturing efficiencies, price increases and select hedging transactions. Our results are also influenced by changes in fuel prices in the form of freight rates, which in some cases are borne by our customers and in other cases are paid by us.
Seasonality. Although there is demand for our products throughout the year, in each of the past three years approximately 16% to 27% of our net sales occurred in the first quarter, 20% to 23% in the second quarter, 24% to 30% in the third quarter and 25% to 34% in the fourth quarter, with different seasonality depending on the presence, timing and severity of major power outage activity in each year. Major outage activity is unpredictable by nature and, as a result, our sales levels and profitability may fluctuate from period to period. For example, there were multiple major power outage events that occurred during the second half of both 2011 and 2012, which were significant in terms of severity. As a result, the seasonality experienced during this time period varied relative to other periods where no major outage events occurred. We maintain a flexible production and supply chain infrastructure in order to respond to outage-driven peak demand, but assuming no major outage events, typically increase production levels in the second and third quarters of each year.
Factors influencing interest expense. Interest expense can be impacted by a variety of factors, including market fluctuations in LIBOR, interest rate election periods, interest rate swap agreements and repayments of indebtedness. Interest expense increased during 2013 compared to 2012, primarily due to an increase in outstanding debt and the full-year weighted-average cost of debt associated with our credit agreement refinancings. See Note 6 – Credit Agreements in Item 8 of this Annual Report on Form 10-K for additional details.
Factors influencing provision for income taxes and cash income taxes paid. We had approximately $960 million of tax-deductible goodwill and intangible asset amortization remaining as of December 31, 2013 related to our acquisition by CCMP in 2006 that we expect to generate cash tax savings of approximately $374 million through 2021, assuming continued profitability and a 39% tax rate. The recognition of the tax benefit associated with these assets for tax purposes is expected to be $122 million annually through 2020 and $102 million in 2021, which generates annual cash tax savings of $48 million through 2020 and $40 million in 2021, assuming profitability and a 39% tax rate. As a result of the asset acquisition of the Magnum Products business in the fourth quarter of 2011, we had approximately $48.3 million of incremental tax deductible goodwill and intangible assets remaining as of December 31, 2013. We expect these assets to generate cash tax savings of $18.9 million through 2026 assuming continued profitability and a 39% tax rate. The amortization of these assets for tax purposes is expected to be $3.8 million annually through 2025 and $2.8 million in 2026, which generates an additional annual cash tax savings of $1.5 million through 2025 and $1.1 million in 2026, assuming profitability and a 39% tax rate. Based on current business plans, we believe that our cash tax obligations through 2026 will be significantly reduced by these tax attributes. Other domestic acquisitions have resulted in additional tax deductible goodwill and intangible assets that will generate tax savings, but are not material to the Company’s consolidated financial statements.
In the second quarter of 2013, the dividend recapitalization discussed under “Liquidity and financial position” was completed. After considering the increased debt and related interest expense, the Company believes it will still generate sufficient taxable income to fully utilize the tax attributes discussed above.
Transactions with CCMP
In November 2006, affiliates of CCMP, together with certain other investors and members of our management, purchased an aggregate of $689 million of our equity capital. In addition, on November 10, 2006, Generac Power Systems borrowed an aggregate of $1.38 billion, consisting of an initial drawdown of $950 million under a $1.1 billion first lien secured credit facility and $430 million under a $430 million second lien secured credit facility. With the proceeds from these equity and debt financings, together with cash on hand at Generac Power Systems, we (1) acquired all of the capital stock of Generac Power Systems and repaid certain pre-transaction indebtedness of Generac Power Systems for $2.0 billion, (2) paid $66 million in transaction costs related to the transaction and (3) retained $3 million for general corporate purposes. Subsequently, during 2007, 2008 and 2009, affiliates of CCMP acquired approximately $249.2 million of second lien term loans and $9.9 million of first lien term loans for approximately $155.9 million. CCMP’s affiliates then exchanged this debt for additional shares of then-existing Class B Common Stock and Series A Preferred Stock, which were subsequently converted into the same class of our common stock through a corporate reorganization in conjunction with the initial public offering in February 2010.
In August 2013, CCMP completed the last of a series of sale transactions that began in November 2012 by which it sold substantially all of the shares of common stock that it owned as of the initial public offering.
Initial public offering
On February 17, 2010, the Company completed its initial public offering of 18,750,000 shares of its common stock at a price of $13.00 per share. In addition, the underwriters exercised their option and purchased an additional 1,950,500 shares of the Company’s common stock from the Company on March 18, 2010. We received a total of approximately $247.9 million in net proceeds from the initial public offering and underwriters’ option exercise, after deducting the underwriting discounts and expenses. All shares sold in this offering were primary shares. Immediately following the IPO and underwriters’ option exercise, we had 67,529,290 total shares of common stock outstanding.
Components of net sales and expenses
Net sales
Substantially all of our net sales are generated through the sale of our generators and other engine powered products for the residential, light commercial, industrial and construction markets. We also sell engines to certain customers and service parts to our dealer network. Net sales, which include shipping and handling charges billed to customers, are recognized upon shipment of products to our customers. Related freight costs are included in cost of sales. Our generators and other products are fueled by natural gas, liquid propane, gasoline, diesel or Bi-Fuel™ systems with power output from 800W to several megawatts (mW) using our multi-generator systems. Our products are primarily manufactured and assembled at our Wisconsin (USA), Mexico, Italy and Brazil facilities and distributed through thousands of outlets primarily across the U.S. and Canada, with an expanding presence internationally including Latin America, Europe, the Middle East, Africa and Asia/Pacific regions. Our smaller kW generators for the residential and commercial markets, as well as light towers and power washers, are primarily built to stock, while our larger kW products for the industrial markets are generally customized and built to order.
During 2013, our net sales were affected primarily by the U.S. economy as sales outside of the United States represented approximately 12% of total net sales.
We are not dependent on any one channel or customer for our net sales, with no single customer representing more than 6% of our sales for the year ended December 31, 2013 and our top ten customers representing less than 24% of our sales for the same period.
Costs of goods sold
The principal elements of costs of goods sold in our manufacturing operations are component parts, raw materials, factory overhead and labor. Component parts and raw materials comprised over 85% of costs of goods sold for the year ended December 31, 2013. The principal component parts are engines and alternators. We design and manufacture air-cooled engines for certain of our products up to 20kW. We source engines for certain of our smaller products and all of our products larger than 20kW. For natural gas engines, we’re recognized as the OEM of those engines. We design all the alternators for our units and manufacture alternators for certain of our units. We also manufacture other generator components where we believe we have a design and cost advantage. We source component parts from an extensive global network of reliable, high quality suppliers. In some cases, these relationships are proprietary.
The principal raw materials used in our manufacturing and warehousing processes and in the manufacturing of the components we source are steel, copper and aluminum. We are susceptible to fluctuations in the cost of these commodities, impacting our costs of goods sold. We seek to mitigate the impact of commodity prices on our business through a continued focus on global sourcing, product design improvements, manufacturing efficiencies, price increases and select hedging transactions. However, there is typically a lag between raw material price fluctuations and their effect on our costs of goods sold.
Other sources of costs include our manufacturing and warehousing facilities, factory overhead, labor and shipping costs. Factory overhead includes utilities, support personnel, depreciation, general supplies, support and maintenance. Although we attempt to maintain a flexible manufacturing cost structure, our margins can be impacted when we cannot timely adjust labor and manufacturing costs to match fluctuations in net sales.
Operating expenses
Our operating expenses consist of costs incurred to support our sales, marketing, distribution, service parts, engineering, information systems, human resources, finance, risk management, legal and tax functions. All of these categories include personnel costs such as salaries, bonuses, employee benefit costs and taxes. We typically classify our operating expenses into four categories: selling and service, research and development, general and administrative, and amortization of intangibles.
Selling and service. Our selling and service expenses consist primarily of personnel expense, marketing expense, warranty expense and other sales expenses. Our personnel expense recorded in selling and services expenses includes the expense of our sales force responsible for our national accounts and other personnel involved in the marketing, sales and service of our products. Warranty expense, which is recorded at the time of sale, is estimated based on historical trends. Our marketing expenses include direct mail costs, printed material costs, product display costs, market research expenses, trade show expenses, media advertising and co-op advertising costs. Marketing expenses are generally related to the launch of new product offerings and opportunities within selected markets or associated with specific events such as awareness marketing in areas impacted by major power outages, participation in trade shows and other events.
Research and development. Our research and development expenses support numerous projects covering all of our product lines. We currently operate engineering facilities at eight locations globally and employ over 250 personnel with focus on new product development, existing product improvement and cost containment. Our commitment to research and development has resulted in a significant portfolio of over 100 U.S. and international patents and patent applications. Our research and development costs are expensed as incurred.
General and administrative. Our general and administrative expenses include personnel costs for general and administrative employees, accounting and legal professional services fees, information technology costs, insurance, travel and entertainment expense and other corporate expense.
Amortization of intangibles. Our amortization of intangibles expenses include the straight-line amortization of definite-lived customer lists, patents and other intangibles assets.
Goodwill and trade name. Goodwill primarily represents the excess of the amount paid over the fair market value of net tangible and intangible assets acquired in business combinations.
Other indefinite-lived intangible assets consist of trade names. The fair value of trade names is measured using a relief-from-royalty approach, which assumes the fair value of the trade name is the discounted cash flows of the amount that would be paid had we not owned the trade name and instead licensed the trade name from another company.
During the fourth quarter of 2011, we recorded a non-cash charge which primarily related to the write down of a certain trade name. We refer you to Note 2-Significant accounting policies-Goodwill and other indefinite-lived intangible assets in Item 8 of this Annual Report on Form 10-K for additional information about this charge.
Other income (expense)
Other income (expense) includes the interest expense on our outstanding borrowings, amortization of debt financing costs and original issue discount as well as expenses related to interest rate swap agreements. Other income (expense) also includes other financial items such as loss on extinguishment of debt and interest income earned on our cash and cash equivalents.
Costs related to acquisition. In 2013, other expenses include one-time transaction-related expenses related to the acquisitions of Tower Light and Baldor Generators. In 2012, other expenses include one-time transaction-related expenses related to the acquisition of the Ottomotores businesses. In 2011, other expenses include one-time transaction-related expenses related to the acquisition of the Magnum business.
Results of operations
Year ended December 31, 2013 compared to year ended December 31, 2012
The following table sets forth our consolidated statement of operations data for the periods indicated:
| (Dollars in thousands) | Year ended December 31, 2013 | Year ended December 31, 2012 | ||||||
|---|---|---|---|---|---|---|---|---|
| Net sales | $ | 1,485,765 | $ | 1,176,306 | ||||
| Costs of goods sold | 916,205 | 735,906 | ||||||
| Gross profit | 569,560 | 440,400 | ||||||
| Operating expenses: | ||||||||
| Selling and service | 107,515 | 101,448 | ||||||
| Research and development | 29,271 | 23,499 | ||||||
| General and administrative | 55,490 | 46,031 | ||||||
| Amortization of intangibles | 25,819 | 45,867 | ||||||
| Total operating expenses | 218,095 | 216,845 | ||||||
| Income from operations | 351,465 | 223,555 | ||||||
| Total other expense, net | (72,749 | ) | (67,203 | ) | ||||
| Income before provision for income taxes | 278,716 | 156,352 | ||||||
| Provision for income taxes | 104,177 | 63,129 | ||||||
| Net income | $ | 174,539 | $ | 93,223 | ||||
| (Dollars in thousands) | Year ended December 31, 2013 | Year ended December 31, 2012 | ||||||
| Residential power products | $ | 843,727 | $ | 705,444 | ||||
| Commercial & Industrial power products | 569,890 | 410,341 | ||||||
| Other | 72,148 | 60,521 | ||||||
| Net sales | $ | 1,485,765 | $ | 1,176,306 |
Net sales. Net sales increased $309.5 million, or 26.3%, to $1,485.8 million for the year ended December 31, 2013 from $1,176.3 million for the year ended December 31, 2012. Residential product sales increased 19.6% to $843.7 million from $705.4 million for the comparable period in 2012. The increase in residential product sales was primarily driven by increases in shipments for home standby generators due to a combination of factors including the additional awareness and adoption of our products created by major power outages in recent years, the Company’s expanded distribution, increased sales and marketing initiatives, overall strong operational execution and an improving environment for residential investment. The strength in home standby generators was partially offset by a decline in shipments of portable generators due to less severe power outage events relative to the prior year. In addition, increased revenue from power washer products contributed to the year-over-year sales growth in residential products. Commercial & industrial product sales increased 38.9% to $569.9 million from $410.3 million for the comparable period in 2012. The increase was driven by the acquisitions of Ottomotores, Tower Light and Baldor Generators along with strong organic growth for stationary and mobile generators. The increase in organic revenues was primarily driven by strong shipments to national account customers and increased sales of natural gas generators used in light commercial applications.
Gross profit. Gross profit increased $129.2 million, or 29.3%, to $569.6 million for the year ended December 31, 2013 from $440.4 million for the year ended December 31, 2012. Gross profit margin for the year ended December 31, 2013 increased to 38.3% from 37.4% for the year ended December 31, 2012. Gross margin improved over the prior year due to the combination of improved product mix, improved pricing and a moderation in product costs due to lower commodity prices and execution of cost reduction initiatives. These margin improvements were partially offset by the mix impact from the Ottomotores and Baldor acquisitions.
Operating expenses. Operating expenses increased $1.3 million to $218.1 million for the year ended December 31, 2013 from $216.8 million for the year ended December 31, 2012. Operating expenses increased as a result of the addition of the Ottomotores, Tower Light and Baldor Generator businesses, as well as increased sales, engineering and administrative infrastructure to support the strategic growth initiatives and higher sales levels of the Company. These increases were mostly offset by warranty rate improvements resulting in a $17.6 million favorable adjustment to warranty reserves driven by better claims experience, which impacted selling and service expense, as well as a decline in the amortization of intangibles.
Other expense. Other expense increased $5.5 million, or 8.3%, to $72.7 million for the year ended December 31, 2013 from $67.2 million for the year ended December 31, 2012. These additional expenses were primarily driven by an increase in interest expense over prior year. Interest expense increased by $5.3 million, or 10.8% over the prior year due to the higher debt levels from the May 2012 and 2013 refinancing transactions, partially offset by a slight reduction in interest rate on the new credit facility.
Income tax expense. Income tax expense increased $41.1 million to $104.2 million for the year ended December 31, 2013 from $63.1 million for the year ended December 31, 2012. The increase in income tax expense was primarily driven by the increase in pre-tax income during 2013 compared to 2012, partially offset by a lower effective tax rate. The decrease in the effective income tax rate year-over-year is primarily due to the lower tax rate of a foreign subsidiary acquired during the fourth quarter of 2012 and the reinstatement of the federal research and development tax credit in 2013.
Net income. As a result of the factors identified above, we generated net income of $174.5 million for the year ended December 31, 2013 compared to $93.2 million for the year ended December 31, 2012. The increase in net income is due to the items previously described.
Adjusted EBITDA. Adjusted EBITDA, as reconciled in “Item 6 - Selected Financial Data,” increased to $402.6 million as compared to $289.8 million in 2012 due to the factors discussed above.
Adjusted net income. Adjusted Net Income, as reconciled in “Item 6 - Selected Financial Data,” increased to $301.7 million in 2013 compared to $220.8 million in 2012 due to the factors discussed above.
Year ended December 31, 2012 compared to year ended December 31, 2011
| (Dollars in thousands) | Year ended December 31, 2012 | Year ended December 31, 2011 | ||||||
|---|---|---|---|---|---|---|---|---|
| Net sales | $ | 1,176,306 | $ | 791,976 | ||||
| Costs of goods sold | 735,906 | 497,322 | ||||||
| Gross profit | 440,400 | 294,654 | ||||||
| Operating expenses: | ||||||||
| Selling and service | 101,448 | 77,776 | ||||||
| Research and development | 23,499 | 16,476 | ||||||
| General and administrative | 46,031 | 30,012 | ||||||
| Amortization of intangibles | 45,867 | 48,020 | ||||||
| Trade name write-down | - | 9,389 | ||||||
| Total operating expenses | 216,845 | 181,673 | ||||||
| Income from operations | 223,555 | 112,981 | ||||||
| Total other expense, net | (67,203 | ) | (26,015 | ) | ||||
| Income before provision for income taxes | 156,352 | 86,966 | ||||||
| Provision (benefit) for income taxes | 63,129 | (237,677 | ) | |||||
| Net income | $ | 93,223 | $ | 324,643 | ||||
| (Dollars in thousands) | Year ended December 31, 2012 | Year ended December 31, 2011 | ||||||
| Residential power products | 705,444 | 491,016 | ||||||
| Commercial & Industrial power products | 410,341 | 250,270 | ||||||
| Other | 60,521 | 50,690 | ||||||
| Net sales | 1,176,306 | 791,976 |
Net sales. Net sales increased $384.3 million, or 48.5%, to $1,176.3 million for the year ended December 31, 2012 from $792.0 million for the year ended December 31, 2011. This increase was driven by a $214.4 million, or a 43.7% increase in residential product sales largely driven by increased demand created by major power outages in recent quarters along with expanded distribution and new product offerings. Commercial & industrial product sales increased $160.1million, or 64.0%, driven primarily by the additional Magnum Products revenue, and to a lesser extent, increased shipments of natural gas backup generators.
Gross profit. Gross profit increased $145.7 million, or 49.5%, to $440.4 million for the year ended December 31, 2012 from $294.7 million for the year ended December 31, 2011. Gross profit margin for the year ended December 31, 2012 increased to 37.4% from 37.2% for the year ended December 31, 2011. Gross margin increased over the prior year primarily due to the positive impact from price increases, improved manufacturing overhead absorption and moderation in commodity costs relative to the prior year. These margin improvements were partially offset by the mix impact from the addition of Magnum Products sales.
Operating expenses. Operating expenses increased $35.2 million to $216.8 million for the year ended December 31, 2012 from $181.7 million for the year ended December 31, 2011. These additional expenses were driven primarily by operating expenses associated with Magnum, increased sales, engineering and administrative infrastructure to support the strategic growth initiatives and higher sales levels of the Company, increased incentive compensation expenses as a result of the Company’s financial performance during the year, and increased variable expenses resulting from the increase in organic sales.
Other expense. Other expense increased $41.2 million, or 158.3%, to $67.2 million for the year ended December 31, 2012 from $26.0 million for the year ended December 31, 2011. Interest expense increased by $25.4 million, or 107.1% as a result of the higher debt levels from the May 2012 refinancing transaction. In addition, losses on extinguishment of debt increased $13.9 million in 2012 as a result of the February 2012 and May 2012 debt refinancing transactions.
Income tax expense. Income tax expense increased $300.8 million to a provision of $63.1 million for the year ended December 31, 2012 from a benefit of $237.7 million for the year ended December 31, 2011. The large income tax benefit in the prior year consisted primarily of the reversal of the full valuation allowance on the Company’s net deferred tax assets. We refer you to Note 9, “Income Taxes,” of our consolidated financial statements included in Item 8 of this Annual Report on Form 10-K for additional information.
Net income. As a result of the factors identified above, we generated net income of $93.2 million for the year ended December 31, 2012 compared to net income of $324.6 million for the year ended December 31, 2011. The decrease in net income is due to the items previously described.
Adjusted EBITDA. Adjusted EBITDA, as reconciled in “Item 6 - Selected Financial Data,” increased to $289.8 million as compared to $188.5 million in 2011 due to the factors discussed above.
Adjusted net income. Adjusted Net Income, as reconciled in “Item 6 - Selected Financial Data,” increased to $220.8 million in 2012 compared to $147.2 million in 2011 due to the factors discussed above.
Liquidity and financial position
Our primary cash requirements include payment for our raw material and component supplies, salaries & benefits, operating expenses, interest and principal payments on our debt and capital expenditures. We finance our operations primarily through cash flow generated from operations and, if necessary, borrowings under our revolving credit facility.
In February 2012, we paid in full our previously existing debt and entered into a new credit agreement (Credit Agreement). The Credit Agreement provided for borrowings under a $150.0 million revolving credit facility, a $325.0 million tranche A term loan facility and a $250.0 million tranche B term loan facility. Proceeds received from loans made under the Credit Agreement were used to repay in full all outstanding borrowings under the former credit agreement, dated as of November 10, 2006, as amended from time to time, and for general corporate purposes.
In May 2012, we amended and restated our then existing Credit Agreement by entering into a new credit agreement (Term Loan Credit Agreement) and a new revolving credit agreement (ABL Credit Agreement). The Term Loan Credit Agreement provided for a $900.0 million term loan B credit facility (Term Loan) and included a $125.0 million uncommitted incremental term loan facility and the ABL Credit Agreement provided for borrowings under a $150.0 million senior secured ABL revolving credit facility and an uncommitted $50.0 million incremental revolving credit facility. A portion of the proceeds from the Term Loan were used to repay the previous Credit Agreement. The remaining proceeds from the Term Loan were used, together with cash on hand, to pay a special cash dividend of $6.00 per share on our common stock (”2012 dividend recapitalization”).
On May 31, 2013, we amended and restated our then existing Term Loan Credit Agreement by entering into a new term loan credit agreement (New Term Loan Credit Agreement). The New Term Loan Credit Agreement provides for a $1.2 billion term loan B credit facility (New Term Loan) and includes a $300.0 million uncommitted incremental term loan facility. The New Term Loan Credit Agreement matures on May 31, 2020. Proceeds from the New Term Loan were used to repay the previous Term Loan Credit Agreement and to fund a special cash dividend of $5.00 per share on our common stock (“2013 dividend recapitalization”). Remaining funds from the New Term Loan were used for general corporate purposes and to pay related financing fees and expenses. The New Term Loan initially bears interest at rates based upon either a base rate plus an applicable margin of 1.75% or adjusted LIBOR rate plus an applicable margin of 2.75%, subject to a LIBOR floor of 0.75%. Beginning in the second quarter of 2014, the applicable margin related to base rate loans can be reduced to 1.50% and the applicable margin related to LIBOR rate loans can be reduced to 2.50%, in each case, if Generac Power Systems’ (Borrower) net debt leverage ratio falls below 3.00 to 1.00. Concurrent with the closing of the New Term Loan Credit Agreement, on May 31, 2013, we amended our existing ABL Credit Agreement. The amendment provides for a one year extension of the maturity date in respect of the $150.0 million senior secured ABL revolving credit facility provided under the ABL Credit Agreement (ABL Facility). The extended maturity date of the ABL Facility is May 31, 2018.
We refer you to Note 6, “Credit Agreements,” of our consolidated financial statements included in Item 8 of this Annual Report on Form 10-K for additional information.
At December 31, 2013, we had cash and cash equivalents of $150.1 million and $147.5 million of availability under our revolving credit facility, net of outstanding letters of credit and outstanding borrowings. On August 1, 2013, we used a substantial portion of our cash on hand to acquire the equity of Tower Light SRL and its wholly-owned subsidiaries (collectively, “Tower Light”). On November 1, 2013, we used a substantial portion of our cash on hand to purchase substantially all of the assets of Baldor Electric Company’s generator division (“Baldor Generators”).
Long-term liquidity
We believe that our cash flow from operations and our availability under our revolving credit facility, combined with our relatively low ongoing capital expenditure requirements and favorable tax attributes, which result in a lower cash tax rate as compared to the U.S. statutory tax rate, provides us with sufficient capital to continue to grow our business in the future. We will use a significant portion of our cash flow to pay interest and principal on our outstanding debt, impacting the amount available for working capital, capital expenditures and other general corporate purposes. As we continue to expand our business, we may in the future require additional capital to fund working capital, capital expenditures or acquisitions.
Cash flow
Year ended December 31, 2013 compared to year ended December 31, 2012
The following table summarizes our cash flows by category for the periods presented:
| Year ended December 31, | ||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| (Dollars in thousands) | 2013 | 2012 | Change | % Change | ||||||||||||
| Net cash provided by operating activities | $ | 259,944 | $ | 235,594 | $ | 24,350 | 10.3 | % | ||||||||
| Net cash used in investing activities | $ | (144,549 | ) | $ | (69,345 | ) | $ | (75,204 | ) | (108.5 | )% | |||||
| Net cash used in financing activities | $ | (73,399 | ) | $ | (151,352 | ) | $ | 77,953 | 51.5 | % |
Net cash provided by operating activities was $259.9 million for 2013 compared to $235.6 million in 2012. This increase of $24.4 million, or 10.3%, is primarily attributable to strong operating earnings as a result of strong organic sales growth and improved operating margins partially offset by increased working capital investments, such as increases in inventory levels to support higher production rates and replenish finished good inventories.
Net cash used for investing activities for the year ended December 31, 2013 was $144.6 million. This included cash payments of $30.8 million for the purchase of property and equipment, $122.4 million for the acquisitions of the Tower Light and Baldor Generators businesses, partially offset by cash proceeds of $2.3 million from the sale of a business and $6.3 million relating to the finalization of the Ottomotores purchase price. Net cash used for investing activities for the year ended December 31, 2012 was $69.3 million. This included $22.4 million for the purchase of property and equipment and $47.0 million for the acquisition of the Ottomotores businesses.
Net cash used for financing activities was $73.4 million for the year ended December 31, 2013, primarily representing the net cash impact of debt prepayments and the dividend recapitalization transaction that occurred during the first half of 2013, including cash proceeds from long-term borrowings of $1,200.0 million offset by $901.2 million of long-term borrowing repayments. The Company paid $22.4 million for transaction fees incurred in connection with May 2013 refinancing transaction. Following the refinancing, the Company paid a special cash dividend of $5.00 per share ($340.8 million) on the Company’s common stock (incremental to the $2.6 million cash dividends paid during 2013, related to the 2012 dividend, due to the vesting of restricted stock awards). In addition, the Company paid $15.0 million in taxes related to the net share settlement of equity awards which was partially offset by approximately $11.6 million of excess tax benefits of equity awards. Finally, the Company received net cash proceeds of $16.0 million from short-term borrowings, which were more than offset by approximately $19.0 million of short-term borrowing repayments.
Net cash used for financing activities was $151.4 million for the year ended December 31, 2012, primarily representing the net cash impact of our refinancing activities and the dividend recapitalization transaction that occurred during the first half of 2012, including cash proceeds from long-term borrowings of $1,455.6 million offset by $1,175.1 million of long-term borrowing repayments. The Company made $25.7 million of cash payments for transaction fees incurred in connection with these refinancing transactions. Following the refinancing, the Company paid a special cash dividend of $6.00 per share ($404.3 million, which excludes dividends for unvested restricted stock) on the Company’s common stock during the second quarter of 2012.
Year ended December 31, 2012 compared to year ended December 31, 2011
The following table summarizes our cash flows by category for the periods presented:
| Year ended December 31, | ||||||||||||||||
| (Dollars in thousands) | 2012 | 2011 | Change | % Change | ||||||||||||
| Net cash provided by operating activities | $ | 235,594 | $ | 169,712 | $ | 65,882 | 38.8 | % | ||||||||
| Net cash used in investing activities | $ | (69,345 | ) | $ | (95,953 | ) | $ | 26,608 | 27.7 | % | ||||||
| Net cash used in financing activities | $ | (151,352 | ) | $ | (59,216 | ) | $ | (92,136 | ) | (155.6 | )% |
Net cash provided by operating activities was $235.6 million for 2012 compared to $169.7 million in 2011. This increase of $65.9 million, or 38.8%, is primarily attributable to strong operating earnings partially offset by increased working capital investments, such as increases in inventory levels to support higher production rates.
Net cash used for investing activities for the year ended December 31, 2012 was $69.3 million. This included $22.4 million for the purchase of property and equipment and $47.0 million for the acquisition of the Ottomotores businesses. Net cash used for investing activities for the year ended December 31, 2011 was $96.0 million and included $12.1 million for the purchase of property and equipment and $83.9 million for the acquisition of the Magnum Products business. The increase in purchases of property and equipment was primarily driven by the purchase of a manufacturing facility and expansion of our corporate headquarters and engineering lab facilities.
Net cash used in financing activities was $151.4 million for the year ended December 31, 2012, an increase of $92.1 million in net cash outflows from 2011 primarily representing the net cash impact of our refinancing activities and dividend recapitalization transaction during the first half of 2012, including gross proceeds from long-term borrowings of $1,455.6 million offset by $1,175.1 million of long-term borrowing repayments. The Company made $25.7 million of cash payments for transaction fees incurred in connection with these refinancing transactions. Following the refinancing, the Company paid a special cash dividend of $6.00 per share ($404.3 million, which excludes dividends for unvested restricted stock) on the Company’s common stock during the second quarter of 2012. Net cash used in financing activities was $59.2 million for the year ended December 31, 2011, primarily related to long-term borrowing repayments.
Senior secured credit facilities
On May 31, 2013, the Borrower amended and restated its then existing Term Loan Credit Agreement by entering into the New Term Loan Credit Agreement with certain commercial banks and other lenders. The New Term Loan Credit Agreement provides for a $1,200.0 million New Term Loan and includes a $300.0 million uncommitted incremental term loan facility. The New Term Loan Credit Agreement matures on May 31, 2020. Proceeds from the New Term Loan were used to repay amounts outstanding under the Company’s previous Term Loan Credit Agreement and to fund a special cash dividend of $5.00 per share on the Company’s common stock. We refer you to Note 12, “Special Cash Dividend,” of our consolidated financial statements included in Item 8 of this Annual Report on Form 10-K for additional information. Remaining funds from the New Term Loans were used for general corporate purposes and to pay related financing fees and expenses.
The New Term Loan is guaranteed by all of the Borrower’s wholly-owned domestic restricted subsidiaries, Generac Acquisition Corp. (GAC) and the Company, and is secured by associated collateral agreements which pledge a first priority lien on virtually all of the Borrower’s assets, including fixed assets and intangibles, and the assets of the guarantors (other than the Company), other than all cash, trade accounts receivable, inventory, and other current assets and proceeds thereof, which will be secured by a second priority lien.
The New Term Loan amortizes in equal installments of 0.25% of the original principal amount of the New Term Loan payable on the first day of April, July, October and January commencing on October 1, 2013 until the final maturity date of the New Term Loan on May 31, 2020. The New Term Loan initially bears interest at rates based upon either a base rate plus an applicable margin of 1.75% or adjusted LIBOR rate plus an applicable margin of 2.75%, subject to a LIBOR floor of 0.75%. Beginning in the second quarter of 2014, the applicable margin related to base rate loans can be reduced to 1.50% and the applicable margin related to LIBOR rate loans can be reduced to 2.50%, in each case, if the Borrower’s net debt leverage ratio falls below 3.00 to 1.00.
Concurrent with the closing of the New Term Loan Credit Agreement, on May 31, 2013, the Borrower amended its existing ABL Credit Agreement by entering into the New ABL Credit Agreement. The amendment provides for a one year extension of the maturity date in respect of the $150.0 million ABL Facility. The extended maturity date of the ABL Facility is May 31, 2018.
Borrowings under the ABL Facility are guaranteed by all of the Borrower’s wholly-owned domestic restricted subsidiaries and GAC, and are secured by associated collateral agreements which pledge a first priority lien on all cash, trade accounts receivable, inventory, and other current assets and proceeds thereof, and a second priority lien on all other assets, including fixed assets and intangibles of the Borrower, certain domestic subsidiaries of the Borrower and the guarantors (other than the Company).
Borrowings under the ABL Facility continue to bear interest at rates based upon either a base rate plus an applicable margin of 1.00% or adjusted LIBOR rate plus an applicable margin of 2.00%, in each case, subject to adjustments based upon average availability under the ABL Facility. The New ABL Credit Agreement requires the Borrower to maintain a minimum consolidated fixed charge coverage ratio of 1.0x, tested on a quarterly basis, when Availability plus the amount of Qualified Cash (up to $5.0 million) (as defined in the New ABL Credit Agreement) under the ABL Facility is less than the greater of (i) 10.0% of the Line Cap (as defined in the New ABL Credit Agreement) and (ii) $10.0 million. As of December 31, 2013, no amounts were outstanding under the ABL Facility. As of December 31, 2013, the Company had $150.1 million of unrestricted cash and cash equivalents and $147.5 million of availability under the ABL Facility, net of outstanding letters of credit.
On February 11, 2013, the Company made an $80.0 million voluntary prepayment of debt with available cash on hand that was applied to future principal amortizations on the previous Term Loan Credit Agreement. As a result, the Company wrote off $1.8 million of original issue discount and capitalized debt issuance costs during the first quarter of 2013. On May 2, 2013, the Company made an additional $30.0 million voluntary prepayment of existing debt with available cash on hand. As a result, the Company wrote off $0.9 million of original issue discount and capitalized debt issuance costs during the second quarter of 2013.
In connection with the May 31, 2013 refinancing and in accordance with ASC 470-50, Debt Modifications and Extinguishments, the Company capitalized $21.8 million of new debt issuance costs, recorded $13.8 million of fees paid to creditors as a debt discount, and expensed $7.1 million of transaction fees. The Company evaluated on a lender by lender basis if the debt related to returning lenders was significantly modified or not, resulting in the write-off of $5.5 million in unamortized debt issuance costs and original issue discount relating to the previous Term Loan Credit Agreement and ABL Credit Agreement. Amounts expensed are recorded as a loss on extinguishment of debt in the condensed consolidated statement of comprehensive income for the year ended December 31, 2013. The Company amortizes both the capitalized debt issuance costs and the original issue discount on its loans under the effective interest method.
Covenant compliance
The New Term Loan Credit Agreement contains restrictions on the Borrower’s ability to pay distributions and dividends (but which permitted the payment of the special cash dividend described in Note 12 – Special Cash Dividend of our consolidated financial statements included in Item 8 of this annual report on Form 10-K). Payments can be made by the Borrower to the Company or other parent companies for certain expenses such as operating expenses in the ordinary course, fees and expenses related to any debt or equity offering and to pay franchise or similar taxes. Dividends can be used to repurchase equity interests, subject to limitations in certain circumstances. Additionally, the New Term Loan Credit Agreement restricts the aggregate amount of dividends and distributions that can be paid and, in certain circumstances, requires pro forma compliance with certain fixed charge coverage ratios or gross leverage ratios, as applicable in order to pay certain dividends and distributions. The New Term Loan Credit Agreement also contains other affirmative and negative covenants that, among other things, limit the incurrence of additional indebtedness, liens on property, sale and leaseback transactions, investments, loans and advances, mergers or consolidations, asset sales, acquisitions, transactions with affiliates, prepayments of certain other indebtedness and modifications of our organizational documents. The New Term Loan Credit Agreement does not contain any financial maintenance covenants.
The New Term Loan Credit Agreement contains customary events of default, including, among others, nonpayment of principal, interest or other amounts, failure to perform covenants, inaccuracy of representations or warranties in any material respect, cross-defaults with other material indebtedness, certain undischarged judgments, the occurrence of certain ERISA or bankruptcy or insolvency events or the occurrence of a change in control (defined in the New Term Loan Credit Agreement). A bankruptcy or insolvency event of default will cause the obligations under the New Term Loan Credit Agreement to automatically become immediately due and payable.
The New ABL Credit Agreement also contains covenants and events of default substantially similar to those in the New Term Loan Credit Agreement, as described above.
Contractual obligations
The following table summarizes our expected payments for significant contractual obligations as of December 31, 2013:
| (Dollars in thousands) Payment due by period | ||||||||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Contractual obligations | Total | Less than 1 year | 2-3 years | 4-5 years | After 5 years | |||||||||||||||||||
| Long-term debt, including current portion(1) | $ | 1,198,824 | $ | 13,021 | $ | 24,803 | $ | 23,999 | $ | 1,137,001 | ||||||||||||||
| Capital lease obligation, including current portion | 2,529 | 185 | 389 | 418 | 1,537 | |||||||||||||||||||
| Interest on long-term debt(2) | 263,935 | 42,316 | 83,417 | 81,560 | 56,642 | |||||||||||||||||||
| Operating leases | 6,228 | 1,952 | 3,443 | 833 | - | |||||||||||||||||||
| Total contractual cash obligations(3) | $ | 1,471,516 | $ | 57,474 | $ | 112,052 | $ | 106,810 | $ | 1,195,180 |
(1) On May 31, 2013, the Borrower amended and restated its then existing Credit Agreement by entering into a new credit agreement (“New Term Loan Credit Agreement”) with certain commercial banks and other lenders. The New Term Loan Credit Agreement provides for a $1,200.0 million term loan credit facility (“New Term Loan”) and a $300.0 million uncommitted incremental term loan facility. The New Term Loan Credit Agreement matures on May 31, 2020.
(2) Assumes normal debt amortization payments until maturity and using interest rates in effect for our New Term Loan Credit Agreement as of December 31, 2013.
(3) Pension obligations are excluded from this table as we are unable to estimate the timing of payment due to the inherent assumptions underlying the obligation. However, the Company estimates we will contribute $2.1 million to our pension plans in 2014.
Capital expenditures
Our operations require capital expenditures for technology, tooling, equipment, capacity expansion and upgrades. Capital expenditures were $30.8 million and $22.4 million for the years ended December 31, 2013 and 2012, respectively, and were funded through cash from operations.
Off-balance sheet arrangements
We have an arrangement with a finance company to provide floor plan financing for selected dealers. This arrangement provides liquidity for our dealers by financing dealer purchases of products with credit availability from the finance company. We receive payment from the finance company after shipment of product to the dealer and our dealers are given a longer period of time to pay the finance provider. If our dealers do not pay the finance company, we may be required to repurchase the applicable inventory held by the dealer. We do not indemnify the finance company for any credit losses they may incur.
Total inventory financed accounted for approximately 7% of net sales for the year ended December 31, 2012 and approximately 8% of net sales for the year ended December 31, 2013. The amount financed by dealers which remained outstanding was $16.6 million and $24.3 million as of December 31, 2012 and 2013, respectively.
Critical accounting policies
In preparing the financial statements in accordance with accounting principles generally accepted in the U.S., management is required to make estimates and assumptions that have an impact on the asset, liability, revenue and expense amounts reported. These estimates can also affect supplemental information disclosures of the Company, including information about contingencies, risk and financial condition. The Company believes, given current facts and circumstances, that its estimates and assumptions are reasonable, adhere to accounting principles generally accepted in the U.S., and are consistently applied. Inherent in the nature of an estimate or assumption is the fact that actual results may differ from estimates and estimates may vary as new facts and circumstances arise. The Company makes routine estimates and judgments in determining net realizable value of accounts receivable, inventories, property, plant and equipment, and prepaid expenses. Management believes the Company’s most critical accounting estimates and assumptions are in the following areas: goodwill and other indefinite-lived intangible asset impairment assessment, business combinations and purchase accounting, defined benefit pension obligations, estimates of allowance for doubtful accounts, excess and obsolete inventory reserves, product warranty, other contingencies, derivative accounting, income taxes, and share based compensation.
Goodwill and other intangible assets
Goodwill represents the excess of the purchase price over fair value of identifiable net assets acquired from business acquisitions. Goodwill is not amortized, but is reviewed for impairment on an annual basis and between annual tests if indicators of impairment are present. The Company evaluates goodwill for impairment annually on October 1 or more frequently when an event occurs or circumstances change that indicates the carrying value may not be recoverable. The Company has the option to assess goodwill for impairment by first performing a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If the Company determines that it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, then further goodwill impairment testing is not required to be performed. If the Company determines that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, the Company is required to perform a two-step goodwill impairment test. In the first step, the fair value of the reporting unit is compared to its book value including goodwill. If the fair value of the reporting unit is in excess of its book value, the related goodwill is not impaired and no further analysis is necessary. If the fair value of the reporting unit is less than its book value, there is an indication of potential impairment and a second step is performed. When required, the second step of testing involves calculating the implied fair value of goodwill for the reporting unit. The implied fair value of goodwill is determined in the same manner as goodwill recognized in a business combination, which is the excess of the fair value of the reporting unit determined in step one over the fair value of its net assets and identifiable intangible assets as if the reporting unit had been acquired. If the carrying value of the reporting unit's goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to that excess. For reporting units with a negative book value (i.e., excess of liabilities over assets), qualitative factors are evaluated to determine whether it is necessary to perform the second step of the goodwill impairment test.
The Company performed the required annual impairment tests for fiscal years 2013, 2012 and 2011 and found no impairment of goodwill.
Other indefinite-lived intangible assets consist of trade names. The Company tests the carrying value of these trade names by comparing the assets fair value to its carrying value. Fair value was measured using a relief-from-royalty approach, which assumes the fair value of the trade name is the discounted cash flows of the amount that would be paid had the Company not owned the trade name and instead licensed the trade name from another company. The Company conducts its annual impairment test for indefinite-lived intangible assets on October 31st of each year.
The Company performed the required annual impairment tests for fiscal years 2013 and 2012 and found no impairment of indefinite-lived trade names. During the fourth quarter of 2011, the Company decided to strategically transition certain products to their more widely known Generac brand. Based on this decision, the Company recorded a $9.4 million non-cash trade name impairment charge as of October 31, 2011 which primarily related to the write down of the impacted trade name to net realizable value.
We can make no assurances that remaining goodwill or indefinite-lived trade names will not be impaired in the future. When preparing a discounted cash flow analysis, we make a number of key estimates and assumptions. We estimate the future cash flows of the business based on historical and forecasted revenues and operating costs. This, in turn, involves further estimates, such as estimates of future growth rates and inflation rates. In addition, we apply a discount rate to the estimated future cash flows for the purpose of the valuation. This discount rate is based on the estimated weighted average cost of capital for the business and may change from year to year. Weighted average cost of capital includes certain assumptions such as market capital structures, market betas, risk-free rate of return and estimated costs of borrowing. Changes in these key estimates and assumptions, or in other assumptions used in this process, could materially affect our impairment analysis for a given year. Additionally, since our measurement also considers a market approach, changes in comparable public company multiples can also materially impact our impairment analysis.
In the long term, our remaining goodwill and indefinite-lived trade name balances could be further impaired in future periods. A number of factors, many of which we have no ability to control, could affect our financial condition, operating results and business prospects and could cause actual results to differ from the estimates and assumptions we employed. These factors include:
| · | a prolonged global economic crisis; |
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| · | a significant decrease in the demand for our products; |
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| · | the inability to develop new and enhanced products and services in a timely manner; |
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| · | a significant adverse change in legal factors or in the business climate; |
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| · | an adverse action or assessment by a regulator; and |
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| · | successful efforts by our competitors to gain market share in our markets. |
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Our cash flow assumptions are based on historical and forecasted revenue, operating costs and other relevant factors. If management's estimates of future operating results change or if there are changes to other assumptions, the estimate of the fair value of our business may change significantly. Such change could result in impairment charges in future periods, which could have a significant impact on our operating results and financial condition.
Business combinations and purchase accounting
We account for business combinations using the acquisition method of accounting, and accordingly, the assets and liabilities of the acquired business are recorded at their respective fair values. The excess of the purchase price over the estimated fair value is recorded as goodwill. Assigning fair market values to the assets acquired and liabilities assumed at the date of an acquisition requires knowledge of current market values, and the values of assets in use, and often requires the application of judgment regarding estimates and assumptions. While the ultimate responsibility resides with management, for material acquisitions we retain the services of certified valuation specialists to assist with assigning estimated values to certain acquired assets and assumed liabilities, including intangible assets and tangible long-lived assets. Acquired intangible assets, excluding goodwill, are valued using certain discounted cash flow methodologies based on future cash flows specific to the type of intangible asset purchased. This methodology incorporates various estimates and assumptions, the most significant being projected revenue growth rates, earnings margins, and forecasted cash flows based on the discount rate and terminal growth rate.
Defined benefit pension obligations
The funded status of our pension plans is more fully described in Note 9 to our audited consolidated financial statements included in Item 8 of this Annual Report on Form 10-K. The Company’s pension benefit obligation and related pension expense or income are calculated in accordance with ASC 715-30, Defined Benefit Plans—Pension, and are impacted by certain actuarial assumptions, including the discount rate and the expected rate of return on plan assets.
Rates are evaluated on an annual basis considering such factors as market interest rates and historical asset performance. Actuarial valuations for fiscal year 2013 used a discount rate of 4.98% for the salaried pension plan and 5.01% for the hourly pension plan. Our discount rate was selected using a methodology that matches plan cash flows with a selection of “Aa” or higher rated bonds, resulting in a discount rate that better matches a bond yield curve with comparable cash flows. In estimating the expected return on plan assets, we study historical markets and preserve the long-term historical relationships between equities and fixed-income securities. We evaluate current market factors such as inflation and interest rates before we determine long-term capital market assumptions and review peer data and historical returns to check for reasonableness and appropriateness. Changes in the discount rate and return on assets can have a significant effect on the funded status of our pension plans, stockholders' equity and related expense. We cannot predict these changes in discount rates or investment returns and, therefore, cannot reasonably estimate whether the impact in subsequent years will be significant.
The funded status of our pension plans is the difference between the projected benefit obligation and the fair value of its plan assets. The projected benefit obligation is the actuarial present value of all benefits expected to be earned by the employees' service. No compensation increase is assumed in the calculation of the projected benefit obligation, as the plans were frozen effective December 31, 2008.
Our funding policy for our pension plans is to contribute amounts at least equal to the minimum annual amount required by applicable regulations. Given this policy, we expect to make $2.1 million in contributions to our pension plans in 2014.
Allowance for doubtful accounts, excess and obsolete inventory reserves, product warranty reserves and other contingencies
The reserves, if any, for customer rebates, product warranty, product liability, litigation, excess and obsolete inventory and doubtful accounts are fact-specific and take into account such factors as specific customer situations, historical experience, and current and expected economic conditions. These reserves are reflected under Notes 2, 4, 5 and 14 to our audited consolidated financial statements included in Item 8 of this Annual Report on Form 10-K.
Derivative accounting
We enter into interest rate swap contracts, or Swaps, to fix a portion of our variable rate indebtedness. Due to the incorporation of a new interest rate floor provision in the Term Loan Credit Agreement, which constituted a change in critical terms, the Company concluded that as of May 30, 2012, the Swaps outstanding at that time would no longer be highly effective in achieving offsetting changes in cash flows during the periods the hedges are designated. As a result, the Company was required to de-designate the hedges as of May 30, 2012. Beginning May 31 2012, the effective portion of the swaps prior to the change (i.e. amounts previously recorded in Accumulated Other Comprehensive Loss) were amortized into interest expense over the period of the originally designated hedged transactions which had various dates through October 2013. Subsequent changes in fair value of the related swaps were immediately recognized in the consolidated statements of comprehensive income as interest expense.
As required by ASC 815 Derivatives and Hedging, we record the Swaps at fair value pursuant to ASC 820 Fair Value Measurements and Disclosures, which defines fair value, establishes a consistent framework for measuring fair value and expands disclosure for each major asset and liability category measured at fair value. When determining the fair value of the Swaps, we considered our credit risk in accordance with ASC 820. The fair value of our outstanding Swaps, including the impact of credit risk, at December 31, 2013 and 2012 was an asset of $1.2 million and a liability of $3.0 million, respectively.
Income taxes
We account for income taxes in accordance with ASC 740 Income Taxes. Our estimate of income taxes payable, deferred income taxes and the effective tax rate is based on an analysis of many factors including interpretations of federal, state and international income tax laws, the difference between tax and financial reporting bases of assets and liabilities, estimates of amounts currently due or owed in various jurisdictions, and current accounting standards. We review and update our estimates on a quarterly basis as facts and circumstances change and actual results are known.
We have generated significant deferred tax assets as a result of goodwill and intangible asset book versus tax differences. In assessing the realizability of these deferred tax assets, we consider whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the years in which those temporary differences become deductible. We consider the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies in making this assessment. As of September 30, 2011, we were in a three year cumulative loss position and had a full valuation allowance recorded against our net deferred tax assets. In the fourth quarter of 2011, we came out of a three-year cumulative loss position and, as part of the normal assessment of the future realization of our net deferred tax assets, determined that a valuation allowance was no longer required. As a result, the valuation allowance previously recorded was reversed in the fourth quarter of 2011 and was recorded as a component of the income tax provision.
Ottomotores Brazil, acquired in the Ottomotores acquisition in December 2012, is in a three-year cumulative net loss position and therefore we have not considered expected future taxable income in analyzing the realizability of their deferred tax assets as of December 31, 2013. As a result, a full valuation allowance was recorded against the deferred tax assets of Ottomotores Brazil.
In performing the assessment of the realization of our deferred tax assets as of December 31, 2013, excluding Ottomotores Brazil, we have determined that it is more likely than not that our deferred tax assets will be realized, and therefore no valuation allowance is required.
Share based compensation
Under the fair value recognition provisions of ASC 718 Compensation – Stock Compensation, share based compensation cost is measured at the grant date based on the fair value of the award and is recognized as expense over the requisite service period. Determining the fair value of share based awards at the grant date requires judgment, including estimating expected dividends and market volatility of our stock. In addition, judgment is also required in estimating the amount of share based awards that are expected to be forfeited. If actual results differ significantly from these estimates, share based compensation expense and our results of operations could be impacted.
New Accounting Standards
For information with respect to new accounting pronouncements and the impact of these pronouncements on our consolidated financial statements, we refer you to Note 2, “New Accounting Pronouncements,” of our consolidated financial statements included in Item 8 of this Annual Report on Form 10-K.
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