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
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The following discussion contains management’s discussion and analysis of our financial condition and results of operations and should be read together with “Item 6. Selected Financial Data” and our audited consolidated financial statements and related notes to our consolidated financial statements included elsewhere in this Form 10-K. This discussion contains forward-looking statements and involves numerous risks and uncertainties. Our actual results may differ materially from those anticipated in any forward-looking statements as a result of many factors, including those set forth under the “Special Note Regarding Forward-Looking Statements,” “Item 1A. Risk Factors” and elsewhere in this Form 10-K.
Executive Overview
Our Company
We are a leading global provider of mission-critical flow control and compression equipment and associated aftermarket parts, consumables and services, which we sell across multiple attractive end-markets within the industrial, energy and medical industries. We manufacture one of the broadest and most complete ranges of compressor, pump, vacuum and blower products in our markets, which, combined with our global geographic footprint and application expertise, allows us to provide differentiated product and service offerings to our customers. Our products are sold under a collection of premier, market-leading brands, including Gardner Denver, CompAir, Nash, Emco Wheaton, Robuschi, Elmo Rietschle and Thomas, which we believe are globally recognized in their respective end-markets and known for product quality, reliability, efficiency and superior customer service. These attributes, along with over 155 years of engineering heritage, generate strong brand loyalty for our products and foster long-standing customer relationships, which we believe have resulted in leading market positions within each of our operating segments. We have sales in more than 175 countries and our diverse customer base utilizes our products across a wide array of end-markets that have favorable near- and long-term growth prospects, including industrial manufacturing, energy (with particular exposure to the North American upstream land-based market), transportation, medical and laboratory sciences, food and beverage packaging and chemical processing.
Our products and services are critical to the processes and systems in which they are utilized, which are often complex and function in harsh conditions where the cost of failure or downtime is high. However, our products and services typically represent only a small portion of the costs of the overall systems or functions that they support. As a result, our customers place a high value on our application expertise, product reliability and the responsiveness of our service. To support our customers and market presence, we maintain significant global scale with 41 key manufacturing facilities, more than 30 complementary service and repair centers across six continents and approximately 6,700 employees worldwide as of December 31, 2018.
The process-critical nature of our product applications, coupled with the standard wear and tear replacement cycles associated with the usage of our products, generates opportunities to support customers with our broad portfolio of aftermarket parts, consumables and services. Customers place a high value on minimizing any time their operations are offline. As a result, the availability of replacement parts, consumables and our repair and support services are key components of our value proposition. Our large installed base of products provides a recurring revenue stream through our aftermarket parts, consumables and services offerings. As a result, our aftermarket revenue is significant, representing 39% of total Company revenue and approximately 43% of our combined Industrials and Energy segments’ revenue in 2018.
Our Segments
We report our results of operations through three reportable segments: Industrials, Energy and Medical.
Industrials
In the Industrials segment, we design, manufacture, market and service a broad range of air compression, vacuum and blower products across a wide array of technologies and applications. Almost every manufacturing and industrial facility, and many service and process industries, use air compression and vacuum products in a variety of applications such as operation of pneumatic air tools, vacuum packaging of food products and aeration of waste water. We maintain a leading position in our markets and serve customers globally. We offer comprehensive aftermarket parts and an experienced direct and distributor-based service network world-wide to complement all of our products. In 2018, the Industrials segment generated Segment Revenue of $1,303.3 million and Segment Adjusted EBITDA of $288.2 million, reflecting a Segment Adjusted EBITDA Margin of 22.1%.
Energy
In the Energy segment, we design, manufacture, market and service a diverse range of positive displacement pumps, liquid ring vacuum pumps and compressors, and engineered loading systems and fluid transfer equipment, consumables, and associated aftermarket parts and services. We serve customers in the upstream, midstream, and downstream oil and gas markets, and various other markets including petrochemical processing, power generation, transportation, and general industrial. We are one of the largest suppliers in these markets and have long-standing customer relationships. Our positive displacement pumps are used in the oilfield for drilling, hydraulic fracturing, completion and well servicing. Our liquid ring vacuum pumps and compressors are used in many power generation, mining, oil and gas refining and processing, chemical processing and general industrial applications including flare gas and vapor recovery, geothermal gas removal, vacuum de-aeration, enhanced oil recovery, water extraction in mining and paper and chlorine compression in petrochemical operations. Our engineered loading systems and fluid transfer equipment ensure the safe handling and transfer of crude oil, liquefied natural gas, compressed natural gas, chemicals, and bulk materials. In 2018, the Energy segment generated Segment Revenue of $1,121.1 million and Segment Adjusted EBITDA of $337.8 million, reflecting a Segment Adjusted EBITDA Margin of 30.1%.
Medical
In the Medical segment, we design, manufacture and market a broad range of highly specialized gas, liquid and precision syringe pumps and compressors primarily for use in the medical, laboratory and biotechnology end markets. Our customers are mainly medium and large durable medical equipment suppliers that integrate our products into their final equipment for use in applications such as oxygen therapy, blood dialysis, patient monitoring, wound treatment, and others. Further, with recent acquisitions, we expanded into liquid handling components and systems used in biotechnology applications including clinical analysis instrumentation. We also have a broad range of end use deep vacuum products for laboratory science applications. In 2018, the Medical segment generated Segment Revenue of $265.4 million and Segment Adjusted EBITDA of $75.0 million, reflecting a Segment Adjusted EBITDA Margin of 28.3%.
Components of Our Revenue and Expenses
Revenues
We generate revenue from sales of our highly engineered, application-critical products and by providing associated aftermarket parts, consumables and services. We sell our products and deliver aftermarket services both directly to end-users and through independent distribution channels, depending on the product line and geography. Below is a description of our revenues by segment and factors impacting total revenues.
Industrials Revenue
Our Industrials Segment Revenues are generated primarily through sales of air compression, vacuum and blower products to customers in multiple industries and geographies. A significant portion of our sales in the Industrials segment are made to independent distributors. The majority of Industrials segment revenues are derived from short duration contracts and revenue is recognized at a single point in time when control is transferred to the customer, generally at shipment or when delivery has occurred or services have been rendered. Certain contracts may involve significant design engineering to customer specifications, and depending on the contractual terms, revenue is recognized either over the duration of the contract or at contract completion when equipment is delivered to the customer. Our large installed base of products in our Industrials segment drives demand for recurring aftermarket support services primarily composed of replacement part sales to our distribution partners and, to a lesser extent, by directly providing replacement parts and repair and maintenance services to end customers. Revenue for services is recognized when services are performed.
Energy Revenue
Our Energy Segment Revenues are generated primarily through sales of positive displacement pumps, liquid ring vacuum pumps, compressors and integrated systems and engineered fluid loading and transfer equipment and associated aftermarket parts, consumables and services for use primarily in upstream, midstream, downstream and petrochemical end-markets across multiple geographies. The majority of Energy segment revenues are derived from short duration contracts and revenue is recognized at a single point in time when control is transferred to the customer, generally at shipment or when delivery has occurred or services have been rendered. Certain contracts with
customers in the mid- and downstream and petrochemical markets are higher sales value and often have longer lead times and involve more application specific engineering. Depending on the contractual terms, revenue is recognized either over the duration of the contract or at contract completion when equipment is delivered to the customer. Provisions for estimated losses on uncompleted contracts are recognized in the period in which such losses are determined to be probable. As a result, the timing of these contracts can result in significant variation in reported revenue from quarter to quarter. Our large installed base of products in our Energy segment drives demand for recurring aftermarket support services to customers, including replacement parts, consumables and repair and maintenance services. The mix of aftermarket to original equipment revenue within the Energy segment is impacted by trends in upstream energy activity in North America. Revenue for services is recognized when services are performed. In response to customer demand for faster access to aftermarket parts and repair services, we expanded our direct aftermarket service locations in our Energy segment, particularly in North American markets driven by upstream energy activity. Energy segment products and aftermarket parts, consumables and services are sold both directly to end customers and through independent distributors, depending on the product category and geography.
Medical Revenue
Our Medical Segment Revenues are generated primarily through sales of highly specialized gas, liquid and precision syringe pumps that are specified by medical and laboratory equipment suppliers for use in medical and laboratory applications. Our products are often subject to extensive collaborative design and specification requirements, as they are generally components specifically designed for, and integrated into, our customers’ products. Revenue is recognized when control is transferred to the customer, generally at shipment or when delivery has occurred. Our Medical segment also has limited aftermarket revenues related to certain products.
Expenses
Cost of Sales
Cost of sales includes the costs we incur, including purchased materials, labor and overhead related to manufactured products and aftermarket parts sold during a period. Depreciation related to manufacturing equipment and facilities is included in cost of sales. Purchased materials represent the majority of costs of sales, with steel, aluminum, copper and partially finished castings representing our most significant materials inputs. We have instituted a global sourcing strategy to take advantage of coordinated purchasing opportunities of key materials across our manufacturing plant locations.
Cost of sales for services includes the direct costs we incur, including direct labor, parts and other overhead costs including depreciation of equipment and facilities, to deliver repair, maintenance and other field services to our customers.
Selling and Administrative Expenses
Selling and administrative expenses consist of (i) salaries and other employee-related expenses for our selling and administrative functions and other activities not associated with the manufacture of products or delivery of services to customers; (ii) facility operating expenses for selling and administrative activities, including office rent, maintenance, depreciation and insurance; (iii) marketing and direct costs of selling products and services to customers including internal and external sales commissions; (iv) research and development expenditures; (v) professional and consultant fees; (vi) KKR fees and expenses; (vii) expenses related to our public stock offerings and to establish public company reporting compliance; and (viii) other miscellaneous expenses. Certain corporate expenses, including those related to our shared service centers in the United States and Europe, that directly benefit our businesses are allocated to our business segments. Certain corporate administrative expenses, including corporate executive compensation, treasury, certain information technology, internal audit and tax compliance, are not allocated to the business segments.
Amortization of Intangible Assets
Amortization of intangible assets includes the periodic amortization of intangible assets recognized when an affiliate of KKR acquired us on July 30, 2013 and intangible assets recognized in connection with businesses we acquired since July 30, 2013, including customer relationships and trademarks.
Impairment of Other Intangible Assets
Impairment of other intangible assets includes non-cash charges we recognized for the impairment of other intangible assets.
Other Operating Expense, Net
Other operating expense, net includes foreign currency gains and losses, restructuring charges, certain litigation and contract settlement losses, environmental remediation, stock-based compensation expense and other miscellaneous operating expenses.
Provision (Benefit) for Income Taxes
The provision or benefit for income taxes includes U.S. federal, state and local income taxes and all non-U.S. income taxes. We are subject to income tax in approximately 35 jurisdictions outside of the United States. Because we conduct operations on a global basis, our effective tax rate depends, and will continue to depend, on the geographic distribution of our pre-tax earnings among several different taxing jurisdictions. Our effective tax rate can also vary based on changes in the tax rates of the different jurisdictions, the availability of tax credits and non-deductible items.
On December 22, 2017, the U.S. government enacted comprehensive tax legislation commonly referred to as the Tax Cuts and Jobs Act (the “Tax Act”). The Tax Act makes broad and complex changes to the U.S. tax code that affected 2017 and 2018, including, but not limited to, (1) requiring a one-time transition tax on certain unrepatriated earnings of foreign subsidiaries that is payable over eight years, (2) bonus depreciation that will allow for full expensing of qualified property, and (3) a change in US deferred tax assets and liabilities relating to the US tax rate reduction from 35% to 21%. See Note 15 “Income Taxes” to our audited consolidated financial statements included elsewhere in this Form 10-K.
Items Affecting our Reported Results
General Economic Conditions and Capital Spending in the Industries We Serve
Our financial results closely follow changes in the industries and end-markets we serve. Demand for most of our products depends on the level of new capital investment and planned and unplanned maintenance expenditures by our customers. The level of capital expenditures depends, in turn, on the general economic conditions as well as access to capital at reasonable cost. In particular, demand for our Industrials products generally correlates with the rate of total industrial capacity utilization and the rate of change of industrial production. Capacity utilization rates above 80% have historically indicated a strong demand environment for industrial equipment. In our Energy segment, demand for our products that serve upstream energy end-markets are influenced heavily by energy prices and the expectation as to future trends in those prices. Energy prices have historically been cyclical in nature and are affected by a wide range of factors. In addition to energy prices, demand for our upstream energy products are positively impacted by increasing global land rig count, drilled but uncompleted wells, the level of hydraulic fracturing intensity and activity measured by horsepower utilization and lateral lengths as well as drilling and completion capital expenditures. In the midstream and downstream portions of our Energy segment, overall economic growth and industrial production, as well as secular trends, impact demand for our products. In our Medical segment we expect demand for our products to be driven by favorable trends, including the growth in healthcare spend and expansion of healthcare systems due to an aging population requiring medical care and increased investment in health solutions and safety infrastructures in emerging economies. Over longer time periods, we believe that demand for all of our products also tends to follow economic growth patterns indicated by the rates of change in the GDP around the world, as augmented by secular trends in each segment. Our ability to grow and our financial performance will also be affected by our ability to address a variety of challenges and opportunities that are a consequence of our global operations, including efficiently utilizing our global sales, manufacturing and distribution capabilities and engineering innovative new product applications for end-users in a variety of geographic markets.
Foreign Currency Fluctuations
A significant portion of our revenues, approximately 52% for the year ended December 31, 2018, was denominated in currencies other than the U.S. dollar. Because much of our manufacturing facilities and labor force costs are outside of the United States, a significant portion of our costs are also denominated in currencies other than the U.S. dollar. Changes in foreign exchange rates can therefore impact our results of operations and are quantified when significant to our discussion.
Factors Affecting the Comparability of our Results of Operations
As a result of a number of factors, our historical results of operations are not comparable from period to period and may not be comparable to our financial results of operations in future periods. Key factors affecting the comparability of our results of operations are summarized below.
Variability within Upstream Energy Markets
We sell products and provide services to customers in upstream energy markets, primarily in the United States. For the upstream energy end-market, in our Energy segment, we manufacture pumps and associated aftermarket products and services used in drilling, hydraulic fracturing and well service applications, while in our Industrials segment we sell dry bulk frac sand blowers, which are used in hydraulic fracturing operations. We refer to these products and services in the Energy and Industrial segments as “upstream energy.” Our Medical segment is not exposed to the upstream energy industry.
Demand for upstream energy products has historically corresponded to the supply and demand dynamics related to oil and natural gas products, and has been influenced by oil and natural gas prices, the level and intensity of hydraulic fracturing activity rig count, drilling activity and other economic factors. These factors have caused the level of demand for certain of our Energy products to change at times (both positively and negatively) and we expect these trends to continue in the future.
We believe it is helpful to consider the impact of our exposure to upstream energy in evaluating our 2016, 2017 and 2018 Segment Revenue and Segment Adjusted EBITDA, in order to better understand other drivers of our performance during those periods, including operational improvements. For the Energy segment, we assess the impact of our exposure to upstream energy as the portion of Energy Segment Adjusted EBITDA of the business unit serving the upstream energy market. For the Industrials segment, we assess the impact as the standard profit on the specific upstream energy market products.
Restructuring and Other Business Transformation Initiatives
Since 2013, our top priority has been to implement business transformation initiatives. A key element of those business transformation initiatives was restructuring programs within our Industrials, Energy, and Medical segments as well as at the Corporate level. Restructuring charges, program related facility reorganization, relocation and other costs, and related capital expenditures were impacted most significantly. Under these restructuring programs, we incurred restructuring charges of $5.3 million and $32.9 million in 2017 and 2016, respectively. In addition, we incurred program related facility reorganization, relocation and other costs of $5.3 million and $8.7 million in 2017 and 2016, respectively. We also made capital expenditures related to these programs of approximately $3.1 million in 2017 and $16.2 million in 2016. The Industrials restructuring program included the closure of a business that had approximately $3.0 million in revenues in 2016. These restructuring programs were completed in 2017. We generally expect that the savings associated with these restructuring programs will recover the associated costs within two to three years of such costs being incurred.
We announced a restructuring program in the third and fourth quarters of 2018 that primarily involves workforce reductions and facility consolidations. In the year ended December 31, 2018, $12.7 million was charged to expense related to this restructuring program. We expect additional restructuring activity in the first half of 2019 focused on targeted workforce optimization within general and administrative back-office and manufacturing overhead as well as continued facility consolidation.
Acquisitions
Given our global reach, market leading position in our various product categories, strong channel access and aftermarket presence and operational excellence competency, our Company provides an attractive acquisition platform in the flow control and compression equipment sectors. Part of our strategy for growth is to acquire complementary flow control and compression equipment businesses, which provide access to new technologies or geographies or improve our aftermarket offerings.
In August 2016, we acquired a manufacturer of highly specialized consumable micro-syringes and valves that are used in liquid handling instruments in our Medical segment for approximately $18.8 million.
In June 2017, within our Industrials segment, we acquired a leading North American manufacturer of gas compression equipment and solutions for vapor recovery, biogas and other process and industrial applications for approximately $20.4 million, net of cash acquired (inclusive of an indemnity holdback of $1.9 million recorded in “Accrued liabilities”).
In February 2018, we acquired a leading global manufacturer of turbo vacuum technology systems and optimization solutions for industrial applications in our Industrials segment for total consideration, net of cash acquired, of
approximately $94.9 million. In May 2018, we acquired a leading manufacturer of plungers and other well service pump consumable products in our Energy segment for total consideration, net of cash acquired of approximately $21.0 million (inclusive of cash payments of $18.8 million, a $2.0 million promissory note and a $0.2 million holdback). In November 2018, we acquired a leading manufacturer of rotary screws and piston compressors and associated aftermarket parts in our Industrials segment for total consideration, net of cash acquired, of $16.1 million (inclusive of cash payments of $14.8 million and a $1.3 million holdback). In December 2018, we acquired a leading manufacturer of specialty industrial pumps and associated aftermarket parts in our Industrials segment for total consideration of $58.5 million, net of cash acquired (inclusive of cash payments of $57.8 million, a payable for a $0.1 million purchase price adjustment and a $0.6 million holdback).
The revenues for these acquisitions subsequent to the respective dates of acquisition included in our financial results were $108.0 million, $27.8 million and $4.9 million for the years ended December 31, 2018, 2017 and 2016, respectively. The operating income (loss) for these acquisitions subsequent to their respective dates of acquisition, including organic growth since acquisition, included in our financial results was $8.8 million, $3.7 million and ($0.3) million for the years ended December 31, 2018, 2017 and 2016, respectively.
See Note 3 “Business Combinations” to our audited consolidated financial statements included elsewhere in this Form 10-K for further discussion around the outstanding holdbacks for the years ended December 31, 2018, 2017 and 2016.
KKR Management Fees and Expenses
Through the date of our initial public offering in 2017, KKR charged an annual management fee, as well as fees and expenses for services provided. These fees and charges were $1.1 million and $4.8 million for the years ended December 31, 2017 and 2016, respectively. In May 2017, the monitoring agreement was terminated in accordance with its terms and we paid an additional termination fee of approximately $16.2 million.
Stock-Based Compensation Expense
For the year ended December 31, 2018, we incurred stock-based compensation expense of approximately $2.8 million which was reduced by $5.1 million primarily due to a decrease in the estimated accrual for employer taxes related to DSUs as a result of a lower per share stock price.
The $2.8 million of stock-based compensation expense included expense for the modification of equity awards for certain former employees of $3.8 million and expense for equity awards granted under the 2013 Plan and the 2017 Plan of $7.2 million reduced by a benefit for a reduction in the liability for stock appreciation rights (“SAR”) of $8.2 million. As of December 31, 2018, there was $20.3 million of unrecognized stock-based compensation expense related to outstanding stock options that will be recognized in future periods.
Subsequent to the initial public offering in May 2017, we recognized stock-based compensation expense of approximately $77.6 million related to time-based and performance-based stock options. As of December 31, 2017 there was $9.1 million of unrecognized stock-based compensation expense related to outstanding stock options that will be recognized in future periods. The Company also recognized $97.4 million of compensation expense related to a grant of 5.5 million DSUs to employees at the date of the initial public offering and employer taxes related to DSUs of $19.2 million. The Company expects to make stock-based awards to employees and recognize stock-based compensation expenses in future periods.
Income Taxes
On December 22, 2017, the 2017 Tax Cuts and Jobs Act (“Tax Act”) was enacted into law. The new legislation contains several key tax provisions that affected us, including a one-time mandatory transition tax on accumulated foreign earnings and a reduction of the corporate income tax rate to 21% effective January 1, 2018, among others. We are required to recognize the effect of the tax law changes, including the determination of the transition tax, the remeasurement of our U.S. deferred tax assets and liabilities as well as the reassessment of the net realizability of our deferred tax assets and liabilities, in the period of enactment. In December 2017, the SEC staff issued Staff Accounting Bulletin No. 118, Income Tax Accounting Implications of the Tax Cuts and Jobs Act (“SAB 118”), which allowed us to record provisional amounts during a measurement period not to extend beyond one year of the enactment date. As a result, we previously provided a provisional estimate of the effect of the Tax Act in our financial statements for 2017 and through the first nine months of 2018. In the fourth quarter of 2018, we completed our
accounting for all of the enactment-date income tax effects of the Tax Act by increasing the total benefit taken in 2017 of $95.3 million to $96.5 million. Due to the Tax Act, the total U.S. deferred changed from a tax benefit of $89.6 million in 2017 to $74.5 million in 2018, with a 2018 measurement-period adjustment of $15.1 million and the ASC 740-30 (formerly APB 23) liability, related to the permanent reinvestment of earnings in foreign subsidiaries assertion, changed from a tax benefit of $69.0 million in 2017 to $72.5 million in 2018, with a 2018 measurement-period adjustment of $3.5 million. The provisional one-time transition tax of $63.3 million in 2017 decreased to $50.5 million in 2018, with a 2018 measurement-period adjustment of $12.8 million. The total $1.2 million benefit has a (0.3)% impact to the overall rate in 2018.
The Tax Act creates a new requirement that certain income (i.e., GILTI) earned by controlled foreign corporations (“CFC”) must be included currently in the gross income of the CFCs’ U.S. shareholder. GILTI is the excess of the shareholder’s “net CFC tested income” over the net deemed tangible income return, which is currently defined as the excess of (1) 10% of the aggregate of the U.S. shareholder’s pro rata share of the qualified business asset investment of each CFC with respect to which it is a U.S. shareholder over (2) the amount of certain interest expense taken into account in the determination of net CFC-tested income.
Under U.S. GAAP, we are allowed to make an accounting policy election of either (1) treating taxes due on future U.S. inclusions in taxable income related to GILTI as a current-period expense when incurred (the “period cost method”) or (2) factoring such amounts into a company’s measurement of its deferred taxes (the “deferred method”). The Company has determined that it will follow the period cost method (option 1 above) going forward. The tax provision for the twelve month period ended December 31, 2018 reflects this decision. All of the additional calculations and rule changes found in the Tax Act have been considered in the tax provision for the three and twelve month periods ended December 31, 2018. The Company recorded a tax expense of $11.9 million in the period for the GILTI provisions of the Tax Act that were effective for the first time during 2018.
See Note 15 “Income Taxes” to our audited consolidated financial statements included elsewhere in this Form 10-K.
Outlook
Industrials Segment
The mission-critical nature of our Industrials products across manufacturing processes drives a demand environment and outlook that are correlated with global and regional industrial production, capacity utilization and long-term GDP growth. In the fourth quarter of 2018, we had $322.5 million of orders in our Industrials segment, an increase of 1% over the fourth quarter of 2017, or a 4% increase on a constant currency basis. We believe that we are well positioned to continue to benefit from a slower but positive industrial production and global GDP outlook. Our fourth quarter of 2018 constant currency increase was on top of strong fourth quarter of 2017 growth of 25%.
Energy Segment
Our Energy segment has a diverse range of equipment and associated aftermarket parts, consumables and services for a number of market sectors with both energy exposure, spanning upstream, midstream, downstream and petrochemical applications.
Our upstream products demand environment and outlook are influenced heavily by the supply and demand dynamics related to oil and natural gas products, and has been influenced by oil and natural gas prices, the level and intensity of hydraulic fracturing activity, global land rig count, drilled but uncompleted wells and other economic factors. These factors have caused the level of demand for certain of our upstream products to change at times (both positively and negatively) and we expect these trends to continue in the future. We believe we are well positioned to continue to benefit given our market position, diverse range of equipment, aftermarket parts and consumables and our service presence, but expect the demand environment and economic factors growth will slow with some factors potentially declining.
Our midstream and downstream products demand environment and outlook are relatively stable with attractive, long-term growth trends influenced by long-term GDP growth and the continued increase in the production and transportation of hydrocarbon. Demand for our petrochemical industry products correlates with capital expenditures related to growth and maintenance of petrochemical plants as well as activity levels therein. Advancements in the development of unconventional natural gas resources in North America over the past decade have resulted in the abundant availability of locally-sourced natural gas as feedstock for petrochemical plants in North America, supporting long-term growth.
In the fourth quarter of 2018, we had $269.5 million of orders in our Energy segment, a decrease of 4% over the fourth quarter of 2017, or a 3% decrease on a constant currency basis. This fourth quarter of 2018 constant currency decrease was off strong fourth quarter of 2017 growth of 62%.
Medical Segment
During 2018, we focused on the development and introduction of new products and applications to access the liquid pump market, leveraging our technology and expertise in gas pumps. Entering 2019, we believe that demand for products and services in the Medical space will continue to benefit from attractive secular growth trends in the aging population requiring medical care, emerging economies modernizing and expanding their healthcare systems and increased investment globally in health solutions. In addition, we expect growing demand for higher healthcare efficiency, requiring premium and high performance systems. In the fourth quarter of 2018 we had $65.8 million of orders in our Medical segment, a decrease of 1% over 2017, or a 1% increase on a constant currency basis. This fourth quarter increase on a constant currency basis was on top of strong fourth quarter of 2017 growth of 29%.
How We Assess the Performance of Our Business
We manage operations through the three business segments described above. In addition to our consolidated GAAP financial measures, we review various non-GAAP financial measures, including Adjusted EBITDA, Adjusted Net Income and Free Cash Flow.
We believe Adjusted EBITDA and Adjusted Net Income are helpful supplemental measures to assist us and investors in evaluating our operating results as they exclude certain items whose fluctuation from period to period do not necessarily correspond to changes in the operations of our business. Adjusted EBITDA represents net income (loss) before interest, taxes, depreciation, amortization and certain non-cash, non-recurring and other adjustment items. We believe that the adjustments applied in presenting Adjusted EBITDA are appropriate to provide additional information to investors about certain material non-cash items and about non-recurring items that we do not expect to continue at the same level in the future. Adjusted Net Income is defined as net income (loss) including interest, depreciation and amortization of non-acquisition related intangible assets and excluding other items used to calculate Adjusted EBITDA and further adjusted for the tax effect of these exclusions.
We use Free Cash Flow to review the liquidity of our operations. We measure Free Cash Flow as cash flows from operating activities less capital expenditures. We believe Free Cash Flow is a useful supplemental financial measure for us and investors in assessing our ability to pursue business opportunities and investments and to service our debt. Free Cash Flow is not a measure of our liquidity under GAAP and should not be considered as an alternative to cash flows from operating activities.
Management and our board of directors regularly use these measures as tools in evaluating our operating and financial performance and in establishing discretionary annual compensation. Such measures are provided in addition to, and should not be considered to be a substitute for, or superior to, the comparable measures under GAAP. In addition, we believe that Adjusted EBITDA, Adjusted Net Income and Free Cash Flow are frequently used by investors and other interested parties in the evaluation of issuers, many of which also present Adjusted EBITDA, Adjusted Net Income and Free Cash Flow when reporting their results in an effort to facilitate an understanding of their operating and financial results and liquidity.
Adjusted EBITDA, Adjusted Net Income and Free Cash Flow should not be considered as alternatives to net income (loss) or any other performance measure derived in accordance with GAAP, or as alternatives to cash flow from operating activities as a measure of our liquidity. Adjusted EBITDA, Adjusted Net Income and Free Cash Flow have limitations as analytical tools, and you should not consider such measures either in isolation or as substitutes for analyzing our results as reported under GAAP.
Included in our discussion of our consolidated and segment results below are changes in revenues and Adjusted EBITDA on a Constant Currency basis. Constant Currency information compares results between periods as if exchange rates had remained constant period over period. We define Constant Currency revenues and Adjusted EBITDA as total revenues and Adjusted EBITDA excluding the impact of foreign exchange rate movements and use it to determine the Constant Currency revenue and Adjusted EBITDA growth on a year-over-year basis. Constant Currency revenues and Adjusted EBITDA are calculated by translating current period revenues and Adjusted
EBITDA using corresponding prior period exchange rates. These results should be considered in addition to, not as a substitute for, results reported in accordance with GAAP. Results on a Constant Currency basis, as we present them, may not be comparable to similarly titled measures used by other companies and are not a measure of performance presented in accordance with GAAP.
For further information regarding these measures, see “Item 6. Selected Financial Data.”
Results of Operations
Consolidated results should be read in conjunction with segment results and the Segment Information notes to our audited consolidated financial statements included elsewhere in this Form 10-K, which provide more detailed discussions concerning certain components of our consolidated statements of operations. All intercompany accounts and transactions have been eliminated within the consolidated results.
Consolidated Results of Operations for the Years Ended December 31, 2018, 2017 and 2016
| Year Ended December 31, | |||||||||
|---|---|---|---|---|---|---|---|---|---|
| 2018 | 2017 | 2016 | |||||||
| **Consolidated Statements of Operations: ** | |||||||||
| Revenues | $ | 2,689.8 | $ | 2,375.4 | $ | 1,939.4 | |||
| Cost of sales | 1,677.3 | 1,477.5 | 1,222.7 | ||||||
| Gross profit | 1,012.5 | 897.9 | 716.7 | ||||||
| Selling and administrative expenses | 434.6 | 446.2 | 415.1 | ||||||
| Amortization of intangible assets | 125.8 | 118.9 | 124.2 | ||||||
| Impairment of other intangible assets | — | 1.6 | 25.3 | ||||||
| Other operating expenses, net | 9.1 | 222.1 | 48.6 | ||||||
| Operating income | 443.0 | 109.1 | 103.5 | ||||||
| Interest expense | 99.6 | 140.7 | 170.3 | ||||||
| Loss on extinguishment of debt | 1.1 | 84.5 | — | ||||||
| Other income, net | (7.2 | ) | (3.4 | ) | (3.6 | ) | |||
| Income (loss) before income taxes | 349.5 | (112.7 | ) | (63.2 | ) | ||||
| Provision (benefit) for income taxes | 80.1 | (131.2 | ) | (31.9 | ) | ||||
| Net income (loss) | 269.4 | 18.5 | (31.3 | ) | |||||
| Net income attributable to noncontrolling interest | — | 0.1 | 5.3 | ||||||
| Net income (loss) attributable to Gardner Denver Holdings, Inc | $ | 269.4 | $ | 18.4 | $ | (36.6 | ) | ||
| **Percentage of Revenues: ** | |||||||||
| Gross profit | 37.6 | % | 37.8 | % | 37.0 | % | |||
| Selling and administrative expenses | 16.2 | % | 18.8 | % | 21.4 | % | |||
| Operating income | 16.5 | % | 4.6 | % | 5.3 | % | |||
| Net income (loss) | 10.0 | % | 0.8 | % | (1.6 | )% | |||
| Adjusted EBITDA(1) | 25.3 | % | 23.6 | % | 20.7 | % | |||
| **Other Financial Data: ** | |||||||||
| Adjusted EBITDA(1) | $ | 681.8 | $ | 561.5 | $ | 400.7 | |||
| Adjusted net income(1) | 394.7 | 249.3 | 133.6 | ||||||
| Cash flows - operating activities | 444.5 | 200.5 | 165.6 | ||||||
| Cash flows - investing activities | (235.0 | ) | (60.8 | ) | (82.1 | ) | |||
| Cash flows - financing activities | (373.0 | ) | (17.4 | ) | (43.0 | ) | |||
| Free cash flow(1) | 392.3 | 143.7 | 91.2 |
| (1) | See “Item 6. Selected Financial Data” for a reconciliation to the most directly comparable GAAP measure. |
|---|
Revenues
Revenues for 2018 were $2,689.8 million, an increase of $314.4 million, or 13.2%, compared to $2,375.4 million in 2017. The increase in revenues was due primarily to higher revenues from upstream energy exposed markets (3.8% or $90.2 million), higher volume in other markets in our Energy Segment as well as in our Industrials and Medical Segments including from acquisitions (7.0% or $167.1 million), improved pricing in the other markets of our Energy Segment as well as in our Industrials and Medical Segments (1.2% or $28.8 million) and the favorable impact of foreign currencies (1.2% or $28.3 million). The percentage of consolidated revenues derived from aftermarket parts and services was 39.2% in 2018 compared to 41.3% in 2017.
Revenues for 2017 were $2,375.4 million, an increase of $436.0 million, or 22.5%, compared to $1,939.4 million in 2016. The increase in revenues was due primarily to higher revenues from upstream energy exposed markets (20.9% or $405.5 million), the favorable impact of foreign currencies (1.1% or $21.8 million), improved pricing in the other markets of our Energy segment as well as in our Industrials and Medical segments (1.0% or $18.8 million), and higher volume in our Industrials segment including from acquisitions net of divestitures (0.1% or $1.6 million), partially offset by lower volume including acquisitions in other markets in our Energy segment as well as in our Medical segment (0.6% or $11.7 million). The percentage of consolidated revenues derived from aftermarket parts and services was 41.3% in 2017 compared to 34.7% in 2016.
See further analysis in the segment results below.
Gross Profit
Gross profit in 2018 was $1,012.5 million, an increase of $114.6 million, or 12.8%, compared to $897.9 million in 2017, and as a percentage of revenues was 37.6% in 2018 and 37.8% in 2017. The increase in gross profit reflects primarily higher revenues from upstream energy exposed markets, higher volume in other markets in our Energy Segment as well as in our Industrials and Medical Segments including from acquisitions, improved pricing in the other markets of our Energy Segment as well as in our Industrials and Medical Segments, and the favorable impact of foreign currencies. The slight decrease in gross profit as a percentage of revenues primarily reflects higher materials and other manufacturing costs in our Industrials and Energy Segments, growth rates for original equipment revenues greater than the growth rates for aftermarket products and services in our Industrials Segment, and unfavorable product sales mix in our Industrials and Energy Segments.
Gross profit in 2017 was $897.9 million, an increase of $181.2 million, or 25.3%, compared to $716.7 million in 2016, and as a percentage of revenues was 37.8% in 2017 and 37.0% in 2016. The increase in gross profit reflects higher revenues from upstream energy exposed markets, higher volume in our Industrials segment including acquisitions and net of divestitures, improved pricing in other markets in our Energy segment as well as in our Industrials and Medical segments, and the favorable impact of foreign currencies, partially offset by lower volume including acquisitions in other markets in our Energy segment as well as in our Medical segment.
Selling and Administrative Expenses
Selling and administrative expenses were $434.6 million in 2018, a decrease of $11.6 million, or 2.6%, compared to $446.2 million in 2017. Selling and administrative expenses includes KKR fees and expenses of $0.0 million in 2018 and $17.3 million in 2017 and expenses related to our public stock offerings and establishment of public company financial reporting of $7.2 million in 2018 and $12.2 million in 2017. Excluding these items, selling and administrative expenses were $427.4 million in 2018 compared to $416.7 million in 2017, and selling and administrative expenses as a percentage of revenues decreased to 15.9% in 2018 from 17.5% in 2017. This increase in selling and administrative expense in 2018 primarily reflects increased professional and consulting fees, increased salaries, and additional selling and administrative expenses from acquisitions, partially offset by decreased incentive compensations. Selling and administrative expenses as a percentage of revenues decreased primarily due to higher revenues.
Selling and administrative expenses were $446.2 million in 2017, an increase of $31.1 million, or 7.5%, compared to $415.1 million in 2016. Selling and administrative expenses in 2017 includes $12.2 million of expenses related to our public stock offerings and establishment of public company financial reporting and $17.3 million of KKR fees and expenses, compared to $0.2 million and $4.8 million of expenses related to the establishment of public company financial reporting and KKR fees and expenses in 2016, respectively. Excluding these items, selling and administrative expenses were $416.7 million in 2017 compared to $410.1 million in 2016, and selling and
administrative expenses as a percentage of revenues decreased to 17.5% in 2017 from 21.1% in 2016. This increase in selling and administrative expense in 2017 primarily reflects increased salaries and other employee related expenses, and professional and consulting fees, partially offset by reduced facilities operating expenses and reduced sales commissions. Selling and administrative expenses as a percentage of revenues decreased primarily due to higher revenues.
Amortization of Intangible Assets
Amortization of intangible assets was $125.8 million, $118.9 million, and $124.2 million in 2018, 2017 and 2016, respectively. The increase of $6.9 million in 2018 compared to 2017 was primarily due to the amortization of intangibles acquired in 2018.
The decrease of $5.3 million in 2017 compared to 2016 was primarily due to assets that became fully amortized in 2016, partially offset by changes in foreign currencies.
Impairment of Other Intangible Assets
In 2017, we recorded a non-cash charge for the impairment of other intangible assets of $1.6 million, primarily related to trademarks in our Industrials segment.
In 2016, we recorded a non-cash charge for the impairment of other intangible assets of $25.3 million, primarily related to trademarks in our Industrials segment.
Other Operating Expense, Net
Other operating expense, net was $9.1 million in 2018, a decrease of $213.0 million compared to $222.1 million in 2017, primarily due to lower stock-based compensation expense of $172.3 million and lower employer taxes related to stock-based compensation of $24.3 million, foreign currency transaction gains of $1.9 million in 2018 compared to losses of $9.3 million in 2017, and shareholder litigation settlement recoveries in 2018 of $9.5 million, partially offset by increased restructuring charges of $7.4 million and increased acquisition related expenses and non-cash charges of $6.4 million.
Other operating expense, net was $222.1 million in 2017, an increase of $173.5 million compared to $48.6 million in 2016, primarily due to the recognition of stock-based compensation expense for stock options and deferred stock units of $175.0 million, employer taxes related to deferred stock units of $19.2 million and increased foreign currency transaction losses of $9.3 million in 2017 compared to gains of $5.9 million in 2016, partially offset by lower employee severance costs of $5.3 million in 2017 compared to $32.9 million in 2016, and lower environmental remediation of $0.9 million in 2017 compared to $5.6 million in 2016.
Interest Expense
Interest expense was $99.6 million, $140.7 million and $170.3 million in 2018, 2017 and 2016, respectively. The decrease of $41.1 million in 2018 compared to 2017 was primarily due to repayments of debt with the proceeds of our initial public offering in 2017 and reduced debt as a result of prepayments in 2018 and a lower weighted-average interest rate of 5.2% in 2018 compared to 6.0% in 2017. The decrease of $29.6 million in 2017 compared to 2016 was primarily due to reduced debt as a result of repayments of debt with proceeds of our initial public offering, and a decreased weighted-average interest rate of approximately 6.0% in 2017 compared to 6.1% in 2016.
Other Income, Net
Other income, net was $7.2 million, $3.4 million and $3.6 million in 2018, 2017 and 2016, respectively. The increase in other income, net of $3.8 million in 2018 compared to 2017 was primarily due to a reduction of $5.1 million in the other components of net periodic benefit cost, increased interest income of $0.8 million and increased other financing income of $0.7 million, partially offset by a decrease in the gains on postretirement plan investments of $2.8 million. The decrease of $0.2 million in 2017 compared to 2016 was primarily due to an increase of $1.2 million in the other components of net periodic benefit cost partially offset by the increase in the gain on postretirement plan investments of $1.0 million.
Provision (Benefit) for Income Taxes
The provision for income taxes was $80.1 million resulting in a 22.9% effective tax rate in 2018 compared to a benefit of $131.2 million resulting in a 116.3% effective tax benefit rate in 2017. The increase in the tax provision
and the decreased effective tax rate resulted primarily from an increase in pretax book income, an increase in a benefit related to equity compensation, and a reduction of the overall impact of the Tax Act in 2018 compared to the enactment date in 2017.
The benefit for income taxes was $131.2 million resulting in a 116.3% effective tax benefit rate in 2017 compared to a benefit of $31.9 million resulting in a 50.5% effective tax benefit rate in 2016. The increase in the tax benefit and the effective tax rate resulted primarily from the Tax Act. There was a $89.6 million deferred benefit associated with the rate moving from 35% to 21%. In 2017, we recognized an ASC 740-30 (formerly APB 23) liability reduction related to the permanent reinvestment of earnings in foreign subsidiaries assertion, resulting in a benefit of $69.0 million which was partially offset by a one-time transition tax provision of approximately $63.3 million.
Net Income (Loss)
Net income was $269.4 million in 2018 compared to a net income of $18.5 million in 2017. The increase in net income was primarily due to higher operating income on higher revenues and gross profit, lower stock-based compensation expense, lower loss on extinguishment of debt, and lower interest expense, partially offset by an increase in the provision for income taxes.
Net income was $18.5 million in 2017 compared to a net loss of $31.3 million in 2016. The increase in net income was primarily due to higher operating income on higher revenues and gross profit and lower interest expense, and an increase in the benefit for income taxes, partially offset by higher stock-based compensation expense and loss on extinguishment of debt.
Adjusted EBITDA
Adjusted EBITDA increased $120.3 million to $681.8 million in 2018 compared to $561.5 million in 2017. Adjusted EBITDA as a percentage of revenues increased 170 basis points to 25.3% in 2018 from 23.6% in 2017. The increase in Adjusted EBITDA was primarily due to higher revenues from upstream energy exposed markets ($44.2 million), improved pricing in the other markets of our Energy Segment as well as in our Industrials and Medical Segments ($28.8 million), higher volume in other markets in our Energy Segment as well as in our Industrials and Medical Segments including from acquisitions ($63.1 million) and lower selling and administrative expenses ($22.0 million), partially offset by higher materials and other manufacturing costs in our Industrials and Energy Segments growth rates for original equipment revenues greater than the growth rates for aftermarket products and services in our Industrials Segment, and unfavorable product sales mix in our Industrials Segment and in other markets in our Energy Segment ($43.5 million).
Adjusted EBITDA increased $160.8 million to $561.5 million in 2017 compared to $400.7 million in 2016. Adjusted EBITDA as a percentage of revenues increased 290 basis points to 23.6% in 2017 from 20.7% in 2016. The increase in Adjusted EBITDA was primarily due to increased revenues in upstream energy exposed markets ($159.7 million), improved pricing ($18.8 million), and the favorable impact of foreign currencies ($5.9 million), partially offset by lower volume in other markets in our Energy segment as well as in our Industrials and Medical segments including acquisitions and divestitures ($15.5 million), and higher selling and administrative expenses ($9.3 million).
Adjusted Net Income
Adjusted Net Income increased $145.4 million to $394.7 million in 2018 compared to $249.3 million in 2017. The increase was primarily due to increased Adjusted EBITDA and lower interest expense, partially offset by an increase in the income tax provision, as adjusted.
Adjusted Net Income increased $115.7 million to $249.3 million in 2017 compared to $133.6 million in 2016. The increase was primarily due to increased Adjusted EBITDA and lower interest expense, partially offset by an increase in the income tax provision, as adjusted.
Segment Results
We classify our businesses into three segments: Industrials, Energy and Medical. Our Corporate operations (as described below) are not discussed separately as any results that had a significant impact on operating results are included in the consolidated results discussion above.
We evaluate the performance of our segments based on Segment Revenues and Segment Adjusted EBITDA. Segment Adjusted EBITDA is indicative of operational performance and ongoing profitability. Our management closely monitors Segment Adjusted EBITDA to evaluate past performance and identify actions required to improve profitability.
The segment measurements provided to, and evaluated by, the chief operating decision maker are described in Note 21 “Segment Information” to our audited consolidated financial statements included elsewhere in this Form 10-K.
Included in our discussion of our segment results below are changes in Segment Revenues and Segment Adjusted EBITDA on a Constant Currency basis. Constant Currency information compares results between periods as if exchange rates had remained constant period over period. We define Constant Currency as changes in Segment Revenues and Segment Adjusted EBITDA excluding the impact of foreign exchange rate movements. We use these measures to determine the Constant Currency Segment Revenues and Segment Adjusted EBITDA growth on a year-on-year basis. Constant Currency Segment Revenues and Segment Adjusted EBITDA are calculated by translating current period Segment Revenues and Segment Adjusted EBITDA using prior period exchange rates. These results should be considered in addition to, not as a substitute for, results reported in accordance with GAAP. Results on a constant currency basis, as we present them, may not be comparable to similarly titled measures used by other companies and are not a measure of performance presented in accordance with GAAP.
Segment Results for Years Ended December 31, 2018, 2017 and 2016
The following tables display Segment Revenues, Segment Adjusted EBITDA and Segment Adjusted EBITDA Margin (Segment Adjusted EBITDA as a percentage of Segment Revenues) for each of our Segments and illustrates, on a percentage basis, the impact of foreign currency fluctuations on Segment Revenues and Segment Adjusted EBITDA growth.
Industrials Segment Results
| Years Ended December 31, | Percent Change | **Constant Currency **Percent Change | |||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2018 | 2017 | 2016 | 2018 vs. 2017 | 2017 vs. 2016 | 2018 vs. 2017 | 2017 vs. 2016 | |||||||||||||
| Segment Revenues | $ | 1,303.3 | $ | 1,130.7 | $ | 1,082.4 | 15.3% | 4.5% | 13.3 | % | 3.4% | ||||||||
| Segment Adjusted EBITDA | $ | 288.2 | $ | 242.7 | $ | 217.6 | 18.7% | 11.5% | 16.3 | % | 10.2% | ||||||||
| Segment Margin | 22.1 | % | 21.5 | % | 20.1 | % | 60 bps | 140 bps |
2018 vs. 2017
Segment Revenues for 2018 were $1,303.3 million, an increase of $172.6 million, or 15.3%, compared to $1,130.7 million in 2017. The increase in Segment Revenues was primarily due to higher volume, including through acquisitions (11.0% or $124.8 million), improved pricing (2.3% or $25.8 million), and the favorable impact of foreign currencies (1.9% or $22.0 million). The percentage of Segment Revenues derived from aftermarket parts and service was 31.5% in 2018 compared to 34.0% in 2017.
Segment Adjusted EBITDA in 2018 was $288.2 million, an increase of $45.5 million, or 18.7%, from $242.7 million in 2017. Segment Adjusted EBITDA Margin increased 60 bps to 22.1% from 21.5% in 2017. The increase in Segment Adjusted EBITDA was due primarily to higher volume including through acquisitions ($41.0 million), improved pricing ($25.8 million) and the favorable impact of foreign currencies ($6.0 million), partially offset by higher materials and other manufacturing costs, growth rates for original equipment revenues greater than the growth rates for aftermarket products and services, and unfavorable sales mix within original equipment revenues ($26.8 million).
2017 vs. 2016
Segment Revenues for 2017 were $1,130.7 million, an increase of $48.3 million, or 4.5%, compared to $1,082.4 million in 2016. The increase in Segment Revenues was due to higher volume including acquisitions and net of divestitures (1.9% or $20.4 million, including $18.9 million from upstream energy exposed markets), higher pricing (1.5% or $16.1 million) and the favorable impact of foreign currencies (1.1% or $11.8 million). The percentage of Segment Revenues derived from aftermarket parts and service was 34.0% in 2017 compared to 34.7% in 2016.
Segment Adjusted EBITDA in 2017 was $242.7 million, an increase of $25.1 million, or 11.5%, from $217.6 million in 2016. Segment Adjusted EBITDA Margin increased 140 bps to 21.5% from 20.1% in 2016. The increase in Segment Adjusted EBITDA was due primarily to improved pricing ($16.1 million), higher volume including acquisitions and net of divestitures ($6.0 million, including $13.0 million from upstream energy exposed markets), and the favorable impact of foreign currencies ($2.8 million).
Energy Segment Results
| Years Ended December 31, | Percent Change | **Constant Currency **Percent Change | |||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2018 | 2017 | 2016 | 2018 vs. 2017 | 2017 vs. 2016 | 2018 vs. 2017 | 2017 vs. 2016 | |||||||
| Segment Revenues | $ | 1,121.1 | $ | 1,014.5 | $ | 628.4 | 10.5% | 61.4% | 10.4% | 60.0% | |||
| Segment Adjusted EBITDA | $ | 337.8 | $ | 296.1 | $ | 143.8 | 14.1% | 105.9% | 14.4% | 104.0% | |||
| Segment Margin | 30.1 | % | 29.2 | % | 22.9 | % | 90 bps | 630 bps |
2018 vs. 2017
Segment Revenues for 2018 were $1,121.1 million, an increase of $106.6 million, or 10.5%, compared to $1,014.5 million in 2017. The increase in Segment Revenues was primarily due to higher revenues from upstream energy exposed markets (8.9% or $90.2 million) and higher volume and pricing in other markets in our Energy Segment (1.5% or $15.1 million) The percentage of Segment Revenues derived from aftermarket parts and service was 56.6% in 2018 compared to 58.0% in 2017.
Segment Adjusted EBITDA in 2018 was $337.8 million, an increase of $41.7 million, or 14.1%, from $296.1 million in 2017. Segment Adjusted EBITDA Margin increased 90 bps to 30.1% in 2018 from 29.2% in 2017. The increase in Segment Adjusted EBITDA was primarily due to higher revenues from upstream energy exposed markets ($44.2 million) and higher volume and pricing in other markets in our Energy segment ($8.1 million), partially offset by higher material and manufacturing costs and unfavorable product sales mix in other markets in our Energy Segment ($11.2 million).
2017 vs. 2016
Segment Revenues for 2017 were $1,014.5 million, an increase of $386.1 million, or 61.4%, compared to $628.4 million in 2016. The increase in Segment Revenues was due to higher revenues from upstream energy exposed markets (61.5% or $386.6 million), and the favorable impact of foreign currencies (1.3% or $8.0 million), partially offset by lower volume in other markets of our Energy segment (1.4% or $8.6 million). The percentage of Segment Revenues derived from aftermarket parts and service was 58.0% in 2017 compared to 47.3% in 2016.
Segment Adjusted EBITDA in 2017 was $296.1 million, an increase of $152.3 million, or 105.9%, from $143.8 million in 2016. Segment Adjusted EBITDA Margin increased 630 bps to 29.2% in 2017 from 22.9% in 2016. The increase in Segment Adjusted EBITDA was primarily due to increased revenues from upstream energy exposed markets ($146.7 million), lower selling and administrative expenses ($5.4 million), the favorable impact of foreign currencies ($2.8 million), and lower material and manufacturing costs ($2.0 million), partially offset by lower volume in other markets in our Energy segment ($4.7 million).
Medical Segment Results
| Years Ended December 31, | Percent Change | **Constant Currency **Percent Change | |||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2018 | 2017 | 2016 | 2018 vs. 2017 | 2017 vs. 2016 | 2018 vs. 2017 | 2017 vs. 2016 | |||||||
| Segment Revenues | $ | 265.4 | $ | 230.2 | $ | 228.7 | 15.3% | 0.7% | 13.1% | (0.2)% | |||
| Segment Adjusted EBITDA | $ | 75.0 | $ | 62.4 | $ | 61.9 | 20.2% | 0.8% | 17.8% | (0.3)% | |||
| Segment Margin | 28.3 | % | 27.1 | % | 27.1 | % | 120 bps | — |
2018 vs. 2017
Segment Revenues for 2018 were $265.4 million, an increase of $35.2 million, or 15.3%, compared to $230.2 million in 2017. The increase in Segment Revenues was due to higher volume and pricing (13.2% or $30.3 million) and the
favorable impact of foreign currencies (2.2% or $5.0 million). The percentage of Segment Revenues derived from aftermarket parts, consumables and services was 3.3% in 2018 compared to 3.7% in 2017.
Segment Adjusted EBITDA in 2018 was $75.0 million, an increase of $12.6 million, or 20.2%, from $62.4 million in 2017. Segment Adjusted EBITDA Margin increased 120 bps to 28.3% in 2018 from 27.1% in 2017. The increase in Segment Adjusted EBITDA was primarily due to higher volume and pricing ($17.1 million) and favorable impact of foreign currencies ($1.5 million), partially offset by higher material and other manufacturing costs ($6.3 million).
2017 vs. 2016
Segment Revenues for 2017 were $230.2 million, an increase of $1.5 million, or 0.7%, compared to $228.7 million in 2016. The increase in Segment Revenues was due to improved pricing (1.1% or $2.6 million), the favorable impact of foreign currencies (0.9% or $2.0 million), partially offset by lower volume including acquisitions (1.3% or $3.1 million). The percentage of Segment Revenues derived from aftermarket parts, consumables and services was 3.7% in 2017 compared to 0.0% in 2016.
Segment Adjusted EBITDA in 2017 was $62.4 million, an increase of $0.5 million, or 0.8%, from $61.9 million in 2016. Segment Adjusted EBITDA Margin remained constant at 27.1% in 2017 and 2016. The increase in Segment Adjusted EBITDA was primarily due to improved pricing ($2.6 million), lower selling and administrative expense ($2.1 million), and the favorable impact of foreign currencies ($0.7 million), partially offset by lower volume including acquisitions ($3.7 million), and higher material and other manufacturing costs ($1.2 million).
Unaudited Quarterly Results of Operations
| Year Ended December 31, 2018 | Year Ended December 31, 2017 | |||||||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| (in millions, except per share amounts) | Q1 | Q2 | Q3 | Q4(2) | Q1 | Q2 | Q3 | Q4 | ||||||||||||||||
| Revenues | $ | 619.6 | $ | 668.2 | $ | 689.3 | $ | 712.7 | $ | 481.7 | $ | 579.1 | $ | 649.6 | $ | 665.0 | ||||||||
| Gross profit | 231.9 | 249.3 | 262.4 | 268.9 | 174.6 | 215.9 | 253.9 | 253.5 | ||||||||||||||||
| Operating income (loss) | 89.8 | 101.4 | 117.7 | 134.1 | 36.8 | (101.6 | ) | 96.0 | 77.9 | |||||||||||||||
| Net income (loss) | 42.4 | 60.3 | 72.2 | 94.5 | (7.0 | ) | (146.3 | ) | 28.0 | 143.8 | ||||||||||||||
| Weighted average shares, basic(1) | 201.6 | 201.8 | 201.9 | 201.1 | 176.9 | 201.3 | 201.4 | |||||||||||||||||
| Weighted average shares, diluted(1) | 209.9 | 209.6 | 209.1 | 207.7 | 176.9 | 208.1 | 209.3 | |||||||||||||||||
| Basic earnings (loss) per share(1) | 0.21 | 0.30 | 0.36 | 0.47 | (0.83 | ) | 0.14 | 0.71 | ||||||||||||||||
| Diluted earnings (loss) per share(1) | 0.20 | 0.29 | 0.35 | 0.45 | (0.83 | ) | 0.13 | 0.69 | ||||||||||||||||
| Adjusted EBITDA(3) | 148.2 | 161.6 | 182.2 | 189.8 | 92.1 | 132.1 | 164.7 | 172.6 |
| (1) | Weighted average shares, basic, weighted average shares, diluted, basic earnings (loss) per share and diluted (loss) earnings per share have not been provided for the quarter prior to the initial public offering due to the significant change in capital structure. |
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| (2) | See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Factors Affecting the Comparability of our Results of Operations.” |
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| (3) | Set forth below are the reconciliations of Net Income (Loss) to Adjusted EBITDA |
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| Year Ended December 31, 2018 | Year Ended December 31, 2017 | |||||||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Q1 | Q2 | Q3 | Q4 | Q1 | Q2 | Q3 | Q4 | |||||||||||||||||
| Net Income (Loss) | 42.4 | 60.3 | $ | 72.2 | 94.5 | (7.0 | ) | (146.3 | ) | $ | 28.0 | 143.8 | ||||||||||||
| Plus: | ||||||||||||||||||||||||
| Interest expense | 26.0 | 26.1 | 24.4 | 23.1 | 45.9 | 39.5 | 30.1 | 25.2 | ||||||||||||||||
| Provision (benefit) for income taxes | 23.4 | 17.2 | 22.6 | 16.9 | (1.6 | ) | (43.9 | ) | 4.4 | (90.1 | ) | |||||||||||||
| Depreciation and amortization expense | 45.0 | 45.3 | 44.4 | 45.7 | 39.7 | 43.8 | 43.5 | 46.8 | ||||||||||||||||
| Impairment of other intangible assets(a) | — | — | — | — | — | — | — | 1.6 | ||||||||||||||||
| KKR fees and expenses(b) | — | — | — | — | 1.1 | 16.2 | — | — | ||||||||||||||||
| Restructuring and related business transformation costs (c) | 4.5 | 8.4 | 12.3 | 13.6 | 8.6 | 5.6 | 6.3 | 4.2 | ||||||||||||||||
| Acquisition related expenses and non-cash charges (d) | 4.6 | 5.7 | 2.8 | 3.6 | 0.7 | 1.2 | 1.2 | 1.0 | ||||||||||||||||
| Environmental remediation loss reserve (e) | — | — | — | — | 1.0 | (0.1 | ) | — | — | |||||||||||||||
| Expenses related to public stock offerings(f) | 1.4 | 0.5 | 0.3 | 0.7 | 1.3 | 1.8 | 0.5 | 0.5 | ||||||||||||||||
| Establish public company financial reporting compliance(g) | 0.8 | 1.1 | 1.3 | 1.1 | 1.3 | 2.1 | 3.8 | 0.9 |
| Year Ended December 31, 2018 | Year Ended December 31, 2017 | |||||||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Q1 | Q2 | Q3 | Q4 | Q1 | Q2 | Q3 | Q4 | |||||||||||||||||
| Stock-based compensation(h) | 2.7 | (0.8 | ) | 1.1 | (5.3 | ) | — | 156.2 | 9.8 | 28.2 | ||||||||||||||
| Loss on extinguishment of debt(i) | — | 0.2 | 0.9 | 0.0 | — | 50.4 | 34.1 | — | ||||||||||||||||
| Foreign currency transaction losses (gains), net | 2.6 | (2.4 | ) | (0.8 | ) | (1.3 | ) | 0.6 | 4.0 | 1.7 | 3.0 | |||||||||||||
| Shareholder litigation settlement recoveries(j) | (4.5 | ) | — | — | (5.0 | ) | — | — | — | — | ||||||||||||||
| Other adjustments(k) | (0.7 | ) | — | 0.7 | 2.2 | 0.5 | 1.6 | 1.3 | 7.5 | |||||||||||||||
| Adjusted EBITDA | 148.2 | 161.6 | 182.2 | 189.8 | 92.1 | 132.1 | 164.7 | 172.6 |
| (a) | Represents non-cash charges for the impairment of other intangible assets. |
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| (b) | Represents management fees and expenses paid to KKR. |
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| (c) | Restructuring and related business transformation costs consist of (i) restructuring charges, (ii) severance, sign-on, relocation and executive search costs, (iii) facility reorganization, relocation and other costs, (iv) information technology infrastructure transformation, (v) gains and losses on asset and business disposals, (vi) consultant and other advisor fees and (vii) other miscellaneous costs. These restructuring and related business transformation costs amounted to $38.8 million and $24.7 million for the years ended December 31, 2018 and 2017. |
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| (d) | Represents costs associated with successful and/or abandoned acquisitions, including third-party expenses, post-closure integration costs (including certain incentive and non-incentive cash compensation costs) and non-cash charges and credits arising from fair value purchase accounting adjustments. |
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| (e) | Represents estimated environmental remediation costs and losses relating to a former production facility. |
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| (f) | Represents certain expenses related to our initial public offering and subsequent secondary offerings. |
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| (g) | Represents third party expenses to comply with the requirements of Sarbanes-Oxley in 2018 and the accelerated adoption of the new accounting standards (ASC 606 – Revenue from Contracts with Customers and ASC 842 – Leases) in the first quarter of 2018 and 2019 respectively, one year ahead of the required adoption dates for a private company. |
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| (h) | Represents stock-based compensation expense recognized for the year ended December 31, 2018 of $2.8 million, reduced by $5.1 million primarily due to a decrease in the estimated accrual for employer taxes related to DSUs as a result of a lower per share stock price. |
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Represents stock-based compensation expense recognized for the year ended December 31, 2017 for stock options outstanding of $77.6 million and DSUs granted to employees at the date of the initial public offering of $97.4 million under the 2013 Stock Incentive Plan and employer taxes related to DSUs granted to employees at the date of the initial public offering of $19.2 million.
| (i) | Represents losses on extinguishment of the senior notes, extinguishment of a portion of the U.S. Term Loan, refinancing of the Original Dollar Term Loan Facility and the Original Euro Term Loan Facility and losses reclassified from AOCI into income related to the amendment of the interest rate swaps in conjunction with the debt repayment. |
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| (j) | Represents insurance recoveries of the Company’s shareholder litigation settlement in 2014. |
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| (k) | Includes (i) non-cash impact of net LIFO reserve adjustments, (ii) effects of amortization of prior service costs and amortization of losses in pension and other postretirement benefits (OPEB) expense, (iii) certain legal and compliance costs and (iv) other miscellaneous adjustments. |
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Liquidity and Capital Resources
Our investment resources include cash generated from operations and borrowings under our Revolving Credit Facility and the Receivables Financing Agreement.
For a description of our material indebtedness, see Note 10 “Debt” to our audited consolidated financial statements included elsewhere in this Form 10-K.
As of December 31, 2018, we had $6.5 million of outstanding letters of credit written against the Revolving Credit Facility and $263.4 million of unused availability. We also had $26.8 million of letters of credit outstanding against the Receivables Financing Agreement and $83.3 million unused availability.
As of December 31, 2018, 2017 and 2016 we were in compliance with all of our debt covenants and no event of default had occurred or was ongoing.
Liquidity
A substantial portion of our liquidity needs arise from debt service requirements, and from the ongoing cost of operations, working capital and capital expenditures.
| Year Ended December 31, | |||||||||
|---|---|---|---|---|---|---|---|---|---|
| 2018 | 2017 | 2016 | |||||||
| Cash and cash equivalents | $ | 221.2 | $ | 393.3 | $ | 255.8 | |||
| Short-term borrowings and current maturities of long-term debt | 7.9 | 20.9 | 24.5 | ||||||
| Long-term debt | 1,664.2 | 2,019.3 | 2,753.8 | ||||||
| Total debt | $ | 1,672.1 | $ | 2,040.2 | $ | 2,778.3 |
We can increase the borrowing availability under the Senior Secured Credit Facilities by up to $250.0 million in the form of additional commitments under the Revolving Credit Facility and/or incremental term loans plus an additional amount so long as we do not exceed a specified senior secured leverage ratio. We can incur additional secured indebtedness under the Term Loan Facilities if certain specified conditions are met under the credit agreement governing the Senior Secured Credit Facilities. Our liquidity requirements are significant primarily due to debt service requirements. See Note 10 “Debt” to our audited consolidated financial statements included elsewhere in this Form 10-K.
Our principal sources of liquidity have been existing cash and cash equivalents, cash generated from operations and borrowings under the Senior Secured Credit Facilities and the Receivables Financing Agreement. Our principal uses of cash will be to provide working capital, meet debt service requirements, fund capital expenditures and finance strategic plans, including possible acquisitions. We may also seek to finance capital expenditures under capital leases or other debt arrangements that provide liquidity or favorable borrowing terms. We continue to consider acquisition opportunities, but the size and timing of any future acquisitions and the related potential capital requirements cannot be predicted. In the event that suitable businesses are available for acquisition upon acceptable terms, we may obtain all or a portion of the necessary financing through the incurrence of additional long-term borrowings. As market conditions warrant, we may from time to time, seek to repay loans that we have borrowed, including the borrowings under the Senior Secured Credit Facilities. Based on our current level of operations and available cash, we believe our cash flow from operations, together with availability under the Revolving Credit Facility and the Receivables Financing Agreement, will provide sufficient liquidity to fund our current obligations, projected working capital requirements, debt service requirements and capital spending requirements for the foreseeable future. Our business may not generate sufficient cash flows from operations or future borrowings may not be available to us under our Revolving Credit Facility or the Receivables Financing Agreement in an amount sufficient to enable us to pay our indebtedness, or to fund our other liquidity needs. Our ability to do so depends on, among other factors, prevailing economic conditions, many of which are beyond our control. In addition, upon the occurrence of certain events, such as a change in control, we could be required to repay or refinance our indebtedness. We may not be able to refinance any of our indebtedness, including the Senior Secured Credit Facilities, on commercially reasonable terms or at all. Any future acquisitions, joint ventures, or other similar transactions may require additional capital and there can be no assurance that any such capital will be available to us on acceptable terms or at all.
The majority of our cash is in jurisdictions outside of the United States. As a result of the KKR Transaction and the significant increase in our long-term debt balance as of July 30, 2013, the KKR Transaction date, we modified our assertion concerning the permanent reinvestment of undistributed earnings of our non-U.S. subsidiaries. We asserted that we intended to repatriate approximately $200.0 million of accumulated earnings for the purpose of servicing our Senior Secured Credit Facilities, which would have resulted in net United States tax liabilities as these foreign earnings were distributed. Due to the Tax Act we decided to reverse our ASC 740-30 (formerly APB 23) position, effective the fourth quarter of 2018. We no longer assert the indefinite reinvestment of our historical non-U.S. earnings or future non-U.S. earnings. The Company adjusted its ASC 740-30 deferred foreign tax liability to cover all estimated withholding, state income tax, and foreign income tax associated with repatriating all non-U.S. earnings as of December 31, 2018 back to the United States. Our deferred income tax liability as of December 31, 2018 is $5.6 million which consists mainly of withholding taxes. As a result of the significant reduction in distributable profits due to restructuring and repatriation and the change in assertion, a $3.5 million tax benefit was created in 2018.
Working Capital
| For the Years Ended December 31, | |||||||||
|---|---|---|---|---|---|---|---|---|---|
| 2018 | 2017 | 2016 | |||||||
| **Net Working Capital ** | |||||||||
| Current assets | $ | 1,331.2 | $ | 1,463.6 | $ | 1,188.5 | |||
| Less: Current liabilities | 596.4 | 561.8 | 497.9 | ||||||
| Net working capital | $ | 734.8 | $ | 901.8 | $ | 690.6 | |||
| **Operating Working Capital ** | |||||||||
| Accounts receivable and contract assets | $ | 545.0 | $ | 536.3 | $ | 441.6 | |||
| Plus: Inventories (excluding LIFO) | 510.7 | 481.1 | 428.0 | ||||||
| Less: Accounts payable | 340.0 | 269.7 | 214.9 | ||||||
| Less: Contract liabilities | 69.6 | 42.7 | 43.0 | ||||||
| Operating working capital | $ | 646.1 | $ | 705.0 | $ | 611.7 |
Net working capital decreased $167.0 million to $734.8 million as of December 31, 2018 from $901.8 million as of December 31, 2017. Operating working capital decreased $58.9 million to $646.1 million as of December 31, 2018 from $705.0 million as of December 31, 2017. Operating working capital as of December 31, 2018 was 24.0% of 2018 revenues as compared to 29.7% as of December 31, 2017 as a percentage of 2017 revenues. The decrease in operating working capital was due to higher accounts payable and higher contract liabilities, partially offset by higher accounts receivable and contract assets and higher inventories. During 2018, management proactively focused on improving net working capital performance through centralized process improvement initiatives. Excluding 2018 acquisitions and the impact of foreign currencies, despite higher revenues in the fourth quarter of 2018 compared to the fourth quarter of 2017 and delays in the timing of collections from certain upstream energy customers, accounts receivable decreased modestly resulting from the enhanced receivables collection efforts. The increase in contract assets resulted from the adoption of ASU 2014-09, Revenue from Contracts with Customers (Topic 606) (“ASC 606”) in the first quarter of 2018. Excluding 2018 acquisitions and the impact of foreign currencies, inventories as of December 31, 2018 were essentially flat compared to the prior year due to improved management of production inventory levels at certain key manufacturing facilities offset by higher than expected inventory levels in our upstream energy business resulting primarily from reduced demand in the fourth quarter of 2018. Accounts payable increased significantly as of December 31, 2018 as compared to December 31, 2017 due to continuing efforts to standardize and extend vendor payment terms and pay practices. The increase in contract liabilities was primarily due to an acquisition in 2018 and the timing of progress collections on certain long term contracts.
Net working capital increased $211.2 million to $901.8 million as of December 31, 2017 from $690.6 million as of December 31, 2016. Operating working capital increased $93.3 million to $705.0 million as of December 31, 2017 from $611.7 million as of December 31, 2016. Operating working capital at December 31, 2017 as a percentage of 2017 revenues was 29.7% as compared to 31.5% at December 31, 2016 as a percentage of 2016 revenues. This increase was primarily due to higher accounts receivable, higher inventories, and lower contract liabilities, partially offset by higher accounts payable. The increase in accounts receivable was primarily due to a higher level of sales in the fourth quarter of 2017 compared to the fourth quarter of 2016 as a result of the recovery in the upstream energy markets. The increase in accounts receivable was also due to a difference in sales mix between the fourth quarter of 2016 and the fourth quarter of 2017. A higher portion of revenues in the fourth quarter of 2016 were related to highly engineered solution product contracts with higher advance payments ahead of revenue recognition than in the fourth quarter of 2017. The increase in inventories was primarily due to additions to inventories in anticipation of increased demand for certain products primarily in the Energy segment evidenced by increased orders in the Energy segment in the fourth quarter of 2017 compared to the fourth quarter of 2016. The increase in accounts payable was due to increased levels of inventories and continuing efforts to standardize vendor payment terms and pay practices. Contract liabilities were essentially flat as of December 31, 2017 in comparison to 2016.
Cash Flows
The following table reflects the major categories of cash flows for the years ended December 31, 2018, 2017 and 2016, respectively.
| Year Ended December 31, | |||||||||
|---|---|---|---|---|---|---|---|---|---|
| 2018 | 2017 | 2016 | |||||||
| Cash flows - operating activities | $ | 444.5 | $ | 200.5 | $ | 165.6 | |||
| Cash flows - investing activities | (235.0 | ) | (60.8 | ) | (82.1 | ) | |||
| Cash flows - financing activities | (373.0 | ) | (17.4 | ) | (43.0 | ) | |||
| Free cash flow(1) | 392.3 | 143.7 | 91.2 |
| (1) | See “Item 6. Selected Financial Data” for a reconciliation to the most directly comparable GAAP measure. |
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Operating activities
Cash provided by operating activities increased $244.0 million to $444.5 million in 2018 from $200.5 million in 2017, primarily due to higher net income (excluding non-cash charges for depreciation and amortization, the impairment of other intangible assets, stock-based compensation expense, foreign currency transaction (gains) losses, net (gain) loss on asset dispositions, the loss on the extinguishment of debt, the non-cash change in the LIFO reserve and deferred taxes), and from cash generated by reduced operating working capital.
Operating working capital generated cash of $54.9 million in 2018 compared to using cash of $55.0 million in 2017. Changes in accounts receivable generated cash of $13.2 million in 2018 compared to using cash of $65.7 million in 2017 and changes in contract assets used cash of $19.9 million in 2018 compared to no impact on cash in 2017. Changes in inventory used cash of $13.0 million in 2018 compared to using cash of $22.7 million in 2017. Changes in accounts payable generated cash of $69.6 million in 2018 as compared to generating cash of $39.9 million in 2017. Changes in contract liabilities generated cash of $5.0 million in 2018 compared to using cash of $6.5 million in 2017.
Cash provided by operating activities increased $34.9 million to $200.5 million in 2017 from $165.6 million in 2016, primarily due to higher net income (excluding non-cash charges for impairments of other intangible assets, stock-based compensation, depreciation and amortization, foreign currency transaction (gains) losses, loss on extinguishment of debt) and deferred income taxes, partially offset by increased cash used by working capital.
Operating working capital used cash of $55.0 million in 2017 compared to providing cash of $20.5 million in 2016. Changes in accounts receivable used cash of $65.7 million in 2017 compared to using cash of $48.8 million in 2016. Changes in inventory used cash of $22.7 million in 2017 compared to generating cash of $23.5 million in 2016. Changes in accounts payable generated cash of $39.9 million in 2017 as compared to generating cash of $58.1 million in 2016. Changes in advance payments on sales contracts used cash of $6.5 million in 2017 and used cash of $12.3 million in 2016.
Investing activities
Cash flows from investing activities included capital expenditures of $52.2 million (1.9% of consolidated revenues), $56.8 million (2.4% of consolidated revenues) and $74.4 million (3.8% of consolidated revenues), in 2018, 2017 and 2016, respectively. We currently expect capital expenditures to total approximately $50.0 million to $60.0 million in 2019. Cash paid in business combinations was $186.3 million in 2018, $18.8 million in 2017 and $18.8 million in 2016. Proceeds from the termination of derivatives was $6.2 million in 2017. Net proceeds from business divestitures and disposals of property, plant and equipment were $3.5 million, $8.6 million and $11.1 million in 2018, 2017, and 2016, respectively.
Financing activities
Cash used in financing activities of $373.0 million in 2018 reflects repayments of long-term borrowings of $337.6 million, purchases of treasury stock of $40.7 million, a $1.4 million payment of contingent considerations and $0.1 million of other items, partially offset by proceeds from stock option exercises of $6.8 million associated with approved stock-based compensation plans.
Cash used in financing activities of $17.4 million in 2017 reflects net repayments of long-term borrowings of $868.6 million, a premium paid on the extinguishment of senior notes of $29.7 million, purchases of treasury stock of $3.6 million, purchases of shares of noncontrolling interest of $5.2 million, and the payment of debt issuance costs of $4.1 million, partially offset by proceeds from the issuance of common stock $893.6 million, net of share issuance costs, and other items of $0.2 million.
Cash used in financing activities of $43.0 million in 2016, reflects scheduled principal payments on long-term borrowings of $25.5 million, purchases of treasury stock of $14.1 million, a $4.7 million payment of contingent consideration related to an acquisition, payments of debt issuance costs of $1.1 million and other items of $0.9 million, partially offset by issuances of common stock of $3.3 million.
Free cash flow
Free cash flow increased $248.6 million to $392.3 million in 2018 from $143.7 million in 2017 due to increased cash provided by operating activities of $244.0 million and a decrease in capital expenditures of $4.6 million in 2018 compared to 2017.
Free cash flow increased $52.5 million to $143.7 million in 2017 from $91.2 million in 2016 due to increased cash provided by operating activities of $34.9 million and a decrease in capital expenditures of $17.6 million in 2017 compared to 2016.
Off-Balance Sheet Arrangements
We have no off-balance sheet arrangements that have or are materially likely to have a current or future material effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.
Contractual Obligations
The following table summarizes our future minimum payments as of December 31, 2018 for all contractual obligations for years subsequent to the year ended December 31, 2018.
| Contractual Obligations | Total | Payments Due by Period | |||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2019 | 2020-2021 | 2022-2023 | **More than **5 years | ||||||||||||
| Debt | $ | 1,649.2 | $ | 7.1 | $ | 14.1 | $ | 14.1 | $ | 1,613.9 | |||||
| Estimated interest payments(1) | 454.3 | 86.5 | 159.4 | 153.0 | 55.4 | ||||||||||
| Capital leases | 26.2 | 0.8 | 2.1 | 2.6 | 20.7 | ||||||||||
| Operating leases | 81.7 | 25.8 | 33.4 | 13.1 | 9.4 | ||||||||||
| Purchase obligations(2) | 284.4 | 277.9 | 6.5 | — | — | ||||||||||
| Total | $ | 2,495.8 | $ | 398.1 | $ | 215.5 | $ | 182.8 | $ | 1,699.4 |
| (1) | Estimated interest payments for long-term debt were calculated as follows: for fixed-rate debt and term debt, interest was calculated based on applicable rates and payment dates; for variable-rate debt and/or non-term debt, interest rates and payment dates were estimated based on management’s determination of the most likely scenarios for each relevant debt instrument. |
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| (2) | Purchase obligations consist primarily of agreements to purchase inventory or services made in the normal course of business to meet operational requirements. The purchase obligation amounts do not represent the entire anticipated purchases in the future, but represent only those items for which we are contractually obligated as of December 31, 2018. For this reason, these amounts will not provide a complete and reliable indicator of our expected future cash outflows. |
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Total pension and other postretirement benefit liabilities recognized on our consolidated balance sheet as of December 31, 2018 were $96.9 million. The total pension and other postretirement benefit liabilities are included in our consolidated balance sheet line items “Accrued liabilities” and “Pensions and other postretirement benefits.” Because these liabilities are impacted by, among other items, plan funding levels, changes in plan demographics and assumptions and investment return on plan assets, these liabilities do not represent expected liquidity needs. Accordingly, we did not include these liabilities in the “Contractual Obligations” table above.
We fund our U.S. qualified pension plans in accordance with the Employee Retirement Income Security Act of 1974 regulations for the minimum annual required contribution and Internal Revenue Service regulations for the maximum annual allowable tax deduction. We are committed to making the required minimum contributions and expect to contribute a total of approximately $0.1 million to our U.S. qualified pension plans during 2019. Furthermore, we expect to contribute a total of approximately $0.3 million to our postretirement life insurance benefit plans during 2019. Future contributions are dependent upon various factors including the performance of the plan assets, benefit payment experience and changes, if any, to current funding requirements. Therefore, no amounts were included in the “Contractual Obligations” table related to expected plan contributions. We generally expect to fund all future contributions to our plans with cash flows from operating activities.
Our non-U.S. pension plans are funded in accordance with local laws and income tax regulations. We expect to contribute a total of approximately $4.7 million to our non-U.S. qualified pension plans during 2019. No amounts have been included in the “Contractual Obligations” table related to these plans due to the same reasons indicated above.
Disclosure of amounts in the “Contractual Obligations” table regarding expected benefit payments in future years for our pension plans and other postretirement benefit plans cannot be properly reflected due to the ongoing nature of the obligations of these plans. We currently anticipate the annual benefit payments for the U.S. plans to be in the range of approximately $4.5 million to $5.5 million for the next several years, and the annual benefit payments for the non-U.S. plans to be in the range of approximately $10.0 million to $12.0 million for the next several years.
Contingencies
We are a party to various legal proceedings, lawsuits and administrative actions, which are of an ordinary or routine nature for a company of our size and in our sector. We believe that such proceedings, lawsuits and administrative actions will not materially adversely affect our operations, financial condition, liquidity or competitive position. We have accrued liabilities and other liabilities on our consolidated balance sheet to include a total litigation reserve of $105.8 million as of December 31, 2018 with respect to potential liability arising from our asbestos-related litigation. Other than our asbestos-related litigation reserves, we only have de minimis accrued liabilities and other liabilities on our consolidated balance sheet with respect to other legal proceedings, lawsuits and administrative actions. A more detailed discussion of certain of these proceedings, lawsuits and administrative actions is set forth in “Item 3. Legal Proceedings.”
Critical Accounting Estimates
Accounting estimates and assumptions discussed in this section are those that we consider to be the most critical to an understanding of our financial statements because they involve significant judgments and uncertainties. Certain of these estimates include determining fair value. All of these estimates reflect our best judgment about current, and for some estimates, future economic and market conditions and their effect based on information available as of the date of these financial statements. If these conditions change from those expected, it is reasonably possible that the judgments and estimates described below could change, which may result in future impairments of goodwill, intangibles and long-lived assets, increases in reserves for contingencies, establishment of valuation allowances on deferred tax assets and increase in tax liabilities, among other effects. Also see Note 1 “Summary of Significant Accounting Policies” to our audited consolidated financial statements included elsewhere in this Form 10-K, which discusses the significant accounting policies that we have selected from acceptable alternatives.
Impairment of Goodwill and Other Identified Intangible Assets
We test goodwill for impairment annually in the fourth quarter of each year using data as of October 1 of that year and whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Upon adoption of ASU 2018-04, the impairment test consists of comparing the fair value of the reporting unit to the carrying value of the reporting unit. An impairment charge is recognized for the amount by which the carrying amount exceeds the reporting unit’s fair value; provided, the loss recognized cannot exceed the total amount of goodwill allocated to the reporting unit. If applicable, we consider income tax effects from any tax deductible goodwill on the carrying amount of the reporting unit when measuring the goodwill impairment loss. We determined fair values for each of the reporting units using a combination of the income and market multiples approaches which are weighted 75% and 25%, respectively.
Under the income approach, fair value is determined based on the present value of estimated future cash flows, discounted at an appropriate risk-adjusted rate. We use our internal forecasts to estimate future cash flows and include an estimate of long-term future growth rates based on our most recent views of the long-term outlook for each business. Actual results may differ from those assumed in our forecasts. We derive our discount rates using a capital asset pricing model and analyzing published rates for industries relevant to our reporting units to estimate the cost of equity financing. We use discount rates that are commensurate with the risks and uncertainty inherent in the respective businesses and in our internally developed forecasts. Discount rates used in our 2018 reporting unit valuations ranged from 10.3% to 11.5%. Additionally, we assumed 3.0% terminal growth rates for all reporting units.
Under the market multiples approach, fair value is determined based on multiples derived from the stock prices of publically traded guideline companies to develop a business enterprise value (“BEV”) for our reporting units. The
application of the market multiples method entails the development of book value multiples based on the market value of the guideline companies. The multiples are developed by first calculating the market value of equity of the guideline companies and then adjusting these multiples for cash and debt to arrive at a BEV multiple. Identifying appropriate guideline companies and computing appropriate market multiples is subjective. We considered various public companies that had reasonably similar qualitative factors as our reporting units while also considering quantitative factors such as revenue growth, profitability and total assets.
For all reporting units, the excess of the estimated fair value over carrying value (expressed as a percentage of carrying value) was a minimum of 92.2%. With each reporting unit’s fair value in excess of its carrying value, no goodwill impairment was recorded.
We annually test intangible assets with indefinite lives for impairment utilizing a discounted cash flow valuation referred to as the relief from royalty method. We estimated forecasted revenues for a period of five years with discount rates ranging from 11.3% to 12.5%, a terminal growth rate of 3.0%, and royalty rates ranging from 3.0% to 4.0%.
We review identified intangible assets with defined useful lives and subject to amortization for impairment whenever events or changes in circumstances indicate that the related carrying amounts may not be recoverable. Determining whether an impairment loss occurred requires comparing the carrying amount to the sum of undiscounted cash flows expected to be generated by the asset.
Also see Note 8 “Goodwill and Other Intangible Assets” to our audited consolidated financial statements included elsewhere in this Form 10-K.
Income Taxes
Our annual tax rate is based on our income, statutory tax rates and tax planning opportunities available to us in the various jurisdictions in which we operate. Tax laws are complex and subject to different interpretations by the taxpayer and respective governmental taxing authorities. Significant judgment is required in determining our tax expense and in evaluating our tax positions, including evaluating uncertainties. We review our tax positions quarterly and adjust the balances as new information becomes available.
On December 22, 2017, the Tax Act was enacted into law and the new legislation contains several key tax provisions that affected us, including a one-time mandatory transition tax on accumulated foreign earnings and a reduction of the corporate income tax rate to 21% effective January 1, 2018, among others. We are required to recognize the effect of the tax law changes, including the determination of the transition tax, the remeasurement of our U.S. deferred tax assets and liabilities as well as the reassessment of the net realizability of our deferred tax assets and liabilities in the period of enactment. In December 2017, the SEC staff issued Staff Accounting Bulletin No. 118, Income Tax Accounting Implications of the Tax Cuts and Jobs Act (“SAB 118”), which allowed us to record provisional amounts during a measurement period not to extend beyond one year of the enactment date. As a result, we previously provided a provisional estimate of the effect of the Tax Act in our financial statements for 2017 and through the first nine month period of 2018. In the fourth quarter of 2018, we completed our accounting for all of the enactment-date income tax effects of the Tax Act by increasing the total benefit taken in 2017 of $95.3 million to $96.5 million. The total U.S. deferred change due to the Tax Act went from a tax benefit of $89.6 million in 2017 to $74.5 million in 2018, with a 2018 measurement-period adjustment of $15.1 million. The ASC 740-30 (formerly APB 23) liability related to the permanent reinvestment of earnings in foreign subsidiaries assertion, changed from a tax benefit of $69.0 million in 2017 to $72.5 million in 2018, with a 2018 measurement-period adjustment of $3.5 million resulting from a reduction in distributable profits due to restructuring and repatriations and the change in policy that occurred in 2018. The provisional one-time transition tax of $63.3 million in 2017 decreased to $50.5 million in 2018, with a 2018 measurement-period adjustment of $12.8 million. The total $1.2 million benefit has a (0.3)% impact to the overall rate in 2018.
The Tax Act creates a new requirement that certain income (i.e., GILTI) earned by CFCs must be included currently in the gross income of the CFCs’ U.S. shareholder. GILTI is the excess of the shareholder’s “net CFC tested income” over the net deemed tangible income return, which is currently defined as the excess of (1) 10% of the aggregate of the U.S. shareholder’s pro rata share of the qualified business asset investment of each CFC with respect to which it is a U.S. shareholder over (2) the amount of certain interest expense taken into account in the determination of net CFC-tested income.
Under U.S. GAAP, we are allowed to make an accounting policy choice of either (1) treating taxes due on future U.S. inclusions in taxable income related to GILTI as a current-period expense when incurred (the “period cost method”) or (2) factoring such amounts into a company’s measurement of its deferred taxes (the “deferred method”). We determined that we will follow the period cost method (option 1 above) going forward. The tax provision for the twelve month period ended December 31, 2018 reflects this decision. All of the additional calculations and rule changes found in the Tax Act have been considered in the tax provision for year and quarter ended December 31, 2018. The Company recorded a tax expense of $11.9 million in the period for the GILTI provisions of the Tax Act that were effective for the first time during 2018.
Stock-Based Compensation
We account for stock-based compensation plans under the fair value recognition and measurement provisions in accordance with applicable accounting standards, which require all stock-based payments to employees and non-employees, including grants of stock options and deferred stock units (“DSU”), to be measured based on the grant date fair value of the awards.
The fair value of each stock option grant is estimated using the Black-Scholes-Merton valuation model. The model requires certain assumptions including the estimated expected term of the stock options, the risk-free interest rate and the assumed volatility, of which certain assumptions are highly complex and subjective. The expected option life represents the period of time that the options granted are expected to be outstanding based on management's best estimate of the timing of a liquidity event and the contractual term of the stock option. As there is not sufficient trading history of our common stock, we use a group of our competitors which we believe are similar to us, adjusted for our capital structure, in order to estimate volatility. Our exercise price is the stock price on the date in which shares were granted.
Concurrent with the Company’s initial public offering in May of 2017, the Company’s Board authorized the grant of 5.5 million DSUs to all permanent employees that had not previously received stock-based awards under the 2013 Plan. The DSUs vested immediately upon grant, however contain restrictions such that the employee may not sell or otherwise realize the economic benefits of the award until certain dates through April 2019. The fair value of each DSU grant under the Stock-Based Compensation Plan is estimated on the date of grant or modification using the Finnerty discount for lack of marketability pricing model. The discount for lack of marketability is commensurate with the period of sale restrictions related to the Company’s initial public offering.
Prior to our initial public offering, our stock price was calculated based on a combination of the income approach and the market approach. Under the income approach, specifically the discounted cash flow method, forecasted cash flows are discounted to the present value at a risk-adjusted discount rate. The valuation analyses determine discrete free cash flows over several years based on forecast financial information provided by management and a terminal value for the residual period beyond the discrete forecast, which are discounted at an appropriate rate to estimate our enterprise value. Under the market approach, specifically the guideline public company method, we select publicly traded companies with similar financial and operating characteristics as us and calculate valuation multiples based on the guideline public company’s financial information and market data. Subsequent to the initial public offering, the estimation of our stock price is no longer necessary as we rely on the market price to determine the market value of our common stock. For additional information related to the assumptions used, see Note 16 “Stock-Based Compensation Plans” to our audited consolidated financial statements included elsewhere in this Form 10-K.
Loss Contingencies
Loss contingencies are uncertain and unresolved matters that arise in the ordinary course of business and result from events or actions by others that have the potential to result in a future loss. Such contingencies include, but are not limited to, asbestos and silica related litigation, environmental obligations, litigation, regulatory proceedings, product quality and losses resulting from other events and developments.
When a loss is considered probable and reasonably estimable, we record a liability in the amount of our best estimate for the ultimate loss. When there appears to be a range of possible costs with equal likelihood, liabilities are based on the low-end of such range. However, the likelihood of a loss with respect to a particular contingency is often difficult to predict and determining a meaningful estimate of the loss or a range of loss may not be practicable based on the information available and the potential effect of future events and decisions by third parties that will determine the ultimate resolution of the contingency. Moreover, it is not uncommon for such matters to be resolved over many years, during which time relevant developments and new information must be continuously evaluated to determine
both the likelihood of potential loss and whether it is possible to reasonably estimate a range of possible loss. When a loss is probable but a reasonable estimate cannot be made, disclosure is provided.
Disclosure also is provided when it is reasonably possible that a loss will be incurred or when it is reasonably possible that the amount of a loss will exceed the recorded provision. We regularly review all contingencies to determine whether the likelihood of loss has changed and to assess whether a reasonable estimate of the loss or range of loss can be made. As discussed above, development of a meaningful estimate of loss or a range of potential loss is complex when the outcome is directly dependent on negotiations with or decisions by third parties, such as regulatory agencies, the court system and other interested parties. Such factors bear directly on whether it is possible to reasonably estimate a range of potential loss and boundaries of high and low.
Recent Accounting Pronouncements
See Note 2 “New Accounting Standards” to our audited consolidated financial statements included elsewhere in this Form 10-K for a discussion of recent accounting standards.
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