Alamo Group Inc: Form 10-Q for the period ended Jun 30, 2019

The following tables set forth, for the periods indicated, certain financial data:

Overview

This report contains forward-looking statements that are based on Alamo Group’s current expectations. Actual results in future periods may differ materially from those expressed or implied because of a number of risks and uncertainties which are discussed below and in the Forward-Looking Information section. Unless the context otherwise requires, the terms the "Company", "we", "our" and "us" means Alamo Group Inc.

For the first six months of 2019, the Company's net income increased by approximately 7.7% when compared to the same period in 2018. This increase was the result of improved sales growth in the Company's Industrial Division and, to a lesser extent, the acquisition of Dutch Power Company B.V. ("Dutch Power") completed in early March of 2019. Negatively affecting the Company's performance during the first six months of 2019 was the continued soft market conditions in the agricultural market, which impacted our North American agricultural sales. Also, while higher material costs hurt profitability during the first quarter of 2019, steel costs eased during the second quarter as margins improved, although not yet to the level we saw during the first half of 2018.

The Company's Industrial Division experienced a 15.7% increase in sales for the first six months of 2019 compared to the first six months of 2018. Sales across all Industrial product groups, with the exception of mowing equipment which was flat, outperformed during the first six months of 2019 compared to the same period in 2018. Agricultural sales were down in the first six months of 2019 by 8.0% compared to the first six months of 2018 as a result of continued weak demand for our products due to soft agricultural market conditions and declining farm incomes. Also negatively impacting results was a shutdown during the first quarter of 2019 of the Division's largest manufacturing facility for several days to install an upgrade to its paint system and heavy rains and flooding throughout the mid-west part of the U.S. during the second quarter. European sales for the first six months of 2019 were up in U.S. dollars by 17.9% compared to the same period in 2018 mainly due to the acquisition of Dutch Power. Excluding Dutch Power, sales in local currency were up during the second quarter of 2019 compared to the same time in 2018, but were negatively affected by changes due to currency translation. Consolidated income from operations was $52.0 million in the first six months of 2019 compared to $48.1 million for the first six months of 2018. The Company's backlog increased 3.9% to $228.8 million at the end of the second quarter of 2019 versus the backlog of $220.2 million at the end of the second quarter of 2018. The increase in the Company's backlog was attributable to greater demand for our products, specifically in the Company's Industrial Division and from the acquisition of Dutch Power, partially offset by lower new orders in the Company's Agricultural and European Divisions.

The Company is cautiously optimistic about its outlook for the remainder of 2019, but we continue to face several ongoing challenges. Beginning in 2018, the Company saw increases in raw material, freight, tariff surcharges and other input costs including labor, at above rates seen in recent years though some of these inflationary pressures have begun to ease. We continue to experience longer lead times for certain key components of our products. The Company also continues to be impacted by a tight labor market and difficulties in hiring and retaining skilled workers. Additional tariffs, future changes in tariff regulations and ongoing trade disputes could further impact the business by increasing the cost of items used in the manufacturing of our products and by softening sales of our products to certain of our customers who may be impacted directly or indirectly by increasing tariffs and other negative effects resulting from trade disputes. The Company may also be negatively affected by several other unanticipated factors such as a weakness in the overall economy; significant changes in currency exchange rates; negative economic impacts resulting from geopolitical events such as the unresolved Brexit situation, changes in trade policy, increased levels of government regulations; weakness in the agricultural sector; acquisition integration issues; budget constraints or revenue shortfalls in governmental entities; and other risks and uncertainties as described in “Risk Factors" section of the Company's Annual Report on Form 10-K for the year ended December 31, 2018 (the "2018 Form 10-K").

Results of Operations

Three Months Ended June 30, 2019 vs. Three Months Ended June 30, 2018

Net sales for the second quarter of 2019 were $285,186,000, an increase of $28,061,000 or 10.9% compared to $257,125,000 for the second quarter of 2018. The increase in sales was attributable to strong demand for our products in the Company's Industrial Division as well as $14,034,000 of net sales from the acquisition of Dutch Power.

Net Industrial sales increased by $17,969,000 or 12.0% to $168,000,000 for the second quarter of 2019 compared to $150,031,000 during the same period in 2018. The increase was attributable to increased sales across all product groups in the Division with the exception of mowing equipment which was down due to soft market conditions and adverse weather conditions.

Net Agricultural sales were $55,159,000 in the second quarter of 2019 compared to $59,071,000 for the same period in 2018, a decrease of $3,912,000 or 6.6%. The decrease was primarily the result of weak market conditions which limited sales growth in both equipment and replacement parts as farm incomes continued to be challenged. Also, negatively affecting sales were heavy rains and flooding throughout the mid-west part of the U.S.

Net European sales for the second quarter of 2019 were $62,027,000, an increase of $14,004,000 or 29.2% compared to $48,023,000 during the second quarter of 2018. The increase was driven by the acquisition of Dutch Power which added $14,034,000 of net sales during the quarter. Excluding Dutch Power, sales in the European Division were flat in U.S. dollars. Excluding Dutch Power, sales in local currency were up during the second quarter of 2019 compared to the same time in 2018, but were offset by unfavorable currency translation.

Gross profit for the second quarter of 2019 was $73,133,000 (25.6% of net sales) compared to $66,454,000 (25.8% of net sales) during the same period in 2018, an increase of $6,679,000. The increase in gross profit during the second quarter of 2019 was primarily due to improved sales in the Company's Industrial Division and to a lesser extent the acquisition of Dutch Power, which more than offset the profit decline in the Agricultural and European

Divisions. Gross profit and gross margin percentage for the quarter saw some improvement since the first quarter of 2019 as commodity costs, specifically raw materials such as steel eased.

Selling, general and administrative expenses (“SG&A”) were $43,784,000 (15.4% of net sales) during the second quarter of 2019 compared to $39,668,000 (15.4% of net sales) during the same period of 2018, an increase of $4,116,000. The increase primarily came from the acquisition of Dutch Power in the amount of $2,338,000. Also, higher selling expenses due to increased sales and increased spending on research and development projects added to SG&A expenses during the second quarter of 2019.

Interest expense was $1,935,000 for the second quarter of 2019 compared to $1,497,000 during the same period in 2018, an increase of $438,000. The increase during the second quarter of 2019 came from increased borrowings due to the Dutch Power acquisition.

Other expense was $295,000 for the second quarter of 2019 compared to $92,000 during the same period in 2018. The expenses in 2019 and 2018 were primarily the result of changes in currency exchange rates.

Provision for income taxes was $6,782,000 (24.7% of income before income tax) in the second quarter of 2019 compared to $6,535,000 (25.8% of income before income tax) during the same period in 2018. The increase was due to higher pre-tax income during the second quarter of 2019.

The Company’s net income after tax was $20,667,000 or $1.75 per share on a diluted basis for the second quarter of 2019 compared to $18,771,000 or $1.60 per share on a diluted basis for the second quarter of 2018. The increase of $1,896,000 resulted from the factors described above.

Six Months Ended June 30, 2019 vs. Six Months Ended June 30, 2018

Net sales for the first six months of 2019 were $547,120,000, an increase of $51,908,000 or 10.5% compared to $495,212,000 for the first six months of 2018. The increase was primarily attributable to increased demand for our products in the Company's Industrial Division. Our recent acquisition of Dutch Power added to the increase in net sales in the amount of $17,648,000. Negatively affecting sales during the first six months of 2019, were weak agricultural market conditions as well as unfavorable currency translation effects primarily in our European Division.

Net Industrial sales increased during the first six months by $44,227,000 or 15.7% to $326,425,000 for 2019 compared to $282,198,000 during the same period in 2018. The increase came from higher sales of all product lines, with the exception of mowing equipment which was flat compared to the same time in 2018.

Net Agricultural sales were $108,332,000 during the first six months of 2019 compared to $117,718,000 for the same period in 2018, a decrease of $9,386,000 or 8.0%. The decrease in sales for the first six months of 2019 compared to the first six months of 2018 was a result of weak market conditions and lower farm incomes which have been impacted by lower commodity prices as well as tariffs. A first quarter 2019 shutdown in the Division's largest manufacturing facility to install an upgrade to its paint system in addition to heavy rains and flooding throughout the mid-west part of the U.S. during the second quarter of 2019 also negatively hampered sales.

Net European sales for the first six months of 2019 were $112,363,000, an increase of $17,067,000 or 17.9% compared to $95,296,000 during the same period of 2018. The increase in 2019 was due to the acquisition of Dutch Power. Excluding Dutch Power, sales in local currency were up during the first six months of 2019 compared to the same time in 2018, but were offset by unfavorable currency translation.

Gross profit for the first six months of 2019 was $136,441,000 (24.9% of net sales) compared to $126,711,000 (25.6% of net sales) during the same period in 2018, an increase of $9,730,000. The increase in gross profit for the first six months of 2019 came from higher equipment sales in the Company's Industrial Division and, to a lesser extent, the acquisition of Dutch Power. Negatively affecting both gross margin and margin percentage for the first six months of 2019 were higher steel, freight and other input costs, some of which began to ease during the second quarter. Productivity improvements, pricing actions, and purchasing initiatives helped offset these negative affects.

SG&A expenses were $84,486,000 (15.4% of net sales) during the first six months of 2019 compared to $78,564,000 (15.9% of net sales) during the same period of 2018, an increase of $5,922,000. The increase primarily came from higher selling expenses due to increased sales along with increased spending on research and development projects. To a lesser extent, our the recent acquisition of Dutch Power added $2,949,000 in SG&A expenses.

Interest expense was $3,385,000 for the first six months of 2019 compared to $2,834,000 during the same period in 2018, an increase of $551,000. The increase during the first six months of 2019 came from increased borrowings due to the Dutch Power acquisition.

Other income (expense), net was $684,000 of expense during the first six months of 2019 compared to $226,000 of expense in the first six months of 2018. The expenses in 2019 and 2018 were primarily the result of changes in exchange rates.

Provision for income taxes was $12,469,000 (25.8% of income before income taxes) in the first six months of 2019 compared to $11,942,000 (26.4% of income before income taxes) during the same period in 2018. The increase was due to higher pre-tax income during the first six months of 2019.

The Company's net income after tax was $35,920,000 or $3.05 per share on a diluted basis for the first six months of 2019 compared to $33,354,000 or $2.84 per share on a diluted basis for the first six months of 2018. The increase of $2,566,000 resulted from the factors described above.

Liquidity and Capital Resources

In addition to normal operating expenses, the Company has ongoing cash requirements which are necessary to operate the Company’s business, including inventory purchases and capital expenditures. The Company’s inventory and accounts payable levels typically build in the first half of the year and in the fourth quarter in anticipation of the spring and fall selling seasons. Accounts receivable historically build in the first and fourth quarters of each year as a result of fall preseason sales programs and out of season sales, particularly in our Agricultural Division. Preseason sales, primarily in the Agricultural Division, help level the Company’s production during the off season.

As of June 30, 2019, the Company had working capital of $418,949,000 which represents an increase of $66,958,000 from working capital of $351,991,000 at December 31, 2018. The increase in working capital was primarily due to seasonality and increased demand for our products reflected in the Company's higher sales and backlog and to a lesser extent the acquisition of Dutch Power.

Capital expenditures were $12,423,000 for the first six months of 2019, compared to $10,829,000 during the first six months of 2018. The Company expects higher capital expenditures in 2019 in order to increase production capacity, support improvements in operational efficiencies, invest in technology and for the previously announced construction of a new manufacturing facility for its Super Products vacuum truck operation in Wisconsin as well as the expansion of our Tenco facility in Canada. The Company will fund future expenditures from operating cash flows or through our revolving credit facility, described below.

Net cash provided by financing activities was $76,686,000 and $58,130,000 during the six month periods ended June 30, 2019 and June 30, 2018, respectively. The majority of the increase in net cash provided by financing activities in 2019 as compared to the prior year, was mainly due to borrowings to finance the acquisition of Dutch Power, partially offset by the repurchase activity related to the Company's common stock.

The Company had $44,605,000 in cash and cash equivalents held by its foreign subsidiaries as of June 30, 2019. The majority of these funds are at our European and Canadian facilities. As a result of the fundamental changes to the taxation of multinational corporations created by Tax Cuts and Jobs Act, we no longer intend to permanently reinvest all of the undistributed earnings of our European foreign affiliates. While the Company intends to use some of these funds for working capital and capital expenditures outside the U.S., recent changes in the U.S. tax laws have substantially mitigated the cost of repatriation. During the second quarter of 2018, the Company repatriated excess cash from its European operations of approximately $24,000,000. The Company will continue to repatriate foreign cash and cash equivalents in excess of amounts needed to fund foreign operating and investing activities. Repatriated funds will initially be used to reduce funded debt levels under the Company's current credit facility and subsequently used to fund working capital, capital investments and acquisitions company-wide.

The Company maintains an unsecured revolving credit facility with certain lenders under its Amended and Restated Revolving Credit Agreement ("the Agreement"). The aggregate commitments from lenders under the Agreement is $250,000,000 and, subject to certain conditions and bank approval, the Company has the option to request an increase in aggregate commitments of up to an additional $50,000,000. The Agreement requires the Company to maintain various financial covenants including a minimum earnings before interest and tax to interest expense ratio, a maximum leverage ratio and a minimum asset coverage ratio. The Agreement also contains various covenants relating to limitations on indebtedness, limitations on investments and acquisitions, limitations on sale of properties and limitations on liens and capital expenditures. The Agreement also contains other customary covenants, representations and events of defaults. Effective December 20, 2016, the Company amended its revolving credit facility to extend the termination date, reduce LIBOR interest margin and to modify certain financial and other covenants in order to meet the ongoing needs of the Company's business and to allow for greater flexibility in relation to future acquisitions. The expiration date of the revolving credit facility is December 20, 2021. As of June 30, 2019, $166,000,000 was outstanding under the Agreement. On June 30, 2019, $3,152,000 of the revolver capacity was committed to irrevocable standby letters of credit issued in the ordinary course of business as required by vendors' contracts resulting in $80,848,000 in available borrowings. As of June 30, 2019, the Company was in compliance with the covenants under the Agreement.

Management believes the Agreement and the Company’s ability to internally generate funds from operations should be sufficient to meet the Company’s cash requirements for the foreseeable future. However, future challenges affecting the banking industry and credit markets in general could potentially cause changes to credit availability, which creates a level of uncertainty.

Critical Accounting Estimates

Management’s Discussion and Analysis of Financial Condition and Results of Operations are based upon our Consolidated Financial Statements, which have been prepared in accordance with GAAP. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. Management bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

Critical Accounting Policies

An accounting policy is deemed to be critical if it requires an accounting estimate to be made based on assumptions about matters that are highly uncertain at the time the estimate is made, and if different estimates that reasonably could have been used, or changes in the accounting estimates that are reasonably likely to occur periodically, could materially impact the financial statements. Management believes that of the Company's significant accounting policies, which are set forth in Note 1 of the Notes to Consolidated Financial Statements in the 2018 Form 10-K, the policies relating to the business combinations, sales discounts, and goodwill and other intangible assets involved a higher degree of judgment and complexity. There have been no material changes to the nature of estimates, assumptions and levels of subjectivity and judgment related to critical accounting estimates disclosed in Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations" of the 2018 Form 10-K.

Off-Balance Sheet Arrangements

There are no off-balance sheet arrangements that have or are likely to have a current or future material effect on our financial condition.

Forward-Looking Information

Part I of this Quarterly Report on Form 10-Q and the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in Item 2 of this Quarterly Report contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. In addition, forward-looking statements may be made orally or in press releases, conferences, reports or otherwise, in the future by or on behalf of the Company.

Statements that are not historical are forward-looking. When used by or on behalf of the Company, the words “estimate,” "anticipate," "expect," “believe,” “intend”, "will", "would", "should", "could" and similar expressions generally identify forward-looking statements made by or on behalf of the Company.

Forward-looking statements involve risks and uncertainties. These uncertainties include factors that affect all businesses operating in a global market, as well as matters specific to the Company and the markets it serves. Particular risks and uncertainties facing the Company include changes in market conditions; ongoing weakness in the agricultural sector; changes in tariff regulations and the imposition of new tariffs; a strong U.S. dollar; increased competition; trade wars or other negative economic impacts resulting from geopolitical events; decreases in the prices of agricultural commodities, which could affect our customers' income levels; increase in input costs; our inability to increase profit margins through continuing production efficiencies and cost reductions; repercussions from the pending exit by the U.K. from the European Union (EU); acquisition integration issues; budget constraints or income shortfalls which could affect the purchases of our type of equipment by governmental customers; credit availability for both the Company and its customers, adverse weather conditions such as droughts, floods, snowstorms, etc. which can affect buying patterns of the Company’s customers and related contractors; the price and availability of critical raw materials, particularly steel and steel products; energy cost; increased cost of new governmental regulations which effect corporations including related fines and penalties (such as the new European General Data Protection Regulation); the potential effects on the buying habits of our customers due to animal disease outbreaks and other epidemics; the Company’s ability to develop and manufacture new and existing products profitably; market acceptance of new and existing products; the Company’s ability to maintain good relations with its employees; the Company's ability to successfully complete acquisitions and operate acquired businesses or assets; the ability to hire and retain quality skilled employees; and cyber security risks affecting information technology or data security breaches.

In addition, the Company is subject to risks and uncertainties facing the industry in general, including changes in business and political conditions and the economy in general in both domestic and international markets; weather conditions affecting demand; slower growth in the Company’s markets; financial market changes including increases in interest rates and fluctuations in foreign exchange rates; actions of competitors; the inability of the Company’s suppliers, customers, creditors, public utility providers and financial service organizations to deliver or provide their products or services to the Company; seasonal factors in the Company’s industry; litigation; government actions including budget levels, regulations and legislation, primarily relating to the environment, commerce, infrastructure spending, health and safety; and availability of materials.

The Company wishes to caution readers not to place undue reliance on any forward-looking statements and to recognize that the statements are not predictions of actual future results. Actual results could differ materially from those anticipated in the forward-looking statements and from historical results, due to the risks and uncertainties described above, as well as others not now anticipated. The foregoing statements are not exclusive and further information concerning the Company and its businesses, including factors that could potentially materially affect the Company’s financial results, may emerge from time to time. It is not possible for management to predict all risk factors or to assess the impact of such risk factors on the Company’s businesses.

The Company is exposed to various market risks. Market risks are the potential losses arising from adverse changes in market prices and rates. The Company does not enter into derivative or other financial instruments for trading or speculative purposes.

Foreign Currency Risk

International Sales

A portion of the Company’s operations consists of manufacturing and sales activities in international jurisdictions. The Company primarily manufactures its products in the U.S., U.K., France, Canada, Brazil, Australia and the Netherlands. The Company sells its products primarily in the functional currency within the markets where the products are produced, but certain sales from the Company's U.K. and Canadian operations are denominated in other foreign currencies. As a result, the Company’s financials, specifically the value of its foreign assets, could be affected by factors such as changes in foreign currency exchange rates or weak economic conditions in the other markets in which the subsidiaries of the Company distribute their products.

To mitigate the short-term effect of changes in currency exchange rates on the Company’s functional currency-based sales, the Company’s U.K. subsidiaries regularly enter into foreign exchange forward contracts to hedge approximately 90% of its future net foreign currency collections over a period of six months. As of June 30, 2019, the Company had $1,578,000 outstanding in forward exchange contracts related to accounts receivable. A 15% fluctuation in exchange rates for these currencies would change the fair value of these contracts by approximately $237,000. However, since these contracts hedge foreign currency denominated transactions, any change in the fair value of the contracts should be offset by changes in the underlying value of the transaction being hedged.

Exposure to Exchange Rates

The Company translates the assets and liabilities of foreign-owned subsidiaries at rates in effect at the balance sheet date. Revenues and expenses are translated at average rates in effect during the reporting period. Translation adjustments are included in accumulated other comprehensive income within the statement of stockholders’ equity. The total foreign currency translation adjustment for the current quarter increased stockholders’ equity by $1,194,000.

The Company’s earnings are affected by fluctuations in the value of the U.S. dollar as compared to foreign currencies, predominately in Europe and Canada, as a result of the sales of its products in international markets. Forward currency contracts are used to hedge against the earnings effects of such fluctuations. The result of a uniform 10% strengthening or 10% decrease in the value of the dollar relative to the currencies in which the Company’s sales are denominated would result in a change in gross profit of $4,375,000 for the six month period ending June 30, 2019. This calculation assumes that each exchange rate would change in the same direction relative to the U.S. dollar. In addition to the direct effects of changes in exchange rates, which include a changed dollar value of the resulting sales, changes in exchange rates may also affect the volume of sales or the foreign currency sales price as competitors’ products become more or less attractive. The Company’s sensitivity analysis of the effects of changes in foreign currency exchange rates does not factor in a potential change in sales levels or local currency prices.

In March 2019, the Company entered into fixed-to-fixed cross-currency swaps and designated these swaps to hedge a portion of its net investment in a euro functional currency denominated subsidiary against foreign currency fluctuations. These contracts involve the exchange of fixed U.S. dollars with fixed euro interest payments periodically over the life of the contracts and an exchange of the notional amounts at maturity. The fixed-to-fixed cross-currency swaps include €40 million ($45 million) maturing December 2021.

Interest Rate Risk

The Company’s long-term debt bears interest at variable rates. Accordingly, the Company’s net income is affected by changes in interest rates. Assuming the current level of borrowings at variable rates and a two percentage point change for the second quarter 2019 average interest rate under these borrowings, the Company’s interest expense would have changed by approximately $830,000. In the event of an adverse change in interest rates, management could take actions to mitigate its exposure. However, due to the uncertainty of the actions that would be taken and their possible effects this analysis assumes no such actions. Further this analysis does not consider the effects of the change in the level of overall economic activity that could exist in such an environment.

Disclosure Controls and Procedures.

An evaluation was carried out under the supervision and with the participation of Alamo’s management, including our President and Chief Executive Officer, Executive Vice President and Chief Financial Officer (Principal Financial Officer) and Vice President, Controller and Treasurer, (Principal Accounting Officer), of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934). Based upon the evaluation, the President and Chief Executive Officer, Executive Vice President and Chief Financial Officer (Principal Financial Officer) and Vice President, Controller and Treasurer, (Principal Accounting Officer) concluded that the Company’s design and operation of these disclosure controls and procedures were effective at the end of the period covered by this report.

Changes in internal control over financial reporting

There has been no change in our internal control over financial reporting that occurred during our last fiscal year that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

There have not been any material changes from the risk factors previously disclosed in the 2018 Form 10-K for the year ended December 31, 2018.