Alamo Group Inc: Form 10-Q for the period ended Mar 31, 2020

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.

In March 2020, the World Health Organization categorized the current coronavirus disease (“COVID-19”) as a pandemic, and the President of the United States declared the COVID-19 outbreak a national emergency. COVID-19 continues to spread throughout the United States and other countries across the world, and the duration and severity of its effects are currently unknown. The outbreak has resulted in governments around the world implementing increasingly stringent measures to help control the spread of the virus, including quarantines, “shelter-in-place” and “stay-at-home” orders, travel restrictions, business curtailments, school closures and other measures. In addition, governments and central banks in several parts of the world have enacted fiscal and monetary stimulus measures to counteract the impacts of COVID-19. The Company has begun to see the impacts of COVID-19 on its markets and operations including operational disruptions and softening demand. The full extent to which COVID-19 will adversely impact the Company’s business depends on future developments, which are highly uncertain and unpredictable, including new information concerning the severity of the outbreak and the effectiveness of actions globally to contain or mitigate its effects.

For the first three months of 2020, the Company's net sales and net income increased by approximately 20% and 1.8% respectively when compared to the same period in 2019. The increase in net sales and net income was due to the acquisitions of Morbark and Dutch Power. However, the COVID-19 pandemic began to materially affect our operations in March, which negatively impacted the Company's overall financial performance during the first quarter of 2020.

The Company's Industrial Division experienced a 32.5% increase in sales for the first three months of 2020 compared to the first three months of 2019 all due to the acquisitions of Morbark and Dutch Power. Without factoring in contributions from Morbark and Dutch Power, sales across all legacy Industrial product groups (with the exception of vegetation control, which was slightly up) were down during the first three months of 2020 compared to the same period in 2019, primarily as a result of adverse impacts from the COVID-19 pandemic which included temporary plant closures in France and Canada, and other operational disruptions across the Division.

The Company's Agricultural Division sales were down in the first three months of 2020 by 4.4% compared to the first three months of 2019. Agricultural sales during the first two months of the quarter showed improvement from the ongoing soft market agricultural market conditions of the last several years, but the effects of the COVID-19 pandemic began to hurt Agricultural sales as well as operations in March, as the Division's operations in the UK and France were temporarily closed while the Division's North American units suffered less drastic operational disruptions.

Despite the negative effects of the coronavirus, consolidated income from operations was $23.8 million in the first quarter of 2020 which included almost $2.0 million of non-cash inventory step-up expense related to the Morbark acquisition. This was a 5.5% improvement when compared to the first three months of 2019, but the Company's backlog decreased 9.8% to $232.6 million at the end of the first quarter of 2020 versus the backlog of $257.8 million at the end of the first quarter of 2019. The decrease in the Company's backlog was primarily attributable to negative effects from the COVID-19 pandemic.

We believe the COVID-19 pandemic will continue to adversely impact our business in the second quarter of 2020. At this time, however, it is not clear how significant these impacts will be given the current level of uncertainty. The impacts will depend on numerous evolving factors which cannot be predicted, including the duration and scope of the pandemic, the effectiveness of containment and treatment efforts, continuing governmental actions taken in response, including the extent to which economies will remain under stay-at-home or similar orders, and the immediate and longer term economic consequences felt by our dealers and government customers as a result of the pandemic, which could result in budgetary tightening and weaker demand for our products. We have experienced delays in customer deliveries, and we expect to see continued uncertainty when it comes to customer behavior which could result in order delays or a reduction in overall market demand.

In response to the pandemic, the Company has taken a number of actions to maintain our financial stability including adjusting staff levels based on the continuous changes in customer demand, freezing and/or rolling back pay increases for salaried employees in the U.S. and most of our international operations, restricting travel, reducing inventory levels to match current demand, limiting capital expenditures, temporarily suspending the Company's share repurchase program and delaying other discretionary spending.

While the direct and indirect consequences of the COVID-19 pandemic will certainly pose the greatest risk for the Company during 2020, the Company may also be negatively affected by several other factors such as an increase in tariff rates, ongoing trade disputes, weakness in the overall world-wide economy; significant changes in currency exchange rates; negative economic impacts resulting from geopolitical events, 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 in this Quarterly Report on Form 10-Q and our Annual Report on Form 10-K for the year ended December 31, 2019 (the "2019 Form 10-K").

Results of Operations

Three Months Ended March 31, 2020 vs. Three Months Ended March 31, 2019

Net sales for the first quarter of 2020 were $314.4 million, an increase of $52.5 million or 20.0% compared to $261.9 million for the first quarter of 2019. The increase in sales was due to the acquisition of Morbark which contributed $53.2 million in net sales and from the acquisition of Dutch Power which added an increase of $9.6 million of net sales quarter over quarter. Negatively affecting net sales during the first quarter of 2020 was the outbreak of the COVID-19 virus which began to affect the business during the month of March.

Net Industrial sales increased by $56.4 million or 32.5% to $230.0 million for the first quarter of 2020 compared to $173.5 million during the same period in 2019. The increase was attributable to the acquisitions of Morbark and Dutch Power. The combined increase from the acquisitions was $66.5 million during the first quarter of 2020 compared to a $3.6 million contribution by Dutch Power in the first quarter of 2019. The impact from the COVID-19 issues began to materially affect the Division during the month of March. This included temporary plant closures in France and Canada along with other operational disruptions throughout North America from health concerns and governmental directives and customer delivery restrictions.

Net Agricultural sales were $84.5 million in the first quarter of 2020 compared to $88.4 million for the same period in 2019, a decrease of $3.9 million or 4.4%. The decrease was primarily the result of the COVID-19 pandemic as sales during the first part of 2020 began to show signs of improvement from the soft agricultural market conditions that have hurt this Division for the last several years. This Division's North American operations did reasonably well and benefited from the contributions of Dixie Chopper but the coronavirus affected both sales and operations in March and specifically hurt both the U.K. and French Agricultural business as they experienced temporary plant closures.

Gross profit for the first quarter of 2020 was $78.9 million (25.1% of net sales) compared to $63.3 million (24.2% of net sales) during the same period in 2019, an increase of $15.6 million. The increase in gross profit during the first quarter of 2020 was primarily due to the acquisition of Morbark and Dutch Power. Negatively affecting the gross margin and gross margin percentage during the first quarter of 2020 were almost $2.0 million of inventory step-up charge related to the Morbark acquisition.

Selling, general and administrative expenses (“SG&A”) were $51.2 million (16.3% of net sales) during the first quarter of 2020 compared to $39.8 million (15.2% of net sales) during the same period of 2019, an increase of $11.4 million. The increase came from the acquisitions of Morbark and Dutch Power which accounted for $9.3 million of the net increase quarter over quarter. Amortization expense in the first quarter of 2020 was $3.8 million compared to $0.9 million in the same period in 2019, an increase of $2.9 million. The increased amortization expense was primarily from the acquisitions of Dutch Power and Morbark.

Interest expense was $5.5 million for the first quarter of 2020 compared to $1.5 million during the same period in 2019, an increase of $4.0 million. The increase during the first quarter of 2020 came from increased borrowings due to the Morbark acquisition in October of 2019.

Other income (expense), net was $2.3 million of income for the first quarter of 2020 compared to $0.4 million of expense during the same period in 2019. The income in 2020 was primarily the result of changes in currency exchange rates and a gain of $0.7 million from the sale of the Super Products building.

Provision for income taxes was $5.5 million (26.2% of income before income tax) in the first quarter of 2020 compared to $5.7 million (27.2% of income before income tax) during the same period in 2019.

The Company’s net income after tax was $15.5 million or $1.31 per share on a diluted basis for the first quarter of 2020 compared to $15.3 million or $1.30 per share on a diluted basis for the first quarter of 2019. The increase of $0.2 million 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 March 31, 2020, the Company had working capital of $461.2 million which represents an increase of $53.2 million from working capital of $408.0 million at December 31, 2019. The increase in working capital was primarily due to higher cash balances held in our foreign subsidiaries. The Company limited repatriation of cash due to a strong U.S. dollar which negatively affected currency exchange rates. Also increasing working capital, to a lesser extent, was seasonality.

Capital expenditures were $7.4 million for the first three months of 2020, compared to $5.3 million during the first three months of 2019. The Company initially expected to continue capital expenditures at a rate consistent with the rate of spending for the entire year of 2019, but we began to limit such expenditures in March of 2020 in response to the COVID-19 pandemic. The Company will fund any future expenditures from operating cash flows or through our revolving credit facility, described below.

Net cash used for investing activities was $5.0 million during the first three months of 2020 compared to $55.3 million during the first three months of 2019. The 2019 increase in the use of funds was to acquire Dutch Power which was approximately $52.6 million.

Net cash provided by financing activities was $45.1 million and $92.3 million during the three month periods ended March 31, 2020 and March 31, 2019, respectively. The majority of the increase in net cash provided by financing activities in 2019 as compared to 2020, was due to borrowings to finance the acquisition of Dutch Power.

The Company had $79.5 million in cash and cash equivalents held by its foreign subsidiaries as of March 31, 2020. The majority of these funds are at our European and Canadian facilities. While the Company intends to use some of these funds for working capital and capital expenditures outside the U.S., changes in the U.S. tax laws have substantially mitigated the cost of repatriation and the Company intends to repatriate excess cash from our European affiliates. The Company will continue to repatriate European cash and cash equivalents in excess of amounts needed to fund operating and investing activities, but will need to monitor exchange rates to determine the appropriate timing of such repatriation given the current relative strength of the U.S. dollar. 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.

On October 24, 2019, the Company, as Borrower, and each of its domestic subsidiaries as guarantors, entered into a Second Amended and Restated Credit Agreement (the Credit Agreement) with Bank of America, N.A., as Administrative Agent. The Credit Agreement provides the Company with the ability to request loans and other financial obligations in an aggregate amount of up to $650.0 million and, subject to certain conditions, the Company has the option to request an increase in aggregate commitments of up to an additional $200.0 million. Pursuant to the Credit Agreement, the Company has borrowed $300.0 million pursuant to a Term Facility repayable with interest quarterly at a percentage of the initial principal amount of the Term Facility of 5.0% per year with the remaining principal due in 5 years. Up to $350.0 million is available under the Credit Agreement pursuant to a Revolver Facility which terminates in 5 years. The Agreement requires the Company to maintain two financial covenants, a maximum consolidated leverage ratio and a minimum consolidated fixed charge 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. The expiration date of the Term Facility and the Revolver Facility is October 24, 2024. As of March 31, 2020, $491.3 million was outstanding under the Credit Agreement, $296.3 million on the Term Facility and $195.0 million on the Revolver Facility. On March 31, 2020, $3.0 million 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 $119.2 million in available borrowings. The Company is in compliance with the covenants under the Agreement as of March 31, 2020.

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, particularly given the uncertainty created by the COVID-19 pandemic.

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 2019 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 2019 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; the impact of the current COVID-19 outbreak; 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; cyber security risks affecting information technology or data security breaches; and the possible effects of events beyond our control, such as political unrest, acts of terror, natural disasters and pandemics, on the Company or its customers, suppliers and the economy in general. The Company has begun to see the impacts of COVID-19 on its markets and operations including operational disruption and softening demand. The full extent to which COVID-19 will adversely impact the Company’s business depends on future developments, which are highly uncertain and unpredictable, including new information concerning the severity of the outbreak and the effectiveness of actions globally to contain or mitigate its effects. While this situation will negatively impact the Company’s results of operations, cash flows and financial position, the current level of uncertainty over the economic and operational impacts of COVID-19 means the full financial impact cannot be reasonably estimated at this time.

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. Foreign exchange rates and economic conditions in these foreign markets may be further impacted by the effects of the COVID-19 pandemic.

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 March 31, 2020, the Company had $0.5 million 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

$0.1 million. 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 decreased stockholders’ equity by $20.5 million.

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 $2.2 million for the three month period ending March 31, 2020. 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 first quarter 2020 average interest rate under these borrowings, the Company’s interest expense would have changed by approximately $2.5 million. 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.

In January 2020, the Company entered into an interest rate swap agreement with three of it's total lenders that hedge future cash flows related to it's outstanding debt obligations. As of March 31, 2020, the Company had $491.3 million outstanding under the Credit Agreement of which $200.0 million was hedged in a three year interest rate swap contract with a fixed LIBOR base rate of 1.43%.

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.

Our business has been and will continue to be adversely affected by the COVID-19 pandemic.

In March 2020, the World Health Organization characterized the outbreak of COVID-19 as a pandemic, and the President of the United States declared the COVID-19 outbreak a national emergency. COVID-19 continues to spread throughout the United States and other countries across the world, and the duration and severity of its effects are currently unknown. Given the ongoing and dynamic nature of the circumstances, it is difficult to predict the impact of the COVID-19 pandemic on our business, and there is no guarantee our efforts to address the adverse impacts of COVID-19 will be effective. We have experienced operational interruptions as a result of the pandemic, including the temporary suspension or reduced capacity of operations due to health concerns and government imposed restrictions, which have had and will have an adverse effect on the productivity and profitability of such manufacturing facilities, and in turn is expected to have an adverse effect on our business and financial results. Moreover, a prolonged pandemic, or the threat thereof, could result in continued operational and other disruptions for us and for our customers and suppliers. We may also incur significant costs to remedy damages caused by operational and supply chain disruptions, performance delays, and payment defaults or bankruptcy of our customers and suppliers, all of which could adversely affect our financial condition and results of operations.

The rapid spread of COVID-19 has also created significant uncertainty and global economic disruption. The extent to which the COVID-19 pandemic impacts our business, operations, financial results, financial condition and prospects will depend on numerous evolving factors which cannot be predicted, including: the duration and scope of the pandemic; governmental, business and individual actions taken in response; the short and long term effects on the operational and financial condition of our dealers and our governmental and other customers; and the impact on the overall demand for our products. Any of the above factors could result in negative direct and indirect impacts on our business which could have a material adverse effect on our financial condition and results of operations. In addition, the impact of COVID-19 on macroeconomic conditions may impact the proper functioning of financial and capital markets, foreign currency exchange rates, commodity and energy prices, and interest rates. Even after the COVID-19 pandemic has subsided, we may continue to experience material adverse impacts to our business as a result of any economic recession or depression that has occurred or may occur in the future. Any of these events could amplify the other risks and uncertainties described in our Annual Report on Form 10-K for the year ended December 31, 2019 and could otherwise materially adversely affect our business, financial condition, results of operations, prospects and/or stock price.

Other than as set forth under this Item 1A, there have not been any material changes from the risk factors previously disclosed in the 2019 Form 10-K for the year ended December 31, 2019.