The following discussion and analysis should be read in conjunction with the Consolidated Financial Statements and related notes contained within Item 8 - Financial Statements and Supplementary Data and the other financial information found elsewhere in this Report. Management's Discussion and Analysis uses forward-looking statements that involve certain risks and uncertainties as described previously in our Disclosure Regarding Forward-looking Statements and Item 1A. Risk Factors . General Overview
DXP Enterprises, Inc.is a leading North American distributor of technical products and services. Our comprehensive knowledge, specialized services and leading brands serve MRO, OEM and capital equipment end users in virtually all industrial markets through our multi-channel capabilities that provide choice, convenience, expertise, timely response and an overall ease of doing business. DXP's products are marketed in the United States, Canadaand Dubaito customers that are engaged in a variety of industries, many of which may be counter cyclical to each other. Demand for our products generally is subject to changes in the United Statesand Canada, and global and macro-economic trends affecting our customers and the industries in which they compete in particular. Certain of these industries, such as the oil and gas industry, are subject to volatility driven by a variety of factors, while others, such as the petrochemical industry and the construction industry, are cyclical and materially affected by changes in the United Statesand global economy. As a result, we may experience changes in demand within particular markets, segments and product categories as changes occur in our customers' respective markets.
CURRENT MARKET CONDITIONS AND OUTLOOK
December 2019, the novel SARS-CoV-2 virus and associated COVID 19 disease ("COVID-19") were reported in China, and in March 2020the World Health Organizationdeclared a pandemic. The pandemic had a significant impact on our business during 2020. The marketplace broadly, and the Company specifically, throughout the year operated with certain modifications to balance re-opening with employee and customer safety. However, most of the markets in which we operate began to normalize during the second half of 2020. This improved the outlook of the manufacturing and construction customers that support our traditional branch and onsite business. Although the rate of improvement remains gradual and the overall activity level remains below pre-pandemic levels, DXP saw a modest improvement from monthly lows experienced in July. Consistent with broader social trends, we took steps to safeguard the health of our employees. This included closing branch and corporate facilities to outside personnel, enabled through technology, significant work from home capabilities for many employees, and where employees remained in the workplace, created space between work areas, provided ample personal protective equipment and cleaning supplies, and instituting formal policies for mitigation in the event of cases of illness. Due to these precautions, our operations continued to function effectively, including internal controls over financial reporting. 26 -------------------------------------------------------------------------------- Table of Contents As restrictions ease and the roll out of various vaccines continue, we will actively monitor the situation and may take further actions that alter our business operations as may be required by federal, state, or local authorities or that we determine are in the best interests of our employees, customers, suppliers, and shareholders. While we are unable to determine or predict the nature, duration, or scope of the overall impact the COVID-19 pandemic will have on our business, results of operations, liquidity, or capital resources, we believe that it is important to share where the Company stands today, how our response to the COVID-19 pandemic has progressed, and how our operations and financial condition may change as the fight against COVID-19 progresses.
Impact of the COVID-19 pandemic
During the twelve months ended
December 31, 2020, the widely publicized and discussed coronavirus (COVID-19) outbreak rapidly spread across the world, driving a sharp erosion in demand for crude oil and other products and services, as whole economies ordered curtailed activity. In response to declining demand for crude oil, members of the Organization of the Petroleum Exporting Countriesand other producing countries (OPEC+), including Russia, met in early March to discuss additional production cuts to help stabilize prices. The group failed to reach an agreement, and production was instead increased into the already oversupplied market, decimating oil prices and rapidly filling worldwide oil storage facilities. OPEC+ eventually reached an agreement in April 2020to reduce production, which had a muted effect on oil prices due to the belief that the cuts were significantly less than the demand destruction caused by COVID-19. As a result, companies across the oil and gas industry responded with severe capital spending budget cuts, cost cuts, personnel layoffs, facility closures and bankruptcy filings. We made a number of mitigation decisions and took proactive steps in response to the issues presented by the COVID-19 pandemic and ongoing uncertainties related to the oil and gas industry. We moved forward with our plans to increase our ABL revolver facility from $85 millionto $135 million. In addition, we reduced certain discretionary expenditures and suspended the Company's matching contributions to retirement plans. Some of these measures may have an adverse impact on our businesses, but we believe we took the necessary steps to stabilize the business in unprecedented times. Throughout the COVID-19 pandemic crisis, we continued to operate our business despite the challenges that arose from closing offices and operating our branch locations. Our use of technology and third party conferencing platforms enabled our office employees to work from home, performing their job functions with little to no loss of productivity. We required our employees to work from home as a result of governmental isolation orders and, in many cases, in advance of those orders for the health and safety of our employees. For the most part, our warehouses and regional distribution centers remained open. Under various isolation orders by national, state, provincial and local governments, we were exempted as an "essential" business as the products we sell are necessary for the maintenance and functioning of many industries including energy infrastructure. We took measures to safeguard the health and welfare of our employees, including social distancing measures while at work, certain screening, providing personal protection equipment such as gloves, face masks and hand sanitizer and sterilizing cleaning services at Company facilities. As various governmental restrictions continue to be lifted or phased out, we will review our operational plans to continue operating our business while addressing the health and safety of our employees and those with whom our business comes into contact. As a distribution business, we continue to closely monitor the ability of our suppliers and transportation providers to continue the functioning of our supply chain. We have not experienced significant delays by transportation providers or significant delays in our supply chains. Our inventory position for most products has allowed us to continue supply to most customers with little interruption. In those instances where there was interruption, we worked with our customers to discuss the impact of the delay. We will continue to monitor the situation and have ongoing dialogue with our vendors and customers regarding the status of impacted orders. Management expects industry activity levels and spending by customers to remain volatile in the near term, but we do expect some increased activity as the nation and the world become vaccinated and the oil and gas demand destruction from COVID-19 begins to subside. DXP remains committed to streamlining operations and improving organizational efficiencies while continuing to focus on delivering the products and services that remain in the Company's backlog. We believe this strategy has further advanced the Company's competitive position, regardless of the market environment. DXP monitors several economic indices that have been key indicators for industrial and oil & gas economic activity in the United States. These include the Industrial Production (IP) and Manufacturing Capacity Utilization (MCU) indices published by the Federal Reserve Boardand the Purchasing Managers Index (PMI) published by the Institute for Supply Management(ISM). Additionally, we track the Metalworking Business Index ("MBI"). A reading above 50 generally indicates expansion. 27 -------------------------------------------------------------------------------- Table of Contents Below are readings for the fourth quarter versus the full year average: Index Reading * Period MCU PMI IP MBI October 73.0 59.3 103.6 53.9 November 73.4 57.5 104.1 51.0 December 74.5 60.5 105.7 53.5 Fiscal 2020 Q4 average 73.7 59.1 104.5 52.8 Fiscal 2020 average 71.9 52.5 101.8 47.6 Fiscal 2019 average 77.8 51.3 109.4 50.6 Fiscal 2018 average 78.7 58.6 108.6 57.1
* The information in this table was obtained from publicly available third-party sources.
DXP also monitors various oil & gas indicators including active drilling rigs, gross
U.S.domestic production and the West Texas Intermediate ("WTI") price of oil. Below are readings for the last three years:
Presentation of the operating environment *
December 31, 2020 2019 2018 Active Drilling Rigs** U.S 436 944 1,032 Canada 90 135 191 International 825 1,098 988 Worldwide 1,352 2,177 2,211
Gross Domestic Product (in billions)
West Texas Intermediate ** (per barrel)
Purchasing Managers Index 60.5 47.8 54.3 * The information contained in this table has been obtained from third party publicly available sources. ** Averages for the years indicated. During 2019, the growth rate of the general economy improved from 2018 while the rig count decreased, but remained higher than 2016 peaks. Sales for the year ended
December 31, 2019increased $46.1 million, or 3.8%, to approximately $1.3 billionfrom $1.2 billionfor the prior corresponding period. The majority of the 2019 sales increase is the result of increased sales of pumps, bearings, industrial supplies, metal working and safety services to customers engaged in oilfield service, oil and gas exploration and production, mining, manufacturing and petrochemical processing. During 2020, the growth rate of the general economy declined from 2019 as well as the rig count. Sales for the year ended December 31, 2020decreased $259.6 million, or 20.5%, to approximately $1.0 billionfrom $1.3 billionfor the prior corresponding period. The majority of the 2020 sales decrease is the result of a decrease in the capital spending by oil and gas producers and related businesses stemming from a decrease in U.S.crude oil production due to low crude prices and the negative economic impacts of COVID-19. Our sales growth strategy in recent years has focused on internal growth and acquisitions. Key elements of our sales strategy include leveraging existing customer relationships by cross-selling new products, expanding product offerings to new and existing customers, and increasing business-to-business solutions using system agreements and supply chain solutions for our integrated supply customers. We will continue to review opportunities to grow through the acquisition of distributors and other businesses that would expand our geographic reach and/or add additional products and services. Our results will depend on our success in executing our internal growth strategy and, to the extent we complete any acquisitions, our ability to integrate such acquisitions effectively. 28 -------------------------------------------------------------------------------- Table of Contents Our strategies to increase productivity include consolidated purchasing programs, centralizing product distribution, customer service and inside sales functions, and using information technology to increase employee productivity.
Consolidated operating results
Years Ended December 31, 2020 % 2019 % 2018 % (Restated) (Restated) (Restated) ( in millions, except percentages and per share amounts) Sales
$ 1,005.3100.0 $ 1,264.9100.0 $ 1,218.7100.0 Cost of sales 728.1 72.4 915.1 72.3 882.9 72.4 Gross profit $ 277.227.6 $ 349.827.7 $ 335.827.6 Selling, general & administrative expense 245.0 24.4 282.4 22.3 263.8 21.6 Impairment and other charges $ 59.96.0 $ - - $ - - Operating income (loss) $ (27.7)(2.8) $ 67.45.3 $ 72.05.9 Other( income) expense, net 0.1 - - - (1.2) (0.1) Interest expense 20.6 2.0 19.5 1.5 20.9 1.7 Income (loss) before income taxes $ (48.4)(4.8) $ 47.93.8 $ 52.3
Provision for income taxes (benefit) (18.7) (1.9) 11.2 0.9 14.1 1.2 Net income (loss)
$ (29.7)(3.0) $ 36.72.9 $ 38.23.1 Net loss attributable to noncontrolling interest (0.3) - (0.3) - (0.1)
Net income (loss) attributable to DXP Enterprises, Inc.
$ (29.4)(2.9) $ 37.02.9 $ 38.33.1 Per share Basic earnings per share $ (1.65) $ 2.10 $ 2.18Diluted earnings per share $ (1.65) $ 2.01 $ 2.08
SALES. Sales for the year ended
December 31, 2020decreased $259.6 million, or 20.5%, to approximately $1.0 billionfrom $1.3 billionfor the year ended December 31, 2019. Sales from businesses acquired accounted for $19.6 millionof the sales for the twelve months ended December 31, 2020. Excluding the 2020 sales of the business acquired, sales for the year decreased by $279.2 million, or 22.1% from the prior year's corresponding period. This sales decrease is the result of a decrease in sales in our SC, IPS and SCS segments of $97.3 million, $115.7 millionand $46.6 million, respectively. The fluctuations in sales is further explained in our business segment discussions below. Years Ended December 31 2020 2019 Change Change% (Restated) Sales by Business Segment (in thousands, except change%) Service Centers $ 662,617 $ 759,918 $ (97,301)(12.8) % Innovative Pumping Solutions 187,991 303,655 (115,664) (38.1) % Supply Chain Services 154,658 201,278 (46,620) (23.2) % Total DXP Sales $ 1,005,266 $ 1,264,851 $ (259,585)(20.5) % Service Centers Segment. Sales for the Service Centers segment decreased by $97.3 million, or 12.8% for the year ended December 31, 2020, compared to the year ended December 31, 2019. Excluding $19.6 millionof 2020 Service Centers segment sales from businesses acquired, Service Centers segment sales decreased $116.9 million, or 15.4% from the prior year's corresponding period. This sales decrease is primarily the result of decreased sales of metal working, safety supply products and bearings to customers engaged in the OEM oil and gas markets in connection with decreased capital spending by oil and gas producers as well as the negative economic impacts of the COVID-19 pandemic. We expect that this level of sales to the oil and gas industry will likely continue to decline if U.S.crude oil production remains at levels experienced during the year. 29 -------------------------------------------------------------------------------- Table of Contents Innovative Pumping Solutions Segment. Sales for the IPS segment decreased by $115.7 million, or 38.1% for the year ended December 31, 2020, compared to the year ended December 31, 2019. This decrease was primarily the result of a decrease in the capital spending by oil and gas producers and related businesses stemming from a decrease in U.S.crude oil production due to low crude prices and the negative economic impacts of COVID-19. With a prolonged economic recession related to COVID-19, we will likely experience a further decline in overall segment sales. Supply Chain Services Segment. Sales for the SCS segment decreased by $46.6 million, or 23.2%, for the year ended December 31, 2020, compared to the year ended December 31, 2019. The decline in sales is primarily related to decreased sales to customers in the aerospace and oil and gas industries due to the economic impacts of the COVID-19 pandemic. GROSS PROFIT. Gross profit as a percentage of sales for the year ended December 31, 2020decreased by approximately 8 basis points from the prior year's corresponding period. Excluding the impact of the businesses acquired, gross profit as a percentage of sales decreased by approximately 12 basis points. The decrease in the gross profit percentage excluding the businesses acquired is primarily the result of an approximate 78 basis point decrease in the gross profit percentage in our IPS segment and a 96 basis point increase in the gross profit percentage in our SCS segment partially offset by a 45 basis point decrease in the gross profit percentage in our SC segment. Service Centers Segment. The gross profit percentage for the Service Centers decreased approximately 45 basis points and approximately 46 basis points, adjusting for the businesses acquired, from the prior year's corresponding period. This was primarily the result of decreased sales of metal working, safety services and bearings to customers engaged in the OEM oil and gas markets in connection with decreased capital spending by oil and gas producers as well as the negative economic impacts of the COVID-19 pandemic. Innovative Pumping Solutions Segment. The 2020 gross profit percentage for the IPS segment decreased approximately 78 basis points from the prior year's corresponding period. The decrease in gross profit is primarily the result of a decrease in the capital spending by oil and gas producers and related businesses stemming from a decrease in U.S.crude oil production due to low crude prices and the economic impacts of COVID-19. Supply Chain Services Segment. Gross profit as a percentage of sales increased approximately 96 basis points for the year ended December 31, 2020, compared to the prior year's corresponding period. This was primarily as a result of costs associated with new customer implementation in 2019 with no comparable activity in 2020. SELLING, GENERAL AND ADMINISTRATIVE ("SG&A"). SG&A for the year ended December 31, 2020decreased by approximately $37.4 million, or 13.2%, to $245.0 millionfrom $282.4 millionfor prior year's corresponding period. SG&A expense from businesses acquired accounted for $4.9 million. Excluding expenses from businesses acquired, SG&A for the twelve months ended December 31, 2020decreased by $42.3 million, or 15.0 percent. The overall decrease in SG&A is the result of decreased payroll, incentive compensation and related taxes and 401(k) expenses as a result of decreased business activity and cost reduction actions associated with COVID-19 and depressed demand in oil and gas markets.
DEPRECIATION AND OTHER CHARGES. Due to the circumstances mentioned above, during the twelve months ended
Service Centers segment. In 2020, we recorded
$1.8 millionof noncash impairment charges related primarily to certain long-lived assets that were not recoverable and $20.5 millionof non-cash impairment charges related to goodwill associated with our operations in Canada.
Segment Innovative pumping solutions. In 2020, we recorded
For additional information on our impairment charges, see Note 5 - Impairments and Other Charges of the Notes to Consolidated Financial Statements in this Annual Report. OPERATING INCOME. Operating income for the year ended
December 31, 2020decreased by $95.1 million, or 141.0%, to a loss of $27.7 millionfrom income of $67.4 millionin the prior year's corresponding period. This decrease in operating income is primarily related to the decrease in sales discussed above and the impact of impairment and other charges. INTEREST EXPENSE. Interest expense for year ended December 31, 2020increased by $1.1 million, or 5.5%, from the prior year's corresponding period primarily due to refinancing costs incurred in connection with the modification and 30 -------------------------------------------------------------------------------- Table of Contents extinguishment of debt, partially offset by lower LIBOR rates and a reduction in the principal balance through voluntary pay-downs until the Company's refinancing in December. INCOME TAXES. Our effective tax rate was a tax benefit of 38.7% for the year ended December 31, 2020compared to a tax expense of 23.3% for the year ended December 31, 2019. The Company reported a loss before income taxes for the year ended December 31, 2020. As a result, items that ordinarily increase or decrease the tax rate will have the opposite effect. Compared to the U.S.statutory rate for the year ended December 31, 2020, the effective tax rate was increased by state taxes, foreign taxes, research and development tax credits and other tax credits. This was partially offset by nondeductible expenses and reserve for uncertain tax positions. Compared to the U.S.statutory rate for the year ended December 31, 2019, the effective tax rate was increased by state taxes, foreign taxes, and non-deductible expenses and partially offset by research and development tax credits and other tax credits.
For the full year 2019 to 2018 comparative discussion, see Item 7: Management's Discussion and Analysis of Financial Condition and Results of Operations in DXP's Annual Report on Form 10-K for the fiscal year ended
December 31, 2019. Inflation We do not believe the effects of inflation have any material adverse effect on our results of operations or financial condition. We attempt to minimize inflationary trends by passing manufacturer price increases on to the customer whenever practicable. The rate of inflation, as measured by changes in the producer price index, affects different commodities, the cost of products purchased and ultimately the pricing of our different products and product classes to our customers. Our pricing related to inflation did not have a measurable impact on our sales revenue for the year. Historically, price changes from suppliers have been consistent with inflation and have not had a material impact on the results of our operations.
Non-GAAP Financial Measures and Reconciliations
In an effort to provide investors with additional information regarding our results of operations as determined by GAAP, we disclose non-GAAP financial measures. The non-GAAP financial measures we provide in this report should be viewed in addition to, and not as an alternative for, results prepared in accordance with accounting principles generally accepted in
the United States of America(" U.S.GAAP"). Our primary non-GAAP financial measures are organic sales (Organic Sales), sales per business day ("Sales per Business Day"), free cash flow ("Free Cash Flow"), earnings before interest, taxes, depreciation and amortization ("EBITDA") and adjusted EBITDA ("Adjusted EBITDA"). The non-GAAP financial measures presented may differ from similarly titled non-GAAP financial measures presented by other companies, and other companies may not define these non-GAAP financial measures in the same way. These measures are not substitutes for their comparable U.S.GAAP financial measures, such as net sales, net income/(loss), diluted earnings per common share ("EPS"), or other measures prescribed by U.S.GAAP, and there are limitations to using non-GAAP financial measures. Management uses these non-GAAP financial measures to assist in comparing our performance on a consistent basis for purposes of business decision making by removing the impact of certain items that management believes do not directly reflect our underlying operations. Management believes that presenting our non-GAAP financial measures (i.e., Organic Sales, Sales per Business Day, Free Cash Flow, EBITDA and Adjusted EBITDA) are useful to investors because it (i) provides investors with meaningful supplemental information regarding financial performance by excluding certain items, (ii) permits investors to view performance using the same tools that management uses to budget, make operating and strategic decisions, and evaluate historical performance, and (iii) otherwise provides supplemental information that may be useful to investors in evaluating our results. We believe that the presentation of these non-GAAP financial measures, when considered together with the corresponding U.S.GAAP financial measures and the reconciliations to those measures, provides investors with additional understanding of the factors and trends affecting our business than could be obtained absent these disclosures. Organic Sales is defined as net sales excluding, when they occur, the impact of acquisitions and divestitures. Organic Sales is a tool that can assist management and investors in comparing our performance on a consistent basis by removing the impact of certain items that management believes do not directly reflect our underlying operations.
Sales per business day are defined as the total net sales divided by the business days for the period. Sales per business day help management and investors assess the historical performance of the company.
31 -------------------------------------------------------------------------------- Table of Contents Free Cash Flow is defined cash provided by operations less net purchase of property and equipment. We believe Free Cash Flow is an important liquidity metric because it measures, during a given period, the amount of cash generated that is available to fund acquisitions, make investments, repay debt obligations, repurchase company shares, and for certain other activities. EBITDA is defined as the sum of consolidated net income in such period, plus to the extent deducted from consolidated net income: (i) income tax expense, (ii) franchise tax expense, (iii) consolidated interest expense, (iv) amortization and depreciation during such period, (v) all non-cash charges and adjustments, and (vi) non-recurring cash expenses related to the Term Loan; in addition to these adjustments, we exclude, when they occur, the impacts of impairment losses and losses/(gains) on the sale of a business. EBITDA is a tool that can assist management and investors in comparing our performance on a consistent basis by removing the impact of certain items that management believes do not directly reflect our underlying operations.
From time to time, due to accounting guidelines and rules, the Company incurs non-monetary, one-time or one-time items. As such, the Company will add these elements to determine adjusted EBITDA.
We use internal EBITDA and Adjusted EBITDA to assess and manage the operations of the Company, as we believe it provides additional useful information regarding the continued economic performance of the Company. We have chosen to provide this information to investors to enable them to make more meaningful comparisons of operating results.
A reconciliation of the non-GAAP financial measures, to its most comparable GAAP financial measure is included below. The following table sets forth the reconciliation of net sales to organic net sales (in millions): Reconciliation of Net Sales to Organic Net Sales Fiscal 2020 Net Sales Acquisition Sales Divestiture Sales Organic Sales Service Centers $ 662 $ 20 $ - $ 642 Innovative Pumping Solutions 188 - - 188 Supply Chain Services 155 - - 155 Total Sales
$ 1,005$ 20 $ - $ 985 Fiscal 2019 (Restated) Service Centers $ 760 $ - $ - $ 760 Innovative Pumping Solutions 304 - - 304 Supply Chain Services 201 - - 201 Total Sales $ 1,265$ - $ - $ 1,265Year-over-year growth rates Service Centers (12.9) % - - (15.5) % Innovative Pumping Solutions (38.2) % - - (38.2) % Supply Chain Services (22.9) % - - (22.9) % Total Sales (20.6) % - - (22.1) %
Sales per working day were as follows (in thousands):
Years Ended December 31, 2020 2019 2018 Business days 253 252 252 Sales per Business Day
$ 3,974 $ 5,019 $ 4,836
We use internal EBITDA and Adjusted EBITDA to assess and manage the operations of the Company, as we believe it provides additional useful information regarding the continued economic performance of the Company. We have chosen to provide this information to investors to enable them to make more meaningful comparisons of operating results.
For more information on free cash flow as a management measure, see “Liquidity and Capital Resources – Free Cash Flow” below.
32 -------------------------------------------------------------------------------- Table of Contents The following table sets forth the reconciliation of EBITDA and Adjusted EBITDA to the most comparable GAAP financial measure (in thousands): Year Ended December 31, 2020 2019 2018 (Restated) (Restated) (Restated) GAAP net income (loss) attributable to DXP Enterprises, Inc.
$ (29,269) $ 37,025 $ 38,345Loss attributable to non-controlling interest (348) (260) (111) Provision for income taxes (18,696) 11,194 14,107 Depreciation and amortization 22,683 25,174 26,164 Interest and other financing expenses 20,571 19,498 20,937 EBITDA $ (5,059) $ 92,631 $ 99,442EBITDA margin as % of sales (0.5) % 7.3 % 8.2 % NCI loss before tax* 632 342 157 Impairment and other charges 59,883 - - Stock compensation expense 3,532 1,963 2,549 Adjusted EBITDA $ 58,988 $ 94,936 $ 102,148Adjusted EBITDA margin as % of sales 5.9 % 7.5 % 8.4 %
* NCI represents the non-controlling interest
Liquidity and capital resources
December 31, 2020, we had cash and cash equivalents of $119.4 millionand bank and other borrowings of $320.4 million. We have a $135 millionasset-based Loan facility that is due to mature in August 2022, under which we had no borrowings outstanding as of December 31, 2020and a Term Loan B with $330 millionin borrowings.
Our primary source of capital is cash flow from operations, supplemented as necessary by company shares, bank loans or other sources of debt. As a distributor of MRO products and services, we require significant working capital to fund inventory and accounts receivable. Additional cash is needed for capital assets related to information technology, warehouse equipment, leasehold improvements, pump manufacturing equipment and security services equipment. We also need cash to pay our lease obligations, finance ongoing work on the project, and service our debt.
The following table summarizes our net cash flows used in and provided by operating activities, net cash used in investing activities and net cash (used in) provided by financing activities for the periods presented (in thousands): Years Ended December 31, 2020 2019 Change Change(%) (Restated) (Restated) Net cash provided by (used in): Operating activities
$ 109,650 $ 41,306 $ 68,344165 % Investing activities (121,796) (22,085) (99,711) 451 % Financing activities 77,406 (6,092) 83,498 (1,371) % Effect of foreign currency (168) 679 (847) (125) % Net change in cash $ 65,092 $ 13,808 $ 51,284371 % 33
-------------------------------------------------------------------------------- Table of Contents Operating Activities The Company generated
$109.7 millionof cash in operating activities during the year ended December 31, 2020compared to generating $41.3 millionof cash during the prior year's corresponding period. The $68.3 millionincrease in the amount of cash generated between the two periods was primarily driven by the collections of receivables associated with trade accounts receivables and decreased inventory purchases.
For the year ended
December 31, 2020, net cash used in investing activities was $121.8 millioncompared to $22.1 millionin the corresponding period in 2019. This increase was primarily driven by acquisitions during the year of $115.2 million. For the twelve months ended December 31, 2020, purchases of property and equipment decreased to approximately $6.7 millioncompared to $22.1 millionin 2019 primarily due to leasehold improvements and software upgrades in 2019 with no comparable activity in 2020. The maintenance capital expenditures for 2021 are expected to be within the range of $4 millionto $10 million.
For the year ended
December 31, 2020, net cash generated in financing activities was $77.4 million, compared to net cash used in financing activities of $6.1 millionfor the corresponding period in 2019. The activity in the period was primarily attributed to the Company refinancing our Term Loan raising $330 millionpartially offset by the extinguishment of our previous term loan and higher principal repayments of debt in 2019. On December 23, 2020, DXP entered into a new seven year, $330 millionSenior Secured Term Loan (the "Term Loan Agreement"), which replaced DXP's previously existing Senior Secured Term Loan. On May 11, 2020, the Company entered into an Equity Distribution Agreement (the "Equity Distribution Agreement") with BMO Capital Markets Corp.(the "Distribution Agent") pursuant to which the Company may offer and sell shares of the Company's common stock, par value $0.01per share, having an aggregate offering price of up to $37.5 millionfrom time to time through the Distribution Agent. Sales of the Company's common stock pursuant to the Equity Distribution Agreement are made in "at the market offerings" as defined in Rule 415(a)(4) promulgated under the Securities Act of 1933, as amended. During the twelve months ended December 31, 2020, the Company issued and sold 46 thousand shares of common stock under the Equity Distribution Agreement, with net proceeds totaling approximately $1.1 millionless Agent's commission. On March 17, 2020, the Company entered into an Increase Agreement (the "Increase Agreement") which provides for a $135 millionasset-backed revolving line of credit (the "ABL Revolver"), a $50 millionincrease from the $85.0 millionavailable under the original revolver. During the twelve months ended December 31, 2020, the amount available to be borrowed under our credit facility increased to $131.9 millioncompared to $81.6 millionat December 31, 2019, primarily as a result of the above mentioned Increase Agreement offset by outstanding letters of credit.
We believe this is adequate funding to meet the working capital needs of the business.
December 31, 2020, our total long-term debt, including the current portion, less principal repayments, was $330.0 million, or 47.7% of total capitalization (total long-term debt including current portion plus shareholders' equity) of $691.1 million. Approximately $330.0 millionof this outstanding debt bears interest at various floating rates. See Item 7A. Quantitative and Qualitative Disclosure about Market Risk Free Cash Flow We believe Free Cash Flow is an important liquidity metric because it measures, during a given period, the amount of cash generated that is available to fund acquisitions, make investments, repay debt obligations, repurchase company shares, and for certain other activities. Our Free Cash Flow, which is calculated as cash provided by operations less net purchase of property and equipment, was $103.1 million, $19.2 millionand $29.1 millionfor years 2020, 2019 and 2018, respectively. Free Cash Flow is not a measure of liquidity under generally accepted accounting principles in the United States, and may not be defined and calculated by other companies in the same manner. Free Cash Flow should not be considered in isolation or as an alternative to net cash provided by operating activities. Free Cash Flow reconciles to the most directly comparable GAAP financial measure of cash flows from operations as follows: 34
The following table presents the reconciliation of free cash flow to the most comparable GAAP financial measure (in thousands):
2020 2019 2018 Net cash provided by operating activities
$ 109,650 $ 41,306 $ 35,840Less: Purchase of property and equipment 6,672 22,120 9,323 Add: Proceeds from the disposition of property and equipment 123 35 2,558 Free Cash Flow $ 103,101 $ 19,221 $ 29,075
ABL Facility and Senior B Secured Term Loan
Loan facility on assets:
March 17, 2020, the Company entered into an Increase Agreement (the "Increase Agreement") that provided for a $135 millionasset-backed revolving line of credit (the "ABL Revolver") a $50 millionincrease from the $85.0 millionavailable under the original revolver. During the twelve months ended December 31, 2020, the amount available to be borrowed under our credit facility increased to $131.9 millioncompared to $81.6 millionat December 31, 2019primarily as a result of the above mentioned Increase Agreement offset by outstanding letters of credit.
The Company's consolidated Fixed Charge Coverage Ratio was 3.40 to 1.00 as of
December 31, 2020. DXP was in compliance with all such covenants that were in effect on such date under the ABL Revolver as of December 31, 2020. The ABL Credit Agreement may be increased in increments of $10.0 millionup to an aggregate of $50.0 million. The facility will mature on August 29, 2022. Interest accrues on outstanding borrowings at a rate equal to LIBOR or CDOR plus a margin ranging from 1.25% to 1.75% per annum, or at an alternate base rate, Canadian prime rate or Canadian base rate plus a margin ranging from 0.25% to 0.75% per annum, in each case, based upon the average daily excess availability under the facility for the most recently completed calendar quarter. Fees ranging from 0.25% to 0.375% per annum are payable on the portion of the facility not in use at any given time. The unused line fee was 0.375% at December 31, 2020.
The interest rate on the ABL facility was 1.9% at
Term loan B:
The Term Loan B Agreement provides for a
$330 millionterm loan (the "Term Loan") that amortizes in equal quarterly installments of 0.25% with the balance payable in December 2027, when the facility matures. Subject to securing additional lender commitments, the Term Loan B Agreement allows for incremental increases in facility size up to an aggregate of $52.5 million, plus an additional amount such that DXP's Secured Leverage Ratio (as defined in the Term Loan B Agreement) would not exceed 3.75 to 1.00. Interest accrues on the Term Loan at a rate equal to the base rate plus a margin of 3.75% for the Base Rate Loans (as defined in the Term Loan B Agreement), or LIBOR plus a margin of 4.75% for the Eurodollar Rate Loans (as defined in the Term Loan B Agreement). We are required to repay the Term Loan with certain asset sales and insurance proceeds, certain debt proceeds and 50% of excess cash flow, reducing to 25%, if our total leverage ratio is no more than 3.00 to 1.00 and 0%, if our total leverage ratio is no more than 2.50 to 1.00.
The interest rate on the term loan was 5.8% as of
35 -------------------------------------------------------------------------------- Table of Contents Financial Covenants:
DXP’s main financial commitments under the ABL Credit Agreement and the B Term Loan Agreement include:
Fixed Charge Coverage Ratio - The Fixed Charge Coverage Ratio under the ABL Credit Agreement is defined as the ratio for the most recently completed four-fiscal quarter period, of (a) EBITDA minus capital expenditures (excluding those financed or funded with debt (other than the ABL Loans), (ii) the portion thereof funded with the net proceeds from asset dispositions of equipment or real property which DXP is permitted to reinvest pursuant to the Term Loan and the portion thereof funded with the net proceeds of casualty insurance or condemnation awards in respect of any equipment and real estate which DXP is not required to use to prepay the ABL Loans pursuant to the Term Loan B Agreement or with the proceeds of casualty insurance or condemnation awards in respect of any other property) minus cash taxes paid (net of cash tax refunds received during such period), to (b) fixed charges. The Company is restricted from allowing its fixed charge coverage ratio be less than 1.00 to 1.00 during a compliance period, which is triggered when the availability under the ABL facility falls below a threshold set forth in the ABL Credit Agreement. As of
December 31, 2020, the Company's consolidated Fixed Charge Coverage Ratio was 3.40 to 1.00. Secured Leverage Ratio - The Term Loan B Agreement requires that the Company's Secured Leverage Ratio, defined as the ratio, as of the last day of any fiscal quarter of consolidated secured debt (net of unrestricted cash, not to exceed $30 million) as of such day to EBITDA, beginning with the fiscal quarter ending December 31, 2020, is either equal to or less than as indicated in the table below: Fiscal QuarterSecured Leverage Ratio December 31, 20205.75:1.00 March 31, 20215.75:1.00 June 30, 20215.75:1.00 September 30, 20215.50:1.00 December 31, 20215.50:1.00 March 31, 20225.25:1.00 June 30, 20225.25:1.00 September 30, 20225.25:1.00 December 31, 20225.00:1.00 March 31, 20235.00:1.00 June 30, 2023and each Fiscal Quarterthereafter 4.75:1.00 EBITDA as defined under the Term Loan B Agreement for financial covenant purposes means, without duplication, for any period of determination, the sum of, consolidated net income during such period; plus to the extent deducted from consolidated net income in such period: (i) income tax expense, (ii) franchise tax expense, (iii) consolidated interest expense, (iv) amortization and depreciation during such period, (v) all non-cash charges and adjustments, and (vi) non-recurring cash expenses related to the Term Loan, provided, that if the Company acquires or disposes of any property during such period (other than under certain exceptions specified in the Term Loan B Agreement, including the sale of inventory in the ordinary course of business, then EBITDA shall be calculated, after giving pro forma effect to such acquisition or disposition, as if such acquisition or disposition had occurred on the first day of such period. As of December 31, 2020, the Company's consolidated Secured Leverage Ratio was 3.25 to 1.00.
The ABL loans and the term loan are secured by substantially all of the assets of the Company.
Table of Contents Borrowings (in thousands): Increase December 31, 2020 December 31, 2019 (Decrease) Current portion of long-term debt $ 3,300 $ 2,500 $ 800 Long-term debt 326,700 241,875 84,825 Total long-term debt 330,000 244,375 85,625 We believe our cash generated from operations will meet our normal working capital needs during the next twelve months. However, we may require additional debt outside of our credit facilities or equity financing to fund potential acquisitions. Such additional financings may include additional bank debt or the public or private sale of debt or equity securities. In connection with any such financing, we may issue securities that substantially dilute the interests of our shareholders.
Borrowing capacity (in thousands):
The following table summarizes the amount of borrowing capacity under our ABL Revolver as follows: Increase December 31, 2020 December 31, 2019 (Decrease) Total borrowing capacity $ 135,000 $ 85,000
$ 50,000Less : ABL - - - Less : Outstanding letters of credit 3,131 3,442 (311) Total amount available $ 131,869 $ 81,558 $ 50,311Contractual Obligations
The impact that our contractual obligations from
Payments due per period
Less than 1 More than 5 Year 1-3 Years 3-5 Years Years Total Long-term debt, including current portion (1)
$ 3,300 $ 6,600
19,183 26,561 10,008 7,271 63,023 Estimated interest payments (2) 18,880 56,999 55,829 - 131,708 Total
$ 41,363 $ 90,160 $ 72,437 $ 320,771 $ 524,731(1) Amounts represent the expected cash payments of our long-term debt and do not include any fair value adjustment. (2) Assumes interest rates in effect at December 31, 2020. Assumes debt is paid on maturity date and not replaced.
Off-balance sheet provisions
As part of our ongoing business, we do not participate in transactions that generate relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities ("SPE's"), which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As of
December 31, 2020, we were not involved in any unconsolidated SPE transactions. The Company has not made any guarantees to customers or vendors nor does the Company have any off-balance sheet arrangements or commitments, that have, or are reasonably likely to have, a current or future effect on the Company's financial condition, change in financial condition, revenue, expenses, results of operations, liquidity, capital expenditures or capital resources that are material to investors. Indemnification In the ordinary course of business, DXP enters into contractual arrangements under which DXP may agree to indemnify customers from any losses incurred relating to the services we perform. Such indemnification obligations may not be subject to maximum loss clauses. Historically, payments made related to these indemnities have been immaterial. 37 -------------------------------------------------------------------------------- Table of Contents DISCUSSION OF CRITICAL ACCOUNTING POLICIES The Consolidated Financial Statements of DXPE are prepared in accordance with United Statesgenerally accepted accounting principles ("US GAAP"), which require management to make estimates, judgments and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and the disclosure of contingent assets and liabilities. Management bases its estimates on historical experience and on various other assumptions that it believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying amount of assets and liabilities that are not readily apparent from other sources. Management has discussed the development, selection and disclosure of these estimates with the Audit Committee of the Board of Directors of DXP. Management believes that the accounting estimates employed and the resulting amounts are reasonable; however, actual results may differ from these estimates. Making estimates and judgments about future events is inherently unpredictable and is subject to significant uncertainties, some of which are beyond our control. Should any of these estimates and assumptions change or prove to have been incorrect, it could have a material impact on our results of operations, financial position and cash flows. A summary of significant accounting policies is included in Note 2 - Summary of Significant Accounting and Business Policies to the Consolidated Financial Statements in Item 8. Financial Statements and Supplementary Data , which is incorporated herein by reference. 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, if different estimates reasonably could have been used, or if changes in the estimate that are reasonably possible could materially impact the financial statements. Management believes the following critical accounting policies reflect the significant estimates and assumptions used in the preparation of the Consolidated Financial Statements.
Receivables and credit risk
Trade receivables consist primarily of uncollateralized customer obligations due under normal trade terms, which usually require payment within 30 days of the invoice date. However, these payment terms are extended in select cases and customers may not pay within stated trade terms. The Company has trade receivables from a diversified customer base located primarily in the
Rocky Mountain, Northeastern, Midwestern, Southeastern and Southwestern regions of the United States, and Canada. The Company believes no significant concentration of credit risk exists. The Company evaluates the creditworthiness of its customers' financial positions and monitors accounts on a regular basis, but generally does not require collateral. Provisions to the allowance for doubtful accounts are made monthly and adjustments are made periodically (as circumstances warrant) based upon management's best estimate of the collectability of such accounts under the current expected credit losses model. The Company writes-off uncollectible trade accounts receivable when the accounts are determined to be uncollectible. No customer represents more than 10% of consolidated sales. Uncertainties require the Company to make frequent judgments and estimates regarding a customer's ability to pay amounts due in order to assess and quantify an appropriate allowance for doubtful accounts. The primary factors used to quantify the allowance are customer delinquency, bankruptcy, and the Company's estimate of its ability to collect outstanding receivables based on the number of days a receivable has been outstanding.
Many of the Company’s clients operate in the energy sector. The cyclical nature of the industry can affect the operating performance and cash flow of customers, which could affect the Company’s ability to collect these obligations.
The Company continues to monitor the economic climate in which its customers operate and the aging of its accounts receivable. The allowance for doubtful accounts is based on the aging of accounts and an individual assessment of each invoice. Additionally, the overall allowance is adjusted accordingly based upon historical experience and economic factors that impact our business and customers. At
December 31, 2020, the allowance was approximately 4.9% of the gross accounts receivable remaining unchanged from a year earlier. While credit losses have historically been within expectations and the provisions established, should actual write-offs differ from estimates, revisions to the allowance would be required.
The Company tests goodwill and other indefinite lived intangible assets for impairment on an annual basis in the fourth quarter and when events or changes in circumstances indicate that the carrying amount may not be recoverable . The Company assigns the carrying value of these intangible assets to its "reporting units" and applies the test for goodwill at the reporting unit level. A reporting unit is defined as an operating segment or one level below a segment (a "component") if the component is a business and discrete information is prepared and reviewed regularly by segment management. 38
The Company's goodwill impairment assessment first permits evaluating qualitative factors to determine if a reporting unit's carrying value would more likely than not exceed its fair value. If the Company concludes, based on the qualitative assessment, that a reporting unit's carrying value would more likely than not exceed its fair value, the Company would perform a quantitative test for that reporting unit.
Goodwillis deemed to be impaired if the carrying amount of a reporting unit's net assets including goodwill exceeds its estimated fair value. The Company determines fair value using widely accepted valuation techniques, including discounted cash flows and market multiples analyses. These types of analyses contain uncertainties as they require management to make assumptions and to apply judgments regarding industry economic factors and the profitability of future business strategies. The Company's policy is to conduct impairment testing based on current business strategies, taking into consideration current industry and economic conditions, as well as the Company's future expectations. Key assumptions used in the discounted cash flow valuation model include, among others, discount rates, growth rates, cash flow projections and terminal value rates. Discount rates and cash flow projections are the most sensitive and susceptible to change as they require significant management judgment. Discount rates are determined using a weighted average cost of capital ("WACC"). The WACC considers market an industry data, as well as Company-specific risk factors for each reporting unit in determining the appropriate discount rate to be used. The discount rate utilized for each reporting unit is indicative of the return an investor would expect to receive for investing in a similar business. Management uses industry considerations and Company-specific historical and projected results to develop cash flow projections for each reporting unit. Additionally, as part of the market multiples approach, the Company utilizes market data from publicly traded entities whose businesses operate in industries comparable to the Company's reporting units, adjusted for certain factors that increase comparability. The Company cannot predict the occurrence of events or circumstances that could adversely affect the fair value of goodwill. Such events may include, but are not limited to, deterioration of the economic environment, increase in the Company's weighted average cost of capital, material negative changes in relationships with significant customers, reductions in valuations of other public companies in the Company's industry, or strategic decisions made in response to economic and competitive conditions. If actual results are not consistent with the Company's current estimates and assumptions, impairment of goodwill could be required. During the third quarter of 2020, the Company's market capitalization and overall sales declined significantly driven by current macroeconomic and geopolitical conditions including the collapse of oil prices caused by both surplus production and supply as well as the decrease in demand caused by the COVID-19 pandemic. In addition, the uncertainty related to oil demand continued to have a significant impact on the investment and operating plans of many of our customers. Based on these events, the Company concluded that it was more likely than not that the fair values of certain of its reporting units were less than their carrying values. Therefore, the Company performed an interim goodwill impairment test. For the twelve months ended December 31, 2020, goodwill was evaluated for impairment at the reporting unit level. The Company had four goodwill reporting units: Service Centers, Innovative Pumping Solutions, Canadaand Supply Chain Services. The Company determined the fair values of two reporting units with goodwill were below their carrying values, resulting in a $36.4 milliongoodwill impairment, which was included in impairments and other charges in the consolidated statement of operations.
Innovative pumping solutions
The oil and gas industry experienced unprecedented disruption during 2020 as a result of a combination of factors, including the substantial decline in global demand for oil caused by the COVID-19 pandemic and subsequent mitigation efforts. This disruption created a substantial surplus of oil and a decline in oil prices. West Texas Intermediate (WTI) oil spot prices decreased sharply during the first quarter of 2020 from a high of
$63per barrel in early January of 2020 to approximately $21per barrel by the end of the first quarter of 2020. Although oil prices recovered modestly, WTI oil spot prices averaged approximately $41per barrel during the third quarter of 2020, which was approximately 28% less than the average price per barrel during 2019. The U.S.average rig count continued to decline in the third quarter of 2020, dropping 35% compared to the second quarter of 2020. These factors, along with the continued impact of COVID-19, constituted a triggering event and required a goodwill impairment analysis for our manufacturing reporting unit. With the adverse economic impacts discussed above and the uncertainty surrounding the COVID-19 pandemic, the results of the impairment test indicated that the carrying amount of the manufacturing reporting unit exceeded the estimated fair value of the reporting unit, and a full impairment of its remaining goodwill was required. Significant assumptions inherent in the valuation methodologies for goodwill impairment calculations include, but are not limited to, prospective financial information, growth rates, discount rates, inflationary factors, and the cost of capital. To evaluate the sensitivity of the fair value calculations for the reporting unit, the Company applied a hypothetical 100 bps reduction in the weighted average cost of capital, and separately, increased the revenue projections by 10 39 -------------------------------------------------------------------------------- Table of Contents percent, holding other factors steady. Even with more favorable assumptions, the results of these sensitivity analyses led the Company to record a non-cash impairment charge of $16.0 millionfor goodwill during the twelve months ended December 31, 2020. CanadaAs a result of the reductions in capital spending for oil and gas producers and processors and the economic repercussions from the COVID-19 pandemic, we determined these events constituted a triggering event that required us to review the recoverability of our long-lived assets and perform an interim goodwill impairment assessment as of July 31, 2020. Our review resulted in the recording of impairments and other charges during the third quarter of 2020. As a result of our goodwill impairment assessments, we determined that the fair value of our Canadian reporting unit was lower than its net book value and, therefore, resulted in a partial goodwill impairment. The enterprise value of the Canadian reporting unit at July 31, 2020was less than its carrying value by approximately 40 percent. This resulted in a partial goodwill impairment of approximately $20.5 millionfor Canada. Per the impairment test and respective sensitivity analyses, it was noted that a decrease of approximately 480 basis points in the pre-tax discount rate and an approximately 150 basis points increase in our revenue long-term growth rate projections would cause the Canadabusiness enterprise value to increase to the level of its carrying value and thus avoid a full impairment.
Other deficiencies and methodology
The negative market indicators described above were triggering events that indicated that certain of the Company's long-lived intangible and tangible assets and additional inventory items may also have been impaired. Recoverability testing indicated that certain long-lived assets and inventory were indeed impaired or otherwise not recoverable. The estimated fair value of these assets was determined to be below their carrying value. As a result, the Company recorded the following additional impairment and other charges as detailed in the table below (in thousands). Twelve months ended December
Long-lived asset impairments $
Inventory and work-in-progress costs
Total impairment and other charges $
The Company determined the fair value of both long-lived assets and goodwill, discussed above, primarily using the discounted cash flow method and in the case of goodwill, a multiples-based market approach for comparable companies. Given the current volatile market environment and inherent complexities it presents, the Company utilized third-party valuation advisors to assist us with these valuations. These analyses included significant judgment, including management's short-term and long-term forecast of operating performance, discount rates based on the weighted average cost of capital, as derived from peers, revenue growth rates, profitability margins, capital expenditures, the timing of future cash flows based on an eventual recovery of the oil and gas industry, and in the case of long-lived assets, the remaining useful life and service potential of the asset, all of which were classified as Level 3 inputs under the fair value hierarchy. These impairment assessments incorporate inherent uncertainties, including supply and demand for the Company's products and services and future market conditions, which are difficult to predict in volatile economic environments. The discount rates utilized to value the reporting units were in a range from 14.8 percent to 16.4 percent. Given the dynamic nature of the COVID-19 pandemic and related market conditions, we cannot reasonably estimate the period that these events will persist or the full extent of the impact they will have on our business. If market conditions continue to deteriorate, including crude oil prices further declining or remaining at low levels for a sustained period, we may record further asset impairments, which may include an impairment of the carrying value of our goodwill associated with other reporting units. For inventory and work-in-progress we evaluated the recoverability based upon their net realizable value, factoring in the costs to complete work-in-progress and the salability of inventory items primarily tied to oil and gas. The net realizable value was derived from quotes for similar items and recent transactions. 40 -------------------------------------------------------------------------------- Table of Contents Revenue Recognition In our Innovative Pumping Solutions segment, we make a substantial portion of our sales to customers pursuant to long-term contracts to fabricate tangible assets to customer specifications that can range from three to eighteen months or more. We account for these long-term contracts under the percentage-of-completion method of accounting, which is an input method as defined by ASC 606, Revenue Recognition. Under this method, we recognize sales and profit based upon the cost-to-cost method, in which sales and profit are recorded based upon the ratio of costs incurred to estimated total costs to complete the asset. The percentage-of-completion method of accounting involves the use of various estimating techniques to project costs at completion and, in some cases, includes estimates of recoveries asserted against the customer for changes in specifications (change orders). Due to the size, length of time and nature of many of our contracts, the estimation of total contract costs and revenues through completion is complicated and subject to many variables relative to the outcome of future events over a period of several months. We are required to make numerous assumptions and estimates relating to items such as expected engineering requirements, complexity of design and related development costs, product performance, availability and cost of materials, labor productivity and cost, overhead, manufacturing efficiencies and the achievement of contract milestones, including product deliveries, technical requirements, or schedule. Management performs detailed quarterly reviews of all of our open contracts. Based upon these reviews, we record the effects of adjustments in profit estimates each period. If at any time management determines that in the case of a particular contract total costs will exceed total contract revenue, we record a provision for the entire anticipated contract loss at that time. Due to the significance of judgment in the estimation process described above, it is likely that materially different profit margins and/or cost of sales amounts could be recorded if we used different assumptions or if the underlying circumstances were to change. The percentage-of-completion method requires that we estimate future revenues and costs over the life of a contract. Revenues are estimated based upon the original contract price, with consideration being given to exercised contract options, change orders and in some cases projected customer requirements. Contract costs may be incurred over a period of several months, and the estimation of these costs requires significant judgment based upon the acquired knowledge and experience of program managers, engineers, and finance professionals. Estimated costs are based primarily on anticipated purchase contract terms, historical performance trends, business base and other economic projections. The complexity of certain designs as well as technical risks and uncertainty as to the future availability of materials and labor resources could affect the company's ability to accurately estimate future contract costs. Our earnings could be reduced by a material amount resulting in a charge to earnings if (a) total estimated contract costs are significantly higher than expected due to changes in customer specifications prior to contract amendment, (b) total estimated contract costs are significantly higher than previously estimated due to cost overruns or inflation, (c) there is a change in engineering efforts required during the development stage of the contract or (d) we are unable to meet contract milestones or product specifications. Management continues to monitor and update program cost estimates quarterly for all open contracts. A significant change in an estimate on several of these contracts could have a material effect on our financial position and results of operations.
DXP estimates the fair value of assets, including property, machinery and equipment and their related useful lives and salvage values, intangibles and liabilities when allocating the purchase price of an acquisition. The fair value estimates are developed using the best information available. Third party valuation specialists assist in valuing the Company's significant acquisitions. Our purchase price allocation methodology contains uncertainties because it requires management to make assumptions and to apply judgment to estimate the fair value of acquired assets and liabilities. Management estimates the fair value of assets and liabilities based upon quoted market prices, the carrying value of the acquired assets and widely accepted valuation techniques, including the income approach and the market approach. Unanticipated events or circumstances may occur which could affect the accuracy of our fair value estimates, including assumptions regarding industry economic factors and business strategies. We typically engage an independent valuation firm to assist in estimating the fair value of goodwill and other intangible assets. We do not expect that there will be material change in the future estimates or assumptions we use to complete the purchase price allocation and estimate the fair values of acquired assets and liabilities for the acquisitions completed in fiscal 2020. However, if actual results are not consistent with our estimates or assumptions, we may be exposed to losses or gains that could be material. Some of our acquisitions may include as additional compensation, contingent consideration. Contingent consideration is a financial liability recorded at fair value upon acquisition. The amount of contingent consideration to be paid is based on the occurrence of future events, such as the achievement of certain revenue or earnings milestones of the target after consummation. Accordingly, the estimate of fair value contains uncertainties as it involves judgment about the likelihood and timing of achieving these milestones as well as the discount rate used. Changes in fair value of the contingent consideration 41 -------------------------------------------------------------------------------- Table of Contents obligation result from changes to the assumptions used to estimate the probability of success for each milestone, the anticipated timing of achieving the milestones and the discount period and rate to be applied. A change in any of these assumptions could produce a different fair value, which could have a material impact on the results from operations. The impact of changes in key assumptions is described in Note 7- Fair Value of Financial Assets and Liabilities . Income Taxes The Company utilizes the asset and liability method of accounting for income taxes. Deferred income tax assets and liabilities are computed for differences between the financial statement and income tax bases of assets and liabilities. Such deferred income tax asset and liability computations are based on enacted tax laws and rates applicable to periods in which the differences are expected to reverse. We are required to assess the likelihood that our deferred tax assets, which may include net operating loss carryforwards, tax credits or temporary differences that are expected to be deductible in future years, will be recoverable from future taxable income. In making that assessment, we consider the nature of the deferred tax assets and related statutory limits on utilization, recent operating results, future market growth, forecasted earnings, future taxable income, the mix of earnings in the jurisdictions in which we operate and prudent and feasible tax planning strategies. If, based upon available evidence, recovery of the full amount of the deferred tax assets is not likely, we provide a valuation allowance on amounts not likely to be realized. Changes in valuation allowances are included in our tax provision in the period of change. Assessments are made at each balance sheet date to determine how much of each deferred tax asset is realizable. These estimates are subject to change in the future, particularly if earnings of a particular subsidiary are significantly higher or lower than expected, or if management takes operational or tax planning actions that could impact the future taxable earnings of a subsidiary.
Accounting for uncertainty in income taxes
In the normal course of business, we are audited by federal, state and foreign tax authorities, and are periodically challenged regarding the amount of taxes due. These challenges relate primarily to the timing and amount of deductions and the allocation of income among various tax jurisdictions. A position taken or expected to be taken in a tax return is recognized in the financial statements when it is more likely than not (i.e. a likelihood of more than fifty percent) that the position would be sustained upon examination by tax authorities. A recognized tax position is then measured at the largest amount of benefit that is greater than fifty percent likely of being realized upon ultimate settlement. Although we believe we have adequately reserved for our uncertain tax positions, no assurance can be given with respect to the final resolution of these matters. We adjust reserves for our uncertain tax positions due to changing facts and circumstances, such as the closing of a tax audit, judicial rulings, refinement of estimates or realization of earnings or deductions that differ from our estimates. To the extent that the outcome of these matters is different than the amounts recorded, such differences generally will impact our provision for income taxes in the period in which such a determination is made. Our provisions for income taxes include the impact of reserve provisions and changes to reserves that are considered appropriate as well as related interest and penalties. Our effective tax rate in a given period could be impacted if, upon final resolution with taxing authorities, we prevail on positions for which unrecognized tax benefits have been accrued, or are required to pay amounts in excess of accrued unrecognized tax benefits. The Company and its subsidiaries file income tax returns in the
U.S.federal jurisdiction and various states. With few exceptions, the Company is no longer subject to U. S. federal, state and local tax examination by tax authorities for years prior to 2015. The Company's policy is to recognize interest related to unrecognized tax benefits as interest expense and penalties as operating expenses. The Company believes that it has appropriate support for the income tax positions taken and to be taken on its tax returns and that its accruals for tax liabilities are adequate for all open years based on an assessment of many factors including past experience and interpretations of tax law applied to the facts of each matter.
RECENT ACCOUNTING POSITION STATEMENTS
See Note 3 – Recent accounting pronouncements to the consolidated financial statements for information on recent accounting pronouncements.
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