Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
This report on Form 10-Q contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, and Section 27A of the Securities Act of 1933, as amended. The words "expects," "anticipates," "believes," "intends," "plans," "will" and similar expressions identify forward-looking statements. In addition, any statements that refer to expectations, projections or other characterizations of future events or circumstances are forward-looking statements. We undertake no obligation to publicly disclose any revisions to these forward-looking statements to reflect events or circumstances occurring subsequent to filing this Form 10-Q with the Securities and Exchange Commission. These forward-looking statements are subject to risks and uncertainties, including, without limitation, those discussed in this report and those identified in Part I, Item 1A, "Risk Factors" included in our Form 10-K. In addition, new risks emerge from time to time, and it is not possible for management to predict all such risk factors or to assess the impact of such risk factors on our business. Accordingly, our future results may differ materially from historical results or from those discussed or implied by these forward-looking statements. Given these risks and uncertainties, the reader should not place undue reliance on these forward-looking statements.
OVERVIEW
We are a global leader in highly engineered motion control and electronic controls technology for diverse end markets, including construction, material handling, agriculture, energy, recreational vehicles, marine and health and wellness.
We operate under two business segments: Hydraulics and Electronics. The Hydraulics segment designs and manufactures hydraulic cartridge valves, manifolds, hydraulic quick release couplings, machined components and assemblies as well as engineers hydraulic solutions and in some cases complete systems. Our Hydraulics segment includes products sold under the Sun Hydraulics, Faster, Custom Fluidpower, Seungwon, NEM, Taimi, Daman and Schultes brands. The Electronics segment designs and manufactures customized electronic controls systems and displays for a variety of end markets including industrial and mobile, recreational and health and wellness. The Electronics segment includes products sold under the Enovation Controls, Murphy, Zero Off, HCT, Balboa Water Group and Joyonway brands.
During 2021, we augmented our strategy and accelerated our growth plans by two years with intent to achieve our targeted milestone of over $1 billion in sales with top tier adjusted EBITDA margin of approximately 25% in 2023. We plan to achieve this milestone on a run-rate basis ending the fourth quarter of 2023 through a combination of organic growth, acquisitions made to date as well as execution of our manufacturing and operating strategy.
Recent Acquisitions
In January 2023, we completed the acquisition of Schultes Precision Manufacturing, Inc. Schultes is a highly trusted specialist in manufacturing precision machined components and assemblies for customers requiring very tight tolerances, superior quality and exceptional value-added manufacturing processes. Currently serving the hydraulic, aerospace, communication, food services, medical device and dental industries, Schultes brings the manufacturing quality, reliability and responsiveness critical to its customers’ success. Schultes provides additional manufacturing know-how and expands our business into new end markets with attractive secular tailwinds.
We recently announced our intent to acquire i3 Product Development (or “i3”.) i3 is a custom design and engineering services firm, with over 55 engineers with expertise in electronics, mechanical, industrial, embedded and software engineering. They will equip Helios with significant value-added professional services capabilities to provide customization to Helios platforms or develop greenfield solutions. They have also built and patented a remote support platform that provides customers in the field support for their IoT (Internet of Things) devices.
21
Restructuring Activities
We continued our restructuring activities within our Hydraulics segment related to the creation of our two new Regional Operational Centers of Excellence ("CoE"). Facility expansion is currently underway in Mishawaka, Indiana, the future Hydraulic Manifold Solutions CoE, to accept the manifold machining and integrated package assembly operations from Sun Hydraulics, the integrated package business from Faster Inc. and to allow for Daman’s core organic growth. The quick release coupling (QRC) manufacturing will then transfer from Maumee, OH to the cartridge valve technology location in Sarasota, FL to complete the Hydraulic Valve and Coupling Solutions CoE. The relocation of manufacturing operations is expected to be completed in the third quarter of 2023.
Manufacturing and Operating Strategy Activities
Over the last couple years, we have presented the major areas for integration as we transform from being a holding company into an operating company. We have developed the strategies and tactics and have several projects in various phases from ideation to execution. We started with the Electronics segment and then moved to the Hydraulics segment. We created manufacturing roadmaps with several programs, each of which might stretch over a couple of years, and are comprised of multiple projects that have clear structure and owners. Work is moving forward on multiple programs and projects simultaneously. This is a continuous improvement process that will drive efficiency and improvements across the business, and we are now doing this as an integrated operating company versus at the business unit level. Some of our recent notable activities include: the creation of our new Centers of Excellence, transferring some of the board assembly and wire harness production from our Tulsa location to our facility in Tijuana, adding capacity at our plants in both India and Tijuana and constructing an automated warehouse for our Faster Italy location which also frees up space for additional production capacity.
Global Economic Conditions
We continue to navigate through challenges and disruptions created by the Russia-Ukraine war and the ongoing impacts of the COVID-19 pandemic that have created economic uncertainty, market disruption, supply constraints and inflation. We have been mitigating some of the inflation effects through pricing efforts and cost savings measures. We continue to face constraints related to sourcing certain electronic and other components, which originated from the high demand for these products caused by the pandemic. We are mitigating some of the impact with our procurement efforts, production schedule adjustments and product redesigns.
Demand in the health and wellness market was favorably impacted by the pandemic in 2020 and 2021, as consumers invested in leisure products and activities. However, during 2022, we experienced a sharp decline in sales in this end market as demand declined and inventory levels in the channel increased. The trend continued in the first quarter of 2023, although we have seen a small positive trend in order rates for spa and bath products recently.
Refer to Item 1A "Risk Factors" of our Form 10-K for additional discussion of risks related to global economic conditions.
Industry Conditions
Market demand for our products is dependent on demand for the industrial goods in which the products are incorporated. The capital goods industries in general, and the Hydraulics and Electronics segments specifically, are subject to economic cycles. We utilize industry trend reports from various sources, as well as feedback from customers and distributors, to evaluate economic trends. We also rely on global government statistics such as Gross Domestic Product and Purchasing Managers Index to understand macroeconomic conditions.
22
Hydraulics
According to the National Fluid Power Association (the fluid power industry’s trade association in the U.S.), the U.S. index of shipments of hydraulic products increased 17% during the first three months of 2023, after increasing 20% during 2022. In Europe, the CEMA Business Barometer reported in April that the general business climate index for the European agricultural machinery industry remains at a good level but has declined in the past few months driven by a less favorable evaluation of the current business situation and a downgrade of future expectations. Easing on the supply side has been seen but uncertainties are increasing with regard to the market side and confidence levels are declining accordingly. The CECE (Committee for European Construction Equipment) business climate index stayed in high levels throughout the first quarter of the year despite the challenging economic and geopolitical environment. They reported incoming orders have calmed down slightly and industry order backlog and production capacity utilization are getting closer to normal levels.
Electronics
The Federal Reserve’s Industrial Production Index, which measures the real output of all relevant establishments located in the U.S., reports first quarter 2023 sales of semiconductors and other electronics components declined to the lowest level since the third quarter of 2020. The Institute of Printed Circuits Association (“IPC”) reported that total North American printed circuit board (“PCB”) shipments were up 11.6% in March 2023 compared with the same month last year but PCB bookings were down 10.5% in March compared to the same month last year. Further noted was that order flow is holding steady but at lower levels than a year ago. The IPC also reported that North American electronics manufacturing services (“EMS”) shipments were down 3.1% in March 2023 compared with the same month last year and EMS bookings in March were down 7.1% compared with the same month last year. Further noted was that EMS shipments continue to show strength as supply chain challenges dissipate but order flow remains weak.
2023 First Quarter Results and Comparison of the Three Months Ended April 1, 2023 and April 2, 2022
(in millions except per share data)
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Three Months Ended |
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April 1, 2023 |
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April 2, 2022 |
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$ Change |
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% Change |
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Net sales |
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$ |
213.2 |
|
|
$ |
240.5 |
|
|
$ |
(27.3 |
) |
|
|
(11.4 |
)% |
Gross profit |
|
$ |
71.0 |
|
|
$ |
83.6 |
|
|
$ |
(12.6 |
) |
|
|
(15.1 |
)% |
Gross profit % |
|
|
33.3 |
% |
|
|
34.8 |
% |
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|
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|
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Operating income |
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$ |
24.8 |
|
|
$ |
42.9 |
|
|
$ |
(18.1 |
) |
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(42.2 |
)% |
Operating income % |
|
|
11.6 |
% |
|
|
17.8 |
% |
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Net income |
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$ |
13.9 |
|
|
$ |
30.5 |
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$ |
(16.6 |
) |
|
|
(54.4 |
)% |
Diluted net income per share |
|
$ |
0.42 |
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$ |
0.94 |
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$ |
(0.52 |
) |
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(55.3 |
)% |
First quarter consolidated net sales declined $27.3 million, 11.4%, over the prior-year first quarter. We experienced organic net sales decline of $41.0 million, 17%, over the prior-year first quarter, which was offset partially by acquisition growth of $13.7 million. Discrete impacts to our first quarter organic sales compared to the prior-year quarter are as follows:
•Changes in foreign currency exchange rates - unfavorable by $3.5 million, 1.5%
•Pricing changes - favorable by $6.4 million, 2.7%
•Delayed sales due to supply chain constraints - unfavorable by an estimated $12.4 million
Organic sales were impacted by reduced demand for electronics products in our health and wellness end market, which declined sharply from the prior-year first quarter. Sales in this end market were previously strengthened by the pandemic as consumers invested in health and leisure products. Sales were down in all regions compared to the prior-year first quarter, with organic sales to the Americas region having the largest impact.
23
First quarter gross profit decreased $12.6 million, 15.1%, over the prior-year first quarter driven by lower volume as well as unfavorable foreign currency. Changes in foreign currency exchange rates compared to the first quarter of 2022 reduced gross profit by $0.9 million. Gross margin declined by 150 basis points compared with the prior-year first quarter, impacted most significantly by lower leverage of our fixed cost base on the reduced sales. Acquisitions unfavorably impacted gross margin due to their margin profile, which generally has higher cost of sales and lower selling, engineering and administrative expenses (“SEA”). Material costs as a percentage of sales were favorable compared to the first quarter of 2022 primarily from segment and product mix. Excluding pricing changes and acquisition-related sales, material costs as a percentage of sales decreased by 110 basis points compared to the prior-year first quarter.
In the first quarter of 2023, we incurred $1.2 million of costs related to our restructuring activities in the Hydraulics segment; $0.7 million of the costs are included in cost of goods sold and $0.5 million are reflected in SEA expenses. The restructuring costs are comprised of $0.6 million of labor costs, which are not expected to continue after completion of the projects, and $0.6 million of travel and other expenses associated with the manufacturing relocation.
Operating income as a percentage of sales decreased 6.2 percentage points to 11.6% in the first quarter of 2023 compared to the prior-year first quarter. The margin erosion was primarily caused by: gross margin level changes, restructuring costs that were $0.9 million higher than the prior-period quarter, amortization expense increase of $1.1 million from our 2022 and 2023 acquisitions, higher officer transition costs of $0.5 million, increased wages and benefit costs totaling $1.6 million for merit increases, market adjustments and new hires for investments primarily in engineering, sales and corporate activities and reduced leverage of our SEA level fixed cost base on the lower sales volume.
SEGMENT RESULTS
Hydraulics
The following table sets forth the results of operations for the Hydraulics segment (in millions):
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Three Months Ended |
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April 1, 2023 |
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April 2, 2022 |
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$ Change |
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% Change |
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Net sales |
|
$ |
147.7 |
|
|
$ |
137.1 |
|
|
$ |
10.6 |
|
|
|
7.7 |
% |
Gross profit |
|
$ |
50.0 |
|
|
$ |
50.8 |
|
|
$ |
(0.8 |
) |
|
|
(1.6 |
)% |
Gross profit % |
|
|
33.9 |
% |
|
|
37.1 |
% |
|
|
|
|
|
|
Operating income |
|
$ |
28.0 |
|
|
$ |
31.6 |
|
|
$ |
(3.6 |
) |
|
|
(11.4 |
)% |
Operating income % |
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|
19.0 |
% |
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23.1 |
% |
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|
First quarter net sales for the Hydraulics segment increased by $10.6 million, 7.7%, compared with the prior-year first quarter. We experienced organic net sales decline of $3.1 million, 2.3%, over the prior-year first quarter and acquisition growth of $13.7 million. Discrete impacts to our first quarter organic sales compared to the prior-year quarter are as follows:
•Changes in foreign currency exchange rates - unfavorable by $3.3 million, 2.4%
•Pricing changes - favorable by $5.4 million, 3.9%
•Delayed sales due to supply chain constraints - unfavorable by an estimated $7.9 million
The following table presents net sales based on the geographic region of the sale for the Hydraulics segment (in millions):
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Three Months Ended |
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April 1, 2023 |
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April 2, 2022 |
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$ Change |
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% Change |
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Americas |
|
$ |
57.9 |
|
|
$ |
43.1 |
|
|
$ |
14.8 |
|
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|
34.3 |
% |
EMEA |
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|
49.4 |
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52.9 |
|
|
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(3.5 |
) |
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(6.6 |
)% |
APAC |
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40.4 |
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41.1 |
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(0.7 |
) |
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(1.7 |
)% |
Total |
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$ |
147.7 |
|
|
$ |
137.1 |
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|
Regional sales performance in the first quarter compared to the prior-year quarter was driven by:
24
Americas - pricing and our recent acquisitions contributed to a 34.3% increase in sales
EMEA - excluding unfavorable changes in foreign currency rates of $2.2 million, sales were down $1.3 million, 2.5%, primarily from softer demand in the region
APAC - excluding unfavorable changes in foreign currency rates of $1.1 million, sales improved $0.4 million, 1.0%, primarily from pricing
In the first quarter of 2023, gross profit decreased $0.8 million, 1.6%, compared with the same quarter of the prior year. Changes in foreign currency exchange rates compared to the first quarter of 2022 reduced gross profit by $0.8 million. Gross profit margin declined over the same period by 320 basis points to 33.9%, which is attributable to rising material and energy costs, for which margin was not fully recovered by pricing efforts, as well as the different margin profile of our recent acquisitions. Material costs as a percentage of sales, excluding pricing changes and acquisition-related sales, increased in the first quarter by 230 basis points compared to the prior-year first quarter.
Restructuring costs totaled $1.2 million for the first quarter of 2023; $0.7 million of the costs are included in cost of goods sold and $0.5 million are reflected in SEA expenses.
SEA expenses increased $2.8 million, 14.6%, in the first quarter of 2023 compared with the prior-year quarter. Changes in foreign currency rates compared to the prior year reduced SEA costs by $0.5 million. SEA expenses increased from our acquisitions and higher operating costs for: restructuring activities of $0.2 million, travel and marketing of $0.4 million and benefit costs of $0.5 million. SEA as a percent of sales was 14.9%, an increase of 90 basis points compared to the 2022 first quarter.
Electronics
The following table sets forth the results of operations for the Electronics segment (in millions):
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Three Months Ended |
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April 1, 2023 |
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April 2, 2022 |
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$ Change |
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% Change |
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Net sales |
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$ |
65.5 |
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$ |
103.4 |
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$ |
(37.9 |
) |
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(36.7 |
)% |
Gross profit |
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$ |
21.0 |
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$ |
32.8 |
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$ |
(11.8 |
) |
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|
(36.0 |
)% |
Gross profit % |
|
|
32.1 |
% |
|
|
31.7 |
% |
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|
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Operating income |
|
$ |
7.5 |
|
|
$ |
20.5 |
|
|
$ |
(13.0 |
) |
|
|
(63.4 |
)% |
Operating income % |
|
|
11.5 |
% |
|
|
19.8 |
% |
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|
First quarter net sales for the Electronics segment declined $37.9 million, 36.7%, compared with the prior-year first quarter. Discrete impacts to our first quarter sales compared to the prior-year quarter are as follows:
•Changes in foreign currency exchange rates - unfavorable by $0.2 million
•Pricing changes - favorable by $1.0 million, 1.0%
•Delayed sales due to supply chain constraints - unfavorable by an estimated $4.5 million
First quarter demand in our health and wellness end market declined sharply compared to the prior-year quarter, which was strengthened by the pandemic as consumers invested in health and leisure products. Inventory held by customers remained inflated in this end market, which further led to the decline. We have seen a small positive trend in order rates for spa and bath products over the past few months. We realized growth in our mobile and industrial machinery end markets compared to the first quarter of 2022.
The following table presents net sales based on the geographic region of the sale for the Electronics segment (in millions):
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Three Months Ended |
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April 1, 2023 |
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April 2, 2022 |
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$ Change |
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% Change |
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Americas |
|
$ |
55.1 |
|
|
$ |
77.7 |
|
|
$ |
(22.6 |
) |
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|
(29.1 |
)% |
EMEA |
|
|
6.7 |
|
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11.8 |
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(5.1 |
) |
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(43.2 |
)% |
APAC |
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3.7 |
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13.9 |
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(10.2 |
) |
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(73.4 |
)% |
Total |
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$ |
65.5 |
|
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$ |
103.4 |
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|
25
Reduced demand in the health and wellness end market contributed the decline in sales in all regions in the first quarter compared to the prior-year quarter.
First quarter gross profit decreased $11.8 million, 36.0%, compared with the first quarter of the prior year due to the lower sales volume. Gross margin improved over the same period by 40 basis points to 32.1% as a favorable sales mix more than offset the reduced leverage of our fixed cost base on the lower sales and labor inefficiencies from decreased production. Material costs as a percentage of sales, excluding pricing changes and acquisition-related sales, decreased in the first quarter by 430 basis points compared to the prior-year quarter due to the favorable sales mix.
SEA expenses increased by $1.2 million, 9.8%, in the first quarter of 2023, compared with the first quarter of 2022, primarily from wages and benefits for merit increases, market adjustments and new hires for investments in engineering, sales and corporate activities. SEA costs as a percentage of sales increased to 20.6%, in the first quarter of 2023 compared with 11.9% in the prior-year first quarter further impacted by lost leverage of our fixed costs on the lower sales.
Corporate and Other
Certain costs are excluded from business segment results as they are not used in evaluating the results of, or in allocating resources to, our operating segments. For the first quarter of 2023, these costs totaled $10.7 million for: transition costs for one of our executive officers of $0.8 million, amortization of acquisition-related intangible assets of $8.1 million and $1.8 million related to our acquisition and integration activities.
Interest Expense, net
Net interest expense increased $2.4 million to $6.2 million in the first quarter of 2023 compared with $3.8 million in the prior-year first quarter. In addition to higher interest rates in the current quarter, average net debt balances increased with the acquisitions of Daman in September 2022 and Schultes in January 2023. Average net debt increased to $446.0 million during the first quarter of 2023 compared with $410.8 million during the first quarter of 2022.
Income Taxes
The provision for income taxes for the first quarter of 2023 was 22.8% of pretax income compared to 22.4% for the prior-year first quarter. These effective rates fluctuate relative to the levels of income and different tax rates in effect among the countries in which we sell our products.
On August 16, 2022, the Inflation Reduction Act was enacted into law, and includes, among other things, a new 15% minimum tax and 1% excise tax on stock repurchases after December 31, 2022. These tax law changes have no immediate material effect and are not expected to have a material impact on our future financial results, we will continue to evaluate its impact as further information becomes available.
LIQUIDITY AND CAPITAL RESOURCES
Our primary sources of capital are cash generated from operations and borrowings on our credit facilities to fund acquisitions. During the first three months of 2023, cash provided by operating activities totaled $12.3 million. At the end of the first quarter, we had $36.3 million of available cash and cash equivalents on hand and $54.3 million of available credit on our revolving credit facilities. We also have a $300.0 million accordion feature available on our credit facility, subject to certain pro forma compliance requirements, intended to support potential future acquisitions.
Our principal uses of cash are operating expenses, capital expenditures, servicing debt, acquisition-related payments and dividends to shareholders.
26
We believe that cash generated from operations and our borrowing availability under our credit facilities will be sufficient to satisfy our operating expenses. In the event that economic conditions were to severely worsen for a protracted period of time, we would have several options available to ensure liquidity in addition to increased borrowings. Capital expenditures could be postponed since they primarily pertain to long-term improvements in operations, operating expense reductions could be made and finally, the dividend to shareholders could be reduced or suspended.
Cash Flows
The following table summarizes our cash flows for the periods (in millions):
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Three Months Ended |
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|
|
April 1, 2023 |
|
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April 2, 2022 |
|
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$ Change |
|
Net cash provided by operating activities |
|
$ |
12.3 |
|
|
$ |
14.7 |
|
|
$ |
(2.4 |
) |
Net cash used in investing activities |
|
|
(94.6 |
) |
|
|
(2.7 |
) |
|
|
(91.9 |
) |
Net cash provided by (used in) financing activities |
|
|
73.8 |
|
|
|
(8.8 |
) |
|
|
82.6 |
|
Effect of exchange rate changes on cash and cash equivalents |
|
|
1.1 |
|
|
|
1.3 |
|
|
|
(0.2 |
) |
Net (decrease) increase in cash and cash equivalents |
|
$ |
(7.4 |
) |
|
$ |
4.5 |
|
|
$ |
(11.9 |
) |
Cash on hand decreased $7.4 million in the first quarter of 2023 to $36.3 million as of April 1, 2023. Changes in exchange rates during the three months ended April 1, 2023, favorably impacted cash and cash equivalents by $1.1 million. Cash balances on hand are a result of our cash management strategy, which focuses on maintaining sufficient cash to fund operations while reinvesting cash in the Company and paying down borrowings on our credit facilities.
Operating activities
Cash from operations declined by $2.4 million in the first quarter of 2023 compared to the prior-year first quarter. Current quarter cash earnings (calculated as net income plus adjustments to reconcile net income to net cash provided by operating activities, excluding changes in net operating assets and liabilities) decreased by $11.8 million over the prior-year period. Changes in net operating assets and liabilities improved cash flow by $9.4 million, compared to the prior-year period, primarily from favorable cash flows from accounts receivable and inventories only partially offset by reductions in accounts payable. Investments in inventory reduced cash by $6.5 million and $15.5 million in the first quarter of 2023 and 2022, respectively. Days of inventory on hand increased to 126 days as of April 1, 2023, compared with 100 days as of April 2, 2022. The increase is due to the decline in sales to the health and wellness end market. We have higher inventory than needed for current sales levels to that end market. Changes in accounts receivable reduced cash by $9.5 million and $17.4 million in the first quarter of 2023 and 2022, respectively. Days sales outstanding increased slightly to 60 days as of April 1, 2023, compared to 57 days as of April 2, 2022, as our collection patterns remain fairly consistent with the prior period.
Investing activities
Cash used in investing activities totaled $94.6 million in the first quarter of 2023, compared to cash used of $2.7 million in the first quarter of the prior year. Cash paid, net of cash acquired, for our acquisition of Schultes in the first quarter of 2023 totaled $84.7 million.
Capital expenditures totaled $9.1 million for the first quarter of 2023, an increase of $3.5 million over the prior-year comparable period. Capital expenditures for 2023 are forecasted to be approximately 3%-5% of sales, for investments in machinery and equipment for capacity expansion projects, improvements to manufacturing technology and maintaining/replacing existing machine capabilities.
27
Financing activities
Net cash provided by financing activities totaled $73.8 million during the first quarter of 2023, compared with cash used of $8.8 million in the prior-year period. We borrowed $88.5 million on our credit facility to fund the acquisition of Schultes in January 2023. Excluding these acquisition related borrowings, repayments, net of borrowings, on our credit facilities totaled $10.1 million for the first quarter of 2023 compared to $4.3 million during the same period of 2022.
During the first quarter of 2023, we declared a quarterly cash dividend of $0.09 per share payable on January 20, 2023, to shareholders of record as of January 5, 2023. The declaration and payment of future dividends is subject to the sole discretion of the board of directors, and any determination as to the payment of future dividends will depend upon our profitability, financial condition, capital needs, future prospects and other factors deemed pertinent by the board of directors.
Off Balance Sheet Arrangements
We do not engage in any off-balance sheet financing arrangements. In particular, we do not have any material interest in variable interest entities, which include special purpose entities and structured finance entities.
Inflation
As more fully described in Item 2 above, we are experiencing supply shortages and increasing material costs. Continued increases in the global demand for the materials used in our products could result in significant increases in the costs of the components we purchase, and we may not be able to fully offset such higher costs through price increases. There is no assurance that our business will not be materially affected by inflation in the future.
Critical Accounting Policies and Estimates
We currently apply judgment and estimates that may have a material effect on the eventual outcome of assets, liabilities, revenues and expenses for impairment of long-lived assets, inventory, goodwill, accruals, income taxes and fair value measurements. Our critical accounting policies and estimates are included in our Form 10-K, and any changes made during the first three months of 2023, are disclosed in Note 2 to the Consolidated, Unaudited Financial Statements.
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