CECO Environmental Corp. — Q3 2016 Form 10-Q Summary
Business Context and Reporting Period
CECO Environmental Corp. is a global provider of engineered environmental, energy, and fluid-handling and filtration technologies. Its reportable segments are Environmental, Energy, and Fluid Handling and Filtration. This unaudited Form 10-Q covers the three and nine months ended September 30, 2016, with comparisons to the corresponding 2015 periods. The September 2015 acquisition of PMFG materially affects comparability.
Key Financial Metrics
| Metric | Q3 2016 | Q3 2015 | 9M 2016 | 9M 2015 |
|---|---|---|---|---|
| Net sales | $101.6 million | $98.2 million | $317.0 million | $266.2 million |
| Gross profit | $33.7 million | $30.8 million | $99.2 million | $78.4 million |
| Gross margin | 33.2% | 31.4% | 31.3% | 29.5% |
| Operating income (loss) | $10.5 million | $(2.2) million | $24.9 million | $5.3 million |
| Operating margin | 10.3% | (2.2)% | 7.9% | 2.0% |
| Net income attributable to CECO | $5.8 million | $(4.8) million | $13.0 million | $(2.5) million |
| Diluted EPS | $0.17 | $(0.17) | $0.38 | $(0.09) |
| Non-GAAP operating income | $14.4 million | $13.0 million | $38.2 million | $32.8 million |
For the nine months, operating cash flow was $52.9 million versus cash used of $8.9 million in the prior-year period. Investing cash flow was $(0.5) million, compared with $(35.3) million, while financing cash flow was $(44.3) million, primarily reflecting debt repayments, earn-out payments, and dividends.
Cash and cash equivalents were $41.8 million at September 30, 2016, up from $34.2 million at December 31, 2015. Working capital was $68.7 million, down from $80.3 million, and the current ratio was 1.47 to 1 versus 1.54 to 1.
Total outstanding borrowings were $133.4 million, down from $177.3 million at year-end 2015. Total debt, net of the current portion, was $123.2 million. The company reported $78.1 million of total unused credit availability, subject to borrowing limitations, with $42.9 million available based on those limitations. The company was in compliance with its debt covenants.
Material Changes Versus the Prior Comparable Period
- Q3 sales increased 3.5%; nine-month sales increased 19.1%, primarily from PMFG. PMFG contributed $23.9 million of Q3 sales and $73.8 million of nine-month sales in 2016.
- Gross margin improved by 180 basis points in Q3 and 180 basis points for the nine months, driven principally by PMFG’s higher-than-average margins and improved segment performance.
- Operating results improved substantially as acquisition and integration costs and earn-out expenses declined from 2015 levels. Q3 acquisition and integration expense fell to $0.2 million from $5.7 million, and amortization and earn-out expense fell to $3.5 million from $9.3 million.
- The Energy segment benefited from PMFG and improved margins. Q3 Energy sales increased to $50.3 million from $40.0 million, and segment operating income improved to $8.5 million from a $1.1 million loss.
- Environmental sales declined to $36.6 million from $40.6 million, although operating income increased to $5.5 million from $5.2 million. Fluid Handling and Filtration sales declined to $14.9 million from $17.1 million, and operating income declined to $3.1 million from $4.0 million.
- Backlog increased to $219.3 million at September 30, 2016, from $211.2 million at December 31, 2015. Third-quarter orders were $96.2 million and nine-month orders were $325.1 million.
- The company repaid $31.6 million of debt during the nine months, including $23.3 million of term-loan prepayments, and paid $6.7 million in common dividends.
Outlook, Commentary, Risks, Contingencies, and Unusual Items
Management emphasized growth opportunities from environmental regulations, natural-gas infrastructure, cleaner power generation, and international markets. It also stated that future bolt-on acquisitions, operational excellence, margin expansion, after-market revenue, and Asia expansion remain strategic priorities. The filing does not provide quantitative earnings or revenue guidance.
- During the second quarter, the Zhongli division began recognizing certain revenue using the percentage-of-completion method after implementing controls to track project costs and estimates. The division recognized $5.2 million of such revenue in Q3 and $13.4 million for the nine months.
- Management recorded a $0.2 million provision for estimated losses on uncompleted contracts. Contract profitability remains exposed to changes in project scope, costs, schedules, subcontractor performance, weather, and labor availability.
- The company entered into three sale-leaseback transactions, generating $14.2 million of financing proceeds and creating sale-leaseback and capital-lease obligations. It also classified $8.1 million of Chinese real property as held for sale and recorded a $5.3 million note payable related to acquiring the remaining interest in Peerless Propulsys.
- No goodwill or indefinite-lived intangible impairment was recorded through September 30, 2016. However, a reporting unit with $77.9 million of goodwill and $5.0 million of tradename assets was performing below forecast, and the annual impairment assessment was incomplete as of the filing date. A material noncash impairment charge remains possible.
- There were 217 asbestos-related cases pending at September 30, 2016. Management believes insurance coverage is adequate and does not expect a material adverse effect, but coverage and claim volume are outside the company’s control.
- PMFG shareholder litigation was dismissed with prejudice in September 2016; the court retained jurisdiction over potential attorneys’ fees and expenses, and related briefing was ongoing.
- Disclosure controls were not effective because four material weaknesses in internal control over financial reporting remained unresolved. The weaknesses relate principally to revenue recognition, controls over acquired businesses, accounting personnel and expertise, documentation and review controls, information technology controls, manual journal entries, and segregation of duties.
- The company is exposed to variable interest rates and foreign currency movements. A hypothetical 10% change in the estimated weighted-average borrowing rate was expected to affect annual earnings and cash flow by approximately $0.3 million, excluding debt hedged by the interest-rate swap.
Most Important Facts for Investors to Verify
- Whether the PMFG-related revenue and margin contribution is sustainable and how results perform excluding acquisition-related comparability effects.
- The outcome of the annual impairment assessment for the underperforming reporting unit and the potential size of any impairment charge.
- Management’s remediation of the material weaknesses, particularly revenue-recognition controls and controls over Zhongli and PMFG.
- Debt repayment capacity, covenant compliance, borrowing limitations, variable-rate exposure, and the September 2020 Credit Facility maturity.
- Conversion of the $219.3 million backlog into revenue and cash, including cancellation, execution, subcontractor, and fixed-price contract risks.
- Cash requirements associated with earn-outs, dividends, sale-leaseback and capital-lease obligations, and the $5.3 million Peerless Propulsys note.
- Developments in asbestos claims, PMFG-related attorneys’ fee requests, and other litigation or insurance disputes.