CECO Environmental Corp. — Form 10-Q Summary
Business context and reporting period
CECO is a global provider of engineered environmental, energy, fluid-handling and filtration technologies. The report covers the three and nine months ended September 30, 2015, compared with the corresponding 2014 periods. Results include acquisitions completed during 2014 and the September 3, 2015 acquisition of PMFG, which contributed $12.6 million of revenue during the nine months after closing.
- Reportable segments: Environmental, Energy, and Fluid Handling and Filtration.
- Backlog was $212.3 million at September 30, 2015, including $75.5 million related to PMFG, versus $140.1 million at December 31, 2014.
Financial performance and liquidity
| Metric | Q3 2015 | Q3 2014 | 9M 2015 | 9M 2014 |
|---|---|---|---|---|
| Net sales | $98.2 million | $63.3 million | $266.2 million | $187.1 million |
| Gross profit | $30.8 million | $21.1 million | $78.4 million | $62.2 million |
| Gross margin | 31.4% | 33.3% | 29.5% | 33.2% |
| Operating income (loss) | $(2.2) million | $5.2 million | $5.3 million | $17.9 million |
| Operating margin | (2.2)% | 8.3% | 2.0% | 9.6% |
| Net income (loss) | $(4.8) million | $3.7 million | $(2.5) million | $11.2 million |
| Diluted EPS | $(0.17) | $0.14 | $(0.09) | $0.43 |
- Non-GAAP operating income was $13.0 million, or 13.2% of sales, in Q3 2015 and $32.8 million, or 12.3% of sales, for the nine months. These measures exclude acquisition-related, amortization, earn-out, valuation and legal items and are not GAAP measures.
- Operating cash flow was $(10.6) million for the first nine months of 2015 versus $6.3 million provided in the prior-year period. Working-capital investment included increases in accounts receivable and costs and estimated earnings in excess of billings.
- Investing cash outflow was $35.3 million, primarily reflecting $37.1 million of net cash paid for acquisitions, principally PMFG.
- Financing activities provided $58.5 million, including $170.0 million of new long-term borrowings, partly offset by $101.966 million of debt repayments, $2.9 million of financing fees and $5.7 million of dividends.
- Cash and cash equivalents were $30.8 million at September 30, 2015; including restricted cash, reported cash totaled approximately $36.1 million. Total debt was $194.3 million, compared with $111.9 million at December 31, 2014.
- Unused credit availability was reported at $46.8 million before borrowing limitations, but only $5.2 million was available based on borrowing limitations. The Credit Facility itself had $45.7 million of unused availability.
- The company remained in compliance with its debt covenants. The senior secured Credit Facility includes a leverage-ratio covenant of less than 3.75 and a fixed-charge-coverage covenant of more than 1.25.
Material changes versus the prior comparable period
- Revenue increased 55.1% in Q3 and 42.3% for the nine months, primarily from Emtrol, Zhongli and PMFG acquisitions, plus growth at Aarding and Buell-FKI.
- Gross margin declined by 190 basis points in Q3 and 370 basis points for the nine months, reflecting lower margins at Emtrol and Zhongli and weaker performance at Aarding and Effox-Flextor.
- Acquisition and integration expense increased to $5.7 million in Q3 and $7.0 million for the nine months, mainly due to PMFG.
- Amortization and earn-out expense increased to $9.3 million in Q3 and $20.0 million for the nine months. The Zhongli earn-out fair-value adjustment contributed $5.4 million in Q3 and $9.9 million year to date.
- Environmental segment operating income improved to $5.2 million in Q3 and $14.4 million for the nine months. Energy shifted to an operating loss of $1.1 million in Q3 and $0.4 million for the nine months, while FHF operating income was $4.0 million in Q3 and $11.4 million year to date.
- Shares outstanding increased materially due to the PMFG transaction. Approximately 7.6 million CECO shares were issued for the stock portion of the acquisition.
- The company declared and paid a quarterly dividend of $0.066 per share. Future dividends remain subject to board and lender approval.
Guidance, outlook, risks and unusual items
The filing does not provide formal quantitative earnings or revenue guidance. Management describes its strategy as pursuing global growth, operational excellence, margin expansion, aftermarket revenue and additional bolt-on acquisitions, with particular emphasis on China and the expanded PMFG platform.
- Impairment risk: The annual goodwill and indefinite-lived intangible impairment assessment had not been completed as of the filing date. Several reporting units had lower-than-expected sales and operating profits, and certain units had only a small excess of estimated fair value over carrying value. A material non-cash impairment charge was possible if performance or projections deteriorated.
- Liquidity and leverage: Debt increased substantially to fund PMFG, while operating cash flow turned negative. Borrowing capacity was constrained by borrowing limitations, and interest expense increased with higher debt and rates.
- Integration and acquisition accounting: Purchase accounting for PMFG, Zhongli and Emtrol remained preliminary and could change materially during the measurement period.
- Contract and operating risks: Fixed-price contracts, cost overruns, project delays, cancellations, subcontractor performance, seasonality, raw-material costs and regulatory or economic conditions may affect profitability.
- Legal contingencies: The company had 213 pending asbestos cases at September 30, 2015. Management believed insurance coverage was adequate and that the cases would not materially affect results, but noted uncertainty regarding claim volume, insurers and coverage. Other matters included the Viron settlement and PMFG shareholder litigation.
- Internal controls: Management concluded that disclosure controls and internal control over financial reporting were not effective because of material weaknesses involving the financial close process, accounting personnel and oversight, income-tax accounting and segregation of duties. A new material weakness related to income-tax controls was identified during the quarter; remediation was ongoing.
- Foreign exchange and interest-rate exposure: Most debt was subject to variable interest rates. The company estimated that a hypothetical 10% change in its weighted-average borrowing rate would affect annual earnings and cash flow by approximately $0.7 million.
Most important facts for investors to verify
- Whether PMFG integration produces the expected revenue, margins and synergies without further material acquisition or earn-out charges.
- Whether Zhongli and other underperforming reporting units recover sufficiently to avoid goodwill or intangible-asset impairment charges.
- Actual borrowing capacity under the Credit Facility after covenant and borrowing-base limitations, and the company’s ability to reduce leverage.
- Conversion of backlog and contract assets into cash, particularly given negative operating cash flow and significant costs in excess of billings.
- Progress in remediating the disclosed material weaknesses in internal control over financial reporting, especially income-tax accounting.
- Developments in asbestos claims, PMFG shareholder litigation, other legal matters and the adequacy of related insurance or reserves.
- Whether lower gross margins, higher interest expense and recurring acquisition-related costs affect sustainable GAAP profitability.