CECO ENVIRONMENTAL CORP annual report, FY2015

CECO Environmental Corp. 2015 Form 10-K Summary

Business context and reporting period

CECO provides engineered environmental, energy, fluid-handling and filtration technologies through three reportable segments: Environmental, Energy, and Fluid Handling and Filtration. The filing covers the fiscal year ended December 31, 2015, with comparisons to 2014 and 2013. The company had approximately 7,000 active customers, approximately 1,170 employees and operations in the United States, Asia, Europe and other international markets.

CECO completed its acquisition of PMFG on September 3, 2015 for approximately $136.7 million, consisting of approximately $64.6 million in cash and 7.6 million CECO shares. PMFG results are included in the Energy segment from the acquisition date.

Key financial metrics

Metric	2015	2014	Change
Net sales	$367.4 million	$263.2 million	+39.6%
Gross profit	$109.2 million	$84.8 million	+28.8%
Gross margin	29.7%	32.2%	Down 250 bps
Operating income	$4.9 million	$21.7 million	Down 77.2%
Operating margin	1.3%	8.2%	Down 690 bps
Net income attributable to CECO	$(5.6) million	$13.1 million	Declined to a loss
Diluted EPS	$(0.19)	$0.50	Declined
Cash flow from operations	$12.6 million	$17.7 million	Down $5.1 million

Non-GAAP operating income increased to $42.8 million from $34.0 million, but non-GAAP operating margin declined to 11.6% from 12.9%. Non-GAAP net income attributable to CECO was $28.0 million versus $24.6 million in 2014. These measures exclude acquisition and integration costs, amortization and earn-out expenses, impairment, selected valuation adjustments, foreign-currency effects and related tax impacts.

Fourth-quarter 2015 sales were $101.2 million, gross profit was $30.8 million and GAAP operating income was a loss of $0.3 million. Non-GAAP operating income was $10.1 million, or 10.0% of sales.
Environmental sales were $158.4 million and segment operating income was $17.0 million.
Energy sales were $142.2 million, up 102.3%, but segment operating income fell to $3.5 million, primarily because of an $11.2 million Zhongli earn-out fair-value adjustment.
Fluid Handling and Filtration sales were $67.6 million and segment operating income was $11.7 million, including a $2.9 million tradename impairment charge.
Backlog increased to $211.2 million from $140.1 million; approximately $80.5 million of 2015 backlog came from PMFG.

Liquidity, debt and cash flow

Cash and cash equivalents were $34.2 million at December 31, 2015, including $18.0 million held by non-U.S. subsidiaries. Restricted cash was $5.3 million.
Total debt was $177.3 million, compared with $111.9 million at December 31, 2014. Current debt was $19.5 million and long-term debt was $157.8 million.
The company amended its credit agreement in connection with PMFG, adding a $170.0 million term loan and reducing U.S. dollar revolving commitments to $60.5 million. Total unused credit availability was $56.2 million, but availability after borrowing limitations was $11.9 million.
Debt covenants required a consolidated leverage ratio below 3.75 and fixed-charge coverage above 1.25. CECO reported compliance with its covenants at year-end.
Operating cash flow was $12.6 million. Investing activities used $35.0 million, including $37.5 million for acquisitions and $0.8 million for capital expenditures. Financing activities provided $38.9 million, primarily through borrowings.
Management stated that operating cash flow, cash on hand and available borrowings should fund anticipated needs for at least the next twelve months, subject to future operating performance, cash flow and covenant compliance.
Scheduled debt principal payments were $19.5 million in 2016, $13.8 million in 2017, $18.1 million in 2018, $21.3 million in 2019 and $108.9 million in 2020.

Material changes versus the prior comparable period

Revenue growth was driven principally by acquisitions, which contributed approximately $103.0 million of incremental 2015 sales. Organic growth and acquisition contribution are not separately quantified clearly throughout the filing.
Margins deteriorated despite higher gross profit dollars, reflecting product mix and higher acquisition-related costs, amortization and earn-out expenses.
Acquisition and integration expense increased to $7.9 million from $1.3 million; amortization and earn-out expense increased to $25.6 million from $10.1 million.
CECO recorded a $3.3 million intangible asset impairment charge. No goodwill impairment was recorded, although one reporting unit had only an 8% fair-value cushion over carrying value.
Shares outstanding increased materially due primarily to the PMFG stock consideration. Issued shares increased to approximately 34.1 million at year-end from 26.4 million.
International sales rose to approximately 38% of consolidated sales from 30% in 2014. Asia represented approximately 18% and Europe approximately 11% of 2015 sales.
Quarterly dividends increased to $0.066 per share in 2015 from $0.060 or less per share during 2014. Total dividends paid were $8.0 million.

Guidance, outlook, commentary and unusual items

CECO did not provide formal quantitative revenue or earnings guidance in the filing. Management emphasized operational excellence, margin expansion, recurring aftermarket revenue and expansion in global natural-gas infrastructure, power, petrochemical and environmental markets. Management expected PMFG integration to generate approximately $15 million of annual cost savings early in the next fiscal year.

Growth depends on environmental regulation, natural-gas infrastructure investment, power generation, industrialization and customer capital spending.
Most contracts are fixed-price and a substantial portion of revenue is recognized using the percentage-of-completion method, creating exposure to cost overruns, inaccurate estimates, delays and contract changes.
Management identified material weaknesses in internal control over financial reporting involving revenue recognition, controls over the Zhongli and PMFG acquisitions, staffing and accounting expertise, manual journal entries, information-technology controls and segregation of duties. Disclosure controls were deemed ineffective, and BDO issued an adverse opinion on internal control effectiveness.
The filing reports 221 pending asbestos-related cases at year-end, compared with 195 at the beginning of 2015. Management believed insurance coverage was adequate and did not expect a material adverse impact, but noted uncertainty regarding future claim volume, severity and insurer coverage.
The Zhongli earn-out liability increased to approximately $27.0 million at year-end, with $11.2 million recognized as expense in 2015. Total contingent liabilities related to acquisitions were $32.7 million.
The company had an underfunded pension plan with a funded status deficit of approximately $10.8 million. Estimated 2016 pension and retiree healthcare contributions were approximately $29,000 and $27,000, respectively, although longer-term contributions are uncertain.
Interest-rate exposure remained significant because most debt carried variable rates. Management estimated that a hypothetical 10% change in the weighted-average borrowing rate would affect annual earnings and cash flow by approximately $0.4 million.
The filing contains different descriptions of fourth-quarter closing adjustments: the MD&A discusses a $2.7 million sales decrease and $0.4 million pretax-income reduction, while the quarterly note refers to a $5.2 million sales decrease and $5.0 million cost-of-goods-sold decrease. Investors should reconcile these disclosures to the final audited quarterly amounts.

Most important facts for investors to verify

Whether PMFG integration produces the expected approximately $15 million of annual savings and improves Energy segment margins.
The sustainability of reported non-GAAP profitability after acquisition, amortization, earn-out and impairment charges.
Progress in remediating the four material weaknesses and whether subsequent filings report effective internal controls.
Debt repayment capacity, covenant headroom and the large scheduled 2020 maturity relative to operating cash flow.
The final accounting for fourth-quarter revenue adjustments and the reliability of percentage-of-completion estimates.
Potential exposure from asbestos litigation, PMFG merger-related litigation, contingent acquisition payments and the underfunded pension plan.
Goodwill and intangible-asset sensitivity, particularly the reporting unit with only an 8% fair-value cushion and the tradenames already impaired in 2015.