ITEM 1. Business
Company Overview
DXP was incorporated in Texas in 1996 to be the successor to SEPCO Industries, Inc., founded in 1908. Since our predecessor company was founded, we have primarily been engaged in the business of distributing maintenance, repair and operating ("MRO") products, equipment and service to energy and industrial customers. The Company is organized into three business segments: Service Centers ("SC"), Supply Chain Services ("SCS") and Innovative Pumping Solutions ("IPS"). Sales, operating income, and other financial information for 2019, 2018 and 2017, and identifiable assets at the close of such years for our business segments are presented in Note 19 - Segment and Geographical Reporting to the Consolidated Financial Statements in Item 8. Financial Statements and Supplementary Data.
Our total sales have increased from $125 million in 1996 to $1.3 billion in 2019 through a combination of internal growth and business acquisitions. At December 31, 2019, we operated from 155 locations which included 35 states in the U.S., nine provinces in Canada and one location in Dubai serving customers engaged in a variety of industrial end markets. We have grown sales and profitability by adding additional products, services, and locations and becoming customer driven experts in maintenance, repair and operating solutions.
Our principal executive office is located at 5301 Hollister Houston, Texas 77040, and our telephone number is (713) 996-4700. Our website address on the internet is www.dxpe.com and emails may be sent to info@dxpe.com. The reference to our website address does not constitute incorporation by reference of the information contained on the website and such information should not be considered part of this report.
Industry Overview
The industrial distribution market is highly fragmented. Based on 2018 sales as reported by Industrial Distribution magazine, we were the 16 th largest distributor of MRO products in the United States. Most industrial customers currently purchase their industrial supplies through numerous local distribution and supply companies. These distributors generally provide the customer with repair and maintenance services, technical support and application expertise with respect to one product category. Products typically are purchased by the distributor for resale directly from the manufacturer and warehoused at distribution facilities of the distributor until sold to the customer. The customer also typically will purchase an amount of product inventory for its near term anticipated needs and store those products at its industrial site until the products are used.
We believe that the distribution system for industrial products, as described in the preceding paragraph, creates inefficiencies at both the customer and the distributor levels through excess inventory requirements and duplicative cost structures. To compete more effectively, our customers and other users of MRO products are seeking ways to enhance efficiencies and lower MRO product and procurement costs. In response to this customer desire, three primary trends have emerged in the industrial supply industry:
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Industry Consolidation. Industrial customers have reduced the number of supplier relationships they maintain to lower total purchasing costs, improve inventory management, assure consistently high levels of customer service and enhance purchasing power. This focus on fewer suppliers has led to consolidation within the fragmented industrial distribution industry.
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Customized Integrated Service. As industrial customers focus on their core manufacturing or other production competencies, they increasingly demand customized integration services, consisting of value-added traditional distribution, supply chain services, modular equipment and repair and maintenance services.
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Single Source, First-Tier Distribution. As industrial customers continue to address cost containment, there is a trend toward reducing the number of suppliers and eliminating multiple tiers of distribution. Therefore, to lower overall costs to the customer, some MRO product distributors are expanding their product coverage to eliminate second-tier distributors and become a “one stop source”.
We believe we have increased our competitive advantage through our traditional fabrication of integrated system pump packages and integrated supply programs, which are designed to address our customers’ specific product and procurement needs. We offer our customers various options for the integration of their supply needs, ranging from serving as a single source of supply for all our specific lines of products and product categories to offering a fully integrated supply package in which we assume procurement and management functions, which can include ownership of inventory, at the customer's location. Our approach to integrated
supply allows us to design a program that best fits the needs of the customer. Customers purchasing large quantities of product are able to outsource all or most of those needs to us. For customers with smaller supply needs, we are able to combine our traditional distribution capabilities with our broad product categories and advanced ordering systems to allow the customer to engage in one-stop sourcing without the commitment required under an integrated supply contract.
Business Segments
The Company is organized into three business segments: Service Centers (“SC”), Supply Chain Services (“SCS”) and Innovative Pumping Solutions (“IPS”). Our segments provide management with a comprehensive financial view of our key businesses. The segments enable the alignment of strategies and objectives and provide a framework for timely and rational allocation of resources within our businesses. In addition to the three business segments, our consolidated financial results include "Corporate and other expenses" which includes costs related to our centralized support functions, consisting, of accounting and finance, information technology, human resources, legal, inventory management & procurement and other support services and removes inter-company transactions. The following table sets forth DXP’s sales by business segments as of December 31, 2019. See Results of Operations under Item 7. Management Discussion and Analysis of Financial Condition and Results of Operations for further information on our segments’ financial results.
Service Centers
The Service Centers are engaged in providing MRO products, equipment and integrated services, including technical expertise and logistics capabilities, to energy and industrial customers with the ability to provide same day delivery. We offer our customers a single source of supply on an efficient and competitive basis by being a first-tier distributor that can purchase products directly from manufacturers. As a first-tier distributor, we are able to reduce our customers' costs and improve efficiencies in the supply chain. We offer a wide range of industrial MRO products, equipment and integrated services through a continuum of customized and efficient MRO solutions. We also provide services such as field safety supervision, in-house and field repair and predictive maintenance.
A majority of our Service Center segment sales are derived from customer purchase orders for products. Sales are directly solicited from customers by our sales force. DXP Service Centers are stocked and staffed with knowledgeable sales associates and backed by a centralized customer service team of experienced industry professionals. At December 31, 2019, our Service Centers’ products and services were distributed from 141 service centers and 4 distribution centers. DXP Service Centers provide a wide range of MRO products in the rotating equipment, bearing, power transmission, hose, fluid power, metal working, industrial supply and safety product and service categories. We currently serve as a first-tier distributor of more than 1,000,000 items of which more than 60,000 are stock keeping units (SKUs) for use primarily by customers engaged in the oil and gas, food and beverage, petrochemical, transportation and other general industrial industries. Other industries served by our Service Centers include mining, construction, chemical, municipal, agriculture and pulp and paper.
The Service Centers segment’s long-lived assets are located in the United States, Canada and Dubai. Approximately 10.1% of the Service Centers segment’s revenues were in Canada and the remainder was virtually all in the U.S. Our foreign operations are subject to certain unique risks, which are more fully disclosed in Item 1A
ITEM 1A. Risk Factors
We are subject to various risks and uncertainties in the course of our business. Investing in DXP involves risk. In deciding whether to invest in DXP, you should carefully consider the risk factors below as well as those matters referenced in the foregoing pages under “Disclosure Regarding Forward-Looking Statements” and other information included and incorporated by reference into this Report and other reports and materials filed by us with the Securities and Exchange Commission. Any of these risk factors could have a significant or material adverse effect on our businesses, results of operations, financial condition or liquidity. They could also cause significant fluctuations and volatility in the trading price of our securities. Readers should not consider any descriptions of these factors to be a complete set of all potential risks that could affect DXP. Further, many of these risks are interrelated and could occur under similar business and economic conditions, and the occurrence of certain of them may in turn cause the emergence or exacerbate the effects of others. Such a combination could materially increase the severity of the impact of these risks on our results of operations, liquidity and financial condition.
Decreased capital expenditures in the energy industry can adversely impact our customers’ demand for our products and services.
A significant portion of our revenue depends upon the level of capital and operating expenditures in the oil and natural gas industry, including capital expenditures in connection with the upstream, midstream, and downstream phases in the energy industry. Therefore, a significant decline in oil or natural gas prices could lead to a decrease in our customers’ capital and other expenditures and could adversely affect our revenues.
Demand for our products could decrease if the manufacturers of those products sell them directly to end users.
Typically, MRO products have been purchased through distributors and not directly from the manufacturers of those products. If customers were to purchase our products directly from manufacturers, or if manufacturers sought to increase their efforts to sell directly to end users, we could experience a significant decrease in sales and earnings.
Changes in our customer and product mix, or adverse changes to the cost of goods we sell, could cause our gross margin percentage to fluctuate or decrease, and we may not be able to maintain historical margins.
Changes in our customer mix have resulted from geographic expansion, daily selling activities within current geographic markets, and targeted selling activities to new customers. Changes in our product mix have resulted from marketing activities to existing customers and needs communicated to us from existing and prospective customers. There can be no assurance that we will be able to maintain our historical gross margins. In addition, we may also be subject to price increases from vendors that we may not be able to pass along to our customers.
Our manufacturers may cancel our oral or written distribution authorizations upon little or no notice, which could adversely impact our revenues and profits from distributing certain manufacturer’s products.
We are authorized to distribute certain manufacturers’ products in specific geographic areas and all of our oral or written distribution authorizations are subject to cancellation by the manufacturer, some upon little or no notice. If certain manufacturers cancel the distribution authorizations they granted to us, our distribution of their products could be disrupted and such occurrence could have a material adverse effect on our results of operations and financial conditions.
A deterioration in the oil and gas sector or other circumstances may negatively impact our business and results of operations and thus hinder our ability to comply with financial covenants under our credit facilities, including the Secured Leverage Ratio and Fixed Charge Coverage Ratio financial covenants.
A deterioration of the oil and gas sector or other circumstances that reduce our earnings may hinder our ability to comply with certain financial covenants under our credit facilities. Specifically, compliance with the Secured Leverage Ratio and Fixed Charge Coverage Ratio covenants depend on our ability to maintain net income and prevent losses. In the future we may not be able to comply with the covenants and, if we are not able to do so, our lenders may not be willing to waive such non-compliance or amend such covenants. If we are unable to comply with our financial covenants or obtain a waiver or amendment of those covenants or obtain alternative financing, our business and financial condition would be adversely affected.
We rely upon third-party transportation providers for our merchandise shipments and are subject to increased shipping costs as well as the potential inability of our third-party transportation providers to deliver products on a timely basis.
We rely upon independent third-party transportation providers for our merchandise shipments, including shipments to and from all of our service centers. Our utilization of these delivery services for shipments is subject to risks, including increases in fuel prices, labor availability, labor strikes and inclement weather, which may impact a shipping company’s ability to provide delivery services that adequately meet our shipping needs. If we change the shipping companies we use, we could face logistical difficulties that could adversely affect deliveries and we would incur costs and expend resources in connection with such change. In addition, we may not be able to obtain favorable terms as we have with our current third-party transportation providers.
Our business has substantial competition that could adversely affect our results.
Our business is highly competitive. We compete with a variety of industrial supply distributors, some of which may have greater financial and other resources than us. Although many of our traditional distribution competitors are small enterprises selling to customers in a limited geographic area, we also compete with larger distributors that provide integrated supply programs such as those offered through outsourcing services similar to those that are offered by our SCS segment. Some of these large distributors may be able to supply their products in a more timely and cost-efficient manner than us. Our competitors include catalog suppliers, large warehouse stores and, to a lesser extent, certain manufacturers. Competitive pressures could adversely affect DXP’s sales and profitability.
Adverse weather events or natural disasters could negatively disrupt our operations.
Certain areas in which we operate are susceptible to adverse weather conditions or natural disasters, such as hurricanes, tornadoes, floods and earthquakes. These events can disrupt our operations, result in damage to our properties and negatively affect the local economies in which we operate. Additionally, we may experience communication disruptions with our customers, vendors and employees.
We cannot predict whether or to what extent damage caused by these events will affect our operations or the economies in regions where we operate. These adverse events could result in disruption of our purchasing or distribution capabilities, interruption of our business that exceeds our insurance coverage, our inability to collect from customers and increased operating costs. Our business or results of operations may be adversely affected by these and other negative effects of these events.
Pandemic or other public health crisis could result in disruptions in supply chain, decreased customer demand, lower oil price and volatility in the stock market and the global economy, which could negatively impact our operations.
Pandemic or other public health crisis occurring at our or our vendors’ facilities could adversely impact or disrupt our operations, negatively affect the local economies where we operate and these types of events could negatively impact our customers’ spending in the impacted regions or depending upon the severity, globally, which could adversely impact our business, reputation, results of operations or financial conditions. For example, since December 2019, a strain of 2019 Novel Coronavirus (“COVID-19”) has surfaced from China and has spread into several regions globally, resulting in certain supply chain disruptions, volatilities in the stock market, lower oil prices, lockdown in international travels, which could adversely impact the global economy and potential decreased demand from our customers. At this point, the extent to which the COVID-19 virus may impact our operation results is uncertain.
The loss of or the failure to attract and retain key personnel could adversely impact our results of operations.
The loss of the services of any of the executive officers of the Company could have a material adverse effect on our financial condition and results of operations. In addition, our ability to grow successfully will be dependent upon our ability to attract and
retain qualified management and technical and operational personnel. The failure to attract and retain such persons could materially adversely affect our financial condition and results of operations.
The loss of any key supplier could adversely affect DXP’s sales and profitability.
We have distribution rights for certain product lines and depend on these distribution rights for a substantial portion of our business. Many of these distribution rights are pursuant to contracts that are subject to cancellation upon little or no prior notice. The termination or limitation by any key supplier of its relationship with the Company could result in a temporary disruption of our business and, in turn, could adversely affect our results of operations and financial condition.
We are subject to various government regulations, the cost of compliance of such regulations could increase our cost of conducting business and any violations of such regulations could materially adversely affect our financial condition or results of operations.
We are subject to laws and regulations in every jurisdiction where we operate. Compliance with laws and regulations increases our cost of doing business. We are subject to a variety of laws and regulations, including without limitation import and export requirements, the Foreign Corrupt Practices Act (the “FCPA”), tax laws (including U.S. taxes on our foreign subsidiaries), data privacy requirements, labor laws and anti-competition regulations. We are also subject to audits and inquiries in the ordinary course of business. Changes to the legal and regulatory environments could increase the cost of doing business, and such costs may increase in the future as a result of changes in these laws and regulations or in their interpretation. Our employees, contractors or agents may violate laws and regulations despite our attempts to implement policies and procedures to comply with such laws and regulations. Any such violations could individually or in the aggregate materially adversely affect our financial condition or results of operations.
We are subject to environmental, health and safety laws and regulations.
We are subject to federal, state, local, foreign and provincial environmental, health and safety laws and regulations. Fines and penalties may be imposed for non-compliance with applicable environmental, health and safety requirements and the failure to have or to comply with the terms and conditions of required permits. The failure by us to comply with applicable environmental, health and safety requirements could result in fines, penalties, enforcement actions, third party claims for property damage and personal injury, requirements to clean up property or to pay for the costs of cleanup, or regulatory or judicial orders requiring corrective measures.
A general slowdown in the economy could negatively impact DXP’s sales growth and profitability.
Economic and industry trends affect DXP’s business. Demand for our products is subject to economic trends affecting our customers and the industries in which they compete in particular. Many of these industries, such as the oil and gas industry, are subject to volatility while others, such as the petrochemical industry, are cyclical and materially affected by changes in the economy. As a result, demand for our products could be adversely impacted by changes in the markets of our customers. We traditionally do not enter into long-term contracts with our customers which increases the likelihood that economic downturns would affect our business.
Tax changes could affect our effective tax rate and profitability.
Future results could be adversely affected by changes in the effective tax rate as a result of changes in our overall profitability and changes in the mix of earnings and losses in countries with differing statutory tax rates, changes in tax legislation, the valuation of deferred tax assets and liabilities, the results of the examination of previously filed tax returns and continuing assessment of the Company's tax exposure.
Risks associated with conducting business in foreign countries.
We conduct a meaningful amount of business outside of the United States of America. We could be adversely affected by economic, legal, political and regulatory developments in countries that we conduct business in. We have meaningful operations in Canada in which the functional currency is denominated in Canadian dollars. We also have operations in Dubai, where the functional currency is dirham. As the value of currencies in foreign countries in which we have operations increases or decreases related to the U.S. dollar, the sales, expenses, profits, losses assets and liabilities of our foreign operations, as reported in our consolidated financial statements, increase or decrease, accordingly. Moreover, our international operations subject us to a variety of foreign laws and regulations, including without limitation, import and export requirements, the FCPA, U.S. and foreign tax laws, data privacy requirements, labor laws and anti-competition regulations. Our employees, contractors or agents may violate laws and
regulations despite our attempts to implement policies and procedures to comply with such laws and regulations. Any such violations could individually or in the aggregate materially adversely affect our financial condition or results of operations.
The trading price of our common stock may be volatile.
The market price of our common stock could be subject to wide fluctuations in response to, among other things, the risk factors described in this and other periodic reports, and other factors beyond our control, such as fluctuations in the valuation of companies perceived by investors to be comparable to us. Furthermore, the stock markets have experienced price and volume fluctuations that have affected and continue to affect the market prices of equity securities of many companies. These fluctuations often have been unrelated or disproportionate to the operating performance of those companies. These broad market and industry fluctuations, as well as general economic, political, and market conditions, such as recessions, interest rate changes or international currency fluctuations, may negatively affect the market price of our common stock. In the past, many companies that have experienced volatility in the market price of their stock have been subject to securities class action litigation. We may be the target of this type of litigation in the future. Securities litigation against us could result in substantial costs and divert our management's attention from other business concerns, which could adversely affect our business.
Our future results will be impacted by our ability to implement our internal growth strategy.
Our future results will depend in part on our success in implementing our internal growth strategy, which includes expanding our existing geographic areas, selling additional products to existing customers and adding new customers. Our ability to implement this strategy will depend on our success in selling more products and services to existing customers, acquiring new customers, hiring qualified sales persons, and marketing integrated forms of supply management such as those being pursued by us through our SmartSource SM program. We may not be successful in efforts to increase sales and product offerings to existing customers. Consolidation in our industry could heighten the impacts of competition on our business and results of operations discussed above. The fact that we do not traditionally enter into long-term contracts with our suppliers or customers may provide opportunities for our competitors.
We are subject to personal injury and product liability claims involving allegedly defective products.
A variety of products we distribute are used in potentially hazardous applications that can result in personal injury and product liability claims. A catastrophic occurrence at a location where the products we distribute are used may result in us being named as a defendant in lawsuits asserting potentially large claims and applicable law may render us liable for damages without regard to negligence or fault.
Risks associated with acquisition strategy.
Our future results will depend in part on our ability to successfully implement our acquisition strategy. We may not be able to consummate acquisitions at rates similar to the past, which could adversely impact our growth rate and stock price. This strategy includes taking advantage of a consolidation trend in the industry and effecting acquisitions of businesses with complementary or desirable product lines, strategic distribution locations, attractive customer bases or manufacturer relationships. Promising acquisitions are difficult to identify and complete for a number of reasons, including high valuations, competition among prospective buyers, the need for regulatory (including antitrust) approvals and the availability of affordable funding in the capital markets. In addition, competition for acquisitions in our business areas is significant and may result in higher purchase prices. Changes in accounting or regulatory requirements or instability in the credit markets could also adversely impact our ability to consummate acquisitions. In addition, acquisitions involve a number of special risks, including possible adverse effects on our operating results, diversion of management’s attention, failure to retain key personnel of the acquired business, difficulties in integrating operations, technologies, services and personnel of acquired companies, potential loss of customers of acquired companies, preserving business relationships of the acquired companies, risks associated with unanticipated events or liabilities, and expenses associated with obsolete inventory of an acquired business, some or all of which could have a material adverse effect on our business, financial condition and results of operations. Our ability to grow at or above our historic rates depends in part upon our ability to identify and successfully acquire and integrate companies and businesses at appropriate prices and realize anticipated cost savings.
Risks related to acquisition financing.
We may need to finance acquisitions by using shares of common stock for a portion or all of the consideration to be paid. In the event that the common stock does not maintain a sufficient market value, or potential acquisition candidates are otherwise unwilling to accept common stock as part of the consideration for the sale of their businesses, we may be required to use more of our cash resources, if available, to maintain our acquisition program. These cash resources may include borrowings under our existing credit agreements or equity or debt financings. Our current credit agreements with lenders contain certain restrictions that could adversely
affect our ability to implement and finance potential acquisitions. Such restrictions include provisions which limit our ability to merge or consolidate with, or acquire all or a substantial part of the properties or capital stock of, other entities without the prior written consent of the lenders. There can be no assurance that we will be able to obtain the lenders’ consent to any of our proposed acquisitions. If we do not have sufficient cash resources, our growth could be limited unless we are able to obtain additional capital through debt or equity financings.
Our failure to comply with financial covenants of our credit facilities may adversely affect our results of operations and our financial conditions.
Our credit facilities require the Company to comply with certain specified covenants, restrictions, financial ratios and other financial and operating tests. The Company’s ability to comply with any of the foregoing restrictions will depend on its future performance, which will be subject to prevailing economic conditions and other factors, including factors beyond the Company’s control. A failure to comply with any of these obligations could result in an event of default under the credit facilities, which could permit acceleration of the Company’s indebtedness under the credit facilities. The Company from time to time has been unable to comply with some of the financial covenants contained in previous credit facilities (relating to, among other things, the maintenance of prescribed financial ratios) and has, when necessary, obtained waivers or amendments to the covenants from its lenders. In the future the Company may not be able to comply with the covenants or, if is not able to do so, that its lenders will be willing to waive such non-compliance or amend such covenants.
We may not be able to refinance on favorable terms or may not refinance, extend or repay our debt, which could adversely affect our results of operations or may result in default of our debt.
We may not be able to refinance existing debt or the terms of any refinancing may not be as favorable as the terms of our existing debt. If principal payments due upon default or at maturity cannot be refinanced, extended or repaid with proceeds from other sources, such as new equity capital, our cash flow may not be sufficient to repay all maturing debt in years when significant payments come due. If such circumstance happens, our business, reputation, results of operations or financial condition could be adversely affected and our existing debt could be in default.
Goodwill and intangible assets recorded as a result of our acquisitions could become impaired.
Goodwill represents the difference between the purchase price of acquired companies and the related fair values of net assets acquired. We test goodwill for impairment annually and whenever events or changes in circumstances indicate that impairment may have occurred. Goodwill and intangibles represent a significant amount of our total assets. As of December 31, 2019, our combined goodwill and intangible assets amounted to $246.6 million, net of accumulated amortization. To the extent we do not generate sufficient cash flows to recover the net amount of any investments in goodwill and other intangible assets recorded, the investment could be considered impaired and subject to write-off which would directly impact earnings. We expect to record additional goodwill and other intangible assets as a result of future business acquisitions. Future amortization of such other intangible assets or impairments, if any, of goodwill or intangible assets would adversely affect our results of operations in any given period.
Interruptions in the proper functioning of our information systems could disrupt operations and cause increases in costs and/or decreases in revenues.
The proper functioning of DXP’s information systems is critical to the successful operation of our business. Our information systems are vulnerable to natural disasters, power losses, telecommunication failures and other problems despite the protection of our information systems through physical and software safeguards and remote processing capabilities. If critical information systems fail or are otherwise unavailable, DXP’s ability to procure products to sell, process and ship customer orders, identify business opportunities, maintain proper levels of inventories, collect accounts receivable and pay accounts payable and expenses could be adversely affected.
Risks associated with insurance.
In the ordinary course of business we at times may become the subject of various claims, lawsuits or administrative proceedings seeking damages or other remedies concerning our commercial operations, the products we distribute, employees and other matters, including potential claims by individuals alleging exposure to hazardous materials as a result of the products we distribute or our operations. Some of these claims may relate to the activities of businesses that we have acquired, even though these activities may have occurred prior to acquisition. The products we distribute, and/or manufacture, are subject to inherent risks that could result in personal injury, property damage, pollution, death or loss of production.
We maintain insurance to cover potential losses, and we are subject to various deductibles and caps under our insurance. It is possible, however, that judgments could be rendered against us in cases in which we would be uninsured and beyond the amounts that we currently have reserved or anticipate incurring for such matters. Even a partially uninsured claim, if successful and of significant size, could have a material adverse effect on our business, results of operations and financial condition. Furthermore, we may not be able to continue to obtain insurance on commercially reasonable terms in the future, and we may incur losses from interruption of our business that exceed our insurance coverage. In cases where we maintain insurance coverage, our insurers may raise various objections and exceptions to coverage which could make uncertain the timing and amount of any possible insurance recovery.
Risks associated with cyber-security.
Through our sales channels and electronic communications with customers generally, we collect and maintain confidential information that customers provide to us in order to purchase products or services. We also acquire and retain information about suppliers and employees in the normal course of business. Computer hackers may attempt to penetrate our information systems or our vendors' information systems and, if successful, misappropriate confidential customer, supplier, employee or other business information. In addition, one of our employees, contractors or other third party may attempt to circumvent security measures in order to obtain such information or inadvertently cause a breach involving such information. Loss of information could expose us to claims from customers, suppliers, financial institutions, regulators, payment card associations, employees and other persons, any of which could have an adverse effect on our financial condition and results of operations. We may not be able to adequately insure against cyber risks.
The nature of our manufactured products carries the possibility of significant product liability and warranty claims, which could harm our business and future results
Customers use some of our products, in particular manufactured pumps and pump packages, in potentially harmful and high-risk applications that may in some instances can cause personal injury or loss of life and/or damage to property, equipment or the environment. In addition, our products are integral to the production process for some end-users, and a failure of our products could result in a business interruption of their operations. Although we maintain quality controls and procedures, our products may not be completely free from defects and/or malfunction or failure. We maintain various levels and types of insurance coverage that we believe are adequate and commensurate with normal industry practice for a company of our risk profile, relative size, and we further limit our liability by contract wherever possible. However, as described earlier, insurance may not be available or adequate to cover all potential liability. We could be named as a defendant in product liability or other lawsuits asserting potentially large claims if an accident occurs at a location where our equipment is installed or services have been or are being used.
ITEM 1B.
ITEM 1B. Unresolved Staff Comments
None.
ITEM 2.
ITEM 2. Properties
We own seven of our facilities while the remainder of our facilities are leased. At December 31, 2019, we had approximately 155 facilities which contained 141 services centers, 4 distribution centers and 10 fabrication facilities.
At December 31, 2019, the Service Centers segment operated out of 141 service center facilities. Of these facilities, 112 were located in the U.S. in 35 states, 28 were located in nine Canadian provinces and one was located in Dubai. All of the distribution centers were located in the U.S., specifically in Texas, Montana and Nebraska. At December 31, 2019, the Innovative Pumping Solutions segment operated out of 10 fabrication facilities located in two states in the U.S. and two provinces in Canada. At December 31, 2019, the Supply Chain Services segment operated supply chain installations in 89 of our customers’ facilities in 26 U.S. states and one in Canada.
At December 31, 2019, our owned facilities ranged from 5,000 square feet to 45,000 square feet in size. We leased facilities for terms generally ranging from one to fifteen years. The leased facilities ranged from approximately 570 square feet to 105,000 square feet in size. The leases provide for periodic specified rental payments and certain leases are renewable at our option. We believe that our facilities are suitable and adequate for the needs of our existing business. We believe that if the leases for any of our facilities were not renewed, other suitable facilities could be leased with no material adverse effect on our business, financial condition or results of operations.
ITEM 3.
ITEM 3. Legal Proceedings
From time to time, the Company is a party to various legal proceedings arising in the ordinary course of business. While DXP is unable to predict the outcome of these lawsuits, it believes that the ultimate resolution will not have, either individually or in the aggregate, a material adverse effect on DXP’s business, consolidated financial position, cash flows, or results of operations.
ITEM 4.
ITEM 4. Mine Safety Disclosures
Not applicable.
PART II
ITEM 5.
ITEM 5. Market for the Registrant's Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities
Our common stock trades on The NASDAQ Global Select Market under the stock ticker symbol "DXPE".
On February 28, 2020, we had approximately registered 367 holders of record for outstanding shares of our common stock. This number does not include shareholders for whom shares are held in “nominee” or “street name”. We do not anticipate paying cash dividends on our common stock in the foreseeable future. The payment of any future dividends will be at the discretion of our Board of Directors and will depend upon, among other things, future earnings, the success of our business activities, regulatory and capital requirements, lenders, and general financial and business conditions.
Stock Performance
The following performance graph compares the performance of DXP’s common stock to the NASDAQ Industrial Index and a customized peer group of three companies that includes: NOW Inc., MRC Global Inc. and Applied Industrial Technologies Inc. The graph assumes that the value of the investment in DXP’s common stock and in each index was $100 at December 31, 2014 and that all dividends were reinvested.
Investors are cautioned against drawing conclusions from the data contained in the graph below as past results are not necessarily indicative of future performance.
Equity Compensation Table
The following table provides information regarding shares covered by the Company’s equity compensation plans as of December 31, 2019:
Unregistered Shares
DXP issued 30,305 unregistered shares of DXP’s common stock as part of the consideration for the January 1, 2018 acquisition of ASI. The unregistered shares were issued to the sellers of ASI.
We relied on Section 4(a)(2) of the Securities Exchange Act as a basis for exemption from registration. All issuances were as a result of private negotiation, and not pursuant to public solicitation. In addition, we believe the shares were issued to “accredited investors” as defined by Rule 501 of the Securities Act.
Repurchases of Common Stock
During 2019, 2018 and 2017 the Company withheld 7,760, 12,122 and 30,500 shares, respectively, to satisfy tax withholding obligations in connection with vesting of employee equity awards.
ITEM 6.
ITEM 6. Selected Financial Data
The selected historical consolidated financial data set forth below for each of the years in the five-year period ended December 31, 2019 has been derived from our audited Consolidated Financial Statements. This information should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the Consolidated Financial Statements and notes thereto included elsewhere in this Report.
(1)The impairment expense in 2015, reduced operating income by $68.7 million, increased the net loss by $58.4 million, and
increased basic and diluted loss per share by $4.05.
(2) See Note 13 - Earnings per Share Data of the Notes to Consolidated Financial Statements for the calculation of basic and
diluted earnings per share.
(1) Cash includes cash and cash equivalents plus restricted cash
(2) Net Working Capital equals current assets minus current liabilities excluding cash and short-term debt
ITEM 7.
ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
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's products are marketed in the United States, Canada and Dubai to customers that are engaged in a variety of industries, many of which may be countercyclical to each other. Demand for our products generally is subject to changes in the United States and 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 States and 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.
* The information contained in this table has been obtained from third party publicly available sources.
** Averages for the years indicated.
During 2017, the growth rate of the general economy improved from 2016 and the rig count increased, but remained significantly below 2014 peaks. The energy market for our products improved. Sales for the year ended December 31, 2017 increased $44.7 million, or 4.6%, to approximately $1.0 billion from $962.1 million for the prior corresponding period. Sales from a business sold in 2016 accounted for $22.7 million of 2016 sales. Excluding the 2016 sales of the sold business, on a same store sales basis, sales for 2017 increased by $67.4 million, or 7.2% from the prior corresponding period. This same store sales increase is the result of sales increases in our SC, IPS and SCS segments of $42.9 million, $16.9 million and $7.5 million respectively. The majority of the 2017 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 2018, the growth rate of the general economy improved from 2017 and the rig count increased, but remained significantly below 2014 peaks. The energy market for our products improved. Sales for the year ended December 31, 2018 increased $209.4 million, or 20.8%, to approximately $1.2 billion from $1.0 billion for the prior corresponding period. Sales from a business acquired in 2018 accounted for $47.5 million of 2018 sales. Excluding the 2018 sales of the business acquired, on a same store sales basis, sales for 2018 increased by $161.9 million, or 16.1% from the prior corresponding period. This same store sales increase is the result of sales increases in our IPS, SC and SCS segments of $87.6 million, $61.3 million and $13.0 million respectively. The majority of the 2018 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 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, 2019 increased $51.0 million, or 4.2%, to approximately $1.3 billion from $1.2 billion for 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.
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.
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 Results of Operations
Year Ended December 31, 2019 compared to Year Ended December 31, 2018
SALES. Sales for the year ended December 31, 2019 increased $51.0 million, or 4.2%, to approximately $1.3 billion from $1.2 billion for the year ended December 31, 2018. This sales increase is the result of an increase in our SCS, SC and IPS segments of $26.8 million, $12.2 million and $12.0 million, respectively. The fluctuations in sales is further explained in our business segment discussions below.
Service Centers Segment. Sales for the Service Centers segment increased by $12.2 million, or 1.6% for the year ended December 31, 2019, compared to the year ended December 31, 2018. This sales increase is primarily the result of increased sales of rotating equipment to customers engaged in the late upstream, midstream or downstream oil and gas markets or manufacturing equipment for these markets in connection with increased capital spending by oil and gas producers. If crude oil and natural gas prices and the drilling rig count remain at levels experienced during the year ended December 31, 2019, this level of sales to the oil and gas industry might continue, or improve, during 2020; however, signs of contraction have appeared in the oil and gas markets in early 2020.
Innovative Pumping Solutions Segment. Sales for the IPS segment increased by $12.0 million, or 4.1% for the year ended December 31, 2019, compared to the year ended December 31, 2018. This increase was primarily the result of an increase in the capital spending by oil and gas producers and related businesses stemming from an increase in U.S. crude oil production during the year ended December 31, 2019. This level of IPS sales might continue, or improve, during 2020 if crude oil and natural gas prices and the drilling rig count remain at levels experienced during 2019; however, signs of contraction have appeared in the oil and gas markets in early 2020.
Supply Chain Services Segment. Sales for the SCS segment increased by $26.8 million, or 15.4%, for the year ended December 31, 2019, compared to the year ended December 31, 2018. The improved sales are primarily related to increased sales to customers in the medical device, aerospace, oil and gas and food and beverage industries as a result of new locations.
GROSS PROFIT. Gross profit as a percentage of sales for the year ended December 31, 2019 increased by approximately 9 basis points from the prior year's corresponding period. The increase in the gross profit percentage is primarily the result of an approximate 95 basis points increase in the gross profit percentage in our IPS segment. These fluctuations are explained in the segment discussions below.
Service Centers Segment. As a percentage of sales, the gross profit percentage for the Service Centers increased approximately 3 basis points from the prior year's corresponding period. This was primarily as a result of sales mix and price increases from vendors. Operating income for the Service Centers segment increased $6.1 million, or 7.5%. The increase in operating income is primarily the result of the improved sales.
Innovative Pumping Solutions Segment. As a percentage of sales, 2019 gross profit percentage for the IPS segment increased approximately 95 basis points from the prior year's corresponding period primarily as a result of increased utilization and capacity within IPS' engineered-to-order business and an overall improvement in the pricing environment driven by an increase in capital spending by oil and gas producers. Additionally, gross profit margins for individual orders have continued to improve because of the increase in sales of built to order customer specific products. Operating income for the IPS segment decreased $5.0 million, or 14.9%, primarily as a result of an increase in SG&A expense due to increased payroll, incentive compensation and related taxes and 401(k) expenses mainly due to increased headcount offset by the above mentioned increase in sales.
Supply Chain Services Segment. Gross profit as a percentage of sales decreased approximately 40 basis points for the year ended December 31, 2019, compared to the prior year's corresponding period. This was primarily as a result of costs associated with new customer implementation. Operating income for the year ended December 31, 2019 decreased $1.8 million compared to the prior year's corresponding period mainly due to an increase in SG&A of $7.1 million as a result of increased payroll, incentive compensation and related taxes and 401(k) expenses mainly due to increased headcount partially offset by an increase in gross profit of $5.3 million.
SELLING, GENERAL AND ADMINISTRATIVE ("SG&A"). Selling, general and administrative expense for year ended December 31, 2019 increased by approximately $17.3 million, or 6.6%, to $281.1 million from $263.8 million for prior year's corresponding period. The overall increase in SG&A is primarily the result of increased payroll, incentive compensation and related taxes and 401(k) expenses. The remaining increase in SG&A expense for the year ended December 31, 2019 is primarily a result of the increase in sales. As a percentage of sales, the year ended December 31, 2019 expense increased 50 basis points to 22.2% from 21.7% for the prior year's corresponding period.
OPERATING INCOME. Operating income for the year ended December 31, 2019 decreased by $2.3 million, or 3.4%, to $66.1 million from $68.5 million in the prior year's corresponding period. This decrease in operating income is primarily related to the increase in SG&A discussed above.
INTEREST EXPENSE. Interest expense for year ended December 31, 2019 decreased by $1.4 million, or 6.9%, from prior year's corresponding period primarily as a result of third party fees of $0.9 million and $60 thousand of accelerated deferred debt issuance cost in connection with the Repricing Amendment in June 2018.
INCOME TAXES. Our effective tax rate from continuing operations was a tax expense of 23.2% for the year ended December 31, 2019 compared to a tax expense of 27.1% for the year ended December 31, 2018. 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 nondeductible expenses and partially offset by research and development tax credits and other tax credits. Compared to the U.S. statutory rate for the year ended December 31, 2018, the effective tax rate was increased by state taxes, foreign taxes, and nondeductible expenses and partially offset by research and development tax credits and other tax credits.
Year Ended December 31, 2018 compared to Year Ended December 31, 2017
SALES. Sales for the year ended December 31, 2018 increased $209.4 million, or 20.80%, to approximately $1.2 billion from $1.0 billion for the year ended December 31, 2017. Sales from a business acquired on January 1, 2018 accounted for $47.5 million of the increase in sales. Excluding the 2018 sales of the business acquired, sales for the year ended December 31, 2018 increased by $161.9 million, or 16.1% from prior year's corresponding period. This sales increase is the result of an increase in our SC, IPS and SCS segments of $108.8 million, $87.6 million and $13.0 million, respectively. The fluctuations in sales is further explained in our business segment discussions below.
Service Centers Segment. Sales for the Service Centers segment increased by $108.8 million, or 17.0% for the year ended December 31, 2018, compared to the year ended December 31, 2017. Excluding $47.5 million of Service Centers segment sales for year ended December 31, 2018 from a business acquired, Service Centers segment sales for the period increased $61.3 million, or 9.6% from prior year's corresponding period. This sales increase is primarily the result of increased sales of rotating equipment, bearings and metal working products to customers engaged in the late upstream, midstream or downstream oil and gas markets or manufacturing equipment for these markets in connections with increased capital spending by oil and gas producers. If crude oil and natural gas prices and the drilling rig count remain at levels experienced during the year ended December 31, 2018, this level of sales to the oil and gas industry might continue, or improve, during 2019.
Innovative Pumping Solutions Segment. Sales for the IPS segment increased by $87.7 million, or 43.0% for the year ended December 31, 2018, compared to the year ended December 31, 2017. This increase was primarily the result of an increase in capital
spending by oil and gas producers and related businesses stemming from an increase in the drilling rig count and the price of oil during the year ended December 31, 2018. This level of IPS sales might continue, or improve, during 2019 if crude oil and natural gas prices and the drilling rig count remain at levels experienced during 2018.
Supply Chain Services Segment. Sales for the SCS segment increased by $13.0 million, or 8.0%, for the year ended December 31, 2018, compared to the year ended December 31, 2017. The increase in sales is primarily related to increased sales to customers
in the oil and gas and aerospace industries. We suspect customers in the oilfield services and oilfield equipment manufacturing industries purchased more from DXP because of the increase in capital spending by oil and gas companies operating in the U.S.
GROSS PROFIT. Gross profit as a percentage of sales for the year ended December 31, 2018 increased by approximately 34 basis points from the prior year's corresponding period. Excluding the impact of business acquired, gross profit as a percentage of sales increased by approximately 77 basis points. The increase in the gross profit percentage excluding the business acquired, is primarily the result of an approximate 314 basis points increase in the gross profit percentage in our IPS segment. These fluctuations are explained in the segment discussions below.
Service Centers Segment. As a percentage of sales, the gross profit percentage for the Service Centers decreased approximately
24 basis points but increased approximately 61 basis points, adjusting for the business acquired, from the prior year's corresponding
period. This was primarily as a result of sales mix and price increases from vendors. Operating income for the Service Centers segment increased $17.5 million, or 27.6%. The increase in operating income is primarily the result of the improved sales.
Innovative Pumping Solutions Segment. As a percentage of sales, 2018 gross profit percentage for the IPS segment increased
approximately 314 basis points from the prior year's corresponding period primarily as a result of increased utilization and capacity
within IPS' engineered-to-order business and an overall improvement in the pricing environment driven by an increase in capital spending by oil and gas producers and a corresponding tightening in market conditions for IPS related work. Additionally, gross profit margins for individual orders have continued to improve because of the increase in sales of built to order customer specific products. Operating income for the IPS segment increased $22.5 million, or 197.1% , primarily as a result of the above mentioned increase in sales.
Supply Chain Services Segment. Gross profit as a percentage of sales decreased approximately 47 basis points for the year ended
December 31, 2018, compared to the prior year's corresponding period. This was primarily as a result of sales mix and contractual
lag effects of price increases from vendors. Operating income for the year ended December 31, 2018 increase $0.8 million compared
to the prior year's corresponding period mainly due to an increase in gross profit of $2.2 million primarily offset by an increase in SG&A of $1.5 million.
SELLING, GENERAL AND ADMINISTRATIVE. Selling, general and administrative expense for year ended December 31, 2018 increased by approximately $25.7 million, or 10.8%, to $263.8 million from $238.1 million for prior year's corresponding period. Selling, general and administrative expense from a business that was acquired accounted for $3.0 million of the increase. Excluding the 2018 expenses from the business acquired, SG&A for the year ended December 31, 2018 increased by $22.7 million, or 9.5%. The overall increase in SG&A adjusting for the business acquired is the result of increased payroll, incentive compensation and related taxes and 401(k) expenses primarily due to increased headcount. The remaining increase in SG&A expense for the year ended December 31, 2018 is primarily a result of the increase in sales. As a percentage of sales, the year ended December 31, 2018 expense decreased 134 basis points to 22.3% from 23.6% for the prior year's corresponding period, adjusting for the business acquired, primarily as a result of the percentage increase in sales exceeding the percentage increase in SG&A.
OPERATING INCOME. Operating income for the year ended December 31, 2018 increased by $35.0 million, or 104.4%, to$68.5 million from $33.5 million in the prior year's corresponding period. The operating income from the business acquired in 2018 increased the overall operating income for the year ended December 31, 2018 in the amount of $5.0 million. Excluding the
operating income from the business acquired, operating income increased $30.0 million, or 89.5% from the prior year'scorresponding period. This increase in operating income is primarily related to the increase in sales discussed above.
INTEREST EXPENSE. Interest expense for year ended December 31, 2018 increased by $3.9 million, or 22.8%, from prior year's corresponding period primarily as a result of increased interest rates and fees associated with the repricing of our credit facilities. Under our senior secured Term Loan B, DXP borrows at a spread over LIBOR. LIBOR increased 95 basis points from January through December 31, 2018. However, DXP repriced the Term Loan B on June 25, 2018 reducing the spread on LIBOR from 5.50% to 4.75%, reducing the impact of increases in LIBOR which DXP should benefit in fiscal 2019.
INCOME TAXES. Our effective tax rate from continuing operations was a tax expense of 27.1% for the year ended December 31,2018 compared to a tax expense of 2.2% for the year ended December 31, 2017. Compared to the U.S. statutory rate for the year ended December 31, 2018, the effective tax rate was increased by state taxes, foreign taxes, and nondeductible expenses and
partially offset by research and development tax credits and other tax credits. Compared to the U.S. statutory rate for the year ended December 31, 2017, the effective tax rate was increased by state taxes and nondeductible expenses. The effective tax rate decreased because of the remeasurement of our net deferred income tax liabilities, lower income tax rates on income earned in foreign jurisdictions, the change in valuation allowance recorded against deferred tax assets, the reduction of tax rates used to establish deferred tax liabilities related to intangibles for customer relationships acquired in Canada in 2012 and 2013, research and development tax credits and domestic production activity deduction.
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 measure is organic sales (Organic Sales) and earnings before interest, taxes, depreciation and amortization (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 and EBITDA) is 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.
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.
A reconciliation of the non-GAAP financial measures, to its most comparable GAAP financial measure is included below.
The following table set forth the reconciliation of net sales to organic net sales (in thousands):
Reconciliation of Net Sales to Organic Net Sales
Note : Table excludes fiscal year 2019. Fiscal 2019 is 100% organic.
We use EBITDA internally to evaluate and manage the Company's operations because we believe it provides useful supplemental information regarding the Company's ongoing economic performance. We have chosen to provide this information to investors to enable them to perform more meaningful comparisons of operating results.
The following table set forth the reconciliation of EBITDA to the most comparable GAAP financial measure (in thousands):
Liquidity and Capital Resources
General Overview
As of December 31, 2019, we had cash and cash equivalents of $54.3 million and bank and other borrowings of $237.9 million. We have a $85 million Asset-Based Loan facility that is due to mature in August 2022, under which we had no borrowings outstanding as of December 31, 2019.
Our primary source of capital is cash flow from operations, supplemented as necessary by bank borrowings or other sources of debt. As a distributor of MRO products and services, we require significant amounts of working capital to fund inventories and accounts receivables. Additional cash is required for capital items for information technology, warehouse equipment, leasehold improvements, pump manufacturing equipment and safety services equipment. We also require cash to pay our lease obligations and to 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):
Operating Activities
The Company generated $41.3 million of cash in operating activities during the year ended December 31, 2019 compared to generating of $35.8 million cash during the prior year's corresponding period. The $5.5 million increase in the amount of cash generated between the two periods was primarily driven by an increase in profitability that exceeded investments in working capital.
Investing Activities
For the year ended December 31, 2019, net cash used in investing activities was $22.1 million compared to $17.6 million in the corresponding period in 2018. This increase was primarily driven by purchases of property, plant and equipment of approximately $22.1 million compared to $9.3 million in the corresponding period in 2018. This increase was partially offset by the cash component of the purchase of ASI for $10.8 million partially offset by proceeds from the sale of a building for $2.6 million in 2018.
Capital expenditures during 2019 were primarily related to building improvements, manufacturing equipment, and patterns. The maintenance capital expenditures for 2020 are expected to be within the range of $5 million to $10 million.
Financing Activities
For the year ended December 31, 2019, net cash used in financing activities was $6.1 million, compared to net cash generated by financing activities of $2.9 million for the corresponding period in 2018. The activity in the period was primarily attributed to the Company making a payment for contingent consideration associated with the acquisition of ASI and higher principal repayments of debt in 2019.
During the year ended December 31, 2019, the amount available to be borrowed under our credit facility increased to $81.6 million compared to $79.3 million at December 31, 2018. This was the result of a reduction in letters of credit outstanding to $3.4 million at December 31, 2019, down from $5.7 million at December 31, 2018.
We believe this is adequate funding to support working capital needs within the business.
At December 31, 2019, our total long-term debt, including the current portion, less principal repayments and less unamortized debt issuance fees, was $237.9 million, or 40.8% of total capitalization (total long-term debt including current portion plus shareholders’ equity) of $582.9 million. Approximately $244.4 million of this outstanding debt bears interest at various floating rates. See Item 7A.
ITEM 7A. Quantitative and Qualitative Disclosures about Market Risk
Our market risk results primarily from volatility in interest rates and fluctuations in the Canadian dollar.
Interest Rate Risk
We are exposed to risk resulting from changes in interest rates as a result of our issuance of variable rate debt. To reduce our interest rate risk we may enter into financial derivative instruments, including, but not limited to, interest rate swaps and rate lock agreements to manage and mitigate our exposure. As of December 31, 2019, we had no interest rate hedges in place. Based on a sensitivity analysis as of December 31, 2019, it was estimated that if short-term interest rates average 100 basis points higher (lower) in 2019 than in 2018, interest expense, would fluctuate by $2.4 million before tax. Comparatively, based on a sensitivity analysis as of December 31, 2018, had short-term interest rates averaged 100 basis points higher (lower) in 2018 than in 2017, it was estimated that interest expense would have fluctuated by approximately $2.5 million. These amounts were estimated by considering the effect of the hypothetical interest rates on variable-rate debt outstanding each year.
Foreign Currency Risk
We are exposed to foreign currency risk from our Canadian operations. To mitigate risks associated with foreign currency fluctuations, contracts may be denominated in or indexed to the U.S. dollar and/or local inflation rates, or investments may be naturally hedged through debt and other liabilities denominated or issued in the foreign currency. To monitor our currency exchange rate risks, we use sensitivity analysis, which measures the effect of devaluation of the Canadian dollar. An average 10% devaluation in the Canadian dollar exchange rate during 2019 would have resulted in an estimated net loss on the translation of local currency earnings of approximately $0.4 million on our Consolidated Statement of Operations.
Also see “Risk Factors,” included in Item 1A of this Report for additional risk factors associated with our business.
ITEM 8.
ITEM 8. Financial Statements and Supplementary Data
Report of Independent Registered Public Accounting Firm
To the Shareholders and the Board of Directors of
DXP Enterprises, Inc.
Opinions on the Financial Statements and Internal Control over Financial Reporting
We have audited the accompanying consolidated balance sheets of DXP Enterprises, Inc. and subsidiaries (the “Company”) as of December 31, 2019 and 2018, the related consolidated statements of operations and comprehensive income, equity and cash flows for each of the three years in the period ended December 31, 2019, and the related notes (collectively referred to as the “consolidated financial statements”). We also have audited the Company’s internal control over financial reporting as of December 31, 2019, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of the Company as of December 31, 2019 and 2018, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2019, in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2019, based on criteria established in Internal Control - Integrated Framework (2013) issued by COSO.
Change in Accounting Principle
As discussed in Note 4 to the consolidated financial statements, the Company changed its method of accounting for leases in 2019 due to the adoption of Accounting Standards Codification Topic No. 842.
Basis for Opinions
The Company’s management is responsible for these consolidated financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management Report on Internal Control over Financial Reporting included in Item 9A. Our responsibility is to express an opinion on the Company’s consolidated financial statements and an opinion on the Company’s internal control over financial reporting based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (“PCAOB”) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud, and whether effective internal control over financial reporting was maintained in all material respects.
Our audits of the consolidated financial statements included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures to respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
Definition and Limitations of Internal Control Over Financial Reporting
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
/s/ Moss Adams LLP
Houston, Texas
March 13, 2020
We have served as the Company’s auditor since 2017.
DXP ENTERPRISES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)
(in thousands, except per share amounts)
The accompanying notes are an integral part of these consolidated financial statements.
DXP ENTERPRISES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in thousands, except share and per share amounts)
The accompanying notes are an integral part of these consolidated financial statements.
DXP ENTERPRISES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
DXP ENTERPRISES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF EQUITY
(in thousands, except share amounts)
The accompanying notes are an integral part of these consolidated financial statements.
DXP ENTERPRISES INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 - THE COMPANY
DXP Enterprises, Inc. together with its subsidiaries (collectively “DXP,” “Company,” “us,” “we,” or “our”) was incorporated in Texas on July 26, 1996. DXP Enterprises, Inc. and its subsidiaries are engaged in the business of distributing maintenance, repair and operating (MRO) products, and service to energy and industrial customers. Additionally, DXP provides integrated, custom pump skid packages, pump remanufacturing and manufactures branded private label pumps to energy and industrial customers. The Company is organized into three business segments: Service Centers (“SC”), Supply Chain Services (“SCS”) and Innovative Pumping Solutions (“IPS”). See Note 19 - Segment and Geographical Reporting for discussion of the business segments.
NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING AND BUSINESS POLICIES
Basis of Presentation
The Company’s financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (“US GAAP”). The accompanying consolidated financial statements include the accounts of the Company, its wholly owned subsidiaries and its variable interest entity (“VIE”).
DXP is the primary beneficiary of a VIE in which DXP owns 47.5% of the equity. DXP consolidates the financial statements of the VIE with the financial statements of DXP. As of December 31, 2019, the total assets of the VIE were approximately $4.6 million including approximately $4.0 million of fixed assets. DXP is the primary customer of the VIE. Consolidation of the VIE decreased cost of sales by approximately $0.4 million for the year ended December 31, 2019 and decreased cost of sales by approximately $0.7 million for the year ended December 31, 2018, respectively. The Company recognized a related income tax benefit of $83 thousand and $46 thousand related to the VIE for the years ended December 31, 2019 and December 31, 2018, respectively. As of December 31, 2019, the owners of the 52.5% of the equity not owned by DXP included employees of DXP.
All significant intercompany accounts and transactions have been eliminated in consolidation. Certain prior year amounts have been reclassified to conform to the current year presentation; none affected net income.
Foreign Currency
The financial statements of the Company’s Canadian subsidiaries are measured using local currencies as their functional currencies. Assets and liabilities are translated into U.S. dollars at current exchange rates, while income and expenses are translated at average exchange rates. Translation gains and losses are reported in other comprehensive income (loss). Gains and losses on transactions denominated in foreign currency are reported in the consolidated statements of operations and comprehensive income (loss).
Use of Estimates
The preparation of financial statements in conformity with US GAAP requires management to make estimates and assumptions in determining the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. In the opinion of management, all adjustments necessary in order to make the financial statements not misleading have been included. Actual results could differ from those estimates.
Cash and Cash Equivalents
The Company’s presentation of cash includes cash equivalents. Cash equivalents are defined as short-term investments with maturity dates of 90 days or less at time of purchase. The Company places its cash and cash equivalents with institutions with high credit quality. However, at certain times, such cash and cash equivalents may be in excess of Federal Deposit Insurance Corporation (“FDIC”) insurance limits. The Company has not historically experienced any losses when in excess of these limits.
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. 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. 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.
Changes in this allowance for 2019, 2018 and 2017 were as follows (in thousands):
(1) Uncollectible accounts written off, net of recoveries
(2) Includes allowance for doubtful accounts from acquisitions and divestiture
(3) Primarily due to translation adjustments
Inventories
Inventories consist principally of equipment purchased for resale or finished goods and are priced at net realizable value, cost being primarily determined using the weighted average cost method. Provisions are provided against inventories for estimated excess and obsolescence based upon the aging of the inventories and market trends and are applied as a reduction in cost of associated inventory.
Property and Equipment
Property and equipment are carried on the basis of cost. Depreciation of property and equipment is computed using the straight-line method over their estimated useful lives. Maintenance and repairs of depreciable assets are charged against earnings as incurred. When properties are retired or otherwise disposed of, the cost and accumulated depreciation are removed from the accounts and gains or losses are credited or charged to earnings.
The principal estimated useful lives used in determining depreciation are as follows:
Impairment of Goodwill and Other Intangible Assets
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.
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. Should the reporting unit's carrying amount exceed the fair value, then an impairment charge for the excess would be recognized. The impairment charge is limited to the amount of goodwill allocated to the reporting unit, and goodwill will not be reduced below zero.
Impairment of Long-Lived Assets, Excluding Goodwill
The Company tests long-lived assets or asset groups for recoverability when events or changes in circumstances indicate that their carrying amount may not be recoverable. Circumstances which could trigger a review include, but are not limited to: significant decreases in the market price of the asset; significant adverse changes in the business climate or legal factors; accumulation of costs significantly in excess of the amount originally expected for the acquisition or construction of the asset; current period cash flow or operating losses combined with a history of losses or a forecast of continuing losses associated with the use of the asset; and current expectation that the asset will more likely than not be sold or disposed significantly before the end of its estimated useful life. Recoverability is assessed based on the carrying amount of the asset and its fair value which is generally determined based on the sum of the undiscounted cash flows expected to result from the use and the eventual disposal of the asset, as well as specific appraisal in certain instances. An impairment loss is recognized when the carrying amount is not recoverable and exceeds fair value. No impairment of long-lived assets excluding goodwill, was required in 2019, 2018 and 2017.
Revenue Recognition
The Company fabricates and assembles custom-made pump packages, remanufactures pumps and manufactures branded private label pumps within our Innovative Pumping Solutions segment. For binding agreements to fabricate tangible assets to customer specifications, the Company recognizes revenues over time when the customer is able to direct the use of and obtain substantially all of the benefits of the work performed. This typically occurs when the products have no alternative use for us and we have a right to payment for the work completed to date plus a reasonable profit margin. Contracts generally include cancellation provisions that require the customer to reimburse us for costs incurred through the date of cancellation. We recognize revenue for these contracts using the percentage of completion method, an "input method" as defined by the new standard. Under this method, revenues are recognized as costs are incurred and include estimated profits calculated on the basis of the relationship between costs incurred and total estimated costs at completion. If at any time expected costs exceed the value of the contract, the loss is recognized immediately. The typical time span of these contracts is approximately one to two years.
The Service Centers segment provides a wide range of maintenance, repair and operating (MRO) products, equipment and integrated services, including logistics capabilities, to industrial customers. The Supply Chain Services segment provides a wide range of MRO products and manages all or part of a customer's supply chain, including warehouse and inventory management services. Revenue is recognized upon the completion of our performance obligation(s) under the sales agreement. The majority of the Service Centers and Supply Chain Services segment revenues originate from the satisfaction of a single performance obligation, the delivery of products. Revenues are recognized when an agreement is in place, the performance obligations under the contract have been identified, and the price or consideration to be received is fixed and allocated to the performance obligation(s) in the contract. We believe our performance obligation has been satisfied when title passes to the customer or services have been rendered under the contract. Revenues are recorded net of sales taxes.
The Company reserves for potential customer returns based upon the historical level of returns.
Shipping and Handling Costs
The Company classifies shipping and handling charges billed to customers as sales. Shipping and handling charges paid to others are classified as a component of cost of sales.
Self-insured Insurance and Medical Claims
We generally retain up to $100,000 of risk for each claim for workers compensation, general liability, automobile and property loss. We accrue for the estimated loss on the self-insured portion of these claims. The accrual is adjusted quarterly based upon reported claims information. The actual cost could deviate from the recorded estimate.
We generally retain up to $175,000 of risk on each medical claim for our employees and their dependents with the exception of less than 0.05% of employees where a higher risk is retained. We accrue for the estimated outstanding balance of unpaid medical claims for our employees and their dependents. The accrual is adjusted monthly based on recent claims experience. The actual claims could deviate from recent claims experience and be materially different from the reserve.
The accrual for these claims at December 31, 2019 and 2018 was approximately $2.5 million and $2.3 million, respectively.
Cost of Sales and Selling, General and Administrative Expense
Cost of sales includes product and product related costs, inbound freight charges, internal transfer costs and depreciation. Selling, general and administrative expense includes purchasing and receiving costs, inspection costs, warehousing costs, depreciation and amortization.
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. Valuation allowances are established to reduce deferred income tax assets to the amounts expected to be realized under a more likely than not criterion.
Accounting for Uncertainty in Income Taxes
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. 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 2013. 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.
Comprehensive Income (Loss)
Comprehensive income (loss) includes net income and foreign currency translation adjustments. The Company’s other comprehensive (loss) income is comprised of changes in the market value of an investment with quoted market prices in an active market for identical instruments and translation adjustments from translating foreign subsidiaries to the reporting currency.
Out-of-Period Items
Deferred tax liabilities related to intangibles for customer relationships acquired in Canada during 2012 and 2013 were reduced by $2.2 million during the fourth quarter of 2017 to correct the tax rate used to establish the deferred tax liabilities at the dates of acquisition. The Company evaluated the misstatement of each period since these acquisitions were completed and concluded the effects were immaterial.
NOTE 3 - RECENT ACCOUNTING PRONOUNCEMENTS
Recently Adopted Accounting Pronouncements
Leases. In February 2016, the Financial Accounting Standards Board's ("FASB") issued Accounting Standards Update ("ASU") No. 2016-02, Leases (Topic 842) as modified by subsequently issued ASUs 2018-01, 2018-10, 2018-11 and 2018-20. The Company adopted the standard effective January 1, 2019. We have elected to apply the current period transition approach as introduced by ASU 2018-11 for our transition at January 1, 2019 and we have elected to apply several of the practical expedients in conjunction with accounting policy elections. See Note 4 - Leases for further discussion.
Accounting Pronouncements Not Yet Adopted
Intangibles-Goodwill and Other. In August 2018, the FASB issued ASU No. 2018-15, Internal-Use Software (Subtopic 350-40): Customer’s Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract based on a consensus of the FASB’s Emerging Issues Task Force (EITF) that requires implementation costs incurred by customers in cloud computing arrangements (CCAs) to be deferred and recognized over the term of the arrangement, if those costs would be capitalized by the customer in a software licensing arrangement under the internal-use software guidance in ASC 350-40, “Intangibles-Goodwill and Other-Internal-Use Software”. The ASU does not affect the accounting by cloud service providers, other software vendors or customers’ accounting for software licensing arrangements. The ASU will require companies to recognize deferred implementation costs to expense over the ‘term of the hosting arrangement’. Under the ASU, the term of the hosting
arrangement comprises the non-cancellable period of the CCA plus any optional renewal periods that are reasonably certain to be exercised by the customer or for which exercise of the option is controlled by the vendor. The guidance is effective for fiscal years beginning after December 15, 2019, and interim periods within those fiscal years. We will adopt the new standard beginning January 1, 2020. We do not anticipate that the new standard will have a material impact on our results of operations.
Fair Value Measurement. In August 2018, the FASB issued ASU 2018-13: Fair Value Measurement: Disclosure Framework-Changes to the Disclosure Requirements for Fair Value Measurement which eliminates, adds and modifies certain disclosure requirements for fair value measurements as part of its disclosure framework project. Entities will no longer be required to disclose the amount of and reasons for transfers between Level 1 and Level 2 of the fair value hierarchy, but public companies will be required to disclose the range and weighted average used to develop significant unobservable inputs for Level 3 fair value measurements. The guidance is effective for all entities for fiscal years beginning after December 15, 2019 and for interim periods within those fiscal years, but entities are permitted to early adopt either the entire standard or only the provisions that eliminate or modify the disclosure requirements. The new standard will not have an impact on our results of operations, but it will significantly modify our disclosures around fair value measurements.
Financial Instruments - Credit Losses. In June 2016, the FASB issued ASU 2016-13: Financial Instruments - Credit Losses, which replaces the incurred loss impairment methodology in current US GAAP with a methodology that reflects expected credit losses ("CECL"). The update is intended to provide financial statement users with more useful information about expected credit losses.
We do not currently hold most of the financial instruments contemplated by the new standard, with the exception of trade receivables and contract assets associated with custom built pump packages. CECL will become the single model to measure impairment on financial assets measured at amortized cost, which include trade receivables and contract assets under ASC 606. Therefore, consistent with other types of financial assets measured at amortized cost, estimates of expected credit losses on trade receivables and contract assets over their contractual life will be required to be recorded at inception, based on historical information, current conditions, and reasonable and supportable forecasts.
Currently, our reserve methodology for trade receivables is based on matrices in which historical loss percentages are applied to respective aging categories. CECL will require us to use a forward-looking methodology that incorporates lifetime expected credit losses. While our current reserving matrices may still be used under CECL, historical loss data will need to be combined with reasonable and supportable forecasts of future losses to determine estimated credit losses. The most visible impact of CECL will therefore be that receivables and contract assets that are either current or not yet due, which today do not generally have a reserve, will have an allowance for expected credit losses.
The CECL model does not prescribe a specific methodology for developing a reasonable and supportable forecast, nor the duration of the period that losses can be forecast, nor the precision required to support the estimate. As a result, the determination of the reasonable and supportable forecast period is a judgment to be made in estimating the overall expected credit loss. Although the CECL model requires entities to perform this new evaluation for trade receivables and contract assets, we generally do not expect to see a significant change in the impairment losses recognized on our trade receivables or contract assets given their short-term nature. We will adopt the standard on January 1, 2020, with a cumulative-effect adjustment to retained earnings. Based upon our current assessment, the adjustment will be less than $3 million to our allowance for doubtful accounts and the company does not expect the adoption of the standard to have a material impact on the consolidated statement of operations and cash flows.
NOTE 4 - LEASES
In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842) which was modified by subsequently issued ASUs 2018-01, 2018-10, 2018-11 and 2018-20. The update requires organizations that lease assets ("lessees") to recognize the assets and liabilities of the rights and obligations created by leases with terms of more than 12 months. The recognition, measurement and presentation of expenses and cash flows arising from a lease by a lessee remains dependent on its classification as a finance or operating lease. The criteria for determining whether a lease is a finance or operating lease was not significantly changed by this ASU. The ASU also requires additional disclosure of the amount, timing, and uncertainty of cash flows arising from leases, including qualitative and quantitative requirements. This pronouncement was effective for financial statements issued for annual periods beginning after December 15, 2018, including interim periods within those fiscal years. Early adoption was permitted.
In July 2018, the FASB issued ASU No. 2018-11, Leases: Targeted Improvements (Topic 842). ASU 2018-11 provided additional relief in the comparative reporting requirements for initial adoption of ASC 842. Prior to ASU 2018-11, a modified retrospective transition was required for financing or operating leases existing at or entered into after the beginning of the earliest comparative period presented in the financial statements. ASU 2018-11 provided an additional transition method to the existing transition method by allowing entities to initially apply the new leases standard at the adoption date (such as January 1, 2019, for calendar
year-end public business entities) and recognize a cumulative-effect adjustment to the opening balance of retained earnings in the period of adoption without adjustment to the financial statements for periods prior to adoption.
The Company adopted the standard effective January 1, 2019. We elected to apply the current period transition approach as introduced by ASU 2018-11 for our transition at January 1, 2019 and we elected to apply the following practical expedients and accounting policy decisions.
We elected a package of transition expedients that allowed us to forgo reassessing certain conclusions reached under ASC 840 which must be elected together. All expedients in this package were applied together for all leases that commenced before the effective date, January 1, 2019, of ASC 842. As a result, in transitioning to ASC 842, for existing leases as of 1/1/2019, we continued to use judgments made under ASC 840 related to embedded leases, lease classification and accounting for initial direct costs. We generally have four classes of leased assets : Real Estate related properties (such as office space, warehouses, distribution centers and land), Automobiles, Office Equipment and Manufacturing Equipment and do not utilize finance leases.
In addition, we have chosen, as an accounting policy election by class of underlying asset, not to separate nonlease components from the associated lease for all of our leased asset classes, except for Real Estate related leases. As a result, for classes of Automobiles, Office Equipment and Manufacturing Equipment, we account for each separate lease component and the nonlease components associated with that lease as a single lease component.
For short-term leases as defined under ASC 842, we elected the short-term lease exception pursuant to ASC 842 to all classes of our leased assets. We do not recognize a lease liability or a right of use asset on our consolidated balance sheets for our leased assets with an original lease term of twelve months or less. Instead, we recognize the lease payments in profit or loss on a straight-line basis over the lease term and variable lease payments in the period in which the obligation for those payments is incurred and disclose in the notes to the consolidated financial statements our short-term lease expense.
The new standard did have a material impact on our consolidated balance sheets related to recording right-of-use (ROU) assets and the corresponding lease liabilities for our inventory of operating leases. In January 2019, we recorded a ROU Asset and total lease liability obligations of $72.7 million and $72.4 million, respectively. The new standard did not have a material impact on our consolidated statements of operations and had no impact on cash flows.
We lease office space, warehouses, land, automobiles, and office and manufacturing equipment. All of our leases are classified as operating leases.
Our leases have remaining lease terms of 1 month to 11 years, some of which include options to extend the leases for up to 14 years. The exercise of lease renewal options is at our sole discretion. Our lease agreements do not include options to purchase the leased property.
The lease expenses were as follows (in thousands):
Supplemental cash flow information related to leases was as follows (in thousands):
Supplemental balance sheet information related to leases was as follows (in thousand):
Note: As most of our leases do not provide an implicit rate, we use our incremental borrowing rate based on the information available at the commencement date in determining the present value of lease payments for lease commenced on or after January 1, 2019. We used our incremental borrowing rate as of the transition date of January 1, 2019 for operating leases that commenced prior to transition.
Maturities of lease liabilities were as follows (in thousands):
(*) Operating lease payments exclude $1.1 million of legally binding minimum lease payments for leases signed but not yet commenced.
Contractual obligations related to operating leases as of December 31, 2018, under ASC 840 (in thousands):
For the twelve months ended December 31, 2019, the Company paid approximately $2.2 million in lease expenses to entities controlled by the Company's Chief Executive Officer, David Little and family.
NOTE 5 - FAIR VALUE OF FINANCIAL ASSETS AND LIABILITIES
Authoritative guidance for financial assets and liabilities measured on a recurring basis applies to all financial assets and financial liabilities that are being measured and reported on a fair value basis. Fair value, as defined in the authoritative guidance, is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The authoritative guidance affects the fair value measurement of an investment with quoted market prices in an active market for identical instruments, which must be classified in one of the following categories:
Level 1 Inputs
Level 1 inputs come from quoted prices (unadjusted) in active markets for identical assets or liabilities.
Level 2 Inputs
Level 2 inputs are other than quoted prices that are observable for an asset or liability. These inputs include: quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; inputs other than quoted prices that are observable for the asset or liability; and inputs that are derived principally from, or corroborated by, observable market data by correlation or other means.
Level 3 Inputs
Level 3 inputs are unobservable inputs for the asset or liability which require the Company's own assumptions.
Financial assets and liabilities are classified based on the lowest level of input that is significant to the fair value measurement. Our assessment of the significance of a particular input to the fair value measurement requires judgment and may affect the valuation of the fair value of assets and liabilities and their placement within the fair value hierarchy levels.
Our acquisitions may include contingent consideration as part of the purchase price. The fair value of the contingent consideration is estimated as of the acquisition date based on the present value of the contingent payments to be made using a weighted probability of possible payments. The unobservable inputs used in the determination of the fair value of the contingent consideration include managements assumptions about the likelihood of payment based on the established benchmarks and discount rates based on an internal rate of return analysis. The fair value measurement includes inputs that are Level 3 inputs as discussed above, as they are not observable in the market. Should actual results increase or decrease as compared to the assumptions used in our analysis, the fair value of the contingent consideration obligations will increase or decrease, up to the contracted limit, as applicable. Changes in the fair value of the contingent earn-out consideration are measured each reporting period and reflected in our results of operations.
As of December 31, 2019, we recorded a $2.7 million liability for contingent consideration associated with the acquisition of ASI in other current and long-term liabilities. See further discussion at Note 15 - Business Acquisitions. For the Company's assets and liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3), the following table provides a reconciliation of the beginning and ending balances for each category therein, and gains or losses recognized during the twelve months ended December 31, 2019:
Quantitative Information about Level 3 Fair Value Measurements
The significant unobservable inputs used in the fair value measurement of the Company's contingent consideration liabilities designated as Level 3 are as follows:
Sensitivity to Changes in Significant Unobservable Inputs
As presented in the table above, the significant unobservable inputs used in the fair value measurement of contingent consideration related to the acquisition of ASI are annualized EBITDA forecasts developed by the Company's management and the probability of achievement of those EBITDA results. The discount rate used in the calculation was 7.5%. Significant increases (decreases) in these unobservable inputs in isolation would result in a significantly (lower) higher fair value measurement.
Other financial instruments not measured at fair value on the Company's consolidated balance sheets at December 31, 2019 but which require disclosure of their fair values include: cash and cash equivalents, trade accounts receivable, trade accounts payable and accrued expenses, accrued payroll and related benefits, and the revolving line of credit and term loan debt under our syndicated credit agreement facility (Note 10). The Company believes that the estimated fair value of such instruments at December 31, 2019 and December 31, 2018 approximates their carrying value as reported on the consolidated balance sheets.
NOTE 6 - INVENTORIES
The carrying values of inventories were as follows (in thousands):
NOTE 7 - COSTS AND ESTIMATED PROFITS ON UNCOMPLETED CONTRACTS
Under our customized pump production contracts in our IPS segment, amounts are billed as work progresses in accordance with agreed-upon contractual terms, upon various measures of performance, including achievement of certain milestones, completion of specified units, or completion of a contract. Generally, billing occurs subsequent to revenue recognition, resulting in contract assets. Our contract assets are presented as “Cost and estimated profits in excess of billings” on our Consolidated Balance Sheets. However, we sometimes receive advances or deposits from our customers before revenue is recognized, resulting in contract liabilities that are presented as “Billings in excess of costs and estimated profits” on our Consolidated Balance Sheets.
Costs and estimated profits on uncompleted contracts and related amounts billed for 2019 and 2018 were as follows (in thousands):
Such amounts were included in the accompanying Consolidated Balance Sheets for 2019 and 2018 under the following captions (in thousands):
During the twelve months ended December 31, 2019, $10.5 million of the balances that were previously classified as contract liabilities at the beginning of the period shipped. Contract assets and liability changes were primarily due to normal activity and timing differences between our performance and customer payments.
NOTE 8 - PROPERTY AND EQUIPMENT
The carrying values of property and equipment were as follows (in thousands):
Depreciation expense was $10.1 million, $9.6 million, and $10.5 million for the years ended December 31, 2019, 2018, and 2017, respectively. Capital expenditures by segment are included in Note 19 - Segment and Geographical Reporting.
NOTE 9 - GOODWILL AND OTHER INTANGIBLE ASSETS
The following table presents the changes in the carrying amount of goodwill and other intangible assets during the year ended December 31, 2019 (in thousands):
The following table presents the changes in the carrying amount of goodwill and other intangible assets during the year ended December 31, 2018 (in thousands):
The following table presents the goodwill balance by reportable segment as of December 31, 2019 and 2018 (in thousands):
The following table presents a summary of amortization of other intangible assets ( in thousands):
Gross carrying amounts as well as accumulated amortization are partially affected by the fluctuation of foreign currency rates. Other intangible assets are amortized according to estimated economic benefits over their estimated useful lives.
Customer relationships are amortized over their estimated useful lives. Amortization expense is recognized according to estimated economic benefits and was $15.1 million, $16.6 million, and $17.3 million for the years ended December 31, 2019, 2018, and 2017, respectively. The estimated future annual amortization of intangible assets for each of the next five years and thereafter are as follows (in thousands):
The weighted average remaining estimated life for customer relationships and non-compete agreements are 7.33 and 2.58, respectively.
NOTE 10 - LONG-TERM DEBT
Long-term debt consisted of the following (in thousands):
(1) Carrying value amount do not include unamortized debt issuance costs of $6.5 million and $8.3 million for year ended December 31, 2019 and December 31, 2018 respectively.
(2) Note payable in monthly installments at 2.9% through January 2021, collateralized by equipment. In August 2019, the Company
made a cash payment of $1.3 million to repay the remaining balance of the outstanding promissory note payable.
August 2017 Credit Agreements
On August 29, 2017, the Company entered into two credit agreements (the "August 2017 Credit Agreements") that provided for an $85.0 million asset-backed revolving line of credit (the "ABL Revolver") and a $250.0 million senior secured term loan B (the "Term Loan B"). Under the ABL Revolver, the Company may request $10.0 million incremental revolving loan commitments in an additional aggregate amount not to exceed $50.0 million, subject to pro forma compliance with certain net secured leverage ratio tests.
The applicable rate for the ABL Revolver is LIBOR plus a margin ranging from 1.25% to 1.75% per annum. The applicable rate for the Term Loan B was LIBOR plus 5.50% subject to a LIBOR floor of 1.00%. The maturity date of the ABL Revolver is August 29, 2022 and the maturity date of the Term Loan B is August 29, 2023.
On June 25, 2018, the Company entered into Amendment No. 1 (the "Repricing Amendment") to the Senior Secured Term Loan B Agreement. The Repricing Amendment, among other things, reduced the applicable rate for the term loans to LIBOR plus 4.75% (subject to a LIBOR floor of 1.00%) from LIBOR plus 5.50% for the Eurodollar Rate Loans and reduced the base rate plus a margin of 3.75% for the Base Rate Loans from 4.50%. The Repricing Amendment also included a "soft call" prepayment penalty of 1.0% for a period of six months commencing with the date of the Repricing Amendment for certain prepayments, refinancing, and amendments.
The Company accounted for the Repricing Amendment as a modification of debt. Approximately, $60,000 of prior deferred debt issuance costs were accelerated and recorded as additional interest expense in the consolidated statements of operations and comprehensive income, attributable to prior syndicate lenders who reduced or eliminated their positions during the amendment process. The Company also incurred $0.9 million of third party fees in connection with the Repricing Amendment, which was also recorded as additional interest expense in the consolidated statements of operations and comprehensive income.
As of December 31, 2019, the Company had no amount outstanding under the ABL Revolver and had $81.6 million of borrowing capacity, including the impact of letters of credit.
Debt Issuance Cost Amortization
Fees paid to DXP’s lenders to secure a firm commitment on our term loan and revolving line of credit are presented as a direct deduction from the carrying amount of the debt liability. For the term loan, fees paid by DXP are amortized over the life of the loan as additional interest. Fees paid to secure a firm commitment from our lender on our revolving line of credit are amortized over the term of the arrangement. The total unamortized debt issuance costs reported on the consolidated balance sheets as of December 31, 2019 and 2018 was $6.5 million and $8.3 million, respectively. In connection with the repricing amendment of the Term Loan B and extinguishment of the previously existing credit facility we recorded a $0.1 million and $0.6 million write-off of debt issuance costs, which was included in interest expense during 2018 and 2017.
Interest on Borrowings
The interest rates on our borrowings outstanding at December 31, 2019 and 2018, including the amortization of debt issuance costs, were as follows:
The Company was in compliance with all financial covenants under the August 2017 Credit Agreements as of December 31, 2019.
NOTE 11 - INCOME TAXES
The components of income before income taxes were as follows (in thousands):
The provision for income taxes consisted of the following (in thousands):
The difference between income taxes computed at the statutory income tax rate and the provision for income taxes is as follows (in thousands):
On December 22, 2017, the Tax Cuts and Jobs Act (“The Act”) was enacted into law. The majority of the provisions signed into law in 2017 did not take effect until January 1, 2018. The Act is a comprehensive tax reform legislation that contains significant changes to corporate taxation, of which the reduction in the corporate tax rate from 35.0% to 21.0% and the imposition of Global Intangible Low - Taxable Income ("GILTI") had the most impact to the Company. The Company analyzed other provisions of The Act such as limitation on business interest expense, limitation on net operating losses to 80% of taxable income each year, limitation on officer compensation, mandatory repatriation and transition tax, Base Erosion & Anti-Abuse Tax ("BEAT"), and Foreign-Derived Intangible Income Deduction ("FDII") and determined these provisions to have minimal to no impact on the Company.
In accordance with Staff Accounting Bulletin No. 18 (SAB 118) issued by the Securities and Exchange Commission on December 22, 2017, companies are allowed a one year measurement period to complete the accounting related to The Act. Specifically, SAB 118 permits companies to record a provisional amount which can be remeasured during the measurement period due to obtaining, preparing, or analyzing additional information about facts and circumstances that existed as of the enacted date. As a result, we remeasured our net deferred income tax liabilities by a provisional $1.3 million benefit and a corresponding provisional decrease in the net deferred tax liability as of December 31, 2017. The net deferred tax liability remeasurement analysis was completed as of December 31, 2018, impacting the Company's provision for income taxes less than $0.1 million.
As of December 31, 2018, the Company has completed its accounting for the income tax effects of The Act. The Act subjects a U.S. shareholder to current tax on GILTI earned by certain foreign subsidiaries. Pursuant to FASB Staff Q&A, Topic 740, No. 5 Accounting for Global Intangible Low-Taxed Income, the Company has adopted an accounting policy to recognize the tax effects of GILTI in the year tax is incurred. The Company recorded a GILTI inclusion of $2.3 million, which is partially offset with GILTI foreign tax credits, resulting in a net liability of $0.1 million as of December 31, 2018.
For the year ended December 31, 2019, the effective tax rate was impacted by state taxes, foreign taxes, nondeductible expenses, research and development tax credits, and foreign tax credits.
Deferred tax liabilities and assets were comprised of the following (in thousands):
The Company records a valuation allowance when it is more-likely-than-not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of the deferred tax assets depends on the ability to generate sufficient taxable income of the appropriate character in the future and in the appropriate taxing jurisdictions. If the Company was to determine that it would be able to realize the deferred tax assets in the future in excess of their net recorded amount, the Company would make an adjustment to the valuation allowance, which would reduce the provision for income taxes. At December 31, 2019, the Company had $51.1 million of capital loss carryforward, which will expire in 2021. The Company has recorded a valuation allowance for all of this carryforward amount. The valuation allowance represents a provision for uncertainty as to the realization of the tax benefits of these carryforwards.
To the extent penalties and interest would be assessed on any underpayment of income tax, such accrued amounts are classified as a component of income tax provision (benefit) in the consolidated financial statements consistent with the Company’s policy. For the year ended December 31, 2019, the Company recorded $0.7 million tax expense for interest and penalties related to uncertain tax positions.
The Company is subject to taxation in the United States, various states, and foreign jurisdictions. The Company has significant operations in the United States and Canada and to a lesser extent in various other international jurisdictions. Tax years that remain subject to examination vary by legal entity but are generally open in the United States for the tax years ending after 2012 and outside the United States for the tax years ending after 2011.
NOTE 12 - SHARE-BASED COMPENSATION
Restricted Stock
We issued equity-based awards from the 2016 Omnibus Plan.
2016 Omnibus Incentive Plan
On June 19, 2019, our shareholders approved an amendment to the DXP Enterprises, Inc. 2016 Omnibus Incentive Plan (the “2016 Plan”) to increase the number of shares that can be issued under the 2016 Plan from 500,000 shares to a total of 1,000,000 shares, which represents an increase of 500,000 shares (the “Amendment”), which authorized grants of restricted stock awards, restricted stock units (“RSUs”), performance awards, options, investment rights, and cash-based awards. This plan authorizes the issuance of up to 1,000,000 shares of our common stock.
Under the 2016 Omnibus Plan approved by our shareholders, directors, consultants and employees may be awarded shares of DXP’s common stock. The shares of restricted stock awards granted to employees that are outstanding as of December 31, 2019 vest in accordance with one of the following vesting schedules: 100% one year after the grant date; 50% each year for two years after the grant; 33.3% each year for three years after the grant date; 20% each year for five years after the grant date; or 10% each year for ten years after the date of grant. The shares of restricted stock awards granted to non-employee directors of DXP vest one year after the grant date. The fair value of restricted stock awards is measured based upon the closing prices of DXP’s common stock on the grant dates and is recognized as compensation expense over the vesting period of the awards. Once restricted stock vests, new shares of the Company’s stock are issued. At December 31, 2019, 697,797 shares were available for future grant.
Changes in restricted stock awards for the twelve months ended December 31, 2019 were as follows:
Changes in restricted stock awards for the twelve months ended December 31, 2018 were as follows:
Changes in restricted stock awards for the twelve months ended December 31, 2017 were as follows:
Compensation expense, associated with restricted stock awards, recognized in the years ended December 31, 2019, December 31, 2018 and December 31, 2017 was $2.0 million, $2.1 million, and $1.7 million, respectively. Related income tax benefits recognized
in earnings in the years ended December 31, 2019, December 31, 2018 and December 31, 2017 were approximately $0.5 million, $0.5 million and $0.7 million, respectively. Unrecognized compensation expense under the DXP Enterprises, Inc. 2016 Omnibus Plan at December 31, 2019, December 31, 2018 and December 31, 2017 was $3.0 million, $3.6 million and $1.6 million, respectively. As of December 31, 2019, the weighted average period over which the unrecognized compensation expense is expected to be recognized is 22.7 months.
NOTE 13 - EARNINGS PER SHARE DATA
Basic earnings per share is computed based on weighted average shares outstanding and excludes dilutive securities. Diluted earnings per share is computed including the impacts of all potentially dilutive securities.
The following table sets forth the computation of basic and diluted earnings per share for the periods indicated (in thousands, except per share data):
Basic earnings per share have been computed by dividing net earnings by the weighted average number of common shares outstanding during the period and excludes dilutive securities. Diluted earnings per share reflects the potential dilution that could occur if the preferred stock was converted into common stock. Restricted stock is considered a participating security and is included in the computation of basic earnings per share as if vested.The preferred stock is convertible into 840,000 shares of common stock.
NOTE 14 - CAPITAL STOCK
The Company has Series A and Series B preferred stock of 1,122 shares and 15,000 shares outstanding as of December 31, 2019, 2018 and 2017, respectively. The preferred stock did not have any activity during 2019, 2018 and 2017.
Series A Preferred Stock
The holders of Series A preferred stock are entitled to one-tenth of a vote per share on all matters presented to a vote of shareholders generally, voting as a class with the holders of common stock, and are not entitled to any dividends or distributions other than in the event of a liquidation of the Company, in which case the holders of the Series A preferred stock are entitled to $100 liquidation preference per share.
Series B Preferred Stock
Each share of the Series B convertible preferred stock is convertible into 56 shares of common stock and a monthly dividend per share of $.50. The holders of the Series B convertible stock are entitled to a $100 liquidation preference per share after payment of the distributions to the holders of the Series A preferred stock and to one-tenth of a vote per share on all matters presented to a vote of shareholders generally, voting as a class with the holders of the common stock.
The activity related to outstanding common stock and common stock held in treasury was as follows:
There were not any treasury shares outstanding for the years ended 2019, 2018 and 2017.
NOTE 15 - BUSINESS ACQUISITIONS
On January 1, 2018, the Company completed the acquisition of Application Specialties, Inc. ("ASI"), a distributor of cutting tools, abrasives, coolants and machine shop supplies. The Company paid approximately $11.7 million in cash and stock. The purchase price also includes approximately $4.6 million in contingent consideration. The purchase was financed with $10.8 million of cash on hand as well as issuing $0.9 million of the Company's common stock. ASI provides the Company's metal working division with new geographic territory and enhances DXP's end market mix. For the twelve months December 31, 2019, ASI contributed sales of $51.1 million and earnings before taxes of approximately $3.8 million.
As part of our purchase agreement, we may pay up to an additional $4.6 million of contingent consideration over three years based on the achievement of certain earnings benchmarks established for calendar years 2018, 2019 and 2020. The purchase price includes the estimated fair value of the contingent consideration recorded at the present value of approximately $2.7 million. The estimated fair value of the contingent consideration was determined using a probability-weighted discounted cash flow model. We determined the fair value of the contingent consideration obligations by calculating the probability-weighted payments based on our assessment of the likelihood that the benchmarks will be achieved. The probability-weighted payments were then discounted using a discount rate based on an internal rate of return analysis using the probability-weighted cash flows. The fair value measurement includes earnings forecasts which are a Level 3 measurement as discussed in Note 5 - Fair Value of Financial Assets and Liabilities. The fair value of the contingent consideration is reviewed quarterly over the earn-out period to compare actual earnings before interest, taxes, depreciation and amortization ("EBITDA") achieved to the estimated EBITDA used in our forecasts.
As of December 31, 2019, approximately $1.5 million of the actual cash due toward the contingent consideration earned is recorded in current liabilities. We may pay up to an additional $1.6 million over the remaining earn-out period based on the achievement of certain EBITDA benchmarks. The estimated fair value of the contingent consideration is recorded at the present value of $2.7 million at December 31, 2019. Changes in the estimated fair value of the contingent earn-out consideration, up to the total contractual amount, are reflected in our results of operations in the periods in which they are identified. Changes in the fair value of the contingent consideration may materially impact and cause volatility in our future operating results. Changes in our estimates for the contingent consideration are discussed in Note 5 - Fair Value of Financial Assets and Liabilities to our consolidated financial statements.
The total acquisition consideration is equal to the sum of all cash payments, the fair value of stock issued, and the present value of any contingent consideration. The following table summarizes the total acquisition consideration for the ASI Purchase at closing (in thousands):
The following table summarizes the estimated fair values of the assets acquired and liabilities assumed during 2018 in connection with the ASI acquisition described above (in thousands):
NOTE 16 - COMMITMENTS AND CONTINGENCIES
The Company leases equipment, automobiles and office facilities under various operating leases. The future minimum rental commitments as of December, 2019, for non-cancelable leases are as follows (in thousands):
Rental expense for operating leases was $25.0 million, $18.5 million and $27.7 million for the years ended December, 2019, 2018 and 2017, respectively.
From time to time, the Company is a party to various legal proceedings arising in the ordinary course of business. While DXP is unable to predict the outcome of these lawsuits, it believes that the ultimate resolution will not have, either individually or in the aggregate, a material adverse effect on DXP’s consolidated financial position, cash flows, or results of operations.
NOTE 17 - EMPLOYEE BENEFIT PLANS
The Company offers a 401(k) plan which is eligible to substantially all employees in the United States. For the year ended December 31, 2019, the Company elected to match employee contributions at a rate of 50 percent of up to 4 percent of salary deferral. The Company contributed $1.7 million, $1.8 million, and $0.2 million to the 401(k) plan in the years ended December 31,
2019, 2018, and 2017, respectively. The Company reinstated the employee match program in October 2017 contributing $0.2 million to the 401(k) plan for 2017.
NOTE 18 - OTHER COMPREHENSIVE INCOME
Other comprehensive income generally represents all changes in shareholders’ equity during the period, except those resulting from investments by, or distributions to, shareholders.
During 2012 and 2013, the Company acquired four entities that operate in Canada. These Canadian entities maintain financial data in Canadian dollars. Upon consolidation, the Company translates the financial data from these foreign subsidiaries into U.S. dollars and records cumulative translation adjustments in other comprehensive income. The Company recorded $(0.7) million, $0.2 million, and $(1.2) million in translation adjustments, net of tax, in other comprehensive income during the years ended December 31, 2019, 2018 and 2017, respectively.
NOTE 19 - SEGMENT AND GEOGRAPHICAL REPORTING
The Company’s reportable business segments are: Service Centers, Innovative Pumping Solutions and Supply Chain Services. The Service Centers segment is engaged in providing maintenance, MRO products and equipment, including logistics capabilities, to industrial customers. The Service Centers segment provides a wide range of MRO products in the rotating equipment, bearing, power transmission, hose, fluid power, metal working, fastener, industrial supply, safety products and safety services categories. The Innovative Pumping Solutions segment fabricates and assembles custom-made pump packages, remanufactures pumps and manufactures branded private label pumps. The Supply Chain Services segment provides a wide range of MRO products and manages all or part of a customer's supply chain, including warehouse and inventory management.
The high degree of integration of the Company’s operations necessitates the use of a substantial number of allocations and apportionments in the determination of business segment information. Sales are shown net of intersegment eliminations.
The following table sets out financial information related to the Company’s segments (in thousands):
The Company had capital expenditures at Corporate of $9.5 million, $0.6 million, and $0.2 million for the years ended December 31, 2019, 2018, and 2017, respectively. The Company had identifiable assets at Corporate of $56.8 million, $54.7 million, and $19.4 million as of December 31, 2019, 2018, and 2017, respectively. Corporate depreciation was $1.7 million, $1.5 million, and $1.8 million for the years ended December 31, 2019, 2018, and 2017, respectively.
Geographical Information
Revenues are presented in geographic area based on location of the facility shipping products or providing services. Long-lived assets are based on physical locations and are comprised of the net book value of property.
The Company’s revenues and property and equipment by geographical location are as follows (in millions):
(1) Other includes Mexico and Dubai.
(1) Other includes Dubai.
NOTE 20 - QUARTERLY FINANCIAL INFORMATION (unaudited)
Summarized quarterly financial information for the years ended December 31, 2019, 2018 and 2017 is as follows (in millions, except per share data):
The sum of the individual quarterly earnings per share amounts may not agree with year-to-date earnings per share as each quarter’s computation is based on the weighted average number of shares outstanding during the quarter, the weighted average stock price during the quarter and the dilutive effects of the stock options and restricted stock in each quarter.
NOTE 21 - RELATED PARTIES DISCLOSURES
The Board uses policies and procedures, to be applied by the Audit Committee of the Board, for review, approval or ratification of any transactions with related persons. Those policies and procedures will apply to any proposed transactions in which DXP is a participant, the amount involved exceeds $120,000 and any director, executive officer or significant shareholder or any immediate family member of such a person has a direct or material indirect interest. Any related party transaction will be reviewed by the Audit Committee of the Board of Directors to determine, among other things, the benefits of any transaction to DXP, the availability of other sources of comparable products or services and whether the terms of the proposed transaction are comparable to those provided to unrelated third parties.
For the year ended December 31, 2019, the Company paid approximately $ 2.2 million in lease expenses to entities controlled by the Company’s Chief Executive Officer, David Little.
NOTE 22 - SUBSEQUENT EVENTS
Subsequent to the fourth quarter of fiscal 2019, the Company completed the acquisition of two companies, Turbo Machinery Repair ("Turbo") and Pumping Systems, Inc. ("PSI"). Combined, the Company paid $16.3 million consisting of $14.3 million in cash and $2.0 million in DXP common stock.
On January 31, 2020, the Company completed the acquisition of Turbo, a pump and industrial equipment repair, maintenance, machining and labor services company. Turbo was funded with cash on hand.
On January 2, 2020, the Company completed the acquisition of PSI, a distributor of pumps, systems and related services. The PSI acquisition was funded with cash on hand as well as issuing DXP's common stock.
ITEM 9.
ITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
ITEM 9A.
ITEM 9A. Controls and Procedures
Disclosure Controls and Procedures
DXP carried out an evaluation, under the supervision and with the participation of its management, including the Chief Executive Officer and the Chief Financial Officer, of the effectiveness as of December 31, 2019, of the design and operation of DXP’s disclosure controls and procedures pursuant to Exchange Act Rules 13a-15e and 15d-15e. Disclosure controls and procedures are the controls and other procedures of DXP that are designed to ensure that information required to be disclosed by DXP in the reports that it files or submits under the Securities Exchange Act of 1934, as amended, (the “Exchange Act”) is recorded, processed, summarized and reported, within the time periods specified in the rules and forms of the U.S. Securities and Exchange Commission (the “Commission”). Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by DXP in the reports that it files or submits under the Exchange Act, is accumulated and communicated to the issuer’s management, including its principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure. Based on their evaluation as of the end of the period covered by this Annual Report on Form 10-K, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures were effective as of December 31, 2019 at a reasonable assurance level.
MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
DXP Enterprises, Inc.’s management is responsible for establishing and maintaining adequate internal control over financial reporting, as defined in Exchange Act Rule 13a-15(f). DXP Enterprises, Inc.’s internal control system was designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.
Internal control over financial reporting cannot provide absolute assurance of achieving financial reporting objectives because of its inherent limitations. Internal control over financial reporting is a process that involves human diligence and compliance and is subject to lapses in judgment and breakdowns resulting from human failures. Internal control over financial reporting can also be circumvented by collusion or improper management override. Because of such limitations, there is a risk that material misstatements may not be prevented or detected on a timely basis by internal control over financial reporting. However, these inherent limitations are known features of the financial reporting process. Therefore, it is possible to design into the process safeguards to reduce, though not eliminate, this risk.
Under the supervision and with the participation of the Company’s management, including its Chief Executive Officer and Chief Financial Officer, the Company conducted an evaluation of the effectiveness of its internal control over financial reporting based on the framework established by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) as set forth in Internal Control - Integrated Framework. Based on our evaluation under the COSO framework, our management has concluded that the Company’s internal control over financial reporting were effective as of December 31, 2019 following our remediation of the material weaknesses in internal control over financial reporting that existed as of December 31, 2018 as further discussed below. Management’s remediation efforts and results are also discussed below.
A material weakness is a deficiency, or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the Company’s annual or interim financial statements will not be prevented or detected on a timely basis.
REMEDIATION OF PREVIOUSLY DISCLOSED MATERIAL WEAKNESSES IN INTERNAL CONTROL OVER FINANCIAL REPORTING
As previously disclosed in our Annual Report on Form 10-K for the year ended December 31, 2018, we had material weaknesses in our control environment and monitoring to support the financial reporting process. We specifically did not maintain effective management review controls over the monitoring and review of certain accounts; and management did not effectively design, document nor monitor (review, evaluate and assess) the key internal control activities that provide the accounting information contained in the Company’s financial statements.
We committed to remediating the material weaknesses and, as such, implemented changes to our internal control over financial reporting throughout 2018 and 2019.
During the last two years, the following actions were implemented:
•
Engaged a third party consulting firm to lead our remediation efforts.
•
Conducted a review of our organization structure, reporting relationships and adequacy of staffing levels and made specific staffing changes as a result of our review.
•
Completed training for all appropriate personnel regarding the applicable accounting guidance and requirements.
•
Training was conducted by both an outside expert and through internal training meetings and provided to accounting personnel, remote location personnel, and management positions.
•
Strengthened our risk assessment, materiality and scoping, and fraud risk assessment.
•
Significantly improved our COSO mapping of entity level controls.
•
Developed or revised process maps for all key business processes.
•
Identified and documented key controls and control gaps in a comprehensive consolidated risk control matrix
•
Developed controls to address gaps and enhanced management review controls.
•
Educated process owners as to the expectations for documentation to evidence key controls.
•
The procedures described above have been implemented and controls have been successfully tested by our third party consultants and external auditors.
Management is committed to a strong internal control environment. We believe the full implementation and testing of the design and operating effectiveness of the newly implemented and revised controls, the actions described above successfully remediated the material weaknesses in our internal control over financial reporting.
The effectiveness of the Company's internal control over financial reporting as of December 31, 2019 has been audited by Moss Adams LLP, an independent registered public accounting firm, as stated in their audit report which is included herein.
Changes in Internal Control over Financial Reporting
Except for the changes described above, there were no changes in our internal control over financial reporting identified in our evaluation pursuant to Rules 13a-15(d) or 15d-15(d) of the Exchange Act during the year ended December 31, 2019 that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
/s/ David R. Little
/s/ Kent Yee
David R. Little
Kent Yee
President and Chief Executive Officer
(Principal Executive Officer)
Senior Vice President and Chief Financial Officer
(Principal Financial Officer)
ITEM 9B.
ITEM 9B. Other Information
None.
PART III
ITEM 10.
ITEM 10. Directors, Executive Officers and Corporate Governance
The information required by this item will be included in our definitive proxy statement for the 2020 Annual Meeting of Shareholders that we will file with the SEC within 120 days of the end of the fiscal year to which this Report relates (the “Proxy Statement”) and is hereby incorporated by reference thereto.
ITEM 11.
ITEM 11. Executive Compensation
The information required by this item will be included in the Proxy Statement and is hereby incorporated by reference.
ITEM 12.
ITEM 12. Security Ownership of Certain Beneficial Owners and Management and Related Shareholder Matters
The information required by this item will be included in the Proxy Statement and is hereby incorporated by reference.
ITEM 13.
ITEM 13. Certain Relationships and Related Transactions, and Director Independence
The information required by this item will be included in the Proxy Statement and is hereby incorporated by reference.
ITEM 14.
ITEM 14. Principal Accounting Fees and Services.
The information required by this item will be included in the Proxy Statement and is hereby incorporated by reference.
PART IV
ITEM 15.
ITEM 15. Exhibits, Financial Statement Schedules.
(a) Documents included in this Report:
1.
Financial Statements - See Part II, Item 8 of this Report.
2.
Financial Statement Schedules - All other schedules have been omitted since the required information is not applicable or significant or is included in the Consolidated Financial Statements or notes thereto.
3.
Exhibits:
The following exhibits are filed herewith or are incorporated by reference to exhibits previously filed with the Commission.
Exhibits designated by the symbol * are filed with this Report. All exhibits not so designated are incorporated by reference to a prior filing with the Commission as indicated.
+ Indicates a management contract or compensation plan or arrangement.
The Company undertakes to furnish to any shareholder so requesting a copy of any of the exhibits to this Report on upon payment to the Company of the reasonable costs incurred by the Company in furnishing any such exhibit.
ITEM 16. Form 10-K Summary
None.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
DXP ENTERPRISES, INC. (Registrant)
By:
/s/
DAVID R. LITTLE
David R. Little
Chairman of the Board,
President and Chief Executive Officer
Dated: March 13, 2020
Each person whose signature appears below appoints David R. Little, as his or her true and lawful attorney-in-fact and agent, with full power of substitution and resubstitution, for him or her and in his or her name, place and stead, in any and all capacities, to sign any and all amendments to this Annual Report on Form 10-K, and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, with full power and authority to said attorney-in-fact and agent to do and perform each and every act whatsoever that is necessary, appropriate or advisable in connection with any or all of the above-described matters and to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that said attorney-in-fact and agent or his substitute, may lawfully do or cause to be done by virtue thereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated: