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THR > SEC Filings for THR > Form 10-K on 30-May-2014All Recent SEC Filings

Show all filings for THERMON GROUP HOLDINGS, INC.

Form 10-K for THERMON GROUP HOLDINGS, INC.


30-May-2014

Annual Report


ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion should be read in conjunction with, and is qualified in its entirety by reference to, Item 6, "Selected Financial Data" and our consolidated financial statements and related notes included elsewhere in this annual report. The discussions in this section contain forward-looking statements that involve risks and uncertainties, including, but not limited to, those described in Item 1A,"Risk Factors." Actual results could differ materially from those discussed below.

Overview

We are one of the largest providers of highly engineered thermal solutions for process industries. For 60 years, we have served a diverse base of thousands of customers around the world in attractive and growing markets, including energy, chemical processing and power generation. We are a global leader and one of the few thermal solutions providers with a global footprint and a full suite of products and services required to deliver comprehensive solutions to complex projects. We serve our customers locally through a global network of sales and service professionals and distributors in more than 30 countries and through our four manufacturing facilities on three continents. These global capabilities and longstanding relationships with some of the largest multinational energy, chemical processing, power and EPC companies in the world have enabled us to diversify our revenue streams and opportunistically access high growth markets worldwide. For fiscal 2014, approximately 67% of our revenues were generated outside of the United States.

Revenue. Our revenues are derived from providing customers with a full suite of innovative and reliable heat tracing solutions, including electric and steam heat tracing, tubing bundles, control systems, design optimization, engineering services and installation services. Our sales are primarily to industrial customers for petroleum and chemical plants, oil and gas


production facilities and power generation facilities. Demand for industrial heat tracing solutions falls into two categories: (i) new facility construction, which we refer to as Greenfield projects, and (ii) recurring maintenance, repair and operations and facility upgrades or expansions, which we refer to as MRO/UE. Greenfield construction projects often require comprehensive heat tracing solutions. We believe that Greenfield revenue consists of sales revenues by customer in excess of $1 million annually (excluding sales to resellers), and typically includes most orders for projects related to facilities that are new or that are built independent of existing facilities. We refer to sales revenues by customer of less than $1 million annually, which we believe are typically derived from MRO/UE, as MRO/UE revenue. Based on our experience, we believe that $1 million in annual sales is an appropriate threshold for distinguishing between Greenfield revenue and MRO/UE revenue. However, we often sell our products to intermediaries or subcontract our services; accordingly, we have limited visibility into how our products or services may ultimately be used and can provide no assurance that our categorization may accurately reflect the sources of such revenue. Furthermore, our customers do not typically enter into long-term forward maintenance contracts with us. In any given year, certain of our smaller Greenfield projects may generate less than $1 million in annual sales, and certain of our larger plant expansions or upgrades may generate in excess of $1 million in annual sales, though we believe that such exceptions are few in number and insignificant to our overall results of operations.

We believe that our pipeline of planned projects, in addition to our backlog of signed purchase orders, provides us with strong visibility into our future revenue, as historically we have experienced few order cancellations, and the cancellations that have occurred in the past have not been material compared to our total contract volume or total backlog. The small number of order cancellations is attributable in part to the fact that a large portion of our solutions are ordered and installed toward the end of Greenfield project construction. Our backlog at March 31, 2014 was $84.8 million, as compared to $95.2 million at March 31, 2013. The decline in backlog is mostly attributable to the progress and completion of several large Greenfield projects and a decrease in new order volume of the same magnitude. The timing of recognition of revenue out of backlog is not always certain, as it is subject to a variety of factors that may cause delays, many of which are beyond our control (such as customers' delivery schedules and levels of capital and maintenance expenditures). When delays occur, the recognition of revenue associated with the delayed project is likewise deferred.

Cost of sales. Our cost of revenues includes primarily the cost of raw material items used in the manufacture of our products, cost of ancillary products that are sourced from external suppliers and construction labor cost. Additional costs of revenue include contract engineering cost directly associated to projects, direct labor cost, external sales commissions, and other costs associated with our manufacturing/fabrication shops. The other costs associated with our manufacturing/fabrication shops are mainly indirect production costs, including depreciation, indirect labor costs, and the costs of manufacturing support functions such as logistics and quality assurance. Key raw material costs include polymers, copper, stainless steel, insulating material, and other miscellaneous parts related to products manufactured or assembled as part of our heat tracing solutions. Historically, the costs of our primary raw materials have been stable and readily available from multiple suppliers, and we have been generally successful with passing along raw material cost increases to our customers. Therefore, increases in the cost of key raw materials of our products have not generally affected our gross margins. We cannot provide any assurance that we may be able to pass along such cost increases to our customers in the future, and if we are unable to do so, our results of operations may be adversely affected.

Operating expenses. Our marketing, general and administrative and engineering expenses are primarily comprised of compensation and related costs for sales, marketing, pre-sales engineering and administrative personnel, as well as other sales related expenses and other costs related to research and development, insurance, professional fees, the global integrated business information system, provisions for bad debts and warranty expense.

Key drivers affecting our results of operations. Our results of operations and financial condition are affected by numerous factors, including those described above under Item 1A, "Risk Factors" and elsewhere in this annual report and those described below:

Timing of Greenfield projects. Our results of operations in recent years have been impacted by the various construction phases of large Greenfield projects. On very large projects, we are typically designated as the heat tracing provider of choice by the project owner. We then engage with multiple contractors to address incorporating various heat tracing solutions throughout the overall project. Our largest Greenfield projects may generate revenue for several quarters. In the early stages of a Greenfield project, our revenues are typically realized from the provision of engineering services. In the middle stages, or the material requirements phase, we typically experience the greatest demand for our heat tracing cable, at which point our revenues tend to accelerate. Revenues tend to decrease gradually in the final stages of a project and are generally derived from installation services and demand for electrical panels and other miscellaneous electronic components used in the final installation of heat tracing cable, which we frequently outsource from third-party manufacturers. Therefore, we


typically provide a mix of products and services during each phase of a Greenfield project, and our margins fluctuate accordingly.

Cyclicality of end-users' markets. Demand for our products and services depends in large part upon the level of capital and maintenance expenditures of our customers and end users, in particular those in the energy, chemical processing and power generation industries, and firms that design and construct facilities for these industries. These customers' expenditures historically have been cyclical in nature and vulnerable to economic downturns. Greenfield projects, and in particular large Greenfield projects (i.e., new facility construction projects generating in excess of $5 million in annual sales), have been a substantial source of revenue growth in recent years, and Greenfield revenues tend to be more cyclical than MRO/UE revenues. In recent years we have noted particular cyclicality in capital spending for new facilities in Asia, Eastern Europe and the Middle East. Revenues derived from Europe, including the Middle East, accounted for 21% of our total revenues during each of fiscal 2014 and fiscal 2013 and revenues derived from the Asia region accounted for 12% and 15% of our total revenues during fiscal 2014 and fiscal 2013, respectively. A sustained decrease in capital and maintenance spending or in new facility construction by our customers could have a material adverse effect on the demand for our products and services and our business, financial condition and results of operations.

Impact of product mix. Typically, both Greenfield and MRO/UE customers require our products as well as our engineering and construction services. The level of service and construction needs will affect the profit margin for each type of revenue. We tend to experience lower margins from our design optimization, engineering, installation and maintenance services than we do from sales of our heating cable, tubing bundle and control system products. We also tend to experience lower margins from our outsourced products, such as electrical switch gears and transformers, than we do from our manufactured products. Accordingly, our results of operations are impacted by our mix of products and services.

We estimate that Greenfield and MRO/UE have each made the following contribution as a percentage of revenue in the periods listed:
Fiscal Year Ended March 31,

                 2014    2013    2012
Greenfield        33 %    42 %    39 %
MRO/UE            67 %    58 %    61 %

We believe that our analysis of Greenfield and MRO/UE is an important measurement to explain the trends in our business to investors. Greenfield revenue is an indicator of both our ability to successfully compete for new contracts as well as the economic health of the industries we serve. Furthermore, Greenfield revenue is an indicator of potential MRO/UE revenue in future years.

For MRO/UE orders, the sale of our manufactured products typically represents a higher proportion of the overall revenues associated with such order than the provision of our services. Greenfield projects, on the other hand, require a higher level of our services than MRO/UE orders, and often require us to purchase materials from third party vendors. Therefore, we typically realize higher margins from MRO/UE revenues than Greenfield revenues.

Large and growing installed base. Customers typically use the incumbent heat tracing provider for MRO/UE projects to avoid complications and compatibility problems associated with switching providers. Therefore, with the significant Greenfield activity we have experienced in recent years, our installed base has continued to grow, and we expect that such installed base will continue to generate ongoing high margin MRO/UE revenues. For fiscal 2014, MRO/UE sales comprised approximately 67% of our consolidated revenues.

Seasonality of MRO/UE revenues. Revenues realized from MRO/UE orders tend to be less cyclical than Greenfield projects and more consistent quarter over quarter, although MRO/UE revenues are impacted by seasonal factors. MRO/UE revenues are typically highest during the second and third fiscal quarters, as most of our customers perform preventative maintenance prior to the winter season.


Results of Operations

The following table sets forth data from our statements of operations as a percentage of sales for the periods indicated.

                                                       Fiscal Year Ended March 31,
                                     2014                     2013                     2012
                                                          (dollars in thousands)
Consolidated Statements of
Operations Data:
Sales                            $  277,323      100  %   $  284,036      100  %   $  272,323      100  %
Cost of sales                       142,153       51  %      151,204       53         140,208       51
Gross profit                     $  135,170       49  %   $  132,832       47  %   $  132,115       49  %
Operating Expenses:
   Marketing, general, and
      administrative and
      engineering                    65,463       24  %       64,633       23  %       76,280       28  %
   Amortization of intangible
   assets                            11,090        4          11,211        4          11,379        4
Income from operations           $   58,617       21  %   $   56,988       20  %   $   44,456       16  %
Interest expense, net (1)            (9,773 )     (4 )       (15,113 )     (5 )       (19,462 )     (7 )
Loss on redemption of debt          (15,485 )     (6 )             -        -          (3,825 )     (1 )
Other expense                          (596 )      -            (325 )      -          (1,671 )     (1 )
   Income before provision for
   income taxes                  $   32,763       12  %   $   41,550       15  %   $   19,498        7  %
Income tax expense                    6,964        3          14,576        5           7,468        3
Net income                       $   25,799        9  %   $   26,974        9  %   $   12,030        4  %

(1) Interest expense for fiscal 2014 included a $4.0 million acceleration of the amortization of our deferred debt issuance costs as we redeemed all $118.1 million of aggregate outstanding principal on our 9.5% senior secured notes. During the period we incurred an additional $0.6 million of amortized deferred debt issuance costs. Interest expense for fiscal 2013 included a $2.3 million acceleration of the amortization of our deferred debt issuance costs due to partial redemptions of our senior secured notes and a refinancing of our prior revolving credit facility. $1.0 million of additional amortized deferred debt issuance costs were recorded in the period. Interest expense for fiscal 2012 included a $3.1 million acceleration of the amortization of our deferred debt issuance costs due to certain partial redemptions of our senior secured notes and $1.0 million of additional amortized deferred debt issuance costs.

Year Ended March 31, 2014 Compared to the Year Ended March 31, 2013

Revenues. Revenues for fiscal 2014 were $277.3 million, compared to $284.0 million for fiscal 2013, a decrease of $6.7 million, or 2.4%. The decrease in revenue during fiscal 2014 was mainly attributable to Greenfield revenues which declined $25.7 million or 22%. MRO/UE revenues, on the other hand increased $19.0 million or 12% as compared to fiscal 2013. We believe that the decline in Greenfield sales in fiscal 2014 is a reflection of strong comparative sales in fiscal 2013. The increase of MRO/UE revenue in fiscal 2014 is reflective of our significant installed base of customers who source our products during maintenance and upgrade activities.

In fiscal 2014, we experienced revenue growth of $7.7 million in the United States as compared to fiscal 2013. The increase in demand within the United States is largely attributable to upgrade efforts at refineries that are now processing heavy crude oil, from the Canadian oil sands region, which needs to be heated throughout the refining process, as well demand driven by the proliferation of hydraulic fracturing methods to extract natural gas. We experienced revenue declines in Canada and our Asia regions of $6.2 million and $7.0 million, respectively, as compared to fiscal 2013. In Canada, fiscal 2014 revenues generated from our largest Greenfield project declined $6.0 million from $30.6 million in fiscal 2013 to $24.6 million in fiscal 2014 due to the project being in its later stages when demand for our heat tracing products tends to diminish. Canadian revenues were also negatively impacted during fiscal 2014 by approximately $4.8 million due to the depreciation of the Canadian dollar relative to the U.S. dollar. Within our Asia region, we had several large Greenfield projects in fiscal 2013


whose revenues were not replaced in fiscal 2014. Revenues in our European region declined $1.2 million in fiscal 2014 largely due to overall economic weakness in the region experienced in the first quarter of fiscal 2014, offset in part by improved results in Europe for the remainder of fiscal 2014.

Gross profit and margin. Gross profit totaled $135.2 million in fiscal 2014, compared to $132.8 million in fiscal 2013, an increase of $2.4 million, or 1.8%. As a percentage of revenues, profit margin increased to 48.7% in fiscal 2014 from 46.8% in fiscal 2013. This increase is attributable to the higher mix of MRO/UE sales during fiscal 2014 from which we typically realize higher gross margins than Greenfield sales. In addition, our fiscal 2013 Greenfield sales included two large projects that were competitively bid with comparatively lower margins and in turn reduced overall margins.

Marketing, general and administrative and engineering. Marketing, general and administrative and engineering costs were $65.5 million in fiscal 2014, compared to $64.6 million in fiscal 2013, an increase of $0.9 million, or 1.3%. As a percentage of total revenues, marketing, general and administrative and engineering costs were 23.6% and 22.8% in fiscal 2014 and 2013, respectively. In fiscal 2014, we switched vendors for our data communications and as a result incurred a $0.7 million increase in communication costs related to fees and duplicate services incurred during the transition. As of March 31, 2014, we had nearly completed the transition and do not expect to continue to incur such communication costs in fiscal 2015. Building expenses increased approximately $0.6 million as compared to fiscal 2013, as we relocated our Houston office to a larger and more updated facility. Stock compensation expense increased $0.9 million due to the full year effect of awards granted in August 2012 (fiscal 2013) and additional awards granted in fiscal 2014. The increases in data communications costs, building expenses and stock compensation expense were partially offset by a $1.5 million reduction in our personnel costs, which was driven by a decrease in our annual incentive expense of $3.0 million, as we did not meet the internal goals for the short term incentive plan established by our board of directors, offset in part by an increase in salaries, wages and benefit expense due to additional sales and engineering personnel.

Amortization of intangible assets. Amortization of intangible assets was $11.1 million in fiscal 2014, compared to $11.2 million in fiscal 2013. The decrease is attributed to foreign currency translation adjustments. We expect fiscal 2014 and fiscal 2013 to be representative of our annual amortization expense for the foreseeable future.

Interest expense, net. Interest expense and loss on redemptions of debt totaled $25.3 million in fiscal 2014, compared to $15.1 million in fiscal 2013, an increase of $10.2 million. In fiscal 2014 we redeemed all $118.1 million of the outstanding aggregate principal amount of our 9.5% senior secured notes. In connection with the redemption, we incurred acceleration of deferred debt issuance costs of $4.0 million and a loss on retirement of debt of $15.5 million, related to redemption premiums paid to the noteholders. In fiscal 2013, we made partial redemptions of our 9.5% senior secured notes with $21.0 million of aggregate principal being redeemed, and negotiated a new revolving credit facility. In connection with the fiscal 2013 bond redemptions and the termination of the previous revolving credit facility, we incurred acceleration of deferred debt issuance costs of $2.3 million. Interest expense on outstanding principal was $5.4 million and $11.9 million in fiscal 2014 and fiscal 2013, respectively. The decrease in interest on outstanding principal is due to the difference in the interest rate on our redeemed 9.5% senior secured notes and that of our term loan, which is fixed at approximately 3.62% as a result of our interest rate swap. We expect annual interest expense in fiscal 2015 to be approximately $4.2 million after accounting for scheduled principal reduction payments.

Other expense. Other expense was $0.6 million in fiscal 2014, compared to $0.3 million in fiscal 2013, an increase of $0.3 million due mostly to increased losses on foreign currency exchange transactions in fiscal 2014. See Note 2, "Fair Value Measurements" to our consolidated financial statements included elsewhere in this annual report, for further discussion of our foreign currency exchange transactions.

Income taxes. We reported an income tax expense of $7.0 million in fiscal 2014, compared to $14.6 million in fiscal 2013, a decrease of $7.6 million. Our effective tax rates were 21.3% in fiscal 2014 and 35.1% in fiscal 2013, respectively.
During fiscal 2014, we concluded an income tax audit in the United States and, as a result, released certain liabilities for uncertain tax positions in the amount of $1.0 million. In addition, we received an income tax benefit of $0.6 million in fiscal 2014 related to estimated tax benefits that were determined not to be payable to the Predecessor owners. Excluding these discrete tax benefits, our effective tax rate in fiscal 2014 would have been 25.5%. During fiscal 2014, we adopted a permanent reinvestment position on our foreign earned earnings. Accordingly, we no longer accrue incremental taxation for expected repatriation of earnings into the United States. As a result, our estimated tax rate was reduced from 35.0% to 25.5%, excluding discrete events. The decrease in income tax expense from fiscal 2013 is attributable to our reduced pre-tax net income, the adoption of a permanent reinvestment position as well as the two aforementioned discrete events. See Note 14, "Income Taxes," to our consolidated financial statements, included elsewhere in this annual report, for further detail on income taxes.


Net income. Net income was $25.8 million in fiscal 2014 as compared to $27.0 million in fiscal 2013, a decrease of $1.2 million. In fiscal 2014, interest expense increased $10.2 million, which was attributable to increases in the acceleration of the amortization of our deferred debt issuance costs, as well as the loss on retirement of debt related to the redemption of our 9.5% senior secured notes. Marketing, general and administrative and engineering costs increased $0.9 million in fiscal 2014. These increases in expenses were offset by an increase in fiscal 2014 gross profit of $2.4 million and a decrease of income tax expense of $7.6 million in the same period. The increase in fiscal 2014 gross profit was due to higher gross profit as a percent of total revenues in fiscal 2014, primarily attributable to the increase in MRO/UE sales as a percentage of total revenues. The decrease of income tax expense is due to lower pre-tax net income in fiscal 2014, the adoption of a permanent reinvestment of foreign earnings position, and $1.6 million of income tax benefits from non-recurring discrete events.

Year Ended March 31, 2013 Compared to the Year Ended March 31, 2012

Revenues. Revenues for fiscal 2013 were $284.0 million, compared to $272.3 million for fiscal 2012, an increase of $11.7 million, or 4%. During fiscal 2013, we experienced growth in both Greenfield and MRO/UE sales. In fiscal 2013, we experienced higher than usual Greenfield sales at approximately 42% of total revenue. In fiscal 2012, Greenfield sales contributed approximately 39% to total revenue, whereas MRO/UE sales contributed approximately 61%, which is more in line with our expected product mix based on historical results.

In fiscal 2013, we experienced growth of $16.3 million and $12.3 million in our Canada and Asia regions, respectively. We continued to see strong demand from customers in the Canadian oil sands region, as well as continued growth in our MRO/UE business as we grow our installed base. In Asia, our growth was driven by several large Greenfield jobs. In the United States, revenue declined $9.6 million in fiscal 2013 compared to fiscal 2012. The decline in the United States was attributable to a strong comparable year in fiscal 2012 when we experienced $5.0 million of unexpected revenue due to freeze protection initiatives after an unusually cold winter in the southern United States. Within Europe, our fiscal 2013 revenue decreased $7.2 million from fiscal 2012, which is primarily attributable to macroeconomic volatility in the region, as well as the depreciation of the Euro relative to the U.S. dollar in fiscal 2013.

We expect that revenue contributed from large Greenfield projects will fluctuate from period to period as construction schedules are inherently difficult to estimate. While our percentage of revenue from MRO/UE during fiscal 2013 was comparable to historical averages, we expect MRO/UE percentage to fluctuate as large project volume increases or decreases.

Gross profit and margin. Gross profit totaled $132.8 million in fiscal 2013, compared to $132.1 million in fiscal 2012, an increase of $0.7 million, or 0.5%. As a percentage of revenues, profit margin decreased to 46.8% in fiscal 2013 from 48.5% in fiscal 2012. This decrease is attributable to the higher mix of Greenfield sales during fiscal 2013 as we typically realize higher margins from MRO/UE sales. Within our Greenfield sales in fiscal 2013, we had two large projects that were competitively bid and generated comparatively lower margins which in turn reduced overall margins.

Marketing, general and administrative and engineering. Marketing, general and administrative and engineering costs were $64.6 million in fiscal 2013, compared to $76.3 million in fiscal 2012, a decrease of $11.7 million, or 15.3%. The decrease is primarily attributable to expenses incurred during fiscal 2012 related to our IPO. In connection with our IPO, $7.4 million was paid to our former private equity sponsors to terminate our management services agreement. Additionally, we incurred $6.1 million of stock compensation expense relating to the vesting of all outstanding stock options in connection with our IPO. These decreases were offset by increases in our salaries and benefits of approximately $3.4 million, which were primarily incurred to meet the needs of our growing sales and engineering operations. Excluding stock compensation and other expenses associated with our IPO, marketing, general and administrative and engineering expenses were 23% in both fiscal 2013 and fiscal 2012.

Amortization of intangible assets. Amortization of intangible assets was $11.2 million in fiscal 2014, compared to $11.4 million in fiscal 2012, a decrease of $0.2 million. The decrease is attributed to foreign currency translation adjustments. We expect fiscal 2013 and fiscal 2012 to be representative of our annual amortization expense for the foreseeable future.

Interest expense, net. Interest expense and loss on redemptions of debt totaled $15.1 million in fiscal 2013, compared to $23.3 million in fiscal 2012, a decrease of $8.2 million. In fiscal 2013 and fiscal 2012, we made redemptions on our senior notes totaling $21.0 million and $70.9 million, respectively. The . . .

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