Holley Inc. (HLLY) FY 2022 MD&A
This page reproduces the company's own Item 7 MD&A text from the linked SEC filing. It is filer text, not grepcent analysis, scoring, or investment advice.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Unless the context requires otherwise, references to “Holley,” “we,” “us,” “our” and “the Company” in this section are to the business and operations of Holley Inc. The following discussion and analysis should be read in conjunction with Holley’s consolidated financial statements and related notes thereto included in this Annual Report on Form 10-K. In addition to historical information, this discussion contains forward-looking statements that involve risks, uncertainties, and assumptions that could cause Holley’s actual results to differ materially from management’s expectations. Factors that could cause such differences are discussed herein and under the caption, “Cautionary Note Regarding Forward-Looking Statements.”
Overview
We are a designer, marketer, and manufacturer of high-performance automotive aftermarket products serving car and truck enthusiasts, with sales, processing, and distribution facilities reaching most major markets in the United States, Canada, Europe and China. Holley designs, markets, manufactures and distributes a diversified line of performance automotive products including fuel injection systems, tuners, exhaust products, carburetors, safety equipment and various other performance automotive products. Our products are designed to enhance street, off-road, recreational and competitive vehicle performance and safety.
Innovation is at the core of our business and growth strategy with approximately 34% of our 2022 sales coming from products introduced by us into the market since 2017. We have a history of developing innovative products, including new products in existing product families, product line expansions, and accessories, as well as products that bring us into new categories. We have thoughtfully expanded our product portfolio over time to adapt to consumer needs.
In addition, we have historically used strategic acquisitions to (i) expand our brand portfolio, (ii) enter new product categories and consumer segments, (iii) increase DTC scale and connection, (iv) expand share in current product categories and (v) realize value-enhancing revenue and cost synergies. While we believe our business is positioned for continued organic growth, we intend to continue evaluating opportunities for strategic acquisitions that would complement our current business and expand our addressable target market.
Factors Affecting our Performance
We believe that our performance and future success depend on a number of factors that present significant opportunities for us but also pose risks and challenges, including those discussed below and in the section of this Form 10-K titled “Risk Factors.”
Business Combination
On July 16, 2021, we consummated a business combination (“Business Combination”) pursuant to that certain Agreement and Plan of Merger dated March 11, 2021, (the “Merger Agreement”), by and among Empower Ltd., (“Empower”), Empower Merger Sub I Inc., a direct wholly owned subsidiary of Empower (“Merger Sub I”), Empower Merger Sub II LLC, a direct wholly owned subsidiary of Empower (“Merger Sub II”), and Holley Intermediate Holdings, Inc. ("Holdings").
The Merger Agreement provided for, among other things, the following transactions: (i) Merger Sub I merged with and into Holdings, the separate corporate existence of Merger Sub I ceased and Holdings became the surviving corporation, and (ii) Holdings merged with and into Merger Sub II, the separate corporate existence of Holdings ceased, and Merger Sub II became the surviving limited liability company. Upon closing, Empower changed its name to Holley Inc. and its trading symbol on the New York Stock Exchange (the “NYSE”) from “EMPW” to “HLLY.”
The Business Combination was accounted for as a reverse recapitalization. Holdings was deemed the accounting acquirer with Holley Inc. as the successor registrant. As such, Empower was treated as the acquired company for financial reporting purposes, and financial statements for periods prior to the Business Combination are those of Holdings.
As a result of the Business Combination, Holley Inc. listed on the NYSE, which required us to hire additional personnel and implement procedures and processes to address public company regulatory requirements and customary practices. We have incurred and expect to continue to incur additional annual expenses as a public company for, among other things, directors’ and officers’ liability insurance, director fees, and additional internal and external accounting, legal, and administrative resources, including increased personnel costs, audit and other professional service fees.
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Acquisitions
Holley has historically pursued a growth strategy through both organic growth and acquisitions. The Company has pursued acquisitions that it believes will help drive profitability, cash flow and stockholder value. Holley targets companies that are market leaders, expand the Company’s geographic presence, provide a highly synergistic opportunity and/or enhance Holley’s ability to provide a wide array of its products to its customers through its distribution network.
From 2020 through 2022, Holley completed 15 acquisitions. The most significant of these acquisitions impacting the comparability of our operating results were:
| Column 1 | Column 2 | Column 3 |
|---|---|---|
| • | Baer, Inc.: On December 23, 2021, Holley acquired Baer, Inc. doing business as Baer Brakes, a developer and supplier of brakes and brake systems. This acquisition moves Holley closer to its goals of providing complete vehicle solutions by adding a new product category and brake system expertise. |
| Column 1 | Column 2 | Column 3 |
|---|---|---|
| • | Brothers Mail Order Industries, Inc.: On December 16, 2021, Holley acquired Brothers Mail Order Industries, Inc., doing business as Brothers Trucks, a distributor of Classic and Custom vehicle restoration parts serving the Chevrolet and GMC truck aftermarket. This acquisition increases Holley’s offering in truck and SUV appearance items. |
| Column 1 | Column 2 | Column 3 |
|---|---|---|
| • | Advance Engine Management Inc.: On April 14, 2021, Holley acquired Advance Engine Management Inc., doing business as AEM Performance Electronics, a developer and supplier of electronic control and monitoring systems for performance automotive applications. This acquisition increases Holley’s penetration into the import and other sport compact cars submarket. |
| Column 1 | Column 2 | Column 3 |
|---|---|---|
| • | Simpson Performance Products: On November 16, 2020, Holley acquired Simpson Performance Products, Inc. (“Simpson”), a designer and seller of motorsport safety products including helmets head & neck restraints, seat belts, fire suits and more. This acquisition extended Holley’s footprint into the safety and racing segment. |
| Column 1 | Column 2 | Column 3 |
|---|---|---|
| • | Drake Automotive Group: On November 11, 2020, Holley acquired Drake Automotive Group LLC (“Drake”), a designer and seller of automotive aftermarket appearance parts, wheels, chassis & suspension products and accessories. This acquisition increases Holley’s penetration within the Ford/Mustang platform where it has historically been under indexed relative to the market. |
The acquisitions have all been accounted for in accordance with Financial Accounting Standards Board ("FASB") Accounting Standards Codification ("ASC") Topic 805, Business Combinations, and the operations of the acquired entities are included in our historical results for the periods following the closing of the acquisition. See Note 1, “Description of the Business, Basis of Presentation, and Summary of Significant Accounting Policies,” and Note 2, “Business Combination and Acquisitions,” in the Notes to the Consolidated Financial Statements included elsewhere in this Annual Report on Form 10-K for additional information related to the Company’s acquisitions and investments.
Business Environment
COVID-19 has adversely impacted global supply chain and general economic conditions. The Company has continued to experience disruptions and higher costs in manufacturing, supply chain, logistical operations, and shortages of certain Company products in distribution channels. The full extent of COVID-19's effect on the Company's operational and financial performance in the future will depend on future developments, including but not limited to the duration, spread, intensity and phase of the pandemic in various countries; the emergence of COVID-19 variants and the utilization and effectiveness of treatments and vaccines against these variants; the further impact of COVID-19 on the global economy; and demand for the Company's products and services. Should the ongoing COVID-19 pandemic not improve, or worsen, or if the Company's attempt to mitigate its impact on its supply chain, operations and costs is not successful, the Company's business, results of operations, and financial condition may be adversely affected. See Part I: Item 1A. Risk Factors for additional discussion on the COVID-19 pandemic and the impact on our business.
The Company's business and results of operations, financial condition, and liquidity are impacted by broad economic conditions including inflation, labor shortages, and disruption of the supply chain, as well as by geopolitical events, specifically the conflict in Ukraine. The Company's operations have been adversely impacted by inflationary pressures primarily related to transportation, labor and component costs. Sales growth in certain products has been constrained by continuing supply chain challenges and automotive electronic component shortages. In response to the global supply chain volatility and inflationary impacts, the Company has attempted to minimize potential adverse impacts on its business with cost savings initiatives, price increases to customers, and by increasing inventory levels of certain products and working closely with its suppliers and customers to minimize disruptions in delivering products to customers. The Company's profitability has been, and may continue to be, adversely affected by constrained consumer demand, a shift in sales to lower-margin products, and demands on our performance that increased our costs. Should the ongoing macroeconomic conditions not improve, or worsen, or if the Company's attempt to mitigate the impact on its supply chain, operations and costs is not successful, the Company's business, results of operations and financial condition may be adversely affected.
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Key Components of Results of Operations
Net Sales
The principal activity from which the Company generates its sales is the designing, marketing, manufacturing and distribution of performance aftermarket automotive parts for its end consumers. Sales are displayed net of rebates and sales returns allowances. Sales returns are recorded as a charge against gross sales in the period in which the related sales are recognized.
Cost of Goods Sold
Cost of goods sold consists primarily of the cost of purchased parts and manufactured products, including materials and direct labor costs. In addition, warranty, incoming shipping and handling and inspection and repair costs are also included within costs of goods sold. Reductions in the cost of inventory to its net realizable value are also a component of cost of goods sold.
Selling, General, and Administrative
Selling, general, and administrative consist of payroll and related personnel expenses, IT and office services, office rent expense and professional services. In addition, self-insurance, advertising, research and development, outgoing shipping costs, pre-production and start-up costs are also included within selling, general, and administrative. The Company has incurred additional expenses as a result of operating as a public company, including expenses necessary to comply with the rules and regulations applicable to companies listed on a national securities exchange and related to compliance and reporting obligations pursuant to the rules and regulations of the SEC, as well as higher expenses for general and director and officer insurance, investor relations and other professional services.
Acquisition and Restructuring Costs
Acquisition and restructuring costs consist of professional fees for legal, accounting, consulting, administrative, and other professional services directly attributable to potential acquisitions. In addition, operational restructuring costs are included within this classification.
Related Party Acquisition and Management Fee Costs
Related party acquisition and management fee costs consist of fees paid to the Company’s historical private equity sponsor pursuant to a management services agreement for management services and consulting services directly attributable to potential acquisitions. Upon the Closing of the Business Combination, the management services agreement with our private equity sponsor was terminated.
Interest Expense
Interest expense consists of interest due on the indebtedness under our credit facilities. On December 31, 2022, $659.4 million was outstanding under the Credit Agreement. Interest is based on LIBOR or the prime rate, plus the applicable margin rate.
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Results of Operations
Year Ended December 31, 2022 Compared With Year Ended December 31, 2021
The table below presents Holley’s results of operations for the years ended December 31, 2022 and 2021 (dollars in thousands):
| For the years ended December 31, | ||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2022 | 2021 | Change ($) | Change (%) | |||||||||||||
| Net sales | $ | 688,415 | $ | 692,847 | $ | (4,432 | ) | (0.6 | %) | |||||||
| Cost of goods sold | 434,757 | 406,040 | 28,717 | 7.1 | % | |||||||||||
| Gross profit | 253,658 | 286,807 | (33,149 | ) | (11.6 | %) | ||||||||||
| Selling, general, and administrative | 150,728 | 116,793 | 33,935 | 29.1 | % | |||||||||||
| Research and development costs | 29,083 | 28,280 | 803 | 2.8 | % | |||||||||||
| Amortization of intangible assets | 14,683 | 13,999 | 684 | 4.9 | % | |||||||||||
| Impairment of indefinite-lived intangible assets | 2,395 | — | 2,395 | n/a | ||||||||||||
| Acquisition and restructuring costs | 4,513 | 23,668 | (19,155 | ) | (80.9 | %) | ||||||||||
| Related party acquisition and management fee costs | — | 25,789 | (25,789 | ) | (100.0 | %) | ||||||||||
| Other expense | 1,514 | 755 | 759 | 100.5 | % | |||||||||||
| Operating income | 50,742 | 77,523 | (26,781 | ) | (34.5 | %) | ||||||||||
| Change in fair value of warrant liability | (57,021 | ) | 32,580 | (89,601 | ) | nm | ||||||||||
| Change in fair value of earn-out liability | (10,731 | ) | 8,875 | (19,606 | ) | nm | ||||||||||
| Loss on early extinguishment of debt | — | 13,650 | (13,650 | ) | (100.0 | %) | ||||||||||
| Interest expense | 40,227 | 39,128 | 1,099 | 2.8 | % | |||||||||||
| Income (loss) before income taxes | 78,267 | (16,710 | ) | 94,977 | nm | |||||||||||
| Income tax expense | 4,493 | 10,429 | (5,936 | ) | (56.9 | %) | ||||||||||
| Net income (loss) | 73,774 | (27,139 | ) | 100,913 | nm | |||||||||||
| Foreign currency translation adjustment | (990 | ) | 30 | (1,020 | ) | nm | ||||||||||
| Pension liability gain (loss) | 302 | 388 | (86 | ) | (22.2 | %) | ||||||||||
| Total comprehensive income (loss) | $ | 73,086 | $ | (26,721 | ) | $ | 99,807 | nm |
Net Sales
Net sales for the year ended December 31, 2022, decreased $4.4 million, or 0.6%, to $688.4 million compared to $692.9 million for the year ended December 31, 2021. Non-comparable sales associated with acquisitions contributed $31.3 million to net sales in 2022, or year-over-year growth of 4.5%. The remaining comparable sales decreased by $35.7 million, or 5.2%. The decline in comparable sales was primarily driven by supply chain constraints that prevented the Company from building and shipping to orders received from customers and stabilizing demand due to a reduction in disposable income of our consumers. As a result, lower unit volume drove a decrease of approximately $88.5 million that was partially offset by improved price realization of approximately $52.8 million compared to 2021. Comparable year-over-year results by category include a decrease in electronic system sales of $28.1 million (9.1% category decline), a decrease in exhaust system sales of $11.4 million (14.6% category decline), a decrease in mechanical system sales of $4.6 million (3.0% category decline), a decrease in safety product sales of $3.2 million (4.9% category decline), and accessories sales growth of $11.6 million (13.6% category growth).
Cost of Goods Sold
Cost of goods sold for year ended December 31, 2022, increased $28.7 million, or 7.1%, to $434.8 million compared to $406.0 million for the year ended December 31, 2021. The increase in cost of goods sold during the year ended December 31, 2022, in which sales declined reflects compression in gross profit margin due to manufacturing inefficiencies driven by supply chain constraints, higher product rationalization charges, higher warranty costs, and inflationary pressures on certain other costs.
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Gross Profit and Gross Margin
Gross profit for the year ended December 31, 2022, decreased $33.2 million, or 11.6%, to $253.7 million compared to $286.8 million for the year ended December 31, 2021. Gross margin for the year ended December 31, 2022, of 36.8% decreased from gross margin of 41.4% for the year ended December 31, 2021. The decrease in gross profit and gross profit margin was driven primarily by inflationary factors, higher expenses associated with product rationalization and warranty costs, and a shift in the mix of products sold towards products with lower margins due in part to limitations caused by supply chain challenges. In general, gross margin and margins on individual products will remain under pressure due to various factors, including potential increases in manufacturing costs and the shift of the Company's sales mix towards products with lower gross margins. Future gross margins could also be affected by the Company's ability to manage product quality and warranty costs effectively and to stimulate demand for certain of its products.
Selling, General and Administrative
Selling, general and administrative costs for the year ended December 31, 2022, increased $33.9 million, or 29.1%, to $150.7 million compared to $116.8 million for the year ended December 31, 2021. When expressed as a percentage of sales, selling, general and administrative costs increased to 21.9% of sales for the year ended December 31, 2022, compared to 16.9% of sales in 2021. The increase in costs was driven by a $19.4 million increase in compensation expense related to equity awards, which included an $11.4 million cumulative adjustment related to the early vesting of profit interest units granted by the Holley Stockholder prior to the Business Combination. Outbound shipping and handling costs increased $7.6 million, reflecting inflationary pressures on domestic shipping companies, and recent acquisitions contributed $3.7 million to the increase in selling, general and administrative costs.
Research and Development Costs
Research and development costs for the year ended December 31, 2022, increased $0.8 million, or 2.8%, to $29.1 million compared to $28.3 million for the year ended December 31, 2021. The increase in research and development costs reflects our pursuit of product innovation and new products.
Amortization and Impairment of Intangible Assets
Amortization of intangible assets for the year ended December 31, 2022, increased $0.7 million, or 4.9%, to $14.7 million compared to $14.0 million for the year ended December 31, 2021, due to recent acquisitions. Additionally, an impairment charge of $2.4 million was recognized on certain indefinite-lived tradenames during 2022 (see Note 5, “Goodwill and Other Intangible Assets” in the Notes to the Consolidated Financial Statements included elsewhere in the Annual Report on Form 10-K for additional information related to the Company’s recognition of impairment charges).
Acquisition and Restructuring Costs
Acquisition and restructuring costs for the year ended December 31, 2022, decreased $19.2 million to $4.5 million, as compared to $23.7 million for the year ended December 31, 2021. The year ended December 31, 2021, included an adjustment of $17.2 million for contingent consideration payable for the acquisition of Simpson Performance Products (“Simpson”).
Related Party Acquisition and Management Fee Costs
Upon the Closing of the Business Combination, the management services agreement with our private equity sponsor was terminated. Related party acquisition and management fee costs for the year ended December 31, 2021, were $25.8 million, of which $23.3 million represents a fee paid upon the Closing of the Business Combination.
Operating Income
As a result of factors described above, operating income for the year ended December 31, 2022, decreased $26.8 million, or 34.5%, to $50.7 million compared to $77.5 million for the year ended December 31, 2021.
Change in Fair Value of Warrant Liability
For the year ended December 31, 2022, we recognized a gain of $57.0 million from the change in fair value of the warrant liability as compared to a loss of $32.6 million for the year ended December 31, 2021. The warrant liability reflects the fair value of the warrants issued in connection with the Business Combination.
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Change in Fair Value of Earn-Out Liability
For the year ended December 31, 2022, we recognized a gain of $10.7 million from the change in fair value of the earn-out liability as compared to a loss of $8.9 million for the year ended December 31, 2021. The earn-out liability reflects the fair value of the earn-out shares resulting from the Business Combination.
Interest Expense
Interest expense for the year ended December 31, 2022, increased $1.1 million, or 2.8%, to $40.2 million compared to $39.1 million for the year ended December 31, 2021, due to a higher effective interest rate.
Income (Loss) before Income Taxes
As a result of factors described above, we recognized net income of $78.3 million before income taxes for the year ended December 31, 2022, compared to a net loss before income taxes of $(16.7) million for the year ended December 31, 2021.
Income Tax Expense
We recognized income tax expense of $4.5 million for the year ended December 31, 2022, compared to $10.4 million for the year ended December 31, 2021. The effective tax rate for the year ended December 31, 2022, was 5.7%. The difference between the effective tax rate and the federal statutory rate in 2022 was primarily due to permanent differences resulting from the change in fair value of the warrant and earn-out liabilities. The difference between the effective tax rate for the year ended December 31, 2021, and the federal statutory rate in 2021 was due to the permanent difference resulting from the adjustment to the Simpson earn-out liability during the period and the change in fair value of the warrant and earn-out liabilities.
Net Income (Loss) and Total Comprehensive Income (Loss)
As a result of factors described above, we recognized net income of $73.8 million for the year ended December 31, 2022, compared to a net loss of $(27.1) million for the year ended December 31, 2021. Additionally, we recognized total comprehensive income of $73.1 million for the year ended December 31, 2022, compared to total comprehensive loss of $(26.7) million for the year ended December 31, 2021. Comprehensive income (loss) includes the effect of foreign currency translation and pension liability adjustments.
Year Ended December 31, 2021 Compared With Year Ended December 31, 2020
The table below presents Holley’s results of operations for the years ended December 31, 2021 and 2020 (dollars in thousands):
| For the years ended December 31, | ||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2021 | 2020 | Change ($) | Change (%) | |||||||||||||
| Net sales | $ | 692,847 | $ | 504,179 | $ | 188,668 | 37.4 | % | ||||||||
| Cost of goods sold | 406,040 | 295,935 | 110,105 | 37.2 | % | |||||||||||
| Gross profit | 286,807 | 208,244 | 78,563 | 37.7 | % | |||||||||||
| Selling, general, and administrative | 116,793 | 70,875 | 45,918 | 64.8 | % | |||||||||||
| Research and development costs | 28,280 | 23,483 | 4,797 | 20.4 | % | |||||||||||
| Amortization of intangible assets | 13,999 | 11,082 | 2,917 | 26.3 | % | |||||||||||
| Acquisition and restructuring costs | 23,668 | 9,743 | 13,925 | 142.9 | % | |||||||||||
| Related party acquisition and management fee costs | 25,789 | 6,089 | 19,700 | 323.5 | % | |||||||||||
| Other operating expense | 755 | 1,517 | (762 | ) | (50.2 | %) | ||||||||||
| Operating income | 77,523 | 85,455 | (7,932 | ) | (9.3 | %) | ||||||||||
| Change in fair value of warrant liability | 32,580 | — | 32,580 | n/a | ||||||||||||
| Change in fair value of earn-out liability | 8,875 | — | 8,875 | n/a | ||||||||||||
| Loss on early extinguishment of debt | 13,650 | — | 13,650 | n/a | ||||||||||||
| Interest expense | 39,128 | 43,772 | (4,644 | ) | (10.6 | %) | ||||||||||
| Income (loss) before income taxes | (16,710 | ) | 41,683 | (58,393 | ) | n/a | ||||||||||
| Income tax expense | 10,429 | 8,826 | 1,603 | 18.2 | % | |||||||||||
| Net income (loss) | (27,139 | ) | 32,857 | (59,996 | ) | n/a | ||||||||||
| Foreign currency translation adjustment | 30 | 16 | 14 | 87.5 | % | |||||||||||
| Pension liability gain (loss) | 388 | (293 | ) | 681 | n/a | |||||||||||
| Total comprehensive income (loss) | $ | (26,721 | ) | $ | 32,580 | $ | (59,301 | ) | n/a |
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Net Sales
Net sales for the year ended December 31, 2021, increased $188.6 million, or 37.4%, to $692.8 million compared to $504.2 million for the year ended December 31, 2020. Non-comparable sales associated with acquisitions contributed $116.4 million or 23.1% of year-over-year growth. The remainder of the increase was driven by a $37.3 million, or 25.1%, increase in electronic systems products sold and an $18.4 million, or 18.1%, increase in mechanical systems products sold.
Cost of Goods Sold
Cost of goods sold for year ended December 31, 2021, increased $110.1 million, or 37.2%, to $406.0 million compared to $295.9 million for the year ended December 31, 2020. The increase in cost of goods sold during the year ended December 31, 2021, was in line with a corresponding increase in product sales during such period.
Gross Profit and Gross Margin
Gross profit for the year ended December 31, 2021, increased $78.5 million, or 37.7%, to $286.8 million compared to $208.3 million for the year ended December 31, 2020. The increase in gross profit was driven by the increase in sales. Gross margin for the year ended December 31, 2021, was 41.4% compared to a gross margin of 41.3% for the year ended December 31, 2020.
Selling, General and Administrative
Selling, general and administrative costs for the year ended December 31, 2021, increased $45.9 million, or 64.8%, to $116.8 million compared to $70.9 million for the year ended December 31, 2020. When expressed as a percentage of sales, selling, general and administrative costs increased to 16.9% of sales for the year ended December 31, 2021, compared to 14.1% of sales in 2020. Recent acquisitions accounted for $18.5 million of the increase in selling, general and administrative costs. The increase in costs was also driven by a $4.5 million increase in compensation expense related to equity awards, a $5.4 million increase in outbound shipping costs related to higher sales and domestic supply chain pressure, and a $5.9 million increase in professional fees, primarily due to the Business Combination and as a result of becoming a public company.
Research and Development Costs
Research and development costs for the year ended December 31, 2021, increased $4.8 million, or 20.4%, to $28.3 million compared to $23.5 million for the year ended December 31, 2020. The increase in research and development costs was primarily due to headcount investments as we continue to pursue product innovation and new products.
Amortization of Intangible Assets
Amortization of intangible assets for the year ended December 31, 2021, increased $2.9 million, or 26.3%, to $14.0 million compared to $11.1 million for the year ended December 31, 2020, due to recent acquisitions.
Acquisition and Restructuring Costs
Acquisition and restructuring costs for the year ended December 31, 2021, increased $14.0 million to $23.7 million, which includes $17.2 million in contingent consideration related to the Simpson acquisition, $4.8 million in professional fees associated with the eight acquisitions completed in 2021, and $1.4 million of restructuring costs related to recent acquisitions. Acquisition and restructuring costs for the year ended December 31, 2020, were $9.7 million, which includes $2.3 million in professional fees associated with the Simpson, Drake and Detroit Speed acquisitions completed in 2020 and $3.2 million in restructuring costs incurred with the move of the West Sacramento, CA operations to our Bowling Green, KY facilities.
Related Party Acquisition and Management Fees
Related party acquisition and management fees for the year ended December 31, 2021, were $25.8 million, of which $23.3 million represents a fee paid upon the Closing of the Business Combination. Related party acquisition and management fees for the year ended December 31, 2020, were $6.1 million, which includes $4.2 million in management fees paid to the Company’s former private equity sponsor and $1.9 million that was attributable to the Drake and Simpson acquisitions,
Operating Income
As a result of factors described above, operating income for the year ended December 31, 2021, decreased $8.0 million, or 9.3%, to $77.5 million compared to $85.5 million for the year ended December 31, 2020.
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Change in Fair Value of Warrant Liability
For the year ended December 31, 2021, we recognized a loss of $32.6 million from the change in fair value of the warrant liability. The warrant liability reflects the fair value of the warrants issued in connection with the Business Combination.
Change in Fair Value of Earn-Out Liability
For the year ended December 31, 2021, we recognized a loss of $8.9 million from the change in fair value of the earn-out liability. The earn-out liability reflects the fair value of the earn-out shares resulting from the Business Combination.
Loss on Early Extinguishment of Debt
For the year ended December 31, 2021, we recognized a $13.6 million loss on the early extinguishment of debt. The extinguishment loss includes a write off of $12.2 million in unamortized debt issuance costs associated with our previous first lien and second lien notes due to the refinancing of our previous credit facility (refer to Note 6, “Debt” for further discussion). Additionally, we wrote off $1.4 million of unamortized debt issuance costs when $100 million of the net proceeds from the Business Combination were used to reduce the outstanding principal balance of our second lien note.
Interest Expense
Interest expense for the year ended December 31, 2021, decreased $4.7 million, or 10.6%, to $39.1 million compared to $43.8 million for the year ended December 31, 2020, due to a lower effective interest rate combine with the favorable impact of the $100 million paydown on our second lien note in July 2021.
Income (Loss) before Income Taxes
As a result of factors described above, we recognized a loss of $(16.7) million before income taxes for the year ended December 31, 2021, compared to income before income taxes of $41.7 million for the year ended December 31, 2020.
Income Tax Expense
We recognized income tax expense of $10.4 million for the year ended December 31, 2021, compared to $8.8 million for the year ended December 31, 2020. We recognized tax expense on a net loss for the year ended December 31, 2021, due to permanent differences resulting from the Business Combination, change in fair value of the warrant and earn-out liabilities, and the adjustment to the Simpson earnout during the period.
Net Income (Loss) and Total Comprehensive Income (Loss)
As a result of factors described above, we recognized a net loss of $(27.1) million for the year ended December 31, 2021, compared to net income of $32.9 million for the year ended December 31, 2020. Additionally, we recognized total comprehensive loss of $(26.7) million for the year ended December 31, 2021, compared to total comprehensive income of $32.6 million for the year ended December 31, 2020. Comprehensive income (loss) includes the effect of foreign currency translation and pension liability adjustments.
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Non-GAAP Financial Measures
Holley believes EBITDA and Adjusted EBITDA are useful to investors in evaluating the Company’s financial performance. In addition, Holley uses these measures internally to establish forecasts, budgets and operational goals to manage and monitor its business. Holley believes that these non-GAAP financial measures help to depict a more realistic representation of the performance of the underlying business, enabling the Company to evaluate and plan more effectively for the future. Holley believes that investors should have access to the same set of tools that its management uses in analyzing operating results.
Holley defines EBITDA as earnings before (a) depreciation, (b) amortization of intangible assets, (c) interest expense, and (d) income tax expense. Holley defines Adjusted EBITDA as EBITDA plus (i) acquisition and restructuring costs, which for 2021 includes a $17.2 million adjustment due to a change in the fair value of the Simpson acquisition contingent consideration payable, (ii) impairment of indefinite-lived intangible assets, (iii) changes in the fair value of the warrant liability, (iv) changes in the fair value of the earn-out liability, (v) compensation expense related to equity awards, (vi) product rationalization initiatives aimed at eliminating unprofitable or slow-moving stock keeping units, (vii) loss on the early extinguishment of debt (viii) related party acquisition and management fee costs, (ix) notable items that consist primarily of non-cash adjustments related to the adoption of ASC Topic 842, "Leases," in 2022, amortization of the fair market value increase in inventory due to acquisitions in 2021, and the amortization of the fair market value increase in inventory due to acquisitions and a legal settlement in 2020, and (x) other expenses, which for 2022 includes a $1.0 million loss on the sale of a business (see Note 2, "Business Combination, Acquisitions, and Divestiture," in the Notes to the Consolidated Financial Statements included elsewhere in this Annual Report on Form 10-K for additional information related to the divestiture) and for all periods includes net losses from disposal of fixed assets and foreign currency transactions. We have included within the definition of Adjusted EBITDA impairment of indefinite-lived intangible assets, changes in the fair value of warrant liabilities, changes in the fair value of the earn-out liability, and losses from the early extinguishment of debt, as management believes such matters, when they occur, do not directly reflect the performance of the underlying business.
EBITDA and Adjusted EBITDA are not prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) and may be different from non-GAAP financial measures used by other companies. These measures should not be considered as measures of financial performance under GAAP, and the items excluded from or included in these metrics are significant components in understanding and assessing Holley’s financial performance. These metrics should not be considered as alternatives to net income (loss) or any other performance measures derived in accordance with GAAP.
The following unaudited table presents the reconciliation of net income (loss), the most directly comparable GAAP measure, to EBITDA and Adjusted EBITDA for the years ended December 31, 2022, 2021 and 2020 (dollars in thousands):
| For the years ended December 31, | |||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|
| 2022 | 2021 | 2020 | |||||||||
| Net income (loss) | $ | 73,774 | $ | (27,139 | ) | $ | 32,857 | ||||
| Adjustments: | |||||||||||
| Depreciation | 10,107 | 11,527 | 7,886 | ||||||||
| Amortization of intangible assets | 14,683 | 13,999 | 11,082 | ||||||||
| Interest expense | 40,227 | 39,128 | 43,772 | ||||||||
| Income tax expense | 4,493 | 10,429 | 8,826 | ||||||||
| EBITDA | 143,284 | 47,944 | 104,423 | ||||||||
| Acquisition and restructuring costs | 4,513 | 23,668 | 9,743 | ||||||||
| Impairment of indefinite-lived intangible assets | 2,395 | — | — | ||||||||
| Change in fair value of warrant liability | (57,021 | ) | 32,580 | — | |||||||
| Change in fair value of earn-out liability | (10,731 | ) | 8,875 | — | |||||||
| Equity-based compensation expense | 24,395 | 4,963 | 487 | ||||||||
| Product rationalization | 4,519 | — | — | ||||||||
| Loss on early extinguishment of debt | — | 13,650 | — | ||||||||
| Related party acquisition and management fee costs | — | 25,789 | 6,089 | ||||||||
| Notable items | 1,838 | 11,270 | 3,891 | ||||||||
| Other expense | 1,514 | 755 | 1,517 | ||||||||
| Adjusted EBITDA | $ | 114,706 | $ | 169,494 | $ | 126,150 |
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Liquidity and Capital Resources
Holley’s primary cash needs are to support working capital, capital expenditures, acquisitions, and debt repayments. The Company has generally financed its historical needs with operating cash flows, capital contributions and borrowings under its credit facilities. These sources of liquidity may be impacted by various factors, including demand for Holley’s products, investments made in acquired businesses, plant and equipment and other capital expenditures, and expenditures on general infrastructure and information technology.
On December 31, 2022, the Company had cash of $26.2 million and availability of $113.8 million under its revolving credit facility. The Company has a senior secured revolving credit facility with $125 million in borrowing capacity. On December 31, 2022, the Company had $10.0 million in borrowings and $1.2 million of letters of credit outstanding under the revolving credit facility. In February 2023, the Company entered into an amendment to its Credit Agreement which, among other things, contains a minimum liquidity financial covenant of $45 million, which includes unrestricted cash and any available borrowing capacity under the revolving credit facility. The amendment also increases the consolidated net leverage ratio financial covenant level applicable under the Credit Agreement as of the fiscal quarter ending March 31, 2023 through the fiscal quarter ending March 31, 2024 (the “Covenant Relief Period”), to initially 7.25:1.00, and provides for modified step-down levels for such covenant thereafter.
The Company is obligated under various operating leases for facilities, equipment, and automobiles with estimated lease payments of approximately $7.2 million, including short-term leases, due in fiscal year 2023. See Note 14, "Lease Commitments" in the Notes to the Consolidated Financial Statements included elsewhere in this Annual Report on Form 10-K for additional information related to the Company’s lease obligations.
Holley's capital expenditures for the year ended December 31, 2022 of $13.6 million are primarily related to ongoing maintenance and improvements, including investments related to upgrading and maintaining our information technology systems, tooling for new products, vehicles for product development, and machinery and equipment for operations. We expect capital expenditures in the range of $10 million to $15 million in fiscal year 2023.
See Note 6, "Debt" in the Notes to the Consolidated Financial Statements included elsewhere in this Annual Report on Form 10-K for further detail of our credit facility and the timing of principal maturities. On December 31, 2022, based on the then current weighted average interest rate of 8.4%, expected interest payments associated with outstanding debt totaled approximately $55.7 million for fiscal year 2023.
As discussed under “Business Environment” above, although the future impact of supply chain disruptions and inflationary pressures are highly uncertain, the Company believes that its current operating performance, operating plan, cash position, and borrowings available under its revolving credit facility will be sufficient to satisfy its liquidity needs and capital expenditure requirements for at least the next twelve months and thereafter for the foreseeable future.
Cash Flows
The following table provides a summary of cash flows from operating, investing, and financing activities for the periods presented (dollars in thousands):
| For the years ended December 31, | ||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2022 | 2021 | 2020 | ||||||||||
| Cash flows provided by operating activities | $ | 12,312 | $ | 21,583 | $ | 88,413 | ||||||
| Cash flows used in investing activities | (25,037 | ) | (134,089 | ) | (165,618 | ) | ||||||
| Cash flows provided by financing activities | 2,850 | 77,157 | 140,544 | |||||||||
| Effect of foreign currency rate fluctuations on cash | (300 | ) | — | — | ||||||||
| Net decrease in cash and cash equivalents | $ | (10,175 | ) | $ | (35,349 | ) | $ | 63,339 |
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Operating Activities. Cash provided by operating activities for the year ended December 31, 2022, was $12.3 million compared to cash provided by operating activities of $21.6 million for the year ended December 31, 2021. Cash provided by prepaids and other current assets, accrued interest and accounts receivable increased by $14.6 million, $5.9 million, and $3.3 million, respectively. Offsetting these increases were decreases in cash provided by inventory, accrued liabilities and accounts payable of $13.3 million, $13.0 million, and $9.5 million, respectively. The changes in accounts receivable, accounts payable, and inventory are impacted by fluctuations in sales and accrued interest, accounts receivable and accounts payable are impacted by the timing of receipts and payments.
Cash provided by operating activities for the year ended December 31, 2021, was $21.6 million compared to cash provided by operating activities of $88.4 million for the year ended December 31, 2020. Cash provided by accounts receivable, accrued liabilities and accounts payable increased by $11.8 million, $9.2 million, and $0.3 million, respectively. Offsetting these increases were decreases in cash provided by inventory and prepaids and other current assets of $67.1 million and $15.3 million, respectively. The changes in accounts receivable, accounts payable and inventory reflect the growth in the business in 2021.
Investing Activities. Cash used in investing activities for the year ended December 31, 2022, was $25.0 million, primarily relating to acquisitions of $14.3 million and capital expenditures of $13.6 million. For the year ended December 31, 2021, cash used in investing activities was $134.1 million, primarily relating to acquisitions of $119.2 million and capital expenditures of $15.2 million. For the year ended December 31, 2020, cash used in investing activities was $165.6 million, primarily relating to acquisitions of $156.8 million and capital expenditures of $9.4 million.
Financing Activities. Cash provided by financing activities for the year ended December 31, 2022, was $2.9 million, which primarily reflected net borrowings on long-term debt. Cash provided by financing activities for the year ended December 31, 2021, was $77.2 million, which included $630.0 million in proceeds from long-term debt, $132.3 million in cash received due to the recapitalization, and $25.0 million in net borrowings under the revolving credit agreement, largely offset by $687.5 million in principal payments on long-term debt, $13.4 million in deferred financing fees, and $9.2 million in payment of contingent consideration on acquisitions. Cash provided by financing activities for the year ended December 31, 2020, was $140.5 million, which included $170.0 million of proceeds from long-term debt, net of $24.6 million in debt payments and $4.7 million in deferred financing fees.
Working Capital. On December 31, 2022, working capital was $223.7 million compared to $199.9 million on December 31, 2021. For the year ended December 31, 2022, inventories increased by $48.5 million. Offsetting this increase in working capital were a decrease in cash of $10.2 million, an increase in accrued liabilities of $8.5 million, and a decrease in accounts receivable of $4.3 million,
Holley’s working capital on December 31, 2021, increased $23.9 million from $176.0 million at December 31, 2020. For the year ended December 31, 2021, inventories increased by $51.1 million, prepaid and other current assets increased by $13.9 million, while acquisition contingent consideration payable decreased by $9.2 million. Offsetting these items were a decrease in Holley's cash balance of $35.3 million and an increase in accounts payable of $11.1 million.
Critical Accounting Estimates
The discussion and analysis of Holley's financial condition and results of operations are based upon its consolidated financial statements, which have been prepared in accordance with GAAP. See Note 1, "Description of the Business, Basis of Presentation, and Summary of Significant Accounting Policies", in the Notes to the Consolidated Financial Statements included elsewhere in this Annual Report on Form 10-K for a complete summary of the significant accounting policies used in the presentation of Holley's financial statements. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts and related disclosures of assets, liabilities, revenue, and expenses. Holley evaluates its estimates and assumptions on an ongoing basis. The estimates and assumptions used by management are based on historical experience and other factors, which are believed to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions, impacting Holley's reported results of operations and financial condition.
Critical accounting policies and estimates are those that management considers the most important to the portrayal of Holley's financial condition and results of operations because they require the most difficult, subjective, or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. Holley believes that its most critical accounting estimates are related to accounting for inventory reserves, the fair value of assets and liabilities acquired in the Business Combination and acquisitions, and accounting for goodwill and intangible assets. These critical accounting policies are addressed below.
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Inventory Reserve
The Company’s inventories are stated at the lower of cost or net realizable value using the first-in, first-out (FIFO) method. Adjustments to reduce the cost of inventory to its net realizable value are made, if required, for estimated excess, obsolescence or impaired balances. See Part IV, Item 15 in this Annual Report on Form 10-K for additional information related to the Company's inventory valuation reserve.
We regularly monitor inventory quantities on hand and on order and record write-downs for excess and obsolete inventories based on our estimate of the demand for our products, potential obsolescence of technology, product life cycles, and when pricing trends or forecast indicate that the carrying value of inventory exceeds our estimated selling price. These factors are affected by market and economic conditions, technology changes, and new product introductions and require estimates that may include elements that are uncertain. Actual demand may differ from forecasted demand and may have a material effect on our gross margin. If inventory is written down, a new cost basis will be established that cannot be increased in future periods.
Fair Value of Acquired Assets and Liabilities
Assigning fair market values to the assets acquired and liabilities assumed at the date of an acquisition requires knowledge of current market values and the values of assets in use, and often requires the application of significant judgment regarding estimates and assumptions. The same applies to assigning fair market values to the liabilities assumed in the Business Combination at the date of the transaction and at each reporting date thereafter. While the ultimate responsibility resides with management, for certain acquisitions the Company retains the services of certified valuation specialists to assist with assigning estimated values to certain acquired assets and assumed liabilities, including intangible assets, tangible long- lived assets, and liabilities assumed in the Business Combination. Acquired intangible assets, excluding goodwill, are valued using various methodologies including discounted cash flows, relief from royalty, and multiperiod excess earnings depending on the type of intangible asset purchased. These methodologies incorporate various estimates and assumptions, such as projected revenue growth rates, profit margins and forecasted cash flows based on discount rates and terminal growth rates. The Company uses a Monte Carlo simulation model to estimate the fair value of its private warrants and earn-out liability assumed in the Business Combination, which requires certain subjective inputs and assumptions, including expected common stock price volatility, expected term, and risk-free interest rates. These estimates and assumptions could vary significantly, which could result in material differences in the fair values assigned to the assets and liabilities. See Note 2, "Business Combination, Acquisitions, and Divestiture" and Note 8, "Fair Value Measurements" in the Notes to the Consolidated Financial Statements included elsewhere in this Annual Report on Form 10-K for additional information related to the Company’s assets and liabilities measured at fair value.
Goodwill and Intangible Assets
Goodwill represents the excess of purchase price over the fair value of the net tangible and identifiable intangible assets of businesses acquired. Goodwill amounts are not amortized, but rather tested for impairment at least annually or more often if circumstances indicate that the carrying value may not be recoverable. During the third quarter of 2022, management concluded it was necessary to reevaluate goodwill and indefinite-lived intangible assets for impairment after supply chain challenges led to management revising its earnings estimate for 2022, which resulted in a decline in the Company's market capitalization. Based on a quantitative assessment in the third quarter of 2022, we did not identify any indicators of goodwill impairment. During the fourth quarter of 2022, management performed the annual impairment test for goodwill, and a quantitative analysis did not identify any indicators of impairment. Based on the annual impairment assessment, the estimated fair value exceeded the carrying value of the reporting unit by 15%. As of December 31, 2022, management concluded it was necessary to reevaluate goodwill for impairment due to a further downward revision of its earnings estimate for 2022 and a continued decline in the Company's market capitalization. Accordingly, management performed a qualitative assessment and did not identify any indicators of impairment. Goodwill was $418.1 million as of December 31, 2022, and is considered at higher risk of failing future quantitative impairment tests due to the narrow difference between fair value and carrying value. No goodwill impairment changes were incurred during 2022 and 2021.
Intangible assets include trade names, customer relationships and developed technology obtained through business acquisitions. Acquired finite-lived intangible assets are initially recorded at fair value and are amortized on a straight-line basis over their estimated useful lives. Indefinite life intangible assets are not amortized but are tested for impairment at least annually or more often if circumstances indicate that the carrying amounts may not be recoverable. During the third quarter of 2022, a quantitative assessment of indefinite life intangible assets identified certain tradenames for which the carrying amounts might not be recoverable. As a result of this evaluation, a pre-tax impairment of $2.4 million was recognized on certain indefinite-lived tradenames. Management did not identify any circumstances to indicate that it was necessary to reevaluate indefinite-lived intangible assets for impairment in the fourth quarter of 2022. No impairment was recognized on intangible assets in 2021.
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The fair value of the indefinite-lived tradenames was estimated using the relief from royalty method, a form of the income approach. Significant judgement is required in estimating the fair value of a reporting unit and in performing impairment tests. The most significant assumptions utilized in the determination of the estimated fair values of the indefinite-lived tradenames were the sales projections and long-term earnings growth rates, the royalty rate and the discount rate. The long-term earnings growth rate represents the expected rate at which the brands are expected to grow beyond the shorter-term business planning period. The royalty rate is based on observed market royalty rates for various industrial, consumer and commercial trademarks. The discount rate is based on our weighted average cost of capital adjusted for risk.
Determining the fair value of the reporting unit requires significant judgment, including judgements about the appropriate terminal growth rates, weighted average costs of capital and the amounts and timing of projected future cash flows. Fair value determinations are sensitive to changes in underlying assumptions, estimates, and market factors. Projected future cash flows are based on our most recent forecasts and strategic plans as well as certain growth rate assumptions. Potential changes in our costs and operating structure, the implementation of synergies, and overall performance in the automotive aftermarket industry, could negatively impact our near-term cash-flow projections and could trigger a potential impairment of our goodwill. In addition, failure to execute our strategic plans as well as increases in weighted average costs of capital could negatively impact the fair value of the reporting unit and increase the risk of future impairment charges.
Recent Accounting Pronouncements
For a discussion of Holley’s new or recently adopted accounting pronouncements, see Note 1, “Description of the Business, Basis of Presentation, and Summary of Significant Accounting Policies,” in the Notes to the Consolidated Financial Statements included elsewhere in this Annual Report on Form 10-K.
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