Holley Inc. (HLLY) FY 2023 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.
Central to our business and growth strategy is a commitment to innovation. We have a history of developing innovative products, including new additions to existing product families, expansions of product lines, accessory offerings, and ventures into entirely new categories. We believe this strategic approach allows us to continually adapt to evolving consumer needs. Furthermore, strategic acquisitions have played a significant role in our evolution. These acquisitions have enabled us to expand our brand portfolio, enter new product categories and consumer segments, enhance DTC scale and connection, increase market share in existing product categories, and realize valuable revenue and cost synergies. While we anticipate continued organic growth, we intend to continue evaluating opportunities for strategic acquisitions that align with our current business, expanding our reach within the 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 the Business Combination pursuant to the Merger Agreement, by and among Empower, Merger Sub I, Merger Sub II, and Holley Intermediate. The Merger Agreement provided for, among other things, the following transactions: (i) Merger Sub I merged with and into Holley Intermediate, the separate corporate existence of Merger Sub I ceased and Holley Intermediate became the surviving corporation, and (ii) Holley Intermediate merged with and into Merger Sub II, the separate corporate existence of Holley Intermediate, and Merger Sub II became the surviving limited liability company. Upon closing of the Business Combination, Empower changed its name to Holley Inc. and its trading symbol on the NYSE from “EMPW” to “HLLY.”
The Business Combination was accounted for as a reverse recapitalization in accordance with GAAP. Holley Intermediate 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 Holley Intermediate.
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
We have historically pursued a growth strategy through both organic growth and acquisitions. We have pursued acquisitions that we believe will help drive profitability, cash flow and stockholder value. We target companies that we believe are market leaders, expand our geographic presence, provide a highly synergistic opportunity and/or enhance our ability to provide a wide array of our products to our customers through our distribution network.
In 2022 and 2021, Holley completed 11 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, we acquired Baer, Inc. doing business as Baer Brakes, a developer and supplier of brakes and brake systems. This acquisition moves us closer to our goal 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, we 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 our offering in truck and SUV appearance items. |
| Column 1 | Column 2 | Column 3 |
|---|---|---|
| • | Advance Engine Management Inc.: On April 14, 2021, we 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 our penetration into the import and other sport compact cars submarket. |
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 applicable 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 in this Annual Report on Form 10-K for additional information related to our acquisitions and investments.
Business Environment
Our 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, including military conflicts (including the conflict in Ukraine, the conflict in Israel and surrounding areas, and the possible expansion of such conflicts). Our operations have been adversely impacted, and may continue to be 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, we have attempted to minimize potential adverse impacts on our business with cost savings initiatives, price increases to customers, and by increasing inventory levels of certain products and working closely with our suppliers and customers to minimize disruptions in delivering products to customers. Our profitability has been, and may continue to be, adversely affected by constrained consumer demand, a shift in sales mix to lower-margin products, and demands on our performance that increased our costs. Should the ongoing macroeconomic conditions not improve, or worsen, or if our attempts to mitigate the impact on our supply chain, operations and costs is not successful, our 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 we generate our sales is the designing, marketing, manufacturing and distribution of performance aftermarket automotive parts for our 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. We have 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 our 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, 2023, $592.5 million was outstanding under the Credit Agreement. Interest is based on the SOFR or prime rate, plus the applicable margin rate.
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Results of Operations
Year Ended December 31, 2023 Compared With Year Ended December 31, 2022
The table below presents our results of operations for the years ended December 31, 2023 and 2022 (dollars in thousands):
| For the years ended December 31, | ||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2023 | 2022 | Change ($) | Change (%) | |||||||||||||
| Net sales | $ | 659,704 | $ | 688,415 | $ | (28,711 | ) | (4.2 | )% | |||||||
| Cost of goods sold | 403,615 | 434,757 | (31,142 | ) | (7.2 | )% | ||||||||||
| Gross profit | 256,089 | 253,658 | 2,431 | 1.0 | % | |||||||||||
| Selling, general, and administrative | 120,244 | 150,728 | (30,484 | ) | (20.2 | )% | ||||||||||
| Research and development costs | 23,844 | 29,083 | (5,239 | ) | (18.0 | )% | ||||||||||
| Amortization of intangible assets | 14,557 | 14,683 | (126 | ) | (0.9 | )% | ||||||||||
| Impairment of indefinite-lived intangible assets | — | 2,395 | (2,395 | ) | (100.0 | )% | ||||||||||
| Acquisition and restructuring costs | 2,641 | 4,513 | (1,872 | ) | (41.5 | )% | ||||||||||
| Other expense | 765 | 1,514 | (749 | ) | (49.5 | )% | ||||||||||
| Operating income | 94,038 | 50,742 | 43,296 | 85.3 | % | |||||||||||
| Change in fair value of warrant liability | 4,111 | (57,021 | ) | 61,132 | n/a | |||||||||||
| Change in fair value of earn-out liability | 2,303 | (10,731 | ) | 13,034 | n/a | |||||||||||
| Gain on early extinguishment of debt | (701 | ) | — | (701 | ) | n/a | ||||||||||
| Interest expense | 60,746 | 40,227 | 20,519 | 51.0 | % | |||||||||||
| Income before income taxes | 27,579 | 78,267 | (50,688 | ) | (64.8 | )% | ||||||||||
| Income tax expense | 8,399 | 4,493 | 3,906 | 86.9 | % | |||||||||||
| Net income | 19,180 | 73,774 | (54,594 | ) | (74.0 | )% | ||||||||||
| Foreign currency translation adjustment | 234 | (990 | ) | 1,224 | n/a | |||||||||||
| Pension liability gain | — | 302 | (302 | ) | (100.0 | )% | ||||||||||
| Total comprehensive income | $ | 19,414 | $ | 73,086 | $ | (53,672 | ) | (73.4 | )% |
Net Sales
Net sales for the year ended December 31, 2023, decreased $28.7 million, or 4.2%, to $659.7 million as compared to $688.4 million for the year ended December 31, 2022. The decline in sales was driven by supply chain constraints in electronic components and a return to the sales trends experienced prior to the increased demand experienced during the COVID-19 pandemic. As a result, lower unit volume drove a decrease of approximately $42.3 million that was partially offset by improved price realization of approximately $13.6 million compared to the prior year period. Comparable year-over-year results by category include a decrease in safety products sales of $9.4 million (14.3% category decline), a decrease in accessories sales of $9.3 million (8.6% category decline), a decrease in mechanical systems sales of $7.6 million (4.6% category decline), a decrease in exhaust system sales of $6.8 million (10.2% category decline), and electronic systems sales growth of $4.4 million (1.5% category growth)
Cost of Goods Sold
Cost of goods sold for year ended December 31, 2023, decreased $31.1 million, or 7.2%, to $403.6 million as compared to $434.8 million for the year ended December 31, 2022. The decrease in cost of goods sold during the year ended December 31, 2023, reflects the decrease in product sales during such period combined with lower freight costs.
Gross Profit and Gross Margin
Gross profit for the year ended December 31, 2023, increased $2.4 million, or 1.0%, to $256.1 million as compared to $253.7 million for the year ended December 31, 2022. Gross margin for the year ended December 31, 2023, was 38.8% as compared to a gross margin of 36.8% for the year ended December 31, 2022. The increase in gross profit and gross profit margin, during a period in which sales volume was down, was driven primarily by meaningful improvements in freight, lower warranty costs, and product mix.
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Selling, General and Administrative
Selling, general and administrative costs for the year ended December 31, 2023, decreased $30.5 million, or 20.2%, to $120.2 million as compared to $150.7 million for the year ended December 31, 2022. When expressed as a percentage of sales, selling, general and administrative costs decreased to 18.2% of sales for the year ended December 31, 2023, compared to 21.9% of sales in 2022. The decrease selling, general and administrative costs was driven by a lower equity compensation cost and the implementation of cost-saving initiatives, which resulted in decreases in outbound shipping and handling, professional fees, personnel and marketing costs.
Research and Development Costs
Research and development costs for the year ended December 31, 2023, decreased $5.2 million, or 18.0%, to $23.8 million as compared to $29.1 million for the year ended December 31, 2022. The decrease in research and development costs was primarily due to headcount reductions, reflecting the implementation of cost-saving initiatives.
Amortization and Impairment of Intangible Assets
Amortization of intangible assets for the year ended December 31, 2023, decreased $0.1 million, or 0.9%, to $14.6 million as compared to $14.7 million for the year ended December 31, 2022. 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 in this Annual Report on Form 10-K for additional information related to our recognition of impairment charges).
Acquisition and Restructuring Costs
Acquisition and restructuring costs for the year ended December 31, 2023, decreased $1.9 million to $2.6 million, as compared to $4.5 million for the year ended December 31, 2022, reflecting a reduction in restructuring activities associated with acquisitions.
Operating Income
As a result of factors described above, operating income for the year ended December 31, 2023, increased $43.3 million, or 85.3%, to $94.0 million as compared to $50.7 million for the year ended December 31, 2022.
Change in Fair Value of Warrant Liability
For the year ended December 31, 2023, we recognized a loss of $4.1 million due to the change in fair value of the warrant liability, which reflects an increase in Holley's stock price during 2023. This compares to a gain of $57.0 million for the year ended December 31, 2022, a period during which Holley's stock price declined. 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, 2023, we recognized a loss of $2.3 million due to the change in fair value of the earn-out liability, which reflects an increase in Holley's stock price during 2023. This compares to a gain of $10.7 million for the year ended December 31, 2022, a period during which Holley's stock price declined. The earn-out liability reflects the fair value of the unvested Earn-Out Shares resulting from the Business Combination.
Gain on Early Extinguishment of Debt
For the year ended December 31, 2023, we recognized a gain of $0.7 million on the early extinguishment of debt. The gain was recognized on the repurchase of $38.8 million of our first lien term loan at a discount to par, net of the write-off of unamortized debt issuance costs (refer to Note 7, “Debt” for further discussion).
Interest Expense
Interest expense for the year ended December 31, 2023, increased $20.5 million, or 51.0%, to $60.8 million as compared to $40.2 million for the year ended December 31, 2022, reflecting a higher effective interest rate on outstanding debt. Interest expense for 2023 is net of a $1.2 million fair value adjustment on the interest rate collar and $0.6 million in cash payments received on the interest rate collar.
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Income before Income Taxes
As a result of factors described above, we recognized $27.6 million of income before income taxes for the year ended December 31, 2023, as compared to net income before income taxes of $78.3 million for the year ended December 31, 2022.
Income Tax Expense
We recognized income tax expense of $8.4 million for the year ended December 31, 2023, as compared to $4.5 million for the year ended December 31, 2022. The effective tax rate was 30.5% and 5.7% for the years ended December 31, 2023 and 2022, respectively. The difference between the effective tax rate and the federal statutory rate in 2023 was primarily due to permanent differences resulting from state income taxes, foreign rate differentials, compensation limits with respect to covered employees, and the change in fair value of warrant and earn-out liabilities. 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 warrant and earn-out liabilities.
Net Income and Total Comprehensive Income
As a result of factors described above, we recognized net income of $19.2 million for the year ended December 31, 2023, as compared to net income of $73.8 million for the year ended December 31, 2022. Additionally, we recognized total comprehensive income of $19.4 million for the year ended December 31, 2023, as compared to total comprehensive income of $73.1 million for the year ended December 31, 2022. Comprehensive income (loss) includes the effect of foreign currency translation and pension liability adjustments.
Year Ended December 31, 2022 Compared With Year Ended December 31, 2021
The table below presents our results of operations for the years ended December 31, 2022 and 2021 (dollars in thousands):
| For the years ended December 31, | ||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2022 | 2021 | Change ($) | 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 operating 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 | ) | n/a | ||||||||||
| Change in fair value of earn-out liability | (10,731 | ) | 8,875 | (19,606 | ) | n/a | ||||||||||
| 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 | n/a | |||||||||||
| Income tax expense | 4,493 | 10,429 | (5,936 | ) | (56.9 | %) | ||||||||||
| Net income (loss) | 73,774 | (27,139 | ) | 100,913 | n/a | |||||||||||
| Foreign currency translation adjustment | (990 | ) | 30 | (1,020 | ) | n/a | ||||||||||
| Pension liability gain | 302 | 388 | (86 | ) | (22.2 | %) | ||||||||||
| Total comprehensive income (loss) | $ | 73,086 | $ | (26,721 | ) | $ | 99,807 | n/a |
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Net Sales
Net sales for the year ended December 31, 2022, decreased $4.4 million, or 0.6%, to $688.4 million as 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 us 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 as 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.
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 as 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 our sales mix towards products with lower gross margins. Future gross margins could also be affected by our ability to manage product quality and warranty costs effectively and to stimulate demand for certain of our 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 as 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 as 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 as 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 in this Annual Report on Form 10-K for additional information related to our 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”).
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Related Party Acquisition and Management Fees
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 as 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.
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 unvested 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 7, “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, 2022, increased $1.1 million, or 2.8%, to $40.2 million as 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, as 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, as 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. We recognized income tax expense on a net loss for the year ended December 31, 2021, due to permanent differences resulting from the Business Combination, 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, as 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, as 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.
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Non-GAAP Financial Measures
We present EBITDA and Adjusted EBITDA as supplemental measures of our operating performance and believe that such non-GAAP financial measures provide useful information to investors, because they exclude the impact of certain items that we do not consider indicative of our ongoing operating performance and we believe are useful in comparing our results of operations between periods. We believe that the presentation of EBITDA and Adjusted EBITDA enhances the usefulness of our financial information by presenting measures that management uses internally to establish forecasts, budgets and operational goals to manage and monitor our business. We believe that these non-GAAP financial measures help to depict a more realistic representation of the performance of our underlying business, enabling us to evaluate and plan more effectively for the future.
We define EBITDA as earnings before depreciation, amortization of intangible assets, interest expense, and income tax expense. We define Adjusted EBITDA as EBITDA adjusted to exclude, to the extent applicable, acquisition and restructuring costs, which includes transaction fees and expenses, termination related benefits, facilities relocation, and executive transition costs; changes in the fair value of the warrant liability; changes in the fair value of the earn-out liability; equity-based compensation expense; non-cash charges due to our product rationalization initiative aimed at eliminating unprofitable or slow-moving stock keeping units; impairment of indefinite-lived intangible assets; loss or (gain) on the early extinguishment of debt; related party acquisition and management fee costs; notable items that we do not believe are reflective of operating performance, which for the year ended December 31, 2023, includes certain costs incurred for advisory services related to identifying performance initiatives, and for the year ended December 31, 2022, includes a non-cash adjustment related to the adoption of ASC Topic 842, “Leases,” and legal fees and costs related to a settlement, and for the year ended December 31, 2021 includes amortization of the fair market value increase in inventory due to acquisitions; and other expenses or gains, which for the year ended December 31, 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 in this Annual Report on Form 10-K for additional information related to the divestiture) and for all periods includes net gains or losses from disposal of fixed assets, franchise taxes, and gains or losses from foreign currency transactions.
EBITDA and Adjusted EBITDA are not prepared in accordance with 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, 2023, 2022 and 2021 (dollars in thousands):
| For the years ended December 31, | ||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2023 | 2022 | 2021 | ||||||||||
| Net income (loss) | $ | 19,180 | $ | 73,774 | $ | (27,139 | ) | |||||
| Adjustments: | ||||||||||||
| Depreciation | 10,308 | 10,107 | 11,527 | |||||||||
| Amortization of intangible assets | 14,557 | 14,683 | 13,999 | |||||||||
| Interest expense, net | 60,746 | 40,227 | 39,128 | |||||||||
| Income tax expense (benefit) | 8,399 | 4,493 | 10,429 | |||||||||
| EBITDA | 113,190 | 143,284 | 47,944 | |||||||||
| Acquisition and restructuring costs | 2,641 | 4,513 | 23,668 | |||||||||
| Change in fair value of warrant liability | 4,111 | (57,021 | ) | 32,580 | ||||||||
| Change in fair value of earn-out liability | 2,303 | (10,731 | ) | 8,875 | ||||||||
| Equity-based compensation expense | 7,291 | 24,395 | 4,963 | |||||||||
| Product rationalization | (800 | ) | 4,519 | — | ||||||||
| Impairment of indefinite-lived intangible assets | — | 2,395 | — | |||||||||
| (Gain) loss on early extinguishment of debt | (701 | ) | — | 13,650 | ||||||||
| Related party acquisition and management fee costs | — | — | 25,789 | |||||||||
| Notable items | 1,285 | 1,838 | 11,270 | |||||||||
| Other expense | 765 | 1,514 | 755 | |||||||||
| Adjusted EBITDA | $ | 130,085 | $ | 114,706 | $ | 169,494 |
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Liquidity and Capital Resources
Our primary cash needs are to support working capital, capital expenditures, acquisitions, and debt repayments. We have generally financed our historical needs with operating cash flows, capital contributions and borrowings under our credit facilities. These sources of liquidity may be impacted by various factors, including demand for our products, investments made in acquired businesses, plant and equipment and other capital expenditures, and expenditures on general infrastructure and information technology.
On December 31, 2023, we had cash of $41.1 million and availability of $123.3 million under our revolving credit facility. We have a senior secured revolving credit facility with $125 million in borrowing capacity. On December 31, 2023, we had $1.7 million in letters of credit outstanding under the revolving credit facility. In February 2023, we entered into an amendment to our 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 April 2, 2023 to initially 7.25:1.00 and provides for modified step-down levels for such covenant thereafter through the fiscal quarter ending March 31, 2024 (the “Covenant Relief Period”). Commencing with the fiscal quarter ending June 30, 2024 (or such earlier date as the Company may choose to end the Covenant Relief Period in its sole discretion), the consolidated net leverage financial covenant reverts back to 5.00:1.00.
We are 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 2024. See Note 16, "Lease Commitments" in the Notes to the Consolidated Financial Statements included in this Annual Report on Form 10-K for additional information related to our lease obligations.
Our capital expenditures for the year ended December 31, 2023 of $5.9 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 $8 million to $12 million in fiscal year 2024.
See Note 7, "Debt" in the Notes to the Consolidated Financial Statements included in this Annual Report on Form 10-K for further detail of our credit facility and the timing of principal maturities. On December 31, 2023, based on the then current weighted average interest rate of 9.2%, expected interest payments associated with outstanding debt totaled approximately $54.6 million for fiscal year 2024.
As discussed under “Business Environment” above, although the future impact of supply chain disruptions and inflationary pressures are highly uncertain, we believe that our current operating performance, operating plan, cash position, and borrowings available under our revolving credit facility will be sufficient to satisfy our 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, | ||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2023 | 2022 | 2021 | ||||||||||
| Cash flows provided by operating activities | $ | 88,092 | $ | 12,312 | $ | 21,583 | ||||||
| Cash flows used in investing activities | (4,453 | ) | (25,037 | ) | (134,089 | ) | ||||||
| Cash flows (used in) provided by financing activities | (69,008 | ) | 2,850 | 77,157 | ||||||||
| Effect of foreign currency rate fluctuations on cash | 300 | (300 | ) | — | ||||||||
| Net (decrease) increase in cash and cash equivalents | $ | 14,931 | $ | (10,175 | ) | $ | (35,349 | ) |
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Operating Activities. Cash provided by operating activities for the year ended December 31, 2023, was $88.1 million compared to cash provided by operating activities of $12.3 million for the year ended December 31, 2022. Cash provided by inventory and prepaids and other current assets increased by $96.6 million and $1.4 million, respectively. Offsetting these increases were decreases in cash provided by accrued interest, accounts receivable, and accounts payable of $8.2 million, $6.1 million, and $0.9 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, 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.
Investing Activities. Cash used in investing activities for the year ended December 31, 2023, was $4.5 million, primarily relating to capital expenditures of $5.9 million. For the year ended December 31, 2022, cash used in investing activities 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.
Financing Activities. Cash used in financing activities for the year ended December 31, 2023, was $69.0 million, which primarily reflected principal payments on long-term debt. 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.
Working Capital. On December 31, 2023, working capital was $203.6 million compared to $223.7 million on December 31, 2022. For the year ended December 31, 2023, inventories decreased by $41.3 million. Offsetting this decrease in working capital was an increase in cash of $14.9 million.
Holley’s working capital on December 31, 2022, increased $23.8 million from $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.
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 in this Annual Report on Form 10-K for a complete summary of the significant accounting policies used in the presentation of our 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. We evaluate our 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 our reported results of operations and financial condition.
Critical accounting policies and estimates are those that management considers the most important to the portrayal of our 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. We believe that our 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
Our 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 our 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 we retain 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. We use a Monte Carlo simulation model to estimate the fair value of our 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 10, "Fair Value Measurements" in the Notes to the Consolidated Financial Statements included in this Annual Report on Form 10-K for additional information related to our 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, we concluded it was necessary to reevaluate goodwill and indefinite-lived intangible assets for impairment after supply chain challenges led to a downward revision of earnings estimates for 2022, which resulted in a decline in our 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, we performed our 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%. On December 31, 2022, we concluded it was necessary to reevaluate goodwill for impairment due to a further downward revision of earnings estimates for 2022 and a continued decline in our market capitalization. Accordingly, we performed a qualitative assessment and did not identify any indicators of impairment. During the fourth quarter of 2023, we performed our annual impairment test for goodwill, and a qualitative assessment did not identify any indicators of impairment. Goodwill was $419.1 million on December 31, 2023, 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 charges were incurred during 2023 and 2022.
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. During the fourth quarter of 2023, we performed our annual impairment test of indefinite-lived intangible assets, and a qualitative assessment did not identify any indicators of impairment. No impairment was recognized on intangible assets in 2023.
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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 in this Annual Report on Form 10-K.
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