Limbach Holdings, Inc. (LMB) 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
The following discussion should be read in conjunction with the consolidated financial statements and related notes thereto included elsewhere 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 actual results to differ materially from our management’s expectations. Factors that could cause such differences are discussed in “Forward-Looking Statements”, “Risk Factor Summary” and “Risk Factors” in this Annual Report. We assume no obligation to update any of these forward-looking statements.
Overview
The Company is an integrated building systems solutions firm whose expertise is in the design, modular prefabrication, installation, management and maintenance of HVAC, mechanical, electrical, plumbing and control systems for commercial, institutional and light industrial markets. The Company operates primarily in the Northeast, Mid-Atlantic, Southeast and Midwest regions of the United States. In February 2022, the Company announced its strategic decision to wind down its
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Southern California GCR and ODR operations. The decision was made to better align the Company’s customer geographic focus and to reduce losses related to unprofitable locations. The Company is currently in the closeout phases on its remaining Southern California business unit projects and expects to fully exit the Southern California region in 2023 aside from certain operational warranty obligations. However, the Company is party to the terms of a sublease agreement for its leased premises in Southern California through April 2027 and remains obligated under the original lease for such office space in the event the sublessee fails to satisfy its obligations under the sublease agreement. See Note 14 – Leases in the accompanying notes to the Company’s consolidated financial statements for further information on the Southern California Sublease.
The Company’s core market sectors consist of the following customer base with mission-critical systems:
◦Healthcare, including research, acute care and inpatient hospitals for regional and national hospital groups, and pharmaceutical and biotech laboratories and manufacturing facilities;
◦Data Centers, including facilities composed of networked computers, storage systems and computing infrastructure that organizations use to assemble, process, store and disseminate large amounts of data;
◦Industrial and light manufacturing facilities, including automotive, energy and general manufacturing plants;
◦Higher Education, including both public and private colleges, universities and research centers;
◦Cultural and entertainment, including sports arenas, entertainment facilities (including casinos) and amusement rides and parks; and
◦Life sciences, including organizations and companies whose work is centered around research and development focused on living things.
The Company operates in two segments, (i) GCR, in which the Company generally manages new construction or renovation projects that involve primarily HVAC, plumbing, or electrical services awarded to the Company by general contractors or construction managers, and (ii) ODR, in which the Company performs owner direct projects and/or provides maintenance or service primarily on HVAC, plumbing or electrical systems, building controls and specialty contracting projects direct to, or assigned by, building owners or property managers. This work is primarily performed under fixed price, modified fixed price, and time and material contracts over periods of typically less than two years.
Key Components of Consolidated Statements of Operations
Revenue
The Company generates revenue principally from fixed-price construction contracts to deliver HVAC, plumbing, and electrical construction services to its customers. The duration of the Company’s contracts generally ranges from three months to two years. Revenue from fixed price contracts is recognized on the cost-to-cost method, measured by the relationship of total cost incurred to total estimated contract costs. Revenue from time and materials service contracts is recognized as services are performed. The Company believes that its extensive experience in HVAC, plumbing, and electrical projects, and its internal cost review procedures during the bidding process, enable it to reasonably estimate costs and mitigate the risk of cost overruns on fixed price contracts.
The Company generally invoices customers on a monthly basis based on a schedule of values that breaks down the contract amount into discrete billing items. Costs and estimated earnings in excess of billings are recorded as a contract asset until billable under the contract terms. Billings in excess of costs and estimated earnings are recorded as a contract liability until the related revenue is recognizable.
Cost of Revenue
Cost of revenue primarily consists of the labor, equipment, material, subcontract, and other job costs in connection with fulfilling the terms of our contracts. Labor costs consist of wages plus taxes, fringe benefits, and insurance. Equipment costs consist of the ownership and operating costs of company-owned assets, in addition to outside-rented equipment. If applicable, job costs include estimated contract losses to be incurred in future periods. Due to the varied nature of the Company’s services, and the risks associated therewith, contract costs as a percentage of contract revenue have historically fluctuated and it expects this fluctuation to continue in future periods.
Selling, General and Administrative
Selling, general and administrative (“SG&A”) expenses consist primarily of personnel costs for its administrative, estimating, human resources, safety, information technology, legal, finance and accounting employees and executives. Also included are
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non-personnel costs, such as travel-related expenses, legal and other professional fees and other corporate expenses to support the growth of the Company’s business and to meet the compliance requirements associated with operating as a public company. Those costs include accounting, human resources, information technology, legal personnel, additional consulting, legal and audit fees, insurance costs, board of directors’ compensation and the costs of achieving and maintaining compliance with Section 404 of the Sarbanes-Oxley Act of 2002.
Change in fair value of contingent consideration
The change in fair value of contingent consideration relates to the remeasurement of the contingent consideration arrangement resulting from the Jake Marshall Transaction. As a part of the total consideration for the Jake Marshall Transaction, the Company initially recognized $3.1 million in contingent consideration associated with the Earnout Payments (as defined in Note 3 – Acquisitions in the accompanying notes to the Company’s consolidated financial statements). The carrying value of the Earnout Payments is subject to remeasurement at fair value at each reporting date through the end of the earnout periods with any changes in the fair value reported as a separate component of operating income in the consolidated statements of operations.
Amortization of Intangibles
Amortization expense represents periodic non-cash charges that consist of amortization of various intangible assets primarily including favorable leasehold interests and certain customer relationships in the ODR segment. As a result of the Jake Marshall Transaction, the Company recognized, in the aggregate, an additional $5.7 million of intangible assets associated with customer relationships with third-party customers, the acquired trade name and acquired backlog. The Jake Marshall-related intangible assets were recorded under the acquisition method of accounting at their estimated fair values at the acquisition date. See Note 3 – Acquisitions in the accompanying notes to the Company’s consolidated financial statements for further discussion of the Company’s acquired intangible assets as a result of the Jake Marshall Transaction.
Other (Expenses) Income
Other (expenses) income consists primarily of interest expense incurred in connection with the Company's debt, net of interest income, a loss associated with the early termination of an operating lease, a loss on early debt extinguishment, losses associated with the disposition of property and equipment, changes in fair value of interest rate swaps and changes in fair value of warrant liability. Deferred financing costs are amortized to interest expense using the effective interest method.
Provision for Income Taxes
The Company is taxed as a C corporation and its financial results include the effects of federal income taxes which will be paid at the parent level.
The Company’s provision for income taxes (including federal, state and local taxes) is calculated based on the estimated annual effective tax rate. The Company accounts for income taxes in accordance with ASC Topic 740 - Income Taxes, which requires the use of the asset and liability method. Under this method, deferred tax assets and liabilities and income or expense are recognized for the expected future tax consequences of temporary differences between the financial statement carrying values and their respective tax bases, using enacted tax rates expected to be applicable in the years in which the temporary differences are expected to reverse. Changes in deferred tax assets and liabilities are recorded in the provision for income taxes.
Operating Segments
The Company manages and measures the performance of its business in two operating segments: GCR and ODR. These segments are reflective of how the Company’s Chief Operating Decision Maker (“CODM”) reviews operating results for the purposes of allocating resources and assessing performance. The Company’s CODM is comprised of its President and Chief Executive Officer, Executive Vice President and Chief Financial Officer and Executive Vice President and Chief Operating Officer.
The CODM evaluates performance based on income from operations of the respective business units after the allocation of corporate office operating expenses. In accordance with ASC Topic 280 – Segment Reporting, the Company has elected to aggregate all of the GCR work performed at individual business units into one GCR reportable segment and all of the ODR work performed at individual business units into one ODR reportable segment. All transactions between segments are eliminated in consolidation. The Company’s corporate department provides general and administrative support services to its two operating segments. The Company allocates costs between segments for selling, general and administrative and depreciation expense. Interest expense is not allocated to segments because of the corporate management of debt service. See
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Note 12 – Operating Segments in the accompanying notes to the Company’s consolidated financial statements for further discussion on its operating segments.
Comparison of Results of Operations for the years ended December 31, 2022 and 2021
The following table presents operating results for the years ended December 31, 2022 and 2021 in dollars and expressed as a percentage of total revenue (except as indicated below):
| For the Years Ended December 31, | ||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| (in thousands except for percentages) | 2022 | 2021 | ||||||||||||
| Statement of Operations Data: | ||||||||||||||
| Revenue: | ||||||||||||||
| GCR | $ | 280,379 | 56.4 | % | $ | 350,015 | 71.4 | % | ||||||
| ODR | 216,403 | 43.6 | % | 140,336 | 28.6 | % | ||||||||
| Total revenue | 496,782 | 100.0 | % | 490,351 | 100.0 | % | ||||||||
| Gross profit: | ||||||||||||||
| GCR | 38,622 | 13.8 | % | (1) | 45,409 | 13.0 | % | (1) | ||||||
| ODR | 55,119 | 25.5 | % | (2) | 40,501 | 28.9 | % | (2) | ||||||
| Total gross profit | 93,741 | 18.9 | % | 85,910 | 17.5 | % | ||||||||
| Selling, general and administrative: | ||||||||||||||
| GCR | 36,332 | 13.0 | % | (1) | 37,558 | 10.7 | % | (1) | ||||||
| ODR | 38,805 | 17.9 | % | (2) | 31,277 | 22.3 | % | (2) | ||||||
| Corporate | 2,742 | 0.6 | % | 2,601 | 0.5 | % | ||||||||
| Total selling, general and administrative | 77,879 | 15.7 | % | 71,436 | 14.6 | % | ||||||||
| Change in fair value of contingent consideration (Corporate) | 2,285 | 5.9 | % | — | — | % | ||||||||
| Amortization of intangibles (Corporate) | 1,567 | 0.3 | % | 484 | 0.1 | % | ||||||||
| Operating income (loss): | ||||||||||||||
| GCR | 2,290 | 0.8 | % | (1) | 7,851 | 2.2 | % | (1) | ||||||
| ODR | 16,314 | 7.5 | % | (2) | 9,224 | 6.6 | % | (2) | ||||||
| Corporate | (6,594) | — | % | (3,085) | — | % | ||||||||
| Total operating income | 12,010 | 2.4 | % | 13,990 | 2.9 | % | ||||||||
| Other expenses (Corporate) | (2,402) | (0.5) | % | (4,513) | (0.9) | % | ||||||||
| Total consolidated income before income taxes | 9,608 | 1.9 | % | 9,477 | 1.9 | % | ||||||||
| Income tax provision | 2,809 | 0.6 | % | 2,763 | 0.6 | % | ||||||||
| Net income | $ | 6,799 | 1.4 | % | $ | 6,714 | 1.4 | % |
(1)As a percentage of GCR revenue.
(2)As a percentage of ODR revenue.
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Revenue
| For the Years Ended December 31, | ||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2022 | 2021 | Increase/(Decrease) | ||||||||||||
| (in thousands except for percentages) | ||||||||||||||
| Revenue: | ||||||||||||||
| GCR: | $ | 280,379 | $ | 350,015 | $ | (69,636) | (19.9) | % | ||||||
| ODR: | 216,403 | 140,336 | 76,067 | 54.2 | % | |||||||||
| Total revenue | $ | 496,782 | $ | 490,351 | $ | 6,431 | 1.3 | % |
Revenue for the year ended December 31, 2022 increased by $6.4 million compared to the year ended December 31, 2021. GCR revenue decreased by $69.6 million, or 19.9%, while ODR revenue increased by $76.1 million, or 54.2%. The decrease in year-over-year GCR segment revenue was primarily due to revenue declines in the New England, Mid-Atlantic, Michigan and Southern California business units. The Company continued to focus on improving project execution and profitability by pursuing GCR opportunities that were smaller in scope and lower in contract value, shorter in duration, and where the Company can leverage its captive design and engineering services. In addition, in February 2022, the Company announced its strategic decision to wind down its Southern California business unit. The Company is currently in the closeout phases on its remaining Southern California business unit projects and expects to fully exit the Southern California region in 2023 aside from certain operational warranty obligations. For the year ended December 31, 2022, GCR and ODR revenue decreased $11.2 million and $2.8 million, respectively, as a result of the Company's announced wind down of its Southern California business unit. The increase in year-over-year ODR segment revenue was primarily due to the Company's continued focus on the accelerated growth of its ODR business. In addition, for the year ended December 31, 2022, GCR and ODR segment revenue increased by $28.6 million and $34.3 million, respectively, as a result of revenue generated by the Acquired Entities in the Jake Marshall Transaction. See Note 3 for further information on the Jake Marshall Transaction.
During 2022, the Company continued to face economic disruptions, including supply chain, production, and other logistical issues, as well as escalating commodity prices, that continued to negatively impact its business. The Company experienced lead times significantly in excess of historical normal levels while also experiencing the effects of inflation through increases in fuel, material, and other commodity prices. These disruptions have escalated in 2022 and have manifested themselves most notably through project delays and reduced labor productivity and efficiency, particularly within our GCR segment.
Gross Profit
| For the Years Ended December 31, | ||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2022 | 2021 | Increase/(Decrease) | ||||||||||||
| (in thousands except for percentages) | ||||||||||||||
| Gross profit: | ||||||||||||||
| GCR | $ | 38,622 | $ | 45,409 | $ | (6,787) | (14.9) | % | ||||||
| ODR | 55,119 | 40,501 | 14,618 | 36.1 | % | |||||||||
| Total gross profit | $ | 93,741 | $ | 85,910 | $ | 7,831 | 9.1 | % | ||||||
| Total gross profit as a percentage of consolidated total revenue | 18.9 | % | 17.5 | % |
The Company's gross profit for the year ended December 31, 2022 increased by $7.8 million, or 9.1% compared to the year ended December 31, 2021. GCR gross profit decreased $6.8 million, or 14.9%, largely due to lower revenue at slightly higher margins. ODR gross profit increased $14.6 million, or 36.1%, due to an increase in revenue despite lower margins driven by project mix and timing. The total gross profit percentage increased from 17.5% for the year ended December 31, 2021 to 18.9% for the year ended December 31, 2022, mainly driven by the mix of higher margin ODR segment work, coupled with a gross profit write-up of $1.3 million related to a settlement of a prior claim. In addition, for the year ended December 31, 2022, gross profit generated by the Acquired Entities in the Jake Marshall Transaction increased by approximately $9.7 million compared to the year ended December 31, 2021.
The Company recorded revisions in its contract estimates for certain GCR and ODR projects. During the year ended December 31, 2022, the Company recorded material gross profit write-ups on three GCR projects for a total of $3.0 million and four material GCR project gross profit write-downs for a total of $2.8 million that had a net gross profit impact of $0.5 million or more. There were no material write-ups or write-downs within the ODR segment during the year ended December 31, 2022. During the year ended December 31, 2021, the Company recorded material gross profit write-downs on five GCR projects for a
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total of $4.9 million and gross profit write-ups of $2.7 million on three GCR projects that had a net gross profit impact of $0.5 million or more. There were no material write-ups or write-downs within the ODR segment during the year ended December 31, 2021.
Selling, General and Administrative
| For the Years Ended December 31, | ||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2022 | 2021 | Increase/(Decrease) | ||||||||||||
| (in thousands except for percentages) | ||||||||||||||
| Selling, general and administrative: | ||||||||||||||
| GCR | $ | 36,332 | $ | 37,558 | $ | (1,226) | (3.3) | % | ||||||
| ODR | 38,805 | 31,277 | 7,528 | 24.1 | % | |||||||||
| Corporate | 2,742 | 2,601 | 141 | 5.4 | % | |||||||||
| Total selling, general and administrative | $ | 77,879 | $ | 71,436 | $ | 6,443 | 9.0 | % | ||||||
| Total selling, general and administrative expenses as a percentage of consolidated total revenue | 15.7 | % | 14.6 | % |
The Company's SG&A expense for the year ended December 31, 2022 increased by approximately $6.4 million, or 9.0% compared to the year ended December 31, 2021. The increase in SG&A was primarily due to a $5.9 million increase associated with costs incurred by the Acquired Entities in the Jake Marshall Transaction, $2.2 million associated with an estimated loss contingency accrual and a $1.0 million increase in travel and entertainment expense. These increases were partially offset by a decrease of $0.5 million associated with professional fee expenses, coupled with other various immaterial decreases to SG&A, which reflect the Company’s ongoing efforts to reduce operating expenses where possible. The Company has also made strategic investments, which are reflected in the SG&A of its ODR segment, consisting primarily of salespeople and support staff to aid the Company’s focus on the accelerated growth of its ODR segment. Additionally, SG&A as a percentage of revenue was 15.7% for the year ended December 31, 2022 and 14.6% for the year ended December 31, 2021.
Change in Fair Value of Contingent Consideration
The change in fair value of the Earnout Payments contingent consideration was a $2.3 million loss for the year ended December 31, 2022. The increase to the contingent liability was primarily attributable to the timing component and probability of meeting the gross profit margins associated with the contingent consideration arrangement as of December 31, 2022.
Amortization of Intangibles
| For the Years Ended December 31, | ||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2022 | 2021 | Increase/(Decrease) | ||||||||||||
| (in thousands except for percentages) | ||||||||||||||
| Amortization of intangibles | $ | 1,567 | $ | 484 | $ | 1,083 | 223.8 | % |
Total amortization expense for the year ended December 31, 2022 increased by approximately $1.1 million compared to the year ended December 31, 2021. As a result of the Jake Marshall Transaction, the Company acquired certain intangible assets in which the Company recognized approximately $1.4 million of amortization expense for the year ended December 31, 2022 compared to $0.1 million for the year ended December 31, 2021. See Note 3 – Acquisitions in the accompanying notes to the Company’s consolidated financial statements for further discussion of the Company’s acquired intangible assets as a result of the Jake Marshall Transaction.
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Other Expenses
| For the Years Ended December 31, | ||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2022 | 2021 | Increase/(Decrease) | ||||||||||||
| (in thousands except for percentages) | ||||||||||||||
| Other (expenses) income: | ||||||||||||||
| Interest expense, net | $ | (2,144) | $ | (2,568) | $ | (424) | (16.5) | % | ||||||
| Loss on early termination of operating lease | (849) | — | (849) | 100.0 | % | |||||||||
| Loss on debt extinguishment | — | (1,961) | (1,961) | (100.0) | % | |||||||||
| Change in fair value of interest rate swap | 310 | — | 310 | 100.0 | % | |||||||||
| Gain on sale of property and equipment | 281 | 2 | (279) | 13,950.0 | % | |||||||||
| Gain on change in fair value of warrant liability | — | 14 | 14 | (100.0) | % | |||||||||
| Total other expenses | $ | (2,402) | $ | (4,513) | $ | (3,189) | (70.7) | % |
Other (expenses) income consisted of interest expense of $2.1 million for the year ended December 31, 2022 as compared to $2.6 million for the year ended December 31, 2021. The reduction in interest expense period over period was due to the refinancing of the higher interest rate debt with a lower interest rate debt instrument as a result of the 2021 Refinancing and the A&R Wintrust Agreement, coupled with a lower overall level of outstanding debt during 2022. The decrease in other expenses year-over-year was also attributable to a prior year loss of $2.0 million on the early extinguishment of debt associated with the Company's 2021 Refinancing and a $0.3 million gain on the change in fair value of the Company's interest rate swap transaction, which was entered in during the third quarter of 2022 in order to manage the risk associated with a portion of its variable-rate long-term debt. During the year ended December 31, 2022, the Company recognized a $0.8 million loss as a result of the early termination of its Pittsburgh operating lease. See Note 14 – leases in the accompanying notes to the Company’s consolidated financial statements for further information.
Income Taxes
The Company’s income tax provision was $2.8 million for both years ended December 31, 2022 and 2021, and it had a 29.2% effective tax rate over those same periods. The Company’s effective tax rate changes based upon its relative profitability, or lack thereof, in states with varying tax rates and rules. In addition, discrete items, such as tax law changes, judgments and legal structures can impact its effective tax rate. See also Note 11 – Income Taxes in the accompanying notes to the Company’s consolidated financial statements.
GCR and ODR Backlog Information
The Company refers to its estimated revenue on uncompleted contracts, including the amount of revenue on contracts for which work has not begun, less the revenue it had recognized under such contracts, as “backlog.” Backlog includes unexercised contract options. The Company’s backlog includes projects that have a written award, a letter of intent, a notice to proceed or an agreed upon work order to perform work on mutually accepted terms and conditions. Additionally, the difference between the Company’s backlog and remaining performance obligations is due to the portion of unexercised contract options that are excluded, under certain contract types, from the Company’s remaining performance obligations as these contracts can be canceled for convenience at any time by the Company or the customer without considerable cost incurred by the customer. Additional information related to the Company’s remaining performance obligations is provided in Note 4 — Revenue from Contracts with Customers in the accompanying notes to its consolidated financial statements. See also “Item 1A. Risk Factors — Our contract backlog is subject to unexpected adjustments and cancellations and could be an uncertain indicator of our future earnings.”
The Company’s GCR backlog was $302.9 million and $337.2 million as of December 31, 2022 and 2021, respectively. Projects are brought into backlog once the Company has been provided a written confirmation of award and the contract value has been established. At any point in time, the Company has a substantial volume of projects that are specifically identified and advanced in negotiations and/or documentation, however those projects are not booked as backlog until the Company has received written confirmation from the owner or the GC/CM of their intention to award it the contract and they have directed the Company to begin engineering, designing, incurring construction labor costs or procuring needed equipment and material. The Company’s GCR projects tend to be built over a 12- to 24-month schedule depending upon scope and complexity. Most major projects have a preconstruction planning phase which may require months of planning before actual construction commences. The Company is occasionally employed to deliver a “fast-track” project, where construction commences as the preconstruction planning work continues. As work on the Company’s projects progress, it increases or decreases backlog to take into account its estimate of the effects of changes in estimated quantities, changes in conditions, change orders and other variations from initially
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anticipated contract revenue, and the percentage of completion of the Company’s work on the projects. Based on historical trends, the Company currently estimates that 68% of its GCR backlog as of December 31, 2022 will be recognized as revenue during 2023. Additionally, the reduction in GCR backlog has been intentional as the Company looks to focus on higher margin projects than historically, as well as its focus on smaller, higher margin owner direct projects.
The Company’s ODR backlog was $108.2 million and $98.0 million as of December 31, 2022 and 2021, respectively. These amounts reflect unrecognized revenue expected to be recognized over the remaining terms of our service contracts and projects. Based on historical trends, the Company currently estimates that 92% of its ODR backlog as of December 31, 2022 will be recognized as revenue during 2023. The Company believes its ODR backlog increased due to its continued focus on the accelerated growth of its ODR business.
COVID-19 and Market Update
In March 2020, the World Health Organization declared the outbreak of the coronavirus disease 2019 (“COVID-19”) a global pandemic. The COVID-19 pandemic has caused significant disruption and volatility on a global scale resulting in, among other things, an economic slowdown, impacts to global supply chains, and the possibility of a continued economic recession. In limited instances, during fiscal 2020, the Company faced disruptions due to the COVID-19 pandemic as certain projects chose to shutdown work irrespective of the existence or applicability of government action. In most markets, construction is considered an essential business and the Company continued to staff its projects and perform work during fiscal 2020 and into 2021, and most of the projects that were in progress at the time that the shutdowns commenced were restarted.
As new variants of the virus emerge, the Company remains cautious as many factors remain unpredictable. The Company actively monitors and responds to the changing conditions created by the pandemic, with focus on prioritizing the health and safety of the Company’s employees, dedicating resources to support the Company’s communities, and innovating to address the Company’s customers’ needs. During 2021, the Company faced impacts of both the Delta and Omicron variants, with disruptions to the Company’s workforce, which impacted revenue.
Although the Company continues to recover from the financial impacts of the COVID-19 pandemic and related government orders implemented to mitigate it, the broader and longer-term implications the pandemic has on the global economy continue to develop. Economic disruptions, including supply chain, production, and other logistical issues, as well as escalating commodity prices, have and may continue to negatively impact our business. For example, we are experiencing lead times significantly in excess of normal levels while also experiencing the effects of inflation through increases in fuel, material, and other commodity prices. These disruptions have escalated in 2022 and have manifested themselves most notably through project delays and reduced labor productivity and efficiency, particularly within our GCR segment. In response to these challenges, the Company continues to strive to more effectively manage its business through enhanced labor planning and project scheduling, increased pricing to the extent contractually permitted, and by leveraging the Company's relationships with its suppliers and customers. However, the impact of these disruptions continues to evolve and the conflict in Ukraine has added another layer of uncertainty, as described under Part I, Item 1A. “Risk Factors” in this Annual Report on Form 10-K. There can be no assurance that the Company's actions will serve to mitigate such impacts in future periods. Further, while the Company believes its remaining performance obligations are firm, and its customers have not provided the Company with indications that they no longer wish to proceed with planned projects, prolonged delays in the receipt of critical equipment could result in the Company's customers seeking to terminate existing or pending agreements. Any of these events could have a material adverse effect on our business, financial condition, and/or results of operations.
The Company continues to monitor developments involving our workforce, customers, suppliers and vendors and take steps to mitigate against additional impacts, but given the unprecedented and evolving nature of these circumstances, it cannot predict the full extent of the impact that the economic disruptions caused by COVID-19 will have on the Company's operating results, financial condition and liquidity.
Outlook for 2023
The Company continues to focus on creating value for building owners by targeting opportunities for long-term relationships with the vision of becoming an indispensable partner to building owners with mission-critical systems. For 2023, the Company plans to continue taking steps to focus on the following key areas: (i) improve profitability, operating cash flows and actions oriented to maintaining sufficient liquidity, (ii) focus on ODR-related work with an emphasis on dedicated account relationships (iii) invest in its workforce and (iv) improve project execution and profitability in its GCR segment by remaining selective and pursuing processes that avoid or reduce exposure to jobs that create potential financial challenges for the Company.
In focusing on profitability and cash flows, among other things, the Company has dedicated and continues to dedicate, its resources toward the growth of its ODR segment as the scope of services provided within the Company’s ODR segment
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typically yield higher margins when compared to its GCR segment work. The Company reaffirms its focus on expanding the number and breadth of owner relationships that it serves on a direct basis and to leverage these expanded owner-direct relationships to deliver a broad suite of services. In addition, the Company proactively manages its current accounts and maintains a high standard of dedication to those account relationships. The Company’s primary focus is working with customers where their systems are mission critical and have needs regardless of the macroeconomic environment. As it relates to the Company’s ODR-related work, the Company has made substantial investments to expand its ODR revenue by increasing the value it can offer to service and maintenance customers and continues to evaluate areas in which it could expand the breadth of its service offerings to better serve its clients. The Company is focused on its differentiated business model that combines engineering, craft labor and a true partner approach, all of which creates value for its customers. This differentiated business model combines elements of traditional non-residential construction, building service and maintenance, energy services, data analytics and property management. Employee development underpins the Company’s efforts to execute its 2023 strategy. The Company is actively concentrating managerial and sales resources on training and hiring experienced employees to sell and profitably perform ODR-related work.
Additionally, the Company believes that it can further increase its cash flow and operating income by acquiring strategically synergistic companies that will supplement the Company’s current business model, address capability gaps and enhance the breadth of its service offerings to better serve its clients. The Company has dedicated, and continues to dedicate, its resources to seek opportunities to acquire businesses that have attractive market positions, a record of consistent positive cash flow, and desirable market locations. However, as a specialty contractor providing HVAC, plumbing, electrical and building controls design, engineering, installation and maintenance services in commercial, institutional and light industrial markets, our operating cash flows are subject to variability, including variability associated with winning, performing and closing work and projects.
The Company’s operating cash flows are also impacted by the timing related to the resolution of the uncertainties inherent in the complex nature of the work that it performs, including claims and back charge settlements. Although the Company believes that it has adequate plans related to providing sufficient operating working capital and liquidity in the short-term, the complex nature of the work the Company performs, including related to claims and back charge settlements could prove those plans to be incorrect. If those plans prove to be incorrect, the Company’s financial position, results of operations, cash flows and liquidity could be materially and adversely impacted.
As it relates to focusing on owner-direct work and the Company’s focus on job selection and processes, the Company believes that it is appropriate in the current contracting environment to reduce risk and exposure to large, complex, non-owner direct projects where the trend has been for such jobs to provide risks that are difficult to mitigate. Currently, management believes the historical industry pricing and associated risks for this type of work does not align with the Company’s stakeholders’ expectations and therefore the Company is continuing to take steps to actively reduce these risks as it looks at future job selection and as it completes current jobs.
Seasonality, Cyclicality and Quarterly Trends
Severe weather can impact the Company’s operations. In the northern climates where it operates, and to a lesser extent the southern climates as well, severe winters can slow the Company’s productivity on construction projects, which shifts revenue and gross profit recognition to a later period. The Company’s maintenance operations may also be impacted by mild or severe weather. Mild weather tends to reduce demand for its maintenance services, whereas severe weather may increase the demand for its maintenance and time-and-materials services. The Company’s operations also experience mild cyclicality, as building owners typically work through maintenance and capital projects at an increased level during the third and fourth calendar quarters of each year.
Effect of Inflation and Tariffs
The prices of products such as steel, pipe, copper and equipment from manufacturers are subject to fluctuation and increases. It is difficult to accurately measure the impact of inflation, tariffs and price escalation due to the imprecise nature of the estimates required. However, these effects are, at times, material to our results of operations and financial condition. During fiscal years 2022 and 2021, we have experienced higher cost of materials on specific projects and delays in our supply chain for equipment and service vehicles from the manufacturers, and we expect these higher costs and delays in our supply chain to persist in 2023. When appropriate, we include cost escalation factors into our bids and proposals, as well as limit the acceptance time of our bid. In addition, we are often able to mitigate the impact of future price increases by entering into fixed price purchase orders for materials and equipment and subcontracts on our projects. Notwithstanding these efforts, if we experience significant disruptions to our supply chain, we may need to delay certain projects that would otherwise be accretive to our business and this may also impact the conversion rate of our current backlog into revenue.
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Liquidity and Capital Resources
Cash Flows
The Company’s liquidity needs relate primarily to the provision of working capital (defined as current assets less current liabilities) to support operations, funding of capital expenditures, and investment in strategic opportunities such as acquisitions. Historically, liquidity has been provided by operating activities and borrowings from commercial banks and institutional lenders.
The following table presents summary cash flow information for the periods indicated:
| For the Years Ended December 31, | ||||||
|---|---|---|---|---|---|---|
| (in thousands) | 2022 | 2021 | ||||
| Net cash provided by (used in): | ||||||
| Operating activities | $ | 35,373 | $ | (24,233) | ||
| Investing activities | (495) | (19,303) | ||||
| Financing activities | (13,353) | 15,865 | ||||
| Net increase (decrease) in cash, cash equivalents and restricted cash | $ | 21,525 | $ | (27,671) | ||
| Noncash investing and financing transactions: | ||||||
| Earnout Payments associated with the Jake Marshall Transaction | $ | — | $ | 3,089 | ||
| Right of use assets obtained in exchange for new operating lease liabilities | — | 5,417 | ||||
| Right of use assets obtained in exchange for new finance lease liabilities | 2,634 | 1,296 | ||||
| Right of use assets disposed or adjusted modifying operating leases liabilities | 2,455 | 219 | ||||
| Right of use assets disposed or adjusted modifying finance leases liabilities | (77) | — | ||||
| Interest paid | 2,005 | 2,549 | ||||
| Cash paid for income taxes | $ | 1,979 | $ | 2,290 |
The Company's cash flows are primarily impacted period to period by fluctuations in working capital. Factors such as the Company’s contract mix, commercial terms, days sales outstanding (“DSO”) and delays in the start of projects may impact its working capital. In line with industry practice, the Company accumulates costs during a given month then bills those costs in the current month for many of its contracts. While labor costs associated with these contracts are paid weekly and salary costs associated with the contracts are paid bi-weekly, certain subcontractor costs are generally not paid until the Company receives payment from its customers (contractual “pay-if-paid” terms). The Company has not historically experienced a large volume of write-offs related to its receivables and contract assets. The Company regularly assesses its receivables for collectability and provides allowances for doubtful accounts where appropriate. The Company believes that its reserves for doubtful accounts are appropriate as of December 31, 2022 and 2021, but adverse changes in the economic environment may impact certain of its customers’ ability to access capital and compensate the Company for its services, as well as impact project activity for the foreseeable future.
The Company's existing current backlog is projected to provide substantial coverage of forecasted GCR revenue for one year from the date of the financial statement issuance. The Company’s current cash balance, together with cash it expects to generate from future operations along with borrowings available under its credit facility, are expected to be sufficient to finance its short- and long-term capital requirements (or meet working capital requirements) for the next twelve months. In addition to the future operating cash flows of the Company, along with its existing borrowing availability and access to financial markets, the Company currently believes it will be able to meet any working capital and future operating requirements, and capital investment forecast opportunities for the next twelve months.
The following table represents our summarized working capital information:
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| As of December 31, | ||||||
|---|---|---|---|---|---|---|
| (in thousands, except ratios) | 2022 | 2021 | ||||
| Current assets | $ | 225,990 | $ | 192,906 | ||
| Current liabilities | (159,085) | (129,742) | ||||
| Net working capital | $ | 66,905 | $ | 63,164 | ||
| Current ratio(1) | 1.42 | 1.49 |
(1) Current ratio is calculated by dividing current assets by current liabilities.
As discussed above and in Note 7 – Debt in the accompanying notes to the Company’s consolidated financial statements, as of December 31, 2022, the Company was in compliance with all financial maintenance covenants as required by its credit facility.
Cash Flows Provided by (Used in) Operating Activities
The following is a summary of the significant sources (uses) of cash from operating activities:
| For the Years Ended December 31, | ||||||||||
|---|---|---|---|---|---|---|---|---|---|---|
| (in thousands) | 2022 | 2021 | Cash Inflow (Outflow) | |||||||
| Cash flows from operating activities: | ||||||||||
| Net income | $ | 6,799 | $ | 6,714 | $ | 85 | ||||
| Non-cash operating activities(1) | 17,634 | 16,997 | 637 | |||||||
| Changes in operating assets and liabilities: | ||||||||||
| Accounts receivable | (35,407) | 3,408 | (38,815) | |||||||
| Contract assets | 22,410 | (15,054) | 37,464 | |||||||
| Other current assets | 1,128 | (555) | 1,683 | |||||||
| Accounts payable, including retainage | 11,282 | (5,578) | 16,860 | |||||||
| Contract liabilities | 17,296 | (20,399) | 37,695 | |||||||
| Prepaid income taxes | 19 | (114) | 133 | |||||||
| Accrued taxes payable | 1,387 | (1,170) | 2,557 | |||||||
| Accrued expenses and other current liabilities | (2,934) | (706) | (2,228) | |||||||
| Operating lease liabilities | (4,133) | (4,083) | (50) | |||||||
| Other long-term liabilities | (108) | (3,693) | 3,585 | |||||||
| Cash provided by (used in) working capital | 10,940 | (47,944) | 58,884 | |||||||
| Net cash provided by (used in) operating activities | $ | 35,373 | $ | (24,233) | $ | 59,606 |
(1)Represents non-cash activity associated with depreciation and amortization, the provision for doubtful accounts, stock-based compensation expense, operating lease expense, amortization of debt issuance costs, deferred income tax provision, (gain) loss on sale of property and equipment, loss on early debt extinguishment, loss on early termination of operating lease, changes in fair value of contingent consideration, changes in the fair value of interest rate swap and changes in the fair value of warrant liabilities.
During the year ended December 31, 2022, the Company generated $35.4 million in cash in its operating activities, which consisted of cash provided by working capital of $10.9 million, non-cash adjustments of $17.6 million (primarily depreciation and amortization, stock-based compensation expense, operating lease expense, loss on early termination of an operating lease and the change in fair value of contingent consideration) and net income for the period of $6.8 million. During the year ended December 31, 2021, the Company used $24.2 million in cash in its operating activities, which consisted of cash used in working capital of $47.9 million, offset by net income for the period of $6.7 million and non-cash adjustments of $17.0 million (primarily depreciation and amortization, stock-based compensation expense, operating lease expense and loss on early extinguishment of debt).
The increase in operating cash flows during the year ended December 31, 2022 compared to the year ended December 31, 2021 were primarily attributable to a $75.2 million cash inflow period-over-period related to the aggregate change in our contract assets and liabilities and a $16.9 million change in accounts payable, including retainage. These cash inflows were partially offset by a $38.8 million period-over-period cash outflow related to the change in accounts receivable. The increase in our
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overbilled position was due to the timing of contract billings and the recognition of contract revenue. The cash inflow/outflow associated with our accounts payable and accounts receivable was due to the timing of cash payments and receipts, respectively.
Cash Flows Used in Investing Activities
Cash flows used in investing activities were $0.5 million for the year ended December 31, 2022 as compared to $19.3 million for the year ended December 31, 2021. Cash used in investing activities for the year ended December 31, 2022 of $0.5 million represented $1.0 million of cash outflows for capital additions pertaining to additional non-leased vehicles, tools and equipment, computer software and hardware purchases, office furniture and office related leasehold improvements, offset by $0.5 million in cash proceeds from the sale of property and equipment. Cash used in investing activities for the year ended December 31, 2021 of $19.3 million was primarily due to the $19.0 million of cash outflows associated with the Jake Marshall Transaction, net of cash acquired. In addition, the Company used $0.8 million of cash for capital additions pertaining to additional non-leased vehicles, tools and equipment, computer software and hardware purchases, office furniture and office related leasehold improvements, offset by $0.5 million in cash proceeds from the sale of property and equipment.
For the years ended December 31, 2022 and 2021, the Company obtained the use of various assets through operating and finance leases, which reduced the level of capital expenditures that would have otherwise been necessary to operate our business.
Cash Flows (Used in) Provided by Financing Activities
Cash flows used in financing activities was $13.4 million for the year ended December 31, 2022 as compared to cash flows provided by financing activities of $15.9 million for the year ended December 31, 2021. For the year ended December 31, 2022, the Company made principal payments of $13.4 million, consisting of monthly installment payments of $0.6 million, an Excess Cash Flow payment of $3.3 million and total Net Claim Proceeds payments of $2.7 million, The Company also borrowed and repaid $15.2 million under the A&R Wintrust Revolving Loan of $15.2 million, made payments of $2.7 million on finance leases, repurchased $2.0 million in common stock under the Company’s Share Repurchase Program (defined below), paid $0.4 million in taxes related to net share settlement of equity awards and incurred $0.4 million in payments for debt issuance costs. These financing cash outflows were partly offset by $5.4 million in proceeds from the Company’s sale-leaseback financing transaction and $0.3 million associated with proceeds from contributions to the Company’s Employee Stock Purchase Plan (“ESPP”).
For the year ended December 31, 2021, the Company received proceeds from the following: $22.8 million, net of fees and expenses, in conjunction with our common stock offering in February 2021, $2.0 million from the exercise of warrants, $30.0 million in connection with the 2021 Refinancing, $10.0 million associated with the A&R Wintrust Term Loan and $0.3 million associated with proceeds from contributions to the ESPP. These proceeds were partly offset by the $39.0 million payment in full of the 2019 Refinancing Term Loan and associated $1.4 million prepayment penalty and other extinguishment costs, $4.5 million and $0.6 million of scheduled principal payments on the Wintrust Term Loan and the A&R Wintrust Term Loan, respectively, $2.6 million for payments on finance leases, $0.5 million in taxes related to net share settlement of equity awards and $0.6 million for payments related to debt issuance costs related to the Wintrust Term Loan and Wintrust Revolving Loan.
The following table reflects the Company’s available funding capacity as of December 31, 2022:
| (in thousands) | ||||
|---|---|---|---|---|
| Cash & cash equivalents | $ | 36,001 | ||
| Credit agreement: | ||||
| A&R Wintrust Revolving Loan | 25,000 | |||
| Outstanding borrowings on the A&R Wintrust Revolving Loan | — | |||
| Outstanding letters of credit | (3,195) | |||
| Net credit agreement capacity available | 21,805 | |||
| Total available funding capacity | $ | 57,806 |
Share Repurchase Program
In September 2022, the Company announced that its Board of Directors approved a share repurchase program (the “Share Repurchase Program”) to repurchase shares of its common stock for an aggregate purchase price not to exceed $2.0 million. The share repurchase authority is valid through September 29, 2023. Share repurchases may be executed through various means, including, without limitation, open market transactions, privately negotiated transactions or by other means in accordance with federal securities laws. The Share Repurchase Program does not obligate the Company to acquire any
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particular amount of common stock, and the program may be suspended or terminated by the Company at any time at its discretion without prior notice. As of December 31, 2022, the Company has made share repurchases of $2.0 million under its Share Repurchase Program.
Debt and Related Obligations
Long-term debt consists of the following obligations as of:
| (in thousands) | December 31, 2022 | December 31, 2021 | ||||
|---|---|---|---|---|---|---|
| A&R Wintrust Term Loan - term loan payable in quarterly installments of principal, (commencing in December 2021) plus interest through February 2026 | $ | 21,453 | $ | 34,881 | ||
| A&R Wintrust Revolving Loan | — | — | ||||
| Finance leases – collateralized by vehicles, payable in monthly installments of principal, plus interest ranging from 3.96% to 6.60% through 2027 | 4,954 | 5,132 | ||||
| Financing liability | 5,351 | — | ||||
| Total debt | $ | 31,758 | $ | 40,013 | ||
| Less - Current portion of long-term debt | (9,564) | (9,879) | ||||
| Less - Unamortized discount and debt issuance costs | (666) | (318) | ||||
| Long-term debt | $ | 21,528 | $ | 29,816 |
On February 24, 2021 (the “2021 Refinancing Date”), the Company refinanced its 2019 Refinancing Term Loan (defined in Note 7 - Debt in the accompanying notes to the Company’s consolidated financial statements) and 2019 Revolving Credit Facility (defined in Note 7 - Debt in the accompanying notes to the Company’s consolidated financial statements) with proceeds from the issuance of the Wintrust Term Loan (defined in Note 7 - Debt in the accompanying notes to the Company’s consolidated financial statements) (the “2021 Refinancing”). As a result of the 2021 Refinancing, the Company prepaid all principal, interest, fees and other obligations outstanding under the 2019 Refinancing Agreements (defined in Note 7 - Debt in the accompanying notes to the Company’s consolidated financial statements) and terminated its 2019 Refinancing Term Loan and 2019 Refinancing Revolving Credit Facility. In addition, on the 2021 Refinancing Date, the Company recognized a loss on the early extinguishment of debt of $2.0 million, which consisted of the write-off of $2.6 million of unamortized discount and financing costs, the reversal of the $2.0 million CB warrants liability and the prepayment penalty and other extinguishment costs of $1.4 million.
In conjunction with the Jake Marshall Transaction, the Company entered into the A&R Wintrust Credit Agreement. In accordance with the terms of the A&R Wintrust Credit Agreement, Lenders provided to LFS (i) a $35.5 million senior secured term loan (the “A&R Wintrust Term Loan”); and (ii) a $25 million senior secured revolving credit facility with a $5 million sublimit for the issuance of letters of credit (the “A&R Wintrust Revolving Loan” and, together with the Term Loan, the “A&R Wintrust Loans”). The overall A&R Wintrust Term Loan commitment under the A&R Wintrust Credit Agreement was recast at $35.5 million in connection with the A&R Wintrust Credit Agreement. A portion of the A&R Wintrust Term Loan commitment was used to fund the closing purchase price of the Jake Marshall Transaction. The A&R Credit Agreement was also amended to: permit the Company to undertake the Jake Marshall Transaction, make certain adjustments to the covenants under the A&R Wintrust Credit Agreement (which were largely done to make certain adjustments for the Jake Marshall Transaction), allow for the Earnout Payments under the Jake Marshall Transaction and make other corresponding changes to the A&R Wintrust Credit Agreement.
See Note 7 – Debt in the accompanying notes to the Company’s consolidated financial statements for further discussion.
Sale-Leaseback Financing Transaction
On September 29, 2022, LC LLC and the Purchaser consummated the purchase of the real property under a sale and leaseback transaction, with an aggregate value of approximately $7.8 million (a purchase price of approximately $5.4 million and $2.4 million in tenant improvement allowances), pursuant to a purchase agreement under which the Purchaser purchased from LC LLC the Pontiac Facility. In connection with the sale and leaseback transaction, LC LLC and the Landlord entered into the Lease Agreement for the Pontiac Facility. The Company accounted for the sale and leaseback arrangement as a financing transaction in accordance with ASC 842, “Leases,” as the Lease Agreement was determined to be a finance lease. See Note 7 – Debt in the accompanying notes to the Company’s consolidated financial statements for further discussion.
Surety Bonding
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In connection with our business, we are occasionally required to provide various types of surety bonds that provide an additional measure of security to our customers for our performance under certain government and private sector contracts. Our ability to obtain surety bonds depends upon our capitalization, working capital, past performance, management expertise and external factors, including the capacity of the overall surety market. Surety companies consider such factors in light of the amount of our backlog that we have currently bonded and their current underwriting standards, which may change from time-to-time. The bonds, if any, we provide typically reflect the contract value. As of December 31, 2022 and 2021, we had approximately $129.6 million and $159.2 million in surety bonds outstanding, respectively. We believe that our $800 million bonding capacity provides us with a significant competitive advantage relative to many of our competitors which have limited bonding capacity. See Note 13 – Commitments and Contingencies in the accompanying notes to the Company’s consolidated financial statements for further discussion.
Insurance and Self-Insurance
We purchase workers’ compensation and general liability insurance under policies with per-incident deductibles of $250,000 per occurrence. Losses incurred over primary policy limits are covered by umbrella and excess policies up to specified limits with multiple excess insurers. We accrue for the unfunded portion of costs for both reported claims and claims incurred but not reported. The liability for unfunded reported claims and future claims is reflected on the consolidated balance sheets as current and non-current liabilities. The liability is computed by determining a reserve for each reported claim on a case-by-case basis based on the nature of the claim and historical loss experience for similar claims plus an allowance for the cost of incurred but not reported claims. The current portion of the liability is included in accrued expenses and other current liabilities on the consolidated balance sheets. The non-current portion of the liability is included in other long-term liabilities on the consolidated balance sheets.
We are self-insured related to medical and dental claims under policies with annual per-claimant and annual aggregate stop-loss limits. We accrue for the unfunded portion of costs for both reported claims and claims incurred but not reported. The liability for unfunded reported claims and future claims is reflected on the consolidated balance sheets as a current liability in accrued expenses and other current liabilities. See Note 13 – Commitments and Contingencies in the accompanying notes to the Company’s consolidated financial statements for further discussion.
Multiemployer Plans
We participate in approximately 40 MEPPs that provide retirement benefits to certain union employees in accordance with various collective bargaining agreements (“CBAs”). As one of many participating employers in these MEPPs, we are responsible with the other participating employers for any plan underfunding. Our contributions to a particular MEPP are established by the applicable CBAs; however, required contributions may increase based on the funded status of an MEPP and legal requirements of the Pension Protection Act of 2006 (the “PPA”), which requires substantially underfunded MEPPs to implement a funding improvement plan (“FIP”) or a rehabilitation plan (“RP”) to improve their funded status. Factors that could impact funded status of an MEPP include, without limitation, investment performance, changes in the participant demographics, decline in the number of contributing employers, changes in actuarial assumptions and the utilization of extended amortization provisions. Assets contributed to the MEPPs by us may be used to provide benefits to employees of other participating employers. If a participating employer stops contributing to an MEPP, the unfunded obligations of the MEPP may be borne by the remaining participating employers.
An FIP or RP requires a particular MEPP to adopt measures to correct its underfunding status. These measures may include, but are not limited to an increase in a company’s contribution rate as a signatory to the applicable CBA, or changes to the benefits paid to retirees. In addition, the PPA requires that a 5.0% surcharge be levied on employer contributions for the first year commencing shortly after the date the employer receives notice that the MEPP is in critical status and a 10.0% surcharge on each succeeding year until a CBA is in place with terms and conditions consistent with the RP.
We could also be obligated to make payments to MEPPs if we either cease to have an obligation to contribute to the MEPP or significantly reduce our contributions to the MEPP because we reduce the number of employees who are covered by the relevant MEPP for various reasons, including, but not limited to, layoffs or closure of a subsidiary assuming the MEPP has unfunded vested benefits. The amount of such payments (known as a complete or partial withdrawal liability) would equal our proportionate share of the MEPPs’ unfunded vested benefits. We believe that certain of the MEPPs in which we participate may have unfunded vested benefits. Due to uncertainty regarding future factors that could trigger withdrawal liability, we are unable to determine (a) the amount and timing of any future withdrawal liability, if any, and (b) whether our participation in these MEPPs could have a material adverse impact on our financial condition, results of operations or liquidity.
Recent Accounting Pronouncements
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We review new accounting standards to determine the expected financial impact, if any, that the adoption of such standards will have on our financial position and/or results of operations. See Note 2 – Significant Accounting Policies in the accompanying notes to the Company’s consolidated financial statements for further information regarding new accounting standards, including the anticipated dates of adoption and the effects on our consolidated financial position, results of operations, or liquidity.
Critical Accounting Policies
Our critical accounting policies are based upon the significance of the accounting policy to our overall financial statement presentation, as well as the complexity of the accounting policy and our use of estimates and subjective assessments. Our most critical accounting policy is revenue recognition. As discussed elsewhere in this Annual Report on Form 10-K, our business has two operating segments: (1) GCR, for which we account for using the cost-to-cost method and (2) ODR, for which we account for using the cost-to-cost method and for certain projects when revenue is recognized as services are provided. In addition, we believe that some of the more critical judgment areas in the application of accounting policies that affect our financial condition and results of operations are the impact of changes in the estimates and judgments pertaining to: (a) collectability or valuation of accounts receivable; (b) the recording of our self-insurance liabilities; (c) valuation of deferred tax assets; and (d) recoverability of goodwill and identifiable intangible assets. These accounting policies, as well as others, are described in Note 2 – Significant Accounting Policies in the accompanying notes to the Company’s consolidated financial statements.
Revenue and Cost Recognition
We believe our most significant accounting policy is revenue recognition from construction contracts for which we use the cost-to-cost method of accounting. Under the cost-to-cost method, contract revenue recognizable at any time during the life of a contract is determined by multiplying expected total contract revenue by the percentage of contract costs incurred to total estimated contract costs. Revenue from fixed price and modified fixed price contracts are recognized on the cost-to-cost method, measured by the relationship of total cost incurred to total estimated contract costs.
Contract costs include direct labor, material, and subcontractor costs, and those indirect costs related to contract performance, such as indirect labor, supplies, tools, repairs, depreciation, and insurance. These contract costs are included in our results of operations under the caption “Cost of revenue.” Then, as we perform under those contracts, we measure costs incurred, compare them to total estimated costs to complete the contract, and recognize a corresponding proportion of contract revenue. Labor costs are considered to be incurred as the work is performed. Subcontractor labor is recognized as the work is performed, but is generally subjected to approval as to milestones or other evidence of completion. Non-labor project costs consist of purchased equipment, prefabricated materials and other materials. Purchased equipment on our projects is substantially produced to job specifications and is a value added element to our work. The costs are considered to be incurred when title is transferred to us, which typically is upon delivery to the worksite. Prefabricated materials, such as ductwork and piping, are generally performed at our shops and recognized as contract costs when fabricated for the unique specifications of the job. Other materials costs are not significant and are generally recorded when delivered to the worksite. This measurement and comparison process requires updates to the estimate of total costs to complete the contract, and these updates may include subjective assessments.
We generally do not incur significant costs prior to receiving a contract, and therefore, these costs are expensed as incurred. Upon receiving the contract, these costs are included in contract costs. Selling, general, and administrative costs are charged to expense as incurred. Bidding and proposal costs are also recognized as an expense in the period in which such amounts are incurred. Total estimated contract costs are based upon management’s current estimate of total costs at completion. As changes in estimates of contract costs at completion and/or estimated total losses on projects are identified, appropriate earnings adjustments are recorded during the period that the change or loss is identified. Contract revenue for construction contracts is based upon management’s estimate of contract prices at completion, including revenue for additional work on which contract pricing has not been finalized (claims). Changes in job performance, job conditions, and estimated profitability, including those arising from contract penalty provisions and final contract settlements, may result in revisions to estimated costs and income, and are recognized in the period in which the revisions are determined. Provisions for estimated losses on uncompleted contracts are recognized in the period in which such losses are determined.
With respect to our service contracts, there are two basic types of service contracts: fixed price service contracts which are signed in advance for maintenance, repair, and retrofit work over a period, typically of one year, and service contracts not signed in advance for similar maintenance, repair, and retrofit work on an as-needed basis. Fixed price service contracts are generally performed evenly over the contract period, and accordingly, revenue is recognized on a pro rata basis over the life of the contract. Revenue derived from other service contracts are recognized when the services are performed. Expenses related to all service contracts are recognized as services are provided.
Project contracts typically provide for a schedule of billings or invoices to the customer based on reaching agreed upon milestones or as we incur costs. The schedules for such billings usually do not precisely match the schedule on which costs are
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incurred. As a result, contract revenue recognized in the statement of operations can and usually does differ from amounts that can be billed or invoiced to the customer at any point during the contract. Amounts by which cumulative contract revenue recognized on a contract as of a given date exceed cumulative billings to the customer under the contract are reflected as a current asset in our balance sheet under the caption “contract assets”. Amounts by which cumulative billings to the customer under a contract as of a given date exceed cumulative contract revenue recognized on the contract are reflected as a current liability in our balance sheet under the caption “contract liabilities”.
The cost-to-cost method of accounting is also affected by changes in job performance, job conditions, and final contract settlements. These factors may result in revisions to estimated costs and, therefore, revenue. Such revisions are frequently based on further estimates and subjective assessments. The effects of these revisions are recognized in the period in which revisions are determined. When such revisions lead to a conclusion that a loss will be recognized on a contract, the full amount of the estimated ultimate loss is recognized in the period such conclusion is reached, regardless of the percent complete of the contract.
Revisions to project costs and conditions can give rise to change orders under which the customer agrees to pay additional contract price. Revisions can also result in claims we might make against the customer to recover project variances that have not been satisfactorily addressed through change orders with the customer. Claims and unapproved change orders are recorded at estimated net realizable value when realization is probable and can be reasonably estimated. No profit is recognized on the construction costs incurred in connection with claim amounts. See Note 4 – Revenue from Contracts with Customers in the accompanying notes to the Company’s consolidated financial statements for information related to unresolved change orders and claims.
Variations from estimated project costs could have a significant impact on our operating results, depending on project size, and the recoverability of the variation via additional customer payments.
In accordance with industry practice, we classify as current all assets and liabilities relating to the performance of long-term contracts. The term of our contracts generally ranges from three months to two years and, accordingly, collection or payment of amounts relating to these contracts may extend beyond one year.
Accounts Receivable and Allowance for Doubtful Accounts
We are required to estimate the collectability of accounts receivable and provide an allowance for doubtful accounts for receivable amounts we believe we will not ultimately collect. This requires us to make certain judgments and estimates involving, among others, the creditworthiness of our customers, prior collection history with our customers, ongoing relationships with our customers, the aging of past due balances, our lien rights, if any, in the property where we performed the work, and the availability, if any, of payment bonds applicable to the contract. These estimates are evaluated and adjusted as needed when additional information is received.
Self-insurance Liabilities
We are substantially self-insured for workers’ compensation, employer’s liability, auto liability, general liability and employee group health claims in view of the relatively high per-incident deductibles we absorb under our insurance arrangements for these risks. Losses are estimated and accrued based upon known facts, historical trends and industry averages. Estimated losses in excess of our deductible, which have not already been paid, are included in our accrual with a corresponding receivable from our insurance carrier.
In addition, we are self-insured related to medical and dental claims under policies with annual per-claimant and annual aggregate stop-loss limits. We accrue for the unfunded portion of costs for both reported claims and claims incurred but not reported.
We believe the liabilities recognized on our balance sheets for these obligations are adequate. However, insurance liabilities are difficult to estimate due to unknown factors, including the severity of any injury, the determination of our liability in proportion to other parties, timely reporting of occurrences, ongoing treatment or loss mitigation, general trends in litigation recovery outcomes and the effectiveness of safety and risk management programs. Therefore, if actual experience differs from the assumptions and estimates used for recording the liabilities, adjustments may be required and would be recorded in the period that such experience becomes known.
Deferred Tax Assets
We regularly evaluate the need for valuation allowances related to deferred tax assets for which future realization is uncertain. We perform this evaluation quarterly. In assessing the realizability of deferred tax assets, we must consider whether it is more likely than not some portion, or all, of the deferred tax assets will not be realized. We consider all available evidence, both
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positive and negative, in determining whether a valuation allowance is required. Such evidence includes the scheduled reversal of deferred tax liabilities, projected future taxable income, taxable income in prior carryback years and tax planning strategies in making this assessment, and judgment is required in considering the relative weight of negative and positive evidence.
Goodwill and Identifiable Intangible Assets
Goodwill is the excess of purchase price over the fair value of the net assets of acquired businesses. We assess goodwill for impairment each year, and more frequently if circumstances suggest an impairment may have occurred. When the carrying value of a given reporting unit exceeds its fair value, an impairment loss is recorded to the extent that the implied fair value of the goodwill of the reporting unit is less than its carrying value. If other reporting units have had increases in fair value, such increases may not be recorded. Accordingly, such increases may not be netted against impairments at other reporting units. The requirements for assessing whether goodwill has been impaired involve market-based information. This information, and its use in assessing goodwill, entails some degree of subjective assessment.
We perform our annual impairment testing as of October 1 and any impairment charges resulting from this process are reported in the fourth quarter. We segregate our operations into reporting units based on the degree of operating and financial independence of each unit and our related management of them. We perform our annual goodwill impairment analysis at the reporting unit level. Each of our operating units represents an operating segment, and our operating segments are our reporting units.
We also review intangible assets with definite lives subject to amortization whenever events or circumstances indicate that a carrying amount of an asset may not be recoverable. Events or circumstances that might require impairment testing include the identification of other impaired assets within a reporting unit, loss of key personnel, the disposition of a significant portion of a reporting unit, a significant decline in stock price or a significant adverse change in business climate or regulations. Changes in strategy and/or market condition, may also result in adjustments to recorded intangible asset balances or their useful lives.
Off-Balance Sheet and Other Arrangements
Aside from the $3.2 million and $3.4 million in irrevocable letters of credit outstanding in connection with the Company’s self-insurance program, at December 31, 2022 and 2021, respectively, the Company did not have any relationships with any entities or financial partnerships, such as structured finance or special purpose entities established for the purpose of facilitating off-balance sheet arrangements or other purposes.