# ROCKY BRANDS, INC. (RCKY) FY 2022 MD&A Verbatim Item 7 Management's Discussion and Analysis from ROCKY BRANDS, INC.'s 10-K for fiscal year 2022. SEC filing source: https://www.sec.gov/Archives/edgar/data/895456/000143774923006169/rcky20221231_10k.htm Accession: 0001437749-23-006169 Filing date: 2023-03-10 Report date: 2022-12-31 Extracted structurally from real Item 7 body heading to real Item 7A/8 boundary. Confidence: high Company profile: /company/RCKY/ All MD&A years: /company/RCKY/mda/ Previous year: /company/RCKY/mda/fy2021/ (FY 2021) Next year: /company/RCKY/mda/fy2023/ (FY 2023) ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. This Management’s Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") describes the matters that we consider to be important to understanding the results of our operations for each of the two years in the period ended December 31, 2022 and 2021, and our capital resources and liquidity as of December 31, 2022 and 2021. A discussion of the changes in our results of operations between the years ended December 31, 2021 and December 31, 2020 has been omitted from this Annual Report on Form 10-K but may be found in Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations of our Annual Report on Form 10-K for the year ended December 31, 2021, filed with the SEC on March 15, 2022, which is available free of charge on the SEC's website at https://www.sec.gov/edgar/search/ and our corporate website (www.rockybrands.com). Use of the terms "Rocky Brands," the "Company," "we," "us" and "our" in this discussion refer to Rocky Brands, Inc. and its subsidiaries. Our fiscal year begins on January 1 and ends on December 31. We analyze the results of our operations for the last two years (including the trends in the overall business), followed by a discussion of our cash flows and liquidity, our credit facilities, and contractual commitments. We then provide a review of the critical accounting judgments and estimates that we have made that we believe are most important to an understanding of our MD&A and our Consolidated Financial Statements. We conclude our MD&A with information on recent accounting pronouncements which we adopted during the year, as well as those not yet adopted that are expected to have an impact on our financial accounting practices. 19 Table of Contents The following discussion should be read in conjunction with our Consolidated Financial Statements and the notes thereto, included elsewhere herein. The forward-looking statements in this section and other parts of this document involve risks and uncertainties including statements regarding our plans, objectives, goals, strategies, and financial performance. Our actual results could differ materially from the results anticipated in these forward-looking statements as a result of factors set forth under the caption "Safe Harbor Statement under the Private Securities Litigation Reform Act of 1995" below. The Private Securities Litigation Reform Act of 1995 provides a "safe harbor" for forward-looking statements made by or on behalf of the Company. EXECUTIVE OVERVIEW We are a leading designer, manufacturer and marketer of premium quality footwear and apparel marketed under a portfolio of well recognized brand names including Rocky, Georgia Boot, Durango, Lehigh, Muck, XTRATUF, Servus, Ranger and the licensed brand Michelin.  On January 24, 2021, we entered into a Purchase Agreement (the "Purchase Agreement") with certain subsidiaries of Honeywell International Inc. (collectively, "Honeywell"), to purchase Honeywell's performance and lifestyle footwear business, including brand names, trademarks, assets and liabilities associated with Honeywell's performance and lifestyle footwear business (the "Acquisition") for an aggregate purchase price of $212 million. We closed on the Acquisition on March 15, 2021 for preliminary aggregate closing price of approximately $207 million, net of cash acquired, based on preliminary working capital and other adjustments. Upon a final agreement of net working capital as of the Acquisition Date, we owed Honeywell an additional $5.4 million. The Acquisition was funded through cash on hand and borrowings under two new credit facilities. See Note 9 for information regarding the two new credit facilities. On September 30, 2022, we completed the sale of the NEOS brand and related assets. See Note 4 for additional information.  The Acquisition expanded our brand portfolio to include Muck, XTRATUF, Servus, Ranger and NEOS brands (the "Acquired Brands"). Our brands have a long history of representing high quality, comfortable, functional and durable footwear and our products are organized around six target markets: outdoor, work, duty, commercial military, military, and western. Our footwear products incorporate varying features and are positioned across a range of suggested retail price points from $26.00 for our value priced products to $520.00 for our premium products. In addition, as part of our strategy of outfitting consumers from head-to-toe, we market complementary branded apparel and accessories that we believe leverage the strength and positioning of each of our brands Our products are distributed through three distinct business segments: Wholesale, Retail and Contract Manufacturing. In our Wholesale business, we distribute our products through a wide range of distribution channels representing over 10,000 retail store locations in the U.S., Canada, U.K., and other international markets such as Europe. Our Wholesale channels vary by product line and include sporting goods stores, outdoor retailers, independent shoe retailers, hardware stores, catalogs, mass merchants, uniform stores, farm store chains, specialty safety stores, specialty retailers and online retailers. Our Retail business includes direct sales of our products to consumers through our business to business web platform, e-commerce websites, third party marketplaces and our Rocky Outdoor Gear Store. Our contract manufacturing segment includes sales to the U.S. military, private label sales and any sales to customers in which we are contracted to manufacture or source a specific footwear product for a customer.  Our growth strategy is founded substantially on the expansion of our brands into new footwear and apparel markets. New products that we introduce may not be successful with consumers or one or more of our brands may fall out of favor with consumers. If we are unable to anticipate, identify or react appropriately to changes in consumer preferences, we may not grow as fast as we plan to grow or our sales may decline, and our brand image and operating performance may suffer. Furthermore, achieving market acceptance for new products will likely require us to exert substantial product development and marketing efforts, which could result in a material increase in our operating expenses and there can be no assurance that we will have the resources necessary to undertake such efforts. Material increases in our operating expenses could adversely impact our results of operations and cash flows. We may also encounter difficulties in producing new products that we did not anticipate during the development stage. Our development schedules for new products are difficult to predict and are subject to change as a result of shifting priorities in response to consumer preferences and competing products. If we are not able to efficiently manufacture newly-developed products in quantities sufficient to support retail distribution, we may not be able to recoup our investment in the development of new products. Failure to gain market acceptance for new products that we introduce could impede our growth, reduce our profits, adversely affect the image of our brands, erode our competitive position and result in long term harm to our business. 20 Table of Contents Net sales. Net sales and related cost of goods sold are recognized at the time products are shipped to the customer and title transfers. Net sales are recorded net of estimated sales discounts and returns based upon specific customer agreements and historical trends. Net sales include royalty income from licensing our brands. Cost of goods sold. Our cost of goods sold represents our costs to manufacture products in our own facilities, including raw materials costs and all overhead expenses related to production, as well as the cost to purchase finished products from our third-party manufacturers. Cost of goods sold also includes the cost to transport these products to our distribution center. Operating expenses. Our operating expenses consist primarily of selling, marketing, wages and related payroll and employee benefit costs, travel and insurance expenses, depreciation, amortization, professional fees, software licensing fees, facility expenses, bank charges, warehouse and outbound freight expenses. We also incurred significant operating expenses and acquisition amortization and restructuring costs associated with the Acquisition during the twelve months ended December 31, 2022. Percentage of Net Sales  The following table sets forth consolidated statements of operations data as percentages of total net sales: [[GREPCENT_TABLE]] [["","","Twelve Months Ended"],["","","December 31,"],["","","2022","","","2021"],["Net sales","","","100.0","%","","","100.0","%"],["Cost of goods sold","","","63.4","","","","62.2"],["Gross margin","","","36.6","","","","37.8"],["Operating expenses","","","29.4","","","","30.8"],["Income from operations","","","7.2","%","","","7.0","%"]] [[/GREPCENT_TABLE]] Results of Operations December 31, 2022 Compared to Year Ended December 31, 2021 [[GREPCENT_TABLE]] [["","","Twelve Months Ended"],["","","December 31,"],["($ in thousands)","","2022","","","2021","","","Inc./ (Dec.)","","","Inc./ (Dec.)"],["NET SALES:"],["Wholesale","","$","484,779","","","$","391,070","","","$","93,709","","","","24.0","%"],["Retail","","","115,354","","","","94,658","","","","20,696","","","","21.9"],["Contract Manufacturing","","","15,342","","","","28,499","","","","(13,157",")","","","(46.2",")"],["Total Net Sales","","$","615,475","","","$","514,227","","","$","101,248","","","","19.7","%"]] [[/GREPCENT_TABLE]] Included in Wholesale net sales for the twelve months ended December 31, 2022 is $216.9 million of net sales attributed to the Acquired Brands and $3.6 million of inventory net sales related to the divestiture of the NEOS brand during the third quarter of 2022. Included in Wholesale net sales for the twelve months ended December 31, 2021 is $160.0 million of net sales attributed to the Acquired Brands. Adjusted Wholesale net sales for the year ended December 31, 2022 to exclude the divestiture of the NEOS brand is $481.2 million.  Wholesale sales increased due to strong demand for our products as consumers continued to respond favorably to our recent product introductions and we were able to capitalize on our strong inventory position which allowed us to gain additional market share and shelf space. Included in Retail net sales for the twelve months ended December 31, 2022 and 2021 is $25.9 and $17.6 million, respectively, of net sales attributed to the Acquired Brands. Retail sales increased due to strong growth in our direct to consumer e-Commerce and marketplace businesses during the year as well as growth in our Lehigh business-to-business platform. We have increased our targeted marketing efforts and brand awareness, which led to increased traffic on our branded websites. 21 Table of Contents Contract Manufacturing net sales decreased due to the expiring contracts with the U.S. military during the twelve months ended December 31, 2022. [[GREPCENT_TABLE]] [["","","Twelve Months Ended"],["","","December 31,"],["($ in thousands)","","2022","","","2021","","","Inc./ (Dec.)"],["GROSS MARGIN:"],["Wholesale Margin $'s","","$","165,059","","","$","140,166","","","$","24,893"],["Margin %","","","34.0","%","","","35.8","%","","","-1.8","%"],["Retail Margin $'s","","$","57,817","","","$","47,792","","","$","10,025"],["Margin %","","","50.1","%","","","50.5","%","","","-0.4","%"],["Contract Manufacturing Margin $'s","","$","2,343","","","$","6,578","","","$","(4,235",")"],["Margin %","","","15.3","%","","","23.1","%","","","-7.8","%"],["Total Margin $'s","","$","225,219","","","$","194,536","","","$","30,683"],["Margin %","","","36.6","%","","","37.8","%","","","-1.2","%"]] [[/GREPCENT_TABLE]] Excluding $1.1 million of gross margin and sales relating to the divestiture of the NEOS brand, Wholesale gross margins were 34.1% for the year ended December 31, 2022. On an adjusted basis, excluding a one-time inventory fair value adjustment associated with the Acquisition of $3.5 million, Wholesale gross margins were 36.7% for the year ended December 31, 2021. The decrease in margin is mainly attributable to increased shipping and freight costs. Retail gross margins decreased due to increased product costs and freight costs for the year ended December 31, 2022. Contract Manufacturing gross margin decreased for the year ended 2022 compared to 2021 due to increased product costs. Gross margin also decreased due to the expiration of certain contracts with the U.S. military during the twelve months ended December 31, 2022. [[GREPCENT_TABLE]] [["","","Twelve Months Ended"],["","","December 31,"],["($ in thousands)","","2022","","","2021","","","Inc./ (Dec.)","","","Inc./ (Dec.)"],["OPERATING EXPENSES:"],["Operating Expenses","","$","181,181","","","$","158,564","","","$","22,617","","","","14.3","%"],["% of Net Sales","","","29.4","%","","","30.8","%","","","-1.4","%"]] [[/GREPCENT_TABLE]] Excluding $5.7 million of Acquisition-related amortization and integration costs, restructuring costs and disposition of assets in 2022 and $11.9 million in Acquisition-related amortization and integration expenses in 2021, adjusted operating expenses were $175.5 million or 28.7% of adjusted net sales in the current year and $146.6 million or 28.5% of net sales in the prior year. The decrease in operating expenses as a percentage of net sales was driven primarily by a decrease in discretionary spending and improved distribution center efficiencies compared with the year ago period. [[GREPCENT_TABLE]] [["","","Twelve Months Ended"],["","","December 31,"],["($ in thousands)","","2022","","","2021","","","Inc./ (Dec.)","","","Inc./ (Dec.)"],["INTEREST AND OTHER EXPENSES:"],["Other Expense","","$","(18,270",")","","$","(10,603",")","","$","(7,667",")","","","72.3","%"]] [[/GREPCENT_TABLE]] Other expenses increased due to higher interest rates on outstanding borrowings on both our senior term loan and credit facility. 22 Table of Contents [[GREPCENT_TABLE]] [["","","Twelve Months Ended"],["","","December 31,"],["($ in thousands)","","2022","","","2021","","","Inc./ (Dec.)","","","Inc./ (Dec.)"],["INCOME TAXES:"],["Income Tax Expense","","$","5,303","","","$","4,810","","","$","493","","","","10.2","%"],["Effective Tax Rate","","","20.6","%","","","19.0","%","","","1.6","%"]] [[/GREPCENT_TABLE]] The effective tax rate for the year ended December 31, 2022 increased primarily due to the one-time benefit received for the year ending December 31, 2021 arising from the release of valuation allowances on state net operating losses and an increase in foreign tax credits.  LIQUIDITY AND CAPITAL RESOURCES Overview Our principal sources of liquidity have been our income from operations and borrowings under our credit facilities. Over the last several years, our principal uses of cash have been for working capital and capital expenditures to support our growth, as well as dividend payments and share repurchases. Our working capital consists primarily of trade receivables and inventory, offset by accounts payable and accrued expenses. Our working capital fluctuates throughout the year as a result of our seasonal business cycle and business expansion and is generally lowest in the months of January through March of each year and highest during the months of May through October of each year. We historically utilize our revolving credit facility to fund our seasonal working capital requirements. As a result, balances on our revolving credit facility could fluctuate significantly throughout the year. Our working capital increased to $244.8 million at December 31, 2022, compared to $235.1 million at the end of the prior year. Our capital expenditures relate primarily to projects relating to our corporate offices, property, merchandising fixtures, molds and equipment associated with our manufacturing and distribution operations and for information technology. Capital expenditures were $7.3 million for 2022 and $25.8 million in 2021. Capital expenditures for 2023 are anticipated to be approximately $7.1 million.  We lease certain machinery, equipment, and manufacturing facilities under operating leases that generally provide for renewal options. Future minimum lease payments under non-cancelable operating leases are outlined in further detail in Note 10 of our Consolidated Financial Statements We believe that our credit facilities coupled with cash generated from operations will provide sufficient liquidity to fund our operations for at least the next twelve months. Our continued liquidity, however, is contingent upon future operating performance, cash flows and our ability to meet financial covenants under our credit facility. For more information regarding our credit facilities please se e No te 9. Refer to Note 3 of our Consolidated Financial  Statements for additional information regarding our recent Acquisition. Cash Flows and Material Cash Requirements [[GREPCENT_TABLE]] [["","","Twelve Months Ended"],["","","December 31,"],["($ in millions)","","2022","","","2021"],["Operating activities","","$","19.1","","","$","(54.9",")"],["Investing activities","","","(1.2",")","","","(233.5",")"],["Financing activities","","","(18.1",")","","","265.9"],["Net change in cash and cash equivalents","","$","(0.2",")","","$","(22.5",")"]] [[/GREPCENT_TABLE]] Operating Activities. Our operating activities during 2022 mainly consisted of proceeds from operations offset by a decrease in accounts payable. The principal use of net cash in 2021 was increased inventories and accounts receivable, partially offset by increased accounts payable.  Investing Activities. The principal use of net cash in 2022 was related to investments in molds and equipment associated with our manufacturing operations, investments in information technology and improvements made to our distribution facility. The principal use of net cash in 2021 was to fund the Acquisition.  23 Table of Contents Financing Activities. The principal use of our net cash during 2022 was payments on the term loan. During 2021, financing activities mainly consisted of proceeds from and payments on the revolving credit facility and term loan. Both debt facilities were incurred to fund the Acquisition and other working capital requirements. On March 8, 2021, we announced a new $7,500,000 share repurchase program, which expired on March 4, 2022. For additional information regarding this share repurchase program, see Note 13 of our Consolidated Financial Statements. There has not been an announcement for a new repurchase program since the expiration of the prior program in March 2022. Contractual Obligations and Commercial Commitments The following table summarizes our contractual obligations at December 31, 2022 resulting from financial contracts and commitments. These amounts are generally consistent from year to year, closely reflect our levels of production, and are not long-term in nature (less than three months). The following table does not include information on our recurring purchases of materials for in our manufacturing operations. Contractual Obligations at December 31, 2022: [[GREPCENT_TABLE]] [["($ in millions)","","Total","","","Less than 1 Year","","","1-3 Years","","","3-5 Years","","","Over 5 Years"],["Long-term debt (Note 9)","","$","259.6","","","$","3.3","","","$","6.5","","","$","249.8","","","","-"],["Long-Term Taxes payable","","","0.2","","","","-","","","","-","","","","0.2","","","","-"],["Minimum operating lease commitments (Note 10)","","","14.3","","","","3.2","","","","6.0","","","","5.1","","","","-"],["Contract Liabilities (Note 16)","","","-","","","","-","","","","-","","","","-","","","","-"],["Consulting commitments","","","0.5","","","","0.5","","","","-","","","","-","","","","-"],["Total contractual obligations","","$","274.6","","","$","7.0","","","$","12.5","","","$","255.1","","","","-"]] [[/GREPCENT_TABLE]] From time to time, we enter into purchase commitments with our suppliers under customary purchase order terms. Any significant losses implicit in these contracts would be recognized in accordance with generally accepted accounting principles. At December 31, 2022, no such losses existed. Our ongoing business activities continue to be subject to compliance with various laws, rules and regulations as may be issued and enforced by various federal, state and local agencies. With respect to environmental matters, costs are incurred pertaining to regulatory compliance. Such costs have not been, and are not anticipated to become, material. We are contingently liable with respect to lawsuits, taxes and various other matters that routinely arise in the normal course of business. See Note 20 of our Consolidated Financial Statements for further discussion of legal matters. We do not have off-balance sheet arrangements, financings, or other relationships with unconsolidated entities, also known as "Variable Interest Entities." Additionally, we do not have any related party transactions that materially affect the results of operations, cash flow or financial condition. OFF-BALANCE SHEET ARRANGEMENTS We have no off-balance sheet arrangements as of December 31, 2022. CRITICAL ACCOUNTING POLICIES AND ESTIMATES Our Consolidated Financial Statements are prepared in accordance with GAAP. The preparation of financial statements in conformity with GAAP requires us to establish accounting policies and make estimates that affect amounts reported in our Consolidated Financial Statements. Note 1 of the Notes to Consolidated Financial Statements, which is incorporated by reference into this MD&A, describes the significant accounting policies and estimates we use in our Consolidated Financial Statements. 24 Table of Contents An accounting estimate requires assumptions and judgments about uncertain matters that could have a material effect on the Consolidated Financial Statements. Estimates are made under facts and circumstances at a point in time, and changes in those facts and circumstances could produce results substantially different from those estimates. The most significant accounting policies and estimates and their related application are discussed below. Revenue recognition Revenue principally consists of sales to customers, and, to a lesser extent, license fees. See Note 16 of our Consolidated Financial Statements for additional information regarding revenues. Accounts receivable allowances Management maintains allowances for uncollectible accounts and estimated losses resulting from the inability of our customers to make required payments. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. The allowance for uncollectible accounts is calculated based on the relative age and status of trade receivable balances. Sales returns and allowances We record a reduction to gross sales based on estimated customer returns and allowances. These reductions are influenced by historical experience, based on customer returns and allowances. The actual amount of sales returns and allowances realized may differ from our estimates. If we determine that sales returns or allowances should be either increased or decreased, then the adjustment would be made to net sales in the period in which such a determination is made. Sales returns and allowances as a percentage of sales for the years ended December 31, 2022 and 2021 were 6.7% and 2.6%, respectively. Inventories Management identifies slow moving inventories and estimates appropriate loss provisions related to these inventories. Historically, these loss provisions have not been significant as the vast majority of our inventories are considered saleable and we have been able to liquidate slow moving or obsolete inventories at amounts above cost through our factory outdoor gear stores or through various discounts to customers and e-commerce channels. Should management encounter difficulties liquidating slow moving or obsolete inventories, additional provisions may be necessary. Management regularly reviews the adequacy of our inventory reserves and makes adjustments as required. See Note 5 of our Consolidated Financial Statements for additional information regarding inventories. Intangible assets Intangible assets, including goodwill, trademarks and patents, are reviewed for impairment annually, and more frequently, if necessary. We perform such testing of indefinite-lived intangible assets in the fourth quarter of each year or as events occur or circumstances change that would more likely than not reduce the fair value of the assets below their carrying amount. We determined the fair values of the indefinite-lived intangibles were in excess of their carrying values. There is no goodwill allocated to our Contract Manufacturing segment. As of December 31, 2022, goodwill allocated to our Wholesale and Retail reporting segments was $25.4 million and $24.8 million, respectively. See Note 1 and Note 7 of our Consolidated Financial Statements for additional information regarding intangible assets and the annual impairment analysis. Income taxes Management records a valuation allowance to reduce its deferred tax assets for a portion of state and local income tax net operating losses that it believes may not be realized. We have considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for a valuation allowance, however, in the event we were to determine that we would not be able to realize all or part of our net deferred tax assets in the future, an adjustment to the deferred tax assets would be charged to income in the period such determination was made. For additional information see Note 12 of our Consolidated Financial Statements. RECENT FINANCIAL ACCOUNTING PRONOUNCEMENTS Note 2 to Consolidated Financial Statements discusses new accounting pronouncements adopted during 2021 and the expected impact of accounting pronouncements recently issued but not yet required to be adopted. To the extent the adoption of new accounting standards materially affect financial condition, results of operations, or liquidity, the impacts are discussed in the applicable section of this MD&A and the Notes to Consolidated Financial Statements. 25 Table of Contents SAFE HARBOR STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 This report, including Management’s Discussion and Analysis of Financial Conditions and Results of Operations, contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, and Section 27A of the Securities Act of 1933, as amended, which are intended to be covered by the safe harbors created thereby. Those statements include, but may not be limited to, all statements regarding our and management’s intent, belief, expectations, such as statements concerning our future profitability and our operating and growth strategy. Words such as "believe," "anticipate," "expect," "will," "may," "should," "intend," "plan," "estimate," "predict," "potential," "continue," "likely," "would," "could" and similar expressions are intended to identify forward-looking statements. Investors are cautioned that all forward-looking statements involve risk and uncertainties including, without limitations, dependence on sales forecasts, changes in consumer demand, seasonality, impact of weather, competition, reliance on suppliers, risks inherent to international trade, changing retail trends, the loss or disruption of our manufacturing and distribution operations, cyber security breaches or disruption of our digital systems, fluctuations in foreign currency exchange rates, economic changes, as well as other factors set forth under the caption "Item 1A, Risk Factors" in this Annual Report on Form 10-K and other factors detailed from time to time in our filings with the Securities and Exchange Commission. Although we believe that the assumptions underlying the forward-looking statements contained herein are reasonable, any of the assumptions could be inaccurate. Therefore, there can be no assurance that the forward-looking statements included herein will prove to be accurate. In light of the significant uncertainties inherent in the forward-looking statements included herein, the inclusion of such information should not be regarded as a representation by us or any other person that our objectives and plans will be achieved. We assume no obligation to update any forward-looking statements.