News Column

LYDALL INC /DE/ - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

July 31, 2014

OVERVIEW AND OUTLOOK

Business

Lydall, Inc. and its subsidiaries (collectively, the "Company" or "Lydall") design and manufacture specialty engineered filtration media, thermal insulating solutions, automotive thermal and acoustical barriers, medical filtration media and devices and biopharmaceutical processing components for filtration/separation, thermal/acoustical, and bio/medical applications. On February 20, 2014, the Company completed an acquisition of certain industrial filtration businesses ("Industrial Filtration") of Andrew Industries Limited, an Altham, United Kingdom based corporation pursuant to the terms of a Sale and Purchase Agreement (the "Sale and Purchase Agreement") for $86.7 million in cash ("the Acquisition"). The Company funded the purchase price of the Acquisition from cash on hand and borrowings under the Company's Amended Credit Facility. The results of Industrial Filtration have been included in the Company's financial statements since the date of the Acquisition. As a result, the consolidated financial results for the six months ended June 30, 2014 do not reflect a full six months of the Industrial Filtration business. The Acquisition resulted in the inclusion of Industrial Filtration's assets and liabilities as of the acquisition date at their respective fair values. Accordingly, the Acquisition materially affected the Company's results of operations and financial position.



Lydall principally conducts its business through four reportable segments: Performance Materials, Industrial Filtration, Thermal/Acoustical Metals and Thermal/Acoustical Fibers, with sales globally.

The Performance Materials segment includes filtration media solutions for air, fluid power, and industrial applications ("Filtration"), air and liquid life science applications ("Life Sciences Filtration"), and thermal insulation solutions for building products, appliances, and energy and industrial markets ("Thermal Insulation"). The Industrial Filtration segment includes non-woven felt filtration media and filter bags used primarily in industrial air filtration applications. Non-woven filter media is used to satisfy increasing emission control regulations in a wide range of industries, including power, cement, steel, asphalt, incineration, food, and pharmaceutical. The Thermal/Acoustical Metals ("T/A Metals") segment and Thermal/Acoustical Fibers ("T/A Fibers") segment offer innovative engineered products to assist in noise and heat abatement within the transportation sector. Included in Other Products and Services ("OPS") is the Life Sciences Vital Fluids business. Life Sciences Vital Fluids offers specialty products for blood filtration devices, blood transfusion single-use containers and bioprocessing single-use containers and products for containment of media, buffers and bulk intermediates used in biotech, pharmaceutical and diagnostic reagent manufacturing processes.



Second Quarter 2014 Highlights

Net sales were $148.8 million in the current quarter, compared to $101.1 million in the second quarter of 2013. The second quarter of 2014 includes net sales of $34.1 million from the acquisition of Industrial Filtration, which was completed in February 2014. Net income was $8.2 million, or $0.49 per diluted share in the second quarter of 2014 compared to $6.0 million, or $0.35 per diluted share, in the second quarter of 2013. Operating margin decreased to 8.4% of consolidated net sales in the second quarter of 2014 compared to 9.4% of consolidated net sales in the second quarter of 2013 as it was negatively impacted by a $2.9 million one-time commission settlement within the T/A Metals segment, as the Company terminated a long-standing commercial sales agreement, and by purchase accounting adjustments and transaction related costs of $0.7 million related to the Acquisition. As a result of these expenses operating margin was negatively impacted by approximately 250 basis points in the second quarter of 2014.



Below are financial highlights comparing Lydall's quarter ended June 30, 2014 ("Q2 2014") results to its quarter ended June 30, 2013 ("Q2 2013") results:

Net sales increased by $47.7 million, or 47.2%, compared to Q2 2013 as net

sales increased 11.7% organically, 33.8% from the Acquisition and 1.7% from favorable foreign currency translation.



Gross margin increased to 23.3%, compared to 22.8% in Q2 2013, primarily

due to increased net sales providing for improved absorption of fixed costs and lower raw material costs, primarily in the T/A Fibers and T/A



Metals segments, offset to some extent by gross margin of the Industrial

Filtration segment. Also, consolidated gross margin in Q2 2014 was negatively impacted by 30 basis points from purchase accounting adjustments of $0.5 million related to the Acquisition. 21

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Selling, product development and administrative expenses were $22.1

million, or 14.8% of net sales, compared to $13.5 million, or 13.4% of net

sales in Q2 2013; - Industrial Filtration segment reported $2.9 million of expenses; - T/A Metals selling expenses included $2.9 million for a commission



settlement related to the termination of a long-standing commercial sales

agreement;

- Corporate office expenses increased $1.6 million primarily due to increases

in non-cash stock based compensation, professional services primarily related to the Acquisition, increased salaries and increases in other administrative costs.



Operating income was $12.6 million, or 8.4% of net sales, compared to $9.5

million, or 9.4% of net sales, in Q2 2013;

- Operating income from Performance Materials, T/A Metals, T/A Fibers, OPS and

corporate office ("pre-acquisition businesses") was $10.4 million, or 9.0%

of pre-acquisition businesses net sales, compared to $9.5 million, or 9.4%

in Q2 2013;

- Industrial Filtration segment operating income was $2.2 million, or 6.4% of

Industrial Filtration segment net sales, including $0.5 million, or 160

basis points of purchase accounting adjustments.

- Consolidated operating income was negatively impacted by 250 basis points

related to a $2.9 million commission settlement within the T/A Metals

segment and by purchase accounting adjustments and transaction related costs

of $0.7 million related to the Acquisition.

Effective tax rate of 31.3% in Q2 2014 compared to 36.8% in Q2 2013 as Q2

2014 was positively impacted by the expectation of increased earnings in

2014 compared to 2013 derived from countries with lower tax rates compared

to that of the United States. Q2 2013 included a discrete tax benefit of

$0.3 million, or $0.02 per share.

Operational and Financial Overview

Net sales for the second quarter of 2014 increased by $47.7 million, or 47.2%, compared to the second quarter of 2013, primarily from the inclusion of Industrial Filtration segment net sales of $34.1 million. In the T/A Fibers segment, higher net sales of $8.3 million, or 29.9%, compared to the same quarter a year ago, were the result of increased consumer demand for vehicles in North America on Lydall's existing and new platforms and the timing of certain customer purchases. The T/A Metals segment net sales increased $2.4 million, or 5.9%, and the Performance Materials segment net sales increased by $2.3 million, or 7.9%, compared to the second quarter of 2013. Higher net sales in the T/A Metals segment were due to continued favorable market conditions in North America and improving market conditions in Europe compared to the second quarter of 2013. Net sales for the Performance Materials segment increased due to higher fluid power and air filtration net sales within the segments European operations, also as a result of improved market conditions, and from higher volumes of sales in life sciences applications. Consolidated operating margin in the second quarter of 2014 was 8.4% compared to 9.4% in the second quarter of 2013. T/A Fibers segment reported operating margin of 25.6%, an increase of 620 basis points compared to the second quarter of 2013, primarily the result of increased net sales and improved absorption of fixed costs and raw material and labor efficiencies compared to the second quarter of 2013. Performance Materials operating margin of 11.4% in the second quarter of 2014 was essentially flat with the same quarter of 2013. The Industrial Filtration segment reported operating margin of 6.4% in the second quarter of 2014, including $0.5 million, or 160 basis points, of purchase accounting adjustments. The T/A Metals segment reported operating margin of 5.9% in the second quarter of 2014, compared to 10.8% in the second quarter of 2013. Operating margin for T/A Metals was negatively impacted by 670 basis points due to a $2.9 million commission settlement as the Company terminated a long-standing commercial sales agreement.



Liquidity

Cash balance was $64.4 million at June 30, 2014 compared to $75.4 million at December 31, 2013. The Acquisition in February 2014 was funded by borrowing $60.0 million from the Company's $100 million Amended Credit Facility, with the remaining purchase price funded from the Company's cash. The Company's consolidated leverage ratio was approximately 1.3 at June 30, 2014 (as defined in the Amended Credit Facility), significantly below a maximum permitted ratio of 3.0. On February 18, 2014, the Company amended and restated its $35.0 million senior secured domestic revolving credit facility ("Amended Credit Facility") with a financial institution and two additional lenders, increasing the available borrowing from $35 million to $100 million. The Company entered into this Amended Credit Facility in part to fund $60 million of the purchase price of the Industrial Filtration acquisition. 22 -------------------------------------------------------------------------------- As of June 30, 2014, the Company had borrowing availability of $37.2 million under the Amended Credit Facility, net of standby letters of credit outstanding of $2.8 million. As of June 30, 2014, the Company's foreign subsidiaries' various credit arrangements with banks totaled 9.0 million (approximately $12.3 million) all of which was available for borrowings, primarily restricted to borrowings by the respective foreign subsidiary.



Outlook

In the Company's first full quarter with the Industrial Filtration business, net sales were $34.1 million due to favorable demand for felt filtration media and filter bags as this business traditionally experiences higher demand in the first half of the year due to many industrial plants coming on-line. The Company continues to remain on track with its integration of this business including the introduction of the Company's Lean Six Sigma principles to achieve future margin and working capital improvements. Going into the third quarter and second half of the year, the Company expects less robust sales growth than the first half due timing of customer orders, typical customer plant shut-downs in North America and Europe as well as seasonality that normally occurs in some of our segments. As a result, the Company expects lower organic sales growth in the second half compared to the first half of 2014. Additionally, in the third quarter of 2014 the Company expects to incur a one-time, non-cash pre-tax expense of $4.9 million in net periodic pension benefit expense. This expense is associated with the partial settlement of its U.S. pension plan as a result of the Company's lump sum payments to certain plan participants in July 2014. Conversely, as a result the of second quarter 2014 settlement of a long-standing commercial sales agreement, the Company expects to realize savings on commission expense in the range of $0.6 million to $0.7 million in the second half of 2014.



Results of Operations

All of the following tabular comparisons, unless otherwise indicated, are for the quarters ended June 30, 2014 (Q2-14) and June 30, 2013 (Q2-13) and for the six months ended June 30, 2014 (YTD-14) and June 30, 2013 (YTD-13). Net Sales Quarter Ended Six Months Ended Percent Percent In thousands Q2-14 Q2-13 Change YTD-14 YTD-13 Change Net sales $ 148,793$ 101,051 47.2 % $ 274,019$ 200,080 37.0 % Net sales for the second quarter ended June 30, 2014 increased by $47.7 million, or 47.2%, compared to the second quarter ended June 30, 2013. This increase was primarily related to the acquisition of Industrial Filtration which occurred on February 20, 2014. As a result, consolidated net sales for the second quarter ended June 30, 2014 include the Industrial Filtration segment net sales of $34.1 million. There were no Industrial Filtration segment net sales in the second quarter of 2013. Pre-acquisition business net sales increased $13.6 million, or 13.5%, in the second quarter of 2014 compared to the same period in 2013. In the T/A Fibers and T/A Metals segments, higher sales volumes resulted in improved net sales of $8.3 million, or 29.9%, and $2.4 million, or 5.9%, respectively, compared to the same quarter a year ago. Additionally, net sales increased in the Performance Materials segment by $2.3 million, or 7.9%, and in the Life Sciences Vital Fluids business by $0.6 million, or 14.1%, in the second quarter of 2014 compared to the second quarter of 2013. Foreign currency translation increased net sales by $1.8 million, or 1.7%, for the current quarter, compared with the second quarter of 2013, favorably impacting the T/A Metals segment by $1.2 million, or 3.0%, and the Performance Materials segment by $0.5 million, or 1.9%. Net sales for the six months ended June 30, 2014 increased by $73.9 million, or 37.0%, compared to the six months ended June 30, 2013. This increase was primarily related to the acquisition of Industrial Filtration. As a result, Industrial Filtration segment net sales of $51.8 million since the date of the acquisition are included in the Company's consolidated net sales for the six months ended June 30, 2014. Pre-acquisition business net sales for the six months ended June 30, 2014 increased $22.1 million, or 11.1% compared to the six months ended June 30, 2013. In the T/A Fibers and T/A Metals segments, higher sales volumes resulted in improved net sales of $12.9 million, or 23.1%, and $4.7 million, or 5.8%, respectively, compared to the six months ended June 30, 2013. Additionally, net sales increased in the Performance Materials segment by $3.7 million, or 6.5%, and in the Life Sciences Vital Fluids business by $1.0 million, or 11.9%, during the six months ended June 30, 2014 compared to the same period of 2013. Foreign currency translation increased net sales by $3.1 million, or 1.5%, for the six months ended June 30, 2014, compared with the first six months of 2013, impacting the T/A Metals segment by $2.1 million, or 2.6%, and the Performance Materials segment by $0.9 million, or 1.7%. Gross Profit Quarter Ended Six Months Ended Percent Percent In thousands Q2-14 Q2-13 Change YTD-14 YTD-13 Change Gross profit $ 34,653$ 23,037 50.4 % $ 60,852$ 44,402 37.0 % Gross margin 23.3 % 22.8 % 22.2 % 22.2 % Gross margin for the second quarter of 2014 was 23.3% compared to 22.8% in the second quarter of 2013. The increase in gross margin was related to pre-acquisition businesses gross margins which increased consolidated gross margin in the second quarter of 2014 compared to the same period in 2013. This increase was primarily the result of higher net sales of $13.6 million across all of the Company's pre-acquisition businesses and the resulting improved absorption of fixed costs as well as lower raw material costs primarily in the T/A Fibers and T/A Metals segments. The increased gross margins of the pre-acquisition businesses was offset to some extent by the Industrial Filtration segment gross margin. The Industrial Filtration segment gross margin included the negative impact of a $0.5 million purchase accounting adjustment in cost of sales relating to inventory step-up. Gross margin for the six months ended June 30, 2014 was 22.2% which was equal to the comparable period of 2013. Gross margin was favorably impacted by the pre-acquisition businesses gross margins which increased consolidated gross margin during the six months ended June 30, 2014 compared to the comparable period of 2013. This increase was primarily the result of higher net sales across all of the Company's pre-acquisition businesses and the resulting improved absorption of fixed costs, as well as labor and manufacturing efficiencies in the T/A Fibers segment. This increase in gross margin was offset due to the inclusion of Industrial Filtration, since the date of acquisition. The Industrial Filtration segment gross margin included the negative impact of a $1.8 million purchase accounting adjustment in cost of sales relating to inventory step-up. Gross margin in the six months ended June 30, 2013 was favorably impacted by a $1.8 million completed pricing negotiation and non-recurring customer project in the T/A Fibers segment.



Selling, Product Development and Administrative Expenses

Quarter Ended Six Months Ended Percent Percent In thousands Q2-14 Q2-13 Change YTD-14 YTD-13 Change Selling, product development and administrative expenses $ 22,080$ 13,516 63.4 % $ 40,653$ 28,364 43.3 % Percentage of sales 14.8 % 13.4 % 14.8 % 14.2 % Selling, product development and administrative expenses for the second quarter of 2014 increased by $8.6 million compared to the quarter ended June 30, 2013. Inclusion of the Industrial Filtration segment increased selling, product development and administrative expenses by $2.9 million in the second quarter of 2014 compared to the second quarter of 2013. Also in the second quarter of 2014, the Company entered into a $2.9 million commission settlement within the T/A Metals segment as the Company terminated a long-standing commercial sales agreement. Other selling, product development and administrative expenses associated with pre-acquisition businesses increased in the second quarter of 2014 compared to the second quarter of 2013 related to salaries, benefits and accrued incentive compensation of $1.5 million, professional services of $0.5 million, other administrative costs of $0.5 million, and product trial costs of $0.3 million. Selling, product development and administrative expenses for the six months ended June 30, 2014 increased $12.3 million compared to the same period of 2013. Inclusion of the Industrial Filtration segment increased selling, product development and administrative expenses by $4.0 million in the first six months of 2014 compared to the first six months of 2013 and $2.6 million of transaction related costs were incurred in the first six months of 2014 by the corporate office, related to the Acquisition. Additionally, the increase in selling, product development and administrative expenses for the six months ended June 30, 2014 compared to the same period of 2013 was due to a $2.9 million commission settlement within the T/A Metals segment as the Company terminated a long-standing commercial sales agreement in the second quarter of 2014. Other selling, product development and administrative expenses associated with pre-acquisition businesses increased in the first six months of 2014, compared to the first six months of 23 -------------------------------------------------------------------------------- 2013, related to salaries, benefits and accrued incentive compensation of $1.3 million, professional services of $0.6 million, other administrative costs of $0.4 million and product trial costs of $0.5 million. Interest Expense Quarter Ended Six Months Ended Percent Percent In thousands Q2-14 Q2-13 Change YTD-14 YTD-13 Change Interest expense $ 280$ 76 268.4 % $ 492$ 154 219.5 % Weighted average interest rate 1.5 % 5.4 % 1.6 %



5.4 %

The increase in interest expense for the quarter and six months ended June 30, 2014 compared to the same periods of 2013 was due to borrowings under the Company's Amended Credit Facility used to finance the Acquisition, partially offset by lower average principal balances on capital lease obligations.



Other Income/Expense

Other income and expense for the quarters and six months ended June 30, 2014 and 2013 consisted of activity related to foreign exchange transaction gains and losses and interest income. Income Taxes The Company's effective tax rate was 31.3% and 36.8% for the quarters ended June 30, 2014 and 2013, respectively, and 38.2% and 34.0% for the six months ended June 30, 2014 and 2013, respectively. The difference in the Company's effective tax rate for the quarter ended June 30, 2014 compared to the second quarter of 2013 was primarily due to the expectation of increased earnings in 2014 compared to 2013 derived from countries with lower tax rates compared to that of the United States. The Company's effective tax rate for the six months ended June 30, 2014 was negatively impacted by discrete income tax charges of approximately $1.0 million, recorded in the first quarter of 2014, primarily for non-deductible transaction related expenses associated with the Acquisition. The Company's effective tax rate for the six months ended June 30, 2013 included a discrete tax benefit of $0.5 million recorded in the first quarter of 2013 as the Company concluded certain U.S. federal income tax matters through the year ended December 31, 2009. The Company and its subsidiaries file a consolidated federal income tax return, as well as returns required by various state and foreign jurisdictions. In the normal course of business, the Company is subject to examination by taxing authorities, including such major jurisdictions as the United States, France, Germany, China, United Kingdom and the Netherlands. With few exceptions, the Company is no longer subject to U.S. federal examinations for years before 2010, state and local examinations for years before 2002, and non-U.S. income tax examinations for years before 2003. The Company's effective tax rates in future periods could be affected by earnings being lower or higher than anticipated in countries where tax rates differ from the United States federal rate, the relative impact of permanent tax adjustments on higher or lower earnings from domestic operations, changes in net deferred tax asset valuation allowances, the impact of the completion of acquisitions or divestitures, changes in tax rates or tax laws and the completion of tax audits. 24

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Segment Results

The following tables present sales information for the key product and service groups included within each operating segment as well as other products and services and operating income by segment, for the quarter and six months ended June 30, 2014 compared with the quarter and six months ended June 30, 2013: Net sales by segment: Quarter Ended In thousands Q2-14 Q2-13 Dollar Change Performance Materials Segment: Filtration $ 19,546$ 17,903$ 1,643 Thermal Insulation 7,993 8,579 (586 ) Life Sciences Filtration 3,713 2,486 1,227



Performance Materials Segment net sales 31,252 28,968

2,284

Industrial Filtration Segment: Industrial Filtration 34,135 -



34,135

Industrial Filtration net sales 34,135 -



34,135

Thermal/Acoustical Metals Segment: Metal parts 38,701 35,957



2,744

Tooling 4,638 4,963 (325 ) Thermal/Acoustical Metals Segment net sales 43,339 40,920



2,419

Thermal/Acoustical Fibers Segment: Fiber parts 34,662 26,458



8,204

Tooling 1,646 1,501



145

Thermal/Acoustical Fibers Segment net sales 36,308 27,959

8,349 Other Products and Services: Life Sciences Vital Fluids 4,864 4,263 601 Other Products and Services net sales 4,864 4,263 601 Eliminations and Other (1,105 ) (1,059 ) (46 ) Consolidated Net Sales $ 148,793$ 101,051$ 47,742 25

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Six Months Ended In thousands YTD-14 YTD-13 Dollar Change Performance Materials Segment: Filtration $ 37,419$ 34,553$ 2,866 Thermal Insulation 16,521 16,735 (214 ) Life Sciences Filtration 6,165 5,163 1,002



Performance Materials Segment net sales 60,105 56,451

3,654

Industrial Filtration Segment: Industrial Filtration 51,791 -



51,791

Industrial Filtration net sales 51,791 -



51,791

Thermal/Acoustical Metals Segment: Metal parts 75,726 69,066



6,660

Tooling 10,069 12,056 (1,987 ) Thermal/Acoustical Metals Segment net sales 85,795 81,122



4,673

Thermal/Acoustical Fibers Segment: Fiber parts 64,984 54,242



10,742

Tooling 3,837 1,644



2,193

Thermal/Acoustical Fibers Segment net sales 68,821 55,886

12,935 Other Products and Services: Life Sciences Vital Fluids 9,588 8,570 1,018 Other Products and Services net sales 9,588 8,570 1,018 Eliminations and Other (2,081 ) (1,949 ) (132 ) Consolidated Net Sales $ 274,019$ 200,080$ 73,939 Operating income by segment: Quarter Ended Q2-14 Q2-13 Operating Operating Operating Operating Dollar In thousands Income Margin % Income Margin % Change Performance Materials $ 3,566 11.4 % $ 3,271 11.3 % $ 295 Industrial Filtration 2,198 6.4 % - 0.0 % 2,198 Thermal/Acoustical Metals 2,564 5.9 % 4,431 10.8 % (1,867 ) Thermal/Acoustical Fibers 9,279 25.6 % 5,432 19.4 % 3,847 Other Products and Services 286 5.9 % 125 2.9 % 161 Corporate Office Expenses (5,320 ) (3,738 ) (1,582 ) Consolidated Operating Income $ 12,573 8.4 % $ 9,521 9.4 % $ 3,052 26



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