Description
Nortek Inc. 10% Owner Opportunities F Ares Corporate bought 700000 shares on 4-18-2012 at $ 40.25
BUSINESS OVERVIEW
General
Nortek was founded in 1967 and is headquartered in Providence, Rhode Island. The Company is incorporated in the State of Delaware. In this annual report, “Nortek,” the “Company,” “we,” “us,” and “our” refer to Nortek, Inc. and its wholly-owned subsidiaries unless the context requires otherwise.
We are a diversified manufacturer of innovative, branded residential and commercial building products, operating within four reporting segments:
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the Residential Ventilation Products (“RVP”) segment,
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the Technology Products (“TECH”) segment,
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the Residential Air Conditioning and Heating Products (“R-HVAC”) segment, and
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the Commercial Air Conditioning and Heating Products (“C-HVAC”) segment.
Through these segments, we manufacture and sell, primarily in the United States, Canada and Europe, a wide variety of products for the remodeling and replacement markets, the residential and commercial new construction markets, the manufactured housing market and the personal and enterprise computer markets.
Our performance is significantly impacted by the levels of residential replacement and remodeling activity, as well as the levels of residential and non-residential new construction. New residential and non-residential construction activity and, to a lesser extent, residential remodeling and replacement activity are affected by seasonality and cyclical factors such as interest rates, credit availability, inflation, consumer spending, employment levels and other macroeconomic factors, over which we have no control.
Additional information concerning our business is set forth in “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” Item 7 of Part II of this report. Additional financial information on our reporting segments, as well as foreign and domestic operations, is set forth in Note 12, “ Segment Information and Concentration of Credit Risk” , to the consolidated financial statements, Item 8 of Part II of this report.
2009 Bankruptcy and Reorganization
On December 17, 2009, we successfully emerged from bankruptcy as a reorganized company after voluntarily filing for bankruptcy on October 21, 2009 with the United States Bankruptcy Court for the District of Delaware (the "Bankruptcy Court"), pursuant to prepackaged plans of reorganization (the “Reorganization”). The purpose of the Reorganization was to reorganize our capital structure while allowing us to continue to operate our business. The Reorganization was necessary because it was determined that we would be unable to operate our business and meet our debt obligations under our pre-Reorganization capital structure.
As a result of the Reorganization, approximately $1.3 billion of debt was eliminated. On December 29, 2009, the Bankruptcy Court closed the bankruptcy cases for Nortek’s subsidiaries and on March 31, 2010, closed the bankruptcy case for Nortek. On December 17, 2009 (the “Effective Date”), we emerged from bankruptcy as a reorganized company with a new capital structure.
For further information regarding our capital structure, see Note 2, “Reorganization Under Chapter 11” , Note 3, “Fresh-Start Accounting” , Note 8, “Notes, Mortgage Notes and Obligations Payable” , and Note 9, “Share-Based Compensation” , to the consolidated financial statements, Item 8 of Part II of this report.
Residential Ventilation Products Segment
Our RVP segment primarily manufactures and distributes room and whole house ventilation and other products primarily for the professional remodeling and replacement markets, residential new construction market and do-it-yourself (“DIY”) market. The principal products of the segment, which are sold under the Broan®, NuTone®, Venmar®, Best® and Zephyr® brand names, among others, are:
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kitchen range hoods,
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exhaust fans (such as bath fans and fan, heater and light combination units), and
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indoor air quality products.
Based on internal research and industry knowledge, we believe that we are one of the world's largest suppliers of residential range hoods and exhaust fans and are the largest supplier of these products in North America, in each case, based on revenues. We also believe, based on internal research and industry knowledge, that we are one of the leading suppliers in Europe of luxury “Eurostyle” range hoods, based on revenues. Our kitchen range hoods expel grease, smoke, moisture and odors from the cooking area and are offered under an array of price points and styles from economy to upscale models. The exhaust fans we offer are primarily used in bathrooms to remove humidity and odors and include combination units, which may have lights, heaters or both. Our range hood and exhaust fan products are differentiated on the basis of air movement as measured in cubic feet per minute and sound output as measured in sones. The Home Ventilating Institute in the United States certifies our range hood and exhaust fan products, as well as our indoor air quality products.
Our sales of kitchen range hoods and exhaust fans accounted for approximately 11.9% and 9.2%, respectively, of consolidated net sales in 2011, 14.1% and 10.3%, respectively, of consolidated net sales in 2010 and approximately 14.2% and 10.3%, respectively, of consolidated net sales in 2009. Based on internal research and analysis, we estimate that approximately 70% to 80% of the segment's 2011 net sales were sold for remodeling and replacement applications versus new residential construction.
We believe, based on revenues, we are one of the largest suppliers in North America of indoor air quality products, which include air exchangers, as well as heat or energy recovery ventilators (HRVs or ERVs, respectively), that provide whole house ventilation. These systems bring in fresh air from the outdoors while exhausting stale air from the home. Both HRVs and ERVs moderate the temperature of the fresh air by transferring heat from one air stream to the other. In addition, ERVs also modify the humidity content of the fresh air. We also sell powered attic ventilators, which alleviate heat built up in attic areas and reduce deterioration of roof structures.
Since the late 1970s, homes have been built more airtight and insulated in order to increase energy efficiency. According to published studies, this trend correlates with an increased incidence of respiratory problems such as asthma and allergies in individuals. In addition, excess moisture, which may be trapped in a home, has the potential to cause significant deterioration to the structure and interiors of the home. Proper intermittent ventilation in high concentration areas, such as kitchens and baths, as well as whole house ventilation help to mitigate these problems.
We sell other products in this segment, including, among others, door chimes, medicine cabinets, trash compactors, ceiling fans and central vacuum systems, by leveraging our strong brand names and distribution network.
We sell the products in our RVP segment to distributors and dealers of electrical and lighting products, kitchen and bath dealers, retail home centers and private label customers under the Broan®, NuTone®, Venmar®, Best® and Zephyr® brand names, among others. Private label customers accounted for approximately 16% of the net sales of this segment in 2011.
A key component of our operating strategy for this segment is the introduction of new products and innovations, which capitalize on the strong brand names and the extensive distribution system of the segment's businesses. New product development efforts are focused on improving the style, performance, cost, and energy efficiency of the products. In this segment, we have introduced a line of upscale range hoods encompassing the latest in style and functionality. Also offered in this segment is a full line of EnergyStar® compliant ventilation fans including heavy-duty models ideal for light commercial installations and offices, recessed fan/lights, as well as 35 different models in the Ultra Silent™ Series. We believe that the variety of product offerings and new product introductions help us to maintain and improve our market position for our principal products. At the same time, we believe that our status as a low-cost producer provides the segment with a competitive advantage.
Our primary residential ventilation products compete with many products supplied by domestic and international companies in various markets. We compete with suppliers of competitive products primarily on the basis of quality, distribution, delivery and price. Although we believe we compete favorably with other suppliers of residential ventilation products, some of our competitors have greater financial and marketing resources than this segment of our business.
Product manufacturing in the RVP segment generally consists of fabrication from coil and sheet steel and formed metal utilizing stamping, pressing and welding methods, assembly with components and subassemblies purchased from outside sources (principally motors, fan blades, heating elements, wiring harnesses, controlling devices, glass, mirrors, lighting fixtures, polyethylene components and electronic components) and painting, finishing and packaging.
Over the past several years, we have moved the production of certain of our product lines from facilities in the United States, Canada and Italy to regions with lower labor costs, such as China, Poland and Mexico. In addition to these moves, in 2008, we consolidated the production of medicine cabinets from our facilities in Los Angeles, California and Union, Illinois to our facility in Cleburne, Texas, which was previously used to manufacture range hoods.
This segment's primary products compete globally with products supplied by many domestic and international suppliers in various markets. In the range hood market, this segment's primary global competitors are Elica Group, Faber S.p.A. and Cata Electrodomesticas S.L. This segment competes with Panasonic Corporation, among others, in the residential exhaust fan market.
Our RVP segment had 11 manufacturing plants and employed approximately 2,700 full-time people as of December 31, 2011, of which approximately 200 were covered by collective bargaining agreements which expired in 2011 and approximately 200 are covered by collective bargaining agreements which expire in 2013. In 2011, management approved a plan to reduce costs and improve production efficiencies at our subsidiary, Best, which included a transfer of certain employees in Italy, and an overall reduction of the total workforce in Italy. During 2011, we recorded expenses in the segment related to severance and other costs arising from the implementation of this plan. As we continue to restructure Best, it is possible that additional expenses may be incurred, however, at this point we do not expect to record any significant additional charges in 2012, and believe our relationships with employees in this segment are satisfactory.
Technology Products Segment
Our TECH segment manufactures and distributes a broad array of products designed to provide convenience and security for residential and certain commercial applications. The principal product categories sold in this segment are:
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audio/video distribution and control equipment,
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security and access control products, and
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digital display mounting and mobility products.
The segment's audio/video distribution and control equipment products include whole-house audio/video systems, video signal transmission and conversion devices, home integration systems as well as certain accessories often used with these systems such as structured wiring, power conditioners and surge protectors. Whole-house audio/video systems include multi-room/multi-source controllers and amplifiers, home theater receivers, intercom systems, speakers, and control devices such as keypads, remote controls and volume controls. The segment's speakers are primarily built-in (in-wall or in-ceiling) and are primarily used in multi-room or home theater applications. These products are sold under the Niles®, Elan®, ATON™, SpeakerCraft®, Proficient Audio Systems®, Sunfire®, and Xantech® brand names, among others. The segment's video signal transmission and conversion devices allow conversion of video signals into various formats as well as the transmission of video signals to multiple display screens. In addition to residential home theater applications, these products are often used in non-residential applications such as retail outlets, airports and casinos and are sold under the Magenta™ and Gefen® brand names. The segment's home integration systems include software and hardware that facilitate the control of third-party residential subsystems such as home theater, whole-house audio, climate control, lighting, security and irrigation. These products are sold under the Home Logic® and Elan g!® brand names. Other products in this category include power conditioners and surge protectors sold under the Panamax® and Furman® brand names and structured wiring products sold under the OpenHouse® and Channel Plus® brand names. Sales of audio/video distribution and control products accounted for approximately 29% and 43% of total TECH segment net sales in 2011 and 2010 , respectively.
The segment's security and access control products include residential and certain commercial intrusion protection systems, components for closed circuit television systems (camera housings), garage and gate operators and devices to gain entry to buildings and gated properties, such as radio transmitters, wireless window and door contacts, control panels, keypads and telephone entry systems. These products are sold under the Linear®, SecureWireless, GTO/PRO®, Mighty Mule®, OSCO®, Aigis®, AllStar®, IEI®, Luxor and certain private label brand names, as well as Westinghouse®, which is licensed. Sales of security and access control products accounted for approximately 33% and 43% of total TECH segment net sales in 2011 and 2010 , respectively.
The segment's digital display mounting and mobility products primarily are designed with ergonomic features and include wall mounts, desk mounts, arms, carts, workstations and stands that attach to a variety of display devices such as computer monitors, notebook computers and flat panel displays. These products are sold under the Ergotron® and OmniMount® brand names, as well as certain original equipment manufacturer brand names in the personal computer industry. Digital display mounting and mobility products accounted for approximately 38% and 14% of total TECH segment net sales in 2011 and 2010 , respectively.
We sell the products in our TECH segment to distributors, professional installers, electronics retailers and original equipment manufacturers. Sales in this segment are primarily driven by replacement applications, new installations in existing properties and purchases of high-priced audio/video equipment such as flat panel televisions and displays and to a lesser extent new construction activity. Sales of digital display mounting and mobility products are primarily driven by personal computer and I.T. spending, as well as from the sale of other products for which a mounting solution is needed. In addition, a portion of the sales in this segment is driven by sales to customers in the non-residential market. Based on internal analysis, we estimate that in 2011, approximately 80% to 90% of this segment's net sales was attributable to end-use applications not related to residential new construction.
The segment offers a broad array of products under widely-recognized brand names with various features and price points, which we believe allows it to expand its distribution in the professional installation and retail markets. Another key component of our operating strategy is the introduction of new products and innovations, which capitalize on our well-known brand names and strong customer relationships.
The segment's primary products compete with products supplied by many domestic and international suppliers in various markets. The segment competes with several portfolio companies of Duchossois Industries, Inc., including Chamberlain Corporation, Milestone AV Technologies and AMX LLC. The segment also competes with Crestron Electronics, Inc., among others. The segment competes with suppliers of competitive products primarily on the basis of quality, distribution, delivery and price. In addition, certain products are sourced from low cost Asian suppliers based on our specifications. Although we believe we compete favorably with other suppliers of technology products, some of our competitors have greater financial and marketing resources than this segment of our business.
In this segment, we have several administrative and distribution facilities in the United States and a significant amount of our products are manufactured at our facilities located in China. Our TECH segment had 11 manufacturing plants and employed approximately 3,300 full-time people as of December 31, 2011. We believe that our relationships with the employees in this segment are satisfactory.
Residential Air Conditioning and Heating Products Segment
Our R-HVAC segment principally manufactures and sells split-system and packaged air conditioners and heat pumps, air handlers, furnaces and related equipment, accessories and parts for the residential and certain commercial markets. For site-built homes and certain commercial structures, the segment markets its products under the licensed brand names Frigidaire®, Tappan®, Philco®, Kelvinator®, Gibson®, Westinghouse® and Maytag®. The segment also supplies products to certain of its customers under the Broan®, NuTone®, Mammoth® and several private label brand names. Within the residential market, we are one of the largest suppliers of HVAC products for manufactured homes in the United States and Canada. In the manufactured housing market, the segment markets its products under the Intertherm® and Miller® brand names.
Demand for replacing and modernizing existing equipment, regulatory changes, the level of housing starts and manufactured housing shipments are the principal factors that affect the market for the segment's residential HVAC products. We anticipate that the demand by the replacement market will continue to exceed the demand for products by the new installation market as a large number of previously installed heating and cooling products become outdated or reach the end of their useful lives. The demand for residential cooling products is also affected by spring and summer temperatures, although the seasonal effects are less dramatic than those experienced in the window air conditioning market which we do not sell to. We believe that our ability to offer both heating and cooling products helps offset the effects of seasonality on this segment's sales.
The segment sells its manufactured housing products to builders of manufactured housing and, through distributors, to manufactured housing retailers and owners. The majority of sales to builders of manufactured housing consist of furnaces designed and engineered to meet or exceed certain standards mandated by the U.S. Department of Housing and Urban Development, or HUD, and other federal agencies. These standards differ in several important respects from the standards for furnaces used in site-built residential homes. The aftermarket channel of distribution includes sales of both new and replacement air conditioning units and heat pumps and replacement furnaces. We believe that we have one major competitor in the manufactured housing furnace market, York by Johnson Controls, which markets its products primarily under the “Coleman” name. The segment competes with most major industry manufacturers in the manufactured housing air conditioning market.
The segment sells residential HVAC products for use in site-built homes through independently owned distributors who sell to HVAC contractors. The site-built residential HVAC market is very competitive. In this market, the segment competes with, among others, Carrier Corporation (a subsidiary of United Technologies Corporation), Rheem Manufacturing Company, Lennox Industries, Inc., Trane, Inc. (a subsidiary of IngersollRand Company), York by Johnson Controls and Goodman Global, Inc. During 2011, we estimate that approximately 60% of this segment's net sales were attributable to the replacement market versus residential construction, including manufactured housing.
In addition, the segment sells residential HVAC products outside of North America, with sales concentrated primarily in Latin America and the Middle East. International sales consist of not only the segment's manufactured products, but also products manufactured to specification by outside sources. The products are sold under the Westinghouse® licensed brand name, the segment's own Miller® brand name, as well as other private label brand names.
The segment competes in both the site-built and manufactured housing markets on the basis of breadth and quality of its product line, distribution, product availability and price. Although we believe that we compete favorably with respect to certain of these factors, most of the segment's competitors have greater financial and marketing resources and the products of certain competitors may enjoy greater brand awareness than our residential HVAC products.
Our R-HVAC segment had 3 manufacturing plants and employed approximately 1,100 full-time people as of December 31, 2011. We believe that our relationships with our employees in this segment are satisfactory.
CEO BACKGROUND
Michael J. Clarke has been a member of the Board, President and Chief Executive Officer of the Company since joining the Company on December 30, 2011. Mr. Clarke has more than 25 years of senior executive, business development and hands-on operational experience managing global companies in a myriad of industries including electronics, telecommunications, industrial, aerospace and automotive. From January 2006 until his appointment as the Company's Chief Executive Officer, Mr. Clarke served as President, FlexInfrastructure and Group President of Integrated Network Solutions of Flextronics International, Ltd, a publicly traded provider of design and electronics manufacturing services to original equipment manufacturers. Prior to Mr. Clarke's position at Flextronics International, he served as a President and General Manager of Sanmina-SCI Corporation, an electronic manufacturing services provider, from October 1999 to December 2005. Previously, Mr. Clarke held senior positions with international companies including Devtek Corporation Ltd., an aerospace, defense, telecommunications and aftermarket automotive company, Hawker Siddeley Group Ltd., an aerospace, defense and industrial company, and Cementation (Pty) Ltd. (Africa), a mining and industrial equipment company. Mr. Clarke serves on the board of Vubiz Ltd. Mr. Clarke's brings experience in a broad array of sectors relevant to Company's business and long track record of expanding several manufacturing divisions through multiple market cycles to the Board.
Daniel C. Lukas has been a member of the Board since July 1, 2010. Mr. Lukas is a Partner in the Private Equity Group of Ares Management LLC, a global alternative asset management firm (“Ares”). Prior to joining Ares in 2008, Mr. Lukas served as a Managing Director of GSC Group from 2006 through 2008, and Vice President of GSC Group from 2003 through 2005. Prior to that, he served as Vice President in the private equity and distressed debt funds at Thomas Weisel Capital Partners from 2000 to 2002, and before that, he was with Consolidated Press Holdings Limited, the private investment vehicle of Kerry Packer in Sydney, Australia. Earlier, Mr. Lukas was at Hellman & Friedman after beginning his career at Goldman, Sachs & Co. Mr. Lukas served as a director of RAM Holdings Ltd. from 2004 until his resignation in 2007, and as a director of Cherokee International Corporation from 2006 until his resignation in 2008. Mr. Lukas serves on the board of directors of City Ventures, LLC, Jacuzzi Brands Corporation and Sotera Defense Solutions, Inc. Mr. Lukas's experience with acquisitions and debt and equity investments, as well as his experience serving on other boards of public companies, allows him to bring valuable insight to the Board.
Bennett Rosenthal has been a member of the Board since December 17, 2009. Mr. Rosenthal is a founding member and Senior Partner of Ares Management where he serves on the Executive Committee and co-heads the Private Equity Group of Ares. Mr. Rosenthal joined Ares in 1998 from Merrill Lynch & Co. where he served as a Managing Director in the Global Leveraged Finance Group and was responsible for originating, structuring, and negotiating many leveraged loan and high yield financings. Mr. Rosenthal was also a senior member of Merrill Lynch's Leveraged Transaction Commitment Committee. Mr. Rosenthal is the Chairman of Ares Capital Corporation and also currently serves on the Boards of Directors of AmeriQual Group, LLC, Aspen Dental Management, Inc., City Ventures LLC, Jacuzzi Brands Corporation and AOT Bedding Super Holdings, LLC (the parent company of Serta International Holdco LLC and Simmons Bedding Company). Mr. Rosenthal previously served on the Boards of Directors of Maidenform Brands, Inc. and Hanger Orthopedic Group, Inc. Mr. Rosenthal's experience with leverage finance and high yield offerings and serving on other boards of directors makes him well-positioned to serve as a director for the Company.
MANAGEMENT DISCUSSION FROM LATEST 10K
Executive Overview
Nortek, Inc. and its wholly-owned subsidiaries are diversified manufacturers of innovative, branded residential and com mercial building products, operating within four reporting segments:
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the Residential Ventilation Products (“RVP”) segment,
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the Technology Products (“TECH”) segment,
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the Residential Air Conditioning and Heating Products (“R-HVAC”) segment, and
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the Commercial Air Conditioning and Heating Products (“C-HVAC”) segment.
Through these segments, we manufacture and sell, primarily in the United States, Canada and Europe, a wide variety of products for the remodeling and replacement markets, the residential and commercial new construction markets, the manufactured housing market and the personal and enterprise computer markets.
The RVP segment manufactures and sells room and whole house ventilation and other products primarily for the professional remodeling and replacement markets, the residential new construction market and the DIY market. The principal products sold by this segment include kitchen range hoods, exhaust fans (such as bath fans and fan, heater and light combination units) and indoor air quality products. Sales of our kitchen range hoods and exhaust fans within the RVP segment accounted for approximately 11.9% and 9.2%, respectively, of consolidated net sales for 2011 , approximately 14.1% and 10.3%, respectively, of consolidated net sales in 2010 and approximately 14.2% and 10.3%, respectively, of consolidated net sales in 2009 .
The TECH segment manufactures and distributes a broad array of products designed to provide convenience and security for residential and certain commercial applications. The principal product categories sold in this segment include audio/video distribution and control equipment, security and access control products, and digital display mounting and mobility products. Sales of our digital display mounting and mobility products accounted for approximately 12.7% of consolidated net sales in 2011.
The R-HVAC segment manufactures and sells heating, ventilating and air conditioning systems for site-built residential and manufactured hous ing structures and certain commercial markets. The principal products sold by the segment are split-system and packaged air conditioners and heat pumps, air handlers, furnaces and related equipment.
The C-HVAC segment manufactures and sells heating, ventilating and air conditioning systems for custom-designed commercial applications to meet customer specifications. The principal products sold by the segment are large custom rooftop cooling and heating products. Sales of our commercial air handlers within the C-HVAC segment accounted for approximately 11.4%, 10.9% and 11.9% of consolidated net sales in 2011 , 2010 and 2009 , respectively.
This Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") is intended to help the reader understand Nortek, Inc., our operations and our present business environment. MD&A is provided as a supplement to, and should be read in conjunction with, our consolidated financial statements and the accompanying notes contained in this report. Unless the context requires otherwise, the terms “Nortek,” “Company,” “we” and “our” in this MD&A refer to Nortek, Inc. and its wholly-owned subsidiaries.
Second Quarter 2011 Debt Transactions
On April 26, 2011, we successfully completed the private placement of $500.0 million in aggregate principal amount of 8.5% Senior Notes due 2021 (the “8.5% Notes”) and also entered into a new senior secured term loan with a final maturity in 2017 (the “Term Loan Facility”). Under the Term Loan Facility, we borrowed $350.0 million aggregate principal amount at a 5.25% interest rate. As discussed further below in “Liquidity and Capital Resources,” we principally used the net proceeds from the 8.5% Notes and the Term Loan Facility to repurchase or redeem all of our 11% Senior Secured Notes due 2013 (the “11% Notes”), which had an outstanding aggregate principal balance of approximately $753.3 million.
Based on the initial interest rate of 5.25% for the Term Loan Facility, we expect that our annual cash interest costs will be reduced by approximately $22.0 million as a result of the debt transactions described above. Approximately $82.9 million of annual cash interest related to the 11% Notes was eliminated and replaced by approximately $60.9 million of annual cash interest related to the 8.5% Notes and the Term Loan Facility.
2009 Bankruptcy and Reorganization
On December 17, 2009, we successfully emerged from bankruptcy as a reorganized company after voluntarily filing for bankruptcy on October 21, 2009 with the United States Bankruptcy Court for the District of Delaware (the "Bankruptcy Court"), pursuant to prepackaged plans of reorganization (the “Reorganization”). The purpose of the Reorganization was to reorganize our capital structure while allowing us to continue to operate our business. The Reorganization was necessary because it was determined that we would be unable to operate our business and meet our debt obligations under our pre-Reorganization capital structure.
As a result of the Reorganization, approximately $1.3 billion of debt was eliminated. On December 29, 2009, the Bankruptcy Court closed the bankruptcy cases for Nortek’s subsidiaries and on March 31, 2010 closed the bankruptcy case for Nortek. On December 17, 2009 (the “Effective Date”), we emerged from bankruptcy as a reorganized company with a new capital structure. See Note 2, “Reorganization Under Chapter 11” , to the consolidated financial statements included elsewhere in this report , for a description of our capital structure.
Adoption of Fresh-Start Accounting
On December 19, 2009, in connection with the Reorganization, we adopted fresh-start accounting in accordance with Accounting Standards Codification (“ASC”) 852, “Reorganization” (“ASC 852”) . Fresh-start accounting requires all assets and liabilities to be recorded at fair value. As a result of the application of fresh-start accounting, our post-emergence financial results (for all periods ending after December 19, 2009) are presented as the “Successor” and our pre-emergence financial results (for all periods ending through December 19, 2009) are presented as the “Predecessor”. Financial statements prepared under accounting principles generally accepted in the United States do not straddle the Effective Date because, in effect, the Successor represents a new entity. Due to the adoption of fresh-start accounting, the results of the Successor periods are not comparable to Predecessor periods. For the readers' convenience, the Successor period from December 20, 2009 to December 31, 2009 ("2009 Successor Period") and the Predecessor period from January 1, 2009 to December 19, 2009 ("2009 Predecessor Period") have been combined for certain purposes and are collectively referred to as “2009” for purposes of this MD&A.
In 2009, we recognized a gain of approximately $488.1 million for reorganization items as a result of the bankruptcy proceedings. This gain reflects the cancellation of our pre-petition debt, partially offset by the recognition of certain of our new equity and debt obligations, as well as professional fees incurred as a direct result of the bankruptcy proceedings.
In 2009, we also recognized a net gain of approximately $131.0 million related to the valuation of our assets and liabilities upon emergence from Chapter 11 bankruptcy proceedings.
In addition, we recognized charges of approximately $22.5 million in the 2009 Predecessor Period as a result of the bankruptcy proceedings.
For additional information regarding the bankruptcy proceedings, reorganization items, and fresh-start accounting adjustments see Note 2, “Reorganization Under Chapter 11” and Note 3, “Fresh-Start Accounting” , to the consolidated financial statements included elsewhere in this report.
Industry Overview
Critical factors affecting our future performance, including our level of sales, profitability and cash flows, are the levels of residential remodeling and replacement activity and new residential and non-residential construction activity. The level of new residential and non-residential construction activity and the level of residential remodeling and replacement activity are affected by seasonality and cyclical factors such as interest rates, inflation, consumer spending, employment levels and other macroeconomic factors, over which we have no control. Any decline in economic activity as a result of these or other factors typically results in a decline in residential and non-residential new construction and, to a lesser extent, residential and non-residential remodeling and replacement spending, which would result in a decrease in our sales, profitability and cash flows.
Instability in the credit and financial markets, troubles in the mortgage market, the level of unemployment and the decline in home values have had a negative impact on residential and non-residential new construction activity, consumer disposable income and spending on home remodeling and repair expenditures. These factors have had an adverse effect on our operating results for the last three years.
In addition, according to the Canada Mortgage and Housing Corporation, Canadian housing starts increased approximately 2.1% in 2011 as compared to 2010, increased approximately 27% in 2010 as compared to 2009 and decreased approximately 29% in 2009 as compared to 2008.
In 2011 , approximately 47% of consolidated net sales were made through independent distributors, dealers, wholesalers and similar channels, approximately 21% were to commercial HVAC markets, approximately 15% were to retailers (of which approximately 8% were sold to the four largest home center retailers), approximately 13% were private label sales and approximately 4% were to manufactured housing original equipment manufacturers and aftermarket dealers. Our largest distributor or dealer accounted for approximately 2% of consolidated net sales in 2011 . Our largest customer (other than a distributor or dealer) accounted for approximately 5% and 4% of consolidated net sales for 2011 and 2010 , respectively.
Based on internal research and analysis, we estimate that approximately 65% to 70% of our consolidated 2011 net sales were related to the residential housing market. Our products that serve the residential housing market primarily include range hoods and bath fans sold by our RVP segment, central air conditioning and heating products sold by our R-HVAC segment, and security and access control products and certain of the audio/video distribution and control products sold by our TECH segment. We believe that approximately 20% to 30% of our consolidated 2011 net sales to the residential housing market were related to new construction activity.
Also based on internal research and analysis, we estimate that approximately 30% to 35% of our consolidated 2011 net sales were related to non-residential applications including healthcare and educational institutions. Our products that serve the non-residential market primarily include air handlers and other heating and cooling products sold by our C-HVAC segment, and digital mounting and mobility products and certain of the audio/video distribution and control products sold by our TECH segment. We believe that approximately 30% to 40% of our consolidated 2011 net sales to the non-residential market were related to new construction activity.
The demand for certain of our products is seasonal, particularly in the Northeast and Midwest regions of the United States where inclement weather during winter months usually reduces the level of building and remodeling activity in both home improvement and new construction markets, thereby reducing our sales levels during the first and fourth quarters.
We are subject to the effects of changing prices and the impact of inflation which could have a significant adverse effect on our results of operations for the periods presented. In some circumstances, market conditions or customer expectations may prevent us from increasing the prices of our products to offset the inflationary pressures that may increase costs in the future. During 2011 , we experienced lower material costs as a percentage of net sales as compared to 2010 related primarily to the effect of acquisitions. Excluding the effect of acquisitions, material costs as a percentage of net sales for 2011was approximately 0.2% higher than in 2010 and is primarily the result of changes in product mix, higher prices related to the purchase of certain purchased components, such as electrical components and plastics, as well as from lower sales prices in the C-HVAC segment for jobs signed during the second half of 2010 and delivered in the first quarter of 2011. A portion of these increases was offset by strategic sourcing initiatives and improvements in manufacturing processes. Should these price levels continue or increase further there can be no assurance that we will be able to sufficiently increase sales prices to offset the adverse effect on earnings from rising material costs.
Revenue Recognition, Accounts Receivable and Related Expenses
We generally recognize sales based upon shipment of products to customers and have procedures in place at each of our subsidiaries to ensure that an accurate cut-off is obtained for each reporting period.
Allowances for cash discounts, volume rebates, other customer incentive programs and gross customer returns, among others, are recorded as a reduction of sales at the time of sale based upon the estimated future outcome. Cash discounts, volume rebates and other customer incentive programs are based upon certain percentages agreed to with our various customers, which are typically earned by the customer over an annual period. We record periodic estimates for these amounts based upon the historical results to date, estimated future results through the end of the contract period, and the contractual provisions of the customer agreements. For calendar year customer agreements, we are able to adjust our periodic estimates to actual amounts as of December 31 each year based upon the contractual provisions of the customer agreements. For those customers who have agreements that are not on a calendar year cycle, we record estimates at December 31 consistent with the above described methodology. Customers are generally not required to provide collateral for purchases. As a result, at the end of any given reporting period, the amounts recorded for these allowances are based upon estimates of the likely outcome of future sales with the applicable customers and may require adjustment in the future if the actual outcome differs. We believe that our procedures for estimating such amounts are reasonable.
Customer returns are recorded on an actual basis throughout the year and also include an estimate at the end of each reporting period for future customer returns related to sales recorded prior to the end of the period. We generally estimate customer returns based upon the time lag that historically occurs between the date of the sale and the date of the return, while also factoring in any new business conditions that might impact the historical analysis, such as new product introductions. We believe that our procedures for estimating such amounts are reasonable.
Provisions for the estimated allowance for doubtful accounts are recorded in selling, general and administrative expense, net
("SG&A"). The amounts recorded are generally based upon historically derived percentages while also factoring in any new business conditions that might impact the historical analysis such as changes in economic conditions, past due and nonperforming accounts, bankruptcies or other events affecting particular customers. We also periodically evaluate the adequacy of our allowance for doubtful accounts recorded in our consolidated balance sheet as a further test to ensure the adequacy of the recorded provisions. The analysis for allowance for doubtful accounts often involves subjective analysis of a particular customer’s ability to pay. As a result, significant judgment is required in determining the appropriate amounts to record and such judgments may prove to be incorrect in the future. We believe that our procedures for estimating such amounts are reasonable.
Inventory Valuation
We value inventories at the lower of the cost or market with approximately 29% of our inventory at December 31, 2011 valued using the last-in, first-out (“LIFO”) method and the remainder valued using the first-in, first-out (“FIFO”) method. On December 19, 2009, inventories were adjusted to their fair value in connection with the application of fresh-start accounting (see Note 3, “Fresh-Start Accounting” , and Note 4, “Summary of Significant Accounting Policies” , to the consolidated financial statements included elsewhere in this report). In connection with both LIFO and FIFO inventories, we record provisions, as appropriate, to write-down obsolete and excess inventory to estimated net realizable value. The process for evaluating obsolete and excess inventory often requires us to make subjective judgments and estimates concerning future sales levels, quantities, and prices at which such inventory will be able to be sold in the normal course of business. Accelerating the disposal process or incorrect estimates of future sales potential may cause the actual results to differ from the estimates at the time such inventory is disposed or sold. We believe that our procedures for estimating such amounts are reasonable.
Income Taxes
We account for income taxes using the liability method in accordance with ASC Topic 740, “Income Taxes” (“ASC 740”), which requires that the deferred tax consequences of temporary differences between the amounts recorded in our consolidated financial statements and the amounts included in our federal, state and foreign income tax returns to be recognized in the balance sheet. As we generally do not file our income tax returns until well after the closing process for the December 31 financial statements is complete, the amounts recorded at December 31 reflect estimates of what the final amounts will be when the actual tax returns are filed for that fiscal year. In addition, estimates are often required with respect to, among other things, the appropriate state income tax rates to use in the various states that we and our subsidiaries are required to file, the potential utilization of operating and capital loss carry-forwards and valuation allowances required, if any, for tax assets that may not be realizable in the future. We require each of our subsidiaries to submit year-end tax information packages as part of the year-end financial statement closing process so that the information used to estimate the deferred tax accounts at December 31 is reasonably consistent with the amounts expected to be included in the filed tax returns. ASC 740 requires balance sheet classification of current and long-term deferred income tax assets and liabilities based upon the classification of the underlying asset or liability that gives rise to a temporary difference. As such, we have historically had prepaid income tax assets due principally to the unfavorable tax consequences of recording expenses for required book reserves for such things as, among others, bad debts, inventory valuation, insurance, product liability and warranty that cannot be deducted for income tax purposes until such expenses are actually paid. We believe the procedures and estimates used in our accounting for income taxes are reasonable and in accordance with established tax law. The income tax estimates used have historically not resulted in material adjustments to income tax expense in subsequent periods when the estimates are adjusted to the actual filed tax return amounts, although there may be reclassifications between the current and long-term portion of the deferred tax accounts.
In connection with the filing of our U.S. federal tax return for the period ended December 17, 2009 in the third quarter of 2010, we made an election to capitalize for tax purposes research and development costs. This election resulted in the creation of a deferred tax asset that will be amortized over a 10 year period. As a result of this election, we recorded a deferred tax benefit of approximately $10.9 million, including a state tax benefit of approximately $1.0 million, in 2010.
MANAGEMENT DISCUSSION FOR LATEST QUARTER
Executive Overview
We are a diversified manufacturer of innovative, branded residential and commercial building products, operating within four reporting segments:
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the Residential Ventilation Products (“RVP”) segment,
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the Technology Products (“TECH”) segment,
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the Residential Air Conditioning and Heating Products (“RHVAC”) segment, and
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the Commercial Air Conditioning and Heating Products (“CHVAC”) segment.
Through these segments, we manufacture and sell, primarily in the United States, Canada and Europe, a wide variety of products for the remodeling and replacement markets, the residential and commercial new construction markets, the manufactured housing market, and the personal and enterprise computer markets.
The RVP segment manufactures and sells room and whole house ventilation and other products primarily for the professional remodeling and replacement markets, the residential new construction market, and the do-it-yourself market. The principal products sold by this segment include kitchen range hoods, exhaust fans (such as bath fans and fan, heater and light combination units), and indoor air quality products.
The TECH segment manufactures and distributes a broad array of products designed to provide convenience and security for residential and certain commercial applications. The principal product categories sold in this segment include audio/video distribution and control equipment, security and access control products, and digital display mounting and mobility products.
The RHVAC segment manufactures and sells heating, ventilating and air conditioning systems for site-built residential and manufactured housing structures and certain commercial markets. The principal products sold by the segment are split-system and packaged air conditioners and heat pumps, air handlers, furnaces, and related equipment.
The CHVAC segment manufactures and sells heating, ventilating and air conditioning systems for custom-designed commercial applications to meet customer specifications. The principal products sold by the segment are air handlers and large custom rooftop cooling and heating products.
Basis of Presentation
We operate on a calendar year and for our interim periods we operate on a 4-4-5 fiscal calendar, where each fiscal quarter is comprised of two 4-week periods and one 5-week period, with each week ending on a Saturday. Our fiscal year always begins on January 1 and ends on December 31. As a result, our first and fourth quarters may have more or less days included than a traditional 4-4-5 fiscal calendar, which consists of 91 days. The first three months ended March 31, 2012 (“first quarter of 2012”) and April 2, 2011 (“first quarter of 2011”) include 91 days and 92 days, respectively.
This Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") is intended to help the reader understand Nortek, Inc., our operations and our present business environment. MD&A is provided as a supplement to, and should be read in conjunction with, our condensed consolidated financial statements and the accompanying notes contained in this report. Unless the context requires otherwise, the terms “Nortek,” “Company,” “we” and “our” in this MD&A refer to Nortek, Inc. and its wholly-owned subsidiaries.
Critical Accounting Policies
Our discussion and analysis of our financial condition and results of operations are based upon our unaudited condensed consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. Certain of our accounting policies require the application of judgment in selecting the appropriate assumptions for calculating financial estimates. By their nature, these judgments are subject to an inherent degree of uncertainty. We periodically evaluate the judgments and estimates used for our critical accounting policies to ensure that such judgments and estimates are reasonable for our interim and year-end reporting requirements. These judgments and estimates are based on our historical experience, current trends, and information available from other sources, as appropriate. If different conditions result from those assumptions used in our judgments, the results could be materially different from our estimates.
Our critical accounting policies include:
•Revenue Recognition, Accounts Receivable and Related Expenses,
•Inventory Valuation,
•Income Taxes,
•Goodwill,
•Other Long-Lived Assets,
•Pensions and Post-Retirement Health Benefits,
•Warranty,
•Insurance Liabilities, including Product Liability, and
•Contingencies.
Further detail regarding our other critical accounting policies can be found in the consolidated financial statements and the notes included in our Annual Report on Form 10-K as filed with the Securities and Exchange Commission ("SEC").
Industry Overview
Critical factors affecting our future performance, including our level of sales, profitability and cash flows, are the levels of residential remodeling and replacement activity, and new residential and non-residential construction activity. The level of new residential and non-residential construction activity and the level of residential remodeling and replacement activity are affected by seasonality and cyclical factors such as interest rates, inflation, consumer spending, employment levels, and other macroeconomic factors, over which we have no control. Any decline in economic activity as a result of these or other factors typically results in a decline in residential and non-residential new construction and, to a lesser extent, residential and non-residential remodeling and replacement spending, which would result in a decrease in our sales, profitability and cash flows.
Instability in the credit and financial markets, troubles in the mortgage market, the level of unemployment, and the decline in home values have had a negative impact on residential and non-residential new construction activity, consumer disposable income, and spending on home remodeling and repair expenditures. These factors have had an adverse effect on our operating results.
Unallocated
Operating Loss. Unallocated operating loss was approximately $7.6 million in the first quarter of 2012 as compared to approximately $6.9 million for the first quarter of 2011. This increase in unallocated operating loss is primarily attributable to approximately $1.1 million of outside consulting fees incurred in the first quarter of 2012 relating to strategic reviews, offset by lower salaries and other expenses.
Interest Expense. Interest expense decreased approximately $4.8 million, or approximately 16.4%, during the first quarter of 2012 as compared to the first quarter of 2011. This decrease is primarily due to the second quarter 2011 debt transactions consisting of the private placement of $500.0 million in aggregate principal amount of 8.5% Senior Notes due 2021 (the “8.5% Notes”) and also entering into a new senior secured term loan with a final maturity in 2017 (the “Term Loan Facility”). The net proceeds from the 8.5% Notes and the Term Loan Facility were principally used to repurchase or redeem all of the 11% Senior Secured Notes due 2013, which had an outstanding aggregate principal balance of approximately $753.3 million.
Provision (Benefit) for Income Taxes. The provision for income taxes for the first quarter of 2012 was approximately $1.6 million as compared to a benefit from income taxes of approximately $6.3 million for the first quarter of 2011. The effective income tax rate for the first quarter of 2012 is not meaningful. Compared to the United States federal statutory rate of 35%, the effective income tax rate for the first quarter of 2012 reflects an increase in the valuation allowances related to certain deferred tax assets. The effective income tax rate of a benefit of approximately 23.0% for the first quarter of 2011 differs from the expected United States federal statutory rate of a benefit of 35% principally as a result of an increase in the valuation allowances related to deferred tax assets and the effect of foreign activities, partially offset by state income tax benefits.
Foreign Net Sales and Operating Earnings
Net sales and earnings derived from international markets are subject to economic, political and currency risks, among others.
Foreign net sales, which are attributed based on the location of our subsidiary responsible for the sale, were approximately 22.5% and 23.2% of consolidated net sales for the first quarter of 2012 and 2011, respectively. Net sales from our Canadian subsidiaries were approximately 11.6% and 11.1% of consolidated net sales for the first quarter of 2012 and 2011, respectively. Net sales from our Canadian subsidiaries include net sales from the RVP and CHVAC segments. Net sales from our European subsidiaries were approximately 8.5% and 8.6% of consolidated net sales for the first quarter of 2012 and 2011, respectively. Net sales from our European subsidiaries include net sales from the RVP, TECH and CHVAC segments.
Operating earnings of foreign operations, consisting primarily of the results of operations of our Canadian and European subsidiaries, were approximately 25.6% and 31.1% of consolidated operating earnings (before unallocated and corporate expenses) for the first quarter of 2012 and 2011, respectively.
Liquidity and Capital Resources
Our primary liquidity needs are to fund general business requirements, including working capital requirements, capital expenditures, interest payments and debt repayments. Our principal sources of liquidity are cash flows from operations, existing unrestricted cash and cash equivalents, and the use of borrowings under our $300.0 million senior secured asset-based revolving credit facility ("ABL Facility") . The indentures related to our 10% Senior Notes due 2018 (the "10% Notes") and 8.5% Notes, the credit agreements governing our ABL Facility and Term Loan Facility, and other agreements governing our indebtedness and the indebtedness of our subsidiaries contain certain restrictive financial and operating covenants, including covenants that restrict our ability and the ability of our subsidiaries to complete acquisitions, pay dividends, incur indebtedness, make investments, sell assets, and take certain other corporate actions. See Note G, " Notes, Mortgage Notes and Obligations Payable" to the unaudited condensed consolidated financial statements included elsewhere herein and “- Debt Covenant Compliance” below.
There can be no assurance that we will generate sufficient cash flow from the operations of our subsidiaries or that future financings will be available on acceptable terms or in amounts sufficient to enable us to service or refinance our indebtedness, or to make necessary capital expenditures.
Contractual Obligations
We have entered into a number of operating lease obligations and purchase obligations, and have guaranteed certain obligations of these parties. There have been no significant changes to these obligations since December 31, 2011.
Nortek, its subsidiaries, affiliates or significant shareholders (subject to the Investor Agreement between the Company and certain significant shareholders, dated as of April 4, 2012, as described in the Form 8-K filed by the Company with the SEC on April 5, 2012) may from time to time, in their sole discretion, purchase, repay, refinance, redeem or retire any of our outstanding debt, in privately negotiated or open market transactions, by tender offer or otherwise, which may be subject to restricted payment limitations.
Adequacy of Liquidity Sources
At March 31, 2012 , we had approximately $ 72.4 million of unrestricted cash and cash equivalents to fund our cash flow needs for the remainder of 2012 .
Our ABL Facility consists of a $280.0 million U.S. facility (with a $60.0 million sublimit for the issuance of U.S. standby letters of credit and a $20.0 million sublimit for U.S. swingline loans) and a $20.0 million Canadian facility. As of May 4, 2012 , we had approximately $12.0 million in outstanding borrowings and approximately $13.8 million in outstanding letters of credit under the ABL Facility. Based on the March 2012 borrowing base calculations, at May 4, 2012 , we had excess availability of approximately $233.2 million under the ABL Facility and approximately $194.3 million of excess availability before triggering the cash deposit requirements as discussed further below.
As noted previously, the indentures and other agreements governing our indebtedness and the indebtedness of our subsidiaries, contain certain restrictive financial and operating covenants, including covenants that restrict our ability and the ability of our subsidiaries to complete acquisitions, pay dividends, incur indebtedness, make investments, sell assets, and take certain other corporate actions. As of March 31, 2012 , we had the capacity to make certain payments, including dividends, under the 10% Notes of approximately $25.0 million.
From time to time, we have evaluated and expect to continue to evaluate possible acquisition transactions and possible dispositions of certain of our businesses and at any given time may be engaged in discussions or negotiations with respect to possible acquisitions or dispositions.
Working Capital
Our working capital increased from approximately $ 317.5 million at December 31, 2011 to approximately $ 327.5 million at March 31, 2012 , while our current ratio remained unchanged at 1.8 :1. The increase in working capital is primarily the result of an increase in unrestricted cash of approximately $14.2 million, as well as the effect of changes in other working capital accounts as described further below.
Refer to “- Cash Flows” , “- Contractual Obligations” and “- Adequacy of Liquidity Sources” above for further discussions on the Company’s working capital and future uses of cash.
Unrestricted cash and cash equivalents increased from approximately $ 58.2 million at December 31, 2011 to approximately $ 72.4 million at March 31, 2012 .
Accounts receivable, less allowances, increased approximately $ 8.2 million, or approximately 3.0% , between December 31, 2011 and March 31, 2012 , while net sales decreased approximately $12.4 million , or approximately 2.3% , in the first quarter of 2012 as compared to the fourth quarter of 2011 . The change in accounts receivable includes an increase of approximately $1.5 million related to the effect of changes in foreign currency exchange rates. Excluding the effect of changes in foreign currency exchange rates, accounts receivable, less allowances, increased approximately $6.7 million between December 31, 2011 and March 31, 2012 . The rate of change in accounts receivable in certain periods may be different than the rate of change in sales in such periods principally due to the timing of net sales, the level of sales recognized on a cash basis, as well as collections from our customers. Increases or decreases in net sales near the end of any period generally result in significant changes in the amount of accounts receivable on the date of the balance sheet at the end of such period. Accounts receivable from customers related to foreign operations increased by approximately $10.5 million, or approximately 14.5%, between December 31, 2011 and March 31, 2012 .
Inventories increased approximately $ 2.5 million, or approximately 0.8% , between December 31, 2011 and March 31, 2012 . The change in inventories includes an increase of approximately $1.1 million related to the effect of changes in foreign currency exchange rates. Excluding the effect of changes in foreign currency exchange rates, inventories increased approximately $1.4 million between December 31, 2011 and March 31, 2012 , primarily related to increased purchases in the CHVAC and RHVAC segments in anticipation of higher sales levels, partially offset by a decrease in purchases in the TECH segment due to seasonality and higher fourth quarter 2011 sales.
Other current assets decreased approximately $1.9 million, or approximately 14.1% , between December 31, 2011 and March 31, 2012 . This decrease is primarily related to a decrease in the cost basis of inventory shipped of approximately $2.0 million relating to a customer in the TECH segment for which we have determined cash basis accounting treatment is appropriate for revenue recognition under the customer agreement. See "Risks and Uncertainties" .
Accounts payable increased approximately $ 24.9 million, or 15.5% , between December 31, 2011 and March 31, 2012 primarily due to increases in the CHVAC and RHVAC segments related to increased purchasing in anticipation of higher sales levels. The change in accounts payable at March 31, 2012 also reflects an increase of approximately $1.2 million related to the effect of changes in foreign currency exchange rates.
Accrued expenses and taxes, net increased approximately $ 3.4 million, or approximately 1.6% , between December 31, 2011 and March 31, 2012 primarily as a result of an increase in accrued interest related to upcoming interest payments on our senior indebtedness, partially offset by a decrease in accrued severance of approximately $7.1 million primarily relating to payments made in the first quarter of 2012.
Changes in certain working capital accounts, as noted above, between December 31, 2011 and March 31, 2012 , differ from the changes reflected in our unaudited condensed consolidated statement of cash flows for such period as a result of non-cash items, including among others, the effect of changes in foreign currency exchange rates.
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Fund Letters
