DXP ENTERPRISES INC - Quarter Report: 2017 September (Form 10-Q)

Texas		76-0509661
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification Number)
7272 Pinemont, Houston, Texas 77040
(Address of principal executive offices, including zip code)
(713) 996-4700
(Registrant's telephone number, including area code)

		September 30, 2017				December 31, 2016
ASSETS
Current assets:
Cash		$	19,473			$	1,590
Restricted Cash			3,614				-
Trade accounts receivable, net of allowance for doubtful accounts of $9,634 in 2017 and $8,160 in 2016			165,235				148,919
Inventories, net			87,720				83,699
Costs and estimated profits in excess of billings on  uncompleted contracts			24,191				18,421
Prepaid expenses and other current assets			4,290				2,138
Income taxes recoverable			2,404				2,558
Total current assets			306,927				257,325
Property and equipment, net			55,703				60,807
Goodwill			187,591				187,591
Other intangible assets, net of accumulated amortization of $80,105 in 2017 and $70,027 in 2016			83,045				94,831
Other long-term assets			1,809				1,498
Total assets		$	635,075			$	602,052
LIABILITIES AND EQUITY
Current liabilities:
Current maturities of long-term debt		$	3,365			$	51,354
Trade accounts payable			81,518				78,698
Accrued wages and benefits			14,735				16,962
Customer advances			4,910				2,441
Billings in excess of costs and estimated profits on uncompleted contracts			3,032				2,813
Other current liabilities			14,726				14,391
Total current liabilities			122,286				166,659
Long-term debt, less current maturities and unamortized debt issuance costs of $10,531 in 2017 and $992 in 2016			239,042				173,331
Deferred income taxes			12,102				9,513
Commitments and contingencies (Note 13)
Equity:
Series A preferred stock, 1/10th vote per share; $1.00 par value; liquidation preference of $112 ($100 per share); 1,000,000 shares authorized; 1,122 shares issued and outstanding			1				1
Series B convertible preferred stock, 1/10th vote per share; $1.00 par value; $100 stated value; liquidation preference of $1,500 ($100 per share); 1,000,000 shares authorized; 15,000 shares issued and outstanding			15				15
Common stock, $0.01 par value, 100,000,000 shares authorized; 17,388,910 at September 30, 2017 and 17,197,380 at December 31, 2016 shares issued			174				172
Additional paid-in capital			152,857				152,313
Retained earnings			127,560				117,396
Accumulated other comprehensive loss			(19,309	)			(18,274	)
Total DXP Enterprises, Inc. equity			261,298				251,623
Noncontrolling interest			347				926
Total equity			261,645				252,549
Total liabilities and equity		$	635,075			$	602,052

		Three Months Ended September 30,								Nine Months Ended September 30,
		2017				2016				2017				2016
Sales		$	251,930			$	230,025			$	741,155			$	739,801
Cost of sales			184,967				166,205				540,741				535,560
Gross profit			66,963				63,820				200,414				204,241
Selling, general and  administrative expenses			60,453				58,887				175,411				192,461
Income from operations			6,510				4,933				25,003				11,780
Other income, net			(153	)			(251	)			(324	)			(397	)
Interest expense			4,928				4,338				12,573				11,698
Income before provision for income taxes			1,735				846				12,754				479
Provision (benefit) for income taxes			(1,176	)			664				2,880				459
Net income			2,911				182				9,874				20
Net loss attributable to noncontrolling interest			(55	)			(81	)			(360	)			(301	)
Net income attributable to DXP Enterprises, Inc.			2,966				263				10,234				321
Preferred stock dividend			23				23				68				68
Net income attributable to  common shareholders		$	2,943			$	240			$	10,166			$	253
Net income		$	2,911			$	182			$	9,874			$	20
Cumulative translation adjustment			830				19				(1,035	)			409
Comprehensive income		$	3,741			$	201			$	8,839			$	429
Basic earnings per share attributable to DXP Enterprises, Inc.		$	0.17			$	0.02			$	0.58			$	0.02
Weighted average common  shares outstanding			17,394				14,600				17,402				14,529
Diluted earnings per share attributable to DXP Enterprises, Inc.		$	0.16			$	0.02			$	0.56			$	0.02
Weighted average common shares  and common equivalent  shares outstanding			18,234				15,440				18,242				15,369

		Nine Months Ended
		September 30,
		2017				2016
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income attributable to DXP Enterprises, Inc.		$	10,234			$	321
Less net loss attributable to non-controlling interest			(360	)			(301	)
Net income			9,874				20
Adjustments to reconcile net income to net cash  provided by operating activities:
Depreciation			7,655				9,070
Amortization of intangible assets			12,943				13,557
Bad debt expense			1,466				1,476
Amortization of debt issuance costs			1,071				673
Write off of debt issuance costs			578				967
Compensation expense for restricted stock			1,392				1,944
Tax loss related to vesting of restricted stock			-				619
Deferred income taxes			2,000				(121	)
Changes in operating assets and liabilities, net of    assets and liabilities acquired in business combinations:
Trade accounts receivable			(16,397	)			9,965
Costs and estimated profits in excess of billings on      uncompleted contracts			(5,701	)			5,067
Inventories			(3,827	)			5,818
Prepaid expenses and other assets			(2,362	)			(608	)
Trade accounts payable and accrued expenses			(354	)			(8,560	)
Billings in excess of costs and  estimated profits on    uncompleted contracts			189				(4,171	)
Net cash provided by operating activities			8,527				35,716
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of property and equipment			(2,157	)			(3,843	)
Proceeds from sale of property and equipment			-				1,198
Equity method investment contribution			-				(3,214	)
Net cash used in investing activities			(2,157	)			(5,859	)
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from debt			728,822				324,229
Principal payments on revolving line of credit and other long-term  debt			(701,561	)			(356,497	)
Costs for registration of common shares			-				5,959
Debt issuance fees			(11,188	)			(616	)
Loss for non-controlling interest owners, net of tax			(219	)			(186	)
Dividends paid			(68	)			(68	)
Payment for employee taxes withheld from stock awards			(848	)			(238	)
Tax loss related to vesting of restricted stock			-				(619	)
Net cash provided by (used in) financing activities			14,938				(28,036	)
EFFECT OF FOREIGN CURRENCY ON CASH			189				(85	)
NET CHANGE IN CASH			21,497				1,736
CASH AT BEGINNING OF PERIOD			1,590				1,693
CASH AT END OF PERIOD		$	23,087			$	3,429

Topic	Method of Adoption	Impact on Consolidated Financial Statements
Recognize all excess tax benefits and tax deficiencies as income tax benefit or expense	Prospective	The Company recognized $0.2 million and $0.3 million of excess tax benefit in income taxes in the three and nine months ended September 30, 2017, respectively, decreasing the effective tax rate for each period.
Excess tax benefits and deficiencies on the statement of cash flows are classified as an operating activity	Prospective	The Company recognized $0.3 million of excess tax benefit in the nine months ended September 30, 2017 as an operating activity.  Prior to the adoption of the ASU 2016-09, the excess tax expense in the nine months ended September 30, 2016 was $0.6 million recognized as a financing activity.
Employee taxes paid when an employer withholds shares for tax-withholding purposes on the statement of cash flows are classified as financing activity	Retrospective	The Company reclassified $0.2 million of employee taxes paid from cash flows from operating activities to cash flows from financing  on the Consolidated Statements of Cash Flows in the nine months ended September 30, 2016.
Accounting for forfeitures and tax withholding elections	Prospective	The Company has not changed its accounting policy for forfeitures.  There is no significant impact on Consolidated Financial Statements.

		September 30, 2017				December 31, 2016
Finished goods		$	75,213			$	74,269
Work in progress			12,507				9,430
Inventories, net		$	87,720			$	83,699

		September 30, 2017				December 31, 2016
Costs incurred on uncompleted contracts		$	31,584			$	25,214
Estimated profits, thereon			3,097				6,274
Total			34,681				31,488
Less: billings to date			13,530				15,864
Net		$	21,151			$	15,624

		September 30, 2017				December 31, 2016
Costs and estimated profits in excess of billings on uncompleted contracts		$	24,191			$	18,421
Billings in excess of costs and estimated profits on uncompleted contracts			(3,032	)			(2,813	)
Translation adjustment			(8	)			16
Net		$	21,151			$	15,624

		September 30, 2017				December 31, 2016
Land		$	2,345			$	2,346
Buildings and leasehold improvements			16,668				16,259
Furniture, fixtures and equipment			96,337				94,784
Less – Accumulated depreciation			(59,647	)			(52,582	)
Total property and equipment, net		$	55,703			$	60,807

		Goodwill				Other Intangible Assets				Total
Balance as of December 31, 2016		$	187,591			$	94,831			$	282,422
Translation adjustment			-				1,157				1,157
Amortization			-				(12,943	)			(12,943	)
Balance as of September 30, 2017		$	187,591			$	83,045			$	270,636

		September 30, 2017				December 31, 2016
Service Centers		$	154,473			$	154,473
Innovative Pumping Solutions			15,980				15,980
Supply Chain Services			17,138				17,138
Total		$	187,591			$	187,591

		As of September 30, 2017												As of December 31, 2016
		Gross Carrying Amount				Accumulated Amortization				Carrying Amount, net				Gross Carrying Amount				Accumulated Amortization				Carrying Amount, net
Customer relationships		$	162,201			$	(79,315	)		$	82,886			$	163,022			$	(68,446	)		$	94,576
Non-compete agreements			949				(790	)			159				1,836				(1,581	)			255
Total		$	163,150			$	(80,105	)		$	83,045			$	164,858			$	(70,027	)		$	94,831

		September 30, 2017				December 31, 2016
ABL Revolver		$	-			$	-
Term Loan B			250,000				-
Line of credit			-				147,600
Term loan			-				74,500
Promissory note payable in monthly installments at 2.9% through   January 2021, collateralized by equipment			2,938				3,577
Less unamortized debt issuance costs			(10,531	)			(992	)
			242,407				224,685
Less: Current portion			(3,365	)			(51,354	)
Long-term debt less current maturities		$	239,042			$	173,331

		Number of Shares				Weighted Average Grant Price
Non-vested at December 31, 2016			143,380			$	26.76
Granted			18,672			$	34.07
Forfeited			(298	)		$	59.60
Vested			(79,853	)		$	25.14
Non-vested at September 30, 2017			81,901			$	29.88

		Three Months Ended September 30,								Nine Months Ended September 30,
		2017				2016				2017				2016
Basic:
Weighted average shares outstanding			17,394				14,600				17,402				14,529
Net income attributable to DXP Enterprises, Inc.		$	2,966			$	263			$	10,234			$	321
Convertible preferred stock dividend			23				23				68				68
Net income attributable to common shareholders		$	2,943			$	240			$	10,166			$	253
Per share amount		$	0.17			$	0.02			$	0.58			$	0.02
Diluted:
Weighted average shares outstanding			17,394				14,600				17,402				14,529
Assumed conversion of convertible  preferred stock			840				840				840				840
Total dilutive shares			18,234				15,440				18,242				15,369
Net income attributable to  common shareholders		$	2,943			$	240			$	10,166			$	253
Convertible preferred stock dividend			23				23				68				68
Net income attributable to DXP Enterprises, Inc. for diluted  earnings per share		$	2,966			$	263			$	10,234			$	321
Per share amount		$	0.16			$	0.02			$	0.56			$	0.02

		For the Three Months Ended September 30,
		2017																2016
		SC				IPS				SCS				Total				SC				IPS				SCS				Total
Sales		$	160,863			$	51,027			$	40,040			$	251,930			$	152,018			$	39,830			$	38,177			$	230,025
Amortization			2,262				1,803				271				4,336				2,292				1,956				271				4,519
Income (loss) from operations			13,288				35				3,711				17,034				11,053				(326	)			3,658				14,385
Income from operations, excluding amortization		$	15,550			$	1,838			$	3,982			$	21,370			$	13,345			$	1,630			$	3,929			$	18,904

 

The following table presents reconciliations of operating income for reportable segments to the consolidated income before taxes (in thousands):

 

NOTE 15 - SUBSEQUENT EVENTS

We have evaluated subsequent events through the date the interim Condensed Consolidated Financial Statements were issued. There were no subsequent events that required recognition or disclosure unless elsewhere identified in this report.

ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following management discussion and analysis (MD&A) of the financial condition and results of operations of

DXP Enterprises, Inc. together with its subsidiaries (collectively "DXP," "Company," "us," "we," or "our") for the three and nine months ended September 30, 2017 should be read in conjunction with our previous annual report on Form 10-K and our quarterly reports on Form 10-Q, and the financial statements and notes thereto included in our annual and quarterly reports. The Company's financial statements are prepared in accordance with accounting principles generally accepted in the United States of America ("US GAAP").

DISCLOSURE REGARDING FORWARD-LOOKING STATEMENTS

This Quarterly Report on Form 10-Q (this "Report") contains statements that constitute "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995, as amended. Such statements can be identified by the use of forward-looking terminology such as "believes", "expects", "may", "might", "estimates", "will", "should", "could", "would", "suspect", "potential", "current", "achieve", "plans" or "anticipates" or the negative thereof or other variations thereon or comparable terminology, or by discussions of strategy. Any such forward-looking statements are not guarantees of future performance and may involve significant risks and uncertainties, and actual results may vary materially from those discussed in the forward-looking statements or historical performance as a result of various factors. These factors include our ability to satisfy our debt covenants under our credit facilities, our ability to refinance our debt on acceptable terms, the effectiveness of management's strategies and decisions, our ability to implement our internal growth and acquisition growth  strategies, general economic and business condition specific to our primary customers, changes in government regulations, our ability to effectively integrate businesses we may acquire, our success in remediating our internal control weaknesses, new or modified statutory or regulatory requirements and changing prices and market conditions, including fluctuating oil and gas prices, and demand for maintenance, repair and operating products, equipment and service, and our ability to obtain financing on favorable terms or amend our credit facilities as needed. This Report identifies other factors that could cause such differences. We cannot assure that these are all of the factors that could cause actual results to vary materially from the forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in "Risk Factors", included in our Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 31, 2017. We assume no obligation and do not intend to update these forward-looking statements. Unless the context otherwise requires, references in this Report to the "Company", "DXP", "we" or "our" shall mean DXP Enterprises, Inc., a Texas corporation, together with its subsidiaries.

RESULTS OF OPERATIONS

(in thousands, except percentages and per share data)

DXP is organized into three business segments: Service Centers ("SC"), Supply Chain Services ("SCS") and Innovative Pumping Solutions ("IPS"). The Service Centers are engaged in providing maintenance, repair and operating ("MRO") products, equipment and integrated services, including technical expertise and logistics capabilities, to industrial customers with the ability to provide same day delivery. The Service Centers provide a wide range of MRO products and services in the rotating equipment, bearing, power transmission, hose, fluid power, metal working, industrial supply and safety product and service categories. The SCS segment provides a wide range of MRO products and manages all or part of our customer's supply chain, including inventory. The IPS segment fabricates and assembles integrated pump system packages custom made to customer specifications, remanufactures pumps and manufactures branded private label pumps. Over 90% of DXP's revenues represent sales of products.

Three Months Ended September 30, 2017 compared to Three Months Ended September 30, 2016

SALES. Sales for the three months ended September 30, 2017 increased $21.9 million, or 9.5%, to approximately $251.9 million from $230.0 million for the prior corresponding period. Sales from Vertex, a business sold on October 1, 2016 accounted for $7.1 million of third quarter 2016 sales. Excluding third quarter 2016 sales of Vertex, on a same store sales basis, sales for the third quarter in 2017 increased by $29.0 million, or 13.0% from the prior corresponding period. This same store sales increase is the result of sales increases in our Service Center, Innovative Pumping Solutions and Supply Chain Services segments of $15.9 million, $11.2 million and $1.9 million. These fluctuations in the sales in our segments are further explained in segment discussions below.

GROSS PROFIT. Gross profit as a percentage of sales for the three months ended September 30, 2017 decreased by approximately 116 basis points from the prior corresponding period. On a same store sales basis, gross profit as a percentage of sales decreased by approximately 69 basis points. The overall decrease in profit percentage, on a same store sales basis is the result of an approximate 186 basis point decrease in the gross profit percentage in our IPS segment, an approximate 61 basis point decrease in the gross profit percentage in our Supply Chain segment and an approximate 16 basis point decrease in the gross profit percentage in our Service Center segment. These fluctuations are explained in the segment discussions below.

SELLING, GENERAL AND ADMINISTRATIVE. Selling, general and administrative expense (SG&A) for the three months ended September 30, 2017 increased by approximately $1.6 million, or 2.7%, to $60.5 million from $58.9 million for the prior corresponding period. Selling, general and administrative expense from a business that was sold accounted for $1.9 million of the third quarter 2016 expense. Excluding third quarter expenses from the business that was sold, on a same store sales basis, SG&A for the quarter increased by $3.5 million, or 6.2%. The overall increase in SG&A, on a same store sales basis, is the result of increased payroll, incentive compensation and related taxes. As a percentage of sales, the third quarter 2017 expense decreased approximately 154 basis points to 24.0% from 25.5% for the prior corresponding period, on a same store sales basis, primarily as a result of the percentage increase in sales exceeding the percentage increase in SG&A.

OPERATING INCOME.  Operating income for the third quarter of 2017 increased $1.6 million, to $6.5 million, from $4.9 million in the prior corresponding period. The third quarter 2016 operating income from the business sold in 2016 was $1.1 million. Excluding the operating income from the business sold, on a same store sales basis, operating income increased $2.6 million, or 68.6% from the prior corresponding period. This increase in operating income is primarily related to the increase in sales discussed above.

INTEREST EXPENSE. Interest expense of $4.9 million for the third quarter of 2017 increased 13.6% from the prior corresponding period.  The increase is primarily the result of the $0.6 million write-off of debt issuance costs in connection with the termination of the previously existing credit facility during the third quarter of 2017. Increased interest rates were partially offset by a lower outstanding balance.

INCOME TAXES. Our effective tax rate from continuing operations was a tax benefit of 67.8% for the three months ended September 30, 2017 compared to a tax expense of 78.5% for the three months ended September 30, 2016. Compared to the U.S. statutory rate for the three months ended September 30, 2017, the effective tax rate was increased by state taxes and nondeductible expenses. The effective tax rate was decreased by lower income tax rates on income earned in foreign jurisdictions, the change in valuation allowance recorded against deferred tax assets, and research and development tax credits. Compared to the U.S. statutory rate for the three months ended September 30, 2016, the effective tax rate was increased by state taxes and nondeductible expenses.

SERVICE CENTERS SEGMENT. Sales for the Service Centers segment increased by $8.8 million, or 5.8%, for the third quarter of 2017 compared to the prior corresponding period. Excluding $7.1 million of third quarter 2016 Service Centers segment sales from a business sold, Service Centers segment sales for the third quarter in 2016 increased $15.9 million, or 11.0% from the prior corresponding period, on a same store sales basis. This sales increase is primarily the result of increased sales of rotating equipment, industrial supplies and bearings to customers engaged in the upstream oil and gas market or manufacturing equipment for the upstream oil and gas market. Increases and decreases in DXP's sales to oil and gas related customers tend to lag many months behind increases and decreases in crude oil and natural gas prices and the drilling rig count. If crude oil and natural gas prices and the drilling rig count remain at levels experienced during the third quarter of 2017, this level of sales to the upstream oil and gas industry could be expected to continue, or improve, during the remainder of 2017.

 

 

As a percentage of sales, the third quarter gross profit percentage for the Service Centers segment decreased approximately 78 basis points but decreased approximately 16 basis points on a same store sales basis, from the prior corresponding period. This decline is primarily the result of a decline in the gross profit percentage for our safety services in Canada. Operating income, on a same store sales basis, for the Service Centers segment increased $3.3 million, or 26.7%. The increase in operating income is primarily the result of the $4.4 million increase in gross profit.

INNOVATIVE PUMPING SOLUTIONS SEGMENT. Sales for the IPS segment increased by $11.2 million, or 28.1 % for the third quarter of 2017 compared to the prior corresponding period. This increase was primarily the result of an increase in capital spending by oil and gas producers and related businesses during 2017 compared to 2016. As a percentage of sales, the third quarter gross profit percentage for the IPS segment decreased approximately 186 basis points from the prior corresponding period primarily as a result of competitive pricing pressures and a reduced level of large, complex, high margin orders in the 2017 period. Additionally, gross profit margins for individual orders for the IPS segment can fluctuate significantly because each order is for a unique package built to customer specifications and subject to varying competition. Operating income for the IPS segment increased $0.2 million, or 12.8%, primarily as a result of the $11.2 million increase in sales discussed above.

SUPPLY CHAIN SERVICES SEGMENT. Sales for the SCS segment increased by $1.9 million, or 4.9%, for the third quarter of 2017 compared to the prior corresponding period. The increase in sales is primarily related to increased sales to customers in the oil and gas related industries.  We suspect customers in the oilfield services and oilfield equipment manufacturing industries purchased more from DXP because of the increase in capital spending by oil and gas companies operating in the U.S and Canada. Gross profit as a percentage of sales decreased approximately 61 basis points compared to the prior corresponding period primarily as a result of increased sales of lower margin products to oil and gas related customers.  Operating income for the SCS segment increased 1.3% primarily as a result of the 4.9% increase in sales.

Nine Months Ended September 30, 2017 compared to Nine Months Ended September 30, 2016

SALES. Sales for the nine months ended September 30, 2017 increased $1.3 million, or 0.2%, to approximately $741.2 million from $739.8 million for the prior corresponding period. Sales from a business sold in 2016 accounted for $22.7 million of 2016 sales. Excluding the first nine months of 2016 sales of the sold business, on a same store sales basis, sales for the first nine months of 2017 increased by $24.0 million, or 3.4% from the prior corresponding period. This same store sales increase is the result of an increase in our Service Centers, SCS and IPS segments of $15.6 million, $5.4 million and $2.9 million respectively, on a same store sales basis. These fluctuations in the sales in our segments are further explained in segment discussions below.

GROSS PROFIT. Gross profit as a percentage of sales for the nine months ended September 30, 2017 decreased by approximately 57 basis points from the prior corresponding period. On a same store sales basis, gross profit as a percentage of sales increased by approximately 18 basis points. The overall decrease in the profit percentage, on a same store sales basis, is the result of an approximate 208 basis point decrease in the gross profit percentage in our IPS segment and an approximate 69 basis point decrease in gross profit percentage in our Supply Chain segment partially offset by a 53 basis point increase in the gross profit percentage in our Service Centers segment. These fluctuations are explained in the segment discussions below.

SELLING, GENERAL AND ADMINISTRATIVE. Selling, general and administrative expense (SG&A) for the nine months ended September 30, 2017 decreased by approximately $17.1 million, or 8.9%, to $175.4 million from $192.5 million for the prior corresponding period. SG&A from a business that was sold accounted for $6.1 million of the decrease. Excluding the first nine months of SG&A from the business that was sold, on a same store sales basis, SG&A decreased by $10.9 million, or 5.9%. The overall decline in SG&A, on a same store sales basis, is the result of decreased payroll, incentive compensation, related taxes and 401(k) expenses due to headcount and salary reductions and other cost reduction measures primarily implemented near the end of the first quarter of 2016. Additionally, amortization expense declined by $0.6 million, on a same store sales basis. As a percentage of sales, the first nine months of 2017 expense decreased approximately 231 basis points to 23.7% from 26.0% for the prior corresponding period, on a same store sales basis, primarily as a result of the percentage increase in sales exceeding the percentage increase in SG&A.

OPERATING INCOME. Operating income for the nine months ended September 30, 2017 increased $13.2 million, to $25.0 million, from $11.8 million in the prior corresponding period. The operating income from the business sold in 2016 reduced the overall increase in operating income in the amount of $2.9 million. Excluding the operating income from the business sold, on a same store sales basis, operating income increased $16.1 million, or 181.6% from the prior corresponding period. This increase in operating income is primarily related to the decrease in SG&A and increase in gross profit discussed above.

INTEREST EXPENSE. Interest expense for the nine months ended September 30, 2017 increased 7.5% from the prior corresponding period primarily as a result of increased interest rates under our credit facilities.

INCOME TAXES. Our effective tax rate from continuing operations was a tax expense of 22.6% for the nine months ended September 30, 2017 compared to a tax expense of 95.8% for the nine months ended September 30, 2016. Compared to the U.S. statutory rate for the nine months ended September 30, 2017, the effective tax rate was increased by state taxes and nondeductible expenses. The effective tax rate was decreased by lower income tax rates on income earned in foreign jurisdictions, the change in valuation allowance recorded against deferred tax assets, and research and development tax credits. Compared to the U.S. statutory rate for the nine months ended September 30, 2016, the effective tax rate was increased by state taxes and nondeductible expenses.

SERVICE CENTERS SEGMENT. Sales for the Service Centers segment decreased by $7.0 million, or 1.5% for the nine months ended September 30, 2017 compared to the prior corresponding period. Excluding $22.7 million of the first nine months 2016 Service Centers segment sales from a business sold, Service Centers segment sales for the first nine months in 2017 increased $15.6 million, or 3.4% from the prior corresponding period, on a same store sales basis. This sales increase is primarily the result of increased sales of rotating equipment, industrial supplies and bearings to customers engaged in the upstream oil and gas market or manufacturing equipment for the upstream oil and gas market. As a percentage of sales, the nine month period gross profit percentage for the Service Centers increased approximately 3 basis points but increased approximately 53 basis points on a same store sales basis, from the prior corresponding period. This increase in the gross profit percentage is primarily the result of improved margins on sales of bearings and industrial supplies. Operating income for the Service Centers segment increased $14.7 million, or 45.2% on a same store sales basis. The increase in operating income is primarily the result of the reduced SG&A combined with increased gross profit.

INNOVATIVE PUMPING SOLUTIONS SEGMENT. Sales for the IPS segment increased by $2.9 million, or 2.1% for the nine months ended September 30, 2017 compared to the prior corresponding period. This increase is primarily the result of increased capital spending by oil and gas producers and related businesses during the first nine months of 2017 compared to the first nine months of 2016.  As a percentage of sales, the nine month period gross profit percentage for the IPS segment decreased approximately 208 basis points from the prior corresponding period primarily as a result competitive pricing pressures and a reduced level of large, complex, high margin orders in in the 2017 period. Additionally, gross profit margins for individual orders for the IPS segment can fluctuate significantly because each order is for a unique package built to customer specifications and subject to varying competition. Operating income for the IPS segment decreased $0.3 million, or 4.3%, primarily as a result of the 208 basis point decrease in the gross profit percentage discussed above, partially offset by a decrease in SG&A.

SUPPLY CHAIN SERVICES SEGMENT. Sales for the SCS segment increased by $5.4 million, or 4.7%, for the nine months ended September 30, 2017 compared to the prior corresponding period. The increase in sales is primarily related to increased sales to customers in the oil and gas industries.  We suspect customers in the oilfield services and oilfield equipment manufacturing industries purchased more from DXP because of the increase in capital spending by oil and gas companies operating in the U.S and Canada. Gross profit as a percentage of sales decreased approximately 69 basis points compared to the prior corresponding period primarily as a result of increased sales of lower margin products to oil and gas related customers.  Operating income for the SCS segment increased 1.3% primarily as a result of gross profit increasing more than SG&A increased.

LIQUIDITY AND CAPITAL RESOURCES

General Overview

As a distributor of MRO products and services, we require significant amounts of working capital to fund inventories and accounts receivable. Additional cash is required for capital items for information technology, warehouse equipment, leasehold improvements, pump manufacturing equipment and safety services equipment. We also require cash to pay our lease obligations and to service our debt.

The Company generated $8.5 million of cash from operating activities during the nine months ended September 30, 2017 compared to $35.7 million during the prior corresponding period. The $27.2 million decrease in the amount of cash generated between the two periods was driven by a greater increase in working capital during the 2017 period, partially offset by a $9.9 million improvement in net income and a lower level of net adjustments to reconcile net income to net cash provided by operating activities.

During the nine months ended September 30, 2017, the amount available to be borrowed under our credit facility increased from $37.3 million at December 31, 2016, to $81.0 million at September 30, 2017. This increase in availability is primarily a result of the Company terminating its previously existing credit facility and replacing it with the ABL Credit Agreement and Term Loan.

Senior Secured Term Loan B and ABL Facility

On August 29, 2017, DXP entered into a five year, $85 million Asset Based Loan and Security Agreement (the "ABL Credit Agreement") and a six year, $250 million Senior Secured Term Loan B (the "Term Loan B Agreement").

The ABL Credit Agreement provides for asset-based revolving loans in an aggregate principal amount of up to $85.0 million (the "ABL Loans").  The ABL Credit Agreement may be increased in increments of $10.0 million up to an aggregate of $50.0 million. The facility will mature on August 29, 2022. Interest accrues on outstanding borrowings at a rate equal to LIBOR or CDOR plus a margin ranging from 1.25% to 1.75% per annum, or at an alternate base rate, Canadian prime rate or Canadian base rate plus a margin ranging from 0.25% to 0.75% per annum, in each case, based upon the average daily excess availability under the facility for the most recently completed calendar quarter. Fees ranging from 0.25% to 0.375% per annum are payable on the portion of the facility not in use at any given time.

The Term Loan B Agreement provides for a $250 million term loan (the "Term Loan") that amortizes in equal quarterly installments of 0.25% with the balance payable in August 2023, when the facility matures.  Subject to securing additional lender commitments, the Term Loan B Agreement allows for incremental increases in facility size up to an aggregate of $30 million, plus an additional amount such that DXP's secured leverage ratio (as defined in the Term Loan B Agreement) would not exceed 3.60 to 1.00. Interest accrues on the Term Loan at a rate equal to the base rate plus a margin of 4.5%, or LIBOR plus a margin of 5.5%. We are required to repay the Term Loan with certain asset sales and insurance proceeds, certain debt proceeds and 50% of excess cash flow, reducing to 25%, if our total leverage ratio is no more than 3.00 to 1.00 and 0%, if our total leverage ratio is no more than 2.50 to 1.00.

The interest rate for the Term Loan was 6.7% as of September 30, 2017.

DXP's principal financial covenants under the ABL Credit Agreement and Term Loan B Agreement include:

Fixed Charge Coverage Ratio – The Fixed Charge Coverage Ratio under the ABL Credit Agreement is defined as the ratio for the most recently completed four-fiscal quarter period, of (a) EBITDA minus capital expenditures (excluding those financed or funded with debt (other than the ABL Loans), the portion thereof funded with the net proceeds from asset dispositions of equipment or real property which DXP is permitted to reinvest pursuant to the Term Loan and the portion thereof funded with the net proceeds of casualty insurance or condemnation awards in respect of any equipment and real estate which DXP is not required to use to prepay the ABL Loans pursuant to the Term Loan B Agreement or with the proceeds of casualty insurance or condemnation awards in respect of any other property) minus cash taxes paid (net of cash tax refunds received during such period), to (b) fixed charges.  The Company is restricted from allowing its fixed charge coverage ratio be less than 1.00 to 1.00 during a compliance period, which is triggered when the availability under the ABL facility falls below a threshold set forth in the ABL Credit Agreement.

Secured Leverage Ratio – The Term Loan B Agreement  requires that the Company's Secured Leverage Ratio, defined as the ratio, as of the last day of any fiscal quarter of consolidated secured debt (net of unrestricted cash, not to exceed $30 million) as of such day to EBITDA, beginning with the fiscal quarter ending December 31, 2017, is either equal to or less than as indicated in the table below:

Borrowings (in thousands):

 

Performance Metrics (in days):

Accounts receivable days of sales outstanding were 63.2 days at September 30, 2017 compared to 65.4 days at September 30, 2016.  The 2.2 days decrease was primarily due to our customers paying us sooner during the 2017 quarter compared to the 2016 quarter.  Inventory turns were 8.5 times at September 30, 2017 compared to 6.7 times at September 30, 2016.  The increase is primarily the result of low inventory turns in 2016 related to the 2016 organic sales decline, which resulted in 2016 sales decreasing faster than inventory decreased.

Funding Commitments

We believe cash generated from our operations will meet our normal working capital needs during the next twelve months. We expect we will be in compliance with the financial covenants under the existing ABL and Term Loan facilities through and including September 30, 2018.

Sales of Common Stock

During September 2016, the Company sold 238,858 shares of common stock at a weighted average price of $26.38 per share through a Form S-3 Registration Statement. Net proceeds were approximately $6.0 million and were used to pay down debt obligations.

On October 31, 2016, the Company closed on the sale of 2,484,000 shares of stock for total net proceeds of $46.2 million after expenses. These proceeds were used to pay down debt obligations.

The Company has not made any sales of common stock in the nine months ended September 30, 2017.

Acquisitions

All of the Company's acquisitions have been accounted for using the purchase method of accounting. Revenues and expenses of the acquired businesses have been included in the accompanying Condensed Consolidated Financial Statements beginning on their respective dates of acquisition. The allocation of purchase price to the acquired assets and liabilities is based on estimates of fair market value.

 

DISCUSSION OF SIGNIFICANT ACCOUNTING AND BUSINESS POLICIES

Critical accounting and business policies are those that are both most important to the portrayal of a company's financial position and results of operations, and require management's subjective or complex judgments. These policies have been discussed with the Audit Committee of the Board of Directors of DXP.

The Company's financial statements are prepared in accordance with accounting principles generally accepted in the United States of America ("US GAAP"). The accompanying Condensed Consolidated Financial Statements include the accounts of the Company, its wholly owned subsidiaries and its variable interest entity ("VIE"). The accompanying unaudited condensed consolidated financial statements have been prepared on substantially the same basis as our annual consolidated financial statements and should be read in conjunction with our annual report on Form 10-K for the year ended December 31, 2016. For a more complete discussion of our significant accounting policies and business practices, refer to the consolidated annual report on Form 10-K filed with the Securities and Exchange Commission on March 31, 2017. The results of operations for the three and nine months ended September 30, 2017 are not necessarily indicative of results expected for the full fiscal year.

DXP is the primary beneficiary of a VIE in which DXP owns 47.5% of the equity. DXP consolidates the financial statements of the VIE with the financial statements of DXP. As of September 30, 2017, the total assets of the VIE were approximately $5.4 million including approximately $4.9 million of property and equipment compared to $5.2 million of total assets and $5.2 million of property and equipment at December 31, 2016. DXP is the primary customer of the VIE. For the three months ended September 30, 2017 and 2016, consolidation of the VIE increased cost of sales by approximately $0.3 million and $0.2 million, respectively and increased SG&A by approximately $0.3 million and $58 thousand, respectively. For the nine months ended September 30, 2017 and 2016, consolidation of the VIE increased cost of sales by approximately $0.7 million and $0.8 million, respectively and increased SG&A by approximately $0.8 million and $0.2 million, respectively.  The Company recognized a related income tax benefit of $33 thousand and $50 thousand, respectively, related to the VIE for the three months ended September 30, 2017 and 2016 and $219 thousand and $130 thousand, respectively, for the nine months ended September 30, 2017 and 2016.  At September 30, 2017, the owners of 52.5% of the equity not owned by DXP included a former executive officer and other employees of DXP.

Equity investments in which we exercise significant influence, but do not control and are not the primary beneficiary, are accounted for using the equity method of accounting. During the first quarter of 2016, DXP invested $4.0 million in a related party equity method investment.  During the third and fourth quarters of 2016, the investment was reduced to zero by $4.0 million of distributions received from the entity.

RECENT ACCOUNTING PRONOUNCEMENTS

See Note 3 to the Condensed Consolidated Financial Statements for information regarding recent accounting pronouncements.

ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

Our market risk results from volatility in interest rates. Our exposure to interest rate risk relates primarily to our debt portfolio. Using floating interest rate debt outstanding at September 30, 2017 and 2016, a 100 basis point change in interest rates would result in approximately a $2.5 million and a $3.2 million change in annual interest expense, respectively. The decrease from 2016 is primarily the result of paying down debt during 2016 and 2017.

ITEM 4: CONTROLS AND PROCEDURES.

We have established disclosure controls and procedures that are designed to ensure that material information relating to us, including our consolidated subsidiaries, is made known to our Chief Executive Officer (principal executive officer) and Chief Financial Officer (principal financial officer) by others within our organization to allow timely decisions regarding required disclosures. Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our disclosure controls and procedures as of September 30, 2017. Based on this evaluation, as a result of the material weakness in our internal control over financial reporting described below, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were not effective as of September 30, 2017.

A material weakness is a deficiency, or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the Company's annual or interim financial statements will not be prevented or detected on a timely basis.

We had material weaknesses in our control environment and monitoring to support the financial reporting process.

We did not design and maintain effective internal control over the accounting for income taxes, including the timely preparation of the income tax provision and schedules supporting the related tax assets and liabilities. Specifically, management did not design and maintain controls with a level of precision that would allow for an effective review to identify a material misstatement. We did not maintain effective management review controls over the monitoring and review of certain accounts, thus we were not able to properly conclude these account reconciliations and analyses were performed at an appropriate level of detail.  We did not design and maintain effective controls to provide reasonable assurance over the accuracy and completeness relating to:

·	Maintaining adequate documentation to support proper revenue recognition;

·	Capturing and accounting for all fixed price contracts;

·	Obtaining proper approvals for contract change orders;

·	Documenting approval of management bonuses in a timely manner;

·	Improperly recording proceeds from property and equipment disposals to cost of sales;

·	Improper recording of valuation accounts in purchase accounting;

·	Obtaining proper approvals for freight invoices;

·	Accounting for fully amortized intangible assets;

·	Improperly recording operating leases on a method other than straight line recognition; and

·	Improper access to payroll records.

We had material weaknesses related to information technology general controls ("ITGC").  We did not maintain effective ITGC, which are required to support automated controls and information technology ("IT") functionality; therefore, automated controls and IT functionality were ineffective.

We had material weaknesses related to internal control activities to support the financial reporting process and failure to maintain adequate evidence of control operations.  We did not effectively design, document nor monitor (review, evaluate and assess) the risks associated with the key internal control activities that provide the accounting information contained in our financial statements.

 

 

Remediation Plans

Beginning in the fourth quarter of 2016, as part of our routine efforts to maintain adequate and effective internal control over financial reporting, we initiated and are continuing to implement measures designed to improve our financial closing process and enhance certain internal controls, processes and procedures. As indicated below, a number of these initiatives relate directly to strengthening our control over accounting for income taxes and address specific control deficiencies which contributed to the material weaknesses as discussed above. As a result of these efforts, the Company believes it has made progress as of September 30, 2017 toward remediating the underlying causes of the material weaknesses. Specifically, the Company has undertaken the following steps to remediate the deficiencies underlying these material weaknesses:

·	We augmented our tax accounting resources by engaging third party professionals and hiring an experienced tax director to strengthen tax accounting review procedures in the United States and Canada.

·	We developed and implemented enhanced policies and procedures relating to tax account reconciliations and analysis.

·	We are implementing close procedures at interim periods to allow for more timely and increased oversight by our management of the calculation and reporting of certain tax balances.

·	We are reassessing the design of our tax review controls to identify areas where enhanced precision will help detect and prevent material misstatements.

·	In connection with the remediation of the material weakness in our control activities, we are enhancing our policies relating to the documentation, review and approval of account reconciliations.

·	To enhance our information technology controls, we are implementing systems and processes in order to create an effective segregation of duties, restrict user access to applications and improve output controls.

·	We are implementing procedures to enhance the level of communication and understanding of our accounting and internal control policies and procedures in an effort to remediate the material weakness in our monitoring efforts.

We are committed to maintaining a strong internal control environment, and believe that these remediation efforts represent significant improvements in our control environment. The identified material weaknesses in internal control will not be considered fully remediated until the internal controls over these areas have been in operation for a sufficient period of time for our management to conclude that the material weakness has been fully remediated. The Company will continue its efforts to implement and test the new controls in order to make this final determination.

 

Changes in Internal Control over Financial Reporting

Except as described above, there are no changes in our internal control over financial reporting that occurred during the three months ended September 30, 2017 that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II: OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS.

From time to time, the Company is a party to various legal proceedings arising in the ordinary course of business. While DXP is unable to predict the outcome of these lawsuits, it believes that the ultimate resolution will not have, either individually or in the aggregate, a material adverse effect on DXP's consolidated financial position, cash flows, or results of operations.

ITEM 1A. RISK FACTORS.

No material changes have occurred from risk factors previously disclosed in the Company's Annual Report on Form 10-K for the year ended December 31, 2016.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.

None.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES.

None

ITEM 4. MINE SAFETY DISCLOSURES.

None.

ITEM 5. OTHER INFORMATION.

None.

ITEM 6. EXHIBITS.

3.1	Restated Articles of Incorporation, as amended (incorporated by reference to Exhibit 4.1 to the Registrant's Registration Statement on Form S-8 (Reg. No. 333-61953), filed with Commission on August 20, 1998).

3.2	Bylaws (incorporated by reference to Exhibit 3.2 to the Registrant's Registration Statement on Form S-4 (Reg. No. 333-10021), filed with the Commission on August 12, 1996).

3.3	Amendment No. 1 to Bylaws (incorporated by reference to Exhibit A to the Registrant's Current Report on Form 8-K, filed with the Commission on July 28, 2011 (file no. 000-71513)).

 

*10.1

Term Loan and Security Agreement Dated as of August 29, 2017 by and among DXP Enterprises, Inc., Borrower and the Other Persons Party hereto from time to time, as Guarantors, and Goldman Sachs Bank USA, as Administrative Agent and Certain Financial Institutions, as Lenders.

*10.2

Loan and Security Agreement Dated as of August 29, 2017 by and among DXP Enterprises, Inc., Pump-PMI, LLC, PMI Operating Company, LTD., PMI Investment, LLC, Integrated Flow Solutions, LLC, DXP Holdings, Inc., Best Holding, LLC, Best Equipment Service & Sales Company, LLC, B27 Holdings Corp., B27, LLC, B27 Resources, Inc. and Pumpworks 610, LLC as US Borrowers, DXP Canada Enterprises, LTD., Industrial Paramedic Services, LTD., HSE Integrated LTD., and National Process Equipment Inc., as Canadian Borrowers and the Other Persons Party hereto from time to time, as Guarantors, and Bank of America, N.A., as agent and Certain Financial Institutions as Lenders, Bank of America, N.A. as Sole Lead Arranger and Sole Bookrunner and BMO Capital Markets Corp., as Documentation Agent.

 

* 31.1

Certification of Chief Executive Officer pursuant to Rule 13a-14(a) and rule 15d-14(a) of the Securities Exchange Act, as amended.

* 31.2

Certification of Chief Financial Officer pursuant to Rule 13a-14(a) and rule 15d-14(a) of the Securities Exchange Act, as amended.

 

* 32.1

Certification of Chief Executive Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

* 32.2

Certification of Chief Financial Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

101	Interactive Data Files

 

Exhibits designated by the symbol * are filed with this Quarterly Report on Form 10-Q. All exhibits not so designated are incorporated by reference to a prior filing with the Commission as indicated.

 

 

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

DXP ENTERPRISES, INC.

(Registrant)

By: /s/ Kent Yee

Kent Yee

Senior Vice President and Chief Financial Officer

(Duly Authorized Signatory and Principal Financial Officer)

Dated: November 9, 2017