PGT Innovations, Inc. - Quarter Report: 2017 September (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended September 30, 2017

OR

For the transition period from                      to                     

Commission file number 001-37971

PGT Innovations, Inc.

1070 Technology Drive

North Venice, FL 34275

Registrant’s telephone number: 941-480-1600

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes  ☒            No  ☐

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes  ☒            No  ☐*

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company.

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section13(a) of the Exchange Act.

Yes  ☐            No  ☐

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes  ☐            No  ☒

Common Stock, $0.01 par value, outstanding was 49,660,699 shares, as of November 2, 2017.

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PGT INNOVATIONS, INC.

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Form 10-Q for the Three and Nine Months Ended September 30, 2017

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PART I — FINANCIAL INFORMATION

PGT INNOVATIONS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(in thousands, except per share amounts)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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PGT INNOVATIONS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except per share amounts)

(unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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PGT INNOVATIONS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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PGT INNOVATIONS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

NOTE 1. BASIS OF PRESENTATION

The accompanying unaudited condensed consolidated financial statements include the accounts of PGT Innovations, Inc. and its wholly-owned subsidiary, PGT Industries, Inc., and its wholly-owned subsidiaries CGI Window and Holdings, Inc. (“CGI”), which includes its wholly-owned subsidiary, CGI Commercial, Inc. (“CGIC”), and WinDoor, Incorporated (collectively the “Company”), after elimination of intercompany accounts and transactions.

These condensed consolidated financial statements have been prepared in accordance with the instructions to Form 10-Q and do not include all of the information and footnotes required by United States Generally Accepted Accounting Principles (“GAAP”) for complete financial statements. In the opinion of management, all adjustments (consisting only of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the interim period is not necessarily indicative of the results that may be expected for the remainder of the current year or for any future periods. Each of our Company’s fiscal quarters ended September 30, 2017, and October 1, 2016, consisted of 13 weeks.

The condensed consolidated balance sheet as of December 31, 2016, is derived from the audited consolidated financial statements, but does not include all disclosures required by GAAP. The condensed consolidated balance sheet as of December 31, 2016, and the unaudited condensed consolidated financial statements as of and for the periods ended September 30, 2017, should be read in conjunction with the more detailed audited consolidated financial statements for the year ended December 31, 2016, included in the Company’s most recent Annual Report on Form 10-K. Except for the adoption of the guidance relating to the accounting for stock-based compensation expense discussed below, the accounting policies used in the preparation of these unaudited condensed consolidated financial statements are consistent with the accounting policies described in the Notes to Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K.

Recently Adopted Accounting Pronouncements

In March 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2016-09, “Compensation - Stock Compensation, Improvements to Employee Share-Based payment Accounting (Topic 718)”. This update is intended to provide simplification of the accounting for share-based payment transactions, including the accounting for income taxes, forfeitures, and statutory tax withholding requirements, as well as classification in the statement of cash flows. We adopted this update effective for our fiscal year beginning January 1, 2017. Impacts of the adoption of ASU 2016-09 are as follows:

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The effects on the Company’s consolidated balance sheet as of December 31, 2016, relating to the adoption of ASU 2016-09 is as follows (in thousands):

In July 2015, the FASB issued ASU No. 2015-11, “Inventory (Topic 330) – Simplifying the Measurement of Inventory”. This guidance changed the subsequent measurement of inventory, excluding inventory accounted for under LIFO or the retail inventory method, to be at lower of cost and net realizable value. Topic 330, Inventory, previously required an entity to measure inventory at the lower of cost or market. Market could have been replacement cost, net realizable value, or net realizable value less an approximately normal profit margin. Under this ASU, an entity measures inventory within its scope at the lower of cost and net realizable value. Net realizable value is the estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation. ASU 2015-11 was effective for us as of January 1, 2017. We prospectively adopted ASU 2015-11 effective on January 1, 2017. The adoption of ASU 2015-11 had no impact on our financial statements.

Recently Issued Accounting Pronouncements

In addition to the pronouncements issued during 2017, ASU 2016-02, “Leases (Topic 842), and ASU 2014-09, “Revenue from Contracts with Customers”, presented below, see Note 3 to the consolidated financial statements included in our recently filed Annual Report on Form 10-K for the year ended December 31, 2016.

In August 2017, the FASB issued ASU 2017-12, “Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities.” The amendments under ASU 2017-12 refine and expand hedge accounting requirements for both financial (e.g., interest rate) and commodity risks. Its provisions create more transparency around how economic results are presented, both on the face of the financial statements and in the footnotes. It also makes certain targeted improvements to simplify the application of hedge accounting guidance. ASU 2017-12 becomes effective for us in the first quarter of 2019. We do not expect the adoption of this guidance to have a significant effect on the Company’s consolidated financial statements.

In February 2017, the FASB issued ASU 2017-05, “Other Income—Gain and Losses from the Derecognition of Nonfinancial Assets.” ASU 2017-05 clarifies the scope of Subtopic 610-20, Other Income—Gains and Losses from the Derecognition of Nonfinancial Assets, and adds guidance for partial sales of nonfinancial assets. Subtopic 610-20, which was issued in May 2014 as a part of ASU 2014-09, provides guidance for recognizing gains and losses from the transfer of nonfinancial assets in contracts with non-customers. This update is effective at the same time as the amendments in ASU 2014-09, therefore, for our fiscal year beginning after December 15, 2017, and may be applied either under a full- or modified-retrospective basis. We do not expect the adoption of this guidance to have a significant effect on the Company’s consolidated financial statements.

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In January 2017, the FASB issued ASU 2017-04, “Intangibles—Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment.” ASU 2017-04 simplifies the subsequent measurement of goodwill by eliminating “Step 2” from the goodwill impairment test. The amendment also eliminates the requirement for any reporting unit with a zero or negative carrying amount to perform a qualitative assessment. An entity still has the option to perform the qualitative assessment for a reporting unit to determine if the quantitative impairment test is necessary. This update is effective for our fiscal year beginning after December 15, 2019, and shall be adopted prospectively. Early adoption is permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017. We do not expect the adoption of this guidance to have a significant effect on the Company’s consolidated financial statements.

In January 2017, the FASB issued ASU 2017-01, “Business Combinations (Topic 805) – Clarifying the Definition of a Business.” ASU 2017-01 affects all companies and other reporting organizations that must determine whether they have acquired or sold a business. The definition of a business affects many areas of accounting including acquisitions, disposals, goodwill, and consolidation. The amendments are intended to help companies and other organizations evaluate whether transactions should be accounted for as acquisitions (or disposals) of assets or businesses. ASU 2017-01 provides a more robust framework to use in determining when a set of assets and activities is a business. It also provides more consistency in applying the guidance, reduces the costs of application, and makes the definition of a business more operable. This update is effective for our fiscal year beginning after December 15, 2017, including interim periods therein. We will apply the provisions of this guidance once it becomes effective.

In February 2016, the FASB issued ASU 2016-02, “Leases (Topic 842)”. This guidance supersedes the existing guidance for lease accounting, Leases (Topic 840). ASU 2016-02 requires lessees to recognize leases on their balance sheets, and leaves lessor accounting largely unchanged. The amendments in this ASU are effective for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. Early adoption is permitted for all entities. ASU 2016-02 requires a modified retrospective approach for all leases existing at, or entered into after, the date of initial application, with an option to elect to use certain transition relief. The Company is continuing to evaluate the impact of this new standard on its consolidated financial statements.

Approaching Adoption of ASU 2014-09, “Revenue from Contracts with Customers”

In May 2014, the FASB issued ASU 2014-09, “Revenue from Contracts with Customers”. ASU 2014-09 replaces the existing accounting standards for revenue recognition with a single comprehensive five-step model. The core principle is to recognize revenue upon the transfer of goods or services to customers at an amount that reflects the consideration expected to be received. The FASB also issued ASU 2015-14, “Deferral of Effective Date”. ASU 2015-14 deferred the effective date for the new guidance until the annual reporting period beginning after December 15, 2017, and interim periods within those annual periods. Early adoption is permitted, but not before the original effective date (periods beginning after December 15, 2016). The standard permits the use of either the full-retrospective (restating all years presented in the Company’s financial statements), or modified-retrospective (recording the impact of adoption as an adjustment to retained earnings at the beginning of the year of adoption) transition methods. Since its issuance, the FASB has also amended several aspects of the new guidance, including; ASU 2016-08, “Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations (Reporting Revenue Gross versus Net)” which clarifies the Topic 606 guidance on principal versus agent considerations, ASU 2016-10, “Revenue from Contracts with Customers (Topic 606) – Identifying Performance Obligations and Licensing”, which clarifies identification of a performance obligation and addresses revenue recognition associated with the licensing of intellectual property, ASU 2016-12, “Revenue from Contracts with Customers (Topic 606), Narrow Scope Improvements and Practical Expedients”, which clarifies assessment of collectability criterion, non-cash consideration and other technical corrections, and ASU 2016-20, “Technical Corrections and Improvements to Topic 606, Revenue from Contracts with Customers”, which is the result of the FASB Board decision to issue a separate Update for technical corrections and improvements. The Company currently plans to adopt the provisions of this new accounting standard at the beginning of fiscal year 2018, using the modified-retrospective method.

The Company completed its preliminary assessment of the impact of its upcoming adoption of ASU 2014-09 on its consolidated financial statements. The Company recognizes revenue currently under existing generally accepted accounting principles, which is a model based on the transfer of the risks and rewards of ownership. Predominantly, for the Company, this has been at the point in time that possession of goods has transferred to the customer upon delivery. The model for recognizing revenue will change under ASU 2014-09, to one based on the transfer of control of the product to the customer. Under ASU 2014-09, revenue is recognized when an entity satisfies its obligation by transferring control of the goods or services to the customer, and transfer of possession of the product is not required in order for transfer of control of the product to the customer to have occurred.

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ASU 2014-09 states that if any one of three defined criteria is met, it is likely that an entity will be required to recognize revenue over time, where previously the entity has recognized revenue at the point in time which possession of the goods or services pass to the customer. Pursuant to our preliminary assessment, we believe that, of these three criteria, the Company meets the criteria which states that revenue is recognized over time if an entity’s performance (i.e. creation of a good or service for the customer) does not create an asset with an alternative use to the entity, and the entity has an enforceable right to payment for performance completed to-date. ASU 2014-09 further states that, when evaluating whether or not the goods or services have an alternative use, an entity should consider the level of customization of the goods or services. A high level of customization is a strong indicator that the goods or services do not have an alternative use and, therefore, revenue would be recognized over time as an entity performs.

The Company is a manufacturer of fully-customized windows and doors, and manufactures products based on design specifications, measurements, colors, finishes, framing materials, glass-types, and other options selected by the customer at the point in time an order is received from the customer. The Company’s initial assessment is that its goods have no alternative use, as that term is defined in ASU 2014-09, and that control of the product passes to the customer no later than completion of the manufacturing of each or all of the products in an order, but before delivery of the products to the customer. Additionally, the Company has an enforceable right to payment at the agreed-upon sales prices contained in our agreements with our customers for all manufacturing efforts expended by the Company on behalf of its customers.

Based on this initial assessment, the Company believes that it will be required to change its method of recognizing revenue, to one of potentially recognizing revenue as products are manufactured, but no later than completion of the manufacturing process, from its current method of recognizing revenue upon delivery of the product to the customer. The Company is continuing to evaluate its manufacturing processes in order to assess at what point the products have no alternative use and the recognition of revenue should begin. However, because revenue will have been recognized on at least all products for which manufacturing has been completed, the Company believes that upon adoption of ASU 2014-09, inventories on its consolidated balance sheets will no longer include finished goods. The Company also believes that it will recognize revenue at an earlier point than prior to the adoption of ASU 2014-09, but that such effect may not materially affect its consolidated statements of operations post-adoption due to the fact that such effects will exist at both the beginning and end of fiscal periods after the initial transition.

ASU 2014-09 also requires entities, primarily in the manufacturing segment, to make policy elections relating to shipping and handling charges. Entities may elect to treat shipping and handling as a separate performance activity, and recognize revenue from shipping and handling as performance occurs. Conversely, entities may also elect to treat shipping and handling as a fulfillment activity, which will require shipping and handling costs for undelivered products to be accrued in order to match this cost with the revenue previously recognized over time. The Company currently recognizes shipping and handling costs as a fulfillment activity, and has preliminarily determined to continue to treat such costs as a fulfillment activity.

The Company expects to continue to evaluate the impact of the adoption of ASU 2014-09 on its consolidated financial statements, and will provide updates and additional information as the effective date of adoption approaches.

NOTE 2. WARRANTY

Most of our manufactured products are sold with warranties. Warranty periods, which vary by product components, generally range from 1 to 10 years; however, the warranty period for a limited number of specifically identified components in certain applications is a lifetime. The majority of the products sold have warranties on components which range from 1 to 3 years. The reserve for warranties is based on management’s assessment of the cost per service call and the number of service calls expected to be incurred to satisfy warranty obligations on the current net sales.

During the three months ended September 30, 2017, we recorded warranty expense at a rate of approximately 2.04% of sales, which decreased from the rate in the second quarter of 2017 of 2.22%. During the three months ended October 1, 2016, we recorded warranty expense at a rate of approximately 2.21% of sales.

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The following table summarizes: current period charges, adjustments to previous estimates, if necessary, as well as settlements, which represent actual costs incurred during the period for the three and nine months ended September 30, 2017, and October 1, 2016. The reserve is determined through specific identification and assessing Company history. Expected future obligations are discounted to a current value using a risk-free rate for obligations with similar maturities.

NOTE 3. INVENTORIES

Inventories consist principally of raw materials purchased for the manufacture of our products. We have limited finished goods inventory since all products are custom, made-to-order and usually ship upon completion. Finished goods inventory and work-in-progress costs include direct materials, direct labor, and overhead. All inventories are stated at the lower of cost (first-in, first-out method) or net realizable value. Inventories consisted of the following:

NOTE 4. STOCK BASED-COMPENSATION

Exercises

For the three months ended September 30, 2017, there were 90,159 options exercised at a weighted average exercise price of $1.99 per share. For the nine months ended September 30, 2017, there were 341,069 options exercised at a weighted average exercise price of $2.00 per share.

Issuance

On March 4, 2017, we granted 251,474 restricted stock awards to certain executives and non-executive employees of the Company. The restrictions on these stock awards lapse over time based solely on continued service. However, the quantity of restricted shares granted on half of these shares, or 125,737 shares, is fixed, whereas the quantity granted on the remaining half, or 125,737 shares, is subject to Company-specific performance criteria. The restricted stock awards have a fair value on date of grant of $10.20 per share based on the closing New York Stock Exchange market price of the common stock on the day prior to the day the awards were granted. Those restricted shares whose quantity is fixed vest in equal amounts over a three-year period on the first, second and third anniversary dates of the grant. Those restricted shares whose quantity is subject to Company performance criteria vest in equal amounts on the second and third anniversary dates of the grant.

The performance criteria, as defined in the share awards, provides for a graded awarding of shares based on the percentage by which the Company meets earnings before interest and taxes, as defined, in our 2017 business plan. The performance percentages, ranging from less than 80% to greater than 120%, provide for the awarding of shares ranging from no shares to 150% of the original amount of shares.

On May 19, 2017, we granted 34,699 restricted stock awards to the seven non-management members of the board of directors of the Company relating to their annual compensation for service on the board. The restricted stock awards have a fair value on date of grant of $11.60 per share based on the closing New York Stock Exchange market price of the common stock on the day prior to the day the awards were granted. The restrictions on these stock awards lapse based solely on continued service on the first anniversary date of the grant.

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Stock Compensation Expense

We record stock compensation expense over an award’s vesting period based on the award’s fair value at the date of grant. Effective on January 1, 2017, we adopted the provisions of ASU 2016-09, pursuant to which we elected to change our method of accounting for forfeitures, from one of estimating forfeitures, to recognizing forfeitures on an actual basis in the period they occur. For more information, see Note 1 under “Recently Adopted Accounting Pronouncements”. We recorded compensation expense for stock based awards of $0.5 million for the three months ended September 30, 2017, and $0.4 million for the three months ended October 1, 2016. We recorded compensation expense for stock based awards of $1.6 million for the nine months ended September 30, 2017, and $1.6 million for the nine months ended October 1, 2016. As of September 30, 2017, and October 1, 2016, there was $2.4 million and $1.9 million, respectively, of total unrecognized compensation cost related primarily to restricted share awards. These costs are expected to be recognized in earnings on an accelerated basis over the weighted average remaining vesting period of 1.5 years at September 30, 2017.

NOTE 5. NET INCOME PER COMMON SHARE

Basic earnings per share (“EPS”) is computed by dividing net income available to common shareholders, by the weighted-average number of common shares outstanding during the period. Diluted EPS reflects the dilutive effect of potential common shares from securities such as stock options.

Weighted average shares outstanding for the nine months ended September 30, 2017, and for the three and nine months ended October 1, 2016, excludes underlying options of 20 thousand because their effects were anti-dilutive. There were no anti-dilutive securities outstanding for the three months ended September 30, 2017.

The table below presents the calculation of EPS and a reconciliation of weighted average common shares used in the calculation of basic and diluted EPS for our Company:

Effective on January 1, 2017, we adopted ASU 2016-09. ASU 2016-09 changes the accounting for excess tax benefits by requiring that they be treated as discrete items of income tax expense in the period they occur. For the three and nine months ended September 30, 2017, income tax expense has been reduced by $347 thousand and $1.1 million, respectively, relating to excess tax benefits on the exercise of stock options and the lapse of restrictions on stock awards. ASU 2016-09 also changed the treasury stock method of calculating diluted shares outstanding to exclude the presumption that common stock equivalents can be reduced by repurchasing shares using excess tax benefits. For the three and nine months ended September 30, 2017, diluted shares outstanding includes 724 thousand and 724 thousand shares, respectively, that prior to the adoption of ASU 2016-09 would have been presumed to be bought-back, and therefore not outstanding, using the proceeds of excess tax benefits. For the three and nine months ended October 1, 2016, diluted shares outstanding would have increased by 826 thousand and 827 thousand shares, respectively, if we had adopted ASU 2016-09 at the beginning of our 2016 fiscal year.

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NOTE 6. SALE OF ASSETS AND ACQUISITIONS

Sale of Door Glass Processing Assets

On September 22, 2017, we entered into an Asset Purchase Agreement (APA) with Cardinal LG Company (Cardinal) for the sale to Cardinal of certain manufacturing equipment we used in processing glass components for PGT-branded doors for a cash purchase price of $28 million. Contemporaneously with entering into the APA, we entered into a seven-year supply agreement (SA) with Cardinal for Cardinal to supply us with glass components for PGT-branded doors. The Company determined to sell these assets, whose net book value at September 30, 2017 was $5.6 million, and enter into the SA in order to allow us to heighten our focus in our core areas of window and door manufacturing and, at the same time, strengthen our supply chain for high-quality door glass from a supplier with whom we have been doing business for many years.

The APA provides for the transfer of the assets from the Company to Cardinal in two phases, with the first date being on or about November 1, 2017, and the second date being on or about March 1, 2018. Under the APA, the cash purchase price of $28 million is to be paid by Cardinal to the Company in three separate payments of $3 million at the time of the first transfer of the assets to Cardinal, $10 million on January 15, 2018, and $15 million at the time of the second transfer of assets to Cardinal.

The SA provides that the Company will purchase, and Cardinal will supply, all of the Company’s requirements for certain glass components used in PGT-branded doors through the end of 2024. The terms of the manufacture by Cardinal and purchase by the Company of such glass components as to purchase orders, forecasts of purchases, pricing, invoicing, delivery and payment terms and other terms, are all as described in the SA.

The Company has determined that, although the APA and SA are separate agreements, they were negotiated contemporaneously. Therefore, the Company has concluded that the $28 million of proceeds under the APA should be bifurcated between the sale of the door glass manufacturing assets, and payment for the Company’s commitment to buy glass components for PGT-branded doors from Cardinal under the SA, and that such bifurcation is predicated on the fair value of the door glass manufacturing assets being sold on or about the date of sale. The Company has engaged an independent machinery and equipment valuation specialist to provide a fair market value appraisal of the assets sold to Cardinal, which is currently in process. Accordingly, as the fair market value appraisal is not yet finalized, and there had been no exchanges of assets or cash under the APA as of September 30, 2017, and no purchases or sales of glass components for PGT-branded doors under the SA as of September 30, 2017, no amounts relating to either the APA or SA have been recognized in the accompanying condensed consolidated financial statements as of and for the three and nine months ended September 30, 2017.

WinDoor Acquisition

On February 16, 2016 (“closing date”), we completed the acquisition of WinDoor, which became a wholly-owned subsidiary of PGT Industries, Inc. The fair value of consideration transferred in the acquisition was $102.6 million, including the then estimated fair value of contingent consideration of $3.0 million, which has been allocated to the net assets acquired and liabilities assumed as of the acquisition date, in accordance with ASC 805, “Business Combinations”. The cash portion of the acquisition was financed with borrowings under the 2016 Credit Agreement, and with $43.5 million of cash on hand.

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The estimated fair value of assets acquired and liabilities assumed as of the closing date, were as follows (in thousands):

The fair value of working capital related items, such as accounts receivable, inventories, prepaids, and accounts payable and accrued liabilities, approximated their book values at the date of acquisition. Valuations of the intangible assets (See Note 7) were valued using income and royalty relief approaches based on projections provided by management, which we consider to be Level 3 inputs.

Acquisition costs totaling $0.9 million are included in selling, general, and administrative expenses on the condensed consolidated statement of comprehensive income for the nine months ended October 1, 2016, and relate to legal expenses, representations and warranties insurance, diligence, and accounting services.

The remaining consideration, after identified intangible assets and the net assets and liabilities recorded at fair value, was determined to be $41.9 million, of which $38.9 million is expected to be deductible for tax purposes. Goodwill represents the increased value of the combined entity through additional sales channel opportunities as well as operational efficiencies.

The stock purchase agreement for the acquisition of WinDoor (“SPA”) provided for the potential for an earn-out contingency payment to sellers had WinDoor achieved a certain level of sales in the calendar year ended December 31, 2016. The potential undiscounted amount of all future payments that could be required to be paid under the contingent earn-out consideration arrangement was between $0 and $3.0 million. We had recorded an earn-out contingency liability of $3.0 million on the closing date, which represented its then estimated fair value using undiscounted cash flows, based on probability adjusted level of revenues with a range whose minimum was $51.0 million. Based on revised estimates using actual sales through the end of the 2016 third quarter, we concluded the probability was remote that WinDoor’s actual sales for 2016 would reach the $46.0 million minimum level required for the minimum payment of $2.7 million possible under the earn-out contingency arrangement and, therefore, determined that the entire initial estimated fair value of $3.0 million should be reversed. For tax purposes, contingent consideration does not become part of tax goodwill until paid. As such, the amount of goodwill deductible for tax purposes is $3.0 million less than the amount recorded for book purposes.

The SPA had a post-closing working capital calculation whereby we were required to prepare, and deliver to the sellers, a final statement of purchase price, including our calculation of the amount we find net working capital actually to have been as of the closing date. During the third quarter of 2016, the Company and the sellers reached agreement on the calculation of net working capital, which resulted in a payment of $0.7 million to the Company from sellers, resulting in a decrease in the purchase price which we recorded as a reduction in goodwill.

The following unaudited pro forma financial information assumes the acquisition had occurred at the beginning of the earliest period presented that does not include WinDoor’s actual results for the entire period. Pro forma results have been prepared by adjusting our historical results to include the results of WinDoor adjusted for the following: amortization expense related to the intangible assets arising from the acquisition and interest expense to reflect the 2016 Credit Agreement entered into in connection with the acquisition. The unaudited pro forma results below do not necessarily reflect the results of operations that would have resulted had the acquisition been completed at the beginning of the earliest periods presented, nor does it indicate the results of operations in future periods. The unaudited pro forma results do not include the impact of synergies, nor any potential impacts on current or future market conditions which could alter the following unaudited pro forma results.

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US Impact Systems, Inc. Acquisition

On August 31, 2016, CGIC, a wholly-owned subsidiary of CGI, which is wholly-owned by PGT Industries, Inc., which, in turn, is wholly-owned by the Company, entered into an asset purchase agreement with US Impact Systems, Inc. (USI) and its stockholders whereby CGIC purchased the operations and certain assets of, and assumed certain liabilities of USI. USI was an established fabricator of storefront window and door products. The fair value of the consideration transferred in the acquisition was $1.9 million, which was allocated to current and other assets totaling $1.8 million and amortizable intangible assets totaling $0.6 million, and goodwill of $0.6 million, less the assumption of accounts payable and accrued liabilities with estimated fair values totaling $1.2 million, in accordance with ASC 805, “Business Combinations”. This transaction did not have a significant impact on our financial position or operating results for 2016.

NOTE 7. GOODWILL, TRADE NAMES, AND OTHER INTANGIBLE ASSETS

Goodwill, trade names, and other intangible assets, net, are as follows:

Software License

In July 2017, we purchased an enterprise-wide software license relating to office productivity software. We estimated the then fair value of this software license to be $590 thousand, our purchase price. The software license is being amortized on a straight-line basis over its estimated useful life, which we have determined to be two years.

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NOTE 8. LONG-TERM DEBT

2016 Credit Agreement

On February 16, 2016, we entered into a Credit Agreement (“2016 Credit Agreement”), among us, the lending institutions identified in the 2016 Credit Agreement, and Deutsche Bank AG New York Branch, as Administrative Agent and Collateral Agent. The 2016 Credit Agreement establishes senior secured credit facilities in an aggregate amount of $310.0 million, consisting of a $270.0 million Term B term loan facility maturing in six years that will amortize on a basis of 1% annually during the six-year term, and a $40.0 million revolving credit facility maturing in five years that includes a swing line facility and a letter of credit facility. Our obligations under the 2016 Credit Agreement are secured by substantially all of our assets as well as our direct and indirect subsidiaries’ assets. As of September 30, 2017, there were $0.2 million of letters of credit outstanding and $39.8 million available on the revolver.

Interest on all loans under the 2016 Credit Agreement is payable either quarterly or at the expiration of any LIBOR interest period applicable thereto. Prior to amending the 2016 Credit Agreement on February 17, 2017, as described below, borrowings under the term loans and the revolving credit facility accrued interest at a rate equal to, at our option, LIBOR (with a floor of 100 basis points in respect of the term loan), or a base rate (with a floor of 200 basis points in respect of the term loan) plus an applicable margin. The applicable margin was 575 basis points in the case of LIBOR and 475 basis points in the case of the base rate. We will pay quarterly fees on the unused portion of the revolving credit facility equal to 50 basis points per annum as well as a quarterly letter of credit fee at 575 basis points per annum plus a 12.5 basis point facing fee per annum on the face amount of any outstanding letters of credit. The weighted average all-in interest rate for borrowings under the term-loan portion of the 2016 Credit agreement was 6.02% as of September 30, 2017, and was 5.75% at December 31, 2016.

On February 17, 2017, we entered into an amendment of our 2016 Credit Agreement (“First Amendment”). The First Amendment, among other things, (a) decreases the applicable interest rate margins for the Initial Term Loans (as defined in the Credit Agreement) from (i) 4.75% to 3.75%, in the case of the Base Rate Loans (as defined in the Credit Agreement), and (ii) 5.75% to 4.75%, in the case of the Eurodollar Loans (as defined in the Credit Agreement), and (b) adds a soft call premium equal to 1.0% of the principal repaid or repriced if the Initial Term Loans are voluntarily refinanced or repriced pursuant to certain refinancing transactions within twelve months of the effective date of the First Amendment.

The 2016 Credit Agreement contains a springing financial covenant, if we draw in excess of twenty percent (20%) of the revolving facility, which requires us to maintain a maximum total net leverage ratio (based on the ratio of total debt for borrowed money to trailing EBITDA, each as defined in the 2016 Credit Agreement), and will be tested quarterly based on the last four fiscal quarters and is set at levels as described in the 2016 Credit Agreement. As of September 30, 2017, no such test is required as we have not exceeded 20% of our revolving capacity. We believe that our total net leverage ratio during the third quarter of 2017 was in compliance with the 2016 Credit Agreement, and that we are in compliance with all covenants.

The 2016 Credit Agreement also contains a number of affirmative and restrictive covenants, including limitations on the incurrence of additional debt, liens on property, acquisitions and investments, loans and guarantees, mergers, consolidations, liquidations and dissolutions, asset sales, dividends and other payments in respect of our capital stock, prepayments of certain debt and transactions with affiliates. The 2016 Credit Agreement also contains customary events of default. Upon the occurrence of an event of default, the amounts outstanding under the 2016 Credit Agreement may be accelerated and may become immediately due and payable. As of September 30, 2017, we were in compliance with all affirmative and restrictive covenants.

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In connection with entering into the 2016 Credit Agreement, on February 16, 2016, we terminated our prior credit agreement, dated as of September 22, 2014, among PGT Industries, Inc., as the borrower, the Company, as guarantor, the lenders from time to time party thereto and Deutsche Bank, as administrative agent and collateral agent (“2014 Credit Agreement”). Along with cash on hand, proceeds from the term loan facility under the 2016 Credit Agreement were used to repay amounts outstanding under the 2014 Credit Agreement, acquire WinDoor, and pay certain fees and expenses.

As of September 30, 2017, the face value of debt outstanding under the 2016 Credit Agreement was $244.0 million, and accrued interest was $0.4 million. During the third quarter of 2017, we made voluntary prepayments of outstanding borrowings under the term-loan portion of the 2016 Credit Agreement totaling $20.0 million, composed of a payment of $8.0 million made on September 29, 2017, and of $12.0 million made on July 7, 2017.

Other Debt

In July 2017, we entered into a two-year financing arrangement for the purchase of an enterprise-wide software license relating to office productivity software. This financing arrangement requires 24 monthly payments of $26 thousand each. We estimated the value of this financing arrangement to be $590 thousand, using an imputed annual interest rate of 6.00%, which approximates our borrowing rate under the 2016 Credit Agreement, a Level 3 input. At September 30, 2017, there was $529 thousand outstanding under this financing arrangement.

The activity relating to third-party fees and costs, lender fees and discount for the three months ended September 30, 2017, are as follows. As a result of the voluntary prepayments of debt discussed above, we accelerated the amortization of lenders fees and discount relating to the term-loan portion of the 2016 Credit Agreement of $1.0 million, which is included in interest expense in the accompanying condensed consolidated statements of operations for the three and nine months ended September 30, 2017. All debt-related fees, costs and original issue discount are classified as a reduction of the carrying value of long-term debt:

Estimated amortization expense relating to third-party fees and costs, lender fees and discount for the years indicated as of September 30, 2017, is as follows:

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As a result of the voluntary prepayments totaling $20.0 million we made during the third quarter of 2017, we have no future scheduled repayments under the 2016 Credit Agreement until the maturity of the facility on February 21, 2022. The contractual future maturities of long-term debt outstanding, including the financing arrangement described as other debt, as of September 30, 2017, are as follows (at face value):

NOTE 9. COMMITMENTS AND CONTINGENCIES

Litigation

Our Company is a party to various legal proceedings in the ordinary course of business. Although the ultimate disposition of those proceedings cannot be predicted with certainty, management believes the outcome of any claim that is pending or threatened, either individually or in the aggregate, will not have a materially adverse effect on our operations, financial position or cash flows.

NOTE 10. INCOME TAXES

Income tax expense was $3.0 million for the three months ended September 30, 2017, compared with $5.3 million for the three months ended October 1, 2016. Our effective tax rate for the three months ended September 30, 2017, was 32.2%, and was 32.8% for the three months ended October 1, 2016. Income tax expense was $9.1 million for the nine months ended September 30, 2017, compared with $10.3 million for the nine months ended October 1, 2016. Our effective tax rate for the nine months ended September 30, 2017, was 31.8%, and was 34.5% for the nine months ended October 1, 2016.

Income tax expense in the three and nine months ended September 30, 2017, includes excess tax benefits relating to exercises of stock options and lapses of restrictions on stock awards treated as a discrete item of income tax upon our adoption of ASU 2016-09 effective on January 1, 2017, totaling $347 thousand and $1.1 million, respectively. Excluding this discrete item of income tax expense, the effective tax rates for the three and nine months ended September 30, 2017, would have been 36.0% and 35.8%, respectively.

The effective tax rates in all periods, excluding the effect of the discrete item discussed above in the 2017 periods, were lower than our combined statutory federal and state tax rate of 38.8% primarily as the result of the estimated impact of the section 199 domestic manufacturing deduction, partially offset by the 50% deductibility-disallowance of meals and entertainment expenses.

At September 30, 2017, an accrued federal income tax payable of $6.6 million was classified within accrued liabilities in the accompanying condensed consolidated balance sheet. At December 31, 2016, a federal income tax receivable of $2.6 million was classified within other current assets in the accompanying condensed consolidated balance sheet. During the three or nine months ended September 30, 2017, we did not make a payment of estimated federal income taxes, nor did we receive any refunds of federal income taxes. Pursuant to tax relief from the Internal Revenue Service relating to taxpayers in certain designated areas of Florida impacted by Hurricane Irma, which includes all counties in Florida in which we operate, the deadline for remitting our required 2017 third quarter estimated payment for corporate income taxes, as well as the deadline for filing our 2016 fiscal year corporate income tax return, has been extended to January 31, 2018.

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NOTE 11. FAIR VALUE

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. A three-tier fair value hierarchy is used to prioritize the inputs used in measuring fair value. The hierarchy gives the highest priority to unadjusted quoted market prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. A financial instrument’s level within the fair value hierarchy is based on the lowest level of any input that is significant to the fair value measurement. The three levels of the fair value hierarchy are as follows:

Level 1 Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities.

Level 2 Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly.

Level 3 Prices or valuations that require inputs that are both significant to the fair value measurement and unobservable.

The accounting guidance concerning fair value allows us to elect to measure financial instruments at fair value and report the changes in fair value through earnings. This election can only be made at certain specified dates and is irrevocable once made. We do not have a policy regarding specific assets or liabilities to elect to measure at fair value, but rather we make the election on an instrument-by-instrument basis as they are acquired or incurred.

During the three months ended September 30, 2017, or October 1, 2016, we did not make any transfers between Level 2 and Level 3 financial assets. We conduct reviews on a quarterly basis to verify pricing, assess liquidity, and determine if significant inputs have changed that would impact the fair value hierarchy disclosure.

Fair Value of Financial Instruments

Our financial instruments include cash, accounts and notes receivable, and accounts payable, and accrued liabilities whose carrying amounts approximate their fair values due to their short-term nature. Our financial instruments also include long-term debt. The fair value of our long-term debt is based on debt with similar terms and characteristics and was approximately $248.5 million as of September 30, 2017, compared to a principal outstanding value of $244.0 million, and $264.6 million as of December 31, 2016, compared to a principal outstanding value of $264.0 million. Fair values were determined based on observed trading prices of our debt between domestic financial institutions.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion of our financial condition and results of operations should be read in conjunction with the Management’s Discussion and Analysis of Financial Condition and Results of Operations and the consolidated financial statements and notes thereto for the year ended December 31, 2016, included in our most recent Annual Report on Form 10-K as well as our reports on Forms 10-Q and 8-K and other publicly available information. All amounts herein are unaudited.

Special Note Regarding Forward-Looking Statements

Except for historical information contained herein, the matters set forth in this Quarterly Report on Form 10-Q are forward-looking statements. These statements are based on management’s current expectations and plans, which involve risks and uncertainties. Such forward-looking statements generally can be identified by the use of forward-looking terminology such as “may,” “will,”“believe,” “expect,” “forecast,” “guidance,” “intend,” “could,” “project,” “estimate,” “anticipate,” “should,” and similar terminology. You are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the filing date of this Quarterly Report and which involve risks and uncertainties that may cause our actual results to differ materially from those set forth in the forward looking statements. Those risks and uncertainties that could cause actual results to differ materially from those described in our forward-looking statements include, but are not limited to:

Any forward-looking statements made by us or on our behalf speak only as of the date they are made and, except as may be required by law, we do not undertake any obligation to update any forward-looking statement to reflect the impact of subsequent events or circumstances.

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EXECUTIVE OVERVIEW

Sales and Operations

We recorded sales of $126.9 million, down 2.3 percent compared to the third quarter of 2016. Sales were $377.0 million for the nine-month period ended September 30, 2017, up 8.0 percent compared to the same period last year.

Our third quarter of 2017 started strong as sales in July and August were up over 5 percent compared to last year, which benefitted operational performance. During this period, we were regularly recording order weeks of between $10 and $11 million, and daily order volumes remained steady during the early part of September.

On September 10th, Hurricane Irma (Irma), a Category 4 storm with sustained 130-mph winds, made landfall in the Florida Keys, one of our primary markets. Impacts from this 400-mile-wide storm were felt over the entire state of Florida, which represents 90 percent of our consolidated sales.

As Irma advanced towards Florida, our daily order levels began to decrease, dropping by as much as 50 percent at times during the month as many customers in our key Florida markets suspended operations. Some of the most severely impacted areas were in our most important markets in southeast and southwest Florida, which represents approximately 70 percent of our sales. When Irma arrived, we were forced to cease operations for a period of up to six days in certain locations, a period during which we did not ship or produce any products.

We estimate that Irma caused a negative sales impact of approximately $13 million to our 2017 third quarter. Irma also caused an added $1.1 million in operating costs, which included $345 thousand classified within cost of sales, and $746 thousand classified within selling, general and administrative expenses. We expect some portion of those sales to be recovered in the 2017 fourth quarter, with the remainder falling into 2018, as some of our customers are still working through their post-Irma recovery efforts. For the month of October 2017, sales finished up 5 percent compared to October 2016, which has driven solid operational performance.

Looking to the balance of 2017, we are making meaningful advertising investments to capture opportunities for growth we expect to see in 2018 and beyond from the heighten awareness of our impact-resistant products following this active hurricane season. We are also looking forward to the opportunity we have to sharpen our focus on window and door manufacturing, having partnered with Cardinal for them to supply us with high-quality door glass. Our recently announced agreement for the sale of glass manufacturing assets to Cardinal, and the related 7-year PGT- branded door glass supply agreement for Cardinal to provide us with PGT-branded door glass will benefit both parties. The $28 million in cash proceeds we expect to receive from the sales of these assets provides us with an added ability to continue to pay down debt, and further strengthen our already strong balance sheet.

For the full year 2017, the Company expects to finish within the previous guidance range for consolidated sales of $490 to $500 million.

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Performance Summary

The following table presents financial data derived from our unaudited condensed consolidated statements of comprehensive income as a percentage of total net sales for the periods indicated (in thousands, except percentages):

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RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2017 AND OCTOBER 1, 2016

The following table represents total sales by product category for the three months ended September 30, 2017, and October 1, 2016 (in millions):

Total net sales during the third quarter of 2017 were $126.9 million, a decrease of $2.9 million, or 2.3%, from $129.8 million in total net sales for the third quarter of 2016. Our primary market is the State of Florida, from which we derive approximately 90% of our sales. On September 10, 2017, Hurricane Irma made landfall in the Florida Keys and moved north over the entire state, affecting all areas of Florida. Irma caused disruption to our ability to manufacture and distribute our products, and required us to shut-down and cease operations for a period of up to six days at certain of our locations. Irma also affected our customers’ ability to accept deliveries of our products. We estimate that lost sales directly attributable to the disruption caused by Irma for the three months ended September 30, 2017, totaled approximately $13 million.

Net sales of impact-resistant window and door products were $108.8 million for the third quarter of 2017, a decrease of $1.4 million, or 1.3%, from $110.2 million in net sales for the third quarter of 2016. Included in sales of our impact-resistant window and door products were $77.2 million of aluminum impact sales, a decrease of $4.3 million, or 5.3%, and $31.6 million of vinyl impact sales, an increase of $2.9 million, or 10.2%.

Net sales of non-impact window and door products were $18.1 million for the third quarter of 2017, a decrease of $1.5 million, or 7.7%, from $19.6 million in net sales for the third quarter of 2016.

Gross profit and gross margin

Gross profit was $39.7 million in the third quarter of 2017, a decrease of $1.3 million, or 3.3%, from $41.1 million in the third quarter of 2016. The gross margin percentage was 31.3% in the third quarter of 2017, compared to 31.7% in the prior year third quarter, a decrease of 0.4%. Adjusting for costs relating to Hurricane Irma, and transition costs associated with WinDoor leadership and the glass supply-chain, which combined totaled $1.0 million in the 2017 three-month period, and product line termination costs totaling $0.8 million in the 2016 three-month period, the gross margin percentage was 32.1% in the third quarter of 2017, compared to 32.3% in the prior year third quarter, a decrease of 0.2%. Improvements in scrap rates and efficiencies, which benefitted gross margin by 0.5% during the third quarter of 2017, and a price increase, which benefitted gross margin by 0.7%, were more than offset by decreases of 0.6% due to the impact of higher depreciation on higher capital spending in recent years, 0.7% due to higher aluminum prices compared to last year’s third quarter, and 0.1% due to the combined effects of lower sales volume and mix of sales.

Selling, general and administrative expenses

Selling, general and administrative expenses were $25.0 million in the third quarter of 2017, an increase of approximately $2.4 million, or 10.7%, from $22.5 million in the third quarter of 2016. As a percentage of sales, these costs increased to 19.7%, an increase of 2.3%, from 17.4% from the third quarter of 2016. Selling, general and administrative expenses increased in the third quarter of 2017, compared to the third quarter of last year, due to higher distribution costs due to disruptions caused by Irma. Selling, general and administrative expenses during the three months ended September 30, 2017, also increased due to our community outreach activities which we undertook to assist those affected by Irma locally.

We record warranty costs as a selling expense within selling, general and administrative expenses. During the three months ended September 30, 2017, we recorded warranty expense at a rate of 2.04% of sales, which decreased when compared to the rate in the second quarter of 2017 of 2.22%. During the three months ended October 1, 2016, we recorded warranty expense at a rate of 2.21% of sales. We believe the decrease in warranty expense as a percentage of sales was the result of our workforce becoming more seasoned through experience and training. We expect that, as our team members continue to gain in experience, and are exposed to improved training initiatives we have implemented, combined with the use of our new thermal plastic spacer system, an innovative technology for the production of insulated glass, warranty expense, as a percentage of sales, will further decline.

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Fair Value Adjustment of Contingent Consideration

The stock purchase agreement for the acquisition of WinDoor provided for the potential for an earn-out contingency payment to sellers had WinDoor achieved a certain level of sales in the calendar year ended December 31, 2016. The potential undiscounted amount of all future payments that could be required to be paid under the contingent earn-out consideration arrangement was between $0 and $3.0 million. We had recorded an earn-out contingency liability of $3.0 million on the closing date, which represented its then estimated fair value using undiscounted cash flows, based on probability adjusted level of revenues with a range whose minimum was $51.0 million. Based on revised estimates using actual sales through the end of the 2016 third quarter, we concluded the probability was remote that WinDoor’s actual sales for 2016 would reach the $46.0 million minimum level required for the minimum payment of $2.7 million possible under the earn-out contingency arrangement and, therefore, determined that the entire initial estimated fair value of $3.0 million should be reversed.

Interest expense, net

Interest expense was $5.5 million in the third quarter of 2017, representing no change from $5.5 million in the third quarter of 2016. Interest expense decreased due to a decrease in the average level of outstanding debt during the third quarter of 2017, compared to the third quarter of 2016, as the result of a total of $20 million in voluntary prepayments made during the third quarter of 2017, offset by an increase in interest expense due to accelerated amortization of lenders fees and discount of $1.0 million, which is included in interest expense in the accompanying condensed consolidated comprehensive income for the three months ended September 30, 2017.

As a result of recent increases in LIBOR, the weighted average all-in interest rate for borrowings under the term-loan portion of the 2016 Credit Agreement was 6.02% as of September 30, 2017.

Income tax expense

Our income tax expense was $3.0 million for the third quarter of 2017, compared with $5.3 million for the third quarter of 2016. Our effective tax rate for the third quarter of 2017 was 32.2%, and was 32.8% for the third quarter of 2016. Income tax expense in the third quarter of 2017 is net of excess tax benefits relating to exercises of stock options and lapses of restrictions on stock awards treated as discrete items of income tax upon our adoption of ASU 2016-09 effective on January 1, 2017, totaling $347 thousand. Excluding this discrete item of income tax expense, the effective tax rate for the third quarter of 2017 would have been 36.0%.

The effective tax rates in all periods, excluding the effect of the discrete item relating to the treatment of excess tax benefits as discussed above, were lower than our combined statutory federal and state tax rate of 38.8% primarily as the result of the estimated impact of the section 199 domestic manufacturing deduction, partially offset by the 50% deductibility-disallowance of meals and entertainment expenses.

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RESULTS OF OPERATIONS FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2017 AND OCTOBER 1, 2016

The following table represents total sales by product category for the nine months ended September 30, 2017, and October 1, 2016 (in millions):

Total net sales during the first nine months of 2017 were $377.0 million, an increase of over $27.9 million, or 8.0%, from $349.0 million in total net sales for the first nine months of 2016. Our primary market is the State of Florida, from which we derive approximately 90% of our sales. On September 10, 2017, Hurricane Irma made landfall in the Florida Keys and moved north over the entire state, affecting all areas of Florida. Irma caused disruption to our ability to manufacture and distribute our products, and required us to shut-down and cease operations for a period of up to six days at certain of our locations. Irma also affected our customers’ ability to accept deliveries of our products. We estimate that lost sales directly attributable to the disruptions caused by Irma for the three months ended, and therefore the nine months ended, September 30, 2017, totaled approximately $13 million.

Net sales of impact-resistant window and door products were $320.2 million for the first nine months of 2017, an increase of $29.1 million, or 10.0%, from $291.1 million in net sales for the first nine months of 2016. Included in sales of our impact-resistant window and door products were $227.3 million of aluminum impact sales, an increase of $13.6 million, or 6.4%, and $93.0 million of vinyl impact sales, an increase of $15.5 million, or 20.0%.

Net sales of non-impact window and door products were $56.8 million for the first nine months of 2017, an decrease of $1.1 million, or 2.0%, from $57.9 million in net sales for the first nine months of 2016.

Gross profit and gross margin

Gross profit was $116.0 million in the first nine months of 2017, an increase of $7.5 million, or 6.9%, from $108.5 million in the first nine months of 2016. The gross margin percentage was 30.8% in the first nine months of 2017, compared to 31.1% in the prior year first nine months, a decrease of 0.3%. Adjusting for costs relating to Hurricane Irma, transition costs associated with WinDoor leadership and the glass supply-chain, and costs relating to the start-up of our Thermal Plastic Spacer system line totaling $1.5 million in the 2017 nine-month period, and product line termination costs totaling $0.8 million in the 2016 nine-month period, the gross margin percentage was 31.2% in the first nine-months of 2017, compared to 31.3% in the prior year first nine-months, a decrease of 0.1%. Gross margin in the first nine months of 2017 was negatively impacted by higher material costs, primarily related to aluminum costs, which lowered gross margin by 0.7%, and by higher depreciation on higher capital spending in recent years, which lowered gross margin by 0.6%. These decreases were partially offset by a benefit of 0.4% from improvements in scrap rates and efficiencies, a benefit of 0.5% from an improved mix of sales, to higher margin products in our repair and modeling markets, and a benefit of 0.3% due to a price increase.

Selling, general and administrative expenses

Selling, general and administrative expenses were $72.4 million in the first nine months of 2017, an increase of $9.2 million, or 14.5%, from $63.2 million in the first nine months of 2016. As a percentage of sales, these costs increased to 19.2%, an increase of 1.1%, from 18.1% from the first nine months of 2016. The increase in selling, general and administrative expenses was primarily related to $3.1 million in higher accrued incentive costs as a result of the improved performance, $0.7 million of costs related to management reorganization actions, $0.9 million of costs from our attendance at and participation in the National Association of Home Builders’ International Builders Show in Orlando, Florida in January 2017, higher distribution costs on the higher level of sales, and added delivery costs due to disruptions caused by Irma, and $0.7 million in higher costs directly related to Irma. Selling, general and administrative expenses during the nine months ended September 30, 2017, also increased due to our community outreach activities which we undertook to assist those affected by Irma locally.

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We record warranty costs as a selling expense within selling, general and administrative expenses. During the three months ended September 30, 2017, we recorded warranty expense at a rate of 2.04% of sales, resulting in a rate of 2.30% of sales for the nine months ended September 30, 2017. During the nine months ended October 1, 2016, we recorded warranty expense at a rate of 2.32% of sales. We believe the decrease in warranty expense as a percentage of sales was the result of our workforce becoming more seasoned through experience and training. We expect that, as our team members continue to gain in experience, and are exposed to improved training initiatives we have implemented, combined with the use of our new thermal plastic spacer system, an innovative technology for the production of insulated glass, warranty expense, as a percentage of sales, will further decline.

Fair Value Adjustment of Contingent Consideration

The stock purchase agreement for the acquisition of WinDoor provided for the potential for an earn-out contingency payment to sellers had WinDoor achieved a certain level of sales in the calendar year ended December 31, 2016. The potential undiscounted amount of all future payments that could be required to be paid under the contingent earn-out consideration arrangement was between $0 and $3.0 million. We had recorded an earn-out contingency liability of $3.0 million on the closing date, which represented its then estimated fair value using undiscounted cash flows, based on probability adjusted level of revenues with a range whose minimum was $51.0 million. Based on revised estimates using actual sales through the end of the 2016 third quarter, we concluded the probability was remote that WinDoor’s actual sales for 2016 would reach the $46.0 million minimum level required for the minimum payment of $2.7 million possible under the earn-out contingency arrangement and, therefore, determined that the entire initial estimated fair value of $3.0 million should be reversed.

Interest expense, net

Interest expense was $15.0 million in the first nine months of 2017, an increase of $0.1 million, from $14.9 million in the first nine months of 2016. During 2016, concurrent with the acquisition of WinDoor in the middle of the first quarter of 2016, we refinanced our then existing credit agreement into the 2016 Credit Agreement, a $270 million senior secured credit facility, which increased our outstanding debt balance to $270 million, up from $197.5 million at the time of the refinancing. The increase in interest expense was due primarily to the increase in outstanding debt under the new credit facility and resulting increase in average outstanding debt balance during the first nine months of 2017, compared to the first nine months of 2016, but was partially offset by a decrease in the average level of outstanding debt as the result of a total of $20 million in voluntary prepayments made during the third quarter of 2017. Interest expense in the first nine months of 2017 also benefitted from the February 17, 2017 repricing of the 2016 Credit Agreement, which resulted in a one-percentage point reduction in the interest rate under the term loan portion of the facility. This benefit was offset by the accelerated amortization of lenders fees and discount of $1.0 million relating to the third quarter 2017 voluntary prepayments of term loan borrowings, which is included in interest expense in the accompanying condensed consolidated statements of operations for the nine months ended September 30, 2017.

As a result of recent increases in LIBOR, the weighted average all-in interest rate for borrowings under the term-loan portion of the 2016 Credit Agreement was 6.02% as of September 30, 2017.

Debt extinguishment costs

Debt extinguishment costs were $3.4 million in the first nine months of 2016. These costs related to the write-off of deferred financing costs and debt discount in connection with entering into the 2016 Credit Agreement effective on February 16, 2016, which resulted in certain then existing lenders exiting the facility, and certain continuing lenders being considered debt extinguishments in the refinancing. This resulted in the write-offs of portions of the deferred financing costs and original issue discount allocated to these lenders.

Income tax expense

Our income tax expense was $9.1 million for the first nine months of 2017, compared with $10.3 million for the first nine months of 2016. Our effective tax rate for the first nine months of 2017 was 31.8%, and was 34.5% for the first nine months of 2016. Income tax expense in the first nine months of 2017 is net of excess tax benefits relating to exercises of stock options and lapses of restrictions on stock awards treated as discrete items of income tax upon our adoption of ASU 2016-09 effective on January 1, 2017, totaling $1.1 million. Excluding this discrete item of income tax expense, the effective tax rate for the first nine months of 2017 would have been 35.8%.

The effective tax rates in all periods, excluding the effect of the discrete item relating to the treatment of excess tax benefits as discussed above, were lower than our combined statutory federal and state tax rate of 38.8% primarily as the result of the estimated impact of the section 199 domestic manufacturing deduction, partially offset by the 50% deductibility-disallowance of meals and entertainment expenses.

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LIQUIDITY AND CAPITAL RESOURCES

Our principal source of liquidity is cash flow generated by operations and supplemented by borrowings under our credit facilities. We expect that this cash generating capability will provide us with financial flexibility in meeting operating and investing needs. Our primary capital requirements are to fund working capital needs, meet required debt service payments on our credit facilities and fund capital expenditures.

Consolidated Cash Flows

Operating activities. Cash provided by operating activities during the first nine months of 2017 was $34.7 million, compared to $33.2 million in the first nine months of 2016. The reduction in cash provided by operating activities for the first nine months of 2017, as compared to the first nine months of 2016, was due to the factors set forth in the table below.

Direct cash flows from operations for the first nine months of 2017 and 2016 are as follows:

Days sales outstanding (DSO), which we calculate as accounts receivable divided by quarterly average daily sales, was 42 days at September 30, 2017, compared to 36 days at October 1, 2016. Our DSO’s to begin the month of September 2017, were 36 days, but were negatively impacted by Irma, which caused disruptions to our customers’ invoice-payment activities, resulting in an increase in our accounts receivable balance as of September 30, 2017. DSO’s were also affected by certain larger customer projects for CGI and WinDoor, which have longer payment terms.

Inventory on hand as of September 30, 2017, was $39.1 million, compared to $30.5 million at December 31, 2016, an increase of $8.6 million. The increase in inventory was due to the seasonal inventory build-up due to the summer continuation of the repair and remodeling season, but also due to delivery disruptions caused by Irma, which affected our customers’ ability to accept deliveries of our products, which required us to return finished products to our warehouses until such time as our customers were able to accept deliveries.

We monitor and evaluate raw material inventory levels based on the need for each discrete item to fulfill short-term requirements calculated from current order patterns and to provide appropriate safety stock. Because all of our products are made-to-order, we have only a small amount of finished goods and work-in-process inventory. As a result of these factors, our inventories are not excessive and we believe the value of such inventories will be realized through sales.

Investing activities. Cash used in investing activities was $9.6 million for the first nine months of 2017, compared to cash used in investing activities of $114.6 million for the first nine months of 2016. We used $101.3 million of cash in the first nine months of 2016 to acquire businesses. Excluding cash used to acquire businesses, there was a decrease in cash used in investing activities due to a decrease in capital expenditures of $3.6 million, which went from $13.3 million in the first nine months of 2016, to $9.7 million in the first nine months of 2017.

Financing activities. Cash used in financing activities was $19.6 million in the first nine months of 2017, compared to cash provided by financing activities of $49.8 million in the first nine months of 2016, a decrease in cash provided of $69.4 million. We made repayments of long-term debt of $20.1 million in the first nine months of 2017, including a total of $20.0 million in voluntary prepayments of outstanding borrowing under the term loan facility of the 2016 Credit Agreement, compared to cash used for repayments of long-term debt in the first nine months of 2016 of $203.5 million. Cash used for payments of long-term debt of $203.5 million in the first nine months of 2016 was the result of the February 2016 refinancing and contemporaneous pay-down of $197.5 million of our then existing credit facility. Subsequent to the refinancing, $2.0 million had been repaid as scheduled debt repayments through the end of the third quarter of 2016. In addition, we made a voluntary prepayment of $4.0 million on September 30, 2016.

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The February 2016 refinancing resulted in $261.0 million in net proceeds from the issuance of long-term debt. In addition, there were payments of financing costs of $7.2 million related to the refinancing. Taxes paid relating to common stock withheld from employees to satisfy tax withholding obligations in connection with the vesting of restricted stock awards were $0.2 million in the first nine months of 2017, versus $0.1 million in the first nine months of 2016, an increase in cash used of $0.1 million. There was a decrease of $2.7 million in cash used to purchase treasury shares. Proceeds from the exercises of stock options were approximately equal in the first nine months of 2017, versus the first nine months of 2016. Also, there was a $1.6 million decrease relating to excess tax benefits due to our adoption of ASU 2016-09, which no longer requires excess tax benefits to be presented as a financing activity.

Capital Resources and Debt Covenant. On February 16, 2016, we entered into the 2016 Credit Agreement, among us, the lending institutions identified in the 2016 Credit Agreement, and Deutsche Bank AG New York Branch, as Administrative Agent and Collateral Agent. The 2016 Credit Agreement establishes new senior secured credit facilities in an aggregate amount of $310.0 million, consisting of a $270.0 million Term B term loan facility maturing in six years that will amortize on a basis of 1% annually during the six-year term, and a $40.0 million revolving credit facility maturing in five years that includes a swing line facility and a letter of credit facility. Our obligations under the 2016 Credit Agreement are secured by substantially all of our assets as well as our direct and indirect subsidiaries’ assets. As of September 30, 2017, there were $0.2 million of letters of credit outstanding and $39.8 million available on the revolver.

Interest on all loans under the 2016 Credit Agreement is payable either quarterly or at the expiration of any LIBOR interest period applicable thereto. Prior to amending the 2016 Credit Agreement on February 17, 2017, as described below, borrowings under the term loans and the revolving credit facility accrued interest at a rate equal to, at our option, LIBOR (with a floor of 100 basis points in respect of the term loan), or a base rate (with a floor of 200 basis points in respect of the term loan) plus an applicable margin. The applicable margin was 575 basis points in the case of LIBOR and 475 basis points in the case of the base rate. We pay quarterly fees on the unused portion of the revolving credit facility equal to 50 basis points per annum as well as a quarterly letter of credit fee at 575 basis points per annum plus a 12.5 basis point facing fee per annum on the face amount of any outstanding letters of credit. The weighted average all-in interest rate for borrowings under the term-loan portion of the 2016 Credit Agreement was 6.02% as of September 30, 2017, and was 5.75% at December 31, 2016.

On February 17, 2017, we entered into an amendment of our 2016 Credit Agreement. The First Amendment, among other things, (a) decreases the applicable interest rate margins for the Initial Term Loans (as defined in the Credit Agreement) from (i) 4.75% to 3.75%, in the case of the Base Rate Loans (as defined in the Credit Agreement), and (ii) 5.75% to 4.75%, in the case of the Eurodollar Loans (as defined in the Credit Agreement), and (b) adds a soft call premium equal to 1.0% of the principal repaid or repriced if the Initial Term Loans are voluntarily refinanced or repriced pursuant to certain refinancing transactions within twelve months of the effective date of the First Amendment.

The 2016 Credit Agreement contains a springing financial covenant, if we draw in excess of twenty percent (20%) of the revolving facility, which requires us to maintain a maximum total net leverage ratio (based on the ratio of total debt for borrowed money to EBITDA, each as defined in the 2016 Credit Agreement), and is tested quarterly based on the last four fiscal quarters and is set at levels as described in the 2016 Credit Agreement. As of September 30, 2017, no test is required as we have not exceeded 20% of our revolving capacity. During 2017, the maximum permitted total net leverage ratio as stated in the 2016 Credit agreement is 4.25:1. We believe that our total net leverage ratio during 2017 has been and will continue to be in compliance with the 2016 Credit Agreement, and that we are in compliance with all covenants.

The 2016 Credit Agreement also contains a number of affirmative and restrictive covenants, including limitations on the incurrence of additional debt, liens on property, acquisitions and investments, loans and guarantees, mergers, consolidations, liquidations and dissolutions, asset sales, dividends and other payments in respect of our capital stock, prepayments of certain debt and transactions with affiliates. The 2016 Credit Agreement also contains customary events of default. Upon the occurrence of an event of default, the amounts outstanding under the 2016 Credit Agreement may be accelerated and may become immediately due and payable. As of September 30, 2017, we were in compliance with all affirmative and restrictive covenants.

As of September 30, 2017, the face value of debt outstanding under the 2016 Credit Agreement was $244.0 million, and accrued interest was $0.4 million. During the third quarter of 2017, we made voluntary prepayments of outstanding borrowings under the term-loan portion of the 2016 Credit Agreement totaling $20.0 million, composed of a payment of $8.0 million made on September 29, 2017, and of $12.0 million made on July 7, 2017.

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The activity relating to third-party fees and costs, lender fees and discount for the three months ended September 30, 2017, are set forth in the table below. As a result of the voluntary prepayments of debt discussed above, we accelerated the amortization of lenders fees and discount relating to the term-loan portion of the 2016 Credit Agreement of $1.0 million, which is included in interest expense in the accompanying condensed consolidated statements of operations for the three and nine months ended September 30, 2017. All debt-related fees, costs and original issue discount are classified as a reduction of the carrying value of long-term debt:

Estimated amortization expense relating to third-party fees and costs, lender fees and discount for the years indicated as of September 30, 2017, is as follows:

As a result of the voluntary prepayments totaling $20.0 million we made during the third quarter of 2017, we have no future scheduled repayments under the 2016 Credit Agreement until the maturity of the facility on February 21, 2022. The contractual future maturities of long-term debt outstanding, including the financing arrangement described as other debt, as of September 30, 2017, are as follows (at face value):

Capital Expenditures. Capital expenditures vary depending on prevailing business factors, including current and anticipated market conditions. For the first nine months of 2017, capital expenditures were $9.7 million, compared to $13.3 million for the first nine months of 2016. In 2017, we expect to spend approximately $12-$15 million on capital expenditures, primarily including machinery and equipment, and distribution equipment such as tractors and trailers.

Share Repurchase Program. On October 28, 2015, the Board of Directors authorized and approved a share repurchase program of up to $20 million. Repurchases are made in open market or privately negotiated transactions, subject to market conditions, applicable legal requirements, our 2016 Credit Agreement, and other relevant factors. We do not intend to repurchase any shares from directors, officers, or other affiliates. The program does not obligate us to acquire any specific number of shares. The timing, manner, price and amount of repurchases will be determined at the Company’s discretion,

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subject to the approval of its Board of Directors, and the program may be suspended, terminated or modified at any time for any reason. During the first nine months of 2017, we made no repurchases of our common stock under this program. In the future, we may make opportunistic repurchases of our common stock as we see fit, subject to the approval of our Board of Directors.

Sale of Door Glass Processing Assets. On September 22, 2017, we entered into an Asset Purchase Agreement (APA) with Cardinal LG Company (Cardinal) for the sale to Cardinal of certain manufacturing equipment we used in processing glass components for PGT-branded doors for a cash purchase price of $28 million. Contemporaneously with entering into the APA, we entered into a seven-year supply agreement (SA) with Cardinal for Cardinal to supply us with glass components for PGT-branded doors. The Company determined to sell these assets, whose net book value at September 30, 2017, was $5.6 million, and enter into the SA in order to allow us to heighten our focus in our core areas of window and door manufacturing and, at the same time, strengthen our supply chain for high-quality door glass from a supplier with whom we have been doing business for many years.

The APA provides for the transfer of the assets from the Company to Cardinal in two phases, with the first date being on or about November 1, 2017, and the second date being on or about March 1, 2018. Under the APA, the cash purchase price of $28 million is to be paid by Cardinal to the Company in three separate payments of $3 million at the time of the first transfer of the assets to Cardinal, $10 million on January 15, 2018, and $15 million at the time of the second transfer of assets to Cardinal.

The SA provides that the Company will purchase, and Cardinal will supply, all of the Company’s requirements for certain glass components used in PGT-branded doors through the end of 2024. The terms of the manufacture by Cardinal and purchase by the Company of such glass components as to purchase orders, forecasts of purchases, pricing, invoicing, delivery and payment terms and other terms, are all as described in the SA.

The Company has determined that, although the APA and SA are separate agreements, they were negotiated contemporaneously. Therefore, the Company has concluded that the $28 million of proceeds under the APA should be bifurcated between the sale of the door glass manufacturing assets, and payment for the Company’s commitment to buy glass components for PGT-branded doors from Cardinal under the SA, and that such bifurcation is predicated on the fair value of the door glass manufacturing assets being sold on or about the date of sale. The Company has engaged an independent machinery and equipment valuation specialist to provide a fair market value appraisal of the assets sold to Cardinal, which is currently in process. Accordingly, as the fair market value appraisal is not yet finalized, and there had been no exchanges of assets or cash under the APA as of September 30, 2017, and no purchases or sales of glass components for PGT-branded doors under the SA as of September 30, 2017, no amounts relating to either the APA or SA have been recognized in the accompanying condensed consolidated financial statements as of and for the three and nine months ended September 30, 2017.

Contractual Obligations

There have been no significant changes to the “Disclosures of Contractual Obligations and Commercial Commitments” table in Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of our Annual Report on Form 10-K for the year ended December 31, 2016.

Significant Accounting Policies and Critical Accounting Estimates

Our consolidated financial statements are prepared in accordance with U.S. Generally Accepted Accounting Principles (GAAP). Significant accounting policies are those that are both important to the accurate portrayal of a Company’s financial condition and results, and those that require subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. We make estimates and assumptions that affect the amounts reported in our financial statements and accompanying notes. Certain estimates are particularly sensitive due to their significance to the financial statements and the possibility that future events may be significantly different from our expectations.

We identified our significant accounting policies in our Form 10-K annual report for the year ended December 31, 2016. There have been no changes to our critical accounting policies during the first nine months of 2017.

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Recently Issued Accounting Pronouncements

In addition to the pronouncements issued during 2017, ASU 2016-02, “Leases”, and ASU 2014-09, “Revenue from Contracts with Customers”, presented below, see Note 3 to the consolidated financial statements included in our recently filed Annual Report on Form 10-K for the year ended December 31, 2016.

In August 2017, the FASB issued ASU 2017-12, “Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities.” The amendments under ASU 2017-12 refine and expand hedge accounting requirements for both financial (e.g., interest rate) and commodity risks. Its provisions create more transparency around how economic results are presented, both on the face of the financial statements and in the footnotes. It also makes certain targeted improvements to simplify the application of hedge accounting guidance. ASU 2017-12 becomes effective for us in the first quarter of 2019. We are currently assessing the impact the adoption of this ASU will have on our consolidated financial statements.

In February 2017, the FASB issued ASU 2017-05, “Other Income - Gain and Losses from the Derecognition of Nonfinancial Assets.” ASU 2017-05 clarifies the scope of Subtopic 610-20, Other Income - Gains and Losses from the Derecognition of Nonfinancial Assets, and adds guidance for partial sales of nonfinancial assets. Subtopic 610-20, which was issued in May 2014 as a part of ASU 2014-09, provides guidance for recognizing gains and losses from the transfer of nonfinancial assets in contracts with non-customers. This update is effective at the same time as the amendments in ASU 2014-09, therefore, for our fiscal year beginning after December 15, 2017, and may apply them either under a full- or modified-retrospective basis. We do not expect the adoption of this guidance to have a significant effect on the Company’s consolidated financial statements.

In January 2017, the FASB issued ASU 2017-04, “Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment.” ASU 2017-04 simplifies the subsequent measurement of goodwill by eliminating “Step 2” from the goodwill impairment test. The amendment also eliminates the requirement for any reporting unit with a zero or negative carrying amount to perform a qualitative assessment. An entity still has the option to perform the qualitative assessment for a reporting unit to determine if the quantitative impairment test is necessary. This update is effective for our fiscal year beginning after December 15, 2019, and shall be adopted prospectively. Early adoption is permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017. We do not expect the adoption of this guidance to have a significant effect on the Company’s consolidated financial statements.

In January 2017, the FASB issued ASU 2017-01, “Business Combinations (Topic 805) – Clarifying the Definition of a Business.” ASU 2017-01 affects all companies and other reporting organizations that must determine whether they have acquired or sold a business. The definition of a business affects many areas of accounting including acquisitions, disposals, goodwill, and consolidation. The amendments are intended to help companies and other organizations evaluate whether transactions should be accounted for as acquisitions (or disposals) of assets or businesses. ASU 2017-01 provides a more robust framework to use in determining when a set of assets and activities is a business. It also provides more consistency in applying the guidance, reduces the costs of application, and makes the definition of a business more operable. This update is effective for our fiscal year beginning after December 15, 2017, including interim periods therein. We do not expect adoption of this guidance to have a significant effect on the Company’s consolidated financial statements.

In February 2016, the FASB issued ASU 2016-02, “Leases (Topic 842)”. This guidance supersedes the existing guidance for lease accounting, Leases (Topic 840). ASU 2016-02 requires lessees to recognize leases on their balance sheets, and leaves lessor accounting largely unchanged. The amendments in this ASU are effective for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. Early adoption is permitted for all entities. ASU 2016-02 requires a modified retrospective approach for all leases existing at, or entered into after, the date of initial application, with an option to elect to use certain transition relief. The Company is continuing to evaluate the impact of this new standard on its consolidated financial statements.

Approaching Adoption of ASU 2014-09, “Revenue from Contracts with Customers”

In May 2014, the FASB issued ASU 2014-09, “Revenue from Contracts with Customers”. ASU 2014-09 replaces the existing accounting standards for revenue recognition with a single comprehensive five-step model. The core principle is to recognize revenue upon the transfer of goods or services to customers at an amount that reflects the consideration expected to be received. The FASB also issued ASU 2015-14, “Deferral of Effective Date”. ASU 2015-14 deferred the effective date for the new guidance until the annual reporting period beginning after December 15, 2017, and interim periods within those annual periods. Early adoption is permitted, but not before the original effective date (periods beginning after December 15, 2016). The standard permits the use of either the full-retrospective (restating all years presented in the Company’s financial

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statements), or modified-retrospective (recording the impact of adoption as an adjustment to retained earnings at the beginning of the year of adoption) transition methods. Since its issuance, the FASB has also amended several aspects of the new guidance, including; ASU 2016-08, “Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations (Reporting Revenue Gross versus Net)” which clarifies the Topic 606 guidance on principal versus agent considerations, ASU 2016-10, “Revenue from Contracts with Customers (Topic 606) – Identifying Performance Obligations and Licensing”, which clarifies identification of a performance obligation and addresses revenue recognition associated with the licensing of intellectual property, ASU 2016-12, “Revenue from Contracts with Customers (Topic 606), Narrow Scope Improvements and Practical Expedients”, which clarifies assessment of collectability criterion, non-cash consideration and other technical corrections, and ASU 2016-20, “Technical Corrections and Improvements to Topic 606, Revenue from Contracts with Customers”, which is the result of the FASB Board decision to issue a separate Update for technical corrections and improvements. The Company currently plans to adopt the provisions of this new accounting standard at the beginning of fiscal year 2018, using the modified-retrospective method.

The Company completed its preliminary assessment of the impact of its upcoming adoption of ASU 2014-09 on its consolidated financial statements. The Company recognizes revenue currently under existing generally accepted accounting principles, which is a model based on the transfer of the risks and rewards of ownership. Predominantly, for the Company, this has been at the point in time that possession of goods has transferred to the customer upon delivery. The model for recognizing revenue will change under ASU 2014-09, to one based on the transfer of control of the product to the customer. Under ASU 2014-09, revenue is recognized when an entity satisfies its obligation by transferring control of the goods or services to the customer, and transfer of possession of the product is not required in order for transfer of control of the product to the customer to have occurred.

ASU 2014-09 states that if any one of three defined criteria is met, it is likely that an entity will be required to recognize revenue over time, where previously the entity has recognized revenue at the point in time which possession of the goods or services pass to the customer. Pursuant to our preliminary assessment, we believe that, of these three criteria, the Company meets the criteria which states that revenue is recognized over time if an entity’s performance (i.e. creation of a good or service for the customer) does not create an asset with an alternative use to the entity, and the entity has an enforceable right to payment for performance completed to-date. ASU 2014-09 further states that, when evaluating whether or not the goods or services have an alternative use, an entity should consider the level of customization of the goods or services. A high level of customization is a strong indicator that the goods or services do not have an alternative use and, therefore, revenue would be recognized over time as an entity performs.

The Company is a manufacturer of fully-customized windows and doors, and manufactures products based on design specifications, measurements, colors, finishes, framing materials, glass-types, and other options selected by the customer at the point in time an order is received from the customer. The Company’s initial assessment is that its goods have no alternative use, as that term is defined in ASU 2014-09, and that control of the product passes to the customer no later than completion of the manufacturing of each or all of the products in an order, but before delivery of the products to the customer. Additionally, the Company has an enforceable right to payment at the agreed-upon sales prices contained in our agreements with our customers for all manufacturing efforts expended by the Company on behalf of its customers.

Based on this initial assessment, the Company believes that it will be required to change its method of recognizing revenue, to one of potentially recognizing revenue as products are manufactured, but no later than completion of the manufacturing process, from its current method of recognizing revenue upon delivery of the product to the customer. The Company is continuing to evaluate its manufacturing processes in order to assess at what point the products have no alternative use and the recognition of revenue should begin. However, because revenue will have been recognized on at least all products for which manufacturing has been completed, the Company believes that upon adoption of ASU 2014-09, inventories on its consolidated balance sheets will no longer include finished goods. The Company also believes that it will recognize revenue at an earlier point than prior to the adoption of ASU 2014-09, but that such effect may not materially affect its consolidated statements of operations post-adoption due to the fact that such effects will exist at both the beginning and end of fiscal periods after the initial transition.

ASU 2014-09 also requires entities, primarily in the manufacturing segment, to make policy elections relating to shipping and handling charges. Entities may elect to treat shipping and handling as a separate performance activity, and recognize revenue from shipping and handling as performance occurs. Conversely, entities may also elect to treat shipping and handling as a fulfillment activity, which will require shipping and handling costs for undelivered products to be accrued in order to match this cost with the revenue previously recognized over time. The Company currently recognizes shipping and handling costs as a fulfillment activity, and has preliminarily determined to continue to treat such costs as a fulfillment activity.

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The Company expects to continue to evaluate the impact of the adoption of ASU 2014-09 on its consolidated financial statements, and will provide updates and additional information as the effective date of adoption approaches.

We experience changes in interest expense when market interest rates change. Changes in our debt could also increase these risks. Based on debt outstanding as of the date of filing of this Quarterly Report on Form 10-Q, of $244.0 million, a 100 basis point increase in interest rate would result in approximately $2.4 million of additional interest costs annually.

ITEM 4. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures. Disclosure controls and procedures are controls and other procedures that are designed to ensure that information required to be disclosed in the Company’s reports filed or submitted under the Exchange Act, is recorded, processed, summarized, and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms.

A control system, however, no matter how well conceived and operated, can at best provide reasonable, not absolute, assurance that the objectives of the control system are met. Additionally, a control system reflects the fact that there are resource constraints, and the benefits of controls must be considered relative to costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of error or fraud, if any, within our Company have been detected, and due to these inherent limitations, misstatements due to error or fraud may occur and not be detected.

Our chief executive officer and chief financial officer, with the assistance of management, evaluated the design, operation and effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this report (“Evaluation Date”). Based on that evaluation, our chief executive officer and chief financial officer concluded that, as of the Evaluation Date, our disclosure controls and procedures were effective for the purposes of ensuring that information required to be disclosed in our reports filed under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and that such information is accumulated and communicated to management, including our chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding required disclosure.

Changes in Internal Control over Financial Reporting.

During the period covered by this report, there have been no changes in our internal control over financial reporting identified in connection with the evaluation described above that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II — OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

We are involved in various claims and lawsuits incidental to the conduct of our business in the ordinary course. We carry insurance coverage in such amounts in excess of our self-insured retention as we believe to be reasonable under the circumstances and that may or may not cover any or all of our liabilities with respect to claims and lawsuits. We do not believe that the ultimate resolution of the matters pending or threatened against us at this time will have a material adverse impact on our financial position or results of operations.

Although our business and facilities are subject to federal, state, and local environmental regulation, environmental regulation does not have a material impact on our operations. We believe that our facilities are in material compliance with such laws and regulations. As owners and lessees of real property, we can be held liable for the investigation or remediation of contamination on such properties, in some circumstances without regard to whether we knew of or were responsible for such contamination. Our current expenditures with respect to environmental investigation and remediation at our facilities are minimal, although no assurance can be provided that more significant remediation may not be required in the future as a result of spills or releases of petroleum products or hazardous substances, or the discovery of previously unknown environmental conditions.

ITEM 1A. RISK FACTORS

In addition to the other information set forth in this report, you should carefully consider the factors discussed in Part 1, “Item 1A. Risk Factors” of our Form 10-K annual report for the year ended December 31, 2016, which could materially affect our business, financial condition, or future results.

Additional risk and uncertainties not currently known to us or that we currently deem to be immaterial, may also materially adversely affect our business, financial condition, and/or operating results.

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

Unregistered Sales of Equity Securities and Use of Proceeds

None during the quarter.

Issuer Purchases of Equity

None during the quarter.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None.

ITEM 4. MINE SAFETY DISCLOSURE

Not applicable.

ITEM 5. OTHER INFORMATION

None.

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ITEM 6. EXHIBITS

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SIGNATURE

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.

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