Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion should be read in conjunction with our unaudited condensed consolidated financial statements and the related notes, both of which are included in Part I, Item 1 of this report. The Company’s critical accounting policies are included in the Company’s Annual Report on Form 10-K for the fiscal year ended April 30, 2017.
Forward-Looking Statements
This report contains statements concerning the Company’s expectations, plans, objectives, future financial performance, and other statements that are not historical facts. These statements may be “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. In most cases, the reader can identify forward-looking statements by words such as “anticipate,” “estimate,” “forecast,” “expect,” “believe,” “should,” “could,” “would,” “plan,” “may,” “intend,” “estimate,” “prospect,” “goal,” “will,” “predict,” “potential” or other similar words. Forward-looking statements contained in this report, including elsewhere in “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” are based on current expectations and our actual results may differ materially from those projected in any forward-looking statements. In addition, the Company participates in an industry that is subject to rapidly changing conditions and there are numerous factors that could cause the Company to experience a decline in sales and/or earnings or deterioration in financial condition. Factors that could cause actual results to differ materially from those in forward-looking statements made in this report include but are not limited to:
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general economic or business conditions and instability in the financial and credit markets, including their potential impact on the Company's (i) sales and operating costs and access to financing, and (ii) customers and suppliers and their ability to obtain financing or generate the cash necessary to conduct their respective businesses;
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the volatility in mortgage rates and unemployment rates;
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slower growth in personal income and residential investment;
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the cyclical nature of the Company’s industry, which is particularly sensitive to changes in consumer confidence, the amount of consumers’ income available for discretionary purchases, and the availability and terms of consumer credit;
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economic weakness in a specific channel of distribution;
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the loss of sales from specific customers due to their loss of market share, bankruptcy or switching to a competitor;
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risks associated with domestic manufacturing operations and suppliers, including fluctuations in capacity utilization and the prices and availability of key raw materials as well as fuel, transportation, warehousing and labor costs, environmental compliance, possible import tariffs and remediation costs;
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the need to respond to price or product initiatives launched by a competitor;
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the ability to retain and motivate Company employees;
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the Company’s ability to successfully implement initiatives related to increasing market share, new products, maintaining and increasing its sales force and new product displays;
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sales growth at a rate that outpaces the Company’s ability to install new manufacturing capacity or a sales decline that requires reduction or realignment of the Company’s manufacturing capacity;
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the occurrence of any event, change or other circumstances that could give rise to the termination of the Merger Agreement or a delay in the completion of the Merger,
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a failure by either or both parties to satisfy conditions to closing under the Merger Agreement,
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a failure to obtain any required regulatory or third-party approvals, including any required antitrust approvals, under the Merger Agreement,
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risks associated with the financing of the Merger,
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the effect of the announcement of the proposed Merger on the ability of the Company and RSI to retain customers, maintain relationships with their suppliers and hire and retain key personnel,
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the Company’s ability to successfully integrate RSI into its business and operations, and
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the risk that the economic benefits, costs savings and other synergies anticipated by the Company under the Merger are not fully realized or take longer to realize than expected.
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Additional information concerning factors that could cause actual results to differ materially from those in forward-looking statements is contained in this report, including elsewhere in "Management’s Discussion and Analysis of Financial Condition and Results of Operations", and also in the Company's most recent Annual Report on Form 10-K for the fiscal year ended April 30, 2017, filed with the SEC, including under Item 1A, "Risk Factors," Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and Item 7A, "Quantitative and Qualitative Disclosures about Market Risk." While the Company believes that these risks are manageable and will not adversely impact the long-term performance of the Company, these risks could, under certain circumstances, have a material adverse impact on its operating results and financial condition.
Any forward-looking statement that the Company makes speaks only as of the date of this report. The Company undertakes no obligation to publicly update or revise any forward-looking statements or cautionary factors, as a result of new information, future events or otherwise, except as required by law.
Overview
American Woodmark Corporation manufactures and distributes kitchen cabinets and vanities for the remodeling and new home construction markets. Its products are sold on a national basis directly to home centers, major builders and home manufacturers, and through a network of independent dealers and distributors. At
October 31, 2017
, the Company operated nine manufacturing facilities and seven service centers across the country.
The three-month period ended
October 31, 2017
was the Company’s
second
quarter of its fiscal year that ends on April 30, 2018 (“fiscal 2018”). During the
second
quarter of fiscal 2018, the Company continued to experience improving market conditions from the housing market downturn that began in 2007.
The Company’s remodeling-based business was impacted by the following trends during the
second
quarter of the Company’s fiscal 2018:
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Residential investment as a percentage of gross domestic product as tracked by the U.S. Department of Commerce for the third calendar quarter of 2017 remained declined to 3.4% from 3.5% for the same period in the prior year;
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The median price per existing home sold rose during the third calendar quarter of 2017 compared to the same period one year ago by 4.3% according to data provided by the National Association of Realtors, and existing home sales increased 0.19% during the third calendar quarter of 2017 compared to the same period in the prior year;
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The unemployment rate improved to 4.1% as of October 2017 compared to 4.8% as of October 2016 according to data provided by the U.S. Department of Labor;
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Mortgage interest rates remained low with a thirty-year fixed mortgage rate of approximately 3.90% in October 2017, an increase of approximately 43 basis points compared to the same period in the prior year, according to Freddie Mac; and
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Consumer sentiment as tracked by Thomson Reuters/University of Michigan improved from 87.2 in October 2016 to 100.7 in October 2017.
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The Company believes there is no single indicator that directly correlates with cabinet remodeling market activity. For this reason, the Company considers other factors in addition to those discussed above as indicators of overall market activity including credit availability, housing affordability and sales reported by the Kitchen Cabinet Manufacturers Association (“KCMA”), a trade organization that issues the aggregate sales that have been reported by its members including the largest cabinet manufacturers in the United States. Based on the totality of factors listed above, the Company believes that the cabinet remodeling market increased in the low single digits during the
second
quarter of fiscal 2018.
The Company’s largest remodeling customers and competitors continued to utilize sales promotions in the Company’s product category to boost sales and some competitors accelerated their promotional activity. These promotions consisted of free products and/or cash discounts to consumers based upon the amount or type of cabinets they purchased. The Company strives to maintain its promotional levels in line with market activity, with a goal of remaining competitive. The Company experienced promotional levels during the
second
quarter of fiscal 2018 that were higher than those experienced in the same period of the prior year.
The Company’s remodeling sales decreased 1% during the
second
quarter and increased 2% during the first half of fiscal 2018 compared with the same prior-year periods. Our Waypoint brand, which serves the dealer channel, represented approximately 11% of our overall sales and grew by 11% during the second quarter and 16% during the first half of fiscal 2018, respectively, when compared to the comparable prior-year periods. Management believes that the Company has improved market share within the dealer channel while it has lost share within big box retailers.
Regarding new construction markets, the Company believes that fluctuations in single-family housing starts are the best indicator of cabinet activity. Assuming a sixty to ninety day lag between housing starts and the installation of cabinetry, single-family housing starts rose approximately 13% during the
second
quarter of the Company’s fiscal 2018 over the comparable prior year period. Completions over that same time period only average 7% as closings were delayed in the TX and FL markets as a result of the two hurricanes. We also believe the construction cycle has been extended and utilizing a 90 to 120 day lag between start and cabinet installation, growth was approximately 10%.
Sales in the new construction channel increased 9% in the
second
quarter and more than 10% during the first half of fiscal 2018 when compared with the same periods of fiscal 2017. The Company believes it continued to over index the market both due to share penetration with our builder partners as well as the health of the markets where we concentrate our business.
The Company’s total net sales rose 4% during the
second
quarter and 6% during the first half of
fiscal 2018 compared to the same prior-year periods,
which management believes was driven primarily by a rise in overall market activity.
As of
October 31, 2017
, the Company had total net deferred tax assets of $10.1 million, down from $18.0 million at April 30, 2017. The reduction in total net deferred tax assets from April 30, 2017 to October 31, 2017 is mainly due to pension contributions and stock based compensation transactions over that time period. The Company regularly considers the need for a valuation allowance against its deferred tax assets. Deferred tax assets are reduced by a valuation allowance when, after considering all positive and negative evidence, it is determined that it is more likely than not that some portion, or all, of the deferred tax asset will not be realized. The Company has recorded a valuation allowance related to deferred tax assets for certain state investment tax credit (“ITC”) carryforwards. These credits expire in various years beginning in fiscal 2020. The Company believes based on positive evidence of the housing industry improvement along with four consecutive years of profitability that the Company will more likely than not realize all other remaining deferred tax assets.
The Company earned net income of $19.8 million for the
second
quarter of fiscal 2018, compared with $17.6 million in the
second
quarter of its prior fiscal year, and earned net income of $42.0 million for the first half of fiscal 2018, compared with $39.3 million in the same period of the prior year.
Results of Operations
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Three Months Ended
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Six Months Ended
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October 31,
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October 31,
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(in thousands)
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2017
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2016
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Percent Change
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2017
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2016
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Percent Change
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Net sales
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$
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274,769
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$
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264,076
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4
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%
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$
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551,596
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$
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522,226
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6
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%
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Gross profit
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57,335
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56,152
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2
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115,829
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115,469
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—
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Selling and marketing expenses
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18,077
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17,146
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5
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36,230
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33,609
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8
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General and administrative expenses
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8,443
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10,675
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(21
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)
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17,950
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21,607
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(17
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)
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Net Sales.
Net sales were $274.8 million for the second quarter of fiscal 2018, an increase of 4% compared with the second quarter of fiscal 2017. For the first six months of fiscal 2018, net sales were $551.6 million, reflecting a 6% increase compared with the same period of fiscal 2017. Overall unit volume for the three- and six-month periods ended
October 31, 2017
improved by 3% and 5%, respectively. Average revenue per unit increased 1% during the three- and six-month period driven by improvements in the Company’s sales mix.
Gross
Profit.
Gross profit margin for the
second
quarter of fiscal 2018 was 20.9%, compared with 21.3% for the same period of fiscal 2017. Gross profit margin was 21.0% for the first half of fiscal 2018, compared with 22.1% in the first half of fiscal 2017. Gross profit in the second quarter was impacted by higher transportation costs and material inflation. Gross profit for the first six months of the current fiscal year was unfavorably impacted by higher transportation costs, material inflation and higher healthcare costs.
Selling and
Marketing Expenses
.
Selling and marketing expenses were 6.6% of net sales in the
second
quarter of fiscal 2018, compared with 6.5% of net sales for the same period in fiscal 2017. For the first six months of fiscal 2018, selling and marketing expenses were 6.6% of net sales, compared with 6.4% of net sales for the same period of fiscal 2017. Selling and marketing expenses as a percentage of net sales slightly increased during the second quarter and first half of fiscal 2018 as a result of higher personnel costs and product launch costs.
General and
Administrative Expenses.
General and administrative expenses were 3.1% of net sales in the
second
quarter of fiscal 2018, compared with 4.0% of net sales in the
second
quarter of fiscal 2017, and 3.3% of net sales in the first half of fiscal 2018 compared with 4.1% of net sales in the same period in fiscal 2017. The decrease in general and administrative expenses as a percentage of net sales during the
second
quarter and first half of fiscal 2018 was driven by favorable leverage from increased sales, lower incentive compensation costs and ongoing expense controls.
Effective Income Tax Rates.
The Company’s effective income tax rate for the three- and
six
-month periods ended
October 31, 2017
was 37.2% and 33.1%, respectively, compared with 38.0% and 34.9%, respectively, in the comparable periods of the prior fiscal year. The decrease in the effective tax rate for the second quarter of fiscal 2018 as compared to the second quarter of fiscal 2017 was primarily due to more favorable permanent tax differences. The decrease in the effective tax rate for the first half of fiscal 2018 as compared to the first half of fiscal 2017 was primarily due to an increase in the benefit from stock-based compensation transactions as well as more favorable permanent tax differences.
Outlook.
The Outlook below for American Woodmark Corporation does not contemplate the merger agreement with RSI:
The Company believes that the average price of existing home sales will continue to increase driven by growth in both employment and new household formations. In this environment, the Company expects the cabinet remodeling market will show modest improvement during the remainder of fiscal 2018 but overall activity will continue to be below historical averages. Within the cabinet remodeling market, the Company expects independent dealers to outperform other channels of distribution primarily due to their more affluent customer base. The Company remains focused on improving market share in the home center channel for the remainder of fiscal 2018, however this is heavily dependent upon competitive promotional activity. The Company also expects to continue to increase market share in the dealer channel. This combination is expected to result in remodeling sales growth that is below the market rate.
The Company expects that single-family housing starts and in turn, new construction cabinet sales, will grow approximately 8-10% during the remainder of its fiscal year 2018, and that the Company’s new construction sales growth will continue to
exceed this level for the remainder of its current fiscal year, but at a lower rate than fiscal 2017, as comparable prior year sales levels become more challenging to exceed.
Merger Agreement with RSI
On November 30, 2017, the Company, RSI Home Products, Inc., a Delaware corporation (“RSI”), Alliance Merger Sub, Inc., a Delaware corporation and wholly-owned subsidiary of the Company (“Merger Sub”), and Ronald M. Simon, solely in his capacity as the Stockholder Representative, entered into an Agreement and Plan of Merger (the “Merger Agreement”) providing for, at closing, the merger of Merger Sub with and into RSI, with RSI surviving as a wholly-owned subsidiary of the Company (the “Merger”). Merger Sub was formed solely for purposes of engaging in the Merger and has not conducted any prior activities.
Pursuant to the terms and subject to the conditions of the Merger Agreement, as of the effective time of the Merger, the stockholders of RSI will be entitled to receive from the Company, in the aggregate, an amount in net cash equal to approximately $346 million, subject to adjustment as described below and less the aggregate amount paid to optionholders as described below, and approximately 1,457,574 shares of newly issued Company common stock (the “Stock Consideration”) with a market value of approximately $140 million based on the average closing price of the Company’s common stock for the five consecutive trading days immediately preceding the date of the Merger Agreement. The Company will also assume approximately $589 million of RSI indebtedness at closing, consisting largely of RSI’s privately placed 6½% Senior Secured Second Lien Notes due 2023 issued in March 2015 (the “Senior Notes”).
The cash consideration to be paid by the Company is subject to adjustments, in certain circumstances, for net working capital, certain costs and expenses of RSI related to the Merger and the amount of cash and indebtedness held by RSI at closing, all as set forth in the Merger Agreement. Each outstanding RSI option that has vested as of the date hereof or is scheduled to vest by February 28, 2018 will be cancelled in exchange for a cash payment in an amount equal to a pro rata share of the aggregate value of the merger consideration described above, less the applicable exercise price of the option (unless such amount would be equal to or less than zero, in which case such option will be cancelled without consideration). Each outstanding RSI option scheduled to vest after February 28, 2018 will be cancelled without consideration in accordance with its terms. The issuance of the Stock Consideration has not been and will not be registered under the Securities Act, and will be conducted in reliance on the exemption for nonpublic offerings provided by Rule 506 of Regulation D promulgated under the Securities Act of 1933, as amended, and analogous state securities law provisions, based, in part, upon certain representations made by RSI’s stockholders.
Each of the Company’s and RSI’s obligation to consummate the Merger is subject to certain customary closing conditions, including (i) the expiration or termination of the applicable antitrust waiting period under the Hart-Scott Rodino Antitrust Improvements Act of 1976, as amended, and the receipt of any other required governmental or third-party consents or approvals, (ii) the absence of any injunction or other legal prohibition preventing consummation of the Merger, the issuance of the Stock Consideration or the other transactions contemplated by the Merger Agreement, (iii) the accuracy of the other party’s representations and warranties, subject to certain materiality thresholds, (iv) the absence of a material adverse effect with respect to the other party, (v) the receipt of certain certificates and other deliverables, (vi) the performance by the other party of its obligations and covenants under the Merger Agreement, and (vii) in the case of the Company, the continued effectiveness of the written consent of the RSI stockholders approving the Merger and the holders of no more than 3% of RSI’s stock having exercised statutory appraisal rights.
The Merger Agreement may be terminated by the parties in certain limited circumstances, including through mutual written consent or by either the Company or RSI unilaterally if the Merger has not occurred on or before April 9, 2018 (subject to certain limited extensions) or the other party breaches its representations, warranties or covenants in a manner that cannot be cured within the time specified in the Merger Agreement. The Merger Agreement may also be terminated by RSI if, after March 30, 2018, all the conditions to closing have been satisfied, RSI has notified the Company that it is ready and willing to close and the Company has nevertheless failed to close within three business days of such notice (in which event the Company would be required to pay a termination fee to RSI in the amount of $22.5 million).
For further information regarding the financing of the Merger, please see “Commitment Letter” under “Liquidity and Capital Resources” below.
LIQUIDITY AND CAPITAL RESOURCES
The Company’s cash and cash equivalents totaled
$162.5 million
at
October 31, 2017
, representing a $14.4 million decrease from its April 30, 2017 levels. At
October 31, 2017
, total long-term debt (including current maturities) was $17.8 million, an
increase of $0.9 million from its balance at April 30, 2017. The Company’s ratio of long-term debt to total capital was 4.1% at
October 31, 2017
, compared with 4.2% April 30, 2017.
The Company’s main source of liquidity is its cash and cash equivalents on hand and cash generated from its operating activities. The Company can borrow up to $35 million under its revolving credit facility with Wells Fargo Bank, N.A. (“Wells Fargo”), which expires on December 31, 2018. This facility had an available borrowing base of $30.1 million at October 31, 2017.
The Company's outstanding indebtedness and other obligations to Wells Fargo are unsecured. Under the terms of its revolving credit facility, the Company must: (1) maintain at the end of each fiscal quarter a ratio of total liabilities to tangible net worth of not greater than 1.4 to 1.0; (2) maintain at the end of each fiscal quarter a ratio of cash flow to fixed charges of not less than 1.5 to 1.0 measured on a rolling four-quarter basis; and (3) comply with other customary affirmative and negative covenants. The Company was in compliance with all covenants specified in the credit facility as of
October 31, 2017
, including as follows: (1) the Company’s ratio of total liabilities to tangible net worth at
October 31, 2017
was 0.37 to 1.0; and (2) cash flow to fixed charges for its most recent four quarters was 3.6 to 1.0.
The revolving credit facility does not limit the Company’s ability to pay dividends or repurchase its common shares as long as the Company is in compliance with these covenants.
Cash provided by operating activities in the first
six
months of fiscal 2018 was $
41.8 million
, compared with $
40.1 million
in the comparable period of fiscal 2017. The increase in the Company’s cash from operating activities was driven primarily by lower increases in customer receivables and higher operating profitability which was partially offset by higher inventories to support increased sales and lower increases in accounts payable.
The Company’s investing activities primarily consist of purchases and maturities of certificates of deposit, investment in property, plant and equipment and promotional displays. Net cash used for investing activities was $31.1 million in the first
six
months of fiscal 2018, compared with $50.4 million in the comparable period of fiscal 2017. The decrease in cash used was due to a $28.5 million decrease in investments in certificates of deposit which was partially offset by increased investment in property, plant and equipment.
During the first
six
months of fiscal 2018, net cash used by financing activities was $25.1 million, compared with $8.5 million in the comparable period of the prior fiscal year. The increase in cash used was driven by the Company’s repurchase of 251,241 shares of common stock at a cost of $23.5 million, a $13.1 million increase from the prior year, and a decrease in proceeds from the exercise of stock options of $1.0 million.
Under a stock repurchase authorization approved by its Board of Directors on November 30, 2015, the Company was authorized to purchase up to $20 million of the Company's common shares. On November 30, 2016, the Board of Directors authorized an additional stock repurchase program of up to $50 million of the Company's common shares. This authorization is in addition to the stock repurchase program authorized on November 19, 2015. Repurchases may be made from time to time in the open market, or through privately negotiated transactions or otherwise, in compliance with applicable laws, rules and regulations, at prices and on terms the Company deems appropriate and subject to the Company's cash requirements for other purposes, compliance with the covenants under the Company’s revolving credit facility, and other factors management deems relevant. At
October 31, 2017
, $41.5 million remained authorized by the Company’s Board of Directors to repurchase the Company’s common shares. The Company purchased a total of 251,241 common shares, for an aggregate purchase price of $23.5 million, during the first
six
months of fiscal 2018, under the authorizations. See Part II. Item 2, "Unregistered Sales of Equity Securities and Use of Proceeds" for further information on share repurchases. The Company announced on December 1, 2017 that it is suspending its stock repurchase program in conjunction with the proposed Merger.
On August 24, 2017, the Board of Directors of the Company approved up to $13.6 million of discretionary funding to reduce its defined benefit pension liabilities.
On November 30, 2016 the Board of Directors of the Company approved the construction of a new corporate headquarters in Winchester, Virginia. The new space will consolidate employees that currently occupy four buildings in Winchester, Virginia and Frederick County, Virginia, in early calendar 2018. It is expected that the new building will be self-funded for approximately $30 million, of which $10.9 million has been spent through October 31, 2017. During the first six months of fiscal 2018, approximately $7.9 million in costs were incurred related to the new company headquarters.
Cash flow from operations combined with accumulated cash and cash equivalents on hand are expected to be more than sufficient to support forecasted working capital requirements, service existing debt obligations and fund capital expenditures for the remainder of fiscal 2018.
Commitment Letter
In connection with the signing of the Merger Agreement, the Company entered into a commitment letter with Wells Fargo and Wells Fargo Securities, LLC providing for a senior secured credit facility consisting of a $250 million term loan facility and a new $100 million revolving credit facility to replace the Company’s current revolving credit facility discussed above (the “Commitment Letter”). The Company intends to use the proceeds of the term loan, together with cash currently on its balance sheet, to fund the cash portion of the merger consideration and its transaction fees and expenses and intends to use the proceeds of the revolving credit facility to provide ongoing working capital and for other general corporate purposes of the Company and its subsidiaries. The obligations of the parties under the Commitment Letter are subject to a number of customary conditions, including the preparation, execution and delivery of certain definitive documentation, as well as the success of (i) a consent solicitation with respect to a change of control tender offer requirement in the indenture governing the Senior Notes or (ii) a refinancing of the Senior Notes.
Seasonal and Inflationary Factors
The Company’s business has historically been subject to seasonal influences, with higher sales typically realized in the second and fourth fiscal quarters.
The costs of the Company’s products are subject to inflationary pressures and commodity price fluctuations. The Company has generally been able over time to recover the effects of inflation and commodity price fluctuations through sales price increases.
Critical Accounting Policies
The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. There have been no significant changes to the Company’s critical accounting policies as disclosed in the Company’s Annual Report on Form 10-K for the fiscal year ended April 30, 2017.