ITEM 1A. RISK FACTORS.
The risks described below are not the only risks facing Zurn Elkay. Additional risks and uncertainties not currently known to us, or those risks we currently view to be immaterial, may also materially and adversely affect our business, financial condition or results of operations. In addition, see Management’s Discussion and Analysis of Financial Condition and Results of Operations in Item 7 for a further discussion of some of the factors that could affect future results. If any of these risks materialize, our business, financial condition, results of operations or cash flows could be materially and adversely affected.
Strategic Risks
Economic and financial market weakness, as well as overall challenging market cycles, may particularly impact the markets we serve, and, as a result may adversely affect our financial condition or results of operations.
Our business operations may be adversely affected by volatility and weaknesses in the overall economy and financial markets. Weak, challenging or volatile economic conditions in the end markets, businesses or geographic areas in which we sell our products typically reduces demand for our products and results in a decrease in sales volume.
Our financial performance depends, in large part, on conditions in the markets that we serve in the U.S. and, to a lessor extent, the global economy generally. Some of the end markets we serve are highly cyclical, and some at times have experienced greater cyclicality than others. Any sustained weakness in demand or downturn or uncertainty in the economy, could materially reduce our net sales and profitability.
For example, sales to the construction industry are driven by trends in commercial, institutional, and residential construction, housing starts and trends in residential repair and remodeling. Consumer confidence, employment rates, weather conditions, interest rates, credit standards and availability of consumer credit and income levels play a significant role in driving demand in commercial and residential construction, repair and remodeling sectors. A drop or weakness in consumer confidence, prolonged adverse weather conditions, lack of availability or increased cost of credit, tightened credit standards or increased unemployment could materially impact demand for and sales of our products and/or result in downward pressure on product pricing and our profit margins, any or all of which could adversely affect our financial results.
Volatility and disruption of financial markets could limit the ability of our customers to obtain adequate financing to maintain operations and may cause them to terminate existing purchase orders, reduce the volume of products they purchase from us in the future or impact their ability to pay their receivables. Adverse economic and financial market conditions may also cause our suppliers to be unable to meet their commitments to us or may cause suppliers to make changes in the credit terms they extend to us, such as shortening the required payment period for outstanding accounts receivable or reducing or eliminating the amount of trade credit available to us.
The markets we serve are highly competitive; an inability to effectively compete would adversely affect our business, financial condition and results of operations.
We operate in highly competitive markets. Some of our competitors have achieved substantially more market penetration in certain of the markets in which we operate. Some of our competitors are larger and may have greater financial and other resources than we do, and our competitors may adopt more aggressive sales policies and devote greater resources to the development, promotion and sale of their products than we do, all of which could result in a loss of customers and adversely affect our results of operations.
We compete against both large international and national rivals, as well as many regional competitors. Increased competition in any of the markets in which we operate could result in substantial downward pressure on product pricing and our profit margins, thereby adversely affecting our financial results. We cannot provide assurance that we will be able to maintain or increase the current market share of our products successfully in the future.
If we are unable to effectively manage risks associated with changing technology, product innovation and new product development, manufacturing techniques, distribution channels and business continuity, we may be at a competitive disadvantage.
The successful implementation of our business strategy requires us to continuously evolve our existing products and introduce new products to meet customers' needs in the industries we serve. Our products are characterized by stringent performance and specification requirements that mandate a high degree of manufacturing and engineering expertise. If we fail to meet these requirements, our business and ability to compete effectively could suffer. We believe our customers rigorously evaluate their suppliers on a number of factors, including product quality, price competitiveness, technical and manufacturing expertise, development and product design capability, new product innovation, reliability and timeliness of delivery, operational flexibility, customer service and overall management. Our ongoing success depends on our ability to continue to meet our customers' changing specifications with respect to these criteria. We cannot ensure that we will be able to address technological advances or introduce new products that may be necessary to remain competitive within our businesses. Further, such new
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products and technologies may create additional exposure or risk. We cannot ensure that we can adequately protect our own technological developments to produce a sustainable competitive advantage. Furthermore, we may be subject to business continuity risk in the event of an unexpected loss of a material facility or operation. We cannot ensure adequate insurance protection against such a loss.
We may be unable to realize intended benefits from our ongoing Supply Chain Optimization and Footprint Repositioning initiatives, restructuring and divestiture efforts, and as a result our profitability may be hurt or our business otherwise might be adversely affected.
To operate more efficiently, control costs and refine our business focus, we periodically undertake restructuring plans, which can include facility consolidations, product rationalizations, workforce reductions and other cost reduction initiatives. We also periodically choose to divest operations or product lines that we no longer believe are additive or complementary to our business or strategic direction. These plans are intended to reduce operating costs, to modify our footprint to reflect changes in the markets we serve, to reflect changes in business focus, to strengthen focus on our core business and/or to address overall manufacturing overcapacity, including as a result of acquisitions. If we do not successfully manage our current restructuring activities, or any other restructuring activities or divestitures that we may undertake in the future, expected efficiencies, benefits and cost savings might be delayed or not realized, and our operations and business could be disrupted.
In addition, as a result of such actions, we expect to incur restructuring expenses and other charges (including, for example, potential impairment charges related to fixed assets, goodwill and other intangibles), which may be material, and may exceed our estimates. Several factors could cause restructuring or divestiture activities to adversely affect our business, financial condition and results of operations. These include potential disruption of our operations, customer relationships and other aspects of our business. Employee morale and productivity could also suffer and may result in unwanted employee attrition. These activities require substantial management time and attention and may divert management from other important work or result in a failure to meet operational targets. Divestitures may also result in obligations to buyers or other parties that could have a financial effect after the transaction is completed. Moreover, we could make changes to, or experience delays in executing, any restructuring or divestiture plans, any of which could cause further disruption and additional unanticipated expense.
An inability to effectively integrate acquisitions, mergers or other business combinations could adversely affect our business, financial condition, results of operations or cash flows.
Acquisitions, mergers and other business combinations are part of our growth strategy, and we have completed several in the last few years. We cannot ensure that we will be able to complete any future acquisition, successfully integrate any acquired business or operations, or accomplish our strategic objectives as a result of any such acquisition.
Acquisitions are often undertaken to improve the operating results of either or both of the acquirer and the acquired company and we cannot ensure that we will be successful in this regard. We cannot provide any assurance that we will be able to fully realize the intended benefits from our acquisitions. Acquisitions involve risks, including the possible inability to integrate an acquired business into our operations, potential failure to realize anticipated benefits, diversion of management's attention, issues in customer transitions, potential inadequacies of indemnities and other contractual remedies and unanticipated problems, risks or liabilities, including environmental, some or all of which could have a material adverse effect on our business, financial condition, results of operations or cash flows.
Refer to Risks Related to the Merger with Elkay section below for additional considerations.
The loss or financial instability of any significant customer or customers accounting for our backlog could adversely affect our business, financial condition, results of operations or cash flows.
A substantial part of our business is concentrated with a few customers, and we have certain customers that are significant to our business. During the year ended December 31, 2022, our top five customers accounted for approximately 40% of our consolidated net sales, with one customer accounting for 22% of consolidated net sales. The loss of one or more of these customers or other major customers, or a deterioration in our relationship with any of them could have a material adverse effect on our business, financial condition, results of operations or cash flows.
Our contracted backlog is comprised of future orders for our products from a broad number of customers. Defaults by any of the customers that have placed significant orders with us, whether because of bankruptcy, illiquidity, operational problems or otherwise, could have a significant adverse effect on our net sales, profitability and cash flow. As of December 31, 2022, all of our backlog was scheduled to ship during the year ending December 31, 2023.
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We rely on independent distributors and independent sales representatives. Termination of one or more of our relationships with any of our key independent distributors and / or a substantial number of independent representatives, or an increase in their sales of our competitors’ products could have a material adverse effect on our business, financial condition, results of operations or cash flows.
We depend on 1,070 independent sales representatives and approximately 75 third-party warehouses to distribute our products. In fiscal 2022, our three largest independent distributors generated approximately 35% of our consolidated net sales with the largest accounting for 22% of consolidated net sales.
The loss of one of our key distributors or of a substantial number of our other distributors or independent sales representatives, or an increase in the distributors' sales of competitors' products to our customers could have a material adverse effect on our business, financial condition, results of operations or cash flows.
The inability to adequately protect intellectual property, or defend against infringement claims brought against us, could adversely affect our business.
We attempt to protect our intellectual property through a combination of patent, trademark, copyright and trade secret protection, as well as third-party nondisclosure and assignment agreements. We cannot assure that any of our applications for protection of our intellectual property rights will be approved and successfully maintained or that our competitors will not infringe or successfully challenge our intellectual property rights. We also rely on unpatented proprietary technology and trade secrets.It is possible that others will independently develop the same or similar technology or otherwise obtain access to our unpatented technology. To protect our trade secrets and other proprietary information, we require employees, consultants and advisors to enter into confidentiality agreements. We cannot assure that these agreements will provide meaningful protection for our trade secrets, know-how or other proprietary information in the event of any unauthorized use, misappropriation or disclosure. If we are unable to maintain the proprietary nature of our technologies, our ability to sustain margins on some or all of our products may be affected, which could have a material adverse effect on our business.
In addition, in the ordinary course of our operations, we periodically seek to enforce our intellectual property rights through litigation or are subject to third party litigation claiming infringement, including in respect of some of our more profitable products. An adverse ruling or other unfavorable outcome in any such litigation could have a material adverse effect on our business, reputation, financial condition, results of operations or cash flows.
Operational Risks
Increases in the cost, and/or the availability, of raw materials, including as a result of tariffs or other trade protection measures, could adversely affect our business, financial condition, results of operations or cash flows.
Our manufacturing processes depend on third parties for raw materials, in particular bar steel, brass, castings, copper, forgings, high-performance engineered plastic, plate steel, resin, sheet steel and zinc, as well as petroleum and other carbon-based fuel products. While we strive to maintain alternative sources for most raw materials, our business is subject to the risk of price fluctuations, including as a result of, or in reaction to, tariffs, import duties, or other trade protection measures instituted by the U.S. or other countries, inefficiencies in the event of a need to change our suppliers, and delays in the delivery of and potential unavailability of our raw materials. Also, trade wars or outbreaks of infectious diseases, could impact the cost or availability of goods or materials, both imported and domestic, or adversely affect demand for our products. Any such price fluctuations or delays, if material, could harm our profitability or operations. In addition, the loss of a substantial number of suppliers could result in material cost increases or reduce our production capacity. In addition to suppliers we also rely on third party shippers to assist in transportation of our product throughout the supply chain. Reduced availability of transportation and the associated cost increases could adversely impact our profitability or operations.
We do not typically enter into hedge transactions to reduce our exposure to purchase price risks and cannot ensure that we would be successful in recouping any increases if these risks were to materialize. In addition, if we are unable to continue to purchase our required quantities of raw materials on commercially reasonable terms, or at all, or if we are unable to maintain or enter into new purchase contracts for our larger commodities, our business operations could be disrupted and our profitability could be adversely impacted.
The ongoing updates to our Enterprise Resource Planning ("ERP") systems, as well as failures of our data security and information technology infrastructure or cyber security breaches, could cause substantial business interruptions and adversely affect our business.
Utilizing a phased approach, we continue to update our ERP systems across our Zurn Elkay operations. If these updates are ineffective, we could incur substantial business interruptions, including the inability to perform routine business transactions, which could have a material adverse effect on our financial performance. Further, these updates may not result in the benefits we intend or be timely implemented.
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In addition, we depend heavily on information technology infrastructure to manage our business objectives and operations, support our customers’ requirements and protect sensitive information. There have been significant and increasing instances of data and security breaches, malicious interference with technology systems and industrial espionage involving companies in numerous industries, including cloud providers, and cyber security threats are becoming more complex. Like other companies, we have experienced these types of threats; however, to date, we have not experienced a material threat or incident. In addition, at times a large percentage of our workforce may be working remotely in response to outbreaks of infectious disease, which may heighten these risks.While we have taken steps to maintain and enhance our cyber security by implementing additional security technologies, internal controls, network and data center resiliency, redundancy and recovery processes, upgrading our remote work environment and by obtaining insurance coverage, these measures may be inadequate.As a result, any inability by us to successfully manage our information systems, or respond effectively to any attack on or interference with our systems, including matters related to system and data security, privacy, reliability, compliance, performance and access, problems related to our systems caused by natural disasters, security breaches or malicious attacks, and any inability of these systems to fulfill their intended business purpose, could impede our ability to record or process orders, manufacture and ship in a timely manner, account for and collect receivables, protect sensitive data of the Company, our customers, our employees, our suppliers and other business partners, comply with our third party obligations of confidentiality and care, or otherwise carry on business in the normal course. Any such events could require costly remediation beyond levels covered by insurance and could cause us to lose customers and/or revenue, including as a result of legal or regulatory claims or proceedings, or damage our reputation, any of which could have a material adverse effect on our business and operating results.
We are also subject to an increasing number of evolving data privacy and security laws and regulations that impose requirements on us. We collect, store, access and otherwise process various types of confidential or sensitive data, including proprietary business information, personal data and other information that is subject to privacy and security laws, regulations and/or customer-imposed controls. Failure to comply with such laws and regulations could result in the imposition of fines, penalties and other costs.
Our inability to attract and retain key personnel, as well as challenges with respect to the management of human capital resources, in a highly competitive industry may adversely affect our business.
Our ongoing success depends on our ability to recruit, retain and develop highly skilled management and key personnel, as well as our ability to effectively manage human capital resources. Competition for talented and skilled individuals in our industry is intense and we may not be able to successfully recruit, train or retain qualified personnel, or to effectively implement successions for existing personnel. If we fail to retain and recruit the necessary personnel or arrange for successors to key personnel, our business could materially suffer.
Increased frequency of weather events could disrupt construction activity and adversely affect the demand for our products.
Demand for our products is primarily driven by commercial construction activity, remodeling and retrofit opportunities, and to a lesser extent, new home starts. Weather is an important variable affecting financial performance as it significantly impacts construction activity. Adverse weather conditions, such as prolonged periods of cold or rain, blizzards, hurricanes and other severe weather patterns, the frequency of which might be affected by climate change, could delay or halt construction and remodeling activity, which could have a negative effect on our business. For example, an unusually severe or prolonged winter can lead to reduced or delayed construction activity which could magnify the seasonal decline in our net sales and earnings during the winter months and hamper the typical seasonal increase in net sales and earnings during the spring months.
The long-term effect of climate change could decrease demand for certain of our products.
Climate change may impact rainfall and water availability in many areas in unpredictable and different ways, which may change the way building owners and municipalities manage drinking, waste and storm water and may lead to new or modified regulations that may impact the market for our products.In certain areas, these changes could lead to a reduction in demand for certain of our products, although it also could increase demand for other of our products.The overall effect of this could be to reduce our sales and addressable market and/or alter our product sales mix in ways that reduce our margins, either of which could adversely impact our results of operations.
The physical impacts of climate change may materially adversely affect our business and financial condition.
The physical impact of climate change on our operations are highly uncertain and could differ amongst the geographic regions of relevant markets and areas of operation. These may include changes in rainfall and storm patterns and intensities, water shortages, changing sea levels and changing temperatures. The impact of climate change may materially and adversely affect the cost, production and financial performance of our operations. Further, any impacts to our business and financial condition as a result of climate change are likely to occur over an extended period of time and are therefore difficult to quantify with any degree of specificity. For example, extreme weather events may result in adverse physical effects on portions of our
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infrastructure, which could disrupt our supply chain and ultimately our business operations. In addition, disruption of transportation and distribution systems could result in reduced operational efficiency and customer service interruption. Climate related events have the potential to disrupt our business, including the business of our suppliers, and may cause us to experience higher attrition, losses and additional costs to resume operations.
Our business and operations, and the operations of our suppliers, business partners and customers, may be adversely affected by future outbreaks of infectious diseases.
Future outbreaks of infectious diseases, including further developments in the COVID pandemic, may result in widespread or localized health crises that adversely affect general commercial activity and the economies and financial markets of the countries and localities in which we operate, sell, and purchases goods and services. Any outbreak of infectious disease poses the risk that we or our employees, contractors, suppliers, customers, transportation providers, and other business partners may be prevented or impaired from conducting ordinary course business activities for an indefinite period of time, either at specific branches or on a broader scale, including due to shutdowns necessitated for the health and well-being of our employees, the employees of our business partners, or shutdowns that may be requested or mandated by governmental authorities. In addition, our suppliers, business partners and customers may also experience similar negative impacts from an outbreak of infectious disease. Global supply chains may be disrupted, causing shortages, which could impact our ability to manufacture or supply our products. Also, we could in the future experience increased compensation expenses associated with employee recruiting and employee retention to the extent employment opportunities multiply post-pandemic, causing the search for and retention of talent to become more competitive. This disruption of our employees, distributors, suppliers and customers may impact our sales and future operating results.
The unpredictable ebbing and flowing of new infectious diseases worldwide may continue to adversely impact our business, operations, suppliers and customers for the foreseeable future. Equally unpredictable are the responses of national and local governments and health authorities in affected regions to reduce community spread and protect employees, which may include mandatory shutdowns or limitations on all or certain types of business operations. The ultimate impact of an infectious disease outbreak on our business, depends on the severity, location and duration of outbreaks, and the actions of government and health official in response to the outbreaks, none of which is predictable at this time.
Financial Risks
Our debt levels could adversely affect our ability to raise additional capital to fund our operations, limit our ability to react to changes in the economy or our industry, inhibit us from making beneficial acquisitions, adversely impact our ability to implement our capital allocation strategy and prevent us from making debt service payments.
As a leveraged company, our ability to generate sufficient cash flow from operations to make scheduled payments on our debt will depend on a range of economic, competitive and business factors, many of which are outside our control. Our business may not generate sufficient cash flow from operations to meet our debt service and other obligations, and currently anticipated cost savings and operating improvements may not be realized on schedule, or at all. If we are unable to meet our expenses and debt service and other obligations, we may need to refinance all or a portion of our indebtedness on or before maturity, sell assets or raise equity. We may not be able to refinance any of our indebtedness, sell assets or raise equity on commercially reasonable terms or at all, which could cause us to default on our obligations and impair our liquidity. Our inability to generate sufficient cash flow to satisfy our debt obligations or to refinance our obligations on commercially reasonable terms would have a material adverse effect on our business, financial condition, results of operations and cash flows.
Our indebtedness could also have other important consequences with respect to our ability to manage and grow our business successfully, including the following:
•it may limit our ability to borrow money for our working capital, capital expenditures, strategic initiatives, acquisitions or other purposes;
•it may make it more difficult for us to satisfy our obligations with respect to our indebtedness, and any failure to comply with the obligations of any of our debt instruments, including restrictive covenants and borrowing conditions, could result in an event of default under our credit agreement and our other indebtedness;
•a portion of our cash flow from operations will be dedicated to the repayment of our indebtedness and so will not be available for other purposes;
•it may limit our flexibility in planning for, or reacting to, changes in our operations or business, or in taking advantage of strategic opportunities;
•at times we may be more highly leveraged than some of our competitors, which may place us at a competitive disadvantage;
•it may make us more vulnerable to downturns in our business or the economy;
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•it may restrict us from making strategic acquisitions or divestitures, introducing new technologies or exploiting business opportunities; and
•along with the financial and other restrictive covenants in the documents governing our indebtedness, among other things, may limit our ability to borrow additional funds, make acquisitions or capital expenditures, acquire or dispose of assets or take certain of the actions mentioned above, or adversely impact our ability to implement our capital allocation strategy (which includes paying dividends on our common stock), any of which could restrict our operations and business plans.
Furthermore, a substantial portion of our indebtedness, including the senior secured credit facilities, bears interest at rates that fluctuate with changes in certain short-term prevailing interest rates, including the London Interbank Offered Rate ("LIBOR"). The United Kingdom’s Financial Conduct Authority announced that after 2021 it would no longer persuade or compel panel banks to submit the rates required to calculate LIBOR. On March 5, 2021, ICE Benchmark Administration (“IBA”) confirmed it would cease publication of 1 Week and 2 Month USD LIBOR settings immediately following the LIBOR publication on December 31, 2021, but it would not cease publication of Overnight, 1, 3, 6 and 12 Month USD LIBOR settings until immediately following the LIBOR publication on June 30, 2023. The extended cessation date for most USD LIBOR tenors will allow for more time for existing legacy USD LIBOR contracts to mature and provide additional time to continue to prepare for the transition from LIBOR.
The Alternative Reference Rates Committee (“ARCC”), which was convened by the Board of Governors of the Federal Reserve and the Federal Reserve Bank of New York, has identified the Secured Overnight Financing Rate (“SOFR”) as the recommended alternative rate for USD LIBOR. The composition and characteristics of SOFR are not the same as those of LIBOR. SOFR is a broad U.S. Treasury repurchase agreement market financing rate that represents overnight secured funding transactions. This means that SOFR is fundamentally different from LIBOR in two key respects. First, SOFR is a secured rate, while LIBOR is an unsecured rate. Second, SOFR is an overnight rate, while LIBOR represents interbank funding over different maturities. As a result, there can be no assurance that SOFR or any alternative reference rate will perform in the same way as LIBOR would have at any time, including, without limitation, as a result of changes in interest and yield rates in the market, market volatility or global or regional economic, financial, political, regulatory, judicial or other events.
The agreement governing our senior secured credit facilities provides that if LIBOR becomes unavailable, or the Financial Conduct Authority determines that LIBOR is not a representative index, then SOFR will automatically replace LIBOR for all purposes of such agreement. Although the consequences of these developments cannot be predicted at this time, should LIBOR, SOFR, or any other alternative reference rate no longer be available, the rates under our variable rate indebtedness could increase and access to capital could be limited. Additionally, we may continue to be subject to risk on outstanding instruments which rely on LIBOR. For example, if a contract or instrument is not transitioned to a new reference rate and LIBOR ceases to exist, we may experience increased interest rate risk. In addition, we may be dependent on third parties to upgrade their systems, software, and other critical functions to assist in our orderly transition from LIBOR. See Item 7A, Quantitative and Qualitative Disclosures About Market Risk for additional information on our debt that is subject to the LIBOR rate.
Also, in spite of the limitations in our credit agreement, we may still incur significantly more debt, which could intensify the risks described above on our business, results and financial condition. For more information about our indebtedness, see Item 8, Note 11, Long-Term Debt.
The agreements governing our financing arrangements impose certain operating and financial restrictions, which could have a material adverse effect on our business, financial condition, results of operations or cash flows.
Our credit agreement contains various covenants that limit or prohibit our ability (subject to certain exceptions), among other things, to:
•incur or guarantee additional indebtedness;
•pay dividends on our capital stock or redeem, repurchase, retire or make distributions in respect of our capital stock or subordinated indebtedness or make other restricted payments;
•make certain loans, acquisitions, capital expenditures or investments;
•sell certain assets, including stock of our subsidiaries;
•enter into sale and leaseback transactions;
•create or incur liens;
•consolidate, merge, sell, transfer or otherwise dispose of all or substantially all of our assets; and
•enter into certain transactions with our affiliates.
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These agreements contain covenants that restrict our ability to take certain actions, such as incurring additional debt, if we are unable to meet defined specified financial ratios, which could result in limiting our long-term growth prospects by hindering our ability to incur future indebtedness or grow through acquisitions. Failure to comply with certain covenants in these agreements could result in a default. For more information, see Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources.
The restrictions contained in the credit agreement could:
•limit our ability to plan for or react to market conditions or meet capital needs or otherwise restrict our activities or business plans;
•restrict our ability to repurchase shares of our common stock and/or adversely impact our ability to implement capital allocation strategy;
•adversely affect our ability to finance our operations, to enter into strategic acquisitions, to fund investments or other capital needs or to engage in other business activities that would be in our interest; and
•limit our access to the cash generated by our subsidiaries.
Upon the occurrence of an event of default under the credit agreement, the lenders could elect to declare all amounts outstanding under the senior secured credit facilities to be immediately due and payable and terminate all commitments to extend further credit. If we were unable to repay those amounts, the lenders under the senior secured credit facilities could proceed against the collateral granted to them to secure the senior secured credit facilities on a first- priority lien basis. If the lenders under the senior secured credit facilities accelerate the repayment of borrowings, such acceleration could have a material adverse effect on our business, financial condition, results of operations or cash flows. For a more detailed description of the limitations on our ability to incur additional indebtedness, see Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations-Liquidity and Capital Resources.
Our goodwill and intangible assets are valued at an amount that is high relative to our total assets and in excess of our stockholders equity.
As of December 31, 2022, our goodwill and intangible assets totaled $777.0 million and $1,009.7 million, respectively, and represent a substantial portion of our assets. These assets result from our acquisitions, representing the excess of cost over the fair value of the tangible net assets we have acquired. We assess at least annually whether there has been impairment in the value of our goodwill and indefinite-lived intangible assets. Significant negative industry or economic trends, disruptions to our business, inability to effectively integrate acquired businesses, unexpected significant changes or planned changes to the use of our assets, changes in the structure of our business, divestitures, market capitalization declines, or increases in associated discount rates may impair our goodwill and other intangible assets. Any determination requiring the impairment of goodwill or intangible assets would negatively affect our results of operations, particularly in the period in which we record any related charges, and financial condition.
Refer to Risks Related to the Merger with Elkay section below for additional considerations.
Our required cash contributions to our pension plans may increase further and we could experience a material change in the funded status of our defined benefit pension plans and the amount recorded in our consolidated balance sheets related to those plans. Additionally, our pension costs could increase in future years.
The funded status of the defined benefit pension plans depends on such factors as asset returns, market interest rates, legislative changes and funding regulations. If the returns on the assets of any of our plans were to decline in future periods, if market interest rates were to decline, if the Pension Benefit Guaranty Corporation ("PBGC") were to require additional contributions to any such plans as a result of acquisitions or if other actuarial assumptions were to be modified, our future required cash contributions and pension costs to such plans could increase. Any such increases could have a material and adverse effect on our business, financial condition, results of operations or cash flows.
The need to make contributions, which may be substantial, to such plans may reduce the cash available to meet our other obligations, including our obligations under our borrowing arrangements or to meet the needs of our business. In addition, the PBGC may terminate our U.S. defined benefit pension plans under limited circumstances, including in the event the PBGC concludes that the risk may increase unreasonably if such plans continue. In the event one of our U.S. defined benefit pension plans is terminated for any reason while it is underfunded, we could be required to make an immediate payment to the PBGC of all or a substantial portion of such plan's underfunding, as calculated by the PBGC based on its own assumptions (which might result in a larger obligation than that based on the assumptions we have used to fund such plan), and the PBGC could place a lien on material amounts of our assets.
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Legal and Compliance Risks
Our failure to comply with government regulations and requirements, third-party certification requirements and policies and standards driven by our customers or other constituencies, including those related to social responsibility, could adversely affect our reputation, business and results of operations.
In addition to complying with laws and applicable government regulations and requirements, prevailing industry standards, competitive pressures and/or our customers may require us to comply with further quality, social responsibility, climate-related or other business policies or standards, before customers and prospective customers commence, or continue, doing business with us. These expectations, policies and standards may be more restrictive than current laws and regulations as well as our own pre-existing policies; they may be customer-driven, established by the industry sectors in which we operate or imposed by third-party organizations or other constituencies.
Our compliance with these policies, standards and third party certification requirements could be costly and could in some cases require us to change the way in which we operate. In addition, if we fail to comply, or if our compliance increases our costs and/or restricts our ability to do business as compared to our competitors that do not adhere to such standards, we could experience an adverse effect on our customer relationships, reputation, operations, cost structure and/or profitability.
Regulatory and legislative developments related to climate change, may materially adversely affect our business and financial condition.
Numerous governmental bodies have introduced or are contemplating legislative and regulatory changes in response to various climate change interest groups and the impact of climate change.Legislation and increased regulation relating to climate change and the transition to a low carbon economy could impose significant costs on us and our suppliers, including costs related to increased energy requirements, capital equipment, environmental monitoring and reporting, and other costs to comply with such regulations. Any future climate change related regulations could also negatively impact our ability to compete with companies situated in areas not subject to such requirements. Given the political significance and uncertainty around the impact of climate change and how it should be addressed, we cannot predict how legislation and regulation will affect our financial condition, operating performance and ability to compete. Furthermore, even without such regulation, increased awareness and any adverse publicity in the global marketplace about impacts on climate change by us could harm our reputation. Any of the foregoing could result in a material adverse effect on our business and financial condition.
We are subject to changes in legislative, regulatory and legal developments involving taxes.
We are subject to U.S. federal and state, and foreign, income, payroll, property, sales and use, value-added, fuel and other types of taxes. Changes in tax rates, enactment of new tax laws, revisions of tax regulations, and claims or litigation with taxing authorities may require significant judgment in determining the appropriate provision and related accruals for these taxes; and as a result, such changes could result in substantially higher taxes and, therefore, could have a significant adverse effect on our results or operations, financial conditions and liquidity.
We may incur significant costs for environmental compliance and/or to address liabilities under environmental laws and regulations, and our reputation may be adversely affected.
Our operations and facilities worldwide are subject to extensive laws and regulations related to pollution and the protection of the environment, health and safety, including those governing, among other things, emissions to air, discharges to water, the generation, handling, storage, treatment and disposal of hazardous wastes and other materials, and the remediation of contaminated sites. A failure by us to comply with applicable requirements or the permits required for our operations could result in civil or criminal fines, penalties, enforcement actions, third-party claims for property damage and personal injury, requirements to clean up property or to pay for the costs of cleanup or regulatory or judicial orders enjoining or curtailing operations or requiring corrective measures, including the installation of pollution control equipment or remedial actions, as well as cause damage to our reputation.
Some environmental laws and regulations impose requirements to investigate and remediate contamination on present and former owners and operators of facilities and sites, and on potentially responsible parties ("PRPs") for sites to which such parties may have sent waste for disposal. Such liability can be imposed without regard to fault and, under certain circumstances, may be joint and several, resulting in one PRP being held responsible for the entire obligation. Liability may also include damages to natural resources. On occasion we are involved in such investigations and/or cleanup, and also have been or could be named as a PRP in environmental matters.
The discovery of additional contamination, including at acquired facilities, the imposition of more stringent environmental, health and safety laws and regulations, including cleanup requirements, disputes with our insurers or the insolvency of other responsible parties could require us to incur significant capital expenditures or operating costs materially in excess of our accruals. Future investigations we undertake may lead to discoveries of contamination that must be remediated, and decisions to close facilities may trigger remediation requirements that are not currently applicable. We may also face
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liability for alleged personal injury or property damage due to exposure to hazardous substances used or disposed of by us, contained within our current or former products, or present in the soil or groundwater at our current or former facilities. We could incur significant costs in connection with such liabilities. See Item 8, Note 18, Commitments and Contingencies for additional information.
Certain subsidiaries are subject to litigation, including numerous asbestos and product liability claims, which could adversely affect our business, reputation, financial condition, results of operations or cash flows.
Certain subsidiaries are co-defendants in various lawsuits in a number of U.S. jurisdictions alleging personal injury as a result of exposure to asbestos that was used in certain components of our products. The uncertainties of litigation and the uncertainties related to insurance and indemnification coverage make it difficult to accurately predict the ultimate financial effect of these claims. If our insurance or indemnification coverage is not adequate to cover our potential financial exposure, our insurers dispute their obligations to provider coverage or the actual number or value of asbestos-related claims differs materially from our existing estimates, we could incur material costs that could have a material adverse effect on our business, financial condition, results of operations or cash flows.
In addition, we may be subject to product liability claims if the use of our products, or the exposure to our products or their raw materials, is alleged to have resulted in injury or other adverse effects. We currently maintain product liability insurance coverage but we cannot assure that we will be able to obtain such insurance on commercially reasonable terms in the future, if at all, or that any such insurance will provide adequate coverage against claims. Product liability claims can be expensive to defend and can divert the attention of management and other personnel for long periods of time, regardless of the ultimate outcome. In addition, our business depends on the strong brand reputation we have developed; if this reputation is damaged as a result of a product liability claim, it may be difficult to maintain our pricing positions and market share with respect to our products. Therefore, an unsuccessful product liability defense could have a material adverse effect on our business, financial condition, results of operations or cash flows. See Item 8, Note 18, Commitments and Contingencies for additional details.
Risks Related to the Spin-Off Transaction
If the Spin-Off Transaction does not qualify as a tax-free reorganization and distribution for purposes of U.S. federal income taxes, we may be subject to substantial additional taxes.
In connection with the Spin-Off Transaction, we obtained a tax opinion and a private letter ruling from the IRS (“IRS Ruling”) as to certain aspects relevant to treatment of the various steps of the transaction as tax-free to us and our shareholders for U.S. federal income tax purposes. The tax opinion and IRS Ruling are based on certain factual representations and assumptions and covenants of the parties to the transaction. If any of the factual representations and assumptions are materially false or incorrect, or one or more of the relevant covenants are breached, the validity of the tax opinion and IRS Ruling could be impaired. Furthermore, a tax opinion only represents counsel’s best legal judgment, and is not binding on the IRS or the courts, which may disagree with the opinion.
If the IRS determines that some or all of the transactions comprising the Spin-Off Transaction are taxable to us, we and our shareholders at the time of the transaction could be subject to significant additional U.S federal and state income taxes. In certain circumstances, we would be entitled to indemnity from Regal Rexnord Corporation for all or a portion of such additional tax, but there is no assurance that Regal Rexnord Corporation would have the ability to satisfy any such indemnity obligation.
As a result of the Spin-Off Transaction, we are subject to certain limitations on Company actions for two years, including certain business combinations, that might otherwise be advantageous.
Under relevant agreements governing the Spin-Off Transaction, we are prohibited from taking certain actions during the two-year period following the closing that could cause aspects of the Spin-Off Transaction to fail to qualify for their intended tax treatment. If we breach or are deemed to have breached these restrictions, the tax-free treatment of some or all of the Spin-Off Transaction could be impaired, and we could be subject to substantial additional U.S. federal and state income taxes. These restrictions might interfere with our current business and prevent us from taking advantage of opportunities that might be advantageous.
Risks Related to the Merger with Elkay
We recorded substantial goodwill and other intangible assets as a result of the Merger that could become impaired and result in material non-cash charges to our results of operations in the future.
We account for the Merger as an acquisition of a business in accordance with GAAP. Under the acquisition method of accounting, the assets and liabilities of Elkay and its subsidiaries have been recorded, as of the completion of the Merger, at their respective fair values. Our reported financial condition and results of operations for periods after completion of the Merger reflect Elkay’s balances and results after completion of the Merger but have not been restated retroactively to reflect the
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historical financial position or results of operations of Elkay and its subsidiaries for periods prior to the Merger. Under the acquisition method of accounting, the total purchase price was allocated to Elkay’s tangible assets and liabilities and identifiable intangible assets based on their fair values as of the date of completion of the Merger. The excess of the purchase price over those fair values, if any, was recorded as goodwill. To the extent the value of goodwill or intangibles, if any, becomes impaired in the future, we may be required to incur material non-cash charges relating to such impairment. Our operating results may be significantly impacted from both the impairment and the underlying trends in the business that triggered the impairment.
We may be unable to successfully integrate Elkay’s business into our business or achieve the anticipated benefits of the Merger.
The success of the Merger depends, in part, on our ability to realize the anticipated benefits and cost savings from adding Elkay’s businesses, and we cannot assure successful integration or realization of the anticipated benefits of the Merger. Potential difficulties that may be encountered in the integration process which may result in Zurn Elkay performing differently than expected include, among others:
•the inability to successfully integrate Elkay in a manner that permits the achievement of full revenue, expected cash flows and cost savings anticipated from the Merger;
•not realizing anticipated synergies;
•integrating personnel from Elkay and the loss of key employees;
•potential unknown liabilities and unforeseen expenses;
•integrating relationships with customers, vendors and business partners;
•performance shortfalls as a result of the diversion of management’s attention caused by completing the Merger and integrating Elkay’s operations; and
•the disruption of, or the loss of momentum in, our ongoing business or inconsistencies in standards, controls, procedures and policies.
Our results may suffer if we do not effectively manage our expanded operations following the Merger.
Following the Merger, the size of our business has increased significantly. Our future success will depend, in part, on our ability to manage this expanded business, resulting in risks and uncertainties, including the need to efficiently and timely integrate the operations and business of Elkay, to combine systems and management controls, and to integrate relationships with customers, vendors and business partners.
Sales of substantial amounts of the Zurn Elkay Common Stock in the open market by the former Elkay stockholders could depress the trading price of our common stock.
The former Elkay stockholders may wish to dispose of some or all of the Zurn Elkay Common Stock that they received in the Merger. These sales may adversely affect the trading price of our Common Stock. Certain of these stockholders, who received Zurn Elkay shares in the Merger aggregating approximately 22% of our outstanding common stock as of December 31, 2022, agreed not to sell or transfer their shares, subject to certain exceptions, prior to December 31, 2023.
Certain former stockholders of Elkay have registration rights, the exercise of which could adversely affect the market price of our Common Stock.
In connection with the Merger, the Company and certain stockholders of Elkay entered into a Registration Rights Agreement, pursuant to which such stockholders have a right to demand registration of one public offering within the first three years after the closing of the Merger, subject to certain minimum and maximum thresholds and other customary conditions. The existence and potential or actual exercise of such rights could adversely impact the market price of our Common Stock.
ITEM 1B. UNRESOLVED STAFF COMMENTS.
None.
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ITEM 2. PROPERTIES.
As of December 31, 2022, we had 40 principal manufacturing and warehouse facilities as set forth below:
Total Square Feet
Location Number of Facilities Owned Leased
USA
International
United Arab Emirates 1 — 6,000
We believe our principal manufacturing and warehouse facilities are suitable for our operations and provide sufficient capacity for our current and future anticipated needs.
ITEM 3. LEGAL PROCEEDINGS.
Information with respect to our legal proceedings is contained in Item 8, Note 18, Commitments and Contingencies.
ITEM 4. MINE SAFETY DISCLOSURES.
Not applicable.
* * *
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Information about our Executive Officers
The following table sets forth information concerning our executive officers as of the date of this report:
Name Age Position(s) In Current Position(s) since
Todd A. Adams 52 Chairman of the Board and Chief Executive Officer 2020
Mark W. Peterson 51 Senior Vice President and Chief Financial Officer 2011
Sudhanshu Chhabra 56 Vice President - Zurn Elkay Business Systems 2018
Jeffrey J. LaValle 44 Vice President, General Counsel and Secretary 2022
Michael D. Troutman 56 Chief Information Officer 2007
Craig G. Wehr 58 Chief Operating Officer 2022
Information about the business experience of our executive officers during at least the past five fiscal years is as follows:
Todd A. Adams became our Chairman of the Board in 2020 and Chief Executive Officer in 2009. Mr. Adams joined us in 2004 as Vice President, Treasurer and Controller; he has also served as Senior Vice President and Chief Financial Officer and as President of the Water Management platform.
Mark W. Peterson became our Senior Vice President and Chief Financial Officer in 2011. Mr. Peterson previously served as Vice President and Controller of Zurn Elkay and as a divisional CFO. Mr. Peterson is a certified public accountant.
Sudhanshu Chhabra became Vice President – Zurn Elkay Business Systems in 2018.Mr. Chhabra was a sector President and Regional Executive - India from 2016 to 2018 after having joined Zurn Elkay in 2014 as President & Regional Executive for India and the Middle East. Prior to joining Zurn Elkay, Mr. Chhabra served in various positions with Danaher Corporation, a diversified manufacturer, most recently as President – Asia, Gilbarco Veeder-Root Inc. and as Managing Director – India, Gilbarco Veeder-Root Inc.
Jeffrey J. LaValle became our Vice President, General Counsel and Secretary in 2022. Mr. LaValle previously served as our Assistant General Counsel since 2013. Prior to joining Zurn Elkay, Mr. LaValle was a partner at Quarles & Brady LLP, an AmLaw 200 full-service law firm.
Michael D. Troutman became Zurn Elkay's Chief Information Officer at Zurn Elkay in 2007 and an executive officer in 2017. Before joining Zurn Elkay, he was with AT&T, Lucent, and Agere Systems in various senior information technology positions implementing global industry leading solutions and processes.
Craig G. Wehr became Chief Operating Officer of Zurn Elkay in 2022. Mr. Wehr previously served in various positions with Zurn Elkay since 1993, including as President of Zurn and Vice President / General Manager of Zurn Specification Drain Operations.
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PART II
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.
Shares of our common stock trade on the New York Stock Exchange under the ticker symbol “ZWS”. As of February 10, 2023, there were 33 holders of record of our common stock. We believe the number of beneficial owners of our common stock exceeds 25,000.
Dividend Policy
On February 3, 2022 and May 5, 2022 our Board of Directors declared a quarterly cash dividend on our common stock of $0.03 per share. On July 21, 2022, October 20, 2022, and February 1, 2023 our Board of Directors declared a quarterly cash dividend on our common stock of $0.07 per share. The decision whether to continue to pay dividends in the future will be made by our Board of Directors in light of conditions then existing, including factors such as our results of operations, financial condition and requirements, business conditions and covenants under any applicable borrowing agreements and other contractual arrangements.
Issuer Purchases of Equity Securities
In fiscal 2015, our Board of Directors approved a stock repurchase program (the "Repurchase Program") authorizing the repurchase of up to $200.0 million of our common stock from time to time on the open market or in privately negotiated transactions. On January 27, 2020, our Board of Directors approved increasing the remaining share repurchase authority under the Repurchase Program to $300.0 million. The Repurchase Program does not require us to acquire any particular amount of common stock and does not specify the timing of purchases or the prices to be paid; however, the program will continue until the maximum amount of dollars authorized has been expended or until it is modified or terminated by the Board. During the three and twelve months ended December 31, 2022, we repurchased approximately $24.7 million of our common stock. The remaining repurchase authority under the Repurchase Program at December 31, 2022 was $138.1 million.
Effective February 8, 2023, the Board approved an increase in the remaining share repurchase authority under the Repurchase Program to $500.0 million.
ISSUER PURCHASES OF EQUITY SECURITIES
Period
(1)See explanation of the Repurchase Program above.
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Performance Graph
Set forth below is a line graph comparing the cumulative total shareholder return of our common stock with the Standard & Poor's (the "S&P") 500 Index and the S&P 1500 Industrials Index for the year ended December 31, 2022, the year ended December 31, 2021, the Transition Period ended December 31, 2020, and our preceding four full fiscal years. The graph assumes the value of the investment in our common stock and each index was $100 on March 31, 2017, and that all dividends were reinvested. The shareholder return shown on the graph below is not necessarily indicative of future performance and the indices included do not necessarily reflect management's opinion that such indices are an appropriate measure of the relative performance of Zurn Elkay's stock.
(1)Zurn Elkay Water Solutions Corporation historical prices were adjusted to reflect the impact of the Spin-Off Transaction that was completed on October 4, 2021.
ITEM 6.
[Reserved]
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ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
The following discussion of results of operations and financial condition includes periods prior to the acquisitions ofthe assets of Hadrian Manufacturing Inc., together with the stock of Hadrian Inc. (Hadrian Inc. and Hadrian Manufacturing Inc. are collectively referred to as "Hadrian"), the assets of Advance Technology Solutions, LLC (d/b/a ATS GREASEwatch) ("ATS GREASEwatch"), and the assets of Wade Drains ("Wade"), and the acquisition of Elkay in the Elkay merger. Our financial performance includes the Hadrian business subsequent to December 11, 2020, the ATS GREASEwatch business subsequent to April 16, 2021, the Wade business subsequent to November 17, 2021, and the Elkay business subsequent to July 1, 2022, the respective dates of their acquisitions. Accordingly, the discussion and analysis does not reflect any impact of Hadrian, ATS GREASEwatch, Wade, or Elkay transactions prior to the respective closing dates.
We completed the spin-off of our Process & Motion Control platform ("PMC") on October 4, 2021 in the Spin-Off Transaction, and, accordingly, the results of operations and financial condition associated with PMC have been reclassified to discontinued operations for all periods presented. As a result, the following discussion of results of operations and financial condition is centered on the Zurn business excluding PMC. The consolidated statements of cash flows for the year ended December 31, 2022, the year ended December 31, 2021, and the nine-month Transition Period ended December 31, 2020 have not been adjusted to separately disclose cash flows related to the discontinued operations. See Item 8, Note 4, Discontinued Operations for additional information on cash flows associated with the discontinued operations.
You should read the following discussion of our financial condition and results of operations together with Item 8, Financial Statements and Supplementary Data. Following the end of our fiscal year ended March 31, 2020, we transitioned to a December 31 fiscal year-end. The nine-month period from April 1, 2020, to December 31, 2020 is referred to as the Transition Period. Fiscal years prior to and including fiscal year 2020 ended on March 31 of each calendar year.
This discussion contains forward-looking statements and involves numerous risks and uncertainties, including, but not limited to, those described in the "Risk Factors" in Item 1A of this report. Actual results may differ materially from those contained in any forward-looking statements. See also "Cautionary Notice Regarding Forward-Looking Statements" found elsewhere in this report.
The information contained in this section is provided as a supplement to the consolidated financial statements and the related notes included elsewhere in this report to help provide an understanding of our financial condition, changes in our financial condition and results of our operations. This section is organized as follows:
Company Overview. This section provides a general description of our business.
Financial Statement Presentation. This section provides a brief description of certain items and accounting policies that appear in our financial statements and general factors that impact these items.
Critical Accounting Estimates. This section discusses the accounting policies and estimates that we consider to be important to our financial condition and results of operations and that require significant judgment and estimates by management in their application.
Recent Accounting Pronouncements. This section cites to the discussion of new or revised accounting pronouncements and standards in Item 8, Note 2, Significant Accounting Policies of our consolidated financial statements.
Overview of Recent Developments. This section provides a description of the recent events impacting our results of operations.
Results of Operations. This section provides an analysis of our results of operations. As noted above, following the end of fiscal 2020, we transitioned to a December 31 fiscal year-end and accordingly we reported the nine-month period from April 1, 2020, to December 31, 2020 as a Transition Period. In providing analysis of the results of our operations, we have provided a comparison of our year ended December 31, 2022 to the year ended December 31, 2021, along with a comparison of the year ended December 31, 2021 to the year ended December 31, 2020.
Non-GAAP Financial Measures. This section provides an explanation of certain financial measures we use that are not in accordance with U.S. generally accepted accounting principles ("GAAP").
Covenant Compliance. This section provides a discussion of certain restrictive covenants in our credit agreement.
Liquidity and Capital Resources. This section provides an analysis of our cash flows and year-to-year comparisons for our years ended December 31, 2022, 2021, and 2020, as well as a discussion of our indebtedness and its potential effects on our liquidity.
Tabular Disclosure of Contractual Obligations. This section provides a discussion of our commitments as of December 31, 2022.
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Quantitative and Qualitative Disclosures about Market Risk. This section discusses our exposure to potential losses arising from adverse changes in interest rates and foreign exchange rates.
Company Overview
We are a growth-oriented, pure-play water management business that designs, procures, manufactures, and markets what we believe is the broadest sustainable product portfolio of specification-driven water management solutions to improve health, human safety and the environment. Our product portfolio includes professional grade water safety and control products, flow system products, hygienic and environmental products, and drinking water products for public and private spaces that deliver superior value to building owners, positively impact the environment and human hygiene and reduce product installation time. Zurn Elkay's heritage of innovation and specification has allowed us to provide highly-engineered, mission-critical solutions to customers for decades and affords us the privilege of having long-term, valued relationships with market leaders. We operate in a disciplined way and the Zurn Elkay Business System (“ZEBS”) is our operating philosophy. Grounded in the spirit of continuous improvement, ZEBS creates a scalable, process-based framework that focuses on driving superior customer satisfaction and financial results by targeting world-class operating performance throughout all aspects of our business.
Refer to Item 1, Business for additional information.
Financial Statement Presentation
The following paragraphs provide a brief description of certain items and accounting policies that appear in our financial statements and general factors that impact these items.
Net sales. Net sales represent gross sales less deductions taken for sales returns and allowances and incentive rebate programs.
Cost of sales. Cost of sales includes all costs of manufacturing required to bring a product to a ready for sale condition. Such costs include direct and indirect materials, direct and indirect labor costs, including fringe benefits, supplies, utilities, depreciation, freight and shipping, insurance, pension and postretirement benefits, information technology costs and other manufacturing related costs.
The largest component of our cost of sales is cost of materials, which represented approximately 35% of net sales in the year ended December 31, 2022. We purchase a broad range of materials and components throughout the world in connection with our manufacturing activities. Major raw materials and components include brass, castings, copper, zinc, forgings, plate steel, high-performance engineered plastic and resin. We have a strategic sourcing program that is designed to significantly reduce the number of direct and indirect suppliers we use and to lower the cost of purchased materials.
Selling, general and administrative expenses. Selling, general and administrative expenses primarily includes sales and marketing, finance and administration, engineering and technical services and warehousing. Our major cost elements include salary and wages, fringe benefits, insurance, depreciation, advertising, travel and information technology costs.
Critical Accounting Estimates
The methods, estimates and judgments we use in applying our critical accounting policies have a significant impact on the results we report in our consolidated financial statements. We evaluate our estimates and judgments on an on-going basis. We base our estimates on historical experience and on assumptions that we believe to be reasonable under the circumstances. Our experience and assumptions form the basis for our judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may vary from what we anticipate and different assumptions or estimates about the future could change our reported results. Within the context of these critical accounting policies, we are not currently aware of any reasonably likely event that would result in materially different amounts being reported.
We believe the following accounting policies are the most critical to us in that they are important to our financial statements and they require difficult, subjective and/or complex judgments in the preparation of our consolidated financial statements. For additional information, see Item 8, Note 2, Significant Accounting Policies, to our consolidated financial statements.
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Revenue recognition. Under Accounting Standards Codification ("ASC") 606, Revenue from Contracts with Customers ("ASC 606"), a performance obligation is a promise in a contract to transfer a distinct good or service to the customer, and is the unit of account. A contract’s transaction price is allocated to each distinct performance obligation and revenue is recognized when obligations under the terms of a contract with the customer are satisfied. For our product sales, revenue is recognized at a point-in-time when control of the product is transferred to the customer, which generally occurs when the product is shipped from our manufacturing facility to the customer. When contracts include multiple products to be delivered to the customer, generally each product is separately priced and is determined to be distinct within the context of the contract. Other than a standard assurance-type warranty that the product will conform to agreed-upon specifications, there are generally no other significant post-shipment obligations. The expected costs associated with standard warranties is recognized as an expense when the products are sold.
When the contract provides the customer the right to return eligible products or when the customer is part of a sales rebate program, we reduce revenue at the point of sale using current facts and historical experience by using an estimate for expected product returns and rebates associated with the transaction. These estimates are adjusted at the earlier of when the most likely amount of consideration that is expected to be received changes or when the consideration becomes fixed. Accordingly, an increase or decrease to revenue is recognized at that time.
Sales and other taxes collected concurrent with revenue-producing activities are excluded from revenue. We have elected to recognize the cost for freight and shipping when control of products has transferred to the customer as a component of cost of sales in the consolidated statements of operations. We classify shipping and handling fees billed to our customers as net sales and the corresponding costs are classified as cost of sales in the consolidated statements of operations.
Receivables. Receivables are stated net of allowances for doubtful accounts of $1.4 million at December 31, 2022 and $1.2 million at December 31, 2021. We assesses the collectability of customer receivables based on the credit worthiness of a customer as determined by credit checks and analysis, as well as the customer’s payment history. In determining the allowance for doubtful accounts, we also consider various factors including the aging of customer accounts and historical write-offs. In addition, we monitor other risk factors, including forward-looking information when establishing adequate allowances for doubtful accounts, which reflects the current estimate of credit losses expected to be incurred over the life of the receivables. Generally, advance payment is not required. Allowances for doubtful accounts established are recorded within selling, general and administrative expenses within the consolidated statements of operations.
Inventory. Inventories are stated at the lower of cost or market. Market is determined based on estimated net realizable values. Approximately 89% and 84% of our total inventories as of December 31, 2022 and December 31, 2021, respectively, were valued using the "last-in, first-out" (LIFO) method. All remaining inventories are valued using the "first-in, first-out" (FIFO) method.
In some cases we have determined a certain portion of our inventories are excess or obsolete. In those cases we write down the value of those inventories to their net realizable value based upon assumptions about future demand and market conditions. If actual market conditions are less favorable than those projected by management, additional inventory write-downs may be required. The total write-down of inventories charged to expense was $0.8 million, $0.9 million and $1.5 million, during the year ended December 31, 2022, the year ended December 31, 2021, and the nine-month Transition Period ended December 31, 2020, respectively.
Purchase accounting and business combinations. Assets acquired and the liabilities assumed as part of a business combination are recognized separately from goodwill at their acquisition date fair values. Goodwill as of the acquisition date is measured as the excess of consideration transferred over the net of the acquisition date fair values of the assets acquired and the liabilities assumed. We review and consider input from outside specialists, if and when appropriate to develop discount rates, and use estimates and assumptions about the future performance of the business to accurately value assets acquired and liabilities assumed at the acquisition date. We may refine these estimates during the measurement period, which may be up to one year from the acquisition date. As a result, during the measurement period, we record adjustments to the assets acquired and liabilities assumed with the corresponding offset recorded to goodwill. Upon the conclusion of the measurement period or final determination of the values of the assets acquired or liabilities assumed, whichever comes first, any subsequent adjustments are recorded in our consolidated statements of operations.
Impairment of intangible assets and tangible fixed assets. The carrying value of long-lived assets, including amortizable intangible assets and tangible fixed assets, are evaluated for impairment whenever events or changes in circumstances indicate that the related carrying amounts may not be recoverable. Impairment of amortizable intangible assets and tangible fixed assets is generally determined by comparing projected undiscounted cash flows to be generated by the asset, or group of assets, to its carrying value. If impairment is identified, a loss is recorded equal to the excess of the asset's net book value over its fair value, and the cost basis is adjusted. Determination of the fair value requires various estimates including internal cash flow estimates generated from the asset, quoted market prices and appraisals as appropriate to determine fair
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value. Actual results could vary from these estimates. During the year ended December 31, 2022, the year ended December 31, 2021, and the nine-month Transition Period ended December 31, 2020, no impairment losses were recognized.
Goodwill, trademarks and certain tradenames have indefinite lives and are not amortized. However, the goodwill and intangible assets are tested annually for impairment, and may be tested more frequently if any triggering events occur that would reduce the recoverability of the asset. In conducting the annual impairment test for goodwill, we have the option to first assess qualitative factors to determine whether it is more likely than not (> 50% likelihood) the fair value of any reporting unit is less than its carrying amount. If a qualitative assessment determines an impairment is more likely than not, we are required to perform a quantitative impairment test. Otherwise, no further analysis is required. Alternatively, we may elect to proceed directly to the quantitative impairment test. In conducting a qualitative assessment, we use a discounted cash flow methodology based on future business projections and a market value approach (guideline public company comparables). We perform our goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount. If the carrying amount exceeds the fair value of the reporting unit, an impairment charge is recognized for the amount by which the carrying amount exceeds the reporting unit's fair value up to the amount of the recorded goodwill.
During the fourth quarter of the year ended December 31, 2022, we completed our annual goodwill impairment test and elected to perform a qualitative assessment. No goodwill impairment charges were recorded during the year ended December 31, 2022, the year ended December 31, 2021, or the nine-month Transition Period ended December 31, 2020.
Retirement benefits. We have significant pension and post-retirement benefit income and expense and assets/liabilities that are developed from actuarial valuations. These valuations include key assumptions regarding discount rates, expected return on plan assets, mortality rates and the current health care cost trend rate. We consider current market conditions in selecting these assumptions. Changes in the related pension and post-retirement benefit income/costs or assets/liabilities may occur in the future due to changes in the assumptions and changes in asset values.
We recognize the net actuarial gains or losses in excess of unrecognized gain or loss exceeding 10 percent of the greater of the market-related value of plan assets or the plan's projected benefit obligation at re-measurement (the "corridor") in our consolidated statements of operations during the fourth quarter of each fiscal year (or upon any re-measurement date). During the year ended December 31, 2022, the year ended December 31, 2021, and the nine-month Transition Period ended December 31, 2020, we recognized non-cash actuarial gain (loss) from continuing operations of $1.9 million, $1.2 million, and $(0.3) million, respectively, in connection with re-measurements of our plans. Net periodic benefit costs recorded on a quarterly basis are primarily comprised of service and interest cost, amortization of unrecognized prior service cost and the expected return on plan assets. See Item 8, Note 16, Retirement Benefits for additional information.
The obligation for postretirement benefits other than pension also is actuarially determined and is affected by assumptions including the discount rate and expected future increase in per capita costs of covered postretirement health care benefits. Changes in the discount rate and differences between actual and assumed per capita health care costs may affect the recorded amount of the expense in future periods.
Income taxes. We are subject to income taxes in the United States and numerous foreign jurisdictions. Significant judgment is required in determining our worldwide provision for income taxes and recording the related deferred tax assets and liabilities.
We assess our income tax positions and record tax liabilities for all years subject to examination based upon management’s evaluation of the facts and circumstances and information available at the reporting dates. For those income tax positions where it is more-likely-than-not, based on technical merits, that a tax benefit will be sustained upon the conclusion of an examination, we have recorded the largest amount of tax benefit having a cumulatively greater than 50% likelihood of being realized upon ultimate settlement with the applicable taxing authority, assuming that it has full knowledge of all relevant information. For those tax positions which do not meet the more-likely-than-not threshold regarding the ultimate realization of the related tax benefit, no tax benefit has been recorded in the financial statements. In addition, we provide for interest and penalties, as applicable, and record such amounts as a component of the overall income tax provision. As of December 31, 2022 and 2021, our liability for unrecognized tax benefits was $5.5 million and $5.9 million, respectively.
We recognize deferred tax assets and liabilities based on the differences between the financial statement carrying amounts and the tax bases of assets and liabilities, net operating losses (“NOL’s”), tax credit and other carryforwards. We regularly review our deferred tax assets for recoverability and establish a valuation allowance based on historical losses, projected future taxable income and the expected timing of the reversals of existing temporary differences. As a result of this review, we established a full valuation allowance against U.S. federal and state capital loss carryforwards, as well as certain state tax credit carryforwards, and continue to maintain a partial valuation allowance against certain foreign NOL carryforwards and other related deferred tax assets, as well as certain U.S. state NOL carryforwards. As of December 31, 2022 and 2021, valuation allowances of $32.2 million and $35.1 million, respectively, were recorded against our deferred tax assets. See Item 8 Note 17, Income Taxes for additional information.
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Commitments and Contingencies. We are subject to proceedings, lawsuits and other claims related to environmental, labor, product and other matters. We are required to assess the likelihood of any adverse judgments or outcomes to these matters as well as potential ranges of probable losses. We determine the amount of accruals needed, if any, for each individual issue based on our professional knowledge and experience and discussions with legal counsel. The required accruals may change in the future due to new developments in each matter, the ultimate resolution of each matter or changes in approach, such as change in strategy.
Accruals are recorded on our consolidated balance sheets to reflect our contractual liabilities relating to warranty commitments to our customers. We provide warranty coverage at various lengths and terms to our customers depending on standard offerings and negotiated contractual agreements. We accrue an estimate for warranty expense at the time of sale based on historical warranty return rates and repair costs. Should future warranty experience differ materially from our historical experience, we may be required to record additional warranty accruals which could have a material adverse effect on our results of operations in the period in which these additional accruals are required.
As noted in Item 8, Note 18, Commitments and Contingencies, certain subsidiaries are subject to asbestos litigation. As a result, we have recorded a liability for pending and potential future asbestos claims, as well as a receivable for insurance coverage of such liability. The valuation of our potential asbestos liability was developed from actuarial studies based on the number and severity of future asbestos claims, future settlement costs, and the effectiveness of defense strategies and settlement initiatives. There are inherent uncertainties involved in estimating the number of future asbestos claims, future settlement costs, and the effectiveness of defense strategies and settlement initiatives.As a result, actual liability could differ from the estimate described herein and could be substantial.
Our receivable for insurance coverage was developed by considering our experience in asbestos litigation, the insurance payments made to date by our insurance carriers, existing insurance policies, the industry ratings of the insurers and the advice of insurance coverage counsel with respect to applicable insurance coverage law relating to the terms and conditions of those policies. As of December 31, 2022, the receivable recorded corresponds to the amount of this potential asbestos liability that we believe is probable to be covered by available insurance. However, there is no assurance our current insurance coverage will ultimately be available or that this asbestos liability will not ultimately exceed our coverage limits. Factors that could cause a decrease in the amount of available coverage or create gaps in coverage include: changes in law governing the policies, potential disputes and settlements with the carriers regarding the scope of coverage, and insolvencies of one or more of our carriers.
Recent Accounting Pronouncements
See Item 8, Note 2, Significant Accounting Policies regarding recent accounting pronouncements.
Overview of Recent Developments
Elkay Merger
On July 1, 2022, we completed the Elkay Merger for a preliminary purchase price of $1,462.9 million. Elkay, a market leader of drinking water solutions and commercial sinks, complements our existing product portfolio. The preliminary purchase price includes $1,417.0 million of our common stock based on the closing stock price of $27.48 on July 1, 2022, and $45.9 million of net cash payments for the repayment of Elkay's term loan and Elkay's transaction related costs outstanding that were in excess of Elkay's cash and cash equivalents at the time of closing. Pursuant to the Merger Agreement, we issued 51,564,524 shares of our common stock, which represented approximately 29% of our outstanding common shares immediately following the Merger. The total number of shares of our common stock issued at closing was preliminary and subject to change upon finalization of customary post-closing adjustments with respect to cash, indebtedness and working capital. We expect that approximately 186,000 of these shares will be returned to us in the first half of calendar year 2023 as a result of lower working capital and cash balances at closing compared to targets stipulated in the Merger Agreement. We incurred transaction-related costs of approximately $33.7 million for the year ended December 31, 2022. These costs were associated with legal and professional services and were recognized as selling, general and administrative expenses in our consolidated statements of operations.
See Item 8, Note 3, Acquisitions for more information.
Discontinued Operations
During the year ended December 31, 2021, we completed the spin-off of our PMC platform. The operating results of PMC are reported as discontinued operations in our consolidated statements of operations for all periods presented, as the Spin-Off Transaction represented a strategic shift that had a major impact on our operations and financial results. During the year ended December 31, 2022, we received $35.0 million from Regal Rexnord Corporation as a result of the final working capital and cash balances at closing exceeding the targets stipulated in the Spin-Off Transaction agreement.
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The major components of the Income from discontinued operations, net of tax presented in the consolidated statements of operations during the year ended December 31, 2022, the year ended December 31, 2021, and the nine-month Transition Period ended December 31, 2020 are included in the table below (in millions):
Year Ended (1) Year Ended (2) Nine-Month Transition Period Ended
Selling, general and administrative expenses (2.9) 260.2 168.0
Restructuring and other similar charges — 1.9 12.9
Amortization of intangible assets — 9.9 10.1
Interest expense, net — 4.1 3.3
Actuarial loss on pension and postretirement benefit obligations — 4.8 1.3
Other non-operating income, net — (5.6) (6.4)
Income from discontinued operations before income tax 2.9 99.1 109.2
Income tax (provision) benefit 1.8 (28.0) (25.8)
Equity method investment income — 0.3 0.2
Non-controlling interest income — (0.2) (0.4)
Income from discontinued operations, net of tax $ 4.7 $ 71.2 $ 83.2
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(1)Results of operations for the year ended December 31, 2022 includes the reversal of certain accruals as a result of costs we are obligated to indemnify Regal Rexnord Corporation for being lower than original estimates.
(2)Results of operations during the year ended December 31, 2021 reflect the period from January 1, 2021 through October 4, 2021, the date on which the Spin-Off Transaction of PMC was completed.
During the fiscal year ended March 31, 2019, we completed the sale of our VAG business, which was previously included in our Water Management platform. The sale agreement provided for contingent consideration based on Earn-out EBITDA, as defined in the sale agreement. During the year ended December 31, 2021, we received a $4.2 million cash payment as a result of the VAG business performance in its fiscal year ended March 31, 2021, which represented the final period of the earn-out, which was recorded in income from discontinued operations, net of tax in our condensed consolidated statements of operations.
See Item 8, Note 4, Discontinued Operations for more information.
Restructuring and Other Similar Costs
During the year ended December 31, 2022, we continued to execute various restructuring actions. These initiatives were intended to drive efficiencies and reduce operating costs while also modifying our footprint to reflect changes in the markets we serve, the impact of acquisitions on our overall manufacturing capacity and the refinement of our overall product portfolio. These restructuring actions primarily resulted in workforce reductions, lease termination costs, and other facility rationalization costs. We expect to continue executing similar initiatives to optimize our operating margin and manufacturing footprint. As such, we expect further expenses related to workforce reductions, potential impairment of assets, lease termination costs, and other facility rationalization costs.
We recorded restructuring charges of $15.4 million, $3.7 million and $1.7 million for the year ended December 31, 2022, the year ended December 31, 2021, and the nine-month Transition Period ended December 31, 2020, respectively. See Item 8, Note 5, Restructuring and Other Similar Costs for more information.
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Results of Operations
Year Ended December 31, 2022 Compared with the Year Ended December 31, 2021
Net sales
(Dollars in Millions)
Year Ended
Net sales were $1,281.8 million for the year ended December 31, 2022, a 40.7% increase year over year. Excluding a 31% increase in sales associated with the Elkay merger and prior year acquisition of Wade and a 1% decrease in sales associated with foreign currency translation, core sales increased 11% year over year as nearly all of our product categories contributed to the sales growth.
Income from operations
(Dollars in Millions)
Year Ended
Income from operations was $107.1 million for the year ended December 31, 2022, or 8.4% of net sales, compared to income from operations of $107.0 million, or 11.7% of net sales for the year ended December 31, 2021. The year over year change is primarily the result of transaction costs related to the Elkay merger, higher intangible asset and other acquisition related amortization, depreciation, and restructuring costs following our merger with Elkay as well as higher year-over-year costs within transportation and material inputs. These costs were partially offset by the favorable impact of year-over-year sales growth (inclusive of price increases), productivity savings, and lower non-cash stock-based compensation expense.
Interest expense, net
Interest expense, net was $26.9 million for the year ended December 31, 2022 compared to $34.7 million for the year ended December 31, 2021, primarily due to lower outstanding borrowings following the Spin-Off Transaction refinancing, partially offset by higher year over year interest rates. See Item 8, Note 11 Long-Term Debt for more information.
Loss on extinguishment of debt
There was no loss on the extinguishment of debt recognized for the year ended December 31, 2022. During the year ended December 31, 2021, we recognized a $20.4 million loss on the extinguishment of debt in connection with the refinancing of our debt in connection with the Spin-Off Transaction. The loss on extinguishment of debt was comprised of $16.2 million of refinancing related costs, as well as a non-cash write-off of unamortized debt issuance costs associated with the previously outstanding debt of $4.2 million. See Item 8, Note 11 Long-Term Debt for more information.
Actuarial gain on pension and postretirement benefit obligations
Actuarial gain on pension and postretirement benefit obligations for the year ended December 31, 2022, was $1.9 million compared to a gain of $1.2 million for the year ended December 31, 2021. The non-cash actuarial gain recognized for the year ended December 31, 2022, was primarily due to a year over year increase in discount rates assumptions utilized in performing the annual remeasurement of our defined benefit plans, partially offset by unfavorable asset performance. The non-cash actuarial gain recognized for the year ended December 31, 2021, was primarily due to a year over year increase in the discount rate assumptions utilized within the annual remeasurement of our defined benefit plans. See Item 8, Note 16 Retirement Benefits for more information.
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Other income (expense), net
Other income, net for the year ended December 31, 2022, was $1.7 million compared to other expense, net of $0.7 million for the year ended December 31, 2021. Other income (expense), net consists primarily of gains and losses from foreign currency transactions, the non-service cost components of net periodic benefit costs associated with our defined benefit plans, and other non-operational gains and losses. The year-over-year change is primarily driven by income recognized in the year ended December 31, 2022 in connection with an insurance settlement, partially offset by a charge recognized for the amount by which our estimated asbestos exposures exceed our estimated insurance coverage available.
Provision for income taxes
The income tax provision for the year ended December 31, 2022 was $26.8 million, or an effective tax rate of 32.0%. The effective income tax rate for the year ended December 31, 2022 was above the U.S. federal statutory rate of 21% primarily due to non-deductible acquisition costs associated with the Merger, the accrual of foreign income taxes, which are generally above the U.S. federal statutory rate, the accrual of additional income taxes associated with compensation deduction limitations under Section 162(m) of the Internal Revenue Code and the accrual of various state income taxes, partially offset by the recognition of income tax benefits associated with share-based payments and the reduction in the valuation allowance associated with certain state NOL carryforwards. The income tax provision for the year ended December 31, 2021 was $2.7 million, or an effective tax rate of 5.2%. The effective income tax rate for the year ended December 31, 2021 was below the U.S. federal statutory rate of 21% primarily due to the recognition of income tax benefits associated with share-based payments, slightly offset by the accrual of foreign income taxes, which are generally above the U.S. federal statutory rate, the accrual of additional income taxes associated with compensation deduction limitations under Section 162(m) of the Internal Revenue Code, the increase in the valuation allowance associated with certain state NOL carryforwards, the accrual of unrecognized income tax benefits in which such realization is not deemed more-likely-than-not and the accrual of various state income taxes.
Net income from continuing operations
Our net income from continuing operations for the year ended December 31, 2022, was $57.0 million, compared to net income from continuing operations of $49.7 million for the year ended December 31, 2021, as a result of the factors described above. Diluted net income per share from continuing operations was $0.37 for the year ended December 31, 2022, as compared to $0.40 per share for the year ended December 31, 2021.
Net income
Net income for the year ended December 31, 2022, was $61.7 million compared to $120.9 million for the year ended December 31, 2021. Diluted net income per share was $0.40 for the year ended December 31, 2022, compared to $0.97 for the year ended December 31, 2021. Income from discontinued operations, net of tax, was $4.7 million for the year ended December 31, 2022 compared to $71.2 million for the year ended December 31, 2021. The year-over-year change in net income from discontinued operations, net of tax, is due to the completion of the PMC Spin-Off Transaction in the year ending December 31, 2021. The year-over-year change in net income is primarily the result of the factors described above.
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Year Ended December 31, 2021 Compared with the Year Ended December 31, 2020
Net sales
(Dollars in Millions)
Year Ended
Net sales were $910.9 million for the year ended December 31, 2021, a 22.1% increase year over year. Excluding a 1% increase to net sales associated with foreign currency translation and an 8% increase in net sales resulting from our 2020 acquisition of Hadrian and the 2021 acquisition of Wade, core net sales increased 13% year over year. The increase in core net sales was driven by increased demand across the majority of our product categories.
Income from operations
(Dollars in Millions)
Year Ended
Income from operations was $107.0 million for the year ended December 31, 2021, or 11.7% of net sales, compared to income from operations of $107.7 million, or 14.4% of net sales, for the year ended December 31, 2020. Income from operations as a percentage of net sales decreased 270 basis points year-over-year as the favorable impact of increased sales was more than offset by the change in the adjustment to state inventories at last-in-first-out cost, higher non-cash stock-based compensation expense, the mix impact of the Hadrian acquisition and the benefit of temporary cost reduction actions in the prior year in response to the COVID-19 pandemic.
Interest expense, net
Interest expense, net was $34.7 million during the year ended December 31, 2021 compared to $45.9 million during the year ended December 31, 2020, primarily due to lower outstanding borrowings following the Spin-Off Transaction refinancing. See Item 8, Note 11 Long-Term Debt for more information.
Loss on extinguishment of debt
During the year ended December 31, 2021, we recognized a $20.4 million loss on the extinguishment of debt in connection with the refinancing of our debt in connection with the Spin-Off Transaction. The loss on extinguishment of debt was comprised of $16.2 million of refinancing related costs, as well as a non-cash write-off of unamortized debt issuance costs associated with the previously outstanding debt of $4.2 million. See Item 8, Note 11 Long-Term Debt for more information. There was no loss on the extinguishment of debt recognized during the year ended December 31, 2020.
Actuarial gain (loss) on pension and postretirement benefit obligations
Actuarial gain on pension and postretirement benefit obligations for the year ended December 31, 2021, was $1.2 million compared to a loss of $21.2 million for the year ended December 31, 2020. The non-cash actuarial gain recognized for the year ended December 31, 2021, was primarily due to a year over year increase in discount rates assumptions utilized in performing the annual remeasurement of our defined benefit plans. The non-cash actuarial loss recognized for the year ended December 31, 2020, was primarily due to favorable asset performance and contributions made to the plan partially offset by decreases in the year over year discount rate assumptions utilized within the annual remeasurement of our defined benefit plans. See Item 8, Note 16 Retirement Benefits for more information.
Other expense, net
Other expense, net for the year ended December 31, 2021, was $0.7 million compared to other expense, net of $2.5 million for the year ended December 31, 2020. Other expense, net consists primarily of gains and losses from foreign currency transactions, the non-service cost components of net periodic benefit costs associated with our defined benefit plans and other non-operational gains and losses. The year-over-year change is primarily driven by changes in foreign currency rates and lower interest cost within the non-service cost components of our defined benefit plans.
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Provision for income taxes
The income tax provision for the year ended December 31, 2021 was $2.7 million, or an effective tax rate of 5.2%. The effective income tax rate for the year ended December 31, 2021 was below the U.S. federal statutory rate of 21% primarily due to the recognition of income tax benefits associated with share-based payments slightly offset by the accrual of foreign income taxes, which are generally above the U.S. federal statutory rate, the accrual of additional income taxes associated with compensation deduction limitations under Section 162(m) of the Internal Revenue Code, the increase in the valuation allowance associated with certain state NOL carryforwards, the accrual of unrecognized income tax benefits in which such realization is not deemed more-likely-than-not and the accrual of various state income taxes. The income tax provision for the year ended December 31, 2020 was $9.5 million, or an effective tax rate of 24.9%. The effective income tax rate for the year ended December 31, 2020 was above the U.S. federal statutory rate of 21% primarily due to the accrual of foreign income taxes, which are generally above the U.S. federal statutory rate, the accrual of additional income taxes associated with compensation deduction limitations under Section 162(m) of the Internal Revenue Code and the accrual of various state income taxes, partially offset by the recognition of income tax benefits associated with share-based payments.
Net income from continuing operations
Our net income from continuing operations for the year ended December 31, 2021, was $49.7 million, compared to net income from continuing operations of $28.6 million for the year ended December 31, 2020, as a result of the factors described above. Diluted net income per share from continuing operations was $0.40 for the year ended December 31, 2021, as compared to $0.23 per share for the year ended December 31, 2020.
Net income
Net income for the year ended December 31, 2021, was $120.9 million compared to $146.7 million for the year ended December 31, 2020. Diluted net income per share was $0.97 for the year ended December 31, 2021, compared to $1.19 for the year ended December 31, 2020. Income from discontinued operations, net of tax, was $71.2 million for the year ended December 31, 2021 compared to $118.1 million for the year ended December 31, 2020. The year-over-year change in net income from discontinued operations, net of tax, is due to the PMC results for the year ended December 31, 2021 only representing activity through the Spin-Off Transaction date and the recognition of approximately $60.0 million in costs associated with completing the Spin-Off Transaction. The year-over-year change in net income is primarily the result of the factors described above.
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Non-GAAP Financial Measures
Non-GAAP financial measures are intended to supplement and not replace financial measures prepared in accordance with GAAP.
Core sales
Core sales excludes the impact of acquisitions (such as the Elkay and Wade Drains acquisitions), divestitures (such as PMC) and foreign currency translation. Management believes that core sales facilitates easier and more meaningful comparisons of our net sales performance with prior and future periods and to our peers. We exclude the effect of acquisitions and divestitures because the nature, size and number of acquisitions and divestitures can vary dramatically from period to period and between us and our peers, and can also obscure underlying business trends and make comparisons of long-term performance difficult. We exclude the effect of foreign currency translation from this measure because the volatility of currency translation is not under management's control.
EBITDA
EBITDA represents earnings before interest and other debt related activities, taxes, depreciation and amortization. EBITDA is presented because it is an important supplemental measure of performance and it is frequently used by analysts, investors and other interested parties in the evaluation of companies in our industry. EBITDA is also presented and compared by analysts and investors in evaluating our ability to meet debt service obligations. Other companies in our industry may calculate EBITDA differently. EBITDA is not a measurement of financial performance under U.S. GAAP and should not be considered as an alternative to cash flow from operating activities or as a measure of liquidity or an alternative to net income as indicators of operating performance or any other measures of performance derived in accordance with U.S. GAAP. Because EBITDA is calculated before recurring cash charges, including interest expense and taxes, and is not adjusted for capital expenditures or other recurring cash requirements of the business, it should not be considered as a measure of discretionary cash available to invest in the growth of the business.
Adjusted EBITDA
Adjusted EBITDA (as described below in "Covenant Compliance") is an important measure because, under our credit agreement, our ability to incur certain types of acquisition debt and certain types of subordinated debt, make certain types of acquisitions or asset exchanges, operate our business and make dividends or other distributions, all of which will impact our financial performance, is impacted by our Adjusted EBITDA, as our lenders measure our performance with a net first lien leverage ratio by comparing our senior secured bank indebtedness to our Adjusted EBITDA (see "Covenant Compliance" for additional discussion of this ratio, including a reconciliation to our net income). We reported net income in the year ended December 31, 2022, of $61.7 million and Adjusted EBITDA for the same period of $264.6 million. See "Covenant Compliance" for a reconciliation of Adjusted EBITDA to GAAP net income.
Covenant Compliance
Our credit agreement, which governs our senior secured credit facilities, contains, among other provisions, restrictive covenants regarding indebtedness, payments and distributions, mergers and acquisitions, asset sales, affiliate transactions, capital expenditures and the maintenance of certain financial ratios. Payment of borrowings under the credit agreement may be accelerated if there is an event of default. Events of default include the failure to pay principal and interest when due, a material breach of a representation or warranty, certain non-payments or defaults under other indebtedness, covenant defaults, events of bankruptcy and a change of control. Certain covenants contained in the credit agreement restrict our ability to take certain actions, such as incurring additional debt or making acquisitions, if we are unable to meet a maximum Net First Lien Leverage Ratio of 5.0 to 1.0 as of the end of each fiscal quarter (the ratio was 1.5 to 1.0 at December 31, 2022). Failure to comply with these covenants could limit our long-term growth prospects by hindering our ability to borrow under the revolver, to obtain future debt and/or to make acquisitions.
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"Adjusted EBITDA" is the term we use to describe EBITDA as defined and adjusted in our credit agreement, which is net income, adjusted for the items summarized in the table below. Adjusted EBITDA is intended to show our unleveraged, pre-tax operating results and therefore reflects our financial performance based on operational factors, excluding non-operational, non-cash or non-recurring losses or gains. It is also provided to aid investors in understanding our compliance with our debt covenants. Adjusted EBITDA is not a presentation made in accordance with GAAP, and our use of the term Adjusted EBITDA varies from others in our industry. This measure should not be considered as an alternative to net income, income from operations or any other performance measures derived in accordance with GAAP. Adjusted EBITDA has important limitations as an analytical tool, and should not be considered in isolation, or as a substitute for analysis of our results as reported under GAAP. For example, Adjusted EBITDA does not reflect: (a) our capital expenditures, future requirements for capital expenditures or contractual commitments; (b) changes in, or cash requirements for, our working capital needs; (c) the significant interest expenses, or the cash requirements necessary to service interest or principal payments, on our debt; (d) tax payments that represent a reduction in cash available to us; (e) any cash requirements for the assets being depreciated and amortized that may have to be replaced in the future; or (f) the impact of earnings or charges resulting from matters that we and the lenders under our credit agreement may not consider indicative of our ongoing operations. In particular, our definition of Adjusted EBITDA allows us to add back certain non-cash, non-operating or non-recurring charges that are deducted in calculating net income, even though these are expenses that may recur, vary greatly and are difficult to predict and can represent the effect of long-term strategies as opposed to short-term results.
In addition, certain of these expenses added back in calculating Adjusted EBITDA can represent the reduction of cash that could be used for other corporate purposes. Further, although not included in the calculation of Adjusted EBITDA below, the measure may at times allow us to add estimated cost savings and operating synergies related to operational changes ranging from acquisitions or dispositions to restructuring, and/or exclude one-time transition expenditures that we anticipate we will need to incur to realize cost savings before such savings have occurred.
The calculation of Adjusted EBITDA under our credit agreement as of December 31, 2022, is presented in the table below. However, the results of such calculation could differ in the future based on the different types of adjustments that may be included in such respective calculations at the time.
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Set forth below is a reconciliation of net income to Adjusted EBITDA for the year ended December 31, 2022.
(in millions) Year Ended December 31, 2022
Net income $ 61.7
Income from discontinued operations, net of tax (1) (4.7)
Provision for income taxes 26.8
Actuarial gain on pension and postretirement benefit obligations (1.9)
Other income, net (2) (1.7)
Interest expense, net 26.9
Depreciation and amortization 54.5
Adjustments to EBITDA
Restructuring and other similar charges (3) 15.4
Stock-based compensation expense 25.0
Merger costs (4) 33.7
LIFO expense (5) 9.7
Acquisition-related fair value adjustment 18.9
Other, net (6) 0.3
Subtotal of adjustments to EBITDA 103.0
Adjusted EBITDA 264.6
Pro forma adjustment for acquisitions (7) 36.2
Pro forma Adjusted EBITDA 300.8
Consolidated indebtedness (8) $ 438.3
Net First Lien Leverage Ratio (9) 1.46
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(1)Income from discontinued operations, net of tax is not included in Adjusted EBITDA in accordance with the terms of our credit agreement.
(2)Other income, net consists primarily of gains and losses from foreign currency transactions, the non-service cost components of net periodic benefit costs associated with our defined benefit plans and other non-operational gains and losses.
(3)Restructuring and other similar charges is comprised of costs associated with workforce reductions, lease termination costs, and other facility rationalization costs. See Item 8, Note 5, Restructuring and Other Similar Charges for more information.
(4)Merger costs is comprised of costs associated with legal and other professional services incurred in connection with completing the merger with Elkay, which are excluded in calculating Adjusted EBITDA as defined in our credit agreement.
(5)Last-in first-out (LIFO) inventory adjustments are excluded in calculating Adjusted EBITDA as defined in our credit agreement.
(6)Other, net consists of gains and losses on the disposition of long-lived assets.
(7)Represents a pro forma adjustment to include Adjusted EBITDA related to the merger with Elkay, which was permitted by our credit agreement. The pro forma adjustment includes the period from January 1, 2022, through the date of the Elkay Merger. See Item 8, Note 3, Acquisitions for more information.
(8)Our credit agreement defines our consolidated indebtedness as the sum of all indebtedness (other than letters of credit or bank guarantees, to the extent undrawn) consisting of indebtedness for borrowed money and capitalized lease obligations, less unrestricted cash, which was $97.6 million (as defined by the credit agreement) at December 31, 2022.
(9)Our credit agreement defines the Net First Lien Leverage Ratio as the ratio of consolidated indebtedness (as described above) to Adjusted EBITDA for the trailing four fiscal quarters.
Liquidity and Capital Resources
Our primary sources of liquidity are available cash and cash equivalents, cash flow from operations, and borrowing availability under our $200.0 million revolving credit facility.
As of December 31, 2022, we had $124.8 million of cash and cash equivalents and $192.5 million of additional borrowing capacity under our revolving credit facility. As of December 31, 2022, the available borrowings under our credit facility were reduced by $7.5 million due to outstanding letters of credit. As of December 31, 2021, we had $96.6 million of cash and cash equivalents and $193.9 million of additional borrowing capacity. As of December 31, 2021, the available borrowings under our credit facility were reduced by $6.1 million, due to outstanding letters of credit.
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Our revolving credit facility is available to fund our working capital requirements, capital expenditures and other general corporate purposes. We believe this resource is adequate for expected needs.
Cash Flows
Amounts below include activities attributable to our discontinued operations, unless otherwise noted. In addition, cash flows for the year ended December 31, 2020 include our continuing operations and discontinued operations for the entire period, while the year ended December 31, 2021 only includes the cash flows associated with our PMC platform for the period from January 1, 2021 to October 4, 2021, the date the Spin-Off Transaction was completed. Refer to Item 8, Note 4 Discontinued Operations for further information.
Year Ended December 31, 2022 Compared with the Year Ended December 31, 2021
Net cash provided by operating activities in the year ended December 31, 2022, was $97.0 million compared to $223.6 million in the year ended December 31, 2021 due to lower net income as a result of the Spin-Off Transaction and timing of payments on accounts payable and accrued expenses.
Cash used for investing activities was $6.6 million in the year ended December 31, 2022 compared to $21.9 million in the year ended December 31, 2021. Investing activities in the year ended December 31, 2022, included $7.6 million of capital expenditures and net cash payments of $44.8 million in connection with acquisitions, which were partially offset by the receipt of $35.0 million from Regal Rexnord Corporation in connection with the final net assets transferred in the PMC Spin-Off Transaction, the receipt of $9.5 million in connection with an insurance settlement and $1.3 million from the sale of certain long-lived assets. Investing activities for the year ended December 31, 2021, included $17.1 million of cash used to fund the acquisitions of Wade and ATS GREASEwatch, $23.3 million of capital expenditures, partially offset by the receipt of $18.5 million in connection with the disposition of certain long-lived assets.
Cash used for financing activities was $61.1 million in the year ended December 31, 2022 compared to cash used for financing activities of $356.2 million in the year ended December 31, 2021. Financing activities in the year ended December 31, 2022 included $32.5 million of cash for the payment of dividends on our common stock, $24.7 million of cash for repurchases of our common stock, $5.7 million of net cash payments on outstanding debt, which were partially offset by $1.8 million of net cash proceeds associated with stock option exercises. During the year ended December 31, 2021, we utilized a net $311.5 million of cash related to the Spin-Off Transaction of PMC, $0.9 million of cash for repurchases of our common stock and $36.4 million of cash for the payment of dividends on our common stock. Cash used for financing activities during the year ended December 31, 2021 also included $24.9 million of cash proceeds associated with stock option exercises, more than offset by $32.3 million of cash used for the payment of withholding taxes on employees' share-based payment awards.
Year Ended December 31, 2021 Compared with the Year Ended December 31, 2020
Net cash provided by operating activities in the year ended December 31, 2021, was $223.6 million compared to $320.2 million in the year ended December 31, 2020 due to lower net income as a result of the Spin-Off Transaction and investments in working capital.
Cash used for investing activities was $21.9 million in the year ended December 31, 2021 compared to $196.6 million in the year ended December 31, 2020. Investing activities in the year ended December 31, 2021, included $17.1 million of net cash used to fund the acquisitions of Wade and ATS GREASEwatch, whereas the year ended December 31, 2020, included $161.4 million of net cash used in connection with acquisitions of Hadrian, Just Manufacturing and the remaining non-controlling interest in a PMC joint venture. We invested $23.3 million in capital expenditures in the year ended December 31, 2021, compared to $44.2 million in the year ended December 31, 2020. We also received $14.3 million in connection with the disposition of certain long-lived assets in the year ended December 31, 2021, compared to $9.0 million in the year ended December 31, 2020.
Cash used for financing activities was $356.2 million in the year ended December 31, 2021 compared to cash used for financing activities of $156.2 million in the year ended December 31, 2020. During the year ended December 31, 2021, we utilized a net $311.5 million of cash related to the Spin-Off Transaction of PMC, $0.9 million of cash for repurchases of our common stock and $36.4 million of cash for the payment of dividends on our common stock. Cash used for financing activities during the year ended December 31, 2021 also included $24.9 million of cash proceeds associated with stock option exercises, more than offset by $32.3 million of cash used for the payment of withholding taxes on employees' share-based payment awards. During the year ended December 31, 2020, we utilized a net $5.7 million of cash for payments on outstanding debt, $140.0 million of cash for repurchases of our common stock and $38.6 million of cash for the payment of dividends on our common stock. Cash used for financing activities during the year ended December 31, 2020 also included $37.5 million of cash proceeds associated with stock option exercises, partially offset by $9.4 million of cash used for the payment of withholding taxes on employees' share-based payment awards.
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Tabular Disclosure of Contractual Obligations
The table below lists our contractual obligations at December 31, 2022 by period when due:
Payments Due by Period
(in millions) Total Less than1 Year 1-3 Years 3-5 Years More than5 Years
Pension and post-retirement plans (3) 35.9 1.5 18.4 16.0 See note (3)
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(1)Excludes unamortized debt issuance costs of $9.2 million at December 31, 2022.
(2)Interest on long-term debt obligations represents the cash interest expense using LIBOR as of December 31, 2022.
(3)Represents expected pension and post-retirement contributions and benefit payments to be paid directly by the Company. Contributions and benefit payments beyond fiscal 2027 cannot be estimated.
No provision has been made for U.S. federal income taxes related to approximately $19.4 million of undistributed earnings of foreign subsidiaries considered to be permanently reinvested; see Item 8, Note 17 Income Taxes for further information.
We may be required to make significant cash outlays related to our unrecognized tax benefits, including interest and penalties. However, due to the uncertainty of the timing of future cash flows associated with our unrecognized tax benefits, we are unable to make reasonably reliable estimates of the period of cash settlement, if any, with the respective taxing authorities. Accordingly, unrecognized tax benefits, including interest and penalties and federal tax benefits where applicable, of $5.5 million as of December 31, 2022, have been excluded from the contractual obligations table above. See Item 8, Note 17 Income Taxes for more information related to our unrecognized tax benefits.
Additionally, the deferred compensation liability of $12.1 million as of December 31, 2022, has been excluded from the contractual obligations table above, as we are unable to reasonably estimate the timing of the payments or the amount by which the liability will increase over time. See Item 8, Note 16, Retirement Benefits for more information related to our deferred compensation plan.
Our pension and post-retirement benefit plans are discussed in detail in Item 8, Note 16, Retirement Benefits. The pension plans provide for monthly pension payments to eligible employees upon retirement. Other post-retirement benefits consist of retiree medical plans that cover a portion of employees in the United States that meet certain age and service requirements and other post-retirement benefits for employees at certain foreign locations. See Item 1A, Risk Factors for more information.
Indebtedness
As of December 31, 2022 we had $535.9 million of total indebtedness outstanding as follows (in millions):
____________________
(1)Includes unamortized original issue discount and debt issuance costs of $9.2 million at December 31, 2022.
See Item 8, Note 11, Long-Term Debt for a description of our outstanding indebtedness.
Off-Balance Sheet Arrangements
We do not have any off-balance sheet or non-consolidated special-purpose entities.
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Quantitative and Qualitative Disclosures about Market Risk
We are exposed to market risk during the normal course of business from changes in foreign currency exchange rates and interest rates. The exposure to these risks is managed through a combination of normal operating and financing activities and at times derivative financial instruments in the form of foreign currency forward contracts to cover certain known foreign currency transactional risks. We also have historically entered into interest rate derivatives to manage interest rate fluctuations.
Foreign Currency Exchange Rate Risk
Our exposure to foreign currency exchange rates relates primarily to our operations in Canada. For our operations in Canada, exchange rates impact the U.S. Dollar ("USD") value of our reported earnings, our investments in the subsidiaries and the intercompany transactions with the subsidiaries.
Approximately 11% of our sales originated outside of the United States in the year ended December 31, 2022. Revenues and expenses denominated in foreign currencies are translated into USD at the end of the fiscal period using the average exchange rates in effect during the period. Fluctuations in currency exchange rates also impact the USD amount of our stockholders' equity. The assets and liabilities of our non-U.S. subsidiaries are translated into USD at the exchange rates in effect at the end of the fiscal periods. As of December 31, 2022, stockholders' equity decreased by $4.2 million from December 31, 2021 as a result of foreign currency translation adjustments. If the USD strengthened by 10% as of December 31, 2022, the result would have decreased stockholders' equity by approximately $11.2 million.
As of December 31, 2022, we had not entered into foreign currency forward contracts.
Interest Rate Risk
Our indebtedness under the senior secured credit facilities bears interest at rates that fluctuate with changes in certain short-term prevailing interest rates. As of December 31, 2022, our outstanding borrowings under the term loan facility were $535.3 million (net of $9.2 million unamortized debt issuance costs) and bore an effective interest rate of 6.39%, determined as London Interbank Offered Rate ("LIBOR") (subject to a 0.5% floor) plus an applicable margin of 2.00%. During the year ended December 31, 2022, the weighted-average interest rate was 4.00%.
Our net income is affected by changes in market interest rates on our variable-rate obligations. As discussed above, our term loan facilities bear interest at LIBOR (subject to a 0.5% floor) plus an applicable margin. Therefore, a 100 basis point increase in LIBOR above where it closed as of December 31, 2022 would increase the annual interest expense under our term loan facility by approximately $5.5 million.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The information with respect to the Company's market risk is contained under the caption "Quantitative and Qualitative Disclosures About Market Risk" in Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations.
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ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
The consolidated financial statements included in this Form 10-K include the accounts of Zurn Elkay Water Solutions Corporation and subsidiaries (collectively, the "Company").
Index to Financial Statements
Zurn Elkay Water Solutions Corporation and Subsidiaries
Consolidated Financial Statements
As of December 31, 2022 and 2021 and for the years ended December 31, 2022 and December 31, 2021,
and the nine-month Transition Period ended December 31, 2020
Consolidated Balance Sheets 46
Consolidated Statements of Operations 47
Consolidated Statements of Comprehensive Income 48
Consolidated Statements of Stockholders' Equity 49
Consolidated Statements of Cash Flows 50
Notes to Consolidated Financial Statements 51
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Report of Independent Registered Public Accounting Firm
To the Stockholders and the Board of Directors of Zurn Elkay Water Solutions Corporation
Opinion on the Financial Statements
We have audited the accompanying consolidated balance sheets of Zurn Elkay Water Solutions Corporation and Subsidiaries (the Company) as of December 31, 2022 and 2021, the related consolidated statements of operations, comprehensive income, stockholders' equity and cash flows for the years ended December 31, 2022 and 2021 and the nine months ended December 31, 2020 and the related notes and financial statement schedule listed in the Index at Item 15(a)(2) (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company at December 31, 2022 and 2021, and the results of its operations and its cash flows for the years ended December 31, 2022 and 2021 and the nine months ended December 31, 2020, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company's internal control over financial reporting as of December 31, 2022, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) and our report dated February 14, 2023 expressed an unqualified opinion thereon.
Basis for Opinion
These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.
Critical Audit Matter
The critical audit matter communicated below is a matter arising from the current period audit of the financial statements that was communicated or required to be communicated to the audit committee and that: (1) relate to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective or complex judgments. The communication of the critical audit matter does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the account or disclosure to which it relates.
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Valuation of acquired intangible assets
/s/ Ernst & Young LLP
We have served as the Company’s auditor since 2002.
Milwaukee, Wisconsin
February 14, 2023
44
Report of Independent Registered Public Accounting Firm
To the Stockholders and the Board of Directors of Zurn Elkay Water Solutions Corporation
Opinion on Internal Control over Financial Reporting
We have audited Zurn Elkay Water Solutions Corporation and Subsidiaries’ internal control over financial reporting as of December 31, 2022, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (the COSO criteria). In our opinion, Zurn Elkay Water Solutions Corporation and Subsidiaries’ (the Company) maintained, in all material respects, effective internal control over financial reporting as of December 31, 2022, based on the COSO criteria.
As indicated in the accompanying Management’s Report on Internal Control Over Financial Reporting, management’s assessment of and conclusion on the effectiveness of internal control over financial reporting did not include the internal controls of Elkay Manufacturing Company, which is included in the 2022 consolidated financial statements of the Company and constituted $1,248.7 million and $912.0 million of total and net assets, respectively, as of December 31, 2022 and net sales of $264.4 million and a net loss of $11.5 million, for the year then ended. Our audit of internal control over financial reporting of the Company also did not include an evaluation of the internal control over financial reporting of Elkay Manufacturing Company.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the consolidated balance sheets of the Company as of December 31, 2022 and December 31, 2021, the related consolidated statements of operations, comprehensive income, stockholders’ equity and cash flows for the years ended December 31, 2022 and 2021, and the nine months ended December 31, 2020 and the related notes and financial statement schedule listed in the Index at Item 15(a)(2) and our report dated February 14, 2023 expressed an unqualified opinion thereon.
Basis for Opinion
The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects.
Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
Definition and Limitations of Internal Control Over Financial Reporting
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
/s/ Ernst & Young LLP
Milwaukee, Wisconsin
February 14, 2023
45
Zurn Elkay Water Solutions Corporation and Subsidiaries
Consolidated Balance Sheets
(in Millions, except share amounts)
Assets
Current assets:
Cash and cash equivalents $ 124.8 $ 96.6
Income taxes receivable 18.3 33.1
Property, plant and equipment, net 183.8 64.4
Insurance for asbestos claims 72.1 66.0
Liabilities and stockholders' equity
Current liabilities:
Current maturities of debt $ 5.7 $ 5.6
Compensation and benefits 19.2 22.0
Current portion of pension and postretirement benefit obligations 1.6 1.3
Pension and postretirement benefit obligations 50.5 57.3
Deferred income taxes 221.4 3.1
Operating lease liability 34.2 8.9
Reserve for asbestos claims 79.0 66.0
Stockholders' equity:
Accumulated other comprehensive loss (75.0) (74.9)
Total liabilities and stockholders' equity $ 2,864.0 $ 1,077.7
See notes to consolidated financial statements.
46
Zurn Elkay Water Solutions Corporation and Subsidiaries
Consolidated Statements of Operations
(in Millions, except share and per share amounts)
Year Ended Nine-Month Transition Period Ended
Selling, general and administrative expenses 309.0 239.0 153.7
Restructuring and other similar charges 15.4 3.7 1.7
Amortization of intangible assets 34.0 23.5 16.9
Non-operating expense:
Loss on the extinguishment of debt — (20.4) —
Other income (expense), net 1.7 (0.7) (1.9)
Provision for income taxes (26.8) (2.7) (10.5)
Net income from continuing operations 57.0 49.7 35.0
Income from discontinued operations, net of tax 4.7 71.2 83.2
Basic net income per share:
Diluted net income per share:
Weighted-average number of common shares outstanding (in thousands):
See notes to consolidated financial statements.
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Zurn Elkay Water Solutions Corporation and Subsidiaries
Consolidated Statements of Comprehensive Income
(in Millions)
Year Ended Nine-Month Transition Period Ended
Other comprehensive income:
Foreign currency translation adjustments (4.2) (4.2) 37.8
Other comprehensive (loss) income, net of tax (0.1) 14.2 50.6
See notes to consolidated financial statements.
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Zurn Elkay Water Solutions Corporation and Subsidiaries
Consolidated Statements of Stockholders’ Equity
(in Millions)
Foreign currency translation and other adjustments — — — 37.8 — 37.8
Acquisition of non-controlling interest — (0.2) — — (0.1) (0.3)
Stock-based compensation expense — 35.9 — — — 35.9
Proceeds from exercise of stock options — 18.3 — — — 18.3
Repurchase of common stock (2) — — (59.3) — — (59.3)
Common stock dividends ($0.24 per share) — — (28.8) — — (28.8)
Net income $ — $ — $ 120.9 $ — $ — $ 120.9
Foreign currency translation and other adjustments — — — (4.2) — (4.2)
Stock-based compensation expense — 51.4 — — — 51.4
Proceeds from exercise of stock options 0.1 24.9 — — — 25.0
Repurchase of common stock (2) — — (0.9) — — (0.9)
Dividend received from Spin-Off Transaction — — 486.8 — — 486.8
Common stock dividends ($0.30 per share) — — (36.4) — — (36.4)
Net income $ — $ — $ 61.7 $ — $ — $ 61.7
Foreign currency translation and other adjustments — — — (4.2) — (4.2)
Total comprehensive income (loss) — — 61.7 (0.1) — 61.6
Stock-based compensation expense — 23.2 — — — 23.2
Proceeds from exercise of stock options — 2.5 — — — 2.5
Repurchase of common stock (2) — — (24.7) — — (24.7)
Common stock dividends ($0.20 per share) — (25.3) — — — (25.3)
____________________
(1) During the Transition Period, the Company acquired the remaining 30% non-controlling interest in a PMC controlled subsidiary for a cash purchase price of $0.3 million. From the time of this transaction through the Spin-Off Transaction, non-controlling interest represents a 5% non-controlling interest in another PMC joint venture relationship. The Company has no remaining non-controlling interest subsequent to the Spin-Off Transaction.
(2) During the years ended December 31, 2022 and 2021 and the nine-month Transition Period ended December 31, 2020, the Company repurchased and canceled 1.1 million shares, 22,300 shares and 1.7 million shares of common stock at a total cost of $24.7 million, $0.9 million and $59.3 million at a weighted average price of $23.00, $39.27 and $34.97 per share, respectively. See Note 19 Common Stock Repurchases for additional information.
(3) Refer to Note 3, Acquisitions for additional information regarding the Elkay Merger.
See notes to consolidated financial statements.
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Zurn Elkay Water Solutions Corporation and Subsidiaries
Consolidated Statements of Cash Flows
(in Millions)
Year Ended Nine-Month Transition Period Ended
Operating activities
Adjustments to reconcile net income to cash provided by operating activities:
Amortization of intangible assets 34.0 33.4 27.0
Loss (gain) on dispositions of long-lived assets 0.3 (10.1) (1.1)
Deferred income taxes 0.5 (12.1) (7.0)
Other non-cash expenses (income) 4.8 (3.6) 0.2
Loss on the extinguishment of debt — 20.4 —
Stock-based compensation expense 25.0 51.4 36.6
Changes in operating assets and liabilities:
Investing activities
Expenditures for property, plant and equipment (7.6) (23.3) (28.3)
Acquisitions, net of cash acquired (44.8) (17.1) (102.0)
Proceeds from dispositions of long-lived assets 1.3 14.3 7.8
Proceeds from insurance claims 9.5 — —
Proceeds associated with divestiture of discontinued operations 35.0 4.2 —
Cash used for investing activities (6.6) (21.9) (122.5)
Financing activities
Dividend received from Spin-Off Transaction of PMC — 486.8 —
Cash transferred to PMC related to Spin-Off Transaction — (192.8) —
Payment of debt issuance costs — (28.8) —
Proceeds from exercise of stock options 2.5 24.9 18.3
Repurchase of common stock (24.7) (0.9) (59.3)
Payment of common stock dividends (32.5) (36.4) (28.8)
Cash used for financing activities (61.1) (356.2) (409.6)
____________________
(1) The Company has combined cash flows from discontinued operations with cash flows from continuing operations within operating, investing and financing categories. As such cash and cash equivalents and restricted cash include $193.3 million of cash and cash equivalents from the discontinued operation as of December 31, 2020.
See notes to consolidated financial statements.
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Zurn Elkay Water Solutions Corporation and Subsidiaries
Notes to Consolidated Financial Statements
December 31, 2022
1. Basis of Presentation and Description of Business
The consolidated financial statements included herein have been prepared by Zurn Elkay Water Solutions Corporation ("Zurn Elkay" or the "Company"), in accordance with accounting principles generally accepted in the United States ("GAAP") pursuant to the rules and regulations of the Securities and Exchange Commission. The consolidated financial statements include the accounts of the Company and its subsidiaries. All intercompany balances and transactions have been eliminated in consolidation. In the opinion of management, the consolidated financial statements include all adjustments necessary for a fair presentation of the financial position and the results of operations for the periods presented.
Following the end of the Company's fiscal year ended March 31, 2020, the Company transitioned to a December 31 fiscal year-end date. As a result, this Form 10-K includes financial information for the nine-month period from April 1, 2020 to December 31, 2020 (the "Transition Period"). Prior to the Transition Period, the Company’s fiscal year ended on March 31 of each year.See Note 12, Comparative Twelve Month Financial Information for additional information.
Elkay Merger
On February 12, 2022, Zurn Water Solutions Corporation (“Zurn”) entered into a definitive agreement to combine with Elkay Manufacturing Company (“Elkay”), pursuant to an Agreement and Plan of Merger (the “Merger Agreement”) by and among Zurn, Elkay, Zebra Merger Sub, Inc., a wholly owned subsidiary of Zurn (“Merger Sub”), and Elkay Interior Systems International, Inc., as representative of the stockholders of Elkay, providing for the merger of Elkay with and into Merger Sub, with Elkay surviving as a wholly owned subsidiary of Zurn (the “Merger”). On July 1, 2022, the Merger was completed following which the Company changed its name to “Zurn Elkay Water Solutions Corporation” (“Zurn Elkay”, "we", "us", "our", or the “Company”). Shares of the Company's common stock continue to trade on the New York Stock Exchange under the ticker symbol “ZWS”. See Note 3, Acquisitions, for additional information.
Spin-Off of Process & Motion Control Segment
On October 4, 2021, the Company completed a Reverse Morris Trust tax-free spin-off transaction (the “Spin-Off Transaction”) in which (i) substantially all the assets and liabilities of the Company's PMC business were transferred to a newly created subsidiary, Land Newco, Inc. (“Land”), (ii) the shares of Land were distributed to the Company's stockholders pro rata, and (iii) Land was merged with a subsidiary of Regal Rexnord Corporation (formerly known as Regal Beloit Corporation), in which the stock of Land was converted into a specified number of shares of Regal Rexnord Corporation in accordance with the exchange ratio. Following completion of the Spin-Off Transaction, the Company's name was changed to “Zurn Water Solutions Corporation” and the ticker symbol for its shares of common stock trading on the New York Stock Exchange was changed to “ZWS”.
As a result of the Spin-Off Transaction, in accordance with the authoritative guidance, the operating results of PMC are reported as discontinued operations in the consolidated statements of operations for all periods presented. The consolidated statements of cash flows for the year ended December 31, 2022, the year ended December 31, 2021 and the nine-month Transition Period ended December 31, 2020 have not been adjusted to separately disclose cash flows related to the discontinued operations. See Note 4, Discontinued Operations for additional information.
In connection with the Spin-Off Transaction, the Company separated certain defined benefit pension and other post-employment benefit plans, and adjusted its employee share-based compensation awards. See Note 15 Stock-Based Compensation and Note 16 Retirement Benefits, respectively, for additional information.
The Company
Zurn Elkay Water Solutions Corporation is a growth-oriented, pure-play water management business that designs, procures, manufactures, and markets what the Company believes to be the broadest sustainable product portfolio of specification-driven water management solutions to improve health, human safety and the environment. The Company's product portfolio includes professional grade water safety and control products, flow system products, hygienic and environmental products, and drinking water products for public and private spaces that deliver superior value to building owners, positively impact the environment and human hygiene and reduce product installation time. The Companmy's heritage of innovation and specification has allowed it to provide highly-engineered, mission-critical solutions to customers for decades and affords it the privilege of having long-term, valued relationships with market leaders. The Company operates in a disciplined way and the Zurn Elkay Business System (“ZEBS”), described below, is its operating philosophy. Grounded in the spirit of continuous improvement, ZEBS creates a scalable, process-based framework that focuses on driving superior customer satisfaction and financial results by targeting world-class operating performance throughout all aspects of its business.
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2. Significant Accounting Policies
Use of Estimates
The preparation of financial statements in accordance with GAAP requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates.