MUELLER WATER PRODUCTS, INC. MANAGEMENT REPORT AND ANALYSIS OF FINANCIAL POSITION AND OPERATING RESULTS (Form 10-K)
The following discussion should be read in conjunction with the consolidated financial statements and related notes included in Item 8. "Financial Statements and Supplementary Data" of this Annual Report. This discussion and analysis contains forward-looking statements that involve risks, uncertainties and other factors that may cause actual results to differ materially from those projected in any forward-looking statements, as discussed in "Disclosure Regarding Forward-Looking Statements." These risks and uncertainties include but are not limited to those set forth in "Item 1A. RISK FACTORS".
We adopted a new management structure effective
October 1, 2021which resulted in a change to our reportable segments. Under this new structure, we operate our business through two segments, Water Flow Solutions and Water Management Solutions.
We estimate that approximately 60% to 65% of the Company’s net sales in 2022 were associated with repairs and replacements directly related to municipal water infrastructure spending, approximately 25% to 30% were related to business residential construction and less than 10% were related to natural gas. utilities.
After experiencing challenges in 2020 and 2021 resulting from the pandemic, municipal spending in 2022 recovered during the fiscal year as compared with the prior year. According to the
United States Department of Labor, the trailing twelve-month average consumer price index for water and sewerage rates at September 30, 2022increased 4.7%. While the economic effects of the pandemic have impacted revenues for some water utilities in the United States, water utilities were generally able to maintain repair and replacement activities. We expect the operating environment during fiscal year 2023 to be very challenging as a result of the inflationary environment, labor challenges and potential recession. We anticipate healthy demand in the municipal repair and replacement market due to favorable budgets, especially at larger municipalities. While demand from the new residential construction end market has been at healthy levels during fiscal 2022, especially for lot and land development activity, we anticipate that activity levels will slow during fiscal 2023 based on higher interest rates leading to a decrease in demand for new residential housing. In November 2022, Blue Chip Economic Indicators forecasted a 12.3% decrease in housing starts for the calendar year 2023 compared to the calendar year 2022. Consolidated For our fiscal year 2023, we anticipate that consolidated net sales will be 6% to 8% higher than our fiscal year 2022 primarily driven by the benefits of higher pricing. In 2022, we encountered increased material costs as a result of higher raw material prices, particularly brass ingot and scrap steel, as well as higher purchased parts, freight, labor costs and energy expenses. In 2023, we anticipate that inflation will continue to increase material and other costs. 26
Financial statement index
Results of Operations
Year ended September 30, 2022 Water Water Flow Management Solutions Solutions Corporate Consolidated (in millions) Net sales
$ 714.1 $ 533.3$ - $ 1,247.4Gross profit 212.4 151.9 - $ 364.3Operating expenses: Selling, general and administrative 87.1 102.8 48.8 238.7 Strategic reorganization and other charges 0.2 0.4 6.6 7.2 Goodwill impairment 6.8 - - 6.8 Total operating expenses 94.1 103.2 55.4 252.7 Operating income (loss) $ 118.3 $ 48.7 $ (55.4)111.6 Pension benefit other than service (3.9) Interest expense, net 16.9 Income before income taxes 98.6 Income tax expense 22.0 Net income $ 76.6Year ended September 30, 2021 Water Water Flow Management Solutions Solutions Corporate Consolidated (in millions) Net sales $ 617.8 $ 493.2$ - $ 1,111.0Gross profit $ 202.8 $ 155.7$ - $ 358.5Operating expenses: Selling, general and administrative 81.8 85.8 51.2 218.8 Strategic reorganization and other charges (benefits) 0.1 (0.4) 8.3 8.0 Total operating expenses 81.9 85.4 59.5 226.8 Operating income (loss) $ 120.9 $ 70.3 $ (59.5)131.7 Pension benefit other than service (3.3) Interest expense, net 23.4 Loss on early extinguishment of debt 16.7 Income before income taxes 94.9 Income tax expense 24.5 Net income $ 70.4Consolidated Analysis
Net sales for 2022 increased
Gross profit increased
$5.8 million, or 1.6%, to $364.3 millionfor 2022 compared with $358.5 millionin the prior year. This increase was primarily a result of higher pricing and increased volumes which were partially offset by higher cost of sales 27
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associated with inflation, adverse manufacturing performance including labor issues and supply chain disruptions. Gross margin decreased to 29.2% in 2022 from 32.3% the previous year.
Selling, general and administrative expenses ("SG&A") increased 9.1% to
$238.7 millionfor 2022 from $218.8 millionin the prior year. The increase in SG&A was primarily a result of higher travel and trade show expenditures, higher costs associated with inflation, investments in research and development as well as information technology, and the inclusion of i2O Water, partially offset by lower incentive compensation in personnel-related expenses and foreign exchange gains. As a percentage of net sales, SG&A decreased 60 basis points to 19.1% of net sales from 19.7% in the prior year. Strategic reorganization and other charges for 2022 of $7.2 millionprimarily consisted of certain transaction-related costs, expenses associated with our ongoing restructuring activities, and the Albertvilletragedy. For the fiscal year 2021, Strategic reorganization and other charges of $8.0 millionprimarily relate to termination benefits associated with our plant closures in Aurora, Illinoisand Surrey, British Columbia, Canada, the Albertvilletragedy, and certain transaction-related costs, partially offset by a one-time settlement gain in connection with an indemnification of a previously owned property.
During the year ended
Interest expense, net down
2022 2021 (in millions) 5.5% Senior Notes $ -
$ 17.64.0% Senior Notes 18.0 6.2 Deferred financing costs amortization 1.0 1.1 ABL Agreement 0.9 0.9 Capitalized interest (2.6) (2.3) Other interest expense 0.3 0.3 Total interest expense 17.6 23.8 Interest income (0.7) (0.4) Total interest expense, net $ 16.9 $ 23.4Income tax expense of $22.0 millionin 2022 resulted in an effective income tax rate of 22.3%, which was lower than the 25.8% rate in the prior year reflecting benefits from research and development tax credits and lower foreign tax rates. Segment Analysis Water Flow Solutions Net sales for 2022 increased $96.3 million, or 15.6%, to $714.1 millionfrom $617.8 millionin the prior year. Net sales increased primarily as a result of higher pricing and increased volumes across most of the Water Flow Solutions segment's product lines. Gross profit for 2022 increased $9.6 million, or 4.7%, to $212.4 millionfrom $202.8 millionin the prior year primarily as a result of higher pricing and increased volumes across most product lines except for service brass products, partially offset by higher cost of sales associated with inflation and unfavorable manufacturing performance, primarily at our brass foundry. Gross margin was 29.7% in 2022, as compared with 32.8% in the prior year. SG&A in 2022 increased 6.5% to $87.1 millionfrom $81.8 millionin the prior year primarily as a result of increased travel and trade show expenditures, higher costs associated with inflation, and investments in research and development and information technology. SG&A as a percentage of net sales was 12.2% and 13.2% for 2022 and 2021, respectively.
During the year ended
Table of Contents Index to Financial Statements Water Management Solutions
Net sales in 2022 increased by 8.1% to reach
Gross profit in 2022 decreased
$3.8 millionto $151.9 millionfrom $155.7 millionin the prior year. Gross margin decreased to 28.5% in 2022 from 31.6% in the prior year primarily as a result of higher cost of sales associated with inflation, and unfavorable manufacturing performance, partially offset by higher pricing and increased volumes. SG&A increased 19.8% to $102.8 millionin 2022 from $85.8 millionin the prior year primarily as a result of investments in research and development, the inclusion of i2O Water, increased travel and trade show expenditures, and higher costs associated with inflation, partially offset by foreign exchange gains. SG&A as a percentage of net sales was 19.3% for 2022 and 17.4% in the prior year.
SG&A decreased by
$2.4 millionfrom $51.2 millionin 2021 to $48.8 millionin 2022 as a result of lower personnel-related expenses partially offset by higher costs associated with inflation. 29
Financial statement index
Year ended September 30, 2021 Water Water Flow Management Solutions Solutions Corporate Consolidated (in millions) Net sales
$ 617.8 $ 493.2$ - $ 1,111.0Gross profit $ 202.8 $ 155.7$ - $ 358.5Operating expenses: Selling, general and administrative 81.8 85.8 51.2 218.8 Strategic reorganization and other (benefits) charges 0.1 (0.4) 8.3 8.0 Total operating expenses 81.9 85.4 59.5 226.8 Operating income (loss) $ 120.9 $ 70.3 $ (59.5)131.7 Pension benefit other than service (3.3) Interest expense, net 23.4 Loss on early extinguishment of debt 16.7 Income before income taxes 94.9 Income tax expense 24.5 Net income $ 70.4Year ended September 30, 2020 Water Water Flow Management Solutions Solutions Corporate Consolidated (in millions) Net sales $ 532.2 $ 431.9$ - $ 964.1Gross profit $ 180.0 $ 148.2$ - $ 328.2Operating expenses: Selling, general and administrative 75.1 78.8 44.5 198.4 Strategic reorganization and other charges - 0.7 12.3 13.0 Total operating expenses 75.1 79.5 56.8 211.4 Operating income (loss) $ 104.9 $ 68.7 $ (56.8)116.8 Pension benefit other than service (3.0) Interest expense, net 25.5 Walter Energy accrual 0.2 Income before income taxes 94.1 Income tax expense 22.1 Net income $ 72.0Consolidated Analysis Net sales for 2021 increased 15.2% to $1,111.0 millionfrom $964.1 millionin the prior year primarily as a result of higher volume across most of our product lines and higher pricing. Additionally, net sales benefited as a result of $6.0 millionof Krausz sales from the elimination of the one-month reporting lag. Gross profit increased $30.3 millionto $358.5 millionfor 2021 compared with $328.2 millionin the prior year. This increase was primarily a result of increased volume and higher pricing, partially offset by higher manufacturing costs as a result of inflation, higher labor costs, and a $2.4 millioninventory write-off associated with the announcement of our plant closures in 30
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SG&A increased 10.3% to
$218.8 millionfor 2021 from $198.4 millionin the prior year. As a percentage of net sales, SG&A decreased 90 basis points to 19.7% of net sales from 20.6% in the prior year. The increase in SG&A was primarily a result of increased personnel-related expenses, including incentive compensation, sales commissions associated with higher net sales and orders, and stock-based compensation. Additional SG&A increases were a result of inflation, new product development and information technology spending. Fiscal year 2020 SG&A included pandemic-driven benefits from temporarily reduced travel, trade show and event spending as well as temporary employee furloughs and temporary salary reductions. Strategic reorganization and other charges of $8.0 millionfor 2021 primarily related to termination benefits associated with our plant closures in Aurora, Illinoisand Surrey, British Columbia, Canada, the Albertvilletragedy, and certain transaction-related costs, partially offset by a one-time settlement gain in connection with an indemnification of a previously owned property. In 2020, Strategic reorganization and other charges of $13.0 millionprimarily related to a legal settlement, facility closure costs, transaction costs associated with the acquisition of Krausz, and personnel matters.
Interest expense, net down
2021 2020 (in millions) 5.5% Senior Notes
$ 17.6 $ 24.84.0% Senior Notes 6.2 - Deferred financing costs amortization 1.1 1.2 ABL Agreement 0.9 0.6 Capitalized interest (2.3) (0.3) Other interest expense 0.3 0.3 Total interest expense 23.8 26.6 Interest income (0.4) (1.1) Total interest expense, net $ 23.4 $ 25.5
Income tax expense of
Net sales for 2021 increased
$85.6 million, or 16.1%, to $617.8 millionfrom $532.2 millionin the prior year. Net sales increased primarily as a result of increased volume, and favorable pricing. The increased volume was a result of strong demand driven by both residential construction and municipal repair and replacement activity. Gross profit for 2021 increased $22.8 million, or 12.7%, to $202.8 millionfrom $180.0 millionin the prior year primarily as a result of increased volume. These increases were partially offset by higher material and other costs associated with inflation, specifically related to brass ingot, scrap steel and purchased parts, a $2.4 millioninventory write-off associated with the announcement of the closure of our Aurora, Illinoisand Surrey, British Columbia, Canada facilities and certain expenses related to the pandemic, including voluntary emergency paid leave and other employee costs as well as additional sanitation and cleaning expenses. Gross margin was 32.8% in 2021, a 100 basis point decrease compared with 33.8% in the prior year. SG&A in 2021 increased $6.7 million, or 8.9% to $81.8 millionfrom $75.1 millionin the prior year primarily as a result of increased personnel-related costs including higher sales commissions associated with higher net sales and orders, inflation, information technology spending, and new product development. Fiscal year 2020 SG&A included pandemic-driven benefits resulting from temporarily reduced travel, trade show and event spending as well as temporary employee furloughs and temporary salary reductions. SG&A was 13.2% and 14.1% of net sales for 2021 and 2020, respectively. 31
Table of Contents Index to Financial Statements Water Management Solutions Net sales in 2021 increased 14.2% to
$493.2 millionfrom $431.9 millionin the prior year primarily as a result of higher volumes, $6.0 millionin Krausz net sales as a result of the elimination of the one-month reporting lag, and the acquisition of i2O.
Gross profit in 2021 increased
SG&A increased to
$85.8 millionin 2021 from $78.8 millionin the prior year primarily as a result of personnel-related expenses and information technology spending. Fiscal year 2020 SG&A included pandemic-driven benefits resulting from temporarily reduced travel, trade show and event spending as well as temporary employee furloughs and temporary salary reductions. SG&A as a percentage of net sales was 17.4% for 2021 and 18.2% in the prior year.
SG&A increased by
$6.7 millionfrom $44.5 millionin 2020 to $51.2 millionin 2021 as a result of increased personnel-related expenses and inflation. Fiscal year 2020 SG&A included pandemic-driven benefits resulting from temporary reductions in travel, trade show and event spending as well as temporary employee furloughs and temporary salary reductions.
Cash and cash equivalents were
$146.5 millionat September 30, 2022and $227.5 millionat September 30, 2021. Cash and cash equivalents decreased during 2022 as a result of capital expenditures of $54.7 million, dividend payments of $36.5 million, $35.0 millionin share repurchases, and $6.4 millionin effect of currency exchange rate changes on cash, partially offset by $52.3 millionin cash provided by operating activities. Receivables, net were $228.0 millionat September 30, 2022and $212.2 millionat September 30, 2021. This increase was primarily a result of the increase in net sales year over year. Inventories, net were $278.7 millionat September 30, 2022and $184.7 millionat September 30, 2021. Inventories increased during 2022 as a result of increased volume, inflationary costs, and inventory management due to supply chain issues. Property, plant and equipment, net was $301.6 millionat September 30, 2022and $283.4 millionat September 30, 2021. Property, plant and equipment increased primarily as a result of our previously-announced capital expansion projects in Kimball, Tennesseeand Decatur, Illinois. Capital expenditures were $54.7 millionin 2022. Depreciation expense was $32.0 millionin 2022 compared with $31.4 millionin 2021 as a result of generally higher level of capital expenditures over the last three years. Intangible assets were $361.2 millionat September 30, 2022and $392.5 millionat September 30, 2021. Finite-lived intangible assets, net totaling $88.5 millionat September 30, 2022, are amortized over their estimated useful lives. Amortization expense was $28.5 millionin 2022 and $28.2 millionin 2021. We expect amortization expense for these assets to be approximately $28 millionand $27 millionin the next two years with a decrease to approximately $8 millionin fiscal 2025, approximately $6 millionin fiscal 2026 and approximately $5 millionin fiscal 2027. Indefinite-lived intangible assets, $272.7 millionat September 30, 2022, are not amortized but are tested for possible impairment at least annually. Accounts payable and other current liabilities were $240.2 millionat September 30, 2022and $219.1 millionat September 30, 2021. Accounts payable increased during 2022 as a result of increased production volume and the impact of higher inventory costs. Other current liabilities decreased during 2022 primarily as a result of lower personnel-related expenses, including incentive compensation and sales commissions, as well as customer rebates and income taxes.
The total outstanding debt was
Deferred income taxes were net liabilities of
$86.3 millionat September 30, 2022and $94.8 millionat September 30, 2021, primarily related to intangible assets. The $8.5 milliondecrease in the net liability was primarily a result of reductions in intangible assets. 32
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Cash and capital resources
We had cash and cash equivalents of
$146.5 millionat September 30, 2022and approximately $160.7 millionof additional borrowing capacity under our asset-based lending arrangement (the "ABL") based on September 30, 2022data. Undistributed earnings from our subsidiaries in Israel, Canadaand Chinaare considered to be permanently invested outside of the United States. At September 30, 2022, cash and cash equivalents included $40.5 million, $18.9 million, and $5.2 millionin Israel, Canadaand China, respectively.
We declared a quarterly dividend of
$35.0 millionof our outstanding common stock during the fiscal year ended September 30, 2022and had $100.0 millionremaining under our share repurchase authorization as of September 30, 2022. The ABL and 4.0% Senior Notes contain customary representations and warranties, covenants and provisions governing an event of default. The covenants restrict our ability to engage in certain specified activities including, but not limited to, the payment of dividends and the redemption of our common stock. Collections from customers were higher during the fiscal year ended September 30, 2022as compared with the prior year period primarily as a result of net sales growth. Inventory purchases increased during the fiscal year ended September 30, 2022as compared with the fiscal year ended September 30, 2021as a result of inflation, increased sales, and inventory management due to supply chain factors. Other current liabilities and other noncurrent liabilities decreased as a result of employee incentive payouts, income tax payments, the repayment of the CARES Act employer payroll tax deferral and the payment of customer rebates. Capital expenditures were $54.7 millionfor 2022 compared with $62.7 millionfor 2021. Capital expenditures decreased primarily as a result of lower expenditures associated with the new Decaturfoundry as compared with the prior year period. We estimate 2023 capital expenditures will be between $70.0 millionand $80.0 million.
Income tax payments were higher in 2022 compared to the prior year, primarily due to the timing of certain federal and state extension payments. We expect the effective tax rate in 2023 to be between 23% and 25%.
Our stock repurchase program allows us to repurchase up to
$250.0 millionof our common stock, of which we had remaining authorization of $100.0 millionas of September 30, 2022. The program does not commit us to any particular timing or quantity of purchases, and we may suspend or discontinue the program at any time. We acquired 2,654,254 and 651,271 shares of our common stock in 2022 and 2021, respectively. We use letters of credit and surety bonds in the ordinary course of business to ensure the performance of contractual obligations. As of September 30, 2022, we had $14.1 millionof letters of credit and $31.1 millionof surety bonds outstanding. We anticipate our existing cash, cash equivalents and borrowing capacity combined with our expected operating cash flows will be sufficient to meet our anticipated operating needs, income tax payments, capital expenditures and debt service obligations as they become due through September 30, 2023. However, our ability to make these payments will depend largely on our future operating performance, which may be affected by general economic, financial, competitive, legislative, regulatory, business and other factors beyond our control.
Our ABL, as amended, is provided by a consortium of banking institutions and consists of a revolving credit facility that
$175.0 millionin borrowing that expires in July 29, 2025. Included in the ABL is the ability to borrow up to $25.0 millionof swing line loans and up to $60.0 millionof letters of credit. The ABL permits us to increase the size of the credit facility by an additional $150.0 millionin certain circumstances subject to adequate borrowing base availability. Borrowings under the ABL bear interest at a floating rate equal to the LondonInter Bank Offered Rate ("LIBOR") plus an applicable margin range of 200 to 225 basis points, or a base rate, as defined in the ABL, plus an applicable margin of 100 to 125 basis points. At September 30, 2022, the applicable margin was 200 basis points for LIBOR-based loans and 100 basis points for base rate loans. 33
Table of Contents Index to Financial Statements The ABL is subject to mandatory prepayments if total outstanding borrowings under the ABL are greater than the aggregate commitments under the revolving credit facility or if we dispose of overdue accounts receivable in certain circumstances. The borrowing base under the ABL is equal to the sum of (a) 85% of the value of eligible accounts receivable and (b) the lesser of (i) 70% of the value of eligible inventory or (ii) 85% of the net orderly liquidation value of eligible inventory, less certain reserves. Prepayments can be made at any time without penalty. Substantially all of our
United Statessubsidiaries are borrowers under the ABL and are jointly and severally liable for any outstanding borrowings. Our obligations under the ABL are secured by a first-priority perfected lien on all of our United Statesinventory, accounts receivable, certain cash balances and other supporting obligations. The ABL includes a commitment fee for any unused borrowing capacity of 37.5 basis points per annum. Borrowings are not subject to any financial maintenance covenants unless excess availability is less than the greater of $17.5 millionand 10% of the Loan Cap as defined in the ABL. Excess availability based on September 30, 2022data was $160.7 million, as reduced by $14.1 millionof outstanding letters of credit and $0.2 millionof accrued fees and expenses.
4.0% Senior Unsecured Notes
May 28, 2021, we privately issued $450.0 millionof 4.0% Senior Unsecured Notes ("4.0% Senior Notes"), which mature on June 15, 2029and bear interest at 4.0%, paid semi-annually in June and December. We capitalized $5.5 millionof financing costs, which are being amortized over the term of the 4.0% Senior Notes using the effective interest method. Proceeds from the 4.0% Senior Notes, along with cash on hand were used to redeem previously existing 5.5% Senior Notes. Substantially all of our U.S.subsidiaries guarantee the 4.0% Senior Notes, which are subordinate to borrowings under our ABL. Based on quoted market prices the outstanding 4.0% Senior Notes had a fair value of $382.1 millionat September 30, 2022. An indenture securing the 4.0% Senior Notes ("Indenture") contains customary covenants and events of default, including covenants that limit our ability to incur certain debt and liens. We believe we were in compliance with these covenants at September 30, 2022. There are no financial maintenance covenants associated with the Indenture. As set forth in the Indenture, we may redeem some or all of the 4.0% Senior Notes at any time prior to June 15, 2024, at certain "make-whole" redemption prices and on or after June 15, 2024at specified redemption prices. Additionally, we may redeem up to 40% of the aggregate principal amount of the 4.0% Senior Notes at any time prior to June 15, 2024, with the net proceeds of specified equity offerings at specified redemption prices as set forth in the Indenture. Upon a change of control as defined in the Indenture, we would be required to offer to purchase the 4.0% Senior Notes at a price equal to 101% of the outstanding principal amount of the 4.0% Senior Notes.
5.5% Senior Unsecured Notes
June 12, 2018, we privately issued $450.0 millionof 5.5% Senior Unsecured Notes ("5.5% Senior Notes"), which were set to mature in 2026 and bore interest at 5.5%, paid semi-annually. We called the 5.5% Senior Notes effective June 17, 2021and settled with proceeds from the issuance of the 4.0% Senior Notes and cash on hand. As a result, we incurred $16.7 millionin loss on early extinguishment of debt, comprised of a $12.4 millioncall premium and a $4.3 millionwrite-off of the remaining deferred debt issuance costs associated with the retirement of the 5.5% Senior Notes.
Our corporate credit rating and the credit ratings for our debt and outlook are presented below. Moody's Standard & Poor's September 30, September 30, 2022 2021 2022 2021 Corporate credit rating Ba1 Ba1 BB BB ABL Agreement Not rated Not rated Not rated Not rated 4.0% Senior Notes Ba1 Ba1 BB BB Outlook Stable Stable Stable Stable Effect of Inflation We experience changing price levels primarily related to purchased components and raw materials. During the fiscal year 2022, we experienced a 40% increase in the average cost per ton of scrap steel and a 20% increase in the average cost of brass as compared to 2021. We anticipate inflation in raw and other material costs in 2023, which may have an adverse effect on our margins to the extent we are unable to pass on such higher costs to our customers. 34
Table of Contents Index to Financial Statements Material Cash Requirements We enter into a variety of contractual obligations as part of our normal operations in addition to capital expenditures. As of
September 30, 2022, we have (i) debt obligations related to our $450.0 million4.0% Senior Notes which mature in 2029 and include cash interest payments of $18.0 millionin 2023 annually through 2029; (ii) cumulative cash obligations of $32.6 millionfor operating leases through 2033 and $1.7 millionfor finance leases through 2026; and (iii) purchase obligations for raw materials and other purchased parts of approximately $155.1 millionwhich we will incur during 2023. We expect to fund these cash requirements from cash on hand and cash generated from operations. Seasonality Our business is seasonal as a result of the impact of cold weather conditions. Net sales and operating income historically have been lowest in the three month periods ending December 31and March 31when the northern United Statesand all of Canadagenerally face weather conditions that restrict significant construction activity. See "Item 1A. RISK FACTORS-Seasonal demand for certain of our products and services may adversely affect our financial results."
Critical accounting estimates
The preparation of financial statements in accordance with accounting principles generally accepted in
the United States("GAAP") requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosure of contingent assets and liabilities. These estimates are based upon experience and on various other assumptions we believe to be reasonable under the circumstances. Actual results may differ from these estimates. We consider an accounting estimate to be critical if changes in the estimate that are reasonably likely to occur over time or the use of reasonably different estimates could have a material impact on our financial condition or results of operations. Our critical accounting estimates include the below items.
We recognize revenue when control of promised products or services is transferred to our customers, in amounts that reflect the consideration to which we expect to be entitled in exchange for those products or services. We account for a contract when it has approval and commitment from both parties, the rights of the parties are identified, the payment terms are identified, the contract has commercial substance and collectability of consideration is probable. We determine the appropriate revenue recognition for our contracts with customers by analyzing the type, terms and conditions of each contract or arrangement with a customer. See Note 3. for more information regarding our revenues.
We record inventories at the lower of first-in, first-out method cost or estimated net realizable value. Inventory cost includes an overhead component that can be affected by levels of production and actual costs incurred. We evaluate the need to record adjustments for impairment of inventory at least quarterly. This evaluation includes such factors as anticipated usage, inventory levels and ultimate product sales value. If in our judgment persuasive evidence exists that the net realizable value of inventory is lower than its cost, the inventory value is written-down to its estimated net realizable value. Significant judgments regarding future events and market conditions must be made when estimating net realizable value.
We recognize deferred tax liabilities and deferred tax assets for the expected future tax consequences of events that have been included in the financial statements or tax returns. Deferred tax liabilities and assets are determined based on the differences between the financial statements and the tax basis of assets and liabilities, using enacted tax rates in effect for the years in which the differences are expected to reverse. A valuation allowance is provided to offset any net deferred tax assets when, based upon the available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. Our deferred tax liabilities and assets are based on our expectations of future operating performance, reversal of taxable temporary differences, tax planning strategies, interpretation of the tax regulations currently enacted and rulings in numerous tax jurisdictions. 35
Table of Contents Index to Financial Statements We only record tax benefits for positions that we believe are more likely than not of being sustained under audit examination based solely on the technical merits of the associated tax position. The amount of tax benefit recognized for any position that meets the more-likely-than-not threshold is the largest amount of the tax benefit that we believe is greater than 50% likely of being realized.
Recognition of the impairment of
We test goodwill and indefinite-lived intangible assets for impairment annually or more frequently if events or circumstances indicate possible impairment. We performed this annual impairment testing at
September 1, 2022, using standard valuation methodologies and rates that we considered reasonable and appropriate. We evaluate goodwill for impairment using a quantitative analysis. The carrying value of the reporting unit, including goodwill, is compared with the estimated fair value of the reporting unit utilizing a combination of the income and market approaches. The income approach, which is a level 3 fair value measurement, is based on projected debt-free cash flow which is discounted to the present value using discount rates that consider the timing and risk of the cash flows. The market approach is based on the guideline public company method, which uses market multiples to value our reporting units. We weight the income and market approaches in a manner considering the risks of the underlying cash flows. This income approach is dependent on management's best estimates of future operating results, including forecasted revenues, earnings before interest, taxes, depreciation and amortization ("EBITDA") margins and the selection of discount rates. There are inherent uncertainties related to the assumptions used and to management's application of these assumptions. We test our trade name indefinite-lived intangible assets for impairment using a "royalty savings method," which is a variation of the discounted cash flow method. This method estimates a fair value by calculating an estimated discounted future cash flow stream from the hypothetical licensing of the indefinite-lived intangible assets. If this estimated fair value exceeds the carrying value, no impairment is indicated. This analysis is dependent on management's best estimates of future operating results and the selection of reasonable discount rates and hypothetical royalty rates. We performed our annual impairment testing at September 1, 2022. As a result of this quantitative testing, we recognized a $6.8 milliongoodwill impairment charge for a reporting unit within our Water Flow Solutions segment as the carrying value exceeded its fair value. Our determination of the estimated fair value was based on a combination of the discounted cash flow method and the guideline public company method. Our testing indicated no other impairment.
We accrue for warranty expenses that can include customer costs of repair and/or replacement, including labor, materials, equipment, freight and reasonable overhead costs. We accrue for the estimated cost of product warranties at the time of sale if such costs are determined to be reasonably estimable at that time. Warranty cost estimates are revised throughout applicable warranty periods as better information regarding warranty costs becomes available. Critical factors in our analyses include warranty terms, specific claim situations, general incurred and projected failure rates, the nature of product failures, product and labor costs, and general business conditions. These estimates are inherently uncertain as they are based on historical data. If warranty claims are made in the current period for issues that have not historically been the subject of warranty claims and were not taken into consideration in establishing the accrual or if claims for issues already considered in establishing the accrual exceed expectations, warranty expense may exceed the accrual for that particular product. Additionally, a significant increase in costs of repair or replacement could require additional warranty expense. We monitor and analyze our warranty experience and costs periodically and revise our warranty accrual as necessary. However, as we cannot predict actual future claims, the potential exists for the difference in any one reporting period to be material. 36
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We are involved in litigation, investigations and claims arising in the normal course of business. We estimate and accrue liabilities resulting from such matters based on a variety of factors, including outstanding legal claims and proposed settlements; assessments by counsel of pending or threatened litigation; and assessments of potential environmental liabilities and remediation costs. We believe we have adequately accrued for these potential liabilities; however, facts and circumstances may change and could cause the actual liability to exceed the estimates, or may require adjustments to the recorded liability balances in the future. As we learn new facts concerning contingencies, we reassess our position both with respect to accrued liabilities and other potential exposures. Estimates particularly sensitive to future changes include liabilities recorded for environmental remediation, tax and legal matters. Estimated future environmental remediation costs are subject to change as a result of such factors as the uncertain magnitude of cleanup costs, the unknown time and extent of such remedial actions that may be required, and the determination of our liability in proportion to that of other responsible parties. Estimated future costs related to tax and legal matters are subject to change as events evolve and as additional information becomes available during the administrative and litigation processes. For more information on these and other contingencies, see Note 17. of the Notes to Consolidated Financial Statements. See also "Item 1. BUSINESS - Regulatory and Environmental Matters," "Item 1A. RISK FACTORS".
Workers’ compensation, defined benefit pension plans, environmental liability and other long-term liabilities
We are obligated for various liabilities that ultimately will be determined over what could be very long future time periods. We established the recorded liabilities for such items at
September 30, 2022using estimates for when such amounts will be paid and what the amounts of such payments will be. These estimates are subject to change based on numerous factors including, among others, regulatory changes, technology changes, the investment performance of related assets, longevity of participants, the discount rate used and changes to plan designs. Business Combinations We recognize assets acquired and liabilities assumed at their estimated acquisition date fair values, with the excess of purchase price over the estimated fair values of identifiable net assets recorded as goodwill. Assigning fair values requires us to make significant estimates and assumptions regarding the fair value of identifiable intangible assets. We may refine these estimates if necessary over a period not to exceed one year by taking into consideration new information that, if known at the acquisition date, would have affected the fair values recognized for assets acquired and liabilities assumed. Significant estimates and assumptions are used in estimating the value of acquired identifiable intangible assets, including estimating future cash flows based on forecasted revenues and EBITDA margins that we expect to generate following the acquisition, selecting an applicable royalty rate where needed, applying an appropriate discount rate to estimate a present value of those cash flows and determining their useful lives. These assumptions are forward-looking and could be affected by future economic and market conditions.
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