Mueller Water Products, Inc. 10-Q

Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion should be read in conjunction with the unaudited condensed consolidated financial statements and notes thereto that appear elsewhere in this report. This report contains certain statements that may be deemed “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. All statements that address activities, events or developments that the Company intends, expects, plans, projects, believes or anticipates will or may occur in the future are forward-looking statements, including, without limitation, statements regarding outlooks, projections, forecasts, trend descriptions, the COVID-19 pandemic, go-to-market strategies, operational excellence, acceleration of new product development, end market performance, net sales performance, adjusted operating income and adjusted EBITDA performance, margins, capital expenditure plans, litigation outcomes, capital allocation and growth strategies, and future warranty charges. Forward-looking statements are based on certain assumptions and assessments made by the Company in light of the Company’s experience and perception of historical trends, current conditions and expected future developments. Actual results and the timing of events may differ materially from those contemplated by the forward-looking statements due to a number of factors, including the extent, duration and severity of the impact of the pandemic on the Company’s operations and results, including effects on the financial health of customers (including collections), the Company and the financial/capital markets, government-mandated facility closures, COVID-19 related facility closures and other manufacturing restrictions, logistical challenges and supply chain interruptions, potential litigation and claims emanating from the COVID-19 pandemic, and health, safety and employee/labor issues in Company facilities around the world; unexpected or greater than expected increases in costs of raw materials; regional, national or global political, economic, market and competitive conditions; cyclical and changing demand in core markets such as municipal spending; government monetary or fiscal policies; residential and nonresidential construction, and natural gas distribution; manufacturing and product performance; expectations for changes in volumes, continued execution of cost productivity initiatives and improved pricing; warranty exposures (including the adequacy of warranty reserves); the Company’s ability to successfully resolve significant legal proceedings, claims, lawsuits or government investigations; compliance with environmental, trade and anti-corruption laws and regulations; changing regulatory, trade and tariff conditions; failure to achieve expected cost savings, net sales expectations, profitability expectations and manufacturing efficiencies from our large capital investments in Chattanooga and Kimball, Tennessee and Decatur, Illinois; the failure to integrate and/or realize any of the anticipated benefits of recent acquisitions or divestitures; and other factors that are described in the section entitled “RISK FACTORS” in Item 1A of the Company’s most recently filed Annual Report on Form 10-K and in this Quarterly Report on Form 10-Q (all of which risks may be amplified by the pandemic). Forward-looking statements do not guarantee future performance and are only as of the date they are made. The Company undertakes no duty to update its forward-looking statements except as required by law. Undue reliance should not be placed on any forward-looking statements. You are advised to review any further disclosures the Company makes on related subjects in subsequent Forms 10-K, 10-Q, 8-K and other reports filed with the U.S. Securities and Exchange Commission. Overview Organization On October 3, 2005, Walter Energy, Inc (“Walter Energy”) acquired all outstanding shares of capital stock representing the Mueller Co. and Anvil businesses and contributed them to its U.S. Pipe business to form Mueller Water Products, Inc. (“Mueller” or the “Company”). In June 2006, we completed an initial public offering of 28,750,000 shares of Series A common stock and in December 2006, Walter Energy distributed to its shareholders all of its equity interests in Mueller, completing our spin-off. We subsequently sold our U.S. Pipe and Anvil businesses in 2012 and 2017, respectively. Business We estimate approximately 60-65% of our 2020 net sales were for repair and replacement directly related to municipal water infrastructure spending, approximately 25-30% were related to residential construction activity and less than 10% were related to natural gas utilities spending. We expect the operating environment during our fiscal year 2021 to continue to be very challenging due to the uncertainty around the depth and duration of the pandemic. We anticipate that growth in the residential construction end market will help offset anticipated challenges in the project-related portion of the municipal market. In January 2021, Blue Chip Economic Indicators forecasted a 7% increase in housing starts for calendar 2021 compared to the prior year primarily due to the low interest rate environment in the United States. 17 We have continued to incur additional costs to address the pandemic as discussed herein, including costs associated with unfavorable volume variances, voluntary emergency paid leave, additional cleaning, disinfectants and sanitation materials for our employees and at our facilities. We expect to continue to incur such costs, which may be significant, as we continue to implement operational changes in response to this pandemic. All of our facilities are operational and our teams have worked effectively to address the few temporary closures we have experienced. The pandemic also caused supply chain disruption that has resulted in higher costs in the manufacture of our products. We expect these conditions to persist in the near term and may worsen until the pandemic abates. Infrastructure In December 2018, we completed our acquisition of Krausz Development Ltd. and subsidiaries (“Krausz”), a manufacturer of pipe couplings, grips and clamps with operations in the United States and Israel. We include financial results of Krausz in our consolidated financial statements on a one-month lag. In October 2019, we acquired the noncontrolling interest of our previously existing joint venture operation for a negotiated purchase price of $5.4 million. Technologies The municipal market is the key end market for Technologies. The businesses in Technologies are project-oriented and depend on customer adoption of their technology-based products and services. 18 Results of Operations Three Months Ended December 31, 2020 Compared to Three Months Ended December 31, 2019 Three months ended December 31, 2020 Infrastructure Technologies Corporate Total (in millions) Net sales $ 215.9 $ 21.5 $ — $ 237.4 Gross profit 73.7 4.7 — $ 78.4 Operating expenses: Selling, general and administrative 32.0 6.2 11.0 49.2 Strategic reorganization and other charges 0.1 — 1.3 1.4 32.1 6.2 12.3 50.6 Operating income (loss) $ 41.6 $ (1.5) $ (12.3) 27.8 Non-operating expenses: Pension benefit other than service (0.8) Interest expense, net 6.1 Income before income taxes 22.5 Income tax expense 5.8 Net income $ 16.7 Three months ended December 31, 2019 (1) Infrastructure Technologies Corporate Total (in millions) Net sales $ 192.3 $ 20.3 $ — $ 212.6 Gross profit 68.0 4.6 — $ 72.6 Operating expenses: Selling, general and administrative 32.5 6.4 11.0 49.9 Strategic reorganization and other charges — — 2.4 2.4 32.5 6.4 13.4 52.3 Operating income (loss) $ 35.5 $ (1.8) $ (13.4) 20.3 Pension benefit other than service (0.7) Interest expense, net 7.4 Walter Energy accrual 0.2 Income before income taxes 13.4 Income tax expense 3.1 Net income $ 10.3 (1) Net sales, gross profit, and SG&A expenses associated with certain products have been reclassified as Technologies segment items to conform to the current period presentation. Consolidated Analysis Net sales for the three months ended December 31, 2020 increased 11.7 percent or $24.8 million to $237.4 million from $212.6 million primarily due to increased shipment volumes across most of our product lines and higher pricing. Gross profit for the three months ended December 31, 2020 increased $5.8 million to $78.4 million from $72.6 million in the prior year period, primarily due to increased shipment volumes and higher pricing, which were offset by $1.5 million of expenses related to the pandemic, including certain unfavorable volume variances treated as period costs, voluntary emergency paid leave for employees and additional sanitation and cleaning fees, and higher costs associated with inflation. Gross margin was 33.0% for the three months ended December 31, 2020 compared to 34.1% in the prior year period. Selling, general and administrative expenses (“SG&A”) for the three months ended December 31, 2020 decreased to $49.2 million from $49.9 million in the prior year period due primarily to temporary expense reductions related to the pandemic, including reduced travel, trade shows and events. These benefits were partially offset by increases in other personnel-related expenses. SG&A as a percentage of net sales was 20.7% and 23.5% in the three months ended December 31, 2020 and 2019, respectively. 19 Strategic reorganization and other charges in the three months ended December 31, 2020 were $1.4 million, which primarily related to legal and professional service expenses, and were $2.4 million in the prior year period. Interest expense, net declined $1.3 million in the three months ended December 31, 2020 compared to the prior year period primarily due to a non-cash adjustment to capitalized interest in the prior year. The components of net interest expense are provided below. Three months ended December 31, 2020 2019 (in millions) Notes $ 6.2 $ 6.2 Deferred financing costs amortization 0.3 0.3 ABL Agreement 0.2 0.1 Capitalized interest (0.6) 1.3 Other interest cost 0.2 — 6.3 7.9 Interest income (0.2) (0.5) Interest expense, net $ 6.1 $ 7.4 The reconciliation between the U.S. federal statutory income tax rate and the effective tax rate is presented below. Three months ended December 31, 2020 2019 U.S. federal statutory income tax rate 21.0 % 21.0 % Adjustments to reconcile to the effective tax rate: State income taxes, net of federal benefit 4.5 4.5 Excess tax benefits related to stock-based compensation (0.6) (1.5) Tax credits (1.4) (1.1) Global Intangible Low-taxed Income 0.6 0.1 Foreign income tax rate differential (0.9) (0.7) Valuation allowance 1.5 (0.7) Other 1.1 1.5 25.8 % 23.1 % Walter Energy accrual — (0.3) % Effective income tax rate 25.8 % 22.8 % Segment Analysis Infrastructure Net sales for the three months ended December 31, 2020 increased 12.3 percent to $215.9 million compared to $192.3 million in the prior year period primarily due to higher shipment volumes across most of our product lines as well as higher pricing. Gross profit for the three months ended December 31, 2020 increased to $73.7 million from $68.0 million in the prior year period primarily due to increased shipment volumes, partially offset by $1.4 million of expenses related to the pandemic, including certain unfavorable volume variances treated as period costs, and higher costs associated with inflation. Gross margin was 34.1% for the three months ended December 31, 2020 and was 35.4% in the prior year period. SG&A for the three months ended December 31, 2020 decreased to $32.0 million from $32.5 million in the prior year period. This decrease was due primarily to temporary expense reductions of $1.4 million related to the pandemic, including reduced travel, trade shows and events, partially offset by increases in other personnel-related expenses. SG&A as a percentage of net sales was 14.8% and 16.9% for the three months ended December 31, 2020 and 2019, respectively. Technologies Net sales in the three months ended December 31, 2020 increased to $21.5 million from $20.3 million in the prior year period, primarily due to higher shipment volumes of our metering and leak detection-related products. 20 Gross profit in the three months ended December 31, 2020 was $4.7 million and was $4.6 million in the prior year period. SG&A decreased to $6.2 million from $6.4 million in the prior year period primarily due to temporary expense reductions related to the pandemic, including reduced travel, trade shows and events. SG&A as a percentage of net sales was 28.8% and 31.5% for the three months ended December 31, 2020 and 2019, respectively. Corporate SG&A was $11.0 million in each of the three months ended December 31, 2020 and 2019. Liquidity and Capital Resources We had cash, cash equivalents and restricted cash on hand of $223.0 million at December 31, 2020 and $113.4 million of additional borrowing capacity under our ABL Agreement based on December 31, 2020 data. Undistributed earnings from our subsidiaries in Canada, China, and Israel are considered to be permanently invested outside the United States. At December 31, 2020, cash and cash equivalents included $13.1 million, $6.7 million and $21.7 million in Canada, China and Israel, respectively. We declared a quarterly dividend of $0.055 per share on January 28, 2021, payable on February 22, 2021, which will result in an estimated $8.7 million cash outlay. We did not repurchase any shares of our outstanding common stock during the three months ended December 31, 2020 and had $145.0 million remaining on our share repurchase authorization. The ABL Agreement and 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. Cash flows from operating activities are categorized below. Three months ended December 31, 2020 2019 (in millions) Collections from customers $ 261.5 $ 253.6 Disbursements, other than interest and income taxes (214.3) (231.4) Walter Energy payment — (22.2) Interest payments, net (12.4) (12.0) Income tax payments, net (0.7) (0.4) Cash provided by operating activities $ 34.1 $ (12.4) Collections from customers were higher during the three months ended December 31, 2020 compared to the prior year period primarily due to net sales growth. Decreased disbursements, other than interest and income taxes, during the three months ended December 31, 2020 primarily reflect the results of improvements in working capital management. Additionally, we disbursed $22.2 million related to the final settlement of the Walter tax matter in the prior year period. Capital expenditures were $15.6 million in the three months ended December 31, 2020 and were $15.2 million in the prior year period. These expenditures were primarily associated with previously-announced large capital projects. For fiscal 2021, we have provided guidance that our capital expenditures are expected to be between $80.0 million and $90.0 million. We anticipate that our existing cash, cash equivalents and borrowing capacity combined with our expected operating cash flows will be sufficient to meet our anticipated operating expenses, income tax payments, capital expenditures and debt service obligations as they become due through December 31, 2021. We believe that additional borrowings through various financing alternatives remain available if required. The future effects of the pandemic cannot be predicted with certainty and may increase our borrowing costs and other costs of capital or otherwise adversely affect our financial condition and liquidity, and we cannot guarantee that we will have access to external financing at times and on terms we consider acceptable, or at all, or that we will not experience other liquidity issues going forward. 21 ABL Agreement At December 31, 2020, the ABL Agreement consisted of a revolving credit facility for up to $175.0 million of revolving credit borrowings, swing line loans and letters of credit. The ABL Agreement permits us to increase the size of the credit facility by an additional $150.0 million in certain circumstances subject to adequate borrowing base availability. We may borrow up to $25.0 million through swing line loans and may have up to $60.0 million of letters of credit outstanding. In July 2020, the maturity of the ABL Agreement was extended to July 29, 2025 and borrowings under the amended ABL Agreement bear interest at a floating rate equal to LIBOR, plus an applicable margin ranging from 200 to 225 basis points, or a base rate, as defined in the ABL Agreement, plus a margin ranging from 100 to 125 basis points. At December 31, 2020, the applicable LIBOR-based margin was 200 basis points. The amended ABL agreement also calls for a commitment fee of 37.5 basis points, annually, on undrawn amounts. The ABL Agreement is subject to mandatory prepayments if total outstanding borrowings under the ABL Agreement 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 Agreement 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 inventories or (ii) 85% of the net orderly liquidation value of the value of eligible inventories, less certain reserves. Prepayments can be made at any time with no penalty. Substantially all of our U.S. subsidiaries are borrowers under the ABL Agreement and are jointly and severally liable for any outstanding borrowings. Our obligations under the ABL Agreement are secured by a first-priority perfected lien on all of our U.S. inventories, accounts receivable, certain cash and other supporting obligations. Borrowings are not subject to any financial maintenance covenants unless excess availability is less than the greater of $17.5 million and 10% of the Loan Cap under the ABL Agreement. 5.5% Senior Unsecured Notes On June 12, 2018, we privately issued $450.0 million of Senior Unsecured Notes (“Notes”), which mature in June 2026 and bear interest at 5.5%, paid semi-annually. Substantially all of our U.S. subsidiaries guarantee the Notes, which are subordinate to borrowings under the ABL. Based on quoted market prices, the outstanding Notes had a fair value of $466.3 million at December 31, 2020. An indenture securing the Notes (“Indenture”) contains customary covenants and events of default, including covenants that limit our ability to incur certain debt and liens, pay dividends and certain other restricted payments and make investments. There are no financial maintenance covenants associated with the Indenture. We believe we were compliant with these covenants at December 31, 2020. We may redeem some or all of the Notes at any time or from time to time prior to June 15, 2021 at certain “make-whole” redemption prices (as set forth in the Indenture) and on or after June 15, 2021 at specified redemption prices (as set forth in the Indenture). Additionally, we may redeem up to 40% of the aggregate principal amount of the Notes at any time or from time to time prior to June 15, 2021 with the net proceeds of specified equity offerings at specified redemption prices (as set forth in the Indenture). Upon a change in control (as defined in the Indenture), we will be required to offer to purchase the Notes at a price equal to 101% of the outstanding principal amount of the Notes. Our corporate credit rating and the credit rating for our debt are presented below. These ratings are not a recommendation to buy, sell or hold securities and may be subject to revision or withdrawal at any time by the assigning rating agencies. Moody’s Standard & Poor’s December 31, September 30, December 31, September 30, 2020 2020 2020 2020 Corporate credit rating Ba2 Ba2 BB BB ABL Agreement Not rated Not rated Not rated Not rated Notes Ba3 Ba3 BB BB Outlook Stable Stable Stable Stable 22 Off-Balance Sheet Arrangements We do not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as “structured finance” or “special purpose” entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. In addition, at December 31, 2020 we did not have any undisclosed borrowings, debt, derivative contracts or synthetic leases. Therefore, we were not exposed to any financing, liquidity, market or credit risk that could have arisen had we engaged in such relationships. We use letters of credit and surety bonds in the ordinary course of business to ensure the performance of contractual obligations. At December 31, 2020, we had $13.8 million of letters of credit and $42.7 million of surety bonds outstanding. Seasonality Our business is seasonal due to the impact of cold weather conditions. Net sales and operating income have historically been lowest in the three month periods ending December 31 and March 31 when the northern United States and all of Canada generally face weather conditions that restrict significant construction activity.