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, growth strategies, restructuring efficiencies and 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 and purchased components; 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 restructuring and consolidation activities and 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; an inability to achieve some or all of our Environmental, Social and Governance (“ESG”) goals ; as well as 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 are only as of the date they are made and do not guarantee future performance. 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 in subsequent Forms 10-K, 10-Q, 8-K and other reports filed with the U.S. Securities and Exchange Commission. Overview Business We estimate approximately 55-60% of our 2021 net sales were for repair and replacement directly related to municipal water infrastructure spending, approximately 30-35% were related to residential construction activity and less than 10% were related to natural gas utilities spending. We expect the operating environment during fiscal year 2022 to be very challenging as a result of the uncertainty around the depth and duration of the pandemic which has accelerated and may continue to accelerate, inflation, labor availability and global supply chain disruptions. 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 2022, Blue Chip Economic Indicators forecasted housing starts to be flat for calendar 2022 as compared with the prior year despite robust demand for housing and low inventories. We have continued to incur additional costs to address the pandemic as discussed herein, including costs associated with unfavorable manufacturing variances, labor shortages, and additional cleaning, including disinfectants and sanitation materials, for our employees and at our facilities. We expect to continue to incur such costs that may be significant as we continue to respond to the pandemic. All of our facilities are operational and our teams have worked effectively to address the few temporary closures we have experienced due to the pandemic. The last such closure was in August 2020. 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. 22 Table of Contents We announced a new management structure effective October 1, 2021. The new structure is designed to increase revenue growth, drive operational excellence, accelerate new product development and enhance profitability. We anticipate the reorganization will strengthen the alignment of products, solutions and services with customer needs, accelerate new product introductions and improve product life cycle management. The two newly named business units and reportable segments are Water Flow Solutions and Water Management Solutions. Water Flow Solutions’ product portfolio includes iron gate valves, specialty valves and service brass products. Water Flow Solutions represented 56% of our fiscal 2021 net sales. Water Management Solutions’ product and service portfolio includes fire hydrants, repair and installation, natural gas, metering, leak detection, pressure control and software products. Water Management Solutions represented 44% of our fiscal 2021 net sales. 23 Table of Contents Results of Operations Three Months Ended December 31, 2021 Compared to Three Months Ended December 31, 2020 Three months ended December 31, 2021 Water Flow Solutions Water Management Solutions Corporate Total (in millions) Net sales $ 154.9 $ 117.4 $ — $ 272.3 Gross profit 52.1 35.5 — $ 87.6 Operating expenses: Selling, general and administrative 20.8 24.0 11.5 56.3 Strategic reorganization and other charges — 0.1 2.3 2.4 Total operating expenses 20.8 24.1 13.8 58.7 Operating income (loss) $ 31.3 $ 11.4 $ (13.8) 28.9 Non-operating expenses: Pension benefit other than service (1.0) Interest expense, net 4.3 Income before income taxes 25.6 Income tax expense 6.2 Net income $ 19.4 Three months ended December 31, 2020 Water Flow Solutions Water Management Solutions Corporate Total (in millions) Net sales $ 128.8 $ 108.6 $ — $ 237.4 Gross profit 41.9 36.5 — $ 78.4 Operating expenses: Selling, general and administrative 18.7 19.5 11.0 49.2 Strategic reorganization and other charges 0.1 — 1.3 1.4 Total operating expenses 18.8 19.5 12.3 50.6 Operating income (loss) $ 23.1 $ 17.0 $ (12.3) 27.8 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 Consolidated Analysis Net sales in the three months ended December 31, 2021 increased $34.9 million or 14.7% to $272.3 million as compared with $237.4 million in the prior period primarily as a result of increased shipment volumes and higher pricing across most of our product lines. Gross profit in the three months ended December 31, 2021 increased $9.2 million to $87.6 million from $78.4 million in the prior year period, primarily as a result of increased shipment volumes and higher pricing which were partially offset by higher costs of sales associated with inflation, unfavorable manufacturing performance, labor challenges, supply chain disruptions and our restructuring activity. Gross margin was 32.2% in the three months ended December 31, 2021 as compared with 33.0% in the prior year period. Selling, general and administrative expenses (“SG&A”) in the three months ended December 31, 2021 increased to $56.3 million from $49.2 million in the prior year period primarily as a result of the inclusion of i2O Water, higher travel and trade show expenditures, inflation, increased information technology related activities, and personnel-related costs. SG&A as a percentage of net sales was 20.7% for both the three months ended December 31, 2021 and 2020. 24 Table of Contents Strategic reorganization and other charges in the three months ended December 31, 2021 were $2.4 million which primarily consisted of expenses associated with the Albertville tragedy, as well as termination benefits associated with the previously announced closures of our facilities in Aurora, Illinois and Surrey, British Columbia, Canada. Strategic reorganization and other charges in the three months ended December 31, 2020 were $1.4 million and primarily related to transaction costs as well as legal and professional service expenses. Interest expense, net declined $1.8 million in the three months ended December 31, 2021 as compared with the prior year period primarily as a result of the refinancing of our 5.5% Senior Unsecured Notes (“5.5% Senior Notes”) with the 4.0% Senior Notes. The components of net interest expense are provided below. Three months ended December 31, 2021 2020 (in millions) 5.5% Senior Notes $ — $ 6.2 4.0% Senior Notes 4.5 — Deferred financing costs amortization 0.2 0.3 ABL Agreement 0.2 0.2 Capitalized interest (0.6) (0.6) Other interest cost 0.1 0.2 Total interest expense 4.4 6.3 Interest income (0.1) (0.2) Interest expense, net $ 4.3 $ 6.1 The reconciliation between the U.S. federal statutory income tax rate and the effective income tax rate is presented below. Three months ended December 31, 2021 2020 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 3.9 4.5 Excess tax benefits related to stock-based compensation (1.0) (0.6) Tax credits (1.2) (1.4) Global Intangible Low-taxed Income 0.3 0.6 Foreign income tax rate differential (0.7) (0.9) Valuation allowances 1.4 1.5 Other 0.5 1.1 Effective income tax rate 24.2 % 25.8 % Segment Analysis Water Flow Solutions Net sales in the three months ended December 31, 2021 increased 20.3% to $154.9 million as compared with $128.8 million in the prior year period primarily as a result of increased shipment volumes and higher pricing across most of the segment’s product lines. Gross profit in the three months ended December 31, 2021 increased 24.3% to $52.1 million from $41.9 million in the prior year period primarily as a result of higher pricing, increased shipment volumes, and favorable manufacturing performance, partially offset by higher costs associated with inflation. Gross margin was 33.6% in the three months ended December 31, 2021 and 32.5% in the prior year period. 25 Table of Contents SG&A in the three months ended December 31, 2021 increased to $20.8 million from $18.7 million in the prior year period primarily as a result of increased travel and trade show expenditures, inflation, increased information technology related activities, and higher personnel-related expenses. SG&A as a percentage of net sales was 13.4% and 14.5% in the three months ended December 31, 2021 and 2020, respectively. Water Management Solutions Net sales in the three months ended December 31, 2021 increased 8.1% to $117.4 million as compared with $108.6 million in the prior year period, primarily as a result of increased shipment volumes and higher pricing across most of the segment’s product lines. Gross profit in the three months ended December 31, 2021 was $35.5 million as compared with $36.5 million in the prior year period. Gross margin declined to 30.2% in the three months ended December 31, 2021 as compared with 33.6% in the prior year period primarily as a result of higher Cost of sales associated with inflation and unfavorable manufacturing performance which was partially offset by higher pricing and increased shipment volumes. SG&A increased to $24.0 million from $19.5 million in the prior year period primarily as a result of the inclusion of i2O Water, engineering investments, inflation, increased travel and trade show expenditures, and higher personnel-related expenses. SG&A as a percentage of net sales was 20.4% and 18.0% in the three months ended December 31, 2021 and 2020, respectively. Corporate SG&A increased to $11.5 million in the three months ended December 31, 2021 as compared with $11.0 million in the three months ended December 31, 2020 primarily as a result of inflation and higher personnel-related expenses. Liquidity and Capital Resources We had cash, and cash equivalents on hand of $207.3 million at December 31, 2021 and $133.8 million of additional borrowing capacity under our ABL Agreement based on December 31, 2021 data. Undistributed earnings from our subsidiaries in Canada, China, and Israel are considered to be permanently invested outside the United States. At December 31, 2021, cash and cash equivalents included $40.6 million, $24.3 million, and $2.9 million in Israel, Canada, and China, respectively. We declared a quarterly dividend of $0.058 per share on January 27, 2022, payable on February 21, 2022 to holders of record as of February 10, 2022, which will result in an estimated $9.2 million cash outlay. We repurchased $20.0 million of our outstanding common stock during the three months ended December 31, 2021 and had $115.0 million remaining of our share repurchase authorization. The ABL Agreement 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 three months ended December 31, 2021 as compared with the prior year period primarily as a result of net sales growth between the periods. Inventory purchases increased during the three months ended December 31, 2021 as compared with the three months ended December 31, 2020 as a result of inflation, increased sales volume and supply change management. Other current liabilities and other noncurrent liabilities decreased as a result of employee incentive payouts and the repayment of the CARES Act employer payroll tax deferral. Capital expenditures were $11.0 million in the three months ended December 31, 2021 as compared with $15.6 million in the prior year period. Capital expenditures decreased as a result of lower expenditures associated with the new Decatur foundry as compared with the prior year period. For fiscal year 2022, we have provided guidance that our capital expenditures are expected to be between $70.0 million and $80.0 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, 2022. 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 26 Table of Contents financing at times and on terms we consider acceptable, or at all, or that we will not experience other liquidity issues in the future. ABL Agreement At December 31, 2021, the ABL Agreement consisted of a $175.0 million revolving credit facility which includes up to $25.0 million through swing line loans and may have up to $60.0 million of 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. Borrowings under the 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 an applicable margin ranging from 100 to 125 basis points. At December 31, 2021, the applicable rate was LIBOR plus 200 basis points. 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 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 related items. The ABL Agreement terminates on July 29, 2025 and 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 million or 10% of the Loan Cap as defined in the ABL Agreement. Excess availability based on December 31, 2021 data was $133.8 million, as reduced by $15.0 million of outstanding letters of credit and $1.4 million of accrued fees and expenses. 4.0% Senior Unsecured Notes On May 28, 2021, we privately issued $450.0 million of 4.0% Senior Unsecured Notes (“4.0% Senior Notes”), which mature in December 2029 and bear interest at 4.0%, paid semi-annually in June and December. We capitalized $5.5 million of 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 Agreement. Based on quoted market prices, the outstanding 4.0% Senior Notes had a fair value of $456.9 million at December 31, 2021. An indenture governing 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. There are no financial maintenance covenants associated with the Indenture. We believe we were in compliance with these covenants at December 31, 2021. We may redeem some or all of the 4.0% Senior Notes at any time or from time to time prior to June 15, 2024 at certain “make-whole” redemption prices (as set forth in the Indenture) and on or after June 15, 2024 at specified redemption prices (as set forth in the Indenture). Additionally, we may redeem up to 40% of the aggregate principal amount of the 4.0% Senior Notes at any time or from time to 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 in 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 On June 12, 2018, we privately issued $450.0 million of 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, 2021 and settled with proceeds from the issuance of the 4.0% Senior Notes and cash on hand. As a result, we incurred $16.7 million in loss on extinguishment of debt, comprised of a $12.4 million call premium and a $4.3 million write-off of the remaining deferred debt issuance costs associated with the retirement of the 5.5% Senior Notes. 27 Table of Contents 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, 2021 2021 2021 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 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, 2021 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, 2021, we had $15.0 million of letters of credit and $32.5 million of surety bonds outstanding. 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 31 and March 31 when the northern United States and all of Canada generally face weather conditions that restrict significant construction activity.