Item 7. Management’s Discussion and Analysis
Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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”. This section of this Form 10-K generally discusses 2024 and 2023 items and year-to-year comparisons between 2024 and 2023. Discussion of year-to-year comparisons between 2023 and 2022 that are not included in this Form 10-K can be found in Management’s Discussion and Analysis of Financial Condition and Results of Operations in Item 7. of our Annual Report on Form 10-K for the year ended September 30, 2023.
Overview
Business
We operate our business through two segments, Water Flow Solutions and Water Management Solutions. The Water Flow Solutions product portfolio includes iron gate valves, specialty valves and service brass products. The Water Management Solutions product and service portfolio includes fire hydrants, repair and installation, natural gas, metering, leak detection, as well as pressure management and control products and solutions.
In August 2023, Marietta Edmunds Zakas was appointed to Chief Executive Officer and to the Board of Directors. Ms. Zakas formerly served as our Chief Financial Officer. In May 2024, Paul McAndrew, Chief Operating Officer, was promoted to President and Chief Operating Officer. In September 2024, we announced that Steven S. Heinrichs, the Company’s Chief Financial Officer (“CFO”) and Chief Legal and Compliance Officer, will be transitioning from his position effective on or about December 31, 2024. Mr. Heinrichs will continue to serve as CFO and Chief Legal and Compliance Officer until a new CFO has been named.
We estimate approximately 60% to 65% of the Company’s 2024 net sales were associated with the repair and replacement of municipal water infrastructure, approximately 25% to 30% were related to residential construction activity and approximately 10% were related to natural gas utilities and industrial applications.
After experiencing challenges resulting from the COVID-19 pandemic and subsequent supply disruptions in years 2020 through 2023, the seasonality of our business returned to more normalized levels in 2024, supported by municipal spending on repair and replacement projects and new residential construction activity. According to the United States Department of Labor, the trailing twelve-month average consumer price index for water and sewerage rates at September 30, 2024 increased 5.2%. Total housing starts in fiscal 2024 decreased 1.6% as compared with fiscal 2023, according to the United States Census Bureau, despite a 13% increase in single family housing starts as compared with fiscal 2023.
Recent Developments
In October 2023, the Israel-Hamas war caused a temporary shutdown in our facility in Ariel, Israel. While we reopened the facility in November 2023, the war has caused supply chain challenges that continue to hinder our ability to most efficiently manufacture our products produced in Israel. These supply chain disruptions have adversely impacted, and continue to adversely impact, our ability to optimally produce and deliver our products from our facility in Ariel, Israel. Additionally, production at this facility has been adversely impacted by limited labor availability in the region. We have made investments in recruiting and training new team members, expanding our suppliers and expediting product shipments to increase production levels and to meet customer delivery times.
The cybersecurity incident in the first quarter of fiscal 2024 consisted of unauthorized access and deployment of ransomware by a third party to a portion of our internal information system infrastructure. The incident caused temporary disruptions and limitations of access to portions of our business applications supporting certain aspects of our operations including shipping, receiving and payment functions. Operational delays as well as investigation and remediation costs in connection with the incident adversely impacted our results for the first quarter of fiscal 2024; however, there was no material impact to our consolidated net sales for the full fiscal 2024. We have restored the impacted applications and systems. As reported on November 29, 2023, we identified a separate cybersecurity incident, which primarily related to a system that was at the end of its useful life and was already in the process of being replaced in the ordinary course of business. We completed the replacement of this system during the second quarter of fiscal 2024.
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In fiscal 2024, we incurred approximately $1.5 million of expenses related to the cybersecurity incidents. We continue to address the impacts of the cybersecurity incidents, including making enhancements to our cybersecurity processes and analyzing the data accessed, exfiltrated or otherwise impacted in connection with the cybersecurity incidents.
Outlook
For fiscal year 2025, we anticipate that consolidated net sales will increase between 1.9% and 3.4% as compared with fiscal 2024. The external operating environment remains dynamic as we face uncertainties and challenges emanating from the interest rate environment, the Israel-Hamas war and unrest in the Middle East, as well as labor inflation and availability. We expect these challenges to continue during fiscal 2025. After our short-cycle channel and customer inventory levels largely normalized during the first quarter of 2024, our orders and shipments reflected a more typical operating environment compared with the high backlog environment we experienced during and after the COVID-19 pandemic. For fiscal 2025, we assume that we will continue to experience a more normalized operating environment leading to normalized seasonality for consolidated net sales. Therefore, we anticipate quarterly consolidated net sales as a percentage of fiscal year 2025 consolidated net sales to be the highest in the third quarter and lowest in the first quarter, with a sequential increase in consolidated net sales in the second quarter as the construction season ramps up for the Spring. We anticipate resilient demand in the municipal repair and replacement end market driven by the aging water infrastructure albeit moderated by budgetary and operational pressures on municipalities. Additionally, we anticipate that new residential construction activity and new lot and land development will be relatively constrained by the interest rate environment, depending on the geography. For fiscal 2025, we anticipate that inflation will continue to modestly impact manufacturing costs, primarily due to wage inflation, as well as raw materials and purchased parts. We will continue to monitor the market and economic conditions impacting our business and take appropriate actions to address inflationary and other cost pressures by implementing price increases, cost containment measures and supplier management measures, among other actions.
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Results of Operations
Year Ended September 30, 2024 Compared to Year Ended September 30, 2023
Year ended September 30, 2024
Water Flow
Solutions Water
Management
Solutions Corporate Consolidated
(in millions)
Net sales $ 755.5 $ 559.2 $ — $ 1,314.7
Gross profit 271.9 187.1 — 459.0
Operating expenses:
Selling, general and administrative
92.5 95.0 57.7 245.2
Strategic reorganization and other charges 0.2 1.8 13.8 15.8
Goodwill impairment — 16.3 — 16.3
Total operating expenses 92.7 113.1 71.5 277.3
Operating income (loss) $ 179.2 $ 74.0 $ (71.5) 181.7
Pension expense other than service 4.0
Interest expense, net 12.7
Other expense 1.6
Income before income taxes 163.4
Income tax expense 47.5
Net income $ 115.9
Year ended September 30, 2023
Water Flow
Solutions Water
Management
Solutions Corporate Consolidated
(in millions)
Net sales $ 634.4 $ 641.3 $ — $ 1,275.7
Gross profit 164.9 214.6 — 379.5
Operating expenses:
Selling, general and administrative
85.3 106.9 49.7 241.9
Strategic reorganization and other charges — 1.7 8.5 10.2
Total operating expenses 85.3 108.6 58.2 252.1
Operating income (loss)
$ 79.6 $ 106.0 $ (58.2) 127.4
Pension benefit other than service 3.7
Interest expense, net 14.7
Income before income taxes 109.0
Income tax expense 23.5
Net income $ 85.5
Consolidated Analysis
Net sales for 2024 were $1,314.7 million as compared with $1,275.7 million in the prior year, an increase of $39.0 million or 3.1%, primarily as a result of higher pricing across most of our product lines, higher volumes at Water Flow Solutions, partially offset by lower volumes at Water Management Solutions which include a negative impact from the Israel-Hamas war of less than 2%.
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Gross profit for 2024 was $459.0 million as compared with $379.5 million in the prior year, an increase of $79.5 million or 20.9%, primarily a result of favorable manufacturing performance related to labor, overhead and logistics efficiencies and favorable price/cost. This increase was partially offset by negative impacts from the Israel-Hamas war of approximately 4%. Gross margin increased to 34.9% in 2024 as compared with 29.7% in the prior year.
Selling, general and administrative expenses (“SG&A”) for 2024 were $245.2 million as compared with $241.9 million in the prior year, an increase of $3.3 million or 1.4%, primarily due to higher employee incentives, higher costs associated with approximately 3% inflation and the impact of foreign currency fluctuation, partially offset by a decrease in salary and benefit expense associated with our restructuring activities, third-party fees and engineering materials expense. As a percentage of net sales, SG&A decreased 30 basis points to 18.7% of net sales from 19.0% in the prior year.
Strategic reorganization and other charges for 2024 of $15.8 million primarily consisted of expenses associated with the leadership transition, certain transaction-related expenses, $1.8 million related to non-cash asset impairment, expenses associated with the cybersecurity incidents and severance. Strategic reorganization and other charges for 2023 of $10.2 million primarily consisted of expenses associated with the leadership transition, severance and certain transaction-related expenses.
During the year ended September 30, 2024, we incurred a non-cash goodwill impairment charge of $16.3 million within the Water Management Solutions segment. No goodwill impairment charge was recorded in 2023.
Interest expense, net for 2024 was $12.7 million as compared with $14.7 million in the prior year, a decrease of $2.0 million or 13.6%, primarily as a result of higher interest income. The components of interest expense, net are provided below.
Year ended September 30,
2024 2023
(in millions)
4.0% Senior Notes $ 18.0 $ 18.0
Deferred financing costs amortization 1.0 1.0
ABL Agreement 0.9 0.9
Capitalized interest (0.1) (1.6)
Other interest expense 1.7 0.1
Total interest expense 21.5 18.4
Interest income (8.8) (3.7)
Total interest expense, net $ 12.7 $ 14.7
Other expense for 2024 was $1.6 million for the release of an indemnification receivable related to an expired uncertain tax position. There was no Other expense for 2023.
Income tax expense of $47.5 million in 2024 resulted in an effective income tax rate of 29.1%, which was higher than the 21.6% rate in the prior year primarily as a result of certain non-deductible items, including non-cash goodwill impairment, an increase in the state income tax rate and lesser foreign tax rate benefits.
Segment Analysis
Water Flow Solutions
Net sales for 2024 were $755.5 million as compared with $634.4 million in the prior year, an increase of $121.1 million or 19.1%, primarily as a result of higher volumes in iron gate valves and service brass products as well as higher pricing across most of Water Flow Solutions’ product lines.
Gross profit for 2024 was $271.9 million as compared with $164.9 million in the prior year, an increase of $107.0 million or 64.9%, primarily as a result of favorable manufacturing performance driven by labor, overhead and logistic efficiencies, higher volumes and favorable price/cost, partially offset by higher custom duties expense. Gross margin increased to 36.0% in 2024, as compared with 26.0% in the prior year.
SG&A for 2024 was $92.5 million as compared with $85.3 million in the prior year, an increase of $7.2 million or 8.4%, primarily as a result of higher employee incentives and approximately 3% inflation, partially offset by lower salary and benefit expense associated with our restructuring activities. SG&A as a percentage of net sales was 12.2% and 13.4% for 2024 and 2023, respectively.
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Water Management Solutions
Net sales for 2024 were $559.2 million as compared with $641.3 million in the prior year, a decrease of $82.1 million or 12.8%, primarily as a result of lower volumes across most product lines, including the impact of the Israel-Hamas war, partially offset by higher pricing across most of Water Management Solutions’ product lines.
Gross profit for 2024 was $187.1 million as compared with $214.6 million in the prior year, a decrease of $27.5 million or 12.8%, primarily as a result of lower volumes including the impact of the Israel-Hamas war, partially offset by favorable price/cost and favorable manufacturing performance. Gross margin was 33.5% in both 2024 and 2023.
SG&A for 2024 was $95.0 million as compared with $106.9 million in the prior year, a decrease of $11.9 million or 11.1% primarily due to lower salary and benefit expense associated with our restructuring activities and lower third-party fees, partially offset by unfavorable foreign currency fluctuation, higher employee incentives and approximately 3% inflation. SG&A as a percentage of net sales was 17.0% for 2024 and 16.7% in the prior year.
During the year ended September 30, 2024, Water Management Solution incurred a non-cash goodwill impairment charge of $16.3 million. No goodwill impairment charge was recorded in 2023.
Corporate
SG&A for 2024 was $57.7 million as compared with $49.7 million in the prior year, an increase of $8.0 million or 16.1% primarily as a result of higher employee incentives, higher third-party fees, unfavorable foreign currency fluctuation and approximately 3% inflation, partially offset by lower salary and benefit expense associated with our restructuring activities.
Financial Condition
Cash and cash equivalents were $309.9 million at September 30, 2024 and $160.3 million at September 30, 2023. Cash and cash equivalents increased during 2024 primarily as a result of $238.8 million in cash provided by operating activities, $4.0 million in effect of currency exchange rate changes on cash, partially offset by capital expenditures of $47.4 million, dividend payments of $39.9 million, and $10.0 million in common stock repurchases.
Receivables, net were $208.9 million at September 30, 2024 and $217.1 million at September 30, 2023. This decrease was a result of lower days sales outstanding.
Inventories, net were $301.7 million at September 30, 2024 and $297.9 million at September 30, 2023. Inventories increased during 2024 as a result of higher finished goods and approximately 1% inflation, partially offset by lower raw materials.
Property, plant and equipment, net was $318.8 million at September 30, 2024 and $311.7 million at September 30, 2023. Property, plant and equipment increased as a result of $47.4 million in capital expenditures primarily associated with our new brass foundry in Decatur, Illinois, partially offset by depreciation expense of $39.1 million. Depreciation expense increased from $34.4 million in 2023 as a result of accelerated depreciation of certain assets.
Intangible assets were $309.7 million at September 30, 2024 and $334.0 million at September 30, 2023. Finite-lived intangible assets, net totaling $37.2 million at September 30, 2024, are amortized over their estimated useful lives. Amortization expense was $27.1 million in 2024 and $28.1 million in 2023. We expect amortization expense for these assets to be approximately $7 million for 2025, approximately $6 million in fiscal 2026 and fiscal 2027, approximately $5 million in fiscal 2028, and approximately $4 million in fiscal 2029. The reduction in amortization expense is a result of certain customer relationship intangibles becoming fully amortized. Indefinite-lived intangible assets, $272.5 million at September 30, 2024, are not amortized but are tested for potential impairment at least annually.
Accounts payable and other current liabilities were $257.2 million at September 30, 2024 and $218.1 million at September 30, 2023. Accounts payable increased during 2024 primarily as a result of timing and inflation. Other current liabilities increased during 2024 primarily as a result of higher personnel-related accruals, customer rebates, and product liabilities, partially offset by lower income taxes payable and accrued restructuring costs.
Total outstanding debt was $449.5 million as of September 30, 2024 and $447.4 million as of September 30, 2023. Total debt increased due to the addition of new financing leases and the amortization of deferred financing costs.
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Deferred income taxes were net liabilities of $55.4 million at September 30, 2024 and $73.8 million at September 30, 2023, primarily related to intangible assets. The $18.4 million decrease in the net liability was primarily a result of an increase in deferred tax assets related to Internal Revenue Code Section 174 pertaining to the amortization of research and development expenditures and an increase in other accrued expenses.
Liquidity and Capital Resources
We had cash and cash equivalents of $309.9 million at September 30, 2024 and approximately $162.6 million of additional borrowing capacity under our asset-based lending arrangement (the “ABL”) based on September 30, 2024 data. Undistributed earnings from our subsidiaries in Israel, Canada and China are considered to be permanently invested outside of the United States. At September 30, 2024, cash and cash equivalents included $80.7 million, $10.3 million, and $10.0 million in Israel, Canada, and China, respectively.
We declared a quarterly dividend of $0.067 per common share on October 22, 2024, payable on or about November 20, 2024 to holders of record as of November 8, 2024, which we expect to result in an estimated $10.5 million cash outlay.
We repurchased $10.0 million of our outstanding common stock during the fiscal year ended September 30, 2024 and had $80.0 million remaining under our share repurchase authorization as of September 30, 2024.
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 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, 2024 as compared with the prior year period primarily as a result of higher sales during the comparative periods. Inventories increased during the fiscal year ended September 30, 2024 primarily as a result of inflation and timing of shipments. Other current liabilities and other noncurrent liabilities increased as a result of higher employee-related accruals, product liabilities, and customer rebates, partially offset by lower income taxes payable and accrued restructuring costs.
Capital expenditures remained fairly constant at $47.4 million for 2024 compared with $47.6 million for 2023. We estimate 2025 capital expenditures will be between $45.0 million and $50.0 million.
Income tax payments were higher during 2024 compared with the prior year primarily as a result of higher income before income taxes as well as the timing of certain federal and state extension payments. We expect the effective tax rate in 2025 to be between 25% and 27%.
Our stock repurchase program allows us to repurchase up to $250.0 million of our common stock, of which we had remaining authorization of $80.0 million as of September 30, 2024. 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 repurchased 636,789 and 714,830 shares of our common stock in 2024 and 2023, 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, 2024, we had $12.2 million of letters of credit and $13.8 million of 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 the twelve months from the date of this filing. 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.
ABL Agreement
Our ABL is provided by a syndicate of banking institutions and consists of a revolving credit facility of $175.0 million in borrowing capacity that matures the earlier of (a) March 16, 2029, which is ninety-one days prior to the stated maturity date of our 4.0% Senior Notes if the Notes are still outstanding on that date or (b) March 28, 2029. The ABL includes the ability to borrow up to $25.0 million of swing line loans and up to $60.0 million of letters of credit. The ABL 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.
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In December 2023, we obtained a waiver under our ABL (“ABL Waiver”) to provide for additional time associated with certain reporting requirements that were delayed as a result of the cybersecurity incident announced on October 28, 2023. Under the ABL Waiver, the maximum aggregate amount of borrowings and other credit extensions under the ABL was temporarily limited to $50.0 million until all of the required reports were delivered. During our first fiscal quarter of 2024, we delivered the required reports, and on February 6, 2024, the ABL Waiver was terminated. Accordingly, we are no longer subject to the $50.0 million temporary limit on credit extensions.
On March 28, 2024, we amended our ABL to, among other things, (i) extend the maturity date from July 29, 2025 to the earlier of (a) March 28, 2029 and (b) 91 days prior to the stated maturity date of the Company’s 4.0% Senior Notes due June 15, 2029 (as may be extended from time to time in accordance with the Indenture governing the notes) if the 4.0% Senior Notes are then outstanding, (ii) decrease the grid-based interest rate margins by approximately 50 basis points to 150 basis points for Secured Overnight Financing Rate (“SOFR”) loans and 50 basis points for base rate loans when average availability is greater than 50% of the aggregate revolving commitments, and to 175 basis points for SOFR loans and 75 basis points for base rate loans, when average availability is less than or equal to 50% of the aggregate revolving credit commitments and (iii) replace the previously fixed 37.5 basis point unused commitment fee with a grid-based, quarterly unused commitment fee equal to (a) 37.5 basis points if average daily outstanding credit extensions for such quarter under the ABL (“Total Outstandings”) are less than or equal to 50% of the aggregate revolving credit commitments or (b) 25.0 basis points if Total Outstandings for such quarter are greater than or equal to 50% of the aggregate revolving credit commitments. We incurred approximately $0.9 million in debt issuance costs in connection with the ABL amendment which were capitalized and are amortized over the term of the ABL.
Borrowings under the ABL bear interest at a floating rate equal to SOFR plus an adjustment of 10 basis points and an applicable margin range of 150 to 175 basis points, or a base rate, as defined in the ABL, plus an applicable margin of 50 to 75 basis points. At September 30, 2024, the applicable margin was 150 basis points for SOFR-based loans and 50 basis points for base rate loans.
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. The ABL allows for certain restricted payments such as cash dividends on our common stock up to certain thresholds.
Substantially all of our United States subsidiaries 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 States inventory, accounts receivable, certain cash balances and other supporting assets.
The ABL includes a commitment fee for any unused borrowing capacity of 37.5 basis points per annum when the unused capacity is above 50% of the credit commitments, with a step down to 25.0 basis points per annum when unused capacity is less than or equal to 50% of the credit commitments. At September 30, 2024, the commitment fee was 37.5 basis points.
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 as defined in the ABL. Excess availability based on September 30, 2024 data was $162.6 million, as reduced by $12.2 million of outstanding letters of credit and $0.2 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 on June 15, 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 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 $430.2 million at September 30, 2024.
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 September 30, 2024.
We may redeem some or all of the 4.0% Senior Notes at any time after June 15, 2024, at specified redemption prices. 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 if there is a Ratings Decline (as defined in the Indenture).
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Credit Ratings
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,
2024 2023 2024 2023
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
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, 2024, we have (i) debt obligations related to our $450.0 million 4.0% Senior Notes which mature in 2029 and include cash interest payments of $18.0 million in 2025 annually through 2029; (ii) cumulative cash obligations of $32.9 million for operating leases through 2034 and $3.1 million for finance leases through 2029; and (iii) purchase obligations for raw materials and other purchased parts of approximately $104.8 million and $1.1 million which we expect to incur during 2025 and 2026, respectively. Additionally, we expect to invest to strengthen our systems, cybersecurity training, policies, programs, response plans and other similar measures. We expect to fund these cash requirements from cash on hand and cash generated from operations.
Effect of Inflation
We experience changing price levels primarily related to purchased components and raw materials. During our fiscal year 2024, we experienced approximately 1% inflation as compared with our fiscal year 2023 for these inventory items. We anticipate inflation in raw and other material costs in 2025, including on purchased components, which is likely to have an adverse effect on our margins to the extent we are unable to pass on such higher costs to our customers.
During fiscal year 2024, we experienced approximately 3% labor inflation, which is slightly lower than the 3.8% released by the U.S. Bureau of Labor Statistics for the 12-month period ended September 30, 2024.
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 most of Canada generally 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, sales, 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.
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Inventories, net
We record inventories at standard cost or estimated net realizable value. Standard cost reasonably approximates cost determined on the first-in, first-out basis. 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 are made when estimating net realizable value.
Accounting for the Impairment of Goodwill and Indefinite-lived Intangible Assets
We test goodwill and indefinite-lived intangible assets for impairment annually or more frequently if events or circumstances indicate possible impairment. We perform this annual impairment testing on September 1, using standard valuation methodologies and rates that we consider to be 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, market and cost approaches as applicable. 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. The cost approach is based on the net aggregate value of the reporting unit’s underlying assets.
The income approach is dependent on management’s best estimates of future operating results, including forecasted sales, 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. Conversely, if the estimated fair value is less than the carrying value, 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, 2024. As a result of this quantitative testing, we recognized a $16.3 million non-cash goodwill impairment charge for a reporting unit within our Water Management Solutions segment as the carrying value exceeded its fair value. Our determination of the estimated fair value was based on our concluded value under the cost approach. Additionally, we performed our annual impairment testing of indefinite-lived intangible assets at September 1, 2024 and recognized a $0.4 million non-cash impairment charge related to trade names within Water Management Solutions. Our testing indicated no other impairment.
Warranty Cost
We accrue for warranty expenses that may 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 to repair or replace 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.
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Index to Financial Statements
Contingencies
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 legal 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 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 15. 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 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, 2024 using 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, claim development, regulatory changes, technology changes, the investment performance of related assets, longevity of participants, the discount rate used and changes to plan designs.