Item 2. Management’s Discussion and Analysis
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
General
Zurn is a growth-oriented, pure-play water business that designs, procures, manufactures, and markets what we believe is the broadest sustainable product portfolio of water management solutions to improve health, human safety and the environment. Our product portfolio includes professional grade water control and safety, water distribution and drainage, finish plumbing, hygienic and environmental and site works products for public and private spaces. Our heritage of innovation and specification has allowed us to provide highly-engineered, mission-critical solutions to customers for decades and affords us the privilege of having long-term, valued relationships with market leaders. We operate in a disciplined way and the Zurn Business System (“ZBS”) is our operating philosophy. Grounded in the spirit of continuous improvement, ZBS creates a scalable, process-based framework that focuses on driving superior customer satisfaction and financial results by targeting world-class operating performance throughout all aspects of our business.
The following information should be read in conjunction with the audited consolidated financial statements and notes thereto, along with Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”), in our Annual Report on Form 10-K for the year ended December 31, 2021.
Critical Accounting Policies and Estimates
The condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States ("GAAP"), which require us to make estimates and assumptions that affect the reported amounts of assets and liabilities on the date of the financial statements and revenues and expenses during the periods reported. Actual results could differ from those estimates. Refer to Item 7, MD&A of our Annual Report on Form 10-K for the year ended December 31, 2021 for information with respect to our critical accounting policies, which we believe could have the most significant effect on our reported results and require subjective or complex judgments by management. Except for the items reported below, management believes that as of March 31, 2022, and during the period from January 1, 2022 through March 31, 2022, there has been no material change to this information.
Recent Accounting Pronouncements
See Item 1, Note 1, Basis of Presentation and Significant Accounting Policies regarding recent accounting pronouncements.
Elkay Merger
On February 12, 2022, we entered into a definitive agreement to combine with Elkay Manufacturing Company (“Elkay”), pursuant to an Agreement and Plan of Merger (the “Merger Agreement”) by and among Zurn, Elkay, Zebra Merger Sub, Inc., a wholly-owned subsidiary of Zurn (“Merger Sub”), and Elkay Interior Systems International, Inc., as representative of the stockholders of Elkay. The Merger Agreement provides that among other matters, and subject to the satisfaction or waiver of the conditions set forth in the Merger Agreement, Elkay would merge with Merger Sub, with Elkay surviving as a wholly-owned subsidiary of Zurn (the “Merger”). Pursuant to the terms and subject to the conditions set forth in the Merger Agreement, at the effective time of the Merger (the “Effective Time”), we will exchange, for 100% of the outstanding equity of Elkay, up to 52.5 million newly issued shares of our common stock, which on a pro forma basis, assuming closing of the Merger on December 31, 2021 (and assuming no adjustments pursuant to the Merger Agreement), would have represented approximately 29% of the outstanding shares of the Company's common stock on a fully diluted basis as of such date (the “Merger Consideration”).
We anticipate the Merger will close early in the third quarter of 2022. The closing of the Merger is subject to customary conditions, including, among others, the absence of laws or orders by a governmental authority enjoining or prohibiting the consummation of the transactions contemplated by the Merger Agreement; the expiration or termination of the applicable waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended (“HSR”) (which waiting period expired on March 30, 2022); the required approvals by the respective stockholders of Zurn and Elkay; a registration statement having become effective in accordance with the provisions of the Securities Act of 1933, as amended, and not being subject to any stop order suspending the registration statement (registration statement became effective on April 26, 2022); the shares of our common stock to be issued in the Merger being approved for listing on the New York Stock Exchange as of the closing; the accuracy of the parties’ representations and warranties contained in the Merger Agreement (subject to certain materiality qualifications); the parties’ compliance with the covenants and agreements in the Merger Agreement in all material respects; and the absence of any material adverse effect on Zurn or Elkay.
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Acquisitions
On November 17, 2021, we completed the acquisition of the Wade Drains business ("Wade Drains") from McWane, Inc. for a preliminary cash purchase price of $13.7 million, excluding transaction costs and net of cash acquired. The preliminary purchase price is subject to customary post-closing adjustments. Wade Drains manufactures a wide range of specified commercial plumbing products for customers across North America and complements the Company's existing flow systems product portfolio.
On April 16, 2021, we acquired substantially all of the assets of Advance Technology Solutions, LLC (d/b/a ATS GREASEwatch) ("ATS GREASEwatch") for a total cash purchase price of $4.5 million. ATS GREASEwatch, headquartered in Saginaw, Michigan, develops, manufactures and markets remote tank monitoring devices, alarms, software and services for various applications and provides technology to enhance and expand our current product offerings within our existing Water Management platform.
Spin-Off of Process & Motion Control Segment
On October 4, 2021, we completed a Reverse Morris Trust tax-free spin-off transaction (the “Spin-off Transaction”) in which (i) substantially all the assets and liabilities of our Process & Motion Control ("PMC") business were transferred to a newly created subsidiary, Land Newco, Inc. (“Land”), (ii) the shares of Land were distributed to our stockholders pro rata, and (iii) Land was merged with a subsidiary of Regal Rexnord Corporation (formerly known as Regal Beloit Corporation), in which the stock of Land was converted into a specified number of shares of Regal Rexnord Corporation in accordance with the exchange ratio. Following completion of the Spin-Off Transaction, our name was changed to “Zurn Water Solutions Corporation” and the ticker symbol for our shares of common stock trading on the New York Stock Exchange was changed to “ZWS”. During the three months ended March 31, 2022, we received $35.0 million from Regal Rexnord Corporation as a result of the final working capital and cash balances at closing exceeded the targets stipulated within the Spin-Off Transaction agreement.
The operating results of PMC are reported as discontinued operations in our condensed consolidated statements of operations for all periods presented. The condensed consolidated statements of cash flows for the period ended March 31, 2021 have not been adjusted to separately disclose cash flows related to the discontinued operations. See Item 1, Note 4, Discontinued Operations for additional information on cash flows associated with the discontinued operations.
The major components of the Income from discontinued operations, net of tax presented in the condensed consolidated statements of operations for the three months ended March 31, 2022 and March 31, 2021, are as follows (in millions):
Three Months Ended
March 31, 2022 March 31, 2021
Net sales $ — $ 320.9
Cost of sales — (201.4)
Selling, general and administrative expenses — (61.6)
Amortization of intangible assets — (3.3)
Interest expense, net — (1.4)
Actuarial loss on pension and postretirement benefit obligations — —
Other expense, net — (0.7)
Income from discontinued operations before income tax — 52.5
Income tax benefit (provision) 0.8 (12.5)
Equity method investment income — 0.1
Non-controlling interest income — 0.1
Income from discontinued operations, net of tax $ 0.8 $ 40.0
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Results of Operations
Three Months Ended March 31, 2022 compared with the Three Months Ended March 31, 2021:
Net sales
(Dollars in Millions)
Three Months Ended
March 31, 2022 March 31, 2021 Change % Change
Net Sales $ 239.6 $ 205.2 $ 34.4 16.8 %
Net sales were $239.6 million during the three months ended March 31, 2022, an increase of 17% year over year. Excluding a 2% increase to net sales resulting from our prior-year acquisition, core sales increased 15% year over year as all of our product categories contributed to the sales growth.
Income from operations
(Dollars in Millions)
Three Months Ended
March 31, 2022 March 31, 2021 Change % Change
Income from operations $ 43.9 $ 24.0 $ 19.9 82.9 %
% of net sales 18.3 % 11.7 % 6.6 %
Income from operations was $43.9 million during the three months ended March 31, 2022, or 18.3% of net sales. Income from operations as a percentage of net sales increased by 660 basis points primarily as a result of the favorable impact of year-over-year sales growth (inclusive of price realization), productivity savings, lower non-cash stock-based compensation expense, lower intangible asset amortization and the year-over-year change in the adjustment to state inventories at last-in-first-out cost, all of which was partially offset by the year-over-year increases in material and transportation costs, as well as incremental growth and productivity investments.
Interest expense, net
Interest expense, net was $4.8 million during the three months ended March 31, 2022, compared to $9.6 million during the three months ended March 31, 2021. The decrease in interest expense as compared to the prior year's period is primarily a result of the lower outstanding borrowings following the Spin-Off Transaction refinancing. See Item 1, Note 13 Long-Term Debt for more information.
Other income, net
Other income, net during the three months ended March 31, 2022 and 2021, was $0.3 million and $0.3 million, respectively. Other income, net consists primarily of foreign currency transaction gains and losses and the non-service cost components associated with our defined benefit plans.
Provision for income taxes
The income tax provision was $10.0 million for the three months ended March 31, 2022, compared to $4.7 million for the three months ended March 31, 2021. The effective income tax rate for the three months ended March 31, 2022 was 25.4% versus 32.0% for the three months ended March 31, 2021. The effective income tax rate for the three months ended March 31, 2022 was above the U.S. federal statutory rate of 21% primarily due to the accrual of foreign income taxes, which are generally above the U.S. federal statutory rate, the accrual of additional income taxes associated with compensation deduction limitations under Section 162(m) of the Internal Revenue Code and the accrual of various state income taxes, partially offset by the recognition of certain previously unrecognized tax benefits due to the lapse of the applicable statutes of limitations and income tax benefits associated with share-based payments. The effective income tax rate for the three months ended March 31, 2021 was above the U.S. federal statutory rate of 21% primarily due to the accrual of foreign income taxes, which are generally above the U.S. federal statutory rate, the accrual of additional income taxes associated with compensation deduction limitations under Section 162(m) of the Internal Revenue Code, and the accrual of various state income taxes, partially offset by the recognition of income tax benefits associated with foreign-derived intangible income (“FDII”).
On a quarterly basis, we review and analyze our valuation allowances associated with deferred tax assets relating to certain foreign and state net operating loss carryforwards as well as U.S. federal and state capital loss carryforwards. In conjunction with this analysis, we weigh both positive and negative evidence for purposes of determining the proper balances of such valuation allowances. Future changes to the balances of these valuation allowances, as a result of our continued review and analysis, could result in a material impact to the financial statements for such period of change.
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Net income attributable to Zurn common stockholders
Net income attributable to Zurn common stockholders during the three months ended March 31, 2022, was $30.2 million compared to $50.0 million during the three months ended March 31, 2021. Diluted net income per share attributable to Zurn common stockholders for the three months ended March 31, 2022 and March 31, 2021, was $0.24 and $0.40, respectively, as a result of the factors described above. Net income from discontinued operations, net of tax, was $0.8 million for the three months ended March 31, 2022 compared to $40.0 million for the three months ended March 31, 2021. Diluted net income per share from discontinued operations for the three months ended March 31, 2022 and March 31, 2021, was $0.01 and $0.32, respectively.
Non-GAAP Financial Measures
Non-GAAP financial measures are intended to supplement and not replace financial measures prepared in accordance with GAAP. The following non-GAAP financial measures are utilized by management in comparing our operating performance on a consistent basis. We believe that these financial measures are appropriate to enhance an overall understanding of our underlying operating performance trends compared to historical and prospective periods and our peers. Management also believes that these measures are useful to investors in their analysis of our results of operations and provide improved comparability between fiscal periods as well as insight into the compliance with our debt covenants. Non-GAAP financial measures should not be considered in isolation from, or as a substitute for, financial information calculated in accordance with GAAP. Investors are encouraged to review the reconciliation of these non-GAAP measures to their most directly comparable GAAP financial measures.
Core sales
Core sales excludes the impact of acquisitions (such as the Wade Drains acquisition), divestitures and foreign currency translation. Management believes that core sales facilitates easier and more meaningful comparisons of our net sales performance with prior and future periods and to our peers. We exclude the effect of acquisitions and divestitures because the nature, size and number of acquisitions and divestitures can vary dramatically from period to period and between us and our peers, and can also obscure underlying business trends and make comparisons of long-term performance difficult. We exclude the effect of foreign currency translation from this measure because the volatility of currency translation is not under management's control.
EBITDA
EBITDA represents earnings before interest and other debt related activities, taxes, depreciation and amortization. EBITDA is presented because it is an important supplemental measure of performance and it is frequently used by analysts, investors and other interested parties in the evaluation of companies in our industry. EBITDA is also presented and compared by analysts and investors in evaluating our ability to meet debt service obligations. Other companies in our industry may calculate EBITDA differently. EBITDA is not a measurement of financial performance under GAAP and should not be considered as an alternative to cash flow from operating activities or as a measure of liquidity or an alternative to net income as indicators of operating performance or any other measures of performance derived in accordance with GAAP. Because EBITDA is calculated before recurring cash charges, including interest expense and taxes, and is not adjusted for capital expenditures or other recurring cash requirements of the business, it should not be considered as a measure of discretionary cash available to invest in the growth of the business.
Adjusted EBITDA
Adjusted EBITDA (as described below in “Covenant Compliance”) is an important measure because, under our credit agreement, our ability to incur certain types of acquisition debt and certain types of subordinated debt, make certain types of acquisitions or asset exchanges, operate our business and make dividends or other distributions, all of which will impact our financial performance, is impacted by our Adjusted EBITDA, as our lenders measure our performance with a net first lien leverage ratio by comparing our senior secured bank indebtedness to our Adjusted EBITDA (see “Covenant Compliance” for additional discussion of this ratio, including a reconciliation to our net income). We reported net income attributable to Zurn common stockholders in the three months ended March 31, 2022, of $30.2 million and Adjusted EBITDA for the same period of $52.0 million. See “Covenant Compliance” for a reconciliation of Adjusted EBITDA to GAAP net income.
Covenant Compliance
Our credit agreement, which governs our senior secured credit facilities, contains, among other provisions, restrictive covenants regarding indebtedness, payments and distributions, mergers and acquisitions, asset sales, affiliate transactions, capital expenditures and the maintenance of certain financial ratios. Payment of borrowings under the credit agreement may be accelerated if there is an event of default. Events of default include the failure to pay principal and interest when due, a material breach of a representation or warranty, certain non-payments or defaults under other indebtedness, covenant defaults, events of
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bankruptcy and a change of control. Certain covenants contained in the credit agreement restrict our ability to take certain actions, such as incurring additional debt or making acquisitions, if we are unable to meet a maximum total net leverage ratio of 5.00 to 1.0 as of the end of each fiscal quarter. At March 31, 2022, our net leverage ratio was 2.36 to 1.0. Failure to comply with these covenants could limit our long-term growth prospects by hindering our ability to borrow under the revolver, to obtain future debt and/or to make acquisitions.
“Adjusted EBITDA” is the term we use to describe EBITDA as defined and adjusted in our credit agreement, which is net income, adjusted for the items summarized in the table below. Adjusted EBITDA is intended to show our unleveraged, pre-tax operating results and therefore reflects our financial performance based on operational factors, excluding non-operational, non-cash or non-recurring losses or gains. In view of our debt level, it is also provided to aid investors in understanding our compliance with our debt covenants. Adjusted EBITDA is not a presentation made in accordance with GAAP, and our use of the term Adjusted EBITDA varies from others in our industry. This measure should not be considered as an alternative to net income, income from operations or any other performance measures derived in accordance with GAAP. Adjusted EBITDA has important limitations as an analytical tool, and should not be considered in isolation, or as a substitute for analysis of our results as reported under GAAP. For example, Adjusted EBITDA does not reflect: (a) our capital expenditures, future requirements for capital expenditures or contractual commitments; (b) changes in, or cash requirements for, our working capital needs; (c) the significant interest expenses, or the cash requirements necessary to service interest or principal payments, on our debt; (d) tax payments that represent a reduction in cash available to us; (e) any cash requirements for the assets being depreciated and amortized that may have to be replaced in the future; or (f) the impact of earnings or charges resulting from matters that we and the lenders under our credit agreement may not consider indicative of our ongoing operations. In particular, our definition of Adjusted EBITDA allows us to add back certain non-cash, non-operating or non-recurring charges that are deducted in calculating net income, even though these are expenses that may recur, vary greatly and are difficult to predict and can represent the effect of long-term strategies as opposed to short-term results.
In addition, certain of these expenses can represent the reduction of cash that could be used for other corporate purposes. Further, although not included in the calculation of Adjusted EBITDA below, the measure may at times allow us to add estimated cost savings and operating synergies related to operational changes ranging from acquisitions or dispositions to restructuring, and/or exclude one-time transition expenditures that we anticipate we will need to incur to realize cost savings before such savings have occurred.
The calculation of Adjusted EBITDA under our credit agreement as of March 31, 2022, is presented in the table below. However, the results of such calculation could differ in the future based on the different types of adjustments that may be included in such respective calculations at the time.
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Set forth below is a reconciliation of net income attributable to Zurn common stockholders to Adjusted EBITDA for the periods indicated below.
(in millions) Three months ended
March 31, 2021 Twelve months ended
December 31, 2021 Three months ended
March 31, 2022 Twelve months ended
March 31, 2022
Net income attributable to Zurn common stockholders $ 50.0 $ 120.9 $ 30.2 $ 101.1
Income from discontinued operations, net of tax (1) $ (40.0) (71.2) (0.8) (32.0)
Provision for income taxes 4.7 2.7 10.0 8.0
Actuarial gain on pension and postretirement benefit obligations — (1.2) — (1.2)
Other (income) expense, net (2) (0.3) 0.7 (0.3) 0.7
Loss on the extinguishment of debt — 20.4 — 20.4
Interest expense 9.6 34.7 4.8 29.9
Depreciation and amortization 8.3 32.7 5.3 29.7
EBITDA 32.3 139.7 49.2 156.6
Adjustments to EBITDA
Restructuring and other similar charges (3) 0.6 3.7 1.1 4.2
Stock-based compensation expense 9.1 37.5 3.9 32.3
LIFO expense (income) (4) 1.7 14.1 (2.8) 9.6
Acquisition-related fair value adjustment 0.6 0.8 0.3 0.5
Other, net (5) — — 0.3 0.3
Subtotal of adjustments to EBITDA 12.0 56.1 2.8 46.9
Adjusted EBITDA $ 44.3 $ 195.8 $ 52.0 $ 203.5
Pro forma adjustment for acquisitions (6)
0.8
Pro forma Adjusted EBITDA 204.3
Consolidated indebtedness (7) $ 481.2
Total net leverage ratio (8) 2.36
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(1) Income from discontinued operations, net of tax is not included in Adjusted EBITDA in accordance with the terms of our credit agreement.
(2) Other (income) expense, net for the periods indicated, consists primarily of gains and losses from foreign currency transactions and the non-service cost components of net periodic benefit costs associated with our defined benefit plans.
(3) Restructuring and other similar charges is comprised of costs associated with workforce reductions, lease termination costs, and other facility rationalization costs. See Item 1, Note 3, Restructuring and Other Similar Charges for more information.
(4) Last-in first-out (LIFO) inventory adjustments are excluded in calculating Adjusted EBITDA as defined in our credit agreement.
(5) Other, net consists of gains and losses on the disposition of long-lived assets.
(6) Represents a pro forma adjustment to include Adjusted EBITDA related to the acquisition of Wade Drains, which was permitted by our credit agreement. The pro forma adjustment includes the period from April 1, 2021, through the date of the Wade Drains acquisition. See Item 1, Note 2, Acquisitions for more information.
(7) Our credit agreement defines our consolidated indebtedness as the sum of all indebtedness (other than letters of credit or bank guarantees, to the extent undrawn) consisting of indebtedness for borrowed money and capitalized lease obligations, less unrestricted cash, which was $57.3 million (as defined by the credit agreement) at March 31, 2022.
(8) Our credit agreement defines the total net leverage ratio as the ratio of consolidated indebtedness (as described above) to Adjusted EBITDA for the trailing four fiscal quarters.
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Liquidity and Capital Resources
Our primary sources of liquidity are available cash and cash equivalents, cash flow from operations, and borrowing availability of up to $200.0 million under our revolving credit facility.
As of March 31, 2022, we had $73.2 million of cash and cash equivalents and $193.9 million of additional borrowing capacity. As of March 31, 2022, the available borrowings under our credit facility were reduced by $6.1 million due to outstanding letters of credit. As of December 31, 2021, we had $96.6 million of cash and cash equivalents and approximately $193.9 million of additional borrowing capacity under our revolving credit facility.
Our revolving credit facility is available to fund our working capital requirements, capital expenditures and for other general corporate purposes. We believe this resource is adequate for expected needs.
Cash Flows
Cash flows for the period ended March 31, 2021 include our continuing operations and discontinued operations for the entire period, while the period ended March 31, 2022 only include the cash flows associated with continuing operations. Refer to Item 1, Note 4, Discontinued Operations for further information.
Cash (used for) provided by operating activities was $(53.9) million and $71.3 million during the three months ended March 31, 2022 and 2021, respectively. The change in year over year operating cash flows was primarily the result of higher trade working capital and the impact of timing of payments on accounts payable and accrued expenses during the three months ended March 31, 2022.
Cash provided by investing activities was $35.5 million during the three months ended March 31, 2022 compared cash used for investing activities of $8.1 million during the three months ended March 31, 2021. Investing activities during the three months ended March 31, 2022, included $0.8 million of capital expenditures which was offset by the receipt of $35.0 million from Regal Rexnord Corporation in connection with the final net assets transferred in the PMC Spin-Off Translation and the receipt of $1.3 million in connection with the sale of certain long-lived assets. Investing activities during the three months ended March 31, 2021, primarily included $9.2 million of capital expenditures, partially offset by the receipt of $0.7 million in connection with the sale of certain long-lived assets and the receipt of $0.4 million in connection with finalizing the acquisition date trade working capital associated with our 2020 acquisition of Hadrian.
Cash used for financing activities was $5.2 million during the three months ended March 31, 2022, compared to $9.4 million during the three months ended March 31, 2021. During the three months ended March 31, 2022, we utilized a net $1.4 million of cash for payments on outstanding debt, $3.8 million for the payment of common stock dividends and $0.5 million for the payment of withholding taxes on employees' share-based awards. The three months ended March 31, 2022, also includes $0.5 million of cash proceeds associated with stock option exercises. During the three months ended March 31, 2021, we utilized $0.5 million of cash for payments on outstanding debt, $10.8 million for the payment of common stock dividends and $0.9 million to repurchase common stock. The three months ended March 31, 2021, also includes $2.8 million of cash proceeds associated with stock option exercises.
Indebtedness
As of March 31, 2022, we had $538.5 million of total indebtedness outstanding as follows (in millions):
Total Debt at
March 31, 2022 Current Maturities of Debt Long-term
Portion
Term loan (1) $ 538.2 $ 5.5 $ 532.7
Finance leases and other subsidiary debt 0.3 0.1 0.2
Total $ 538.5 $ 5.6 $ 532.9
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(1) Includes unamortized debt issuance costs of $10.4 million at March 31, 2022.
See Item 1, Note 13, Long-Term Debt for a description of our outstanding indebtedness.
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