WATTS WATER TECHNOLOGIES, INC. Overview
We are a leading supplier of products, solutions and systems that manage and conserve the flow of fluids and energy into, through and out of buildings in the commercial and residential markets in theAmericas ,Europe and APMEA. For over 140 years, we have designed and produced valve systems that safeguard and regulate water systems, energy efficient heating and hydronic systems, drainage systems and water filtration technology that helps purify and conserve 24
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water. We earn revenue and income almost exclusively from the sale of our products. Our principal product lines include:
Residential & commercial flow control products-includes products typically sold
? into plumbing and hot water applications such as backflow preventers, water
pressure regulators, temperature and pressure relief valves, and thermostatic
mixing valves.
HVAC & gas products-includes commercial high-efficiency boilers, water heaters
and custom heat and hot water solutions, hydronic and electric heating systems
for under-floor radiant applications, hydronic pump groups for boiler
? manufacturers and alternative energy control packages, and flexible stainless
steel connectors for natural and liquid propane gas in commercial food service
and residential applications. HVAC is an acronym for heating, ventilation and
air conditioning.
Drainage & water re-use products-includes drainage products and engineered rain
? water harvesting solutions for commercial, industrial, marine and residential
applications.
Water quality products-includes point-of-use and point-of-entry water
? filtration, conditioning and scale prevention systems, monitoring and metering
products for commercial, marine and residential applications. Our business is reported in three geographic segments:Americas ,Europe , and APMEA. We distribute our products through four primary distribution channels: wholesale, original equipment manufacturers (OEMs), specialty, and do-it-yourself (DIY). We believe that the factors relating to our future growth include continued product innovation that meets the needs of our customers and our end markets; our ability to make selective acquisitions, both in our core markets as well as in complementary markets; regulatory requirements relating to the quality and conservation of water and the safe use of water; increased demand for clean water; and continued enforcement of plumbing and building codes. We have completed 12 acquisitions in the last decade. Our acquisition strategy focuses on businesses that promote our key macro themes around safety & regulation, energy efficiency and water conservation. We target businesses that will provide us with one or more of the following: an entry into new markets and/or new geographies, improved channel access, unique and/or proprietary technologies, advanced production capabilities or complementary solution offerings. Our innovation strategy is focused on differentiated products and solutions that provide greater opportunity to distinguish ourselves in the marketplace. Conversely, we continue to migrate away from commoditized products where it is more difficult to add value. Our goal is to be a solutions provider, not merely a components supplier. We continually look for strategic opportunities to invest in new products and markets or divest existing product lines where necessary in order to meet those objectives. The Internet of Things has allowed companies to transform components into smart and connected devices. Over the last few years we have been building our smart and connected foundation by expanding our internal capabilities and making strategic acquisitions. Our strategy is to deliver superior customer value through smart and connected products and solutions. This strategy focuses on three dimensions: Connect, Control and Conserve. We intend to introduce products that will connect our customers with smart systems, control systems for optimal performance, and conserve critical resources by increasing operability, efficiency and safety. Products representing a majority of our sales are subject to regulatory standards and code enforcement, which typically require that these products meet stringent performance criteria. We have consistently advocated for the development and enforcement of such plumbing codes. We are focused on maintaining stringent quality control and testing procedures at each of our manufacturing facilities in order to manufacture products in compliance with code requirements and take advantage of the resulting demand for compliant products. We believe that the product development, product testing capability and investment in plant and equipment needed to manufacture products in compliance with code requirements, represent a competitive advantage for us. COVID-19 Pandemic The unprecedented global COVID-19 pandemic presents significant risks to our company and continues to cause challenges and uncertainties in our ability to fully predict the impact on our business. Throughout the course of the pandemic we have demonstrated the strength and resiliency of our strategy and the meaningful role we play in our 25
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markets and channels and the value we bring to our customers. Our revenues for the year endedDecember 31, 2020 were adversely impacted as a result of COVID-19. Demand for our products decreased as compared to 2019 as the pandemic continued and various governmental measures were imposed to combat the spread of the virus. Fourth quarter net sales improved when compared to the third quarter of 2020, as did quarter-over-quarter order rates. The exact timing and pace of the recovery remain uncertain and are impacted by different markets which are now experiencing a resurgence of COVID-19 cases. Future sales expansion or contraction is dependent on the duration and severity of the COVID-19 pandemic, including the time it takes for normal economic and operating conditions to resume, the easing of the construction lending markets, improvements in overall investments and capital spending in building services construction markets, additional governmental actions that may be taken, and numerous other uncertainties, including the time to administer and inoculate a sufficient population with the recently approved vaccines or the introduction of new therapeutic treatments. We continue to be concerned about the far reaching impacts of the pandemic on our business, operations and financial results and conditions, directly and indirectly, including, without limitation, impacts on the health of our employees, manufacturing capabilities, supply chains, distribution networks, sales opportunities, customer and consumer behaviors, and the overall economy. The scope and nature of these potential impacts are pervasive, and many impacts are beyond our control and continue to evolve. Many of our products qualify as "essential products" under local, state and national guidelines and orders. We remain focused on protecting the health and safety of our employees and the communities in which we operate while maintaining the continuity of our business operations. We created aCOVID-19 Task Force to develop and implement a coordinated response to protect our employees while maintaining production capabilities, and we have implemented social distancing guidelines and temperature monitoring, provided personal protective equipment, established a COVID-19 website for employees, which includes the latest CDC and other government protocols, and promoted work-from-home where practical. We are in communication with both customers and suppliers, we established a COVID-19 customer hotline in the US to support critical infrastructure projects, and we worked with our suppliers to ensure they could obtain the "essential" product classification from various government organizations. In response to the business impact of the COVID-19 pandemic, we undertook several cost management actions in order to reduce costs, including merit deferrals, compensation reductions, furloughs, reduced discretionary spending, factory overhead cost reductions, and reductions-in-force and other exit activities initiated in the second and third quarters of 2020. In addition to the cost actions noted above, we also implemented various measures to conserve cash and ensure its availability. We entered into an Amended and Restated Credit Agreement onApril 24, 2020 , we temporarily suspended our stock repurchase program during the second quarter, which was reinstated onJune 29, 2020 , maintained a flat dividend rate, and deferred employer payroll tax payments as permitted under the Coronavirus Aid, Relief, and Economic Security Act ("CARES Act"). We have also implemented additional procedures to manage risks related to our working capital, specifically the collectability of our trade accounts receivable, by monitoring the financial stability, credit rating, payment terms and credit limits of our credit customers. Due to the above circumstances and as described generally in this Form 10-K, our results of operations for the year endedDecember 31, 2020 are not necessarily indicative of future results. Management cannot predict the full impact of the COVID-19 pandemic on our sales, supply chain, manufacturing and distribution or on economic conditions generally, including the effects on customer spending. The extent of the effects of the COVID-19 pandemic on us remain uncertain and will depend on future developments, and such effects could exist for an extended period of time even after the pandemic ends. For further information regarding the impact of COVID-19 on us, see Item 1A, "Risk Factors."
Financial Overview
Net sales for 2020 decreased 5.7%, or$91.9 million , on a reported basis and 6.8%, or$109.0 million , on an organic basis, compared to 2019, primarily due to the impact of the COVID-19 pandemic across all of our operating segments. The reported decline was partially offset by an increase in sales from favorable foreign exchange movements of 0.5%, or$7.2 million , primarily driven by a stronger euro, and a net increase in acquired/divested sales of$9.9 million . Organic sales is a non-GAAP financial measure that excludes the impacts of acquisitions, divestitures and foreign exchange from year-over-year comparisons. Management believes reporting organic sales growth provides useful information to investors, potential investors and others, because it allows for additional insight into underlying sales trends by providing sales growth on a consistent basis. We reconcile the change in organic sales to our reported sales for each region within our results below. Operating income of$181.1 million decreased by$16.0 million , or 8.1%, in 2020 compared to 2019. This decrease was primarily driven by lower sales volume as a result of the COVID-19 pandemic, higher general inflation, including tariffs, strategic investments and incremental restructuring costs, partially offset by benefits from 26
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productivity initiatives, reduced long-term incentive costs, lower Corporate-related professional fees, and benefits from cost reduction actions in response to the COVID-19 pandemic.
Despite the challenges presented by the COVID-19 pandemic in 2020, we continued to drive commercial and operational excellence, invest in our business with increased capital expenditures and the acquisitions discussed in the section below, and invest in product innovation, including our smart and connected products and solutions, as we strove to meet the needs of our customers. Management's discussion and analysis of our financial condition, results of operations and cash flows as of and for the year endedDecember 31, 2018 can be found in Item 7 of Part II, "Management's Discussion and Analysis of Financial Condition and Results of Operations," in our Annual Report on Form 10-K for the year endedDecember 31, 2019 . Acquisitions In the third quarter of 2020, we completed the acquisition of 100% of the shares ofAustralian Valve Group Pty Ltd ("AVG") in an all-cash transaction. AVG is based inPerth, Australia , and specializes in the design, marketing and distribution of heating control valves used in the Australian residential and commercial end markets. The acquisition of AVG aligns with our strategy to expand geographically into countries with mature and enforced plumbing codes. AVG will enhance our product offering and channel access into the Australian marketplace. The acquisition of AVG was deemed not to be material to our consolidated financial statements. In the fourth quarter of 2020, we completed the acquisition of 100% of the shares ofThe Detection Group, Inc. ("TDG") in an all-cash transaction. TDG is based inSunnyvale, California , and specializes in the design, marketing and distribution of wireless leak detection systems for commercial buildings. The acquisition of TDG aligns with our smart and connected strategy. The acquisition of TDG was deemed not to be material to our consolidated financial statements. Recent Developments
OnFebruary 8, 2021 , we declared a quarterly dividend oftwenty-three cents ($0.23 ) per share on each outstanding share of Class A common stock and Class B common stock payable onMarch 15, 2021 to stockholders of record onMarch 1, 2021 . Results of Operations
Year Ended
Year Ended Year Ended % Change to
December 31, 2020 December 31, 2019
Consolidated
Net Sales % Sales Net Sales % Sales Change Net Sales
(dollars in millions)
Americas $ 1,025.7 68.0 % $ 1,084.1 67.7 % $ (58.4) (3.6) %
Europe 424.9 28.2 451.0 28.2 (26.1) (1.6)
APMEA 58.0 3.8 65.4 4.1 (7.4) (0.5)
Total $ 1,508.6 100.0 % $ 1,600.5 100.0 % $ (91.9) (5.7) %
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The change in net sales was attributable to the following:
Change As a % Change As a %
of Consolidated Net Sales of Segment Net Sales
Americas Europe APMEA Total Americas Europe APMEA Total Americas Europe APMEA
(dollars in millions)
Organic $ (64.4) $ (33.9) $ (10.7) $ (109.0) (4.0) % (2.1) % (0.7) % (6.8) % (5.9) % (7.5) % (17.3) %
Foreign exchange (0.6) 7.8 - 7.2 - 0.5 - 0.5 (0.1) 1.7 -
Acquired/divested, net 6.6 - 3.3 9.9 0.4 - 0.2 0.6 0.6 - 5.9
Total $ (58.4) $ (26.1) $ (7.4) $ (91.9) (3.6) % (1.6) % (0.5) % (5.7) % (5.4) % (5.8) % (11.4) %
Our products are sold to wholesalers, OEMs, DIY chains, and through various
specialty channels. The change in organic net sales by channel was attributable
to the following:
Change As a %
of Prior Year Sales
Wholesale OEMs DIY Specialty Total Wholesale OEMs DIY Specialty
(dollars in millions)
Americas $ (34.9) $ (6.6) $ 6.2 $ (29.1) $ (64.4) (5.7) % (7.9) % 9.7 % (8.9) %
Europe (31.0) (2.7) (0.2) - (33.9) (10.2) (1.9) (7.5) -
APMEA (11.4) (0.1) - 0.8 (10.7) (19.4) (7.4) - 61.0
Total $ (77.3) $ (9.4) $ 6.0 $ (28.3) $ (109.0)
Organic net sales in the Americas decreased due to a decline in volume in the
majority of our product lines primarily from the impact of the COVID-19
pandemic. This decrease was partially offset by higher volume within our DIY
channel as many DIY customers worked on residential projects during the
pandemic.
Organic net sales in Europe decreased primarily due to lost volume related to
the COVID-19 pandemic within all major regions and across all of our product
lines, partially offset by selected price increases.
Organic net sales in APMEA decreased primarily due to a decline in volume related to the COVID-19 pandemic in all regions.
The net increase in sales due to foreign exchange was primarily due to the appreciation of the euro, partially offset by the depreciation of the Canadian dollar against theU.S. dollar in 2020 as compared to 2019. We cannot predict whether foreign currencies will appreciate or depreciate against theU.S. dollar in future periods or whether future foreign exchange rate fluctuations will have a positive or negative impact on our net sales. The change in net sales due to acquired/divested relates to three immaterial acquisitions, one in the APMEA segment in the third quarter of 2020, one in theAmericas segment in the fourth quarter of 2020, and one in theAmericas segment in the third quarter of 2019, partially offset by an immaterial divestiture in our APMEA segment during the third quarter of 2020.
Gross Profit. Gross profit and gross profit as a percent of net sales (gross margin) for 2020 and 2019 were as follows:
Year Ended
December 31,
2020 2019
(dollars in millions)
Gross profit $ 625.4 $ 677.5
Gross margin 41.5 % 42.3 %
Gross profit and gross margin declined primarily from lower sales volume and
absorption as a result of the COVID-19 pandemic, partially offset by benefits
from price, productivity initiatives, government subsidies within Europe and
APMEA, and cost reduction actions in response to the pandemic.
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Selling, General and Administrative Expenses. Selling, general and
administrative, or SG&A, expenses decreased $43.7 million , or 9.2%, in 2020
compared to 2019. The decrease in SG&A expenses was attributable to the
following:
(in millions) % Change
Organic $ (48.8) (10.2) %
Foreign exchange 1.4 0.7
Acquired/divested, net 3.7 0.3
Total $ (43.7) (9.2) %
The organic decrease was related to cost reduction actions in response to the
COVID-19 pandemic of $31.4 million , decreased variable costs due to sales volume
declines of $9.5 million , restructuring savings of $10.1 million , decreased
stock compensation expense of $4.2 million primarily due to adjustments to
expected attainment levels of performance goals related to our performance stock
units, and reduction in Corporate-related professional fees of $3.1 million .
These decreases were partially offset by strategic investments of $8.8 million ,
including investments in research and development for new products, commercial
excellence, and technology and information systems as well as general inflation
of $5.4 million compared to 2019. The increase in foreign exchange was mainly
due to the appreciation of the euro against the U.S. dollar. The
acquired/divested, net SG&A costs are related to three immaterial acquisitions,
partially offset by SG&A costs related to an immaterial divestiture, as
previously mentioned. Total SG&A expenses, as a percentage of net sales, were
28.7% in 2020 compared to 29.7% in 2019.
Restructuring. In 2020, we recorded a net charge of $9.9 million compared to a
net charge of $4.3 million in 2019. The charge for 2020 was primarily for
severance benefits due to reductions in force programs initiated in the second
and third quarters of 2020 in response to economic challenges related to the
COVID-19 pandemic. For a more detailed description of our current restructuring
plans, see Note 3 of Notes to Consolidated Financial Statements in this Annual
Report Form 10-K.
Other long-lived asset impairment charges. In 2020, we recorded impairment charges of$1.4 million in ourAmericas segment, primarily relating to$1.0 million for a long-lived asset impairment charge and$0.4 million related to a technology intangible asset in which market value expectations indicated the carrying amounts of these assets were in excess of the fair value.
Loss on disposition. In 2020, we recorded a pre-tax loss on disposition of
Operating Income (Loss). Operating income (loss) by geographic segment for 2020
and 2019 was as follows:
% Change to
Consolidated
Year Ended December 31, Operating
2020 2019 Change Income
(dollars in millions)
Americas $ 166.3 $ 187.4 $ (21.1) (10.7) %
Europe 50.2 49.9 0.3 0.2
APMEA 3.5 6.9 (3.4) (1.7)
Corporate (38.9) (47.1) 8.2 4.1
Total $ 181.1 $ 197.1 $ (16.0) (8.1) %
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The (decrease) increase in operating income (loss) is attributable to the
following:
Change As a % of Change As a % of
Consolidated Operating Income Segment Operating Income
Americas Europe APMEA Corporate Total Americas Europe APMEA Corporate Total Americas Europe APMEA Corporate
(dollars in millions)Organic$ (14.1) $ (3.8) $ (1.2) $ 8.3 $ (10.8) (7.2) % (1.9) % (0.6) % 4.2 % (5.5) % (7.5) % (7.6) % (17.4) % 17.6 % Foreign exchange - 1.1 0.2 - 1.3 - 0.6 0.1 - 0.7 - 2.2 2.9 - Acquired/divested, net 0.5 - 0.6 - 1.1 0.3 - 0.3 - 0.6 0.3 - 8.7 - Loss on disposition - - (0.6) - (0.6) - - (0.3) - (0.3) - - (8.7) - Restructuring, impairment charges (7.5) 3.0 (2.4) (0.1) (7.0) (3.8) 1.5 (1.2) (0.1) (3.6) (4.0) 6.0 (34.8)
(0.2)
Total$ (21.1) $ 0.3 $ (3.4) $
8.2 $ (16.0) (10.7) % 0.2 % (1.7) % 4.1 % (8.1) % (11.2) % 0.6 % (49.3) % 17.4 %
The decrease in organic operating income was due to lower sales volume and absorption as a result of the COVID-19 pandemic, higher general inflation, including tariffs, and strategic investments, partially offset by benefits from cost reduction actions including restructuring initiated in response to the COVID-19 pandemic, price, productivity initiatives, reduced variable costs due to sales volume decline, reduced long-term incentive costs and a reduction in Corporate-related professional fees. Interest Expense. Interest expense decreased$0.8 million , or 5.7%, in 2020 as compared to 2019 primarily due to a decline in interest rates and a reduction in the principal balance of debt outstanding. Refer to Note 11 of Notes to Consolidated Financial Statements in this Annual Report on Form10-K for further details. Other expense, (income) net Other expense (income) decreased$1.5 million to an expense balance of$1.0 million compared to 2019. The decrease was primarily due to higher net foreign currency transaction losses. Income Taxes. Our effective income tax rate increased to 31.6% in 2020, from 28.5% in 2019. The tax rate increased primarily from an increase to the valuation allowance as a result of recently issued final tax regulations which reduced the realizability of foreign tax credits. Net Income. Net income for 2020 was$114.3 million , or$3.36 per common share on a diluted basis, compared to$131.5 million , or$3.85 per common share on a diluted basis, for 2019. Results for 2020 include an after-tax charge of$7.4 million , or$0.22 per common share, for restructuring;$9.7 million , or$0.28 per common share, for changes in tax regulations;$1.0 million , or$0.03 per common share, for other long-lived asset impairment charges;$1.0 million , or$0.03 per common share, for acquisition related costs;$0.8 million , or$0.02 per common share, for footprint optimization; partially offset by a$1.5 million benefit, or$0.04 per share for the elimination of an earnout from a prior immaterial acquisition in ourAmericas segment, and$0.7 million , or$0.02 per common share of a net gain on disposal. Results for 2019 include an after-tax charge of$3.1 million , or$0.09 per common share, for Corporate professional fees;$3.2 million , or$0.09 per common share, for restructuring charges;$0.7 million , or$0.02 per common share, for acquisition related costs; and$0.6 million , or$0.02 per common share for footprint optimization.
Liquidity and Capital Resources
2020 Cash Flows We generated$228.8 million of net cash from operating activities in 2020 as compared to$194.0 million in 2019. The increase in cash generated was primarily driven by favorable changes in working capital, including reductions to accounts receivable that more than offset lower net income. We used$54.8 million of net cash for investing activities in 2020 compared to$71.8 million used in 2019. We spent$27.5 million less on acquisitions and$14.6 million more for capital expenditures in 2020 compared to 2019. We received$2.2 million in cash proceeds from the sale of property, plant and equipment and received$2.0 million in proceeds from the disposal of a business in 2020. We anticipate investing between$35 million to$40 million in capital equipment in 2021 to improve our manufacturing capabilities and investment in our commercial and operational excellence initiatives. 30 Table of Contents We used$181.9 million of net cash from financing activities in 2020 primarily due to long-term debt repayments of$517.5 million , dividend payments of$31.4 million , tax withholding payments on vested stock awards of$7.8 million and payments of$28.9 million to repurchase approximately 332,000 shares of Class A common stock. Debt repayments include the termination of the term loan facility under the Prior Credit Agreement, payments made under both the Revolving Credit Facility and the Prior Revolving Credit Facility, and payment of$75 million to retire notes issued under the 2010 Note Purchase Agreement. These payments were partially offset by proceeds from drawdowns on both our Prior and current Revolving Credit Facilities totaling$407.5 million . InFebruary 2016 , we entered into the Credit Agreement (the "Prior Credit Agreement") among the Company, certain subsidiaries of the Company who become borrowers under the Prior Credit Agreement,JPMorgan Chase Bank, N.A ., as Administrative Agent, SwingLine Lender and Letter of Credit Issuer, and the other lenders referred to therein. The Prior Credit Agreement provided for a$500 million , five-year, senior unsecured revolving credit facility (the "Prior Revolving Credit Facility") with a sublimit of up to$100 million in letters of credit. The Prior Credit Agreement also provided for a$300 million , five-year, term loan facility (the "Term Loan Facility") available to us in a single draw, of which the entire$300 million had been drawn inFebruary 2016 . OnApril 24, 2020 , we entered into an Amended and Restated Credit Agreement (the "New Credit Agreement") among the Company, certain subsidiaries of the Company who become borrowers thereunder,JPMorgan Chase Bank, N.A ., as Administrative Agent, SwingLine Lender and Letter of Credit Issuer, and the other lenders referred to therein. The New Credit Agreement amended and restated the Prior Credit Agreement in its entirety while increasing the amount of revolving credit available from$500 million to$800 million , and extending the maturity by one additional year toFebruary 2022 . This senior unsecured revolving credit facility (the "Revolving Credit Facility") also includes sublimits of$100 million for letters of credit and$15 million for swing line loans. As ofDecember 31, 2020 , we had drawn down$200.0 million on this line of credit and had$16.2 million in letters of credit outstanding, which resulted in$583.8 million of unused and available credit under the Revolving Credit Facility. The term loan facility under the Prior Credit Agreement was terminated and paid off effectiveApril 24, 2020 , with funds from the Revolving Credit Facility. Borrowings outstanding under the Revolving Credit Facility bear interest at a fluctuating rate per annum equal to an applicable percentage defined as (i) in the case of Eurocurrency rate loans, the adjustedBritish Bankers Association LIBOR rate (which at all times will not be less than 1.00%) plus an applicable percentage, ranging from 1.50% to 2.10%, determined by reference to our consolidated leverage ratio, or (ii) in the case of alternate base rate loans and swing line loans, interest (which at all times will not be less than 2.00%) at the greatest of (a) the Prime Rate in effect on such day, (b) the FRBNY Rate in effect on such day plus 0.5% and (c) the adjusted LIBOR rate plus 1.0% for a one month interest period in dollars. In addition to paying interest under the New Credit Agreement, we are also required to pay certain fees in connection with the Revolving Credit Facility, including, but not limited to, an unused facility fee and letter of credit fees. The New Credit Agreement matures onFebruary 12, 2022 , subject to extension under certain circumstances and subject to the terms of the New Credit Agreement. We may repay loans outstanding under the New Credit Agreement from time to time without premium or penalty, other than customary breakage costs, if any, and subject to the terms of the New Credit Agreement. OnJune 18, 2010 , we entered into a note purchase agreement with certain institutional investors (the 2010 Note Purchase Agreement). Pursuant to the 2010 Note Purchase Agreement, we issued senior notes of$75.0 million in principal, dueJune 18, 2020 . OnJune 18, 2020 , we borrowed$40.0 million under the Revolving Credit Facility and used$35.0 million of our available cash to pay off all amounts outstanding under the 2010 Note Purchase Agreement. We have historically financed our operating and capital needs primarily through cash flows generated by our operations. We expect to continue funding future operating requirements principally through our cash flows from operations, in addition to existing cash resources. We believe that our existing funds, when combined with cash generated from operations and our ability to access additional financing resources, if needed, are sufficient to satisfy our operating, working capital, strategic investments, capital expenditure and debt service requirements for the foreseeable future. In addition, we may choose to opportunistically return cash to shareholders and pursue other business initiatives, including acquisition activities. We may, from time to time, also seek additional funding through a combination of equity and debt financings should we identify a significant new opportunity.
As of
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rates by utilizing the undrawn borrowings under our Revolving Credit Facility. We believe that our financial resources allow us to manage the anticipated impacts of the COVID-19 pandemic on our business operations for the foreseeable future, which include reductions in revenues and potential delays in payments from customers. We anticipate the impacts of COVID-19 will continue to evolve rapidly, and, as a result, we will continue to evaluate our financial position as additional information becomes available, particularly relating to COVID-19. Subsequent to recording the Toll Tax as part of the Tax Cuts and Jobs Act of 2017, our intent is to permanently reinvest undistributed earnings of foreign subsidiaries, and we do not have any current plans to repatriate post-Toll Tax foreign earnings generated subsequent toDecember 31, 2017 , to fund operations inthe United States . However, if amounts held by foreign subsidiaries were needed to fund operations inthe United States , we could be required to accrue and pay taxes to repatriate these funds. Such charges may include potential state income taxes and other tax charges.
Covenant compliance
Under the New Credit Agreement, we are required to satisfy and maintain specified financial ratios and other financial condition tests as ofDecember 31, 2020 . The financial ratios include a consolidated interest coverage ratio based on consolidated earnings before income taxes, interest expense, depreciation, and amortization (Consolidated EBITDA) to consolidated interest expense, as defined in the New Credit Agreement. The New Credit Agreement defines Consolidated EBITDA to exclude unusual or non-recurring charges and gains. We are also required to maintain a consolidated leverage ratio of consolidated funded debt to Consolidated EBITDA. Consolidated funded debt, as defined in the New Credit Agreement, includes all long and short-term debt, capital lease obligations and any trade letters of credit that are outstanding, less cash and cash equivalents on the balance sheet.
As of
Actual Ratio Required Level
Minimum levelInterest Charge Coverage Ratio 19.1 to 1.00 3.50 to 1.00
Maximum level
Leverage Ratio 0.00 to 1.00 3.25 to 1.00
As of
In addition to financial ratios, the New Credit Agreement contains affirmative and negative covenants that include limitations on disposition or sale of assets, prohibitions on assuming or incurring any liens on assets with limited exceptions and limitations on making investments other than those permitted
by the agreement.
Working capital (defined as current assets less current liabilities) as ofDecember 31, 2020 was$396.7 million compared to$315.6 million as ofDecember 31, 2019 . The ratio of current assets to current liabilities was 2.3 to 1 as ofDecember 31, 2020 compared to 1.8 to 1 as ofDecember 31, 2019 . The increase in working capital is primarily related to a decrease in the current portion of long-term debt due to the payment of the senior note and the current portion of the term loan facility under the Prior Credit Agreement in 2020. The senior note, which is described further in Note 11 of Notes to the Consolidated Financial Statements in this Annual Report 10-K, was paid inJune 2020 . Non-GAAP Financial Measures
In accordance with theSEC's Regulation G and Item 10(e) of Regulation S-K, the following provides definitions of the non-GAAP measures used by management. We believe that these measures enhance the overall understanding of underlying business results and trends. These non-GAAP measures are not intended to be considered by the user in place of the related GAAP measure, but rather as supplemental information to more fully understand our business results. These non-GAAP measures may not be the same as similar measures used by other companies due to possible differences in method and in the items or events
being adjusted. Organic net sales growth is a non-GAAP measure of net sales growth that excludes the impacts of acquisitions, divestitures and foreign exchange from period-over-period comparisons. A reconciliation to the most closely relatedU.S. GAAP measure, net sales, has been included in our discussion within "Results of Operations" above. Organic net sales should be considered in addition to, and not as a replacement for or as a superior measure to net sales. Management 32 Table of Contents
believes reporting organic sales growth provides useful information to investors, potential investors and others, by facilitating easier comparisons of our revenue performance with prior and future periods.
Adjusted operating income, adjusted operating margins, adjusted net income, and
adjusted earnings per share are non-GAAP measures that exclude certain expenses
incurred and benefits recognized in the periods presented that relate primarily
to our global restructuring programs, other long-lived asset impairment charges,
professional fees, acquisition related costs, footprint optimization costs, an
earnout adjustment, loss on disposal, and the related income tax impacts on
these items and other tax adjustments. Management believes reporting these
financial measures provides useful information to investors, potential investors
and others, by facilitating easier comparisons of our performance with prior and
future periods.
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A reconciliation of
Year Ended
December 31, December 31,
2020 2019
Net sales $ 1,508.6 $ 1,600.5 Operating income - as reported 181.1
197.1
Operating margin % 12.0%
12.3%
Adjustments for special items: Acquisitions / divesture costs / adjustments: - Other long-lived asset impairment charge 1.4
-
- Acquisition related costs 1.3 0.9
- Loss on disposal 0.6 -
- Earnout adjustment (1.5) -Total acquisitions / divesture costs / adjustments 1.8
0.9
Restructuring 9.9 4.3
Footprint optimization 1.1 0.8
Professional fees - 3.1
Total adjustments for special items $ 12.8 $
9.1
Operating income - as adjusted$ 193.9 $
206.2
Adjusted operating margin % 12.9% 12.9%
Net income - as reported $ 114.3 $ 131.5
Adjustments for special items - tax effected:
Acquisitions / divesture costs / adjustments:
- Other long-lived asset impairment charge 1.0
-
- Acquisition related costs 1.0 0.7
- Net gain on disposal (0.7) -
- Earnout adjustment (1.5) -Total acquisitions / divesture costs / adjustments (0.2)
0.7
Restructuring 7.4 3.2
Footprint optimization 0.8 0.6
Professional fees - 3.1
Tax adjustments 9.7 -
Total adjustments for special items - tax effected: $ 17.7 $
7.6
Net income as adjusted $ 132.0 $ 139.1
Diluted earnings per share - as reported $ 3.36 $
3.85
Adjustments for special items 0.52
0.22
Diluted earnings per share - as adjusted $ 3.88 $
4.07
Free cash flow is a non-GAAP measure that does not represent cash generated from operating activities in accordance withU.S. GAAP. Therefore, it should not be considered an alternative to net cash provided by operating activities as an indication of our performance. The cash conversion rate of free cash flow to net income is also a measure of our performance in cash flow generation. We believe free cash flow to be an appropriate supplemental measure of our 34
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operating performance because it provides investors with a measure of our ability to generate cash, repay debt, pay dividends, repurchase stock and fund acquisitions.
A reconciliation of net cash provided by operating activities to free cash flow and calculation of our cash conversion rate is provided below:
Year Ended
December 31 , December 31,
2020 2019
(in millions)Net cash provided by operating activities$ 228.8 $ 194.0 Less: additions to property, plant, and equipment (43.8)
(29.2)
Plus: proceeds from the sale of property, plant, and equipment 2.2 0.1 Free cash flow$ 187.2 $ 164.9 Net income -as reported$ 114.3 $ 131.5
Cash conversion rate of free cash flow to net income 163.8 %
125.4 %
Our free cash flow improved in 2020 when compared to 2019 primarily driven by favorable changes in working capital, including reductions in accounts receivable which more than offset lower net income and higher capital expenditures.
Our net (cash) debt to capitalization ratio, a non-GAAP financial measure used by management, atDecember 31, 2020 was (2)% for 2020 compared to 8.4% in 2019. The decrease was driven by a decrease in net debt outstanding atDecember 31, 2020 of$110.2 million , primarily due to the payments of the senior note and the current portion of the term loan facility under the Prior Credit Agreement in 2020. Management believes the net (cash) debt to capitalization ratio is an appropriate supplemental measure because it helps investors understand our ability to meet our financing needs and serves as a basis to evaluate our financial structure. Our computation may not be comparable to other companies that may define their net (cash) debt to capitalization ratios differently.
A reconciliation of long-term debt (including current portion) to net (cash) debt and our net (cash) debt to capitalization ratio is provided below:
December 31, December 31,
2020 2019
(in millions)
Current portion of longterm debt $ - $ 105.0
Plus: long-term debt, net of current portion 198.2
204.2
Less: cash and cash equivalents (218.9) (219.7) Net (cash) debt$ (20.7) $ 89.5
A reconciliation of capitalization is provided below:
December 31, December 31,
2020 2019
(in millions)
Net (cash) debt $ (20.7) $ 89.5
Total stockholders' equity 1,069.8 978.0
Capitalization $ 1,049.1 $ 1,067.5 Net (cash) debt to capitalization ratio (2.0) % 8.4
%
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Contractual Obligations
Our contractual obligations as of December 31, 2020 are presented in the
following table:
Payments Due by Period
Less than More than
Contractual Obligations Total 1 year 13 years 45 years 5 years
(in millions)
Long-term debt obligations, including
current maturities(a) $ 200.0 $ - $ 200.0 $ - $ -
Operating lease obligations (c) 66.9 10.5 16.9 12.2 27.3
Finance lease obligations(a) 4.9 1.7 2.2 1.0 - Pension contributions 11.7 0.5 0.9 1.1 9.2 Interest 5.2 4.5 0.7 - -
2017 Tax Act Toll Tax payable 18.7 -
3.5 15.2 - Other(b) 47.0 39.1 4.3 0.8 2.8 Total$ 354.4 $ 56.3 $ 228.5 $ 30.3 $ 39.3
(a) as recognized in the consolidated balance sheet.
(b) the majority relates to commodity and capital commitments at
2020.
(c) includes obligations as recognized in the consolidated balance sheet.
We maintain letters of credit that guarantee our performance or payment to third parties in accordance with specified terms and conditions. Amounts outstanding were approximately$16.2 million as ofDecember 31, 2020 and$25.8 million as ofDecember 31, 2019 . Our letters of credit are primarily associated with insurance coverage and, to a lesser extent, foreign purchases and generally expire within one year of issuance. These instruments may exist or expire without being drawn down; therefore, they do not necessarily represent future cash flow obligations and are not included in the table above.
Off-Balance Sheet Arrangements
We have no off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that are material to investors.
Application of Critical Accounting Policies and Key Estimates
The preparation of our consolidated financial statements in accordance withU.S. GAAP requires management to make judgments, assumptions and estimates that affect the amounts reported. A critical accounting estimate is an assumption about highly uncertain matters and could have a material effect on the consolidated financial statements if another, also reasonable, amount were used, or, a change in the estimate is reasonably likely from period to period. We base our assumptions on historical experience and on other estimates that we believe are reasonable under the circumstances. Actual results could differ significantly from these estimates. There were no significant changes in our accounting policies or significant changes in our accounting estimates during 2020.
We periodically discuss the development, selection and disclosure of the estimates with our Audit Committee. Management believes the following critical accounting policies reflect our more significant estimates and assumptions.
Revenue recognition
We recognize revenue under the core principle to depict the transfer of control
to our customers in an amount reflecting the consideration to which we expect to
be entitled. In order to achieve that core principle, we apply the following
five-step approach: (1) identify the contract with a customer, (2) identify the
performance obligations in the contract, (3) determine the transaction price,
(4) allocate the transaction price to the performance obligations in the
contract, and (5) recognize revenue when a performance obligation is satisfied.
Our revenue for product sales is recognized on a point in
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time model, at the point control transfers to the customer, which is generally when products are shipped from the Company's manufacturing or distribution facilities or when delivered to the customer's named location. Sales tax, value-added tax, or other taxes collected concurrent with revenue producing activities are excluded from revenue. Freight costs billed to customers for shipping and handling activities are included in revenue with the related cost included in selling, general and administrative expenses. See Note 4 of Notes to Consolidated Financial Statements in this Annual Report on Form 10-K for further disclosures and detail regarding revenue recognition. Inventory valuation Inventories are stated at the lower of cost or net realizable value with costs determined primarily on a first-in first-out basis. We utilize both specific product identification and historical product demand as the basis for determining our excess or obsolete inventory reserve. We identify all inventories that exceed a range of one to three years in sales. This is determined by comparing the current inventory balance against unit sales for the trailing twelve months. New products added to inventory within the past twelve months are excluded from this analysis. A portion of our products contain recoverable materials, therefore the excess and obsolete reserve is established net of any recoverable amounts. Changes in market conditions, lower-than- expected customer demand or changes in technology or features could result in additional obsolete inventory that is not saleable and could require additional inventory reserve provisions. In certain countries, additional inventory reserves are maintained for potential shrinkage experienced in the manufacturing process. The reserve is established based on the prior year's inventory losses adjusted for any change in the gross inventory balance.
We have made numerous acquisitions over the years and have recognized a significant amount of goodwill.Goodwill is tested for impairment annually or more frequently if an event or circumstance indicates that an impairment loss may have been incurred. Application of the goodwill impairment test requires judgment, including the identification of reporting units, assignment of assets and liabilities to reporting units, and determination of the fair value of each reporting unit when a quantitative analysis is performed. We estimate the fair value of our reporting units using an income approach based on the present value of estimated future cash flows, and when appropriate, guideline public company and guideline transaction market approaches. Accounting guidance allows us to assess goodwill for impairment utilizing either qualitative or quantitative analyses. We have the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If, after assessing the totality of events and circumstances, we determine it is more likely than not that the fair value of a reporting unit is greater than its carrying amount, then performing the quantitative impairment test is unnecessary. We first identify those reporting units that we believe could pass a qualitative assessment to determine whether further impairment testing is necessary. For each reporting unit identified, our qualitative analysis includes:
A review of the most recent fair value calculation to identify the extent of
1) the cushion between fair value and carrying amount, to determine if a
substantial cushion existed.
A review of events and circumstances that have occurred since the most recent
fair value calculation to determine if those events or circumstances would
have affected our previous fair value assessment. Items identified and
2) reviewed include macroeconomic conditions, industry and market changes, cost
factor changes, events that affect the reporting unit, and financial
performance against expectations and the reporting unit's performance relative
to peers.
We then compile this information and make our assessment of whether it is more
likely than not that the fair value of the reporting unit is less than its
carrying amount. If we determine it is not more likely than not, then no further
quantitative analysis is required.
In 2020, we had seven reporting units. One of these reporting units, Water Quality, had no goodwill. We performed a qualitative analysis for each of the six remaining reporting units, which include Blücher, US Drains, Fluid Solutions-Europe, Fluid Solutions-Americas, Heating and Hot Water Solutions ("HHWS") and APMEA.
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As of ourOctober 25, 2020 testing date, we had$590.8 million of goodwill on our balance sheet. As a result of our qualitative analyses, we determined that the fair values of the six reporting units noted above were more likely than not greater than the carrying amounts. In 2020, we did not need to proceed beyond the qualitative analysis, and no goodwill impairments were recorded. Intangible assets such as trademarks and trade names are generally recorded in connection with a business acquisition. Values assigned to intangible assets are typically determined by an independent valuation firm based on our estimates and judgments regarding expectations of the success and life cycle of products and technology acquired. Accounting guidance allows us to perform a qualitative impairment assessment of indefinite-lived intangible assets consistent with the goodwill guidance noted previously. For our 2020 impairment assessment, which occurred as ofOctober 25, 2020 , we performed a qualitative assessment for certain tradenames where the fair value significantly exceeded the carrying value in the previous quantitative assessment performed, had sales growth in 2020 or sales declined primarily due to the impact of the COVID-19 pandemic, sales growth is expected in the tradename in 2021, and no other indicators of impairment were present. For the remaining tradenames in 2020, the Company performed a quantitative assessment. The methodology we employed for the quantitative assessments was the relief from royalty method, a subset of the income approach. During 2020, 2019, and 2018, no impairment was recognized on our indefinite-lived intangible assets. Product liability Because of retention requirements associated with our insurance policies, we are generally self-insured for potential product liability claims. We are subject to a variety of potential liabilities in connection with product liability cases, and for our most significant volume of liability matters, we maintain a high self-insured retention limit within our product liability and general liability coverage, which we believe to be generally in accordance with industry practices. We maintain excess liability insurance to minimize our risks related to claims in excess of our primary insurance policies. The product liability accrual is established after considering any applicable insurance coverage. For our product liability cases in theU.S. , we establish a product liability accrual, which includes legal costs associated with accrued claims. For our most significant volume of liability matters, we utilize third-party actuarial valuations which incorporate historical trend factors and our specific claims experience derived from loss reports provided by third-party claims administrators to establish our product liability accrual. For the remainder of our product liability accrual, where we do not utilize third-party actuarial valuations, we maintain insurance and calculate potential product liability accruals which includes legal costs associated with the accrued claims on a case by case basis. Changes in the nature of product liability claims, legal costs, or the actual settlement amounts could affect the adequacy of the estimates and require changes to the accrual. Because the liability is an estimate, the ultimate liability may be more or less than reported. Any material change in the aforementioned factors could have an adverse impact on our operating results for any particular period depending, in part, upon the operating results for such period. Legal contingencies We are a defendant in numerous legal matters including those involving environmental issues and product liability as discussed in more detail in Part I, Item 1. "Business-Product Liability, Environmental and Other Litigation Matters" and Note 15 of Notes to Consolidated Financial Statements in this Annual Report on Form 10-K. As required by GAAP, we determine whether an estimated loss from a loss contingency should be accrued by assessing whether a loss is deemed probable and the loss amount can be reasonably estimated. When it is possible to estimate reasonably possible loss or range of loss above the amount accrued, that estimate is aggregated and disclosed. Estimates of potential outcomes of these contingencies are often developed in consultation with outside counsel. While this assessment is based upon all available information, litigation is inherently uncertain and the actual liability to fully resolve litigation cannot be predicted with any assurance of accuracy. In the event of an unfavorable outcome in one or more legal matters, the ultimate liability may be in excess of amounts currently accrued, if any, and may be material to our operating results or cash flows for a particular quarterly or annual period. However, based on information currently known to us, management believes that the ultimate outcome of all legal contingencies, as they are resolved over time, is not likely to have a material adverse effect on our financial condition, though the outcome could be material to our operating results for any particular period depending, in part, upon the operating results for such period. 38 Table of Contents Income taxes
We are subject to income taxes in the
We estimate and use our expected annual effective income tax rates to accrue income taxes. Effective tax rates are determined based on budgeted earnings before taxes, including our best estimate of permanent items that will affect the effective rate for the year. Management periodically reviews these rates with outside tax advisors and changes are made if material variances from expectations are identified. Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis and operating loss and tax credit carry forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance is provided to offset any net deferred tax assets if, based upon the available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. We consider estimated future taxable income and future reversals of the deferred tax liabilities in assessing the need for a valuation allowance. The 2017 Tax Act was enacted onDecember 22, 2017 and introduced significant changes toU.S. income tax law. Effective in 2018, the 2017 Tax Act reduced theU.S. statutory tax rate from 35% to 21% and created new taxes on certain foreign-sourced earnings and certain related-party payments, which are referred to as the global intangible low-taxed income tax and the base erosion tax, respectively. In addition, in 2017 we were subject to the Toll Tax, a one-time transition tax on accumulated foreign subsidiary earnings not previously subject toU.S. income tax. Accounting for the income tax effects of the 2017 Tax Act atDecember 31, 2017 required significant judgments and estimates in the interpretation and calculations of the provisions of the 2017 Tax Act. We are required to recognize the effect of the tax law changes in the period of enactment, such as determining the Toll Tax, remeasuring ourU.S. deferred tax assets and liabilities as well as reassessing the net realizability of our deferred tax assets and liabilities. Due to the timing of the enactment and the complexity involved in applying the provisions of the 2017 Tax Act, we made reasonable estimates of the effects and recorded provisional amounts in our financial statements for the year endedDecember 31, 2017 . InDecember 2017 , theSEC staff issued Staff Accounting Bulletin No. 118, Income Tax Accounting Implications of the Tax Cuts and Jobs Act (SAB 118), which allowed us to record provisional amounts during a measurement period not to extend beyond one year of the enactment date.December 22, 2018 marked the end of the measurement period for purposes ofSAB 118. As such, we completed the analysis based on legislative updates relating to the Act currently available, which resulted in an additional tax benefit of$3.7 million in the fourth quarter of 2018 and a final total tax charge of$21.4 million related to implementation of the 2017 Tax Act. New Accounting Standards
A discussion of recent accounting pronouncements is included in Note 2 of the Notes to Consolidated Financial Statements in this Annual Report on Form 10-K.
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