WATTS WATER TECHNOLOGIES INC (WTS) FY 2022 MD&A

Item 7.   MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

​

Overview

​

We are a leading supplier of products and solutions that manage and conserve the flow of fluids and energy into, through and out of buildings in the commercial, industrial and residential markets in the Americas, Europe and Asia-Pacific, Middle East and Africa (“APMEA”). For nearly 150 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 water. We earn revenue and income almost exclusively from the sale of our products. Our principal product categories include:

​

​

​

​

​

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 continue 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 since 2012. Our acquisition strategy focuses on businesses that promote our key macro themes around safety and 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, including smart and connected technologies, advanced production capabilities or complementary solution offerings.

​

We believe that sustainability guides and permeates every aspect of our business, including our product development strategy and design, and how we structure our operations. Our innovation strategy is focused on differentiated products and solutions that will provide greater opportunity to distinguish ourselves in the marketplace, while at the same time creating innovative products and smart solutions to protect, control, and conserve critical resources, and help our customers with their sustainability efforts through the use of our products. We continue to migrate away from commoditized products where we cannot 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.

28

Table of Contents

Over the past several 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 are focused on introducing products that 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 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.

​

Market activity levels have generally recovered from the COVID-19 pandemic. In 2022, we experienced some disruptions to our business in China due to government-mandated lockdowns, though these shutdowns and restrictions did not have a material adverse effect on our operations or financial results. We continue to focus on the health and safety of our employees by maintaining health authority and government recommended safety protocols, enabling remote work and hybrid work schedules where feasible, providing personal protective equipment and providing COVID-19 information, which includes the latest CDC and other government protocols and our safety requirements.

​

The global supply chain disruptions have shown signs of easing; however, some logistics issues and electronic component shortages remain. We are experiencing inflation across our cost of materials, labor, transportation, and energy. Labor shortages and workforce disruptions have affected our manufacturing and distribution processes, as well as those of our suppliers. The ongoing war in Ukraine has added strain to the European markets and the global economy, as well as exacerbated inflation, particularly energy inflation. While we believe we were able to effectively manage these disruptions during 2022 by various measures, including raising prices to address cost inflation and taking certain cost reduction actions, we cannot predict how ongoing inflation, risk of recession, the war in Ukraine, supply chain disruptions and related costs may impact our ability to service our customers or the potential impact on our profit margins going forward.

​

We expect that economic conditions in 2023 will be challenging. Higher interest rates and inflation have significantly slowed new residential construction and global GDP is declining, which could impact repair and replacement activity and may reduce the demand for our products. Non-residential new construction may be more resilient, at least through the first half of 2023. Starting in the third quarter of 2022 and continuing into the fourth quarter of 2022 we experienced some channel destocking in Europe. We also saw some destocking In North America in the fourth quarter of 2022 by customers in the residential OEM channel. Our expectation is that it may continue in the first quarter of 2023 and we will monitor this as the year progresses. Despite these anticipated challenges, we continue to invest in our business, including new products, our smart and connected solutions and our growth and productivity initiatives. We remain focused on our customers’ needs and executing on our long-term strategy.

​

Due to the above circumstances and as described generally in this Form 10-K, our results of operations for the year ended December 31, 2022 are not necessarily indicative of future results. Management cannot predict the full impact of the uncertainties discussed above. For further information regarding the impact on the Company, see Item 1A, “Risk Factors.”

​

Financial Overview

We delivered record results for 2022 while facing unprecedented inflationary pressures and supply chain disruptions. Net sales for 2022 increased 9.4%, or $170.3 million, on a reported basis and 13.0%, or $235.6 million, on an organic basis, compared to 2021, primarily driven by incremental price across all of our operating segments. The reported sales increase included the unfavorable impact of foreign exchange of 3.9%, or $71.5 million, primarily driven by the appreciation of the U.S. dollar against the euro and Chinese yuan, and acquired sales of $6.1 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 $315.0 million increased by $75.4 million, or 31.5%, in 2022 compared to 2021.

29

Table of Contents

This increase was primarily driven by incremental price, savings from productivity and restructuring actions, partially offset by inflation and incremental investments.

​

Management’s discussion and analysis of our financial condition, results of operations and cash flows as of and for the year ended December 31, 2020 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 ended December 31, 2021.

​

Recent Developments

​

On February 6, 2023, we declared a quarterly dividend of thirty cents ($0.30) per share on each outstanding share of Class A common stock and Class B common stock payable on March 15, 2023 to stockholders of record on March 1, 2023.

​

Results of Operations

​

Year Ended December 31, 2022 Compared to Year Ended December 31, 2021

​

Net Sales. Our business is reported in three geographic segments: Americas, Europe and APMEA. Our net sales in each of these segments for the years ended December 31, 2022 and December 31, 2021 were as follows:

​

​

The change in net sales was attributable to the following:

​

​

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:

​

​

Organic net sales in the Americas increased primarily due to incremental price across all of our channels, as well as higher volume within our heating and hot water solution products. The increase was partially muted due to 2021 being positively impacted from the severe freezing weather in the South-Central United States, which drove an estimated 2% of incremental sales in our wholesale and DIY channels.

​

30

Table of Contents

Organic net sales in Europe increased due to incremental price, with growth in all platforms as well as all major regions. A significant portion of this growth related to HVAC products within the OEM markets in Italy and Germany driven by government energy incentives. Sales growth was negatively impacted by approximately $9 million due to our decision to exit all direct sales into Russia as a result of the war in Ukraine effective April 1, 2022.

​

Organic net sales in APMEA increased primarily due to higher volumes and price, with sales growth in China, Australia, New Zealand and the Middle East. China’s sales growth was primarily driven by higher demand for commercial valves within data centers.

​

The net decrease in sales due to foreign exchange was mostly due to the appreciation of the U.S. dollar against the euro and Chinese yuan in 2022. We cannot predict whether foreign currencies will appreciate or depreciate against the U.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 acquisitions relates to an immaterial acquisition in the Americas segment in the fourth quarter of 2021.

​

Gross Profit. Gross profit and gross profit as a percent of net sales (gross margin) for 2022 and 2021 were as follows:

​

​

Gross profit and gross margin increased primarily from incremental price, productivity and restructuring savings, partially offset by inflation related to material and labor costs and higher logistic and energy costs.

​

Selling, General and Administrative Expenses. Selling, general and administrative, or SG&A, expenses increased $42.3 million, or 8.3%, in 2022 compared to 2021. The increase in SG&A expenses was attributable to the following:

​

​

The organic increase was primarily due to an increase in investments of $23.0 million, including in our smart and connected and commercial excellence initiatives, general inflation of $15.7 million, increased variable costs due to the higher sales of $14.4 million and an increase in marketing, travel and other normalized spending of $11.2 million compared to 2021. These increases were partially offset by $11.5 million due to productivity initiatives and a decrease in short-term and long-term compensation expense of $6.9 million. The decrease in foreign exchange was mainly due to the appreciation of the U.S. dollar against the euro. The acquired SG&A costs related to an immaterial acquisition in the Americas segment in the fourth quarter of 2021. Total SG&A expenses, as a percentage of sales, were 27.8% in 2022 compared to 28.1% in 2021.

​

Restructuring. In 2022, we recorded a net restructuring charge of $10.6 million, which related to a 2021 French restructuring program as well as other actions related to the decommissioning of machinery at one of our facilities in the Americas and cost reduction actions in Europe and the Americas. In 2021, we recorded a net restructuring charge of $19.3 million, primarily for costs related to the 2021 French restructuring program that was approved in the second quarter of 2021. 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.

​

31

Table of Contents

Operating Income (Loss). Operating income (loss) by geographic segment for 2022 and 2021 was as follows:

​

​

The increase (decrease) in operating income (loss) is attributable to the following:

​

​

The increase in organic operating income was primarily due to incremental price and savings from productivity and restructuring actions. These increases were partially offset by inflation related to material and labor costs, higher logistic and energy costs, incremental investments and the return of expenses related to business normalization.

​

Interest Expense. Interest expense increased $0.7 million, or 11.1%, in 2022 as compared to 2021 primarily due to an increase in interest rates, partially offset by a lower 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) increased $1.8 million to an expense balance of $1.0 million compared to 2021. The increase was primarily due to $1.0 million of additional expense related to the reduction in deferred compensation plan assets. Refer to Note 16 Financial Instruments of Notes to Consolidated Financial Statements in this Annual Report on Form10-K for further details.

​

Income Taxes. Our effective income tax rate decreased to 18.2% in 2022, from 29.2% in 2021. The decrease is primarily due to a $16.1 million tax benefit related to the modification of the structure of our Mexican supply chain operations in 2022, while the initial restructuring of our Mexican supply chain operations in 2021 resulted in a net $7.2 million tax charge. In 2022, we also benefited from the release of tax reserves of $2.5 million due to statute of limitation expirations.

​

Net Income. Net income for 2022 was $251.5 million, or $7.48 per common share on a diluted basis, compared to $165.7 million, or $4.88 per common share on a diluted basis, for 2021. Results for 2022 include an after-tax benefit of $18.2 million, or $0.54 per common share, primarily for an income tax benefit related to the modification of the structure of our Mexican supply chain operations and $1.4 million, or $0.04 per common share, for an after-tax gain on sale of asset; partially offset by an after-tax charge of $7.9 million, or $0.23 per common share, for restructuring.

​

Results for 2021 include an after-tax charge of $14.1 million, or $0.42 per common share, for restructuring and $7.2 million, or $0.22 per common share, for an income tax adjustment related to the restructuring of our Mexican manufacturing supply chain operations.

32

Table of Contents

Liquidity and Capital Resources

​

2022 and 2021 Cash Flows

​

We generated $224.0 million of net cash from operating activities in 2022 as compared to $180.8 million in 2021. The increase in cash generated was primarily due to higher net income and lower investment in inventory, partially offset by lower accounts payable balances associated with the reduction in inventory purchases and increased payments related to income taxes, restructuring and employee and customer incentives.

​

We used $22.9 million of net cash for investing activities in 2022 compared to $30.7 million used in 2021. We spent $1.3 million more on net capital expenditures and $9.1 million less for acquisitions in 2022 compared to 2021.

​

We used $121.7 million of net cash from financing activities in 2022 primarily due to long-term debt repayments of $80.0 million, dividend payments of $39.5 million, tax withholding payments on vested stock awards of $13.3 million and payments of $69.4 million to repurchase 493,733 shares of Class A common stock. These payments were partially offset by proceeds from drawdowns on our line of credit totaling $85.0 million. In 2021, we used $118.6 million of net cash from financing activities primarily due to long-term debt repayments of $95.0 million, dividend payments of $34.3 million, tax withholding payments on vested stock awards of $9.6 million and payments of $16.0 million to repurchase approximately 110,000 shares of Class A common stock. These payments were partially offset by proceeds from drawdowns on our line of credit totaling $40.0 million.

​

On March 30, 2021, we and certain of our subsidiaries entered into the Second Amended and Restated Credit Agreement with JPMorgan Chase Bank, N.A., as administrative agent (the “Credit Agreement”). The Credit Agreement amended the Company’s borrowings under the Amended and Restated Credit Agreement entered into on April 24, 2020 (the “Prior Credit Agreement”), to extend the maturity date of the $800 million senior unsecured revolving credit facility from February 12, 2022 to March 30, 2026 (the “Revolving Credit Facility”). Among other changes from the Prior Credit Agreement, the Credit Agreement increased our maximum consolidated leverage ratio (including both the base ratio and the ratio permitted during temporary step-ups following certain acquisitions), adjusted certain fees to reflect market conditions and reduced the 1.00% floor on the adjusted London interbank offered rate (LIBOR) to 0.00%. On August 2, 2022, we and certain of our subsidiaries entered into Amendment No. 1 to the Credit Agreement (as so amended, the “Amended Credit Agreement”) to replace LIBOR as a reference rate for borrowings with the term secured overnight financing rate (“Term SOFR”), and to provide for a fixed adjustment of 10 basis points added to Term SOFR (“Term Benchmark”) for all Term SOFR borrowings, subject to a 0.00% floor. The Company elected the optional expedient under Accounting Standards Update (“ASC”) No. 2020-04, Reference Rate Reform (Topic 848), in connection with amending its credit agreement to replace the reference rate from LIBOR to Term Benchmark to consider the amendment as a continuation of the existing contract without having to perform an assessment that would otherwise be required under U.S. GAAP.

​

The Revolving Credit Facility also includes sub-limits of $100 million for letters of credit and $15 million for swing line loans. As of December 31, 2022, we had drawn down $150.0 million on this line of credit and had $12.1 million in letters of credit outstanding, which resulted in $637.9 million of unused and available credit under 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 Term Benchmark loans, the Term Benchmark rate plus an applicable percentage, ranging from 1.075% to 1.325%, 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 1.00%) at the greatest of (a) the Prime Rate in effect on such day, (b) the FRBNY Rate in effect on such day plus 0.50% and (c) the Term Benchmark rate plus 1.00% for a one month interest period. The weighted average interest rate on debt outstanding under the Revolving Credit Facility as of December 31, 2022 was 5.35%. The weighted average interest rate on debt outstanding inclusive of the interest rate swap discussed in Note 11 of the Notes to Consolidated Financial Statements and interest rates under the Revolving Credit Facility as of December 31, 2022 was 3.23%. In addition to paying interest under the Amended 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 Amended Credit Agreement matures on March 30, 2026, subject to extension under certain circumstances and subject to the terms of the Amended Credit Agreement. We may repay loans outstanding under the Amended Credit Agreement from time to time without premium or penalty, other than customary breakage costs, if any, and subject to the terms of the Amended Credit Agreement. As of December 31, 2022, we were in compliance with all covenants related to the Amended Credit Agreement.

33

Table of Contents

As of December 31, 2022, we held $310.8 million in cash and cash equivalents. Of this amount, $221.2 million was held by foreign subsidiaries. Our U.S. operations typically generate sufficient cash flows to meet our domestic obligations. However, if we did have to borrow to fund some or all of our expected cash outlays, we can do so at reasonable interest rates by utilizing the undrawn borrowings under our Revolving Credit Facility. 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 to fund operations in the United States. However, if amounts held by foreign subsidiaries were needed to fund operations in the 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 Amended Credit Agreement, we are required to satisfy and maintain specified financial ratios and other financial condition tests as of December 31, 2022. 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 Amended Credit Agreement. The Amended 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 Amended Credit Agreement, includes all long and short-term debt, finance lease obligations and any trade letters of credit that are outstanding, less cash and cash equivalents on the balance sheet.

​

As of December 31, 2022, our actual financial ratios calculated in accordance with the Amended Credit Agreement compared to the required levels under the Amended Credit Agreement were as follows:

​

​

As of December 31, 2022, we were in compliance with all covenants related to the Amended Credit Agreement.

​

In addition to financial ratios, the Amended 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 of December 31, 2022 was $571.9 million compared to $453.0 million as of December 31, 2021. The ratio of current assets to current liabilities was 2.5 to 1 as of December 31, 2022 compared to 2.1 to 1 as of December 31, 2021. The increase in working capital is primarily related to the increase in cash and cash equivalents as a result of increased cash from operating activities.

​

Material Cash Requirements

​

We expect existing cash and cash equivalents and cash flows from operations and financing activities to be sufficient to meet our cash needs during 2023 and thereafter for the foreseeable future.

​

We anticipate investing between $40 million to $45 million in capital expenditures during 2023 to improve our manufacturing capabilities and invest in technology and other commercial and operational excellence initiatives.

​

We anticipate spending approximately $6.0 million during 2023 related to various restructuring programs. 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.

​

34

Table of Contents

We intend to continue to repurchase shares of Class A common stock consistent with prior years. The repurchases are executed from time to time on the open market or in privately negotiated transactions. The timing and number of shares repurchased will be determined based on our evaluation of market conditions and other factors, see Note 12 of Notes to Consolidated Financial Statements in this Annual Report Form 10-K.

​

While we presently intend to continue to pay comparable quarterly cash dividends on both Class A and B common stock, the payment of future cash dividends depends upon the Board of Directors’ assessment of our earnings, financial condition, capital requirements and other factors.

​

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 $12.1 million as of December 31, 2022 and $14.0 million as of December 31, 2021. 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.

​

Our contractual obligations as of December 31, 2022 are presented in the following table:

​

​

​

​

​

​

​

​

35

Table of Contents

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.

​

Non-GAAP Financial Measures

​

In accordance with the SEC'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 related U.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 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, gain on sale of asset, 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.

​

36

Table of Contents

A reconciliation of U.S. GAAP results to these adjusted non-GAAP measures is provided below (dollars in millions, except per share amounts):

​

Free cash flow is a non-GAAP measure that does not represent cash generated from operating activities in accordance with U.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 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:

​

​

37

Table of Contents

Our free cash flow increased in 2022 when compared to 2021 primarily driven by higher net income and lower investment in inventory, partially offset by lower accounts payable balances associated with the reduction in inventory purchases and increased payments related to income taxes, restructuring and employee and customer incentives.

​

Our net debt to capitalization ratio, a non-GAAP financial measure used by management, at December 31, 2022 was (14.3)% for 2022 compared to (9.3)% in 2021. The change was driven by an increase in net cash of $68.8 million, partially offset by an increase in debt outstanding of $5.7 million at December 31, 2022 compared to December 31, 2021. Management believes the net 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 debt to capitalization ratios differently.

​

A reconciliation of long-term debt (including current portion) to net debt and our net debt to capitalization ratio is provided below:

​

​

A reconciliation of capitalization is provided below:

​

​

​

Application of Critical Accounting Policies and Key Estimates

​

The preparation of our consolidated financial statements in accordance with U.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 2022.

​

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. When determining the transaction price of each contract, we consider contractual consideration payable by the customer and assess variable consideration that may affect the total transaction price. Variable consideration, consisting of early payment discounts, rebates and other sources of price variability, are included in the estimated transaction price based on both customer-specific information as well as historical experience. We regularly review our estimates of variable consideration on the transaction price and recognize changes in

38

Table of Contents

estimates on a cumulative catch-up basis as if the most current estimate of the transaction price adjusted for variable consideration had been known as of the inception of the contract.

​

Our revenue for product sales is recognized on a point in 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 evaluate the need to record adjustments for excess or obsolete inventory at least quarterly. We utilize both specific product identification and historical product demand as the basis for estimating our excess or obsolete inventory reserve. We identify all inventories that exceed a range of one to three years in sales to calculate inventory on hand that exceeds estimated demand. 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 estimated recoverable amounts based on historical experience. Changes in market conditions, lower-than- expected customer demand or changes in technology or features could result in additional excess or 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.

​

Goodwill and other intangibles

​

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:

​

​

​

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.

39

Table of Contents

In 2022, 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.

​

As of our October 23, 2022 testing date, we had $581.2 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 2022, we did not need to proceed beyond the qualitative analysis, and no goodwill impairments were recorded. Changes in macroeconomic, industry or market conditions, or our inability to achieve projected results that were used to complete the qualitative analyses could result in the reporting unit fair value not exceeding the carrying amounts and could lead to impairment.

​

Intangible assets such as trademarks and trade names are generally recorded in connection with a business acquisition and we have recorded certain trademarks and trade names as indefinite-lived intangible assets. 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 2022 impairment assessment, which occurred as of October 23, 2022, we performed a qualitative assessment for all trademarks and tradenames as each intangible asset’s fair value significantly exceeded the carrying value in the previous quantitative assessment performed and each had sales growth in 2022, and no other indicators of impairment were present. The majority of the trademarks and tradenames are expected to have sales growth in 2023, with a few expected to potentially have minimal sales decline in 2023 but sales growth in 2024. As a result of our qualitative analyses, we determined that the fair values of the indefinite-lived intangibles assets were more likely than not greater than the carrying amounts. If we were to perform a quantitative assessment, the methodology we employ is the relief from royalty method, a subset of the income approach. During 2022, 2021, and 2020, no impairment was recognized on our indefinite-lived intangible assets. Changes in macroeconomic, industry or market conditions, or our inability to achieve projected results that were used to complete the qualitative analyses could result in the trademark’s or trade name’s fair value not exceeding its carrying amount and could lead to impairment.

​

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 the U.S., we establish a product liability accrual, which includes estimated 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 including, but not limited to, claim frequency and loss severity, and our specific claims experience derived from loss reports provided by third-party claims administrators to establish our product liability accrual. The product liability accrual represents the estimated ultimate losses for all reported and incurred but not reported claims. 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 and volume 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

40

Table of Contents

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.

​

Income taxes

​

We are subject to income taxes in the U.S. (federal and state) and foreign jurisdictions. Significant judgment is required in evaluating our uncertain tax positions and determining our provision for income taxes.

​

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, future reversals of the deferred tax liabilities, and tax planning strategies, in assessing the need for a valuation allowance. Changes in the relevant facts, including the accuracy of our estimated future taxable income, can significantly impact the judgment or need for valuation allowances. In the event we change our determination as to the amount of deferred tax assets that can be realized, we will adjust our valuation allowance with a corresponding impact to the provision for income taxes in the period in which such determination is made.

​

As of December 31, 2021, we released $22.1 million of our valuation allowance on foreign tax credits related to the additional foreign source income resulting from our restructured Mexican manufacturing supply chain operations. As of December 31, 2022, there were no material adjustments to our valuation allowances. See Note 9 of Notes to the Consolidated Financial Statements in this Annual Report for further disclosures.