WATTS WATER TECHNOLOGIES INC (WTS) FY 2023 MD&A
This page reproduces the company's own Item 7 MD&A text from the linked SEC filing. It is filer text, not grepcent analysis, scoring, or investment advice.
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 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 and solutions categories include:
| Column 1 | Column 2 | Column 3 |
|---|---|---|
| ● | Residential & commercial flow control and protection—includes products and solutions typically sold into plumbing and hot water applications such as backflow preventers, water pressure regulators, temperature and pressure relief valves, thermostatic mixing valves, leak detection and protection products, commercial washroom solutions and emergency safety products and equipment. Many of our flow control and protection products are now smart and connected enabled, warning of leaks, floods and freeze with alerts to Building Management System (“BMS”) and/or personal devices giving our customers greater insight into their water management and the ability to shut off the water supply to avoid waste and mitigate damage. |
| Column 1 | Column 2 | Column 3 |
|---|---|---|
| ● | HVAC & gas—includes commercial high-efficiency boilers, water heaters and heating solutions, hydronic and electric heating systems for under-floor radiant applications, custom heat and hot water solutions, 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. Most of our HVAC products and solutions feature advanced controls enabling customers to easily connect to the BMS for better monitoring, control and operation. HVAC is an acronym for heating, ventilation and air conditioning. |
| Column 1 | Column 2 | Column 3 |
|---|---|---|
| ● | Drainage & water re-use—includes drainage products and engineered rain water harvesting solutions for commercial, industrial, marine and residential applications, including connected roof drain systems. |
| Column 1 | Column 2 | Column 3 |
|---|---|---|
| ● | Water quality—includes point-of-use and point-of-entry water filtration, monitoring, conditioning and scale prevention systems 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 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 14 acquisitions since 2013, including three in the last twelve months. 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 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.
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Over the past several years we have been building our smart and connected products 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.
Global economic indicators are mixed and show some signs of softer market conditions in 2024. Elevated interest rates may impact new construction. The European economy continues to show signs of weakening, China’s economy has decelerated, and geo-political risks have heightened. 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, 2023 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
Net sales for 2023 increased 3.9%, or $76.8 million, on a reported basis and 0.8%, or $16.3 million, on an organic basis, compared to 2022, primarily driven by incremental price across all of our operating segments, partially offset by lower volumes. The reported sales increase included acquired sales of 3.0%, or $58.6 million, with $33.4 million reported within the Americas segment and $25.2 million reported with APMEA, and the favorable impact of foreign exchange of 0.1%, or $1.9 million. The foreign exchange impact was primarily driven by the depreciation of the U.S. dollar against the euro, partially offset by the unfavorable impact of the appreciation of the U.S. dollar against the Canadian dollar and Chinese yuan. Operating income of $350.9 million increased by $35.9 million, or 11.4%, in 2023 compared to 2022. This increase was primarily driven by favorable price, product mix, productivity, and cost savings from prior restructuring actions, partially offset by inflation, lower volume and incremental investments.
In discussing our results of operations, we refer to non-GAAP financial measures, including organic sales, organic selling, general and administrative expenses, and organic operating income, that excludes the impacts of acquisitions, divestitures and foreign exchange from year-over-year comparisons. Management believes reporting these non-GAAP financial measures provides useful information to investors, potential investors and others, because it allows for additional insight into underlying trends by providing growth on a consistent basis. We reconcile the change in these non-GAAP financial measures to our reported results below.
Management’s discussion and analysis of our financial condition, results of operations and cash flows as of and for the year ended December 31, 2021 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, 2022.
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Acquisitions
On March 31, 2023, we completed the acquisition of the primary business assets of Enware Australia Pty Ltd (“Enware”) in an all-cash transaction. Enware is based near Sydney, Australia, and has been a leading supplier for specialty plumbing and safety equipment used in the Australian institutional and commercial end markets since 1937. The acquisition of Enware aligns with our strategy to expand geographically into countries with mature and enforced plumbing codes. Enware is expected to enhance our product offering and channel access into the Australian marketplace. The acquisition of Enware was deemed not to be material.
On October 23, 2023, we completed the acquisition of Bradley Corporation following its conversion into Bradley Company, LLC (“Bradley”) in a share purchase transaction. The aggregate net purchase price, including an estimated working capital adjustment, was approximately $301.2 million and is subject to a final post-closing working capital adjustment. We funded the transaction with $210 million of borrowings under our Credit Agreement with the remainder being funded by cash on hand. The net transaction value was approximately $266 million after deducting the estimated net present value of expected tax benefits of approximately $35 million. We accounted for the transaction as a business combination in the fourth quarter of 2023. Bradley’s annual revenues for 2023 were approximately $200 million, of which $33.4 million was included in our 2023 Consolidated Financial Statements. Please see Note 5 of the Notes to the Consolidated Financial Statements for additional information regarding operating results of Bradley.
Bradley is based in Menomonee Falls, WI, and has been a trusted provider and manufacturer of commercial washroom and emergency safety products serving commercial (primarily institutional) and industrial end markets for over 100 years. Bradley offers a comprehensive product portfolio that includes plumbing fixtures, washroom accessories and emergency safety products to a diverse customer base. Bradley’s complementary portfolio will enable us to provide our customers with innovative water solutions, as it adds front-of-the-wall applications to our differentiated back-of-the-wall portfolio and we intend to leverage the combined strengths of our sales networks and channel relationships to facilitate cross selling and accelerate growth. The acquisition of Bradley aligns with our strategy to enhance our product offerings, drive growth and serve our customers.
Recent Developments
Effective January 1, 2024, we completed the acquisition of Josam Company following its conversion into Josam Industries, LLC (“Josam”) in a share purchase transaction funded with cash on hand. The aggregate net purchase price was approximately $98.7 million and is subject to a final post-closing working capital adjustment. The net transaction value was approximately $88.7 million after adjusting for the estimated net present value of expected tax benefits of approximately $10 million. Josam is based in Michigan City, Indiana, and is a leading provider and manufacturer of drainage and plumbing products, serving commercial, industrial, and multi-family end markets for over 100 years. Josam’s annualized sales are approximately $35 million. We will account for the transaction as a business combination in the first quarter of 2024.
On February 7, 2024, the Board of Directors elected Rebecca J. Boll to serve as a member of the Board of Directors. Ms. Boll was appointed as a member of the Governance and Sustainability Committee and the Audit Committee.
On February 7, 2024, we declared a quarterly dividend of thirty-six cents ($0.36) per share on each outstanding share of Class A common stock and Class B common stock payable on March 15, 2024 to stockholders of record on March 1, 2024.
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Results of Operations
Year Ended December 31, 2023 Compared to Year Ended December 31, 2022
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, 2023 and December 31, 2022 were as follows:
| | | | | | | | | | | | | | | | | |
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| | | Year Ended | | Year Ended | | | | | % Change to | |||||||
| | | December 31, 2023 | | December 31, 2022 | | | | | Consolidated | |||||||
| | Net Sales | % Sales | Net Sales | % Sales | Change | Net Sales | ||||||||||
| | | (dollars in millions) | ||||||||||||||
| Americas | | $ | 1,428.1 | | 69.5 | % | $ | 1,390.0 | | 70.2 | % | $ | 38.1 | | 1.9 | % |
| Europe | | 512.1 | 24.9 | | 499.1 | 25.2 | | 13.0 | 0.7 | | ||||||
| APMEA | | 116.1 | 5.6 | | 90.4 | 4.6 | | 25.7 | 1.3 | | ||||||
| Total | | $ | 2,056.3 | 100.0 | % | $ | 1,979.5 | 100.0 | % | $ | 76.8 | 3.9 | % |
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 | | $ | 8.0 | | $ | 3.8 | | $ | 4.5 | $ | 16.3 | 0.4 | % | 0.2 | % | 0.2 | % | 0.8 | % | 0.5 | % | 0.8 | % | 5.0 | % | ||
| Foreign exchange | | (3.3) | | 9.2 | | (4.0) | | 1.9 | (0.2) | 0.5 | (0.2) | 0.1 | (0.2) | 1.8 | (4.5) | | |||||||||||
| Acquired | | 33.4 | | — | | 25.2 | | 58.6 | 1.7 | — | 1.3 | 3.0 | 2.4 | — | 27.9 | | |||||||||||
| Total | | $ | 38.1 | | $ | 13.0 | | $ | 25.7 | | $ | 76.8 | 1.9 | % | 0.7 | % | 1.3 | % | 3.9 | % | 2.7 | % | 2.6 | % | 28.4 | % |
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 | | $ | 47.0 | | $ | (3.2) | | $ | (1.9) | | $ | (33.9) | | $ | 8.0 | 5.9 | % | (3.1) | % | (2.3) | % | (8.2) | % | |
| Europe | | (1.4) | | 5.2 | | — | | | — | | 3.8 | (0.4) | 2.9 | | — | | — | | ||||||
| APMEA | | 4.8 | | (0.3) | | — | | | — | | 4.5 | 5.8 | (3.8) | — | | — | | |||||||
| Total | | $ | 50.4 | | $ | 1.7 | | $ | (1.9) | | $ | (33.9) | | $ | 16.3 | | | | | | | | | |
Americas net sales increased $38.1 million, or 2.7%, in 2023 compared to 2022. The change in net sales was negatively impacted by $3.3 million, or 0.2%, of foreign currency translation, which was more than offset by $33.4 million, or 2.4%, of acquired sales related to the Bradley acquisition completed in the fourth quarter of 2023. Organic net sales increased $8.0 million, or 0.5%, primarily due to incremental price realization partially offset by lower volumes. The organic net sales increase was primarily in the wholesale channel due to growth across our core valve products, mostly offset by decreases in the specialty channel primarily due to volume declines in our gas connectors and marine instrumentation and decreases in products sold through the OEM channel into the residential end markets.
Europe net sales increased $13.0 million, or 2.6%, in 2023 compared to 2022. The change in net sales was positively impacted by $9.2 million, or 1.8%, of foreign currency translation. Organic net sales increased $3.8 million, or 0.8%, primarily due to higher price realization, partially offset by lower volumes. The growth was driven from sales in our fluid solution products, including sales of our HVAC products within the OEM markets in Germany, offset partly by a decline in our drains products.
APMEA net sales increased $25.7 million, or 28.4%, in 2023 compared to 2022. The change in net sales was negatively impacted by $4.0 million, or 4.5%, of foreign currency translation, which was more than offset by $25.2 million, or 27.9%, of acquired sales related to the Enware acquisition completed in the second quarter of 2023. Organic net sales increased $4.5 million, or 5.0%, due to higher prices realization and volumes, primarily from growth in the Middle East and Australia, partially offset by declines in China.
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The net increase in sales due to foreign exchange was mostly due to the favorable impact of the depreciation of the U.S. dollar against the euro, partially offset by the unfavorable impact of the appreciation of the U.S. dollar against the Canadian dollar and Chinese yuan in 2023. 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.
Gross Profit. Gross profit and gross profit as a percent of net sales (gross margin) for 2023 and 2022 were as follows:
| | | | | | | | |
|---|---|---|---|---|---|---|---|
| | | Year Ended | |||||
| | | December 31, 2023 | | December 31, 2022 | | ||
| | | (dollars in millions) | |||||
| Gross profit | | $ | 960.9 | | $ | 874.3 | |
| Gross margin | | 46.7 | % | 44.2 | % |
Gross profit and gross margin increased primarily from higher prices, favorable product mix and productivity, partially offset by inflation and lower volume.
Selling, General and Administrative Expenses. Selling, general and administrative, or SG&A, expenses increased $55.8 million, or 10.2%, in 2023 compared to 2022. The increase in SG&A expenses was attributable to the following:
| | | | | | | |
|---|---|---|---|---|---|---|
| | (in millions) | % Change | ||||
| Organic | | $ | 33.1 | 6.0 | % | |
| Foreign exchange | | 0.6 | 0.1 | | ||
| Acquired | | | 22.1 | | 4.0 | |
| Total | | $ | 55.8 | 10.1 | % |
The organic increase was primarily due to an increase in net investments of $17.9 million, including in our smart and connected and other strategic initiatives, general inflation of $13.7 million, acquisition-related costs of $7.1 million, higher travel and marketing costs of $5.2 million and a net increase in short-term and long-term compensation accruals of $6.0 million, compared to 2022. These increases were partially offset by $6.6 million from productivity initiatives, $4.8 million of restructuring savings and $4.1 million reduction in freight costs. The increase in foreign exchange was mainly due to the depreciation of the U.S. dollar against the euro, partially offset by the appreciation of the U.S. dollar against the Canadian dollar and Chinese yuan. The acquired SG&A costs related to the Bradley acquisition in the Americas segment in the fourth quarter of 2023 and the Enware acquisition in the APMEA segment in the second quarter of 2023. Total SG&A expenses, as a percentage of sales, were 29.4% in 2023 compared to 27.8% in 2022.
Restructuring. In 2023, we recorded a net restructuring charge of $5.5 million, which primarily related to immaterial cost reduction actions in all regions primarily related to severance and other exit costs. 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. 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.
Operating Income (Loss). Operating income (loss) by geographic segment for 2023 and 2022 was as follows:
| | | | | | | | | | | | | |
|---|---|---|---|---|---|---|---|---|---|---|---|---|
| | | | | | | | | | | | % Change to | |
| | Year Ended | | | Consolidated | ||||||||
| | December 31, | | December 31, | | | Operating | | |||||
| | | 2023 | 2022 | Change | Income | | ||||||
| | (dollars in millions) | | | | ||||||||
| Americas | | $ | 325.2 | $ | 283.9 | $ | 41.3 | 13.1 | % | |||
| Europe | | 70.4 | | 66.7 | | 3.7 | 1.2 | | ||||
| APMEA | | 16.1 | | 14.0 | | 2.1 | 0.7 | | ||||
| Corporate | | (60.8) | | (49.6) | | (11.2) | (3.6) | | ||||
| Total | | $ | 350.9 | | $ | 315.0 | | $ | 35.9 | 11.4 | % |
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The increase (decrease) 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 | | $ | 41.6 | | $ | (4.0) | | $ | 2.3 | | $ | (11.2) | | $ | 28.7 | | 13.2 | % | (1.3) | % | 0.7 | % | (3.6) | % | 9.0 | % | 14.7 | % | (6.0) | % | 16.4 | % | 22.6 | % |
| Foreign exchange | | | (1.1) | | | 1.2 | | | (0.1) | | | — | | | — | | (0.4) | | 0.4 | | — | | — | | — | | (0.4) | | 1.8 | | (0.7) | | — | |
| Acquired | | | 1.2 | | | — | | | 1.0 | | | — | | | 2.2 | | 0.4 | | — | | 0.3 | | — | | 0.7 | | 0.4 | | — | | 7.1 | | — | |
| Restructuring, impairment charges | | (0.4) | | 6.5 | | (1.1) | | — | | 5.0 | (0.1) | 2.1 | (0.3) | — | 1.7 | (0.1) | 9.8 | (7.8) | — | | ||||||||||||||
| Total | | $ | 41.3 | | $ | 3.7 | | $ | 2.1 | | $ | (11.2) | | $ | 35.9 | 13.1 | % | 1.2 | % | 0.7 | % | (3.6) | % | 11.4 | % | 14.6 | % | 5.6 | % | 15.0 | % | 22.6 | % |
Operating income increased $35.9 million, or 11.4%, in 2023 compared to 2022. Operating income was positively impacted by $2.2 million, or 0.7%, of acquired sales and the foreign currency translation impact was flat compared to 2022. The increase in organic operating income of $28.7 million, or 9.0%, was due to higher price, favorable product mix, productivity, and savings from prior restructuring actions. These increases were partially offset by inflation, lower volume, incremental investments and acquisition-related costs.
Interest Income. Interest income increased $6.6 million in 2023 as compared to 2022 primarily due to higher interest rates earned on our cash and cash equivalents.
Interest Expense. Interest expense increased $1.2 million, or 17.1%, in 2023 as compared to 2022 primarily due to higher principal balance of debt outstanding due to the acquisition of Bradley during 2023 and an increase in interest rates. Refer to Note 12 of Notes to Consolidated Financial Statements in this Annual Report on Form 10-K for further details.
Other Expense (Income), Net. Other expense (income) decreased $0.6 million compared to 2022. The decrease was primarily due to $1.0 million of reduced expense as a result of the increase in deferred compensation plan assets. Refer to Note 17 Financial Instruments of Notes to Consolidated Financial Statements in this Annual Report on Form 10-K for further details.
Income Taxes. Our effective income tax rate increased to 24.9% in 2023, from 18.2% in 2022. The increase is primarily due to the $16.1 million tax benefit in 2022 related to the modification of the structure of our Mexican supply chain operations and the additional foreign withholding taxes associated with the repatriation of funds in 2023.
Net Income. Net income for 2023 was $262.1 million, or $7.82 per common share on a diluted basis, compared to $251.5 million, or $7.48 per common share on a diluted basis, for 2022. Results for 2023 include after-tax charges of $8.3 million, or $0.25 per common share, for acquisition-related costs, $5.3 million, or $0.16 per common share, primarily for an income tax adjustment related to repatriation of foreign funds and $4.1 million, or $0.12 per common share, for restructuring; partially offset by an after-tax benefit of $2.5 million, or $0.08 per common share, for an adjustment to contingent consideration.
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.
Liquidity and Capital Resources
2023 and 2022 Cash Flows
We generated $310.8 million of net cash from operating activities in 2023 as compared to $224.0 million in 2022. The increase in cash generated was primarily due to higher net income and reduced working capital investments, partially offset by increased payments related to income taxes and customer incentives.
We used $343.1 million of net cash for investing activities in 2023 compared to $22.9 million used in 2022. We spent $313.4 million more cash for the acquisitions in our Americas and APMEA segments and $1.6 million more cash for net capital expenditures in 2023 compared to 2022.
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We generated $69.0 million of net cash from financing activities in 2023 primarily due to proceeds from drawdowns of $240.0 million offset by long-term debt repayments on our line of credit totaling $90.0 million, and partially offset by tax withholding payments on vested stock awards of $15.8 million, dividend payments of $46.5 million and payments of $16.0 million to repurchase 91,622 shares of Class A common stock. In 2022, we used $121.7 million of net cash from financing activities 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.
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 , as amended by Amendment no. 1 dated August 2, 2022, Amendment no. 2 dated December 12, 2023 and as may be further amended, restated, amended and restated, modified or supplemented from time to time (the “Credit Agreement”). The Credit Agreement establishes senior unsecured revolving credit facility of $800 million from February 12, 2022 to March 30, 2026 (the “Revolving Credit Facility”). The maturity date of the Revolving Credit Facility is March 30, 2026 subject to extension under certain circumstances and subject to the terms of the Credit Agreement. The Credit Agreement provides for our maximum consolidated leverage ratio of 3.50 to 1.00 (or 4.00 to 1.00 during temporary step-ups following certain acquisitions) and the minimum consolidated interest ratio of 3.50 to 1.00.
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, 2023, we had drawn down $300.0 million on this line of credit and had $12.5 million in letters of credit outstanding, which resulted in $487.5 million of unused and available credit under the Revolving Credit Facility as of such date. 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%, 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, in each case, determined by reference to our consolidated leverage ratio. For the borrowings denominated in dollars, there is fixed 10 basis point adjustment if the reference rate is Term SOFR. The weighted average interest rate on debt outstanding under the Revolving Credit Facility as of December 31, 2023 was 6.53%. The weighted average interest rate on debt outstanding inclusive of the interest rate swaps discussed in Note 12 of the Notes to Consolidated Financial Statements and interest rates under the Revolving Credit Facility as of December 31, 2023 was 4.89%. In addition to paying interest under the 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. We may repay loans outstanding under the Credit Agreement from time to time without premium or penalty, other than customary breakage costs, if any, and subject to the terms of the Credit Agreement. As of December 31, 2023, we were in compliance with all covenants related to the Credit Agreement.
As of December 31, 2023, we held $350.1 million in cash and cash equivalents. Of this amount, $171.7 million was held by foreign subsidiaries. In the fourth quarter of 2023, we determined we would make a one-time repatriation of foreign earnings to assist in funding recent acquisitions. In 2023 we repatriated approximately $117.9 million of both previously taxed foreign earnings and the fourth quarter one-time repatriation of foreign earnings, using the majority of that cash to reduce our outstanding debt and to fund acquisitions. 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, other than with respect to the one-time repatriation of foreign earnings in 2023, has been to permanently reinvest undistributed earnings of foreign subsidiaries, and we do not have any current plans to repatriate additional 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 Credit Agreement, we are required to satisfy and maintain specified financial ratios and other financial condition tests as of December 31, 2023. The financial ratios include a consolidated interest coverage ratio based on
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consolidated earnings before income taxes, interest expense, depreciation, and amortization (Consolidated EBITDA) to consolidated interest expense, as defined in the Credit Agreement. The 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 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, 2023, our actual financial ratios calculated in accordance with the Credit Agreement compared to the required levels under the Credit Agreement were as follows:
| | | | | |
|---|---|---|---|---|
| | Actual Ratio | Required Level | ||
| | | | Minimum level | |
| Interest Charge Coverage Ratio | 45.5 to 1.00 | 3.50 to 1.00 | ||
| | | | Maximum level | |
| Leverage Ratio | 0.00 to 1.00 | 3.50 to 1.00 (or 4.00 to 1.00 during temporary step-ups following certain acquisitions) |
As of December 31, 2023, we were in compliance with all covenants related to the Credit Agreement.
In addition to financial ratios, the 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, 2023 was $655.2 million compared to $571.9 million as of December 31, 2022. The ratio of current assets to current liabilities was 2.6 to 1 as of December 31, 2023 compared to 2.5 to 1 as of December 31, 2022. 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 2024 and thereafter for the foreseeable future.
We anticipate investing between $55 million to $65 million in capital expenditures during 2024 to improve our manufacturing capabilities and invest in technology and other commercial and operational excellence initiatives.
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 13 of Notes to Consolidated Financial Statements in this Annual Report on 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 our 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 $12.5 million as of December 31, 2023 and $12.1 million as of December 31, 2022. 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.
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Our contractual obligations as of December 31, 2023 are presented in the following table:
| | | | | | | | | | |
|---|---|---|---|---|---|---|---|---|---|
| | | | Next | Beyond | |||||
| Contractual Obligations | | Total | | 12 Months | | 12 Months | |||
| | | (in millions) | |||||||
| Long-term debt obligations, including current maturities(a) | | $ | 300.0 | | $ | — | | $ | 300.0 |
| Operating lease obligations(b) | | 64.1 | | 11.8 | | 52.3 | |||
| Finance lease obligations(c) | | 2.6 | | 1.3 | | 1.3 | |||
| Pension contributions(d) | | 9.2 | | 0.5 | | 8.7 | |||
| Interest(e) | | 25.6 | | 13.5 | | | 12.1 | ||
| 2017 Tax Act Toll Tax payable(f) | | | 15.3 | | | 6.8 | | | 8.5 |
| Capital expenditures(g) | | | 6.1 | | | 6.1 | | | — |
| Purchase obligations(h) | | 171.9 | | 165.4 | | 6.5 | |||
| Total | | $ | 594.8 | | $ | 205.4 | | $ | 389.4 |
(a) Relates to drawdowns on the line of credit under the Credit Agreement as recognized in the consolidated balance sheet. See Note 12 of Notes to the Consolidated Financial Statements in this Annual Report for further disclosures.
(b) Relates to the lease liabilities recognized for right-of-use assets of operating leases with a lease term longer than twelve months. See Note 9 of Notes to the Consolidated Financial Statements in this Annual Report for further disclosures.
(c) Relates to the lease liabilities recognized for right-of-use assets of financing leases with a lease term longer than twelve months. See Note 9 of Notes to the Consolidated Financial Statements in this Annual Report for further disclosures.
(d) Relates to estimated future obligations for the Europe pension plans. See Note 15 of Notes to the Consolidated Financial Statements in this Annual Report for further disclosures.
(e) Represents the current estimate of future interest payments due on the current drawdown on the line of credit under the Credit Agreement referenced above at (a).
(f) Relates to the 2017 Tax Act one time transition tax on accumulated foreign subsidiary earnings not previously subject to U.S. income tax which was payable over a number of years.
(g) Relates to capital expenditure obligations included in the anticipated capital expenditure investment totals of $55 million to $65 million discussed above.
(h) Primarily includes the $98.7 million of a preliminary net purchase price related to the definitive agreement we entered into on December 11, 2023 to acquire Josam, $49.7 million of commodity commitments and $19.4 million relates to cost obligations for an Information Technology investment program.
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.
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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, acquisition-related costs, contingent consideration adjustment, 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.
A reconciliation of U.S. GAAP results to these adjusted non-GAAP measures is provided below (dollars in millions, except per share amounts):
| | | | | | | |
|---|---|---|---|---|---|---|
| | | | | | | |
| | Year Ended | |||||
| | | December 31, | | December 31, | ||
| | | 2023 | | 2022 | ||
| | | | | | | |
| Net sales | | $ | 2,056.3 | | $ | 1,979.5 |
| | | | | | | |
| Operating income - as reported | | | 350.9 | | | 315.0 |
| Operating margin % | | | 17.1% | | | 15.9% |
| | | | | | | |
| Adjustments for special items: | | | | | ||
| Restructuring | | | 5.5 | | | 10.6 |
| Acquisition-related costs | | | 11.3 | | | — |
| Contingent consideration adjustment | | | (2.5) | | | — |
| Gain on sale of asset | | | — | | | (1.8) |
| | | | | | | |
| Total adjustments for special items | | $ | 14.3 | | $ | 8.8 |
| | | | | | | |
| Operating income - as adjusted | | $ | 365.2 | | $ | 323.8 |
| Adjusted operating margin % | | | 17.8% | | | 16.4% |
| | | | | | | |
| Net income - as reported | | $ | 262.1 | | $ | 251.5 |
| | | | | | | |
| Adjustments for special items - tax effected: | | | | | | |
| Restructuring | | | 4.1 | | | 7.9 |
| Acquisition-related costs | | | 8.3 | | | — |
| Contingent consideration adjustment | | | (2.5) | | | — |
| Gain on sale of asset | | | — | | | (1.4) |
| Discrete tax items | | | 5.3 | | | (18.2) |
| | | | | | | |
| Total adjustments for special items - tax effected: | | $ | 15.2 | | $ | (11.7) |
| | | | | | | |
| Net income as adjusted | | $ | 277.3 | | $ | 239.8 |
| | | | | | | |
| Diluted earnings per share - as reported | | $ | 7.82 | | $ | 7.48 |
| Restructuring | | 0.12 | | 0.23 | ||
| Acquisition-related costs | | 0.25 | | — | ||
| Contingent consideration adjustment | | (0.08) | | — | ||
| Gain on sale of asset | | — | | (0.04) | ||
| Discrete tax items | | 0.16 | | (0.54) | ||
| Diluted earnings per share - as adjusted | | $ | 8.27 | | $ | 7.13 |
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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 and cash flow conversion rate 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:
| | | | | | | | |
|---|---|---|---|---|---|---|---|
| | | Year Ended | |||||
| | | December 31, | | December 31, | | ||
| | | 2023 | | 2022 | | ||
| | | (in millions) | |||||
| Net cash provided by operating activities | | $ | 310.8 | | $ | 224.0 | |
| Less: additions to property, plant, and equipment | | (29.7) | | (28.1) | | ||
| Plus: proceeds from the sale of property, plant, and equipment | | — | | 5.2 | | ||
| Free cash flow | | $ | 281.1 | | $ | 201.1 | |
| Net income —as reported | | $ | 262.1 | | $ | 251.5 | |
| Cash conversion rate of free cash flow to net income | | 107.2 | % | 80.0 | % |
Our free cash flow increased in 2023 when compared to 2022 primarily driven by higher net income and reduced working capital investment, partially offset by increased payments related to income taxes and customer incentives.
Our net debt to capitalization ratio, a non-GAAP financial measure used by management, at December 31, 2023 was (3.5)% for 2023 compared to (14.3)% in 2022. The change was driven by an increase in net debt balance due to increase in debt outstanding of $150.7 million, partially offset by an increase in cash and cash equivalents of $39.3, and higher net income contributing to an increase in stockholders’ equity at December 31, 2023 compared to December 31, 2022. 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:
| | | | | | | |
|---|---|---|---|---|---|---|
| | | December 31, | | December 31, | ||
| | | 2023 | | 2022 | ||
| | | (in millions) | ||||
| Current portion of long‑term debt | $ | — | | $ | — | |
| Plus: long-term debt, net of current portion | | 298.3 | | 147.6 | ||
| Less: cash and cash equivalents | | (350.1) | | (310.8) | ||
| Net debt | | $ | (51.8) | | $ | (163.2) |
A reconciliation of capitalization is provided below:
| | | | | | | | |
|---|---|---|---|---|---|---|---|
| | | December 31, | | December 31, | | ||
| | | 2023 | | 2022 | | ||
| | | (in millions) | |||||
| Net debt | | $ | (51.8) | | $ | (163.2) | |
| Total stockholders’ equity | | 1,513.3 | | 1,300.6 | | ||
| Capitalization | | $ | 1,461.5 | | $ | 1,137.4 | |
| Net debt to capitalization ratio | | (3.5) | % | (14.3) | % |
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
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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 2023.
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 recognize revenue in a manner that depicts 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 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.
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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:
| Column 1 | Column 2 | Column 3 |
|---|---|---|
| 1) | A review of the most recent fair value calculation to identify the extent of the cushion between fair value and carrying amount, to determine if a substantial cushion existed. |
| Column 1 | Column 2 | Column 3 |
|---|---|---|
| 2) | 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 reviewed include macroeconomic conditions, industry and market changes, cost factor changes, events that affect the reporting unit, and financial performance against expectations. |
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 2023, we had eight reporting units. Bradley was acquired in the fourth quarter of 2023, after the goodwill testing date (October 22, 2023), however it was considered a separate reporting unit for the year end 2023. One of the eight reporting units, Water Quality, had no goodwill. We performed a qualitative analysis for each of the six 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 22, 2023 testing date, we had $589.6 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 2023, 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 2023 impairment assessment, which occurred as of October 22, 2023, we performed a qualitative assessment for certain trademarks and tradenames where the fair value significantly exceeded the carrying value in the previous quantitative assessment performed. Each had sales growth in 2023, sales growth is expected in 2024, and no other indicators of impairment were present. For the remaining tradenames in 2023, we performed a quantitative assessment. The methodology we employed for the quantitative assessments was the relief from royalty method, a subset of the income approach. As a result of our qualitative and quantitative analyses, we determined that the fair values of the indefinite-lived intangibles assets were more likely than not greater than the carrying amounts. As a result of the quantitative analyses, we determined that fair value exceeded carrying value for each indefinite-lived intangible asset. During 2023, 2022, and 2021, 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 and quantitative 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
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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 legal matters 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 16 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.
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 throughout the interim periods. 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.
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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, 2023 we increased our valuation allowance on foreign tax credits by $4.0 million related to the additional foreign tax credits generated by our fourth quarter one-time repatriation of foreign earnings. See Note 10 of Notes to the Consolidated Financial Statements in this Annual Report for further disclosures.