Zurn Elkay Water Solutions Corp annual report, FY2022

Zurn Elkay Water Solutions Corporation — 2022 Form 10-K

Business context and reporting period. This annual report covers the fiscal year ended December 31, 2022. Zurn Elkay designs and sells specification-driven water management products, including water safety and control, flow systems, hygienic and environmental, and drinking water solutions. It operates as one reportable segment. Comparisons require care: Elkay was acquired on July 1, 2022, so its results are included only from that date; the Process & Motion Control business was spun off in October 2021 and is reported as discontinued operations.

Key financial results

Metric	2022	2021
Net sales	$1,281.8 million	$910.9 million
Gross profit / margin	$465.5 million / 36.3%	$373.2 million / 41.0%
Income from operations / margin	$107.1 million / 8.4%	$107.0 million / 11.7%
Net income from continuing operations	$57.0 million	$49.7 million
Net income, including discontinued operations	$61.7 million	$120.9 million
Diluted EPS, continuing operations / total	$0.37 / $0.40	$0.40 / $0.97
Cash provided by operating activities	$97.0 million	$223.6 million

• Sales rose 40.7%; management attributed 31 percentage points to Elkay and Wade acquisition-related sales, a 1% reduction to foreign currency translation, and 11% growth in core sales.
• Operating income was essentially flat despite higher sales. Margin declined 3.3 percentage points, reflecting merger costs, higher amortization and depreciation, restructuring, and higher transportation and material costs. Sales growth, pricing, productivity savings, and lower stock-based compensation partly offset these pressures.
• Interest expense was $26.9 million, down from $34.7 million, primarily due to lower borrowings after the 2021 refinancing, partly offset by higher rates. The income tax provision was $26.8 million, for a 32.0% effective tax rate, versus $2.7 million and 5.2% in 2021; nondeductible merger costs and other tax items contributed to the increase.
• At December 31, 2022, cash and cash equivalents were $124.8 million. The company had $192.5 million of additional revolving-credit capacity, net of letters of credit.
• Total debt, including finance leases, was $535.9 million; the term loan had a 6.39% effective rate at year-end. The reported Net First Lien Leverage Ratio was 1.46x, below the 5.0x covenant threshold applicable to certain actions.

Material changes and unusual items

• The Elkay merger had a preliminary purchase price of $1,462.9 million, primarily funded with 51.6 million Zurn shares plus net cash payments. Elkay contributed $264.4 million in sales and an $11.5 million net loss from July 1 through year-end, including purchase accounting effects.
• Merger-related legal and professional costs were $33.7 million, recognized in selling, general and administrative expense. The third quarter included these costs and reported a $19.1 million loss from continuing operations; fourth-quarter sales were $340.3 million and net income was $14.2 million.
• Net income fell from $120.9 million to $61.7 million largely because 2021 included $71.2 million of discontinued-operations income from PMC through its spin-off date. 2022 discontinued-operations income was $4.7 million, including reversals of certain spin-off-related accruals.
• Operating cash flow decreased to $97.0 million; management cited lower net income following the spin-off and the timing of accounts payable and accrued expense payments. Cash used for investing was $6.6 million, including $44.8 million of acquisition payments, partly offset by $35.0 million received from Regal Rexnord for final spin-off working-capital and cash balances and $9.5 million from an insurance settlement.
• Restructuring charges increased to $15.4 million from $3.7 million, mainly for workforce reductions and facility rationalization. Management expects further restructuring costs, but did not quantify them.
• Goodwill was $777.0 million and intangible assets were $1,009.7 million at year-end. The Elkay purchase-price allocation remained preliminary; acquired intangible assets were valued at $865.5 million. No goodwill impairment was recorded.

Outlook, risks, and contingencies

The filing gives no quantified 2023 revenue, earnings, or margin guidance. Management describes long-term opportunities in water safety, conservation, hygiene, clean drinking water, and commercial and institutional construction, and expects to continue restructuring to improve margins and optimize its manufacturing footprint. Backlog was $42.1 million at year-end, down from $69.9 million, and was expected to ship during 2023.

• Key risks include cyclical construction demand, raw-material and freight costs, competitive pricing, acquisition integration, and dependence on distributors and major customers. The top five customers represented approximately 40% of 2022 sales; one customer represented 22%. The three largest independent distributors also generated approximately 35% of sales.
• Variable-rate debt creates interest-rate exposure: a 100-basis-point increase in LIBOR above its year-end level was estimated to increase annual interest expense by approximately $5.5 million. The filing discusses the transition from LIBOR to SOFR.
• Asbestos-related claims were estimated at $79.0 million, against a $72.1 million insurance receivable; the company recorded a $6.9 million expense in 2022 for the estimated uninsured gap. Actual claims and insurance recoveries may differ.
• The company reported an underfunded pension position of $40.1 million. Climate-related regulation and physical events, cybersecurity, ERP updates, environmental compliance, and product liability are also identified as risks.
• Ernst & Young issued unqualified opinions on the financial statements and internal control over financial reporting. The internal-control assessment and audit excluded Elkay’s controls, although Elkay’s balances and results were included in the consolidated statements.

Investor verification priorities

1. Assess the underlying margin trend and whether pricing and productivity can offset materials, freight, amortization, and restructuring costs.
2. Track Elkay integration, synergies, the final purchase-price allocation, and the acquired business’s post-close operating performance.
3. Review cash conversion and working-capital movements, including the drivers of lower operating cash flow and the decline in backlog.
4. Monitor debt costs, refinancing and benchmark-rate transition terms, covenant headroom, and capital allocation, including dividends and the expanded repurchase authorization.
5. Evaluate major-customer and distributor concentration, asbestos claim estimates and insurance collectability, and the integration of Elkay’s financial controls.