Watts Water Technologies Inc: Form 10-Q for the period ended Sep 25, 2022

Overview

The following discussion and analysis are provided to increase the understanding of, and should be read in conjunction with, the accompanying unaudited consolidated financial statements and related notes. In this quarterly report on Form 10-Q, references to “the Company,” “Watts,” “we,” “us” or “our” refer to Watts Water Technologies, Inc. and its consolidated subsidiaries.

We are a leading supplier of products, solutions and systems that manage and conserve the flow of fluids and energy into, through and out of buildings in the commercial and residential markets in the Americas, Europe and Asia-Pacific, Middle East and Africa (“APMEA”). For over 140 years, we have designed and produced valve systems that safeguard and regulate water systems, energy efficient heating and hydronic systems, drainage systems and water filtration technology that helps purify and conserve water. We earn revenue and income almost exclusively from the sale of our products. Our principal product lines include:

• Residential & commercial flow control products—includes products typically sold into plumbing and hot water applications such as backflow preventers, water pressure regulators, temperature and pressure relief valves, thermostatic mixing valves and leak detection products.
• HVAC & gas products—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. HVAC is an acronym for heating, ventilation and air conditioning.
• Drainage & water re-use products—includes drainage products and engineered rain water harvesting solutions for commercial, industrial, marine and residential applications.
• Water quality products—includes point-of-use and point-of-entry water filtration, conditioning and scale prevention systems for commercial, marine and residential applications.

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, 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.

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.

Although market activity levels have generally recovered from the COVID-19 pandemic, there are still end markets we serve that have taken longer to recover, and potential regional COVID-19 outbreaks and associated restrictions may occur. Extended lockdowns, the impact of other actions and restrictions due to COVID-19 on a regional and global level could further impact our operating results.

We have remained diligent as a company to mitigate potential future outbreaks in our facilities by taking precautions to reduce the spread of COVID-19 while maintaining our production capabilities. 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 pandemic plan.

Although the global supply chain disruptions have shown some signs of easing, certain logistical issues remain and global shortage of electronic components continues to challenge our supply chain. 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. COVID-19 shutdowns continue to disrupt global ports, though delays have improved since 2021. While we believe we were able to effectively manage these disruptions during the third quarter of 2022 by various measures, including raising prices to address cost inflation, we cannot predict how ongoing inflation, risk of recession, the war in Ukraine, COVID-19 restrictions, supply chain disruptions and related costs may impact our ability to service our customers or the potential impact on our profit margins going forward.

Due to the above circumstances and as described generally in this Form 10-Q, the Company’s results of operations for the third quarter ended September 25, 2022 are not necessarily indicative of the results to be expected for the full fiscal year. Management cannot predict the full impact of the uncertainties discussed above. For further information regarding the impact of supply chain and logistics disruption risks to the Company and information regarding the impact of COVID-19 on the Company, see Part I, Item 1A, “Risk Factors” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2021.

Financial Overview

Third quarter 2022 sales increased 7.2%, or $32.8 million, on a reported basis and 11.5%, or $52.1 million, on an organic basis, compared to the third quarter of 2021, primarily driven by double-digit organic growth in the Americas, mostly due to incremental price. The impact from the war in Ukraine on the third quarter of 2022 was not significant. The reported sales increase included the unfavorable impact of foreign exchange of 4.7%, or $21.3 million, primarily driven by the appreciation of the U.S. dollar against the euro and Chinese yuan, and acquired sales of $2.0 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 $80.4 million increased by $15.7 million, or 24.3%, in the third quarter of 2022 as compared to the third quarter of 2021. This increase was primarily driven by incremental price, productivity gains, and cost savings from prior restructuring actions, partially offset by inflation and incremental investments.

Recent Developments

On October 31, 2022, 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 December 15, 2022 to stockholders of record on December 1, 2022.

Results of Operations

Third Quarter Ended September 25, 2022 Compared to Third Quarter Ended September 26, 2021

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

(dollars in millions)

The change in net sales was attributable to the following:

(dollars in millions)

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:

(dollars in millions)

Organic net sales in the Americas increased primarily due to incremental price across all of our channels and platforms.

Organic net sales in Europe increased primarily due to higher price, with growth in all platforms. A significant portion of this increase was related to sales of our HVAC products within the OEM markets in Italy and Germany driven by government energy incentives. Sales growth in the quarter was negatively impacted by approximately $3 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 demand in China, New Zealand and Australia. China’s sales growth was primarily from increased 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 Chinse yuan in the third quarter of 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 the third quarters of 2022 and 2021 were as follows:

(dollars in millions)

Gross profit and gross margin increased primarily from higher prices and productivity 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 $7.4 million, or 5.8%, in the third quarter of 2022 compared to the third quarter of 2021. The increase in SG&A expenses was attributable to the following:

(in millions)

The organic increase was primarily due to an increase in investments of $5.8 million, including our smart and connected initiatives and commercial excellence, general inflation of $3.3 million, increased variable costs due to the higher sales of $2.9 million, increased insurance costs of $0.7 million and higher travel and marketing spend of $1.5 million compared to the third quarter of 2021. These increases were partially offset by $3.8 million due to productivity initiatives and a net decrease in short-term and long-term compensation accruals of $2.3 million. The decrease in foreign exchange was mainly due to the appreciation of the U.S. dollar against the euro and Chinese yuan. 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 the third quarter of 2022 compared to 28.2% in the third quarter of 2021.

Restructuring. In the third quarter of 2022, we recorded a net restructuring charge of $1.7 million which related to a 2021 French restructuring program that was approved in the second quarter of 2021 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. For a more detailed description of our current restructuring plans, see Note 5 of the Notes to Consolidated Financial Statements.

Operating Income. Operating income (loss) by segment for the third quarters of 2022 and 2021 was as follows:

(dollars in millions)

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

(dollars in millions)

The increase in organic operating income was due to higher price, benefits from productivity initiatives, and savings from prior restructuring actions. These increases were partially offset by inflation related to material and labor costs, higher logistic and energy costs, and incremental investments.

Interest Expense. Interest expense in the third quarter of 2022 increased $0.5 million, or 35.7%, compared to the third quarter of 2021, primarily due to an increase in interest rates during the third quarter of 2022. Refer to Note 10 of the Notes to Consolidated Financial Statements for further details.

Income Taxes. Our effective income tax rate decreased to 25.5% in the third quarter of 2022, from 26.9% in the third quarter of 2021. The decrease is primarily due to the restructuring of our Mexican supply chain operations.

Net Income. Net income was $58.7 million, or $1.75 per common share on a diluted basis, for the third quarter of 2022, compared to $46.4 million, or $1.37 per common share on a diluted basis, for the third quarter of 2021. Results for the third quarter of 2022 include an after-tax charge of $1.3 million, or $0.04 per common share, for restructuring. Results for the third quarter of 2021 include an after-tax charge of $0.7 million, or $0.02 per common share, for restructuring.

Nine Months Ended September 25, 2022 Compared to Nine Months Ended September 26, 2021

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

(dollars in millions)

The change in net sales was attributable to the following:

(dollars in millions)

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:

(dollars in millions)

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 the first nine months of 2021 being positively impacted from the severe freezing weather in the South-Central United States, which drove an estimated 3% of incremental sales in our wholesale and DIY channels.

Organic net sales in Europe increased due to higher 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 $6 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 price and volumes, 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 the first nine months of 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 the first nine months of 2022 and 2021 were as follows:

(dollars in millions)

Gross profit and gross margin increased primarily from higher price, volume increases and productivity 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 $30.9 million, or 8.3%, in the first nine months of 2022 compared to the first nine months of 2021. The increase in SG&A expenses was attributable to the following:

(in millions)

The organic increase was primarily due to increase in investments of $15.1 million, including our smart and connected initiatives and commercial excellence, increased variable costs due to the higher sales of $11.6 million, general inflation of $9.3 million, increased insurance costs of $0.7 million, higher travel and marketing spend of $4.5 million as well as the return of expenses related to business normalization of $8.1 million compared to the first nine months of 2021. These increases were partially offset by $9.6 million due to productivity initiatives and a decrease in short-term and long-term compensation accruals of $4.9 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 27.3% in the first nine months of 2022 compared to 27.9% in the first nine months of 2021.

Restructuring. In the first nine months of 2022, we recorded a net restructuring charge of $4.4 million, which related to a 2021 French restructuring program that was approved in the second quarter of 2021 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. In the first nine months of 2021, we recorded a net restructuring charge of $18.2 million, which included an $18.9 million charge related to a 2021 French restructuring program. For a more detailed description of our current restructuring plans, see Note 5 of the Notes to Consolidated Financial Statements.

Operating Income. Operating income (loss) by segment for the first nine months of 2022 and 2021 was as follows:

(Dollars in millions)

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

(Dollars in millions)

The increase in organic operating income was primarily due to higher price, volume increases, benefits from productivity initiatives, and savings from prior 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 in the first nine months of 2022 increased $0.1 million, or 2.0%, compared to the first nine months of 2021, primarily due to an increase in interest rates, partially offset by a lower principal balance of debt outstanding during the first nine months of 2022. Refer to Note 10 of the Notes to Consolidated Financial Statements for further details.

Income Taxes. Our effective income tax rate decreased to 24.7% in the first nine months of 2022, from 27.4% in the first nine months of 2021. The decrease is primarily due to the restructuring of our Mexican supply chain operations, a higher tax benefit resulting from the vesting of stock compensation awards in the first nine months of 2022 and the favorable impact of changes in tax contingencies.

Net Income. Net income was $182.9 million, or $5.43 per common share on a diluted basis, for the first nine months of 2022, compared to $125.6 million, or $3.70 per common share on a diluted basis, for the first nine months of 2021. Results for the first nine months of 2022 include an after-tax charge of $3.3 million, or $0.10 per common share, for restructuring. Results for the first nine months of 2021 include an after-tax charge of $13.5 million, or $0.40 per common share, for restructuring.

Liquidity and Capital Resources

We generated $86.3 million of net cash provided by operating activities in the first nine months of 2022 compared to $134.9 million in the first nine months of 2021. The decrease in net cash provided by operating activities was primarily related to incremental cash outflows to fund our proactive decision to increase inventories in response to market demand and supply chain disruptions, in addition to increased payments related to income taxes, restructuring and employee and customer incentives. These decreases were partially offset by higher net income. During the fourth quarter of 2022, we expect to spend approximately $3.0 million related to the French restructuring program that was approved in 2021.

We used $19.3 million of net cash for investing activities in the first nine months of 2022 compared to $14.7 million used in the first nine months of 2021. We used $0.6 million more cash for capital expenditures and received $4.0 million less in cash proceeds from asset sales in the first nine months of 2022 compared to the first nine months of 2021. During the fourth quarter of 2022, we expect to invest approximately $15.0 million in capital equipment as part of our ongoing commitment to improve our operating capabilities. We expect to receive cash proceeds from the sale of the manufacturing facility in the French restructuring program of approximately $4.0 million in the fourth quarter of 2022.

We used $68.7 million of net cash for financing activities during the first nine months of 2022 primarily due to payments of $65.1 million to repurchase approximately 463,000 shares of Class A common stock, dividend payments of $29.4 million and tax withholding payments on vested stock awards of $13.0 million; offset by proceeds from drawdowns on our line of credit totaling $85.0 million (offset by long-term debt repayments of $45.0 million). In the first nine months of 2021, we used $95.3 million of net cash for financing activities primarily due to long-term debt repayments of $80.0 million (offset by proceeds from drawdowns of $35.0 million), dividend payments of $25.5 million, tax withholding payments on vested stock awards of $9.6 million, and payments of $11.8 million to repurchase approximately 87,000 shares of Class A common stock.

On March 30, 2021, we and certain of our subsidiaries entered into the Credit Agreement. The Credit Agreement amended and restated 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. Among other changes, 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 LIBOR rate to 0.00%. The Revolving Credit Facility under the Credit Agreement also includes sublimits of $100 million for letters of credit and $15 million for swing line loans. On August 2, 2022, we and certain of our subsidiaries entered into Amendment No. 1 to the Credit Agreement to replace LIBOR as a reference rate for borrowings with Term SOFR. As of September 25, 2022, we had drawn down $185.0 million on this line of credit and had $12.1 million in letters of credit outstanding, which resulted in $602.9 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 September 25, 2022 was 3.79%. 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 September 25, 2022 was 2.94%. 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 September 25, 2022, we were in compliance with all covenants related to the Amended Credit Agreement.

As of September 25, 2022, we held $219.5 million in cash and cash equivalents. Of this amount, $173.9 million of cash and cash equivalents were 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. We believe that our financial resources will allow us to manage the impacts of the COVID-19 pandemic, the war in Ukraine, inflation and supply chain disruption on our business operations for the foreseeable future. We anticipate the impacts related to these matters will continue to evolve, and, as a result we will continue to evaluate our financial position as additional information becomes available. 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.

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 is 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 financial measures used by management. We believe that these measures provide additional insight into underlying business results and trends. These non-GAAP financial measures are not intended to be considered by the user in place of the related GAAP financial measure, but rather as supplemental information to more fully understand our business results. These non-GAAP financial 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 sales growth is a non-GAAP financial measure of 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 financial 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.

Free cash flow is a non-GAAP financial measure that does not represent cash provided by operating activities in accordance with U.S. GAAP. Therefore, it should not be considered an alternative to net cash provided by or used in 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 is provided below:

(in millions)

Free cash flow declined in the first nine months of 2022 when compared to the first nine months of 2021 primarily driven by incremental cash outflows to fund our proactive decision to increase inventories in response to market demand and supply chain disruptions, increased payments related to income taxes, restructuring and employee and customer incentives, partially offset by higher net income.

Our net debt to capitalization ratio, a non-GAAP financial measure used by management, at September 25, 2022 was (3.2%) compared to (9.3%) at December 31, 2021. The increase was driven by an increase in debt outstanding of $40.5 million and a decrease in net cash outstanding of $22.5 million at September 25, 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:

(in millions)

A reconciliation of capitalization is provided below:

(in millions)

Application of Critical Accounting Policies and Key Estimates

We believe that our critical accounting policies are those related to revenue recognition, inventory valuation, goodwill and other intangibles, product liability costs, legal contingencies and income taxes. We believe these accounting policies are particularly important to an understanding of our financial position and results of operations and require application of significant judgment by our management. In applying these policies, management uses its judgment in making certain assumptions and estimates. Our accounting policies are more fully described under the heading “Accounting Policies” in Note 2 of the Notes to Consolidated Financial Statements in our Annual Report on Form 10-K as filed with the SEC on February 22, 2022.

We use derivative financial instruments primarily to reduce exposure to adverse fluctuations in foreign exchange rates, interest rates and costs of certain raw materials used in the manufacturing process. We do not enter into derivative financial instruments for trading purposes. As a matter of policy, all derivative positions are used to reduce risk by hedging underlying economic exposure. The derivatives we use are instruments with liquid markets. See Note 11 of Notes to the Consolidated Financial Statements for further details.

Our consolidated earnings, which are reported in United States dollars, are subject to translation risks due to changes in foreign currency exchange rates. This risk is concentrated in the exchange rate between the U.S. dollar and the euro; the U.S. dollar and the Canadian dollar; and the U.S. dollar and the Chinese yuan.

Our non-U.S. subsidiaries transact most business, including certain intercompany transactions, in foreign currencies. Such transactions are principally purchases or sales of materials and are denominated in European currencies, the Chinese yuan or the U.S. or Canadian dollar. We use foreign currency forward exchange contracts from time to time to manage the risk related to intercompany loans, intercompany purchases and intercompany sales that occur during the course of a year, and certain open foreign currency denominated commitments to sell products to third parties. We have entered into forward exchange contracts which hedge approximately 80% to 85% of the forecasted intercompany purchases between one of our Canadian subsidiaries and our U.S. operating subsidiaries for the next twelve months. We also entered into forward exchange contracts which hedge up to 60% of the forecasted intercompany sales transactions between one of our Chinese subsidiaries and one of our U.S. operating subsidiaries for the next twelve months. We record the effective portion of the designated foreign currency hedge contracts in other comprehensive income until inventory turns and is sold to a third-party. Once the third-party transaction associated with the hedged forecasted transaction occurs, the effective portion of any related gain or loss on the designated foreign currency hedge is reclassified into cost of goods sold within earnings. The fair value of the Company’s designated foreign hedge contracts outstanding as of September 25, 2022 was an asset of $0.4 million.

Under the Amended Credit Agreement, our earnings and cash flows are exposed to fluctuations in interest payments related to our floating rate debt. In order to manage our exposure, we entered into an interest rate swap on March 30, 2021. Under the interest rate swap agreement, we received the one-month USD-LIBOR subject to a 0.00% floor and paid a fixed rate of 1.02975% on a notional amount of $100.0 million. On August 2, 2022, the Company amended the interest rate swap to replace LIBOR as a reference rate for borrowings with Term SOFR. Under the amended interest rate swap agreement, we receive the one-month Term SOFR subject to a -0.1 percent floor and pays a fixed rate of 0.942% on a notional amount of $100.0 million. The swap matures on March 30, 2026. Information about our long-term debt facility and related interest rates appears in Note 10 of the Consolidated Financial Statements.

We purchase significant amounts of bronze ingot, brass rod, cast iron, stainless steel and plastic, which are utilized in manufacturing our many product lines. Our operating results can be adversely affected by changes in commodity prices if we are unable to pass on related price increases to our customers. We manage this risk by monitoring related market prices, working with our suppliers to achieve the maximum level of stability in their costs and related pricing, seeking alternative supply sources when necessary and passing increases in commodity costs to our customers, to the maximum extent possible, when they occur.

Evaluation of Disclosure Controls and Procedures

As required by Rule 13a-15(b) under the Securities Exchange Act of 1934, as amended, or Exchange Act, as of the end of the period covered by this report, we carried out an evaluation under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures. In designing and evaluating our disclosure controls and procedures, we recognize that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and our management necessarily applies its judgment in evaluating and implementing possible controls and procedures. The effectiveness of our disclosure controls and procedures is also necessarily limited by the staff and other resources available to us and the geographic diversity of our operations. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, as of the end of the period covered by this report, our disclosure controls and procedures were effective, in that they provide reasonable assurance that information required to be disclosed by us in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms and are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act are accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.

There was no change in our internal control over financial reporting that occurred during the third quarter ended September 25, 2022, that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. We will continue to review and document our disclosure controls and procedures, including our internal control over financial reporting, and we may from time to time make changes aimed at enhancing their effectiveness and to ensure that our systems evolve with our business.

There have been no material changes to the risk factors included in our Annual Report on Form 10-K for the year ended December 31, 2021, which risk factors are incorporated herein by reference.