Watts Water Technologies Inc: Form 10-Q for the period ended Jun 25, 2023

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, industrial and residential markets in the Americas, Europe and APMEA. For nearly 150 years, we have designed and produced valve systems that safeguard and regulate water systems, energy efficient heating and hydronic systems, drainage systems and water filtration technology that helps purify and conserve water. We earn revenue and income almost exclusively from the sale of our products. Our principal product lines include:

• Residential & commercial flow control and protection 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 and protection products. Many of our flow control and protection products are now smart and connected enabled, warning of leaks and floods with alerts to Building Management Systems (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.
• 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. Most of our HVAC products 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.
• Drainage & water re-use products—includes drainage products and engineered rain water harvesting solutions for commercial, industrial, marine and residential applications, including connected roof drain systems.
• Water quality products—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 12 acquisitions since 2013. 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.

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 enabled 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.

The economic environment for the remainder of 2023 continues to be uncertain. Forecasted global GDP growth in 2023 is lower than 2022, but still forecasted to be positive. Non-residential new construction indicators are mixed, but activity in the first half of 2023 remained stable. High interest rates, lending tightening and inflation have slowed single-family residential construction and may begin to impact multi-family and non-residential new construction. We continue to experience inflation across our labor and overhead costs. Despite these anticipated challenges and uncertainties, 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-Q, the Company’s results of operations for the second quarter ended June 25, 2023 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, see Part I, Item 1A, “Risk Factors” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2022.

Financial Overview

Second quarter 2023 sales increased 1.2%, or $6.2 million, on a reported basis, and were flat organically with mid-single digit organic growth in Europe and APMEA offset by a low-single digit organic decline in the Americas. The reported sales increase included an increase in acquired sales of $7.5 million, partially offset by the net unfavorable impact of foreign exchange of 0.2%, or $1.0 million. Operating income of $100.4 million increased by $4.5 million, or 4.7%, in the second quarter of 2023 as compared to the second quarter of 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 exclude 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 for each region within our results below.

Recent Developments

On July 31, 2023, 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 September 15, 2023 to stockholders of record on September 1, 2023.

On July 31, 2023, the Board of Directors authorized a new stock repurchase program of up to $150 million of our Class A common stock to be purchased from time to time on the open market or in privately negotiated transactions. The timing and number of shares repurchased will be determined by management based on its evaluation of market conditions and other factors.

Results of Operations

Second Quarter Ended June 25, 2023 Compared to Second Quarter Ended June 26, 2022

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 second quarters of 2023 and 2022 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)

Americas net sales decreased $9.0 million, or 2.4%, for the second quarter of 2023 compared to the second quarter of 2022. The change in net sales was negatively impacted by $1.3 million, or 0.3%, of foreign currency translation. Organic net sales decreased $7.7 million, or 2.1%, primarily due to lower volumes partially offset by incremental price realization. The organic net sales decline was primarily in the specialty channel due to the volume declines in our gas connectors and marine instrumentation, as well as declines in our radiant heating products sold through the wholesale and DIY channels. These declines were partially offset by growth across our core valve products in the wholesale channel.

Europe net sales increased $7.7 million, or 6.0%, for the second quarter of 2023 compared to the second quarter of 2022. The change in net sales was positively impacted by $1.7 million, or 1.3%, of foreign currency translation. Organic net sales increased $6.0 million, or 4.7%, primarily due to higher price realization, partially offset by lower volumes. The growth was driven from sales in our fluid solutions products offset partly by a decline in our drains products.

APMEA net sales increased $7.5 million, or 32.9%, for the second quarter of 2023 compared to the second quarter of 2022. The change in net sales was negatively impacted by $1.4 million, or 6.0%, of foreign currency translation, which was more than offset by $7.5 million, or 32.9%, of acquired sales related to an immaterial acquisition completed in the second quarter of 2023. Organic net sales increased $1.4 million, or 6.0%, primarily due to growth in the Middle East and Australia.

The net decrease in sales due to foreign exchange was mostly due to the unfavorable impact of the appreciation of the U.S. dollar against the Canadian dollar and Chinese yuan, partially offset by the favorable impact of the depreciation of the U.S. dollar against the euro in the second quarter of 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 the second quarters of 2023 and 2022 were as follows:

(dollars in millions)

Gross profit and gross margin increased primarily from higher price, favorable product mix and productivity, partially offset by inflation primarily related to labor and overhead costs and lower volume.

Selling, General and Administrative Expenses. Selling, general and administrative, or SG&A, expenses increased $9.2 million, or 6.5%, in the second quarter of 2023 compared to the second quarter of 2022. 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 $4.9 million, including in our smart and connected initiatives and commercial excellence, general inflation of $3.3 million, and a net increase in short-term and long-term compensation accruals of $1.2 million compared to the second quarter of 2022. These increases were partially offset by $3.1 million due to productivity initiatives and $1.4 million of restructuring savings. The decrease in foreign exchange was mainly due to the appreciation of the U.S. dollar against the Canadian dollar and Chinese yuan, partially offset by the U.S. dollar depreciation against the euro. The acquired SG&A costs related to an immaterial acquisition in the APMEA segment in the second quarter of 2023. Total SG&A expenses, as a percentage of sales, were 28.3% in the second quarter of 2023 compared to 26.9% in the second quarter of 2022.

Restructuring. In the second quarter of 2023, we recorded a net restructuring charge of $1.6 million, which primarily related to immaterial actions in Europe and APMEA related to severance and other cost reductions. In the second quarter of 2022, we recorded a net restructuring charge of $1.7 million 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. 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 second quarters of 2023 and 2022 was as follows:

(dollars in millions)

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

(dollars in millions)

Operating income increased $4.5 million, or 4.7%, for the second quarter of 2023 compared to the second quarter of 2022. Operating income was negatively impacted by $0.5 million, or 0.5%, of foreign currency translation. The increase in organic operating income of $4.9 million, or 5.1%, was due to higher price, favorable product mix, productivity, and savings from prior restructuring actions. These increases were partially offset by inflation related to labor and overhead costs, lower volume and incremental investments.

Interest income. Interest income in the second quarter of 2023 increased $1.3 million compared to the second quarter of 2022, primarily due to higher rates earned on our cash and cash equivalents.

Interest Expense. Interest expense in the second quarter of 2023 was flat compared to the second quarter of 2022, primarily due to a lower principal balance of debt outstanding during the second quarter of 2023, offset by an increase in interest rates. Refer to Note 10 of the Notes to Consolidated Financial Statements for further details.

Income Taxes. Our effective income tax rate decreased to 24.6% in the second quarter of 2023, from 26.0% in the second quarter of 2022. The decrease primarily relates to the reduction of foreign tax liabilities associated with the repatriation of funds.

Net Income. Net income was $75.9 million, or $2.26 per common share on a diluted basis, for the second quarter of 2023, compared to $69.7 million, or $2.07 per common share on a diluted basis, for the second quarter of 2022. Results for the second quarter of 2023 included after-tax charges of $2.5 million, or $0.08 per common share, for restructuring and acquisition related costs. Results for the second quarter of 2022 include an after-tax charge of $1.3 million, or $0.04 per common share, for restructuring.

Six Months Ended June 25, 2023 Compared to Six Months Ended June 26, 2022

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 six months of 2023 and 2022 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)

Americas net sales increased $0.3 million for the first six months of 2023 compared to the first six months of 2022. The change in net sales was negatively impacted by $2.6 million, or 0.4%, of foreign currency translation. Organic net sales increased $2.9 million, or 0.4%, 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, partially offset by decreases in the specialty channel primarily due to volume declines in our gas connectors and marine instrumentation, decreases in our radiant heating applications primarily sold through the wholesale channel, and decreases in products sold through the OEM channel into the residential end markets.

Europe net sales increased $6.1 million, or 2.4%, for the first six months of 2023 compared to the first six months of 2022. The change in net sales was negatively impacted by $5.2 million, or 2.0%, of foreign currency translation. Organic net sales increased $11.3 million, or 4.4%, primarily due to higher price realization, partially offset by lower volumes. The growth was driven from sales in our fluid solution products offset partly by a decline in our drains products.

APMEA net sales increased $8.3 million, or 19.7%, for the first six months of 2023 compared to the first six months of 2022. The change in net sales was negatively impacted by $2.7 million, or 6.4%, of foreign currency translation, which was more than offset by $7.5 million, or 17.8%, of acquired sales related to an immaterial acquisition completed in the second quarter of 2023. Organic net sales increased $3.5 million, or 8.3%, primarily due to growth in China, the Middle East and Australia.

The net decrease in sales due to foreign exchange was mostly due to unfavorable impact of the appreciation of the U.S. dollar against the euro, Canadian dollar and Chinese yuan in the first six months of 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 the first six months of 2023 and 2022 were as follows:

(dollars in millions)

Gross profit and gross margin increased primarily from higher prices, favorable product mix and productivity, partially offset by inflation primarily related to labor and overhead costs and lower volume.

Selling, General and Administrative Expenses. Selling, general and administrative, or SG&A, expenses increased $16.8 million, or 6.3%, in the first six months of 2023 compared to the first six months of 2022. 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 $9.0 million, including in our smart and connected initiatives and commercial excellence, general inflation of $6.3 million, and a net increase in short-term and long-term compensation accruals of $4.8 million compared to the first six months of 2022. These increases were partially offset by $3.8 million due to productivity initiatives and $2.4 million of restructuring savings. The decrease in foreign exchange was mainly due to the appreciation of the U.S. dollar against the euro, Canadian dollar and Chinese yuan. The acquired SG&A costs related to an immaterial acquisition in the APMEA segment in the first six months of 2023. Total SG&A expenses, as a percentage of sales, were 28.3% in the first six months of 2023 compared to 27.0% in the first six months of 2022.

Restructuring. In the first six months of 2023, we recorded a net restructuring charge of $1.3 million, which primarily related to immaterial actions in Europe and APMEA related to severance and other cost reductions. In the first six months of 2022, we recorded a net restructuring charge of $2.7 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. For a more detailed description of our current restructuring plans, see Note 6 of the Notes to Consolidated Financial Statements.

Operating Income. Operating income (loss) by segment for the first six months of 2023 and 2022 was as follows:

(Dollars in millions)

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

(Dollars in millions)

Operating income increased $17.7 million, or 10.6%, for the first six months of 2023 compared to the first six months of 2022. Operating income was negatively impacted by $1.2 million, or 0.8%, of foreign currency translation. The increase in organic operating income of $17.5 million, or 10.5%, was due to higher price, favorable product mix, productivity, and savings from prior restructuring actions. These increases were partially offset by inflation related to labor and overhead costs, lower volume and incremental investments.

Interest income. Interest income in the first six months of 2023 increased $1.6 million compared to the first six months of 2022, primarily due to higher rates earned on our cash and cash equivalents.

Interest Expense. Interest expense in the first six months of 2023 increased $0.1 million, or 3.2%, compared to the first six months of 2022, primarily due to an increase in interest rates, partially offset by lower principal balance of debt outstanding during the first six months of 2023. Refer to Note 11 of the Notes to Consolidated Financial Statements for further details.

Income Taxes. Our effective income tax rate decreased to 23.6% in the first six months of 2023, from 24.3% in the first six months of 2022. The decrease primarily relates to the reduction of foreign tax liabilities associated with the repatriation of funds.

Net Income. Net income was $140.6 million, or $4.19 per common share on a diluted basis, for the first six months of 2023, compared to $124.2 million, or $3.68 per common share on a diluted basis, for the first six months of 2022. Results for the first six months of 2023 include after-tax charges of $2.3 million, or $0.07 per common share, for restructuring and acquisition related costs. Results for the first six months of 2022 include an after-tax charge of $2.0 million, or $0.06 per common share, for restructuring.

Liquidity and Capital Resources

We generated $100.5 million of net cash provided by operating activities in the first six months of 2023 compared to $44.9 million of net cash provided by operating activities in the first six months of 2022. The increase in net cash provided by operating activities was primarily related to higher net income and reduced working capital investments.

We used $23.3 million of net cash for investing activities in the first six months of 2023 compared to $12.3 million used in the first six months of 2022. We used $11.7 million more cash for the immaterial acquisition in our APMEA segment, partially offset by $1.5 million less cash used for capital expenditures in the first six months of 2023 compared to the first six months of 2022. For the second half of 2023, we expect to invest approximately $20 million to $25 million in capital expenditure as part of our ongoing commitment to improve our operating capabilities.

We used $96.9 million of net cash for financing activities during the first six months of 2023 primarily due to long-term debt repayments on our line of credit totaling $80.0 million (offset by proceeds from drawdowns of $30.0 million), tax withholding payments on vested stock awards of $15.6 million, dividend payments of $22.3 million and payments of $7.7 million to repurchase approximately 47,000 shares of Class A common stock. In the first six months of 2022, we used $33.7 million of net cash for financing activities primarily due to payments of $61.1 million to repurchase approximately 434,000 shares of Class A common stock, dividend payments of $19.3 million, tax withholding payments on vested stock awards of $12.9 million, offset by proceeds from drawdowns on our line of credit totaling $75.0 million (offset by long-term debt repayments of $15.0 million).

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 June 25, 2023, we had drawn down $100.0 million on this line of credit and had $12.5 million in letters of credit outstanding, which resulted in $687.5 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 June 25, 2023 was 6.34%. 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 June 25, 2023 was 2.12%. 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 June 25, 2023, we were in compliance with all covenants related to the Amended Credit Agreement.

As of June 25, 2023, we held $291.9 million in cash and cash equivalents. Of this amount, $183.5 million of cash and cash equivalents were held by foreign subsidiaries. We repatriated approximately $53 million of previously taxed foreign earnings in the first six months of 2023, using the majority of that cash to reduce our outstanding debt. Our U.S. operations typically generate sufficient cash flows to meet our domestic obligations. However, if we did have to borrow to fund some or all of our expected cash outlays, we can do so at reasonable interest rates by utilizing the undrawn borrowings under our Revolving Credit Facility. Subsequent to recording the Toll Tax as part of the Tax Cuts and Jobs Act of 2017, our intent is to permanently reinvest undistributed earnings of foreign subsidiaries, and we do not have any current plans to repatriate post-Toll Tax foreign earnings to fund operations in the United States. However, if amounts held by foreign subsidiaries were needed to fund operations in the United States, we could be required to accrue and pay taxes to repatriate these funds. Such charges may include potential state income taxes and other tax charges.

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 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 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 net sales growth is a non-GAAP measure of net sales growth that excludes the impacts of acquisitions, divestitures and foreign exchange from period-over-period comparisons. A reconciliation to the most closely related U.S. GAAP measure, net sales, has been included in our discussion within “Results of Operations” above. Organic net sales should be considered in addition to, and not as a replacement for or as a superior measure to net sales. Management believes reporting organic sales growth provides useful information to investors, potential investors and others, by facilitating easier comparisons of our revenue performance with prior and future periods.

Free cash flow is a non-GAAP 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 improved in the first six months of 2023 when compared to the first six months of 2022 primarily driven by higher net income and reduced working capital investments.

Our net debt to capitalization ratio, a non-GAAP financial measure used by management, at June 25, 2023 was (15.9%) compared to (14.3%) at December 31, 2022. The change was driven by a lower net debt balance due to a pay down of debt and higher net income contributing to an increase in stockholders’ equity at June 25, 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:

(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 21, 2023.

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 June 25, 2023 was a liability 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 second quarter ended June 25, 2023, 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, 2022, which risk factors are incorporated herein by reference.