Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis of our financial condition and results of our operations should be read in conjunction with Part II, Item 8, “Financial Statements and Supplementary Data,” of this Annual Report. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from such forward-looking statements. Factors that could cause or contribute to those differences include, but are not limited to, those identified below and those discussed in the section titled “Cautionary Note Regarding Forward-Looking Statements” and in Part I, Item 1A, “Risk Factors” in this Annual Report. Unless otherwise indicated or the context otherwise requires, all references to the “Company,” “Evoqua,” “Evoqua Water Technologies Corp.,” “we,” “us,” “our,” and similar terms refer to Evoqua Water Technologies Corp., together with its consolidated subsidiaries. Unless otherwise specified, all dollar amounts in this section are referred to in millions. Our fiscal year ends on September 30 of each year and references in this section to a year refer to our fiscal year. As such, references to: 2022 relates to the fiscal year ended September 30, 2022, 2021 relates to the fiscal year ended September 30, 2021, and 2020 relates to the fiscal year ended September 30, 2020.
Overview and Background
We are a leading provider of mission-critical water and wastewater treatment solutions, offering a broad portfolio of products, services, and expertise to support customers across various end markets. We are headquartered in Pittsburgh, Pennsylvania, with locations across nine countries. We have a comprehensive portfolio of differentiated, proprietary technologies offered under market‑leading and well‑established brands. Our core technologies are primarily focused on removing impurities from water, rather than neutralizing them through the addition of chemicals.
Our solutions are designed to provide our customers with the quantity and quality of water necessary to meet their unique specifications. We enable our customers to achieve lower costs through greater uptime, throughput and efficiency in their operations while supporting their regulatory compliance and environmental requirements. We deliver and maintain these mission critical solutions through our extensive North American service network, providing our customers continuous uptime with 119 service branches as of September 30, 2022. In addition, we sell our products and technologies internationally through direct and indirect sales channels. We have worked to protect water, the environment, and our employees for more than 100 years. As a result, we have earned a reputation for quality, safety, and reliability around the world. Our employees are united by a common purpose: Transforming water. Enriching life.®
Our vision “to be the world’s first choice for water solutions” and our values of “integrity, customers, sustainable, and performance” foster a culture that is focused on establishing a workforce that is enabled, empowered, and accountable, creating a highly dynamic work environment.
We serve our customers through the following two reportable segments:
• Integrated Solutions and Services segment, which provides application-specific solutions and full lifecycle services for critical water and wastewater applications across numerous end markets, including outsourced water service contracts, capital systems and related recurring aftermarket services, parts and consumables, and emergency services to enable recycle and reuse, improve operational reliability and performance, and promote environmental compliance; and
• Applied Product Technologies segment, which provides highly differentiated and scalable water and wastewater products and technologies as stand-alone offerings or components in integrated solutions to a diverse set of system integrators and end-users globally.
Our segments draw from the same reservoir of leading technologies, shared manufacturing infrastructure, common business processes, and corporate philosophies. The key factors used to identify these reportable operating segments are the organization and alignment of our internal operations, the nature of the products and services and customer type.
For the years ended September 30, 2022 and 2021, our segments accounted for the following percentage of our revenue:
Integrated Solutions and Services segment
Applied Product Technologies segment
Recent Developments, Key Factors, and Trends Affecting Our Business and Financial Statements
The following recent developments have affected our business and operating results during the year ended September 30, 2022:
Macroeconomic conditions. Material, freight, and labor inflation resulted in increased costs in fiscal 2022, and we expect this trend will continue into fiscal 2023. Although we have offset a portion of these increased costs through price increases and operational efficiencies to date, our margin percentage has been negatively impacted. There can be no assurance that we will be able to continue to offset all or any portion of these increased costs. If we are unable to manage commodity fluctuations through pricing actions, cost savings projects, and sourcing decisions as well as through consistent productivity improvements, it may adversely impact our gross profit and gross margin in future periods. Additionally, supply chain disruptions and labor shortages have restricted and could further restrict availability of certain commodities and materials, which may result in delays in our execution of projects in fiscal 2023 and negatively impact revenues. Tight labor markets have resulted in longer times to fill open positions and labor inflation. Continued in filling open positions, particularly among our service technician population, could impact our ability to provide timely service to our customers. Although these factors did not have a material effect on our results of operations for the year ended September 30, 2022, if sustained, they could have a material effect on our results of operations going forward.
In an effort to combat inflation, central banks began raising interest rates in the latter half of fiscal 2022, and interest rates are expected to continue to increase in fiscal 2023. We do not believe that our exposure to rising interest rates in the near term will have a material impact on our business, financial condition, results of operations, or prospects, but if sustained over longer periods, this could have a material adverse effect on our results of operations. We plan to continue to evaluate aspects of our spending, including capital expenditures, discretionary spending, and strategic investments in fiscal 2023.
Impact of the COVID-19 pandemic . We continue to monitor the ongoing effects of the COVID-19 pandemic, particularly as shutdowns and restrictions in parts of China have continued in response to the spread of COVID-19 variants. These shutdowns and restrictions did not have a material adverse effect on our operations or financial results for the year ended September 30, 2022. However, if the duration of these shutdowns and restrictions extends, or if similar shutdowns and restrictions are imposed in other regions, it could impact our sales into those regions and our ability to source materials from those regions.
Russia-Ukraine war. We have no operations in Russia or Ukraine, and our sales into these regions are minimal. However, the conflict in Ukraine has exacerbated the material inflation and availability challenges described above, particularly with respect to the impact it has had on energy and fuel prices and the price of steel and other precious metals that we procure in our supply chain. Although these factors did not have a material adverse effect on our results of operations for the year ended September 30, 2022, we expect the inflationary impact on energy, fuel and steel prices to continue throughout fiscal 2023. If these factors are sustained, or if the duration of the conflict is extended or the conflict spreads into a larger geographic portion of Europe, our results of operations in future periods could be materially and adversely impacted.
Acquisitions and divestitures . On January 3, 2022, we acquired the Mar Cor Business for approximately $195.0 million paid in cash at closing, following adjustments. We utilized cash on hand and borrowed an additional $160.0 million
under our 2021 Revolving Credit Facility (a multi-currency senior secured revolving credit facility in an aggregate principal amount not to exceed the U.S. dollar equivalent of $350.0 million) to fund the acquisition. The purchase price included a $12.3 million earn out, which is being held in escrow and will be paid, pro rata, to the sellers if the Mar Cor Business meets certain sales performance goals (the “Earn Out”). Any portion of the Earn Out not paid to the sellers during the first year following closing of the transaction will be returned to us. The Mar Cor Business is a leading manufacturer and servicer of medical water, commercial and industrial solutions in North America. Headquartered in Plymouth, Minnesota, the Mar Cor Business offers significant technical expertise in designing, building, and servicing high-purity water treatment systems. The addition of this business expands our service footprint in North America, furthering our reach into the healthcare vertical market. During the year ended September 30, 2022, we incurred approximately $4.9 million in acquisition costs, which are included in General and administrative expense on the Consolidated Statements of Operations. Additionally, we expect to incur between $18.0 million to $20.0 million in one-time integration costs within the next 18 to 24 months. The Mar Cor Business is included within the Integrated Solutions and Services segment.
On January 31, 2022, we completed the divestiture of certain resin regeneration assets in Germany (the “Germany Regen Business”) for approximately $0.4 million in cash at closing, resulting in a gain of $0.2 million recognized on the sale. The Germany Regen Business was a part of the Applied Product Technologies segment.
On April 1, 2022, we acquired the remaining 32% equity interest in Frontier Water Systems, LLC (“Frontier”) for an aggregate purchase price of approximately $10.4 million, making Frontier a wholly-owned subsidiary of the Company. This followed our initial acquisition of a 60% equity interest in Frontier in October 2019 and our acquisition of an additional 8% equity interest in Frontier in April 2021. San Diego-based Frontier is a leading supplier of engineered equipment packages for high-rate treatment of selenium, nitrate, and metals in water and wastewater. The business adds to Evoqua’s portfolio of advanced wastewater treatment technologies and is part of our Integrated Solutions and Services segment.
Also on April 1, 2022, we acquired the remaining 50% partnership interest in Treated Water Outsourcing, a joint venture between the Company and Nalco Water, an Ecolab company (“Nalco”), from Nalco for an aggregate purchase price of approximately $1.1 million.
On July 1, 2022, we completed the acquisition of Smith Engineering, Inc. (“Smith Engineering”) for approximately $18.9 million cash paid at closing. Smith Engineering is a leader in the design, manufacturing, and service of custom high purity water treatment equipment serving the biotech/pharmaceutical, data center, food and beverage, healthcare, medical device, and microelectronics markets. With over 1,200 customers in North America, Smith Engineering offers a variety of water treatment products and services, including filtration, UV, reverse osmosis, and deionization. Smith Engineering is part of our Integrated Solutions and Services segment.
On July 15, 2022, we completed the acquisition of Epicor, Inc. (“Epicor”) for $4.3 million cash paid at closing. Epicor has supplied specialty resins for power steam system treatment for fifty years. The resins provide a cost-effective and efficient method for creating and maintaining a continual supply of ultra-pure water for power plants. Epicor is part of our Integrated Solutions and Services segment.
How We Assess the Performance of Our Business
In assessing the performance of our business, we consider a variety of performance and financial measures. The key indicators of the financial condition and operating performance of our consolidated business are revenue, gross profit, gross margin, and net income (loss). Management utilizes these financial measures prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) when reviewing the Company’s performance and making financial, operational, and strategic decisions, and believes they are useful metrics for investors that help with performance comparability period over period. In addition, we consider certain non-GAAP financial measures such as adjusted EBITDA, as described more fully below. We evaluate our business segments’ operating results based on revenue, income from operations (“operating profit”) and adjusted EBITDA on a segment basis. We believe these financial measures are helpful in understanding and evaluating the segments’ core operating results and facilitates comparison of our performance on a consistent basis period over period.
Revenue
Our revenue is a function of sales volumes and selling prices. We report revenue by segment and by source which includes revenue from product sales (capital and aftermarket) and revenue from service. Revenue is used by management to evaluate the performance of our business. Revenue growth is primarily related to organic and inorganic factors. Organic revenue growth, as a component of revenue growth, is defined as period over period revenue growth excluding (i) the impact from acquisitions and divestitures during the first 12 months following the closing of the acquisition or divestiture, which we refer to as inorganic impact, and (ii) the impact of foreign currency translation. Divestitures include sales of insignificant portions of our business that did not meet the criteria for classification as a discontinued operation. We exclude the effect of foreign currency translation from organic revenue growth because foreign currency translation is not under management’s control, is subject to volatility and can obscure underlying business trends. We exclude the effect of acquisitions and divestitures during the first 12 months following the closing of the acquisition or because they can obscure underlying business trends and make comparisons of long-term performance between the Company and its peers due to the varying nature, size, and number of transactions from period to period.
EBITDA and Adjusted EBITDA
EBITDA, which is a non-GAAP financial measure, is defined as earnings before interest, taxes, depreciation and amortization expense. Adjusted EBITDA, which is a non-GAAP financial measure, is one of the primary metrics used by management to evaluate the strength and financial performance of our core business. Adjusted EBITDA is defined as net income (loss) before interest expense, income tax benefit (expense) and depreciation and amortization, adjusted for the impact of certain other items, including restructuring and related business transformation costs, share-based compensation, transaction costs, and other gains, losses, and expenses that we believe do not directly reflect our underlying business operations. We present adjusted EBITDA because we believe it is frequently used by analysts, investors, and other interested parties to evaluate and compare operating performance and value companies within our industry. Further, we believe it is helpful in highlighting trends in our operating results and provides greater clarity and comparability period over period to management and our investors regarding the operational impact of long-term strategic decisions regarding capital structure, the tax jurisdictions in which we operate, and capital investments. In addition, adjusted EBITDA highlights true business performance by removing the impact of certain items that management believes do not directly reflect our underlying operations and provides investors with visibility into the ongoing drivers of our business performance.
Management uses adjusted EBITDA to supplement GAAP measures of performance as follows:
• to assist investors and analysts in comparing our operating performance across reporting periods on a consistent basis by excluding items that we do not believe are indicative of our core operating performance;
• in our management incentive compensation, which is based in part on components of adjusted EBITDA;
• in certain calculations under our senior secured credit facilities, which use components of adjusted EBITDA;
• to evaluate the effectiveness of our business strategies;
• to make budgeting decisions; and
• to compare our performance against that of other peer companies using similar measures.
In addition to the above, our chief operating decision maker uses adjusted EBITDA of each reportable operating segment as a supplement to segment income from operations and segment revenue to evaluate the operating performance of such segments. Adjusted EBITDA on a segment basis is defined as earnings before depreciation and amortization, adjusted for the impact of certain other items that have been reflected at the segment level. Adjusted EBITDA of the reportable operating segments do not include certain charges that are presented within corporate activities. These charges include certain restructuring and other business transformation charges that have been incurred to align and reposition the Company to the current reporting structure, acquisition related costs (including transaction costs and integration costs) and share-based compensation charges.
EBITDA and Adjusted EBITDA should not be considered substitutes for, or superior to, financial measures prepared in accordance with GAAP. The financial results prepared in accordance with GAAP and the reconciliations from these results should be carefully evaluated. See “Non-GAAP Reconciliations” in this Item 7 for a reconciliation of EBITDA and adjusted EBITDA to net income. You are encouraged to evaluate each adjustment and the reasons we consider it appropriate for supplemental analysis. In addition, in evaluating adjusted EBITDA, you should be aware that in the future, we may incur expenses similar to the adjustments in the presentation of adjusted EBITDA. Our presentation of adjusted EBITDA should not be construed as an inference that our future results will be unaffected by unusual or non-recurring items. In addition, other companies in our industry or across different industries may calculate adjusted EBITDA differently.
Basis of Presentation
The discussion that follows includes a comparison of our results of operations and liquidity and capital resources for the fiscal years ended September 30, 2022 and 2021. For a discussion of changes from the fiscal year ended September 30, 2021 to the fiscal year ended September 30, 2020, refer to Management’s Discussion and Analysis of Financial Condition and Results of Operation in Part II, Item 7 of our Annual Report on Form 10-K for the year ended September 30, 2021 (filed November 17, 2021).
Results of Operations
The following tables summarize key components of our results of operations for the periods indicated:
Year Ended September 30,
Variance
(In millions, except per share amounts)
% of Revenue
% of Revenue
Revenue from product sales and services
Gross profit
Total operating expenses
Other operating income, net
Interest expense
Income before income taxes
Income tax benefit (expense)
Net income
Net income attributable to non‑controlling interest
Net income attributable to Evoqua Water Technologies Corp.
Weighted average shares outstanding
Basic
Diluted
Earnings per share
Basic
Diluted
Other financial data:
Adjusted EBITDA (1)
(1) Adjusted EBITDA is a non-GAAP financial measure. For the definition of Adjusted EBITDA and a reconciliation to net income (loss), its most directly comparable financial measure presented in accordance with GAAP, see “Non-GAAP Reconciliations” in this Item 7.
Years Ended September 30, 2022 and September 30, 2021
Consolidated Results
Revenue -Revenue increased $272.7 million, or 18.6%, to $1,737.1 million in the year ended September 30, 2022, from $1,464.4 million in the prior year. Revenue from product sales increased $191.5 million, or 22.2%, to $1,052.5 million in the year ended September 30, 2022, from $861.0 million in the prior year. Revenue from services increased $81.2 million, or 13.5%, to $684.6 million in the year ended September 30, 2022, from $603.4 million in the prior year.
The following tables provide the change in revenue by offering and the components that contributed to revenue growth during the years ended September 30, 2022 and 2021:
Year Ended September 30,
$ Variance
% Variance
(In millions)
Revenue
Revenue
Revenue from product sales:
Capital
Aftermarket
Revenue from services
(In millions)
$ Change
% Change
Year ended September 30, 2021 total revenue
Organic
Inorganic
Foreign currency translation
Year ended September 30, 2022 total revenue
Revenue growth due to organic revenue related primarily to improved price realization and higher volume for products and services across most product lines and all regions. The North America and Asia Pacific regions contributed to strong organic revenue growth in service, capital, and aftermarket across most end markets.
Revenue in future periods could be negatively impacted by commodity and material availability constraints caused by global supply chain disruptions, skilled labor shortages, and the timing of projects based on potential deferrals of orders due to rising interest rates or recessionary conditions.
Cost of Sales and Gross Margin -Total gross margin decreased to 30.9% in the year ended September 30, 2022, from 31.2% in the prior year. The following table provides the change in cost of product sales and cost of services, respectively, along with related gross margins:
Year Ended September 30,
Gross
Margin %
Gross
Margin %
Cost of product sales
Cost of services
Gross margin from product sales increased by 20 bps to 29.6% in the year ended September 30, 2022, from 29.4% in the prior year. The increase in gross margin was primarily driven by favorable price realization and product mix. These factors were partially offset by labor, material and freight inflation.
Gross margin from services decreased by 110 bps to 32.7% in the year ended September 30, 2022, from 33.8% in the prior year. This decrease was driven by increased labor costs and resource constraints.
We expect continued pressure on gross margin in future periods due to material, freight and labor inflation. Although we expect to continue to partially offset those increasing costs with positive price realization, there can be no assurance that we will be able to do so.
Operating Expenses -Operating expenses increased $74.3 million, or 20.5%, to $437.3 million in year ended September 30, 2022 from $363.0 million in the prior year. Operating expenses are comprised of the following:
Year Ended September 30,
(In millions)
% of Revenue
% of Revenue
% Variance
General and administrative expense
Sales and marketing expense
Research and development expense
Total operating expenses
The increase period over period in operating expenses was primarily due to higher employee related costs associated with acquisitions, share-based compensation, and wage inflation. Additionally, non-cash foreign currency translation losses of $18.7 million in the current year, compared to foreign currency translation gains of $0.9 million in the prior year, mostly related to intercompany loans contributed to this increase. In addition, there were increased consulting, marketing and travel expenses, and increased amortization expense due to acquisitions in the current period compared to the prior period. The above increases were partially offset by a decrease in external legal fees compared to the prior period, as well as a benefit in the current period related to changes in the estimate of the Mar Cor Business achieving the earn-out target.
Fluctuations in foreign currency translation and inflation could impact operating expenses in future periods.
Other Operating Income, Net -Other operating income, net, increased $0.3 million, to $5.3 million in the year ended September 30, 2022, from $5.0 million in the prior year. This increase was driven by income from precious metal sales, mainly from scrapped anodes in China, as well as gains on the disposal of fixed assets compared to the prior period. Additionally, we received a refund from the Chinese government in the current period of certain taxes paid, which partially offset COVID-19 pandemic subsidies received from the Canadian government in the prior period, which did not reoccur in the current period.
Interest Expense -Interest expense decreased $2.8 million, or 7.5%, to $34.7 million in the year ended September 30, 2022, from $37.5 million in the prior year. The decrease in interest expense was primarily driven by a $100.0 million debt prepayment in conjunction with the April 2021 refinancing of our senior credit facility. As a result of the April 2021 refinancing, an additional $3.1 million of fees and a write off of $1.3 million of deferred financing fees were incurred in the prior period. This decrease was partially offset by a charge to interest expense of $2.1 million from a fair value increase in the purchase right liability to acquire the remaining equity interest of Frontier in the current period, as well as an increase in interest expense associated with higher outstanding debt that had a higher interest rate spread and LIBOR year over year.
Fluctuations in interest rates could impact interest expense in future periods.
Income Tax Expense -Income tax benefit was $3.0 million for the year ended September 30, 2022, compared to expense of $10.1 million in the prior year. The decrease in tax expense was primarily attributable to a reversal of the U.S.
valuation allowance, a benefit of $17.3 million, which was partially offset by an increase in foreign tax expense due to improved profitability in certain countries.
Net Income -Net income increased by $20.6 million, or 39.8%, to net income of $72.3 million for the year ended September 30, 2022, from $51.7 million in the prior year, as a result of the variances noted above.
Adjusted EBITDA -Adjusted EBITDA is a non-GAAP financial measure. Adjusted EBITDA increased $46.8 million, or 18.7%, to $297.7 million for the year ended September 30, 2022, from $250.9 million for the prior year, primarily driven by sales volume and related gross profit. See “Non-GAAP Reconciliations” in this Item 7 for a reconciliation of adjusted EBITDA to net income.
Segment Results
Year Ended September 30,
(In millions)
% of Total
% of Total
% Variance
Revenue
Integrated Solutions and Services
Applied Product Technologies
Total Consolidated
Operating profit (loss)
Integrated Solutions and Services
Applied Product Technologies
Corporate
Total Consolidated
Adjusted EBITDA (1)
Integrated Solutions and Services
Applied Product Technologies
Corporate
Total Consolidated
(1) Adjusted EBITDA is a non-GAAP financial measure. For a reconciliation of segment adjusted EBITDA to segment operating profit (loss), its most directly comparable financial measure presented in accordance with GAAP, see “Non-GAAP Reconciliations” in this, Item 7.
Integrated Solutions and Services
Revenue in the Integrated Solutions and Services segment increased $224.6 million, or 23.4%, to $1,184.5 million in the year ended September 30, 2022, from $959.9 million in the year ended September 30, 2021. The following tables provide the change in revenue by offering and the components that contributed to revenue growth during the years ended September 30, 2022 and 2021 for the Integrated Solutions and Services segment:
Year Ended September 30,
$ Variance
% Variance
(In millions)
Revenue
Revenue
Revenue from product sales:
Capital
Aftermarket
Revenue from services
(In millions)
$ Change
% Change
Year ended September 30, 2021 total revenue
Organic
Inorganic
Foreign currency translation
Year ended September 30, 2022 total revenue
Revenue growth due to organic revenue related to positive price realization and higher sales volume across service, capital and aftermarket in a variety of end markets. Service revenue was the largest contributor to organic revenue growth, with the largest growth coming from price realization, primarily in the light and general industry, chemical processing and mining, and life sciences end markets.
Operating profit in the Integrated Solutions and Services segment increased $18.3 million, or 12.4%, to $165.6 million in the year ended September 30, 2022, from $147.3 million in the year ended September 30, 2021.
Operating profit growth was driven by favorable price realization and sales volume. These increases were partially offset by operational variances, including material, fuel, and freight inflation, and labor inflation. Also, COVID-19 pandemic
subsidies received from the Canadian government in the prior year did not reoccur in the current year. Employee related expenses increased due to inflation and sales incentive compensation.
Adjusted EBITDA is a non-GAAP financial measure. Adjusted EBITDA in the Integrated Solutions and Services segment increased $39.7 million, or 18.1%, to $259.0 million in the year ended September 30, 2022, compared to $219.3 million in the year ended September 30, 2021. The increase was driven by the same factors that impacted operating profit, other than the change in depreciation and amortization, and also excludes restructuring and other non-recurring activity. See “Non-GAAP Reconciliations” in this Item 7 for a reconciliation of segment adjusted EBITDA to segment operating profit.
Applied Product Technologies
Revenue in the Applied Product Technologies segment increased $48.1 million, or 9.5%, to $552.6 million in the year ended September 30, 2022, from $504.5 million in the year ended September 30, 2021. The following tables provide the change in revenue by offering and the components that contributed to revenue growth during the years ended September 30, 2022 and 2021 for the Applied Product Technologies segment:
Year Ended September 30,
$ Variance
% Variance
(In millions)
Revenue
Revenue
Revenue from product sales:
Capital
Aftermarket
Revenue from services
(In millions)
$ Change
% Change
Year ended September 30, 2021 total revenue
Organic
Inorganic
Foreign currency translation
Year ended September 30, 2022 total revenue
Revenue growth due to organic revenue related to improved price realization and higher volume, across all regions, particularly in the North America and Asia Pacific regions. Unfavorable foreign currency translation primarily affected the Europe, Middle East, and Africa region.
Operating profit in the Applied Product Technologies segment increased $20.2 million, or 24.4%, to $103.1 million in the year ended September 30, 2022, from $82.9 million in the year ended September 30, 2021.
The increase in operating profit was driven by price realization, higher sales volumes, and favorable mix across all regions and multiple product lines. These benefits were partially offset by unfavorable operational variances, including increased costs associated with logistics, labor, and material inflation and availability. Employee related expenses increased due to inflation and sales incentive compensation.
Adjusted EBITDA is a non-GAAP financial measure. Adjusted EBITDA in the Applied Product Technologies segment increased $14.0 million, or 13.2%, to $119.7 million in the year ended September 30, 2022, compared to $105.7 million in the year ended September 30, 2021. The increase was driven by the same factors that impacted operating profit, other than the change in depreciation and amortization, and also excludes restructuring and other non-recurring activity. See “Non-GAAP Reconciliations” in this Item 7 for a reconciliation of segment adjusted EBITDA to segment operating profit.
Corporate
Operating loss in Corporate increased $33.8 million, or 25.8%, to $164.7 million in the year ended September 30, 2022, from $130.9 million in the year ended September 30, 2021. The increase was primarily due to foreign currency translation losses in the current period, compared to foreign currency translation gains in the prior period, most of which is related to intercompany loans. Additionally, there were increased employment expenses, including share-based compensation. These were partially offset by lower costs associated with legal matters in the current year.
Non-GAAP Reconciliations
The following is a reconciliation of our Net income to EBITDA and adjusted EBITDA. See “How We Assess the Performance of Our Business” in this Item 7 for discussion on management’s definition and use of this non-GAAP financial measure.
Year Ended September 30,
(In millions)
% Variance
Net income
Income tax (benefit) expense
Interest expense
Operating profit
Depreciation and amortization
EBITDA
Restructuring and related business transformation costs (a)
Purchase accounting adjustment costs (b)
Share-based compensation (c)
Transaction costs (d)
Other losses (gains) and expenses (e)
Adjusted EBITDA
(a) Restructuring and related business transformation costs
Adjusted EBITDA is calculated prior to considering certain restructuring or business transformation events. These events may occur over extended periods of time and in some cases, it is reasonably possible that events of a similar nature could reoccur in future periods based on reorganizations of the business, cost reduction or productivity improvement needs, or in response to economic conditions. For the periods presented such events include the following:
(i) Certain costs and expenses in connection with various restructuring initiatives, including severance and other employee-related costs, relocation and facility consolidation costs, and third-party consultant costs to assist with these initiatives. This includes:
(A) amounts related to the Company’s restructuring initiatives to reduce the cost structure and rationalize location footprint following the sale of the Memcor product line;
(B) amounts related to the Company’s transition from a three-segment structure to a two-segment operating model designed to better serve the needs of customers worldwide; and
(C) amounts related to various other initiatives implemented to restructure and reorganize our business with the appropriate management team and cost structure.
(ii) Legal settlement costs and intellectual property related fees, including fees and settlement costs associated with legacy matters related to product warranty litigation on MEMCOR® products and certain discontinued products.
(iii) Expenses associated with our information technology and functional infrastructure transformation, including activities to optimize information technology systems and functional infrastructure processes.
(iv) Costs associated with the secondary public offering of common stock held by certain shareholders of the Company, as well as costs incurred by us in connection with establishment of our public company compliance structure and processes, including consultant costs.
(b) Purchase accounting adjustment costs
Adjusted EBITDA is calculated prior to considering adjustments for the effect of the purchase accounting step-up in the value of inventory to fair value recognized in cost of goods sold as a result of the acquisition of the Mar Cor Business. See Note 4, “Acquisitions,” in Part II, Item 8 of this Report for further detail.
(c) Share-based compensation
Adjusted EBITDA is calculated prior to considering share‑based compensation expenses related to equity awards. See Note 18, “Share-Based Compensation” in Part II, Item 8 of this Annual Report for further detail.
(d) Transaction related costs
Adjusted EBITDA is calculated prior to considering transaction, integration and restructuring costs associated with business combinations because these costs are unique to each transaction and represent costs that were incurred as a result of the transaction decision. Integration and restructuring costs associated with a business combination may occur over several years and include, but are not limited to, consulting fees, legal fees, certain employee-related costs, facility consolidation and product rationalization costs, and fair value changes associated with contingent consideration.
(e) Other losses, (gains) and expenses
Adjusted EBITDA is calculated prior to considering certain other significant losses, (gains), and expenses. For the periods presented such events include the following:
(i) impact of foreign exchange gains and losses;
(ii) charges incurred by the Company related to product rationalization in its electrochlorination business;
(iii) amounts related to the sale of the Memcor product line;
(iv) expenses incurred by the Company as a result of the COVID-19 pandemic, including additional charges for personal protective equipment, increased costs for facility sanitization and one-time payments to certain employees;
(v) legal fees incurred in excess of amounts covered by the Company’s insurance related to securities litigation and SEC investigation matters; and
(vi) loss on divestiture of the Lange Product Line.
We do not present net income on a segment basis because we do not allocate interest expense or income tax benefit (expense) to our segments, making operating profit the most comparable GAAP metric. The following is a reconciliation of our segment EBITDA and segment adjusted EBITDA to segment operating profit, their most directly comparable financial measure presented in accordance with GAAP:
Year Ended September 30,
$ Variance
% Variance
Integrated Solutions and Services
Applied Product Technologies
Integrated Solutions and Services
Applied Product Technologies
Integrated Solutions and Services
Applied Product Technologies
Integrated Solutions and Services
Applied Product Technologies
Operating profit
Depreciation and amortization
EBITDA
Restructuring and related business transformation costs (a)
Purchase accounting adjustment costs (b)
Transaction costs (c)
Other (gains) losses and expenses (d)
Segment adjusted EBITDA
(a) Represents costs and expenses in connection with restructuring initiatives. Such expenses are primarily composed of severance, relocation, and facility consolidation costs.
(b) Represents adjustments for the effect of the purchase accounting step-up in the value of inventory to fair value recognized in cost of goods sold as a result of the acquisition of the Mar Cor Business, as well as other transaction related costs for acquisitions made in the current period.
(c) Represents costs associated with a change in the current estimate of certain acquisitions achieving their earn-out targets as well as other costs associated with acquisitions completed during the period.
(d) Other losses, (gains) and expenses as discussed above, distinct to our Integrated Solutions and Services and Applied Product Technologies segments include the following:
(i) trailing costs from the sale of the Memcor product line;
(ii) charges incurred by the Company related to product rationalization in its electro-chlorination business; and
(iii) loss on divestiture of the Lange product line.
Liquidity and Capital Resources
Liquidity describes the ability of a company to borrow or generate sufficient cash flows to meet the cash requirements of its business operations, including working capital needs, debt service, acquisitions, other commitments, and contractual obligations. Our principal sources of liquidity are cash generated by our operating activities, borrowings under the 2021 Revolving Credit Facility and financing arrangements related to capital expenditures for equipment used to provide services to our customers. Historically, we have financed our operations primarily from these sources. Our primary cash needs are for day-to-day operations, to pay interest and principal on our indebtedness, to fund working capital requirements and to make capital expenditures.
Our ability to fund our capital needs depends on our ongoing ability to generate cash from operations and access bank financing and the capital markets. In support of international operations, portions of our cash balances are held in various currencies and may be subject to foreign currency translation and other costs associated with repatriation, if necessary. Neither moderate increases in net working capital nor macroeconomic conditions have materially impacted our liquidity to date. In addition, we do not believe that our exposure to rising interest rates will have a material impact on our business, financial condition, results of operations, or prospects, and we plan to continue to evaluate aspects of our spending, including capital expenditures, discretionary spending, and strategic investments in fiscal 2023. We believe we are currently well-positioned to manage our business and have the ability and sufficient capacity to meet our cash requirements by using available cash, internally generated funds, and borrowing under the 2021 Revolving Credit Facility.
As part of our ongoing efforts to improve our cash flow and related liquidity, we work with suppliers to optimize our terms and conditions, including occasionally extending payment terms. We also facilitate a voluntary supply chain finance program (the “program”) to provide certain of our suppliers with the opportunity to sell receivables due from us to participating financial institutions at the sole discretion of both the suppliers and the financial institutions. A third party administers the program; our responsibility is limited to making payments on the terms originally negotiated with our supplier, regardless of whether the supplier sells its receivable to a financial institution. We do not enter into agreements with any of the participating financial institutions in connection with the program. The range of payment terms we negotiate with our suppliers is consistent, irrespective of whether a supplier participates in the program. The amounts settled through the program and paid to participating financial institutions were $92.9 million and $42.0 million in the year ended September 30, 2022 and 2021, respectively. A downgrade in our credit rating or changes in the financial markets could limit the financial institutions’ willingness to commit to participating in the program.
We expect to continue to finance our liquidity requirements through internally generated funds and borrowings under the 2021 Revolving Credit Facility. We believe that our projected cash flows generated from operations, together with borrowings under the 2021 Revolving Credit Facility and other financing arrangements are sufficient to fund our short-term and long-term principal debt payments, interest expense, working capital needs, and expected capital expenditures. Our capital expenditures for the year ended September 30, 2022 and 2021 were $82.0 million and $75.3 million, respectively. However, our budgeted capital expenditures can vary from period to period based on the nature of capital intensive project awards. Our focus on customer outsourced water projects will continue to be a driver of capital expenditures. From time to time, we may enter into financing arrangements related to capital expenditures for equipment used to provide services to our customers. During the years ended September 30, 2022 and 2021, we entered into equipment financing arrangements totaling $36.4 million and $37.5 million, respectively. In addition, we may draw on the 2021 Revolving Credit Facility from time to time to fund or partially fund an acquisition.
As of September 30, 2022, we had total indebtedness of $890.7 million, including $469.1 million of term loan borrowings under the 2021 Credit Agreement, $151.3 million outstanding under the 2021 Revolving Credit Facility, $150.2 million outstanding under the Securitization Facility which includes $0.2 million of accrued interest and $120.2 million in borrowings related to equipment financing. We also had $9.3 million of letters of credit issued under our 2021 Revolving Credit Facility as of September 30, 2022.
As of September 30, 2022 and September 30, 2021, we were in compliance with the covenants contained in the 2021 Credit Agreement, including the 2021 Revolving Credit Facility.
2021 Credit Agreement
On April 1, 2021, EWT III entered into a Credit Agreement (the “2021 Credit Agreement”) among EWT III, as borrower, EWT II, as parent guarantor, the lenders from time to time party thereto, JPMorgan Chase Bank, N.A., as administrative agent and collateral agent, and ING Capital, LLC, as sustainability coordinator. The 2021 Credit Agreement provides for a multi-currency senior secured revolving credit facility in an aggregate principal amount not to exceed the U.S. dollar equivalent of $350.0 million (the “2021 Revolving Credit Facility”) and a discounted senior secured term loan (the “2021 Term Loan”) in the amount of $475.0 million (together with the 2021 Revolving Credit Facility, the “Senior Facilities”). The 2021 Credit Agreement also provides for a letter of credit sub-facility not to exceed $60.0 million.
The 2021 Credit Agreement contains customary representations, warranties, affirmative covenants, and negative covenants, including, among other things, a springing maximum first lien leverage ratio of 5.55 to 1.00. The Company did not exceed this ratio during the year ended September 30, 2022, does not anticipate exceeding this ratio during the year ending September 30, 2023, and therefore does not anticipate any additional repayments during the year ending September 30, 2023.
Receivables Securitization Program
On April 1, 2021, Evoqua Finance LLC (“Evoqua Finance”), an indirect wholly-owned subsidiary of the Company, entered into an accounts receivable securitization program (the “Receivables Securitization Program”) consisting of, among other agreements, (i) a Receivables Financing Agreement (the “Receivables Financing Agreement”) among Evoqua Finance, as the borrower, the lenders from time to time party thereto (the “Receivables Financing Lenders”), PNC Bank, National Association (“PNC Bank”), as administrative agent, EWT LLC, as initial servicer, and PNC Capital Markets LLC (“PNC Markets”), as structuring agent, pursuant to which the lenders have made available to Evoqua Finance a receivables finance facility (the “Securitization Facility”) in an amount up to $150.0 million and (ii) a Sale and Contribution Agreement (the “Sale Agreement”) among Evoqua Finance, as purchaser, EWT LLC, as initial servicer and as an originator, and Neptune Benson, Inc., an indirectly wholly-owned subsidiary of the Company, as an originator (together with EWT LLC, the “Originators”). Under the Receivables Securitization Program, the Originators, pursuant to the Sale Agreement, are required to sell substantially all of their domestic trade receivables and certain related rights to payment and obligations of the Originators with respect to such receivables (the “Receivables”) to Evoqua Finance, which, in turn, will obtain loans secured by the Receivables from the Receivables Financing Lenders pursuant to the Receivables Financing Agreement. The Receivables underlying any borrowings will continue to be included in Accounts receivable, net, in the Consolidated Balance Sheets of the Company.
The Receivables Securitization Program contains certain customary representations, warranties, affirmative covenants, and negative covenants, subject to certain cure periods in some cases, including the eligibility of the Receivables being sold by the Originators and securing the loans made by the Receivables Financing Lenders, as well as customary reserve requirements, events of default, termination events, and servicer defaults. The Company was in compliance with all covenants during the year ended September 30, 2022, does not anticipate becoming noncompliant during fiscal 2023, and therefore, subject to collateral availability, does not anticipate any additional repayments during fiscal 2023.
Contractual Obligations
We enter into long‑term obligations and commitments in the normal course of business, primarily debt obligations and non‑cancelable operating leases. As of September 30, 2022, our contractual cash obligations over the next several periods were as follows:
(In millions)
Total
Less than
1 year
3 years
5 years
More than
5 years
Long‑term debt obligations (a)
Interest payments on long‑term debt obligations
Operating lease commitments (b)
Finance lease commitments (c)
Total
(a) The amounts shown in this table do not include any net reductions for deferred financing fees. The amounts for current and long-term debt shown on the Consolidated Balance Sheets are net of deferred financing fees.
(b) We occupy certain facilities and operate certain equipment and vehicles under non‑cancelable lease arrangements. Lease agreements may contain lease escalation clauses and purchase and renewal options. We recognize scheduled lease escalation clauses over the course of the applicable lease term on a straight‑line basis.
(c) We lease certain equipment classified as finance leases. The leased equipment is depreciated on a straight line basis over the life of the lease and is included in depreciation expense.
Evoqua Water Technologies Corp. is a holding company and does not conduct any business operations of its own. As a result, our ability to pay cash dividends on our common stock, if any, is dependent upon cash dividends and distributions and other transfers from our operating subsidiaries. Under the terms of the 2021 Credit Agreement, our operating subsidiaries are currently limited in their ability to pay cash dividends to us, and we expect these limitations to continue in the future under the terms of any future credit agreement or any future debt or preferred equity securities of ours or of our subsidiaries.
Our indebtedness could adversely affect our ability to raise additional capital, limit our ability to react to changes in the economy or our industry, expose us to interest rate risk and prevent us from meeting our obligations. See Part I, Item 1A, “Risk Factors-Our substantial indebtedness could adversely affect our financial condition and limit our ability to raise additional capital to fund our operations.”
Cash Flows
The following table summarizes the changes to our cash flows for the periods presented:
Year Ended September 30,
(In millions)
Statement of Cash Flows Data
Net cash provided by operating activities
Net cash (used in) provided by investing activities
Net cash provided by (used in) financing activities
Effect of exchange rate changes on cash
Change in cash and cash equivalents
Operating Activities
Cash flows from operating activities can fluctuate significantly from period‑to‑period as working capital needs and the timing of payments for restructuring activities and other items impact reported cash flows.
Net cash provided by operating activities increased to $181.4 million in the year ended September 30, 2022 from $178.7 million in the year ended September 30, 2021.
• Operating cash flows in the year ended September 30, 2022 reflect an increase in net income of $20.7 million from the year ended September 30, 2021.
• The add back of non‑cash charges increased operating cash flows by $153.4 million for the year ended September 30, 2022 as compared to an increase to operating cash flows of $130.5 million for the year ended September 30, 2021, resulting in an increase of $22.9 million. This increase was primarily related to the add back of foreign currency losses in the current period, compared to the deduction of foreign currency gains in the prior period, as well as an increase in depreciation and amortization and share-based compensation expenses in the current period. This was partially offset by a reversal of the U.S. valuation allowance in the current period, which resulted in a decrease in add backs associated with deferred income taxes compared to the prior period. Non-cash changes also include amortization of deferred financing fees, gains and losses on sale of businesses, and gains and losses on sale of property, plant, and equipment.
• The aggregate of receivables, inventories, contract assets, accounts payable and contract billings used $32.6 million in operating cash flows in the year ended September 30, 2022 compared to the providing of $17.4 million in the prior year.
The amount of cash flow generated from or used by the above mentioned accounts depends upon how effectively we manage our cash conversion cycle, which is a representation of the number of days that elapse from the date of purchase of raw materials and components to the collection of cash from customers. Our cash conversion cycle can be significantly impacted by the timing of collections and payments in a period.
• The aggregate of the remaining assets and liabilities used $14.2 million in operating cash flows in the year ended September 30, 2022 compared to the use of $18.8 million in operating cash flows in the prior year, resulting in an increase to cash flows of $4.6 million. This is mainly due to timing of cash receipts on long-term receivables.
• Cash income taxes provided $2.4 million for the year end September 30, 2022, as compared to the use of $2.1 million during the prior year.
Investing Activities
Net cash used in investing activities was $310.7 million in the year ended September 30, 2022, as compared to net cash used in investing activities of $97.2 million in the year ended September 30, 2021, resulting in a net decrease to cash flow of $213.5 million as compared to the prior year period. This decrease was largely driven by cash outflow associated with the acquisitions of the Mar Cor Business, Smith Engineering, and Epicor, as well as the acquisitions of the remaining interest of Frontier and TWO in the current period as compared to the Ultrapure and WCSI acquisitions that occurred in the prior period. This decrease was also driven by higher cash outflow associated with purchase of capital assets compared to the prior period. Other activity related to purchases of intangible assets, proceeds from the sale of businesses, and proceeds from the sale of property, plant and equipment remained relatively consistent with the prior period.
Financing Activities
Net cash provided by financing activities increased $255.8 million to $125.5 million in the year ended September 30, 2022 from net cash used in financing activities of $130.3 million in the year ended September 30, 2021. The increase was primarily due to the debt refinancing activities that occurred in the prior period, as well as an increased issuance of debt compared to the prior period. This increase was partially offset by an increase of taxes paid related to net share settlements of share-based compensation awards compared to the prior period. Lastly, cash received from the issuance of common stock in connection with the exercise of stock options declined compared to the prior period.
Seasonality
For more information regarding how seasonality may impact our business, results of operations and financial condition, see Part I, Item 1A. “Risk Factors-Seasonality of sales and weather conditions may adversely affect, or cause volatility in, our financial results.”
Seasonal trends historically displayed by our business could be impacted by macroeconomic conditions, including supply chain disruption or recessionary conditions , and past performance should not be considered indicative of future results.
Off‑Balance Sheet Arrangements
We had the following outstanding under our credit arrangements at September 30, 2022 and September 30, 2021:
(In millions)
September 30,
September 30,
Letters of credit
Surety bonds
The longest maturity date of the letters of credit and surety bonds in effect as of September 30, 2022 was March 20, 2030.
Critical Accounting Policies and Estimates
The preparation of financial statements in accordance with GAAP requires management to make estimates and assumptions about future events that affect amounts reported in our Consolidated Financial Statements and related notes, as well as the related disclosure of contingent assets and liabilities at the date of the financial statements. Management evaluates its accounting policies, estimates and judgments on an on‑going basis. Management bases its estimates and judgments on historical experience, current trends and various other factors that are believed to be relevant at the time Consolidated Financial Statements are prepared. Actual results may differ from these estimates under different assumptions and conditions.
Management evaluated the development and selection of its critical accounting policies and estimates and believes that the following involve a higher degree of judgment, complexity or uncertainty and are most significant to reporting our results of operations and financial position, and are therefore discussed as critical. The following critical accounting policies reflect the significant estimates and judgments used in the preparation of our Consolidated Financial Statements. More information on all of our significant accounting policies can be found in Note 2, “Summary of Significant Accounting Policies ” in Part II, Item 8 of this Annual Report.
Acquisitions and Purchase Price Allocation
We evaluate the inputs, processes and outputs of each asset acquired to determine if the transaction meets the definition of a business in accordance with Accounting Standards Codification (“ASC”) 805, Business Combinations (“ASC 805”). Acquisitions that do not meet the definition of a business are accounted for as an asset acquisition. In asset acquisitions, we allocate the purchase price as well as other costs of acquisition, such as transaction costs, to tangible and identifiable intangible assets or liabilities based on the basis of relative fair values. No goodwill is recognized in an asset acquisition.
We record acquisitions that meet the definition of a business using the acquisition method of accounting in accordance with ASC 805, which requires that the assets acquired and liabilities assumed, including contingent consideration, be recorded at their respective fair values at the acquisition date. The excess of the purchase price over the estimated fair values of the net tangible and intangible assets acquired is recorded as goodwill. The application of the acquisition method of accounting requires management to make significant estimates and assumptions in the determination of the fair value of assets acquired and liabilities assumed, in order to properly allocate purchase price consideration. These assumptions and estimates include a market participant’s use of the asset and the appropriate discount rates for a market participant. Our estimates are based on historical experience, information obtained from members of management of the acquired companies and with the assistance of independent third-party appraisal firms. Significant assumptions and estimates include quoted market prices, carrying values, and expected future cash flows, which includes consideration of future growth rates and margins, attrition rates, future changes in technology and brand awareness, loyalty, and the appropriate weighted-average cost of capital and the cost savings expected to be derived from acquiring an asset. These estimates are inherently uncertain and unanticipated events and circumstances may occur which could affect the accuracy or validity of estimates used in purchase accounting. The purchase price allocation recorded in a business combination may change during the measurement period, which is a period not to exceed one year from the date of acquisition, as additional information about conditions existing at the acquisition date becomes available.
We record contingent consideration arrangements at fair value on a recurring basis as earn-outs related to acquisitions. The fair value of earn-outs related to acquisitions is based on significant unobservable inputs including the achievement of certain performance metrics. Significant changes in these inputs would result in corresponding increases or decreases in the fair value of the earn-out each period until the related contingency has been resolved. Changes in the fair value of the contingent consideration obligations can result from adjustments in the probability of achieving future development steps, sales targets and profitability and are recorded in General and administrative expenses in the Consolidated Statements of Operations.
Goodwill Impairment Review
We review goodwill to determine potential impairment annually during the fourth quarter of our fiscal year, or more frequently if events and circumstances indicate that the asset might be impaired. Impairment testing for goodwill is performed at a reporting unit level. A reporting unit is defined as an operating segment or one level below the operating segment. We have determined that we have three reporting units.
The fair values of reporting units are determined using a combination of two methods, one utilizing market revenue and earnings multiples derived from stocks of companies that are engaged in the same or similar lines of business and that are actively traded on a free and open market applied to the corresponding measure of our reporting unit’s financial performance (the market approach - guideline public company (“GPC”) method), and the other derived from discounted cash flow models with estimated cash flows based on internal forecasts of revenue and expenses over a specified period plus a terminal value (the income approach discounted cash flows (“DCF”) method). In estimating the fair value of the reporting unit utilizing a DCF valuation technique, we incorporate our judgment and estimates of future cash flows,
future revenue and gross profit growth rates, terminal value amount, capital expenditures and applicable weighted‑average cost of capital used to discount these estimated cash flows. The estimates and projections used in the estimate of fair value are consistent with our current budget and long‑range plans, including anticipated change in market conditions, industry trends, growth rates and planned capital expenditures, among other considerations.
We believe these two approaches are appropriate valuation techniques and we generally weight the two resulting values equally as an estimate of a reporting unit's fair value for the purposes of our impairment testing. However, we may weigh one value more heavily than the other when conditions merit doing so. If market conditions change compared to those used in our market approach, or if actual future results of operations fall below the projections used in the DCF method, our goodwill could become impaired in the future. As a result of our goodwill impairment assessment, we have concluded that none of our goodwill was impaired as of September 30, 2022, and we do not believe the risk of impairment is significant at this time.
Impairment of Long‑Lived Assets
Long‑lived assets, such as property, plant, and equipment, and purchased intangibles subject to amortization, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset or asset group may not be recoverable. Conditions that may indicate impairment include, but are not limited to, a significant adverse change in customer demand or business climate that could affect the value of an asset based on indicators of reduced profits or losses generated by the asset or asset group, a product recall, or an adverse action by a regulator, such as a successful challenge of patent rights.
When necessary, we record charges for impairments of long-lived assets for the amount by which the fair value is less than the carrying value of the asset or asset group. Fair value of long-lived assets is determined using an appraised value (obtained with the assistance of independent third-party appraisal firms) or using an income approach, specifically the discounted cash flow method. Starting with a forecast of the expected future net cash flows associated with an asset or group of assets, we then apply an asset-specific discount rate to arrive at a net present value amount. There were no material impairments of long-lived assets recorded in the current year.
We amortize long-lived assets with finite lives over their estimated useful lives on a straight‑line basis. This amortization methodology best matches the pattern of economic benefit that is expected from definite‑lived assets.
Revenue Recognition
For sales of aftermarket parts or products with a low level of customization and engineering time, the Company recognizes revenue at the time risks and rewards of ownership pass, which is generally when products are shipped or delivered to the customer as the Company has no obligation for installation. The Company considers shipping and handling services to be fulfillment activities and as such they do not represent separate performance obligations for revenue recognition. Sales of short‑term service arrangements are recognized as the services are performed, and sales of long‑term service arrangements are typically recognized on a straight‑line basis over the life of the agreement.
For certain arrangements where there is significant customization to the product and for long-term construction-type sales contracts, revenue may be recognized over time as performance is completed. In these instances, revenue is recognized using a measure of progress that applies an input method based on costs incurred in relation to total estimated costs at completion (the percentage-of-completion method). These arrangements include large water treatment projects, systems, and solutions for municipal and industrial applications. The nature of the contracts is generally fixed price with milestone billings. In order for revenue to be recognized over a period of time, the product must have no alternative use and the Company must have an enforceable right to payment for the performance completed to date, including a normal profit margin, in the event of termination for convenience. If these two criteria are not met, revenue from these contracts will not be recognized until construction is complete. Contract costs include all direct materials, labor, subcontractors costs and indirect costs related to contract performance. We believe this is the most accurate measure of contract performance because it directly measures the value of the goods and services transferred to the customer.
The percentage-of-completion method of revenue recognition requires us to prepare estimates of cost to complete for contracts in progress. Due to the nature of the work performed on many of our performance obligations, the estimates of total revenue and cost at completion is complex, subject to many variables and may require significant judgment. In making such estimates, judgments are required to evaluate contingencies such as weather, potential variances in schedule and the cost of materials, labor cost and productivity, the impact of change orders, liability claims, contract disputes and achievement of contractual performance standards. As a significant change in one or more of these estimates could affect the profitability of our contracts, we routinely review and update our significant contract estimates through a disciplined project review process in which management reviews the progress and execution of our performance obligations and estimates at completion. Contract revenue and cost estimates are reviewed and revised monthly and the cumulative effect of such adjustments are recognized in current operations. Such changes in contract estimates can result in the recognition of revenue in a current period for performance obligations which were satisfied or partially in a prior period. Changes in contract estimates may also result in the reversal of previously recognized revenue if the current estimate differs from the previous estimate. The amount of such adjustments has not been material.
For contracts with multiple performance obligations, we allocate the transaction price to each performance obligation using our best estimate of the standalone selling price of each distinct good or service in the contract. In cases where we do not provide the distinct good or service on a standalone basis, the primary method used to estimate standalone selling price is the expected cost plus a margin approach, under which we forecast our expected costs of satisfying a performance obligation and then add an appropriate margin for that distinct good or service. Our contracts are sometimes modified for changes in contract specifications and requirements. Judgment is required to determine if such modifications result in goods or services that are distinct from the existing contract. For customized products and long-term construction type contracts, most contract modifications are for goods and services that are not distinct due to the significant integration provided in the context of the contract and are accounted for as if they were part of the original contract on a cumulative catch-up basis. We account for contract modifications prospectively when it results in the promise to deliver additional goods and services that are distinct and the increase in price of the contract is for the same amount as the stand-alone selling price of the additional goods or services included in the modification.
Our contracts sometimes contain variable consideration in the form of incentive fees, performance bonuses, award fees, liquidated damages, or penalties. Other contract provisions also give rise to variable consideration such as claims and unpriced change orders that may either increase or decrease the transaction price. We estimate the amount of variable consideration at the most likely amount we expect to be entitled. Variable consideration is included in the transaction price when it is probable that a significant reversal of cumulative revenue recognized will not occur or when the uncertainty associated with the variable consideration is resolved. Our estimates of variable consideration and determination of whether to include such amounts in the transaction price are based largely on our assessment of legal enforceability, anticipated performance, and any other information (historical, current, or forecasted) that is reasonably available to us. Variable consideration associated with claims and unapproved change orders is included in the transaction price only to the extent of costs incurred.
Product Warranties
Accruals for estimated expenses related to warranties are made at the time products are sold and are recorded as a component of cost of product sales in the Consolidated Statements of Operations in our Consolidated Financial Statements included elsewhere in this Annual Report. The estimated warranty obligation is based on product warranty terms offered to customers, ongoing product failure rates, material usage and service delivery costs expected to be incurred in correcting a product failure, as well as specific obligations for known failures and other currently available evidence. We assess the adequacy of the recorded warranty liabilities on a regular basis and adjust amounts as necessary.
Deferred Taxes, Valuation Allowances, and Tax Contingencies
Deferred tax assets and liabilities are recognized for the expected future tax consequences of events that have been recognized in our Consolidated Financial Statements or tax returns. 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. We record a valuation allowance to reduce certain deferred tax
assets to amounts that are more-likely-than-not to be realized within a reasonable period of time. The factors used to assess the likelihood of realization include our forecast of future taxable income exclusive of reversing temporary differences and carryforwards, future reversals of existing taxable temporary differences and available tax planning strategies that could be implemented to realize the net deferred tax assets.
We consider both positive and negative evidence when evaluating the need for a valuation allowance on our deferred tax assets in accordance with ASC 740, Income Taxes . Available evidence includes historical financial information supplemented by currently available information about future years. Generally, historical financial information is more objectively verifiable than projections of future income and is therefore given more weight in our assessment. We consider cumulative losses in the most recent twelve quarters to be significant negative evidence that is difficult to overcome in considering whether a valuation allowance is required. Conversely, we consider a cumulative income position over the most recent twelve quarters, to be significant positive evidence that a valuation allowance may not be required.
Income tax positions must meet a more-likely-than-not recognition threshold to be recognized. Income tax positions that previously failed to meet the more-likely-than-not threshold are recognized in the first subsequent financial reporting period in which that threshold is met. Previously recognized tax positions that no longer meet the more-likely-than-not threshold are derecognized in the first subsequent financial reporting period in which that threshold is no longer met. Uncertain tax positions are reviewed each balance sheet date. We recognize potential interest and penalties related to unrecognized tax benefits in income tax expense.
Recent Accounting Pronouncements
See Note 2, “Summary of Significant Accounting Policies ” in Item 8, included in this Annual Report for a complete discussion of recently adopted accounting pronouncements and recently issued accounting pronouncements not yet adopted.
