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ZEP > SEC Filings for ZEP > Form 10-K on 8-Nov-2012All Recent SEC Filings

Show all filings for ZEP INC.

Form 10-K for ZEP INC.


Annual Report

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion should be read in conjunction with Item 1A. Risk Factors, Item 6. Selected Financial Data, Item 8. Financial Statements and Supplementary Data, including the notes thereto, and the other financial information included elsewhere in this Annual Report on Form 10-K. Please see "Cautionary Statement Regarding Forward-Looking Information" for a discussion of the uncertainties, risks and assumptions associated with these statements.



We are a leading provider of cleaning and maintenance chemicals and related products and services for commercial, industrial, institutional and consumer applications, which we market under well-recognized brand names, some of which have been in existence since 1896. Our product portfolio, which is currently produced using more than 4,000 unique formulations, includes anti-bacterial and industrial hand care products, cleaners, degreasers, deodorizers, disinfectants, floor finishes, sanitizers, pest- and weed-control products, air-care products and delivery systems, and a wide variety of automotive maintenance chemicals. We sell our products through a sales and service organization, to consumers primarily through home improvement stores and automotive after-market retailers, and to national and regional business-to-business distributors that target the industrial maintenance, janitorial/sanitation, and automotive markets. We are a leading U.S. provider of cleaning and maintenance solutions in the direct-sales channel. Furthermore, as a result of recent acquisitions, we have established a strong presence in various industrial distribution end-markets.

Recent Developments

On October 16, 2012, we entered into a definitive agreement to purchase all of the assets of Ecolab Vehicle Care, a division of Ecolab Inc. for $120 million. Once regulatory approval is obtained, the combination of Ecolab's Vehicle Care division, Zep's existing North American sales and service vehicle wash operations, Niagara and Washtronics will create a new platform, "Zep Vehicle Care," representing approximately 12% of the Company's net sales. Zep Vehicle Care-to be based in Minnesota-will be a leading provider of vehicle care products, including soaps, polishes, sealants, wheel and tire treatments and air fresheners to professional car washes, convenience stores, auto detailers, and commercial fleet wash customers. Zep Vehicle Care will access customers through the direct and distribution channels, and will provide car, truck and fleet wash operators high efficacy products for their wash tunnels and facilities as well as retail operations. We will finance the acquisition using existing debt capacity. We will incur acquisition-related costs associated with advisory, legal and other due diligence-related services during our first and second quarters of fiscal year 2013. In addition, we will be subject to a transition services agreement during a period up to 12 months under which Ecolab will continue to provide certain services to us.

On October 10, 2012, we amended our 2010 Credit Facility in support of this anticipated acquisition. The amendment, among other things, provides that the transaction will not result in an event of default under the 2010 Credit Facility. In addition, the amendment temporarily increases the maximum leverage ratio permitted under the 2010 Credit Facility, which is the ratio of total indebtedness to EBITDA, to 4.25 to 1.00. This maximum leverage ratio limitation will decline over our next six fiscal quarters, reverting to the original ratio of 3.75 to 1.00 on June 1, 2014. The amendment also temporarily decreases the fixed charge coverage ratio permitted under the 2010 Credit Facility, which is the ratio of EBITDA to fixed charges, to 1.15 to 1.00. The fixed charge coverage ratio threshold will increase over our next six fiscal quarters, reverting to 1.25 to 1.00 on June 1, 2014.

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Acquisitions and Loan to Innovation Partner

Fiscal Years 2010 and 2011 Acquisitions

On January 4, 2010, we acquired Amrep, Inc. ("Amrep"), a specialty chemical formulator and packager focused in the automotive, fleet maintenance, industrial/maintenance and repair ("MRO") supply, institutional supply, and motorcycle markets. Amrep's products are marketed under recognized and established brand names such as Misty®, Next Dimension™, Petro®, and i-Chem®. We believe the acquisition of Amrep to be an important strategic step in our efforts to utilize distribution to expand our presence in a number of end markets while minimizing channel conflict through the manufacture of both private branded products and national brands.

On September 2, 2010, Amrep and certain of our other subsidiaries acquired certain brands and assets and assumed certain liabilities of the North American operations of Waterbury Companies, Inc. ("Waterbury"), a provider of air-care delivery systems and products for facility maintenance. We market Waterbury's products under recognized and established brand names such as TimeMist®, TimeWick®, MicrobeMax™, Country Vet®, and Konk™. We did not acquire Waterbury's manufacturing facility.

On October 1, 2010, we completed the acquisition of the brands and assets of Atlanta-based Niagara National LLC ("Niagara"), a manufacturer of truck wash systems and products. The historical total assets and operating results of Niagara are not material to our Consolidated Financial Statements. Through this acquisition, we have added the Niagara brand of custom truck wash, pressure washers, water recovery systems and maintenance chemicals to our transportation product portfolio, which includes the Zep, EnviroEdge, and Armor-All Professional® brands.

During fiscal year 2011, we completed the integration of the Amrep, Waterbury, and Niagara acquisitions. With these acquisitions now complete, we are realizing numerous synergies in the sourcing, manufacturing and delivery of our products and services, including the capability to provide single order invoicing for our customers.

Fiscal Year 2012 Acquisitions and Loan to Innovation Partner

On December 7, 2011, we completed the acquisition of the brands and certain assets of Nevada-based Washtronics of America Inc. ("Washtronics"), a pioneer of automatic truck and fleet wash systems and products in a transaction approved by the United States Bankruptcy Court. Washtronics complements Niagara's operations in the western United States, and with certain key customers. The addition of the Washtronics brand of custom truck wash, pressure washers and maintenance chemicals also expands our overall transportation product portfolio.

On January 31, 2012, we completed the acquisition of 100% of the outstanding shares of Hale Group Limited ("Hale Group"), based in the United Kingdom. Hale Group's two subsidiaries, Forward Chemicals Limited and Rexodan International Limited, manufacture and supply liquid, powder and aerosol chemicals and solutions directly to industrial and commercial laundries. This acquisition supports our strategy to expand our market access in Europe with an extended product offering.

On June 5, 2012 we completed the acquisition of 100% of the outstanding shares of Mykal Industries Limited ("Mykal"), effective June 1, 2012. Mykal, based in the United Kingdom, is a leading manufacturer of a broad range of branded and private label cleaning and degreasing products for the European retail, do-it-yourself ("DIY") and professional distribution markets.

On December 19, 2011, we entered into a $12.5 million bridge loan agreement, as lender, with Adco Products, LLC, ("Adco") as borrower. Adco, is owned by Equinox Chemicals, Inc., a specialty chemical manufacturer with specialty research, innovation, product development and commercialization capabilities that reach markets globally. We entered into the agreement as part of a plan to acquire an equity position in the borrower, which we believe will provide us with access to attractive product-innovation capabilities and new product technologies. In connection with this loan, we entered into a

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master service agreement with the borrower, pursuant to which the borrower will provide us with product-development services, and a technology sharing agreement with the borrower for access to new-product technology. The master service agreement and short-term loan agreement collectively do not provide us either ownership in or control of Adco's operations.

See Note 3 of Notes to Consolidated Financial Statements for more information regarding these events. None of our acquisition activities have affected our compliance with our debt covenants, nor have these activities affected management's belief that we will be able to meet the liquidity needs of our business over the next 12 months.

Liquidity and Capital Resources

The following table sets forth certain indicators of our consolidated financial condition and liquidity as of the end of the fiscal years shown (dollars in thousands):

                                                       2012        2011        2010
  Cash and cash equivalents                          $   3,513   $   7,219   $  25,257
  Operating working capital                            111,512     100,007      92,629
  Total debt and capital lease obligations             139,250     119,650      92,150
  Stockholders' equity                                 167,917     149,123     122,173
  Total debt-to-total capitalization (net of cash)        44.7 %      43.0 %      35.4 %

We have three principal sources of near-term liquidity: (1) existing cash and cash equivalents; (2) cash generated by operations; and (3) available borrowing capacity under our five-year senior, secured credit facility (the "2010 Credit Facility"), which provides for a maximum borrowing capacity of $313 million. As of August 31, 2012, we had approximately $64 million available under the 2010 Credit Facility. In addition, at August 31, 2012, we have $7.2 million of industrial revenue bonds outstanding that are due in 2018. Our industrial revenue bonds were issued by the City of DeSoto Industrial Development Authority, Inc. in May 1991 in connection with the construction of our facility in DeSoto, Texas. We have issued outstanding letters of credit totaling $11.0 million primarily for the purpose of providing credit support for our industrial revenue bonds, securing collateral requirements under our casualty insurance programs as well as supporting certain environmental obligations. These letters of credit were issued under the 2010 Credit Facility as of August 31, 2012, thereby reducing the total availability under the facility by such amount. As of August 31, 2012, we had $3.5 million in cash and cash equivalents of which $2.3 million was held by our foreign subsidiaries. Cash and cash equivalents held by our foreign subsidiaries averaged $13.8 million during fiscal year 2012. A significant portion of the cash held by foreign subsidiaries was utilized in the acquisitions of the Hale Group and Mykal. If in the future it becomes necessary to use all or a portion of the accumulated earnings generated by our foreign subsidiaries for our U.S. operations, we would be required to accrue and pay U.S. taxes on the funds repatriated for use within our U.S. operations. Our plans do not demonstrate a need to repatriate foreign earnings to fund our U.S. operations. Rather, our intent is to reinvest earnings generated by our foreign subsidiaries indefinitely outside of the U.S. for purposes including but not limited to growing our international operations through acquisitions. The increase of operating working capital (calculated by adding accounts receivable and inventories, and subtracting accounts payable), total debt and capital lease obligations, and total debt-to-total capitalization (net of cash) as of the end of fiscal years 2012, 2011 and 2010 reflects the effect of acquisition activity discussed throughout this Form 10-K. We were in compliance with our debt covenants as of August 31, 2012, and we believe that our liquidity and capital resources are sufficient to meet our working capital, capital expenditure and other anticipated cash requirements over the next twelve months, excluding acquisitions that we may choose to execute in pursuit of our strategic initiatives. We do not expect the sources of or intended uses for our cash to change significantly in the foreseeable future, excluding acquisitions. In addition, we have an effective shelf registration statement that registers the issuance of up to an aggregate of $200 million of equity, debt, and certain other types of securities through one or more future offerings. The net proceeds from

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the sale of any securities pursuant to the shelf registration statement may be used for general corporate purposes, which may include funding capital expenditures, pursuing growth initiatives, whether through acquisitions, joint ventures or otherwise, repaying or refinancing indebtedness or other obligations, and financing working capital.

Net debt, which is defined as Current maturities of long-term debt plus Long-term debt, less current maturities minus Cash and cash equivalents, as of August 31, 2012, was $135.7 million, an increase of $23.3 million compared with August 31, 2011. The increase in net debt primarily reflects the increased borrowings required to fund the Washtronics, Hale Group and Mykal acquisitions and our loan to our innovation partner ($24.4 million), capital expenditures during the previous twelve months ($18.4 million), and dividend payments during the previous twelve months ($3.5 million), partially offset by cash flow provided by operating activities of $22.6 million. Additional cash inflows during the year ended August 31, 2012 include proceeds from our incentive-based equity award programs.

Cash Flow

We use available cash and cash flow provided by operating activities primarily to fund operations, capital expenditures and dividend payments to stockholders. Net Cash Provided by Operating Activities for the years ended August 31, 2012 and 2011 was $22.6 million and $37.0 million, respectively. Net Cash Provided by Operating Activities during the year ended August 31, 2012, declined 38.9% from the prior year due largely to our decision to increase inventory balances ahead of our ERP system implementation, which is scheduled for our fiscal year 2013. This increase in inventory levels in fiscal year 2012 contrasts with a successful inventory reduction initiative we undertook in fiscal year 2011. Cash used to fund Accounts payable was greater in fiscal year 2012 than the previous two years due to further centralization of that function into our shared service organization. This centralization increased the number of vendors inherited from prior acquisitions whose payments are now being made in accordance with agreed upon terms, which results in improved relationships with suppliers. The timing of payments associated with our fiscal year 2012 inventory build, which began before the fourth quarter of that fiscal year, as well as third quarter fiscal year 2012 promotional activity, also affected our trade payable balances at the end of fiscal year 2012.

The $5.3 million of cash used to fund Self insurance reserves and other long-term liabilities in fiscal year 2012 reflects $1.5 million of payments made in the normal course with the earlier-described environmental remediation. Also reflected in that $5.3 million use of cash is the $1.3 million adjustment to a related remediation accrual, and a $2.5 million adjustment to an acquisition-related earnout liability necessary to state the liability in accordance with its fair market value. While these environmental and earnout-related accrual adjustments affected the Self insurance reserves and other long-term liabilities line item within our fiscal year 2012 Consolidated Statement of Cash Flows, these adjustments did not have an overall impact on Net Cash Provided by Operating Activities for our fiscal year 2012. The fiscal year 2012 $2.1 million bargain purchase gain is further discussed in Note 3 of Notes to Consolidated Financial Statements and does not represent a net use of cash. The majority of the share-based compensation expense generated through the administration of our share-based equity award programs does not affect our overall cash position. Accordingly, Net Cash Provided by Operating Activities includes approximately $3.8 million of share-based expense, which is presented as Other non-cash charges within our Consolidated Statements of Cash Flows.

We paid cash dividends on our common stock of $3.5 million, or $0.16 per share, during the twelve months ended August 31, 2012. On October 3, 2012, our Board of Directors declared a quarterly dividend of $0.04 per share payable on November 1, 2012 to stockholders of record as of October 18, 2012. Our ability to generate positive cash flow from operating activities directly affects our ability to make dividend payments. In addition, restrictions under the instruments governing our indebtedness could impair our ability to make such payments. Payments on our indebtedness and the

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quarterly dividends are expected to account for the majority of our financing activities as they pertain to normal operations.

Net Cash Provided by Operating Activities for the years ended August 31, 2011 and 2010 was $37.0 million and $34.0 million, respectively. Net Cash Provided by Operating Activities during the year ended August 31, 2011, which improved 8.7% from the prior year, was driven in part by the $17.4 million of net income generated during fiscal year 2011. Additionally, operating working capital provided $6.0 million of cash during the twelve months ended August 31, 2011. The $8.3 million use of cash reflected in the Accrued compensation and other current liabilities line item of our 2011 cash flow statement reflects the year-over-year net decreases of accrued bonuses and restructuring-related severance accruals.

Management believes that investing in assets and programs that will over time increase the overall return on our invested capital is a key factor in driving stockholder value. We invested $18.4 million and $8.9 million in fiscal years 2012 and 2011, respectively. The year-over-year increase in capital spending is primarily due to the funding of ERP implementation activities. We continue to invest in these items primarily to improve productivity and product quality, increase manufacturing efficiencies, and enhance customer service capabilities. We expect to invest approximately $10.0 million to $12.0 million in fiscal year 2013 for machinery and equipment intended to maintain and enhance our operations and future financial performance. Should the purchase of Ecolab's Vehicle Care division close as anticipated, we expect additional capital expenditures to range between $1.0 million and $2.0 million on an annual basis.

     Contractual Obligations

The following table summarizes our contractual obligations at August 31, 2012:

                                                            Payments Due by Period
                                                  Less than     1 to 3     4 to 5     After
                                       Total      One Year       Years      Years    5 Years
Total Debt(1)                        $ 139,250    $   15,000   $ 117,100   $     -   $  7,150
Interest Obligations(2)                 11,366         5,130       6,100       130          6
Operating Leases(3)                     24,638         8,370      10,938     4,155      1,175
Purchase Obligations(4)                 18,042        18,042           -         -          -
Acquisition-related Earnout
Liability(5)                             1,285            77       1,208         -          -
Other Long-term Liabilities(6)           7,275         1,876       2,194     1,222      1,983

Total(7)                             $ 201,856    $   48,495   $ 137,540   $ 5,507   $ 10,314

º (1)
º These amounts (which represent outstanding debt at August 31, 2012) are included in our Consolidated Balance Sheets. The current versus long-term presentation of our outstanding debt within these statements reflects our intent and ability to refinance certain amounts of outstanding debt that are otherwise contractually due within one year. Further detail regarding our debt instruments is provided in the preceding Liquidity and Capital Resources section as well as in Note 5 of Notes to Consolidated Financial Statements.

º (2)
º These amounts represent expected future interest payments on debt that are contractually due within one year but that we anticipate will remain outstanding for longer periods given a consistent interest rate environment as well as our ability and intent to refinance certain borrowings made under our 2010 Credit Agreement. Also included in these expected future interest payments are estimates of interest expense related to our $7.2 million industrial revenue bonds that neither mature nor are expected to be repaid before 2018.

º (3)
º Our operating lease obligations are described in Note 8 of Notes to Consolidated Financial Statements.

º (4)
º Purchase obligations include commitments to purchase goods or services that specify all significant terms. This amount is primarily composed of purchase orders that were open as of August 31, 2012.

º (5)
º This amount represents a $1.3 million acquisition-related earnout obligation whose payout is based upon the attainment of earnings targets over a three-year period.

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º (6)
º These amounts are included in our Consolidated Balance Sheets and largely represent liabilities on which we are obligated to make future payments pursuant to certain deferred compensation programs addressed within Note 7 of Notes to Consolidated Financial Statements. Estimates of the value and timing of these amounts are based on various assumptions, including interest rates and other variables.

º (7)
º At August 31, 2012, our liability recorded for uncertain tax positions, including associated interest and penalties, was approximately $1.1 million. Since the ultimate amount and timing of other potential audit related cash settlements cannot be predicted with reasonable certainty, liabilities for uncertain tax positions are excluded from the contractual obligations table above. See further discussion in Note 10 of Notes to Consolidated Financial Statements.

Basis of Presentation

We prepare our Consolidated Financial Statements, which present our financial position, results of operations, and cash flow, in accordance with U.S. generally accepted accounting principles. The financial statements and other financial information in this Form 10-K as of and for the three years ended August 31, 2012 are presented on a consolidated basis and include our accounts and those of our majority-owned subsidiaries. We consolidate all entities that we control. The general condition for control is ownership of a majority of the voting interests of an entity. Control may also exist in arrangements where we are the primary beneficiary of a variable interest entity ("VIE"). An entity that will have both the power to direct the activities that most significantly impact the economic performance of the VIE and the obligation to absorb the losses or receive the benefits significant to the VIE is considered a primary beneficiary of that entity. We have determined that we are not a primary beneficiary in any material VIE.

We include shipping and handling fees billed to customers in Net Sales. Shipping and handling costs associated with inbound freight and freight between manufacturing facilities are generally recorded in Cost of Products Sold, which also includes the cost normally incurred in acquiring and producing inventory for sale, purchasing and receiving costs, and inspection costs. Certain customer-related shipping and handling costs, as well as other distribution costs, are included in Selling, Distribution, and Administrative Expenses. We believe this presentation is consistent with many of our peers and competitors. However, we acknowledge that our gross profit amounts may not be comparable to certain other entities, as some entities may include all of the costs related to their distribution network in their cost of products sold. Customer-related shipping and handling costs included within our Selling, Distribution, and Administrative Expenses totaled $42.3 million, $42.4 million, and $36.0 million for the fiscal years ended August 31, 2012, 2011, and 2010, respectively. Other distribution costs, which primarily consist of the cost of warehousing finished goods inventory, totaled $23.1 million, $22.0 million, and $21.0 million for the fiscal years ended August 31, 2012, 2011, and 2010, respectively.

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Results of Operations

     Fiscal Year 2012 Compared with Fiscal Year 2011

The following table sets forth information comparing the components of net
income for the year ended August 31, 2012 with the year ended August 31, 2011.
Both dollar and percentage changes included within the tables below were
calculated from our Consolidated Statements of Income:

                                                  Years Ended
           (Dollars in millions)                  August 31,        Percent
                                                2012      2011      Change
           Net Sales                           $ 653.5   $ 646.0         1.2 %
           Gross Profit                          300.8     302.9        (0.7 )%
           Percent of net sales                   46.0 %    46.9 %
           Operating Profit                       38.3      33.2        15.2 %
           Percent of net sales                    5.9 %     5.1 %
           Income before Provision for Taxes      33.8      26.7        26.8 %
           Percent of net sales                    5.2 %     4.1 %
           Net Income                          $  21.9   $  17.4        25.9 %

Net Sales

Net Sales totaled $653.5 million for the year ended August 31, 2012, compared with $646.0 million in the prior fiscal year, an increase of $7.6 million or 1.2%. Higher selling prices contributed $16.5 million in revenue during fiscal year 2012. We implemented these price increases to mitigate the increased cost of our raw materials. Net Sales in fiscal year 2012 reflected strong growth with our automotive aftermarket, home improvement retail, vehicle wash, and industrial maintenance and repair customers. In addition, acquired revenues added $7.6 million to Net Sales during fiscal year 2012. Excluding revenues derived from our recent acquisitions, we experienced volume related sales declines of $12.2 million during fiscal year 2012. These declines resulted primarily from weakness in demand for our products sold through the sales and service channel and for janitorial and sanitation products sold through the distribution channel. Fluctuation in foreign currencies negatively affected Net Sales in fiscal year 2012 by $4.4 million.

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