NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
1.The Company and Basis of Presentation
AZZ Inc. (“AZZ”, the “Company”, "our" or “we”) was established in 1956 and incorporated under the laws of the state of Texas. The Company is a global provider of metal coating solutions, coil coating solutions, welding solutions, specialty electrical equipment and highly engineered services to the power generation, transmission, distribution, refining and industrial markets.
On May 13, 2022, the Company completed the acquisition of the Precoat Metals business division (“Precoat”) of Sequa Corporation (“Sequa”), a portfolio company of global investment firm Carlyle (the "Precoat Acquisition"). See Note 2 for further discussion about the Precoat Acquisition. As a result of the Precoat Acquisition, the Company had a change to its reportable segments, and added Precoat Metals as a new reportable segment. See Note 5.
The Company has three distinct operating segments: the Metal Coatings segment, the Precoat Metals segment and the Infrastructure Solutions segment. AZZ Metal Coatings provides hot-dip galvanizing, spin galvanizing, powder coating, anodizing and plating, and other metal coating applications to the steel fabrication and other industries through 41 galvanizing plants and six surface technologies facilities located in the United States and Canada. AZZ Precoat Metals provides advanced applications of protective and decorative coatings and related value-added services for steel and aluminum coil primarily serving the construction; appliance; heating, ventilation, and air conditioning (HVAC); container; transportation and other end markets. AZZ Precoat Metals operates through 13 facilities located in the United States. AZZ Infrastructure Solutions is dedicated to delivering safe and reliable transmission of power from generation sources to end customers, and automated weld overlay solutions for corrosion and erosion mitigation to critical infrastructure in markets worldwide.
Presentation
The accompanying condensed consolidated balance sheet as of February 28, 2022 was derived from audited financial statements, and the unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) for interim financial information and in accordance with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by U.S. GAAP for complete consolidated financial statements. These financial statements should be read in conjunction with the audited financial statements and related notes for the fiscal year ended February 28, 2022, included in the Company’s Annual Report on Form 10-K covering such period.
The Company's fiscal year ends on the last day of February and is identified as the fiscal year for the calendar year in which it ends. For example, the fiscal year ending February 28, 2022 is referred to as fiscal 2022.
In the opinion of management, the accompanying unaudited condensed consolidated financial statements include all adjustments, consisting only of normal recurring adjustments, which are necessary to present fairly the financial position of the Company as of May 31, 2022, the results of its operations for the three months ended May 31, 2022 and 2021, and cash flows for the three months ended May 31, 2022 and 2021. The interim results reported herein are not necessarily indicative of results for a full year.
Coronavirus (COVID-19)
The continued uncertainty associated with COVID-19, and any of the ongoing variants, did not have a material adverse effect on the Company's results of operations for the three months ended May 31, 2022. While the Company continues to support its customers, there remains uncertainties regarding the duration and, to what extent, if any, that the COVID-19 pandemic, or newly identified variants, or additional regulatory requirements, will ultimately have on the demand for the Company's products and services or with its supply chain or its employees.
The impact of COVID-19 to the Company's personnel and operations has been limited. During the first quarter of fiscal 2023, the Company continued to see improvement in sales and operating income in both the Metal Coatings and Infrastructure Solutions operating segments. In addition, the Precoat Metals segment, which was acquired in the first quarter of fiscal 2023, was not materially impacted by COVID-19. However, labor market and supply chain challenges have increased during the current quarter, resulting in increased operating expenses as the constrained labor market and supply chain disruptions impacted the availability and cost of labor and materials. We cannot reasonably estimate the severity of this pandemic or the government's mandates regarding the same, or the extent to which the disruption may materially impact our consolidated balance sheets, statements of income or statements of cash flows for fiscal year 2023 or beyond.
Recently Adopted Accounting Pronouncements
In October 2021, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update No. ("ASU") 2021-08, Business combinations (Topic 805): Accounting for Contract Assets and Contract liabilities from Contracts with Customers (ASU 2021-08"), which requires contract assets and contract liabilities acquired in a business combination in accordance with ASC Topic 606, Revenue from Contracts with Customers ("ASC 606") at the acquisition date as if the acquirer had originated the contracts rather than adjust them to fair value. The standard is effective for fiscal years beginning after December 15, 2022, including interim periods within those fiscal years. The Company adopted ASU 2021-08 during the first quarter of fiscal 2023. The adoption of ASU 2021-08 did not have a material impact on the Company's financial condition, results of operations or cash flows as of May 31, 2022, including the acquisition of Precoat Metals during the first quarter of fiscal 2023.
In March 2020 and as clarified in January 2021, the FASB issued ASU 2020-04, Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting (“ASU 2020-04”), which provides optional expedients and exceptions for applying GAAP to contracts, hedging relationships, and other transactions affected by the discontinuation of the London Interbank Offered Rate (“LIBOR”) or by another reference rate expected to be discontinued. An entity may elect to apply the amendments on a full retrospective basis as of any date from the beginning of an interim period that includes or is subsequent to March 12, 2020, or on a prospective basis to new modifications from any date between March 12, 2020 and December 31, 2022. The Company continues to evaluate its contracts and transactions for the potential application of ASU 2020-04, but there has been no material impact to its financial condition, results of operations, or cash flows as of May 31, 2022.
2. Acquisitions
Precoat Acquisition
On May 13, 2022, the Company completed the acquisition of the Precoat Metals business division (“Precoat”) of Sequa Corporation (“Sequa”), a portfolio company of global investment firm Carlyle, for a purchase price of approximately $1.3 billion (the "Precoat Acquisition"). Headquartered in St. Louis, Missouri, Precoat is the leading independent provider of metal coil coating solutions in North America. Precoat engages in the advanced application of protective and decorative coatings and related value-added services for steel and aluminum coil primarily serving the construction; appliance; heating, ventilation and air conditioning (HVAC); container; transportation and other end markets. The acquisition represents a continued transition of the Company from a diverse holding company to a focused provider of coating and galvanizing services for critical applications.
The Precoat Acquisition was funded primarily with proceeds from the Term Loan B. See Note 7 for a description of the Term Loan B. The Company incurred acquisition costs of $11.5 million for the three months ended May 31, 2022, which are included in Selling, general and administrative expense in the accompanying condensed consolidated statements of operations. Precoat Metals contributed revenue of $43.7 million and operating income of $6.6 million to the Company's condensed consolidated statements of operations from May 13, 2022, through May 31, 2022.
The Company accounted for the Precoat Acquisition as a business combination under the acquisition method of accounting. Goodwill from the acquisition of $534.6 million represents the excess purchase price over the estimated value of net tangible and intangible assets and liabilities assumed, and is expected to be deductible for income tax purposes. The Company's chief operating decision maker will assess performance and allocate resources to Precoat separately from the Metal Coatings and Infrastructure Solutions segments; therefore, Precoat will be accounted for as a separate segment, the Precoat Metals segment. See Note 5 for more information about the Company's segments. Goodwill from the acquisition was allocated to the Precoat Metals segment. Assets acquired and liabilities assumed in the Precoat Acquisition were recorded at their estimated fair values as of the acquisition date.
The Company has not finalized these estimates; therefore, the fair value estimates set forth below are subject to adjustment during the measurement period following the acquisition date. The final allocation of purchase consideration could include changes in the estimated fair value of working capital (including accounts receivable, inventories, contract assets, prepaid assets, account payable and accrued liabilities), right-of-use assets and lease liabilities, property, plant and equipment, intangible assets, deferred tax liabilities and other long-term liabilities. Adjustments in the purchase price allocation may require a change in the amount allocated to goodwill during the period in which the adjustments are determined.
When determining the fair values of assets acquired and liabilities assumed, management made significant estimates, judgments and assumptions. The Company has engaged third-party valuation experts to assist in the purchase price allocation, the recorded valuation of property and equipment, intangible assets, pension benefit obligation and certain other assets and liabilities. Preliminary estimates from third-party experts along with the analysis and expertise of management have formed the basis for the preliminary allocation. Detailed analysis and review of the condition, existence and utility of assets acquired, and assumptions inherent in the estimation of fair value of intangible assets and pension obligation is currently ongoing. Management believes that the current information provides a reasonable basis for estimating fair values of assets acquired and liabilities assumed. These
estimates, judgments and assumptions are subject to change and should be treated as preliminary values as there could be significant changes upon final valuation. The Company expects to complete the final valuations within one year of the acquisition date.
The following table represents the preliminary summary of the assets acquired and liabilities assumed, in aggregate, related to the Precoat Acquisition, as of the date of the acquisition (in thousands):
| | | | | | | | |
| | May 13, 2022 |
| Assets | | |
| | |
| Accounts receivable | | $ | 77,422 | |
| Inventories | | 44,309 | |
| Contract assets | | 70,731 | |
| Prepaid expenses and other | | 2,245 | |
| Property, plant and equipment | | 262,154 | |
| Right-of-use asset | | 10,954 | |
| Goodwill | | 534,599 | |
| Intangibles and other assets | | 513,546 | |
| Total fair value of assets acquired | | $ | 1,515,960 | |
| Liabilities | | |
| Accounts payable | | $ | (99,223) | |
| Accrued expenses | | (31,891) | |
| Other accrued liabilities | | (3,741) | |
| Customer deposits | | (1,574) | |
| Lease liability, short-term | | (1,706) | |
| Lease liability, long-term | | (9,248) | |
| Deferred tax liabilities | | (3,100) | |
| Other long-term liabilities | | (66,247) | |
| Total fair value of liabilities assumed | | (216,730) | |
| Total Purchase Price, net of cash acquired | | $ | 1,299,230 | |
DAAM Acquisition
On February 28, 2022, the Company entered into an agreement to acquire all the outstanding shares of DAAM Galvanizing Co. Ltd. ("DAAM"), a privately held hot-dip galvanizing company based in Edmonton, Alberta Canada, for approximately $35.5 million. DAAM currently operates two galvanizing facilities in Canada; one located in Edmonton, Alberta and a second in Saskatoon, Saskatchewan, as well as a service depot in Calgary, Alberta. The addition of DAAM expanded the Company's geographical coverage in the Northwest and enhanced the scope of metal coatings solutions in Canada. The business is included in the Company's Metal Coatings segment. The goodwill arising from this acquisition was allocated to the Metal Coatings segment the Company estimates that approximately 50% of the goodwill amount is expected to be deductible for income tax purposes.
The Company has engaged third-party valuation experts to assist in the purchase price allocation, the recorded valuation of property and equipment, intangible assets and certain other assets and liabilities. Preliminary estimates from third-party experts along with the analysis and expertise of management have formed the basis for the preliminary allocation. As of May 31, 2022, the purchase price allocation for certain assets acquired has not been finalized, including property, plant and equipment and intangible assets. As such, the fair values of the assets acquired and liabilities assumed should be treated as preliminary values as there could be significant changes upon final valuation.
The following table represents the preliminary summary of the assets acquired and liabilities assumed, in aggregate, related to the DAAM acquisition, as of the date of the acquisition (in thousands):
| | | | | | | | |
| | February 28, 2022 |
| Assets | | |
| Accounts receivable | | $ | 4,586 | |
| Inventories | | 3,119 | |
| Prepaid and other assets | | 23 | |
| Property, plant and equipment | | 14,436 | |
| Goodwill | | 24,369 | |
| Liabilities | | |
| Accounts payable and other accrued liabilities | | (7,437) | |
| Deferred tax liabilities | | (3,596) | |
| Total purchase price | | $ | 35,500 | |
Unaudited Pro Forma Information
The following unaudited pro forma financial information for the three months ended May 31, 2022 and 2021 combines the historical results of the Company and the acquisitions of Precoat Metals and DAAM, assuming that the companies were combined as of March 1, 2021 and include business combination accounting effects from the Precoat Acquisition, including amortization charges from acquired intangible assets, depreciation expense on acquired property, plant and equipment, interest expense on the financing transactions used to fund the Precoat Acquisition, acquisition-related transaction costs and tax-related effects. The pro forma information as presented below is for informational purposes only and is not indicative of the results of operations that would have been achieved if the acquisitions of Precoat Metals and DAAM had taken place on March 1, 2021 or of future operating performance.
| | | | | | | | | | | | | | |
| | Three Months Ended May 31, |
| | 2022 | | 2021 |
| Revenue | | $ | 507,418 | | | $ | 407,087 | |
| Net income | | $ | 25,774 | | | $ | 16,191 | |
3. Earnings Per Share
Basic earnings per share is computed by dividing net income by the weighted average number of common shares outstanding during the period. Diluted earnings per share is calculated by giving effect to the potential dilution that could occur if stock awards vested and were converted into common shares during the period.
The following table sets forth the computation of basic and diluted earnings per share (in thousands, except per share data):
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| | | Three Months Ended May 31, | | |
| | | 2022 | | 2021 | | | | |
| Numerator: | | | | | | | | |
| Net income | | $ | 24,077 | | | $ | 22,337 | | | | | |
| After-tax interest expense for Convertible Notes | | 547 | | | — | | | | | |
| Numerator for diluted earnings per share | | $ | 24,624 | | | $ | 22,337 | | | | | |
| Denominator: | | | | | | | | |
| Weighted average shares outstanding for basic earnings per share | | 24,709 | | | 25,051 | | | | | |
| Effect of dilutive securities: | | | | | | | | |
| Employee and director stock awards | | 161 | | | 219 | | | | | |
| Convertible Notes | | 805 | | | — | | | | | |
| Denominator for diluted earnings per share | | 25,675 | | | 25,270 | | | | | |
| Earnings per share basic and diluted: | | | | | | | | |
| Basic earnings per share | | $ | 0.97 | | | $ | 0.89 | | | | | |
| Diluted earnings per share | | $ | 0.96 | | | $ | 0.88 | | | | | |
For the three months ended May 31, 2022 and 2021, 81,647 and 154,259 shares, respectively, were excluded from the calculation of diluted earnings per share because the effect would be antidilutive. These shares could be dilutive in future periods.
4. Sales
Disaggregated Sales
The following table presents disaggregated sales by customer industry (in thousands):
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| | | Three Months Ended May 31, | | |
| | | 2022 | | 2021 | | | | |
| Sales: | | | | | | | | |
| Industrial (General industry, Oil & Gas and Construction) | | $ | 207,502 | | | $ | 153,983 | | | | | |
| Transmission and distribution | | 72,312 | | | 43,667 | | | | | |
| Power generation | | 34,584 | | | 32,176 | | | | | |
| Total sales | | $ | 314,398 | | | $ | 229,826 | | | | | |
See Note 5 for sales information by segment.
Contract Liabilities
The timing of sales recognition, billings and cash collections results in accounts receivable, contract assets (unbilled receivables), and contract liabilities (customer advances and deposits) on the consolidated balance sheets, primarily related to the Infrastructure Solutions and Precoat Metals segments. Amounts are billed as work progresses, in accordance with agreed upon contractual terms, either at periodic intervals (e.g., weekly or monthly) or upon the achievement of contractual milestones. Billing can occur subsequent to sales recognition, resulting in contract assets. In addition, the Company sometimes receives advances or deposits from customers, before sales are recognized, resulting in contract liabilities. These assets and liabilities are reported on the consolidated balance sheets on a contract-by-contract basis at the end of each reporting period.
The following table shows the changes in contract liabilities for the three months ended May 31, 2022 and 2021, respectively (in thousands):
| | | | | | | | | | | | | | |
| | 2022 | | 2021 |
| Balance at February 28, | | $ | 42,465 | | | $ | 16,138 | |
| Contract liabilities added during the period | | 36,674 | | | 12,375 | |
| Sales recognized during the period | | (39,457) | | | (11,415) | |
| Balance at May 31, | | $ | 39,682 | | | $ | 17,098 | |
The Company did not record any sales for the three months ended May 31, 2022 or 2021 related to performance obligations satisfied in prior periods. The Company expects to recognize sales, related to the $39.7 million balance of contract liabilities as of May 31, 2022 of approximately $32.1 million, $7.4 million, $0.1 million and $0.1 million in fiscal 2023, 2024, 2025 and 2026, respectively.
5. Operating Segments
Segment Information
The Company has three distinct operating segments: the Metal Coatings segment, the Precoat Metals segment and the Infrastructure Solutions segment. The Metal Coatings segment provides hot-dip galvanizing, spin galvanizing, powder coating, anodizing and plating, and other metal coating applications to the steel fabrication and other industries through facilities located throughout the United States and Canada. Hot-dip galvanizing is a metallurgical process in which molten zinc reacts to steel. The zinc alloying provides corrosion protection and extends the life-cycle of fabricated steel for several decades.
The Precoat Metals segment provides aesthetic and corrosion protective coatings and related value-added services for steel and aluminum coil primarily serving the construction; appliance; heating, ventilation, and air conditioning (HVAC); container; transportation and other end markets in the United States.
The Infrastructure Solutions segment provides specialized products and services designed to support primarily industrial and electrical applications. The product offerings include custom switchgear, electrical enclosures, medium and high voltage bus ducts, explosion proof and hazardous duty lighting and tubular products. The Infrastructure Solutions segment also focuses on life-cycle extension for the power generation, refining and industrial infrastructure, through providing automated weld overlay solutions for corrosion and erosion mitigation.
Sales and operating income by segment for each period were as follows (in thousands):
| | | | | | | | | | | | | | | | | | |
| | | Three Months Ended May 31, | | |
| | | 2022 | | 2021 | | | | |
| Sales: | | | | | | | | |
| | | | | | | | |
| Metal Coatings | | $ | 160,846 | | | $ | 127,735 | | | | | |
| Precoat Metals | | 43,691 | | | — | | | | | |
Infrastructure Solutions | | 109,861 | | | 102,091 | | | | | |
| Total sales | | $ | 314,398 | | | $ | 229,826 | | | | | |
| | | | | | | | |
| Operating income: | | | | | | | | |
| Metal Coatings | | $ | 44,435 | | | $ | 31,576 | | | | | |
| Precoat Metals | | 6,648 | | | — | | | | | |
Infrastructure Solutions | | 12,851 | | | 9,624 | | | | | |
| Corporate | | (24,024) | | | (10,488) | | | | | |
| Total operating income | | $ | 39,910 | | | $ | 30,712 | | | | | |
Asset balances by segment for each period were as follows (in thousands):
| | | | | | | | | | | | | | |
| | May 31, 2022 | | February 28, 2022 |
| Total assets: | | | | |
| Metal Coatings | | $ | 594,207 | | | $ | 575,088 | |
| Precoat Metals | | 1,538,809 | | | — | |
| Infrastructure Solutions | | 526,311 | | | 525,086 | |
| Corporate | | 122,965 | | | 32,854 | |
| Total | | $ | 2,782,292 | | | $ | 1,133,028 | |
Financial Information About Geographical Areas
The following table presents sales by geographic region for each period (in thousands):
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| | | Three Months Ended May 31, | | |
| | | 2022 | | 2021 | | | | |
| Sales: | | | | | | | | |
| United States | | $ | 281,589 | | | $ | 191,116 | | | | | |
| International | | 32,809 | | | 38,710 | | | | | |
| Total | | $ | 314,398 | | | $ | 229,826 | | | | | |
The following table presents fixed assets by geographic region for each period (in thousands):
| | | | | | | | | | | | | | |
| | May 31, 2022 | | February 28, 2022 |
| Property, plant and equipment, net: | | | | |
| United States | | $ | 456,409 | | | $ | 194,539 | |
| Canada | | 25,900 | | | 26,264 | |
| Other countries | | 9,413 | | | 10,045 | |
| Total | | $ | 491,722 | | | $ | 230,848 | |
6. Warranty Reserves
A reserve has been established to provide for the estimated future cost of warranties on certain delivered products. The warranty accrual is included in "Other accrued liabilities" on the condensed consolidated balance sheets. Management monitors established reserves and adjusts warranty estimates based upon the progression of resolution activities with the Company's customers. Warranties typically cover non-conformance to customer specifications or defects in material and workmanship.
The following table shows the changes in warranty reserves for the three months ended May 31, 2022 and 2021 (in thousands):
| | | | | | | | | | | |
| Three Months Ended May 31, |
| 2022 | | 2021 |
| Beginning balance | $ | 3,686 | | | $ | 4,079 | |
| Warranty costs incurred | (721) | | | (112) | |
| Amounts charged to income (expense) | (152) | | | 170 | |
| Acquisitions | 1,662 | | | — | |
| Ending balance | $ | 4,475 | | | $ | 4,137 | |
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7. Debt
The Company's debt consisted of the following for each of the periods presented (in thousands):
| | | | | | | | | | | |
| May 31, 2022 | | February 28, 2022 |
| Revolving Credit Facility | $ | — | | | $ | 77,000 | |
| 2020 Senior Notes | 150,000 | | | 150,000 | |
| Term Loan B | 1,300,000 | | | — | |
| Convertible Notes | 240,000 | | | — | |
| Total debt, gross | 1,690,000 | | | 227,000 | |
| Unamortized debt issuance costs | (82,223) | | | (516) | |
| Total debt, net | 1,607,777 | | | 226,484 | |
| Less amount due within one year | (13,000) | | | — | |
| Total debt due after one year, net | $ | 1,594,777 | | | $ | 226,484 | |
2021 Credit Agreement
On July 8, 2021, the Company entered into a five-year unsecured revolving credit facility under a credit agreement, by and among the Company, borrower, Citibank, N.A., as administrative agent and the other agents and lender parties thereto (the “2021 Credit Agreement”). The 2021 Credit Agreement matures in July 2026 and includes the following significant terms;
i.provides for a senior unsecured revolving credit facility with a principal amount of up to $400.0 million of revolving loan commitments, and includes an additional $200.0 million uncommitted incremental accordion facility;
ii.interest rate margin ranges from 87.5 bps to 175 bps for Eurodollar Rate loans, and from 0.0 bps to 75 bps for Base Rate loans, depending on the leverage ratio of the Company and its consolidated subsidiaries as a group;
iii.includes a letter of credit sub-facility up to $85.0 million for the issuance of standby and commercial letters of credit;
iv.includes a $50.0 million sublimit for swing line loans;
v.includes customary representations and warranties, affirmative covenants and negative covenants, and events of default; including restrictions on incurrence of non-ordinary course debt, investment and dividends, subject to various exceptions, carve-outs and baskets, and;
vi.includes a maximum leverage ratio financial covenant and an interest coverage ratio financial covenant, each to be tested at quarter end;
On May 13, 2022, the 2021 Credit Agreement was repaid with proceeds from the 2022 Credit Agreement, which is described below.
2022 Credit Agreement and Term Loan B
On May 13, 2022, the Company replaced 2021 Credit Agreement with a new Credit Agreement (the "2022 Credit Agreement") by and among the Company, borrower, Citibank, N.A., as administrative and collateral agent, and the other agents and lender parties thereto the 2022 Credit Agreement. The 2022 Credit Agreement includes the following significant terms;
i.provides for a senior secured initial term loan in the aggregate principal amount of $1.3 billion (the "Term Loan B"), due May 13, 2029, which is secured by substantially all of the assets of the Company;
ii.provides for a senior secured revolving credit facility in the aggregate principal amount of $400.0 million (the "Revolving Credit Facility"), due May 13, 2027;
iii.includes a letter of credit sub-facility of up to $100.0 million, which is part of, and not in addition to, the Revolving Credit Facility;
iv.borrowings under the Term Loan B and the Revolving Credit Facility each bear an interest rate of Secured Overnight Financing Rate ("SOFR") plus 4.25%;
v.includes customary affirmative and negative covenants, and events of default; including restrictions on the incurrence of non-ordinary course debt, investment and dividends, subject to various exceptions;
vi.includes a maximum quarterly leverage ratio financial covenant and an interest coverage ratio financial covenant;
The proceeds of the advances under the Revolving Credit Facility will be utilized primarily to finance working capital needs, capital improvements, dividends, acquisitions and for general corporate purposes. The proceeds of the Term Loan B were used to finance a portion of the Precoat Acquisition, pay transaction-related costs owed under the Securities Purchase Agreement (defined below) and refinance certain prior indebtedness, including the repayment of outstanding borrowings under the 2021 Credit Agreement. The proceeds were also utilized to redeem 100% of the Company’s 2020 Senior Notes on June 6, 2022.
Outstanding principal of the Term Loan B is payable on the last business day of each May, August, November and February, beginning August 31, 2022, in a quarterly aggregate principal amount of $3.25 million, with the entire remaining principal amount due on May 13, 2029, the maturity date.
The effective interest rate for the 2022 Credit Facility and the Term Loan B was 4.91% at May 31, 2022.
The Company's credit agreement requires the Company to maintain a maximum Total Net Leverage Ratio (as defined in the loan agreement) no greater than 6.25 through November 2022. For each subsequent quarter, the maximum ratio decreases by 25 basis points through May 31, 2024, when the maximum Total Net Leverage Ratio reaches 4.5.
Convertible Subordinated Notes
On May 13, 2022, the Company completed the issuance of $240.0 million aggregate principal amount of 6.00% convertible subordinated notes due June 30, 2030 (the "Convertible Notes"). Interest on the Convertible Notes is payable semi-annually, on June 30 and December 31.
The Convertible Notes are convertible by the holder thereof at any time into shares of the Company's common stock at a price equal to a 25% premium to the volume-weighted average price of the Company's common stock over the trailing 30 trading days prior to the issuance date of the Convertible Notes. The Convertible Notes are exchangeable for 240,000 shares of the Company's 6.0% Series A Convertible Preferred Stock, subject to shareholder approval for the issuance of preferred shares. If exchanged, the Series A Preferred Stock will be convertible by the holder at any time into shares of the Company's common stock at a price equal to a 25% premium to the volume-weighted average price of the Company's common stock over the trailing 30 trading days, prior to the issuance date of the Convertible Notes. In addition, the Series A Preferred Stock will be subject to a minimum conversion threshold of 1,000 shares per conversion, and customary anti-dilution and dividend adjustments.
The Company used the proceeds of the Convertible Notes to fund the Company’s Precoat Acquisition.
The Company's debt agreements requires the Company to maintain certain affirmative and negative covenants. As of May 31, 2022, the Company was in compliance with all covenants and other requirements set forth in the debt agreements.
8. Leases
The Company is a lessee under various leases for facilities and equipment. As of May 31, 2022, the Company was the lessee for 153 operating leases with terms of 12 months or more and 12 finance leases. Many of the operating leases either have renewal options of between one and five years or convert to month-to-month agreements at the end of the specified lease term.
The Company’s operating leases are primarily for (i) operating facilities, (ii) vehicles and equipment used in operations, (iii) facilities used for back-office functions and (iv) equipment used for back-office functions. The majority of the Company’s long-term lease expenses are at fixed prices.
Leases with an initial term of 12 months or less are not recorded on the consolidated balance sheets and the Company recognizes lease expense for these leases on a straight-line basis over the lease term. The Company has a significant number of short-term leases, including month-to-month agreements, some of which continue in perpetuity until the lessor or the Company terminates the lease agreement. The Company's short-term lease agreements include expenses incurred hourly, daily, monthly and for other durations for a time period of one year or less.
The Company’s future lease commitments as of May 31, 2022 do not reflect all of the Company’s short-term lease commitments.
The following table outlines the classification of the Company's right-of-use assets and lease liabilities in the consolidated balance sheets as of May 31, 2022 and fiscal year end 2022 (in thousands):
| | | | | | | | | | | | | | | | | |
| Balance Sheet | Classification | | May 31, 2022 | | February 28, 2022 |
| Assets | | | | | |
| Right-of-use assets | Right-of-use assets | | $ | 51,909 | | | $ | 43,286 | |
| Liabilities | | | | | |
| Operating lease liabilities ― ST | Lease liability - short-term | | 8,786 | | | 7,140 | |
| Operating lease liabilities ― LT | Lease liability - long-term | | 41,978 | | | 34,965 | |
| Finance lease liabilities ― ST | Lease liability - short-term | | 189 | | | 178 | |
| Finance lease liabilities ― LT | Lease liability - long-term | | 625 | | | 645 | |
Supplemental information related to the Company's portfolio of operating leases was as follows (in thousands):
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| Three Months Ended May 31, | | |
| 2022 | | 2021 | | | | |
| Operating cash flows from operating leases included in lease liabilities | $ | 2,419 | | | $ | 2,299 | | | | | |
| Lease liabilities obtained from new ROU assets - operating | 11,070 | | | 12,661 | | | | | |
| Operating and financing cash flows from financing leases included in lease liabilities | 52 | | | 18 | | | | | |
| Lease liabilities obtained from new ROU assets - financing | 38 | | | — | | | | | |
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| May 31, 2022 | | February 28, 2022 |
| Weighted-average remaining lease term - operating leases (years) | 7.28 | | 7.90 |
| Weighted-average discount rate - operating leases | 4.48 | % | | 4.56 | % |
| Weighted-average remaining lease term - financing leases (years) | 4.48 | | 4.73 |
| Weighted-average discount rate - financing leases | 2.99 | % | | 2.95 | % |
The following table outlines the classification of lease expense in the statements of income (in thousands):
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| Three Months Ended May 31, | | |
| 2022 | | 2021 | | | | |
| Cost of sales | $ | 3,226 | | | $ | 2,546 | | | | | |
| Selling, general and administrative | 946 | | | 1,130 | | | | | |
| Total lease expense | $ | 4,172 | | | $ | 3,676 | | | | | |
As of May 31, 2022, maturities of the Company's lease liabilities were as follows (in thousands):
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| Fiscal year: | | Operating Leases | | Finance Leases | | Total |
| 2023 | | $ | 8,254 | | | $ | 158 | | | $ | 8,412 | |
| 2024 | | 10,144 | | | 211 | | | 10,355 | |
| 2025 | | 9,155 | | | 203 | | | 9,358 | |
| 2026 | | 7,608 | | | 139 | | | 7,747 | |
| 2027 | | 6,815 | | | 111 | | | 6,926 | |
| Thereafter | | 17,851 | | | 46 | | | 17,897 | |
| Total lease payments | | 59,827 | | | 868 | | | 60,695 | |
| Less imputed interest | | (9,064) | | | (53) | | | (9,117) | |
| Total | | $ | 50,763 | | | $ | 815 | | | $ | 51,578 | |
9. Income Taxes
The provision for income taxes reflects an effective tax rate of 23.9% for the three months ended May 31, 2022, compared to 25.5% for the three months ended May 31, 2021. The decrease in the effective tax rate was primarily attributable to unfavorable adjustments recorded in the prior year comparable period, related to uncertain tax positions.
10. Equity
On November 10, 2020, the Company's Board of Directors authorized a $100 million share repurchase program pursuant to which the Company may repurchase its Common Stock (the “2020 Share Authorization”). Repurchases under the 2020 Share Authorization will be made through open market and/or private transactions, in accordance with applicable federal securities laws, and could include repurchases pursuant to Rule 10b5-1 trading plans, which allows stock repurchases when the Company might otherwise be precluded from doing so.
During the three months ended May 31, 2022, to prioritize repayments of debt, including debt incurred to finance the Precoat Acquisition, the Company did not repurchase shares of common stock under the 2020 Share Authorization. During the three months ended May 31, 2021, the Company repurchased 125,770 shares of common stock for $6.3 million, or $49.80 per share.
11. Defined Benefit Pension Plan
In the Company's Precoat Metals segment, certain employees of the Company participate in a defined benefit pension plan sponsored and administered by the Company. The pension plan calls for benefits to be paid to eligible employees at retirement, based primarily upon years of service and compensation rates near retirement. In conjunction with the acquisition of Precoat Metals, the Company assumed an accumulated benefit obligation in excess of related plan assets associated with the defined benefit pension plan of $44.9 million, which is included in "Other long-term liabilities" in the consolidated balance sheets. See Note 2 for a discussion of the acquisition of Precoat Metals.
12. Assets Held for Sale
The Company has been executing on its plan to divest certain non-core businesses. The strategic decision to divest these businesses reflects the Company's long-term strategy to become a predominantly metal coatings focused company. The historical annual sales, operating profit and net assets of these businesses were not significant enough to qualify as discontinued operations.
As of May 31, 2022, one non-operating location in our Metal Coatings segment remains classified as held for sale. The assets of the business include property, plant and equipment of $0.2 million. The assets of the business are expected to be disposed of within the next twelve months and are included in "Assets held for sale" in the accompanying consolidated balance sheets.
13. Commitments and Contingencies
Legal
The Company and its subsidiaries are named defendants and plaintiffs in various routine lawsuits incidental to its business. These proceedings include labor and employment claims, worker’s compensation, environmental matters, and various commercial disputes, all of which arise in the normal course of conducting business. As discovery progresses on all outstanding legal matters, the Company will continue to evaluate opportunities to either settle the disputes for nuisance value or potentially enter into mediation as a way to resolve the disputes prior to trial. As the pending cases progress through additional discovery, including expert testimony and mediation, our assessment of the likelihood of an unfavorable outcome on one or more of the pending lawsuits may change. The outcome of these lawsuits or other proceedings cannot be predicted with certainty, and the amount of any potential liability that could arise with respect to such lawsuits or other matters cannot be predicted at this time. Management, after consultation with legal counsel, believes it has strong defenses to all of these matters and does not expect liabilities, if any, from these claims or proceedings, either individually or in the aggregate, to have a material effect on the Company’s financial position, results of operations or cash flows.
Environmental
The Company assumed certain environmental liabilities as part of the Precoat Acquisition described in Note 2. The preliminary estimated fair value of these liabilities was $22.2 million, of which $1.7 million is classified as current. Environmental remediation liabilities include costs directly associated with site investigation and clean up, such as materials, external contractor costs, legal and consulting expenses and incremental internal costs directly related to the remedy. Estimates used to record environmental remediation liabilities are based on the Company's best estimate of probable future costs based on site-specific facts and circumstances known at the time of the estimate and these estimates are updated on a quarterly basis. Estimates of the cost for the likely remedy are developed using internal resources or by third-party environmental engineers or other service providers. The Company records the environmental remediation liabilities that represent the points in the range of estimates that are most probable, or the minimum amount when no amount within the range is a better estimate than any other amount.
The Company accrues the anticipated cost of environmental remediation when the obligation is probable and can be reasonably estimated. While any revisions could be material to the operating results of any fiscal quarter or fiscal year, the Company does not expect such additional expenses would have a material adverse effect on its liquidity or financial condition.
14. Subsequent Event
On June 23, 2022, The Company and Fernweh Group LLC ("Fernweh"), jointly entered into a definitive agreement whereby AZZ will contribute its AZZ Infrastructure Solutions Segment (“AIS”) to AIS Investment Holdings LLC (the “AIS JV”), and sell a 60% interest in the AIS JV to Fernweh at an implied enterprise value of AIS of $300.0 million. The sale is expected to result in cash proceeds to AZZ of approximately $228.0 million, subject to certain customary purchase price adjustments. As part of recognizing the AIS as held for sale in accordance with GAAP, the Company is required to measure AIS at the lower of its carrying amount or fair value less cost to sell. The Company will complete this assessment during its second quarter of fiscal year 2023. The Company expects the assessment will result in a non-cash loss on disposal of approximately $35 to $65 million. The loss on disposal will be recorded as part of discontinued operations in the Company’s financial statements. Following the close of the transaction, the Company anticipates that the AIS JV will be deconsolidated and the Company's 40% joint venture investment will be accounted for under the equity method of accounting. The transaction, which is subject to certain closing conditions, is expected to close before the end of fiscal 2023.