MUELLER WATER PRODUCTS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Mueller Water Products, Inc., a Delaware corporation, together with its consolidated subsidiaries, operates in two business segments: Infrastructure and Technologies. Infrastructure manufactures valves for water and gas systems, including butterfly, iron gate, tapping, check, knife, plug and ball valves, as well as dry-barrel and wet-barrel fire hydrants and a broad line of pipe connection and repair products, such as clamps and couplings used to repair leaks. Technologies offers metering systems, leak detection, pipe condition assessment and other related smart-enabled products and services. The “Company,” “we,” “us” or “our” refer to Mueller Water Products, Inc. and its subsidiaries. With regard to the Company’s segments, “we,” “us” or “our” may also refer to the segment being discussed.

In July 2014, Infrastructure ownsacquired a 49% ownership interest in an industrial valve joint venture.venture for $1.7 million. Due to substantive control features in the operating agreement, all of the joint venture’s assets, liabilities and results of operations arewere included in our consolidated financial statements. The netWe included an adjustment for the income or loss attributable to the noncontrolling interest is included in selling, general and administrative expenses. NoncontrollingInfrastructure acquired the remaining 51% interest is recorded at its carrying value, which approximates fair value.in the business on October 3, 2019.

UnlessOn December 3, 2018, we completed our acquisition of Krausz Development Ltd. and subsidiaries (“Krausz”). We include the context indicates otherwise, whenever we referfinancial statements of Krausz in our consolidated financial statements on a one-month lag. For the quarter ended December 31, 2018, the consolidated statements of operations and of cash flows exclude the results of Krausz’s operations. Refer to a particular year, we mean our fiscal year ended or ending September 30 in that particular calendar year.Note 2. for additional disclosures related to the acquisition.

Our consolidated financial statements are prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”), which require us to make certain estimates and assumptions that affect the reported amounts of assets, liabilities, sales and expenses and the disclosure of contingent assets and liabilities for the reporting periods. Actual results could differ from those estimates. All significant intercompany balances and transactions have been eliminated. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements included in our Annual Report on Form 10-K for the year ended September 30, 2018.2019. In our opinion, all normal and recurring adjustments that we consider necessary for a fair financial statement presentation have been made. Certain reclassifications have been made to previously reported amounts to conform to the current presentation. The condensed consolidated balance sheet data at September 30, 20182019 was derived from audited financial statements, but it does not include all disclosures required by GAAP.

On December 3, 2018,Unless the context indicates otherwise, whenever we completedrefer to a particular year, we mean our acquisition of Krausz Industries Ltd. (“Krausz”). The operating results of Krausz are reported on a one-month lag beginningfiscal year ended or ending September 30 in the quarter ended December 31, 2018. For the quarter ended December 31, 2018, the consolidated balance sheet includes an estimated opening balance sheet for Krausz, but the consolidated statements of operations and of cash flows exclude the results of Krausz’s operations. Refer to Note 2 for additional disclosures related to the acquisition.that particular calendar year.

HR-1, commonly referred to as the Tax Cuts and Jobs Act, was enacted on December 22, 2017 and made significant revisions to federal income tax laws, including lowering the corporate income tax rate to 21% from 35%, effective January 1, 2018. The effects of these revisions are discussed in Note 4.

On December 3, 2018, we completed our acquisition of Krausz, a manufacturer of pipe couplings, grips and clamps with operations in the United States and Israel, for $136.2$140.7 million, net of cash acquired, including the assumption and simultaneous repayment of certain debt of $13.2 million. The purchase agreement provides for customary final adjustments, including a net working capital adjustment, which we expect to occur in 2019. Annual sales foracquisition of Krausz in 2017 were approximately $43.0 million.was financed with cash on hand.

We have recognized the assets acquired and liabilities assumed at their estimated acquisition date fair values, with the excess of the consideration transferredpurchase price over the estimated fair values of the identifiable net assets acquired recorded as goodwill. The accounting for the business combination is based on currently available information and is considered preliminary. We have retained a third party valuation specialist to assist in our estimate offinal. During the fair value of acquired intangible assets andquarter, we have not yet received a preliminary valuation report and therefore have not yet completed that estimate. We expect the fair value of total intangibles acquired may be significantly more than our estimate for certain intellectual property intangibles, which is included below. In addition, we are gathering information about income taxes and deferred income tax assets and liabilities, accounts receivables, inventories,reduced property, plant and equipment other current assets and current liabilities based on facts that existed asby $0.3 million, which resulted in an increase in goodwill of the date of the acquisition. The final accounting for the business combination may differ materially from that presented in these unaudited consolidated statements.

The preliminary estimated goodwill above is attributable to the strategic opportunities and synergies that we expect to arise from the acquisition of Krausz and the workforcevalue of the acquired businesses.its workforce. The goodwill is nondeductible for income tax purposes. The intangible assets of $47.7 million consist of indefinite-lived tradenames and patents, customer relationships and favorable leasehold interests with an estimated weighted average useful life of approximately 12 years. We determined the values of the intangible assets using discounted cash flow methods.

We recognize revenue in an amount that reflects the consideration we expect to be entitled to in exchange for transferring those products or providing those services, when control of the promised products or services is transferred to our customers.customers, in amounts that reflect the consideration to which we expect to be entitled in exchange for those products or services. We account for a contract when it has approval and commitment from both parties, the rights of the parties are identified, the payment terms are identified, the contract has commercial substance and collectability of consideration is probable. We determine the appropriate revenue recognition for our contracts with customers by analyzing the type, terms and conditions of each contract or arrangement with a customer.

We disaggregate our revenuerevenues from contracts with customers by reporting unit, which are the same as our reportable segmentssegment (Note 10),11.) and further by geographical region as we believe itthis best depicts how the nature, amount, timing and uncertainty of our revenue and cash flows are affected by economic factors. Geographical region represents the location of the customer.

The timing of revenue recognition, billings and cash collections results in customer receivables, advance payments and billings in excess of revenue recognized. Customer receivables includesinclude amounts billed and currently due from customers as well as unbilled amounts (contract assets). Amounts are billed in accordance with contractual terms and unbilled amounts arise when the timing of billing differs from the timing of revenue recognized. Customer receivables are recorded at face amounts less an allowance for doubtful accounts. We maintain an allowance for doubtful accounts for estimated losses as a result of customers’ inability to make required payments. We evaluate the aging of the customer receivable balances, the financial condition of our customers, historical trends and the time outstanding of specific balances to estimate the amount of customer receivables that may not be collected in the future and record the appropriate provision.

Advance payments and billings in excess of revenue are recognized and recorded as deferred revenue, the majority of which is classified as current based on the timing when we expect to recognize revenue. We include current deferred revenue as part of our accrued expenses. Deferred revenues represent contract liabilities and are recorded when customers remit contractual cash payments in advance of us satisfying performance obligations under contractual arrangements. Contract liabilities are reversed when revenue is recognized and the performance obligation is satisfied.

A performance obligation is a promise in a contract to transfer a distinct good or service to the customer. Our performance obligations are satisfied at a point in time as related to sales of equipment or over time as related to our software hosting and leak detection monitoring services. Performance obligations are supported by customer contracts, with customers thatwhich provide a frameworkframeworks for the nature of the distinct products or services. We allocate the transaction price of each contract to the performance obligations on the basis of standalone selling price and recognize revenue when, or as, control of the performance obligation transfers to the customers.

We have elected to use the practical expedient to not adjust the transaction price forof a contract for the effects of a significant financing component if, at the inception of the contract, we expect that the period between when we transfer a product or service to a customer and when a customer remits payment will be one year or less.

RevenueRevenues from products and services transferred to customers at a point in time represented 98% of our revenuerevenues in the first three months of fiscal year 2019.ended December 31, 2019 and 2018. The revenuerevenues recognized at a point in time relatesrelated to the sale of the majority of our products and iswas recognized when the obligations of the terms of our contract arewere satisfied, which generally occurs upon shipment, when control of the product transfers to the customer.

RevenueRevenues from products and services transferred to customers over time represented 2% of our revenuerevenues in the first three months of fiscal year 2019.ended December 31, 2019 and 2018.

We offer warranties to our customers in the form of assurance-type warranties, which provide assurance that the related productproducts provided will function as intended and comply with any agreed-upon specifications. These cannot be purchased separately. There iswas no change to our warranty accounting as a result of the implementation of the new revenue standard and we will continue to use our current cost accrual method in accordance with GAAP.

We incur certain incremental costs to obtain a contract, which primarily relate to incremental sales commissions. Our commissions are paid based on shipment rather than on orderorders and shipments and we reserve the right to claw back any commissions in case of product returns or lost collections. As the expected benefit associated with these incremental costs is one year or less based on the nature of the product sold and benefits received, we have applied thea practical expedient and therefore willdo not capitalize the related costs and will expense them as incurred, consistent with our currentprevious accounting treatment.

On December 22, 2017, HR-1, commonly referredWe adopted the new leasing standard utilizing the modified retrospective approach on October 1, 2019. Adoption of the new standard resulted in an increase to as the Tax Cuts and Jobs Act (“Act”), was enacted, which made significant revisions to federal income tax laws, including lowering the corporate income tax rate to 21% from 35% effective January 1, 2018, overhauling the taxation of income earned outside the United States and eliminating or limiting certain deductions.

We elected the package of three practical expedients for transition, which include the carry forward of our leases without reassessing whether any contracts are recordedleases or contain leases, lease classification and initial direct costs and applying hindsight when determining the lease term and when assessing impairment of right-of-use assets at the enacted tax ratesadoption date. This allows us to update our assessments according to new information and changes in effectfacts and circumstances that have occurred since lease inception.

Our leases have remaining lease terms of 1 year to 14 years. The terms and conditions of our leases may include options to extend or terminate the lease which are considered and included in the lease term when these options are reasonably certain of exercise.

We determine if a contract is (or contains) a lease at inception by evaluating whether the contract conveys the right to control the use of an identified asset. For all classes of leased assets, we expecthave elected the practical expedient to recognizeaccount for any non-lease components in the contract together with the related tax expenses or benefits. These rates vary slightly from year to year but historically had been approximately 39%. With the legislation changing enacted rates taking placelease component in the quarter ended December 31, 2017, we remeasuredsame unit of account.

ROU assets and lease liabilities are recognized in our deferred tax itemscondensed consolidated balance sheets at an average rate of approximately 25% and recorded an income tax benefit of $42.5 million.

Operating leases are included in other noncurrent assets, other current liabilities and Noticesnoncurrent liabilities in our condensed consolidated balance sheets. Finance leases are included in property, plant and regulations issuedequipment, current portion of long-term debt and proposed bylong-term debt in our condensed consolidated balance sheets.

For all classes of leased assets, we have applied an accounting policy election to exclude short-term leases from recognition in our condensed consolidated balance sheets. A short-term lease has a lease term of 12 months or less at the U.S. Departmentcommencement date and does not include a purchase option that is reasonably certain of exercise. We recognize short-term lease expense in our condensed consolidated income statements on a straight-line basis over the Treasury and the IRS,lease term.

Our short-term lease expense for the quarter ended December 31, 2018, we finalized our calculations of the transition tax liability, which reduced our initial provision by $0.6 million,2019 and is included as a component of income tax expenseshort-term lease commitments at December 31, 2019 are immaterial.

We have certain lease contracts with terms and conditions that provide for variability in the quarter. Aspayment amount based on changes in facts or circumstances occurring after the commencement date. These variable lease payments are recognized in our condensed consolidated income statements as the obligation is incurred.

Total lease liabilities at December 31, 2019 have elected to pay will be paid over the next eight years,scheduled maturities as provided in the Act.follows:

At December 31, 20182019 and September 30, 2018,2019, the gross liabilities for unrecognized income tax benefits were $3.4$3.5 million and $3.3 million, respectively.

Borrowings under the ABL Agreement bear interest at a floating rate equal to LIBOR, plus a margin ranging from 125 to 150 basis points, or a base rate, as defined in the ABL Agreement, plus a margin ranging from 25 to 50 basis points. At December 31, 2018,2019, the applicable rate was LIBOR plus 125 basis points.

The ABL Agreement terminates on July 13, 2021.2021. We pay a commitment fee for any unused borrowing capacity under the ABL Agreement of 25 basis points per annum. Our obligations under the ABL Agreement are secured by a first-priority perfected lien on all of our U.S. receivables and inventories, certain cash and other supporting obligations. Borrowings are not subject to any financial maintenance covenants unless excess availability is less than the greater of $17.5 million and 10% of the Loan Cap as defined in the ABL Agreement. Excess availability based on December 31, 20182019 data, as reduced by outstanding letters of credit and accrued fees and expenses of $16.1$14.5 million, was $93.8$122.0 million.

In connection with the acquisition of Singer Valve in 2017, we loaned funds to one of our Canadian subsidiaries. Although this intercompany loan has no direct effect on our consolidated financial statements, it creates exposure to currency risk for the Canadian subsidiary. To reduce this exposure, we entered into a U.S. dollar-Canadian dollar swap contract with the Canadian subsidiary and an offsetting Canadian dollar-U.S. dollar swap with a domestic bank. We have not designated these swaps as hedges and the changes in their fair valuevalues are included in earnings, where they offset the currency gains and losses associated with the intercompany loan. The values of our currency swap contracts were an assetliabilities of $46 thousand$0.6 million and a liability of $0.9$0.3 million as of December 31, 20182019 and September 30, 2018,2019, respectively, and are included in other noncurrent assets and other noncurrent liabilities respectively, in our Condensed Consolidated Balance Sheets.

The amortization of actuarial losses, net of tax, is recorded as a component of other comprehensive loss.

We have granted various forms of stock-based compensation, including stock options, restricted stock units, and performance-based restricted stock units (“PRSUs”) and market-based restricted stock units (“MRSUs”) under our Amended and Restated 2006 Mueller Water Products, Inc. Stock Incentive Plan (the “2006 Stock Plan”).

A PRSU award representsconsists of a target number of units that may be paid out at the end of a multi-year award cycle consisting of a series of annual performance periods coinciding with our fiscal years. After we determineestablish the financial performance targets related to PRSUs for a given performance period, typically during the first quarter of that fiscal year, we consider that portion of a PRSU award to be granted. Thus, each award consists of a grant in the year of award and grants in the designated following years. Settlements, in our common shares, will range from zero0 to two2 times the number of PRSUs granted, depending on our financial performance against the targets.

We awarded 332,875196,284 stock-settled PRSUs and 147,213 MRSUs in the quarterthree months ended December 31, 2018, which2019 that are scheduled to settle in 3 years.

We issued 181,06593,647 shares and 146,061181,065 shares of common stock during the quartersthree months ended December 31, 20182019 and 2017,2018, respectively, to settle PRSUs.PRSUs that vested during the periods.

In addition to the PRSU activity, 143,809132,303 restricted stock units vested during the quarterthree months ended December 31, 2018.2019, respectively.

We have granted cash-settled Phantom Plan instruments under the Mueller Water Products, Inc. Phantom Plan (“Phantom Plan”). At December 31, 2018,2019, the outstanding Phantom Plan instruments had a fair value of $9.10$11.98 per instrument and our liability for Phantom Plan instruments was $0.6$1.0 million.

Operating income included stock-based compensation expense of $1.7$1.9 million and $2.4$1.7 million during the three months ended December 31, 20182019 and 2017,2018, respectively. At December 31, 2018,2019, there was approximately $9.2$11.8 million of unrecognized compensation expense related to stock-based compensation arrangements and there were 279,024218,292 PRSUs that have been awarded for the 20202021 and 20212022 performance periods for which performance goals have not been set.

We excluded 165,467108,976 and 70,996165,467 of stock-based compensation instruments from the calculations of diluted earnings per share for the quarters ended December 31, 20182019 and 2017,2018, respectively, since their inclusion would have been antidilutive.