Table of Contents

 

 

 

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM 10-Q**

 

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**(Mark One)**

 

**x****      QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For the quarterly period ended May 31, 2011**

 

**OR**

 

**o****         TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For the transition period from               to            **

 

**Commission file number 01-33633**

 

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**Zep Inc.**

(Exact name of registrant as specified in its charter)

 

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| **Delaware**                                                    | ** ** | **26-0783366**                           |
|-----------------------------------------------------------------|------------|------------------------------------------|
| (State or other jurisdiction of

incorporation or organization) |       | (I.R.S. Employer

Identification Number) |

 

| **1310 Seaboard Industrial Boulevard,**

**Atlanta, Georgia** | ** ** | **30318-2825** |
|---------------------------------------------------------------|------------|----------------|
| (Address of principal executive offices)                      |       | (Zip Code)     |

 

**(404) 352-1680**

(Registrant’s telephone number, including area code)

 

**None**

(Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report)

 

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Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes  x  No  o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes  o  No  o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

| Large Accelerated Filer o |   | Accelerated Filer x         |
|---------------------------|--------|-----------------------------|
|                      |   |                        |
| Non-accelerated Filer o   |   | Smaller reporting company o |

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.):  Yes o  No x

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

**Common Stock — $0.01 Par Value — 21,955,228 shares as of July 5, 2011.**

 

 

 

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Table of Contents

 

**Zep Inc.**

 

**INDEX**

 
| ** **                    | ** **                                                                                                   | **Page No.** |
|-------------------------------|--------------------------------------------------------------------------------------------------------------|--------------|
| PART I. FINANCIAL INFORMATION | 3                                                                                                            |
|                          |                                                                                                         |         |
| ITEM 1.                       | FINANCIAL   STATEMENTS                                                                                       | 3            |
|                          |                                                                                                         |         |
|                          | CONSOLIDATED BALANCE SHEETS — MAY 31, 2011 (Unaudited)   AND AUGUST 31, 2010                            | 3            |
|                          |                                                                                                         |         |
|                          | CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited) —   THREE AND NINE MONTHS ENDED MAY 31, 2011 and 2010 | 4            |
|                          |                                                                                                         |         |
|                          | CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) —   NINE MONTHS ENDED MAY 31, 2011 and 2010           | 5            |
|                          |                                                                                                         |         |
|                          | NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)                                                       | 6            |
|                          |                                                                                                         |         |
| ITEM 2.                       | MANAGEMENT’S   DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS                 | 13           |
|                          |                                                                                                         |         |
| ITEM 3.                       | QUANTITATIVE   AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                                                 | 23           |
|                          |                                                                                                         |         |
| ITEM 4.                       | CONTROLS AND   PROCEDURES                                                                                    | 23           |
|                          |                                                                                                         |         |
| PART   II. OTHER INFORMATION  | 23                                                                                                           |
|                          |                                                                                                         |         |
| ITEM 1.                       | LEGAL PROCEEDINGS                                                                                            | 23           |
|                          |                                                                                                         |         |
| ITEM 1A.                      | RISK FACTORS                                                                                                 | 23           |
|                          |                                                                                                         |         |
| ITEM 6.                       | EXHIBITS                                                                                                     | 24           |
|                          |                                                                                                         |         |
| SIGNATURES                    | 25                                                                                                           |

 

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**PART I. FINANCIAL INFORMATION**

**Item 1.*****                                   ******Consolidated Financial Statements***

**Zep Inc.**

**CONSOLIDATED BALANCE SHEETS**

*(In thousands, except share and per-share data)*

 
| ** **                                                                                                                                                                    | ** ** | **MAY 31, 2011** | ** ** | **AUGUST 31, 2010** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------|------------|---------------------|------------|
| ** **                                                                                                                                                                    | ** ** | **(unaudited)**  | ** ** | ** **          | ** ** |
| **ASSETS**                                                                                                                                                                    |       |             |       |                |       |
| Current Assets:                                                                                                                                                               |       |             |       |                |       |
| Cash and cash equivalents                                                                                                                                                     |       | $                | 7,930      |                | $          | 25,257 |   |
| Accounts receivable, less reserve for doubtful   accounts of $4,673 at May 31, 2011 and $4,995 at August 31, 2010                                                             |       | 96,999           |       | 90,827              |       |
| Inventories                                                                                                                                                                   |       | 71,761           |       | 53,192              |       |
| Deferred income taxes                                                                                                                                                         |       | 7,408            |       | 8,188               |       |
| Prepayments and other current assets                                                                                                                                          |       | 10,189           |       | 9,779               |       |
| Total Current Assets                                                                                                                                                          |       | 194,287          |       | 187,243             |       |
| Property, Plant, and Equipment, at cost:                                                                                                                                      |       |             |       |                |       |
| Land                                                                                                                                                                          |       | 4,535            |       | 4,504               |       |
| Buildings and leasehold improvements                                                                                                                                          |       | 59,350           |       | 58,224              |       |
| Machinery and equipment                                                                                                                                                       |       | 99,997           |       | 94,172              |       |
| Total Property, Plant, and Equipment                                                                                                                                          |       | 163,882          |       | 156,900             |       |
| Less - Accumulated depreciation and amortization                                                                                                                              |       | 97,148           |       | 90,026              |       |
| Property, Plant, and Equipment, net                                                                                                                                           |       | 66,734           |       | 66,874              |       |
| Other Assets:                                                                                                                                                                 |       |             |       |                |       |
| Goodwill                                                                                                                                                                      |       | 84,295           |       | 53,764              |       |
| Identifiable intangible assets                                                                                                                                                |       | 66,257           |       | 30,271              |       |
| Deferred income taxes                                                                                                                                                         |       | 967              |       | 861                 |       |
| Other long-term assets                                                                                                                                                        |       | 3,631            |       | 3,835               |       |
| Total Other Assets                                                                                                                                                            |       | 155,150          |       | 88,731              |       |
| Total Assets                                                                                                                                                                  |       | $                | 416,171    |                | $          | 342,848 |   |
|                                                                                                                                                                          |       |             |       |                |       |
| **LIABILITIES AND STOCKHOLDERS’   EQUITY**                                                                                                                               |       |             |       |                |       |
| Current Liabilities:                                                                                                                                                          |       |             |       |                |       |
| Current maturities of long-term debt                                                                                                                                          |       | $                | 15,000     |                | $          | 15,000 |   |
| Accounts payable                                                                                                                                                              |       | 56,479           |       | 51,390              |       |
| Accrued compensation                                                                                                                                                          |       | 17,334           |       | 21,322              |       |
| Other accrued liabilities                                                                                                                                                     |       | 27,200           |       | 29,124              |       |
| Total Current Liabilities                                                                                                                                                     |       | 116,013          |       | 116,836             |       |
| Long-term debt, less current maturities                                                                                                                                       |       | 126,725          |       | 77,150              |       |
| Deferred Income Taxes                                                                                                                                                         |       | 3,860            |       | 2,140               |       |
| Self-Insurance Reserves, less current portion                                                                                                                                 |       | 3,444            |       | 5,420               |       |
| Other Long-Term Liabilities                                                                                                                                                   |       | 22,368           |       | 19,129              |       |
| Commitments and Contingencies (see Note 5)                                                                                                                                    |       |             |       |                |       |
| Stockholders’ Equity:                                                                                                                                                    |       |             |       |                |       |
| Preferred stock, $0.01 par value; 50,000,000   shares authorized; none issued and outstanding                                                                                 |       | —           |       | —              |       |
| Common stock, $0.01 par value; 500,000,000 shares   authorized; 21,565,245 issued and outstanding at May 31, 2011, and 21,335,922   issued and outstanding at August 31, 2010 |       | 216              |       | 213                 |       |
| Paid-in capital                                                                                                                                                               |       | 90,435           |       | 85,316              |       |
| Retained earnings                                                                                                                                                             |       | 35,775           |       | 25,052              |       |
| Accumulated other comprehensive income items                                                                                                                                  |       | 17,335           |       | 11,592              |       |
| Total Stockholders’ Equity                                                                                                                                               |       | 143,761          |       | 122,173             |       |
| Total Liabilities and Stockholders’ Equity                                                                                                                               |       | $                | 416,171    |                | $          | 342,848 |   |

 

The accompanying *Notes to Consolidated Financial Statements*are an integral part of these statements*.*

 

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**Zep Inc.**

**CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)**

*(In thousands, except per-share data)*

 
| ** **                                              | ** ** | **THREE MONTHS ENDED   MAY 31,** | ** ** | **NINE MONTHS ENDED   MAY 31,** | ** ** |
|---------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                              | ** ** | **2011**                         | ** ** | **2010**                        | ** ** | **2011** | ** ** | **2010** | ** ** |
| Net Sales                                               |       | $                                | 167,921    |                            | $          | 153,041 |   | $ | 472,197 |   | $ | 407,142 |   |
| Cost of Products Sold                                   |       | 89,554                           |       | 77,489                          |       | 247,188 |   | 201,722 |   |
| Gross Profit                                            |       | 78,367                           |       | 75,552                          |       | 225,009 |   | 205,420 |   |
| Selling, Distribution, and Administrative Expenses      |       | 66,347                           |       | 64,449                          |       | 197,831 |   | 181,966 |   |
| Restructuring Charges                                   |       | —                           |       | 1,951                           |       | 1,469 |   | 2,350 |   |
| Gain on Sale of Building                                |       | —                           |       | —                          |       | (676 | ) | — |   |
| Acquisition and Integration Costs                       |       | 429                              |       | —                          |       | 429 |   | 1,550 |   |
| Operating Profit                                        |       | 11,591                           |       | 9,152                           |       | 25,956 |   | 19,554 |   |
| Other Expense:                                          |       |                             |       |                            |       |   |   |   |   |
| Interest expense, net                                   |       | 1,576                            |       | 555                             |       | 5,061 |   | 1,284 |   |
| (Gain) Loss on foreign currency transactions            |       | 52                               |       | 38                              |       | (168 | ) | 45 |   |
| Miscellaneous expense (income), net                     |       | 10                               |       | (69                             | )          | 137 |   | (90 | ) |
| Total Other Expense                                     |       | 1,638                            |       | 524                             |       | 5,030 |   | 1,239 |   |
| Income before Provision for Income Taxes                |       | 9,953                            |       | 8,628                           |       | 20,926 |   | 18,315 |   |
| Provision for Income Taxes                              |       | 3,710                            |       | 3,394                           |       | 7,594 |   | 6,923 |   |
| Net Income                                              |       | $                                | 6,243      |                            | $          | 5,234 |   | $ | 13,332 |   | $ | 11,392 |   |
|                                                    |       |                             |       |                            |       |   |   |   |   |
| Earnings Per Share:                                     |       |                             |       |                            |       |   |   |   |   |
| Basic Earnings per Share                                |       | $                                | 0.29       |                            | $          | 0.24 |   | $ | 0.61 |   | $ | 0.52 |   |
| Basic Weighted Average Number of Shares   Outstanding   |       | 21,603                           |       | 21,324                          |       | 21,502 |   | 21,247 |   |
| Diluted Earnings per Share                              |       | $                                | 0.28       |                            | $          | 0.23 |   | $ | 0.60 |   | $ | 0.51 |   |
| Diluted Weighted Average Number of Shares   Outstanding |       | 22,071                           |       | 21,857                          |       | 21,975 |   | 21,716 |   |
| Dividends Declared per Share                            |       | $                                | 0.04       |                            | $          | 0.04 |   | $ | 0.12 |   | $ | 0.12 |   |

 

The accompanying *Notes to Consolidated Financial Statements* are an integral part of these statements.

 

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**Zep Inc.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)**

*(In thousands)*

 

| ** **                                                                                     | ** ** | **NINE MONTHS ENDED   May 31,** | ** ** |
|------------------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                                     | ** ** | **2011**                        | ** ** | **2010** | ** ** |
| Cash Provided by (Used for) Operating Activities:                                              |       |                            |       |   |   |
| Net income                                                                                     |       | $                               | 13,332     |   | $ | 11,392 |   |
| Adjustments to reconcile net income to net cash   (used for) provided by operating activities: |       |                            |       |   |   |
| Depreciation and amortization                                                                  |       | 10,717                          |       | 7,260 |   |
| Deferred income taxes                                                                          |       | 2,393                           |       | 945 |   |
| Excess tax benefits from share-based payments                                                  |       | (795                            | )          | (251 | ) |
| Gain on sale of property, plant and equipment                                                  |       | (672                            | )          | — |   |
| Other non-cash charges                                                                         |       | 3,451                           |       | 3,134 |   |
| Change in assets and liabilities:                                                              |       |                            |       |   |   |
| Accounts receivable                                                                            |       | 3,045                           |       | (1,624 | ) |
| Inventories                                                                                    |       | (9,434                          | )          | (2,084 | ) |
| Prepayments and other current assets                                                           |       | 158                             |       | 1,019 |   |
| Accounts payable                                                                               |       | 189                             |       | 69 |   |
| Accrued compensation and other current liabilities                                             |       | (9,467                          | )          | (3,342 | ) |
| Self-insurance and other long-term liabilities                                                 |       | (1,236                          | )          | (1,247 | ) |
| Other assets                                                                                   |       | 61                              |       | (102 | ) |
| Net Cash (Used for) Provided by Operating   Activities                                         |       | 11,742                          |       | 15,169 |   |
|                                                                                           |       |                            |       |   |   |
| Cash Provided by (Used for) Investing Activities:                                              |       |                            |       |   |   |
| Purchases of property, plant, and equipment                                                    |       | (5,189                          | )          | (7,700 | ) |
| Acquisitions                                                                                   |       | (76,065                         | )          | (63,511 | ) |
| Proceeds from sale of property, plant, and   equipment                                         |       | 1,080                           |       | — |   |
| Net Cash Used for Investing Activities                                                         |       | (80,174                         | )          | (71,211 | ) |
|                                                                                           |       |                            |       |   |   |
| Cash Provided by (Used for) Financing Activities:                                              |       |                            |       |   |   |
| Proceeds from revolving credit facility                                                        |       | 132,017                         |       | 129,000 |   |
| Repayments of borrowings from revolving credit   facility                                      |       | (82,442                         | )          | (89,000 | ) |
| Proceeds from receivables facility                                                             |       | —                          |       | 15,000 |   |
| Employee stock issuances                                                                       |       | 997                             |       | 255 |   |
| Excess tax benefit from share-based payments                                                   |       | 795                             |       | 251 |   |
| Dividend payments                                                                              |       | (2,610                          | )          | (2,611 | ) |
| Net Cash Provided by Financing Activities                                                      |       | 48,757                          |       | 52,895 |   |
| Effect of Exchange Rate Changes on Cash                                                        |       | 2,348                           |       | (870 | ) |
| Net Change in Cash and Cash Equivalents                                                        |       | (17,327                         | )          | (4,017 | ) |
| Cash and Cash Equivalents at Beginning of Period                                               |       | 25,257                          |       | 16,651 |   |
| Cash and Cash Equivalents at End of Period                                                     |       | $                               | 7,930      |   | $ | 12,634 |   |

 

The accompanying*Notes to Consolidated Financial Statements*are an integral part of these statements*.*

 

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**Zep Inc.**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)**

*(Amounts in thousands, except share and per-share data and as indicated)*

 

**1. DESCRIPTION OF BUSINESS AND BASIS OF PRESENTATION**

 

***Description of the Business***

 

Zep Inc. (“Zep”, the “Company”, “we”, “our”, or “us”) is 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 we were founded in 1937. Our product portfolio, which is 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 direct-sales organization, to consumers primarily through home improvement stores, and to large 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. We became an independent, publicly owned company in 2007 upon a spin-off from our former parent company. Our common stock trades on the New York Stock Exchange under the ticker symbol “ZEP.”

 

***Basis of Presentation***

 

The financial statements in this Form 10-Q are presented on a consolidated basis and include the accounts of Zep and its subsidiaries. The unaudited interim *Consolidated Financial Statements* included herein have been prepared by management in accordance with U.S. generally accepted accounting principles and present our financial position, results of operations, and cash flows. These consolidated financial statements reflect all normal and recurring adjustments that are, in the opinion of management, necessary to present fairly the consolidated results for the interim periods presented. Certain information and footnote disclosures normally included in our annual financial statements prepared in accordance with U.S. generally accepted accounting principles have been condensed or omitted. However, we believe that the disclosures included herein are adequate to make the information presented not misleading. These financial statements should be read in conjunction with our audited consolidated and combined financial statements as of and for the three years ended August 31, 2010 and notes thereto included within our Annual Report on Form 10-K for the fiscal year ended August 31, 2010 filed with the Securities and Exchange Commission (“SEC”) on November 8, 2010 (File No. 01-33633) (“Form 10-K”).

 

The results of operations for the three and nine months ended May 31, 2011 are not necessarily indicative of the results for the full fiscal year because our net sales and net income are generally higher in the second-half of our fiscal year. More specifically, due to the seasonal nature of a portion of our business and the number of available selling days, sales in the second-half of our fiscal year have historically outpaced those generated in the first-half of the fiscal year.  We anticipate continued volatility in the commodities markets, which could have a negative impact on the cost of raw materials used in our production processes.  Additionally, operating results in the second-half of our fiscal year could be impacted by the uncertainty of general economic conditions facing key end-markets in which we participate.

 

During the first quarter of fiscal year 2010, we renegotiated the terms of our contract with our licensee in France. Separately, we executed a release agreement with this party that addressed historical business transactions. We received a one-time, $1.1 million payment pursuant to this release agreement, all of which we recognized within *Net Sales* on our *Consolidated Statements of Operations* during the three months ended November 30, 2009.

 

During the third quarter of fiscal year 2011, we recorded an out-of-period adjustment in our *Consolidated Financial Statements*.  This adjustment corrected the improper accrual of certain compensation-related expenses that accumulated ratably over a three-year period.  The adjustment reduced *Selling, Distribution and Administrative Expenses* and *Accrued compensation* in the third quarter of fiscal year 2011 by approximately $1.3 million.  Management performed an assessment of the significance of this adjustment including evaluating both quantitative and qualitative factors as well as considering relevant authoritative literature. Management concluded that the adjustment was not material to our *Consolidated Financial Statements*during the last three years.

 

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**2. ACQUISITIONS**

 

We began executing our acquisition growth initiatives during fiscal year 2010. Since January 2010, we have completed three acquisitions. The first was Amrep, Inc. (“Amrep”), which was immediately accretive to earnings, expanded our access to the retail and distributor channels, and provided significant private label capabilities. In September 2010, we acquired certain brands and assets, and assumed certain liabilities of Waterbury Companies, Inc. (“Waterbury”), which we expect will enhance Amrep’s leading position as a provider of air care delivery systems and products for facilities maintenance. Our third acquisition, completed in October 2010, was of the assets of Niagara National, LLC (“Niagara”). This acquisition complements our strength in the vehicle wash market, specifically in the truck and fleet washing equipment markets. Acquisition costs incurred in support of these transactions totaled $3.4 million throughout fiscal year 2010. Our first nine months fiscal 2011 sales performance benefited from $68.5 million of acquisition-related revenue. As stated below, our acquisitions resulted in the recording of goodwill, which is an asset representing the future economic benefits arising from other assets acquired in a business combination that are not individually identified and separately recognized.

 

***Amrep, Inc.***

 

On September 15, 2010, we filed income tax returns for Amrep’s 2009 tax year. The filing of these tax returns concurrently generated a tax payable due from us to Amrep’s former owners, which amount was determined based upon the terms of the Amrep purchase agreement, as amended. The amount of the taxes payable, which is approximately $0.5 million, was not known until September 2010. We also finalized the amount of deferred tax assets associated with fixed assets acquired from Amrep, which decreased our deferred tax assets by approximately $0.5 million. These adjustments increased *Goodwill* on the Company’s *Consolidated Balance Sheets*by a like amount.  These adjustments did not have a material impact on our consolidated financials statements in any period, and, therefore, our consolidated financial statements do not include retrospective adjustment.

 

***Waterbury Companies, Inc.***

 

On September 2, 2010 (the “Waterbury Closing Date”), Amrep and certain other of our 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(R), TimeWick®, MicrobeMax(TM), Country Vet(R), and Konk(TM). We did not acquire Waterbury’s manufacturing facility. Waterbury entered into a transition services agreement with us pursuant to which it is continuing to make products for us until we have completed the transfer of related manufacturing operations to our facilities. We expect to complete this transfer during the fourth quarter of fiscal year 2011. We acquired the Waterbury brands and assets for an initial cash purchase price of approximately $66 million (the “Waterbury Closing Purchase Price”). Of the $66 million purchase price, $62 million was funded through borrowings pursuant to our 2010 Credit Facility (discussed further in Note 4 of *Notes to Consolidated Financial Statements*), and the remaining $4.0 million was funded through available cash.  In January 2011, we finalized Waterbury’s Closing Date working capital in accordance with the asset purchase agreement and received an immaterial amount from the sellers as part of such finalization. This adjustment reduced the purchase price by that immaterial amount, which was reflected as an adjustment to *Goodwill* on the Company’s *Consolidated Balance Sheets*.

 

Under the purchase method of accounting, we made a preliminary allocation of the Waterbury Closing Purchase Price to the net tangible and intangible assets that we acquired from Waterbury based on their estimated fair values as of September 2, 2010. The excess of the Waterbury Closing Purchase Price over the preliminarily recorded net tangible and identifiable intangible assets was recorded as *Goodwill* on our *Consolidated Balance Sheets*. Management continues to gather additional information about the fair value of assets and liabilities acquired from Waterbury and this process may affect this transaction’s final purchase price allocation. Also, we acquired legal title to certain of the equipment used by Waterbury to manufacture products for us on the Waterbury Closing Date. However, as of May 31, 2011, we had not yet taken physical possession of the majority of these assets. Therefore, we have not had the opportunity to finalize our inspection of the fixed assets’ condition. While these assets are being operated by Waterbury and until such time as physical transfer is completed, we have estimated the assets’ fair value and related depreciation expense. Such estimates are subject to change once we have taken physical possession of these assets.

 

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The preliminary purchase price allocation presented below could change as the purchase price allocation becomes final. The following summary allocation includes an estimate of approximately $34.5 million of identifiable intangible assets:

 
| Cash and cash equivalents                               |   | $      | — |   |
|---------------------------------------------------------|--------|--------|--------|--------|
| Inventory                                               |   | 6,998  |   |
| Other current assets                                    |   | 5,500  |   |
| Property, plant and equipment                           |   | 1,186  |   |
| Accounts payable                                        |   | (3,622 | )      |
| Other liabilities assumed                               |   | (941   | )      |
| Total net tangible assets                               |   | $      | 9,121  |   |
|                                                    |   |   |   |
| Identifiable intangible assets                          |   |   |   |
| Customer relationships                                  |   | 27,050 |   |
| Patents and formulations                                |   | 3,700  |   |
| Trademarks                                              |   | 3,700  |   |
| Goodwill                                                |   | 22,652 |   |
| Total preliminary estimated purchase price   allocation |   | $      | 66,223 |   |

 

We recognize the amortization of intangible assets with finite lives over their estimated useful lives using an amortization method that reflects the pattern in which the economic benefits of the intangible assets are consumed or are realized. We will amortize the value allocated to Waterbury’s customer relationships on a straight-line basis during a period ranging from eight to 22 years. As a result of the historical attrition rate in the customer base acquired from Waterbury, the difference between amortizing these intangible assets on a straight-line basis and an attrition-based method is not considered significant. We will amortize the value allocated to patents and technology on a straight-line basis ranging from five to 13 years. We determined that acquired trademarks have an indefinite useful life. We expect amortization expense associated with definite-lived intangible assets acquired from Waterbury to approximate $1.8 million during each of the next five years.

 

Supplemental pro forma information has not been provided for Waterbury as the acquired operations were a component of a larger legal entity and separate historical financial statements were not prepared. Since stand-alone financial information prior to the acquisition is not readily available, compilation of such data is impracticable. Separately, we have determined the presentation of the results of operations beginning from the Waterbury Closing Date for the selected brands and assets acquired through the Waterbury acquisition is impracticable due to the integration activities that have taken place subsequent to the Waterbury acquisition.

 

***Niagara National, LLC***

 

On October 1, 2010, we completed the acquisition of the brands and assets of Atlanta-based 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. Under the purchase method of accounting, we made a preliminary allocation of the Niagara closing purchase price to the net tangible and intangible assets that we acquired from Niagara based on their estimated fair values as of October 1, 2010. Management continues to gather additional information about the fair value of acquired assets and liabilities.  In January 2011, we finalized Niagara’s closing date working capital in accordance with the asset purchase agreement and paid an immaterial additional amount to the sellers of Niagara pursuant to this agreement. This additional outlay of cash increased the purchase price by that amount, and is reflected as an adjustment to *Goodwill* on the Company’s *Consolidated Balance Sheets*.

 

**3. INVENTORIES**

 

Inventories include materials, direct labor, and related manufacturing overhead. Inventories are stated at the lower of cost (on a first-in, first-out or average cost basis) or market and consist of the following:

 
| ** **                 | ** ** | **May 31, 2011** | ** ** | **August 31, 2010** | ** ** |
|----------------------------|------------|------------------|------------|---------------------|------------|
| Raw materials and supplies |       | $                | 26,078     |                | $          | 14,559 |   |
| Work in process            |       | 1,312            |       | 867                 |       |
| Finished goods             |       | 47,134           |       | 40,339              |       |
|                       |       | 74,524           |       | 55,765              |       |
| Less: Reserves             |       | (2,763           | )          | (2,573              | )          |
|                       |       | $                | 71,761     |                | $          | 53,192 |   |

 

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**4. DEBT OBLIGATIONS**

 

On July 15, 2010, the Company entered into a $320 million five-year senior, secured credit facility (the “2010 Credit Facility”). As of May 31, 2011, $119.6 million of the total $134.6 million in borrowings made under the 2010 Credit Facility have been reflected within *Long-term debt, less current maturities* on our *Consolidated Balance Sheets* given our current intent and ability to settle $119.6 million of those borrowings in periods subsequent to May 31, 2012. Under the terms of the 2010 Credit Facility, we may refinance certain amounts borrowed under our 2010 Credit Facility until 2015. Therefore, the short- and long-term classification of debt on our *Consolidated Balance Sheets* may fluctuate not only in response to repayment of those amounts, but also as a result of changes in our projected cash flow for the 12-month period subsequent to the balance sheet date. The base interest rate associated with borrowings made under the 2010 Credit Facility approximated 3.7% during the nine months ended May 31, 2011. As of May 31, 2011, we had additional borrowing capacity under the 2010 Credit Facility of $168.4 million, which represents maximum availability under the 2010 Credit Facility, less the aforementioned borrowings, amounts repaid in accordance with term loan provisions of that facility, and outstanding letters of credit issued under the 2010 Credit Facility totaling $11.0 million. We were in compliance with our debt covenants as of May 31, 2011, and we believe that our liquidity and capital resources are sufficient to meet our working capital, capital expenditure and other anticipated cash requirements, excluding acquisitions, over the next twelve months.

 

**5. COMMITMENTS AND CONTINGENCIES**

 

***Litigation***

 

We are subject to various legal claims arising in the normal course of business. We are self-insured up to specified limits for certain types of claims, including product liability, and are fully self-insured for certain other types of claims, including environmental, product recall, and patent infringement. Based on information currently available and except as discussed below, it is the opinion of management that the ultimate resolution of pending and threatened legal proceedings will not have a material adverse effect on our results of operations, financial position, or cash flows. However, in the event of unexpected future developments, it is possible that the ultimate resolution of such matters, if unfavorable, could have a material adverse effect on our results of operations, financial position, or cash flows.

 

We establish reserves for legal claims when the costs or losses associated with the claims become probable and can be reasonably estimated. The actual costs of resolving legal claims may be substantially higher or lower than the amounts reserved for such claims. However, unless otherwise disclosed, we are unable to make a meaningful estimate of actual costs or a range of reasonably possible losses that could be higher or lower than the amounts reserved. Also, from time to time, we may incur expenses associated with efforts to enforce our non-compete agreements.

 

***Environmental Matters Pertaining to Zep’s Historical Operations***

 

Our operations are subject to federal, state, local, and foreign laws and regulations relating to the generation, storage, handling, transportation, and disposal of hazardous substances and solid and hazardous waste, and the remediation of contaminated sites. Permits and environmental controls are required for certain of our operations to limit air and water pollution, and these permits are subject to modification, renewal, and revocation by issuing authorities. We will incur capital and operating costs relating to environmental compliance on an ongoing basis. Environmental laws and regulations have generally become stricter in recent years, and the cost of responding to future changes may be substantial. While management believes that we are currently in substantial compliance with all material environmental laws and regulations, and has taken reasonable steps to ensure such compliance, there can be no assurance that we will not incur significant costs to remediate violations of such laws and regulations, particularly in connection with acquisitions of existing operating facilities, or to comply with changes in, or stricter or different interpretations of, existing laws and regulations. Such costs could have a material adverse effect on our results of operations.

 

We are currently a party to federal and state administrative proceedings arising under federal and state laws enacted for the protection of the environment where a state or federal agency or a private party alleges that hazardous substances generated by us have been discharged into the environment and a state or federal agency is requiring a cleanup of soil and/or groundwater pursuant to federal or state superfund laws. In each of these proceedings in which we have been named as a party that allegedly generated hazardous substances that were transported to a waste site owned and operated by another party either: (1) we are one of many other identified generators who have reached an agreement regarding the allocation of costs for cleanup among the various generators and our potential liability is not material; (2) we have been identified as a potential generator and the sites have been remediated by the Environmental Protection Agency or by a state for a cost that is not material; or (3) other generators have cleaned up the site and have not pursued a claim against us and our liability, if any, would not be material.

 

We own and operate property located on Seaboard Industrial Boulevard in Atlanta, Georgia where we have been named as a potentially responsible party. We and the current and former owners of adjoining properties have agreed to share the expected costs and responsibilities of remediation. Further, we have executed a Consent Order with the Georgia Environmental Protection Division

 

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(“EPD”) covering this remediation, and are operating under an EPD approved Corrective Action Plan, which may be amended from time to time based on the progression of our remediation.  In May 2007, we accrued an undiscounted pre-tax liability of $5.0 million representing our best estimate of costs associated with subsurface remediation, primarily to remove contaminants from soil underlying this property, and other related environmental issues. While over approximately the next twenty years we could expend an amount ranging up to $10.0 million on these efforts, management’s best estimate of initial remediation costs continues to be $5.0 million. To date, we have expended approximately $2.3 million of the $5.0 million reserve established in May 2007. Further sampling, engineering studies, and/or changes in regulatory requirements could cause us to revise the current estimate. We arrived at the current estimates based on studies prepared by independent third party environmental consulting firms. The actual cost of remediation will vary depending upon the results of additional testing and geological studies, the success of initial remediation efforts in the first five years addressing the most significant areas of contamination, the rate at which site conditions may change, and the requirements of the EPD.

 

In December 2010, we became aware of contamination in one of our waste water treatment facilities caused by a raw material used in our production.  As a result of the contamination, we may be in violation of our Industrial Waste Water Permit issued by the City of Atlanta.  In addition, as a result of this contamination, waste may have been shipped off-site in violation of state and federal rules governing the transportation and disposal of hazardous waste.   We incurred $1.4 million of incremental cost during our second quarter in fiscal 2011 as a result of this contamination.  We voluntarily notified the City of Atlanta and the EPD of this matter.   While we do not expect to incur material elevated operating costs beyond the second quarter of fiscal 2011, we may incur fines and be subject to consent orders, the cost of which is unknown at this time.

 

***Environmental Liabilities Assumed in the Acquisition of Amrep***

 

Amrep is currently a party to federal and state administrative proceedings arising under federal and state laws enacted for the protection of the environment where a state or federal agency or a private party alleges that hazardous substances generated by Amrep have been discharged into the environment and a state or federal agency is requiring a cleanup of soil and/or groundwater pursuant to federal or state superfund laws. In each of these proceedings in which Amrep has been named as a party that allegedly generated hazardous substances that were transported to a waste site owned and operated by another party, either (1) Amrep is one of many other identified generators who have reached an agreement on the allocation of costs for cleanup among the various generators and Amrep’s potential liability is not material, or (2) Amrep has been identified as a potential generator but has been indemnified by its waste broker and transporter.

 

Amrep’s primary manufacturing location in Marietta, Georgia is the only active site involving property that Amrep owns with respect to which Amrep has been named as a potentially responsible party. With regard to this location, Amrep is responsible for the expected costs of implementing an Amended Corrective Action Plan that was submitted in March 2009 under the Georgia Hazardous Response Act (“HSRA”), the approval of which is still pending. The EPD is reviewing the amended Corrective Action Plan and will determine whether additional actions are necessary and, if so, for what period of time.

 

As of May 31, 2011, the liabilities presented within our *Consolidated Balance Sheets* reflect an undiscounted, pre-tax liability of approximately $11.0 million, which represents our best estimate of costs associated with the aforementioned Amended Corrective Action Plan for Amrep’s Marietta, Georgia location, primarily to remediate contaminants underlying the Marietta manufacturing facility and affected adjacent properties, and other related environmental issues. While over approximately the next twenty years we could expend an amount ranging up to $18.0 million on these efforts, management’s best estimate of remaining remediation costs is $11.0 million. Further sampling, engineering studies, and/or changes in regulatory requirements could cause revision to the current estimate. The initially recorded $12.0 million estimate was derived based on studies prepared by independent third party environmental consulting firms. To date, we have expended approximately $1.0 million of what the $12.0 million reserve established in December 2009. The actual cost of remediation will vary depending upon the results of additional testing and geological studies, the success of initial remediation designed to address the most significant areas of contamination, the rate at which site conditions may change, and the requirements of the EPD.

 

Additionally, Amrep previously conducted manufacturing operations at an unrelated property in Georgia that has since been sold. Pursuant to the terms of the sale, Amrep has retained environmental exposure that might arise from its previous use of this property. Management is preparing a plan to address the sub-surface contamination and, at this time, does not anticipate that costs associated with future remediation efforts will be material. As of May 31, 2011, accruals associated with this effort totaled approximately $0.2 million. However, the actual cost of remediation could vary depending upon the results of additional testing and geological studies and the rate at which site conditions may change. Finally, the Company has submitted a comprehensive Affected Property Assessment Report to address the sub-surface contamination at a Texas manufacturing location owned by Amrep, and, at this time, does not anticipate that the costs associated with future remediation efforts will be material. These estimates could change, however, based upon the response of the Texas Commission on Environmental Quality to that plan.

 

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***Britto and Cowan v. Zep Inc. and Acuity Specialty Products, Inc.***

 

The Company is a defendant in Britto and Cowan v. Zep Inc. and Acuity Specialty Products, Inc., a lawsuit that commenced in December 2010 in the Superior Court in Alameda County, California.  The plaintiffs, who are employed as sales representatives by Acuity Specialty Products, Inc., an subsidiary of the Company (“Acuity”), brought the lawsuit on behalf of themselves and on behalf of a putative class that includes all of Acuity’s current sales representatives and all former sales representatives who were employed by Acuity on December 30, 2006 or thereafter.  The putative class consists of 171 members, including 60 current sales representatives and 111 former sales representatives.  The plaintiffs allege that Acuity failed to reimburse the putative class members for work-related expenses and failed to pay the putative class members their wages by assessing unlawful deductions from commissions.  The Plaintiffs are also seeking to recover statutory and/or civil penalties pursuant to the California Labor Private Attorney General Act.  The Court has not yet considered whether to certify the putative class.  The Company believes that it has substantial factual and legal defenses to the Claims made in the lawsuit and intends to assert the defenses aggressively.

 

In May 2011, the Company made settlement offers to all members of the putative class who are currently employed by Acuity in an effort to reduce the expenses of litigating the case and to eliminate any potential adverse impact to ongoing selling efforts.  As of July 6, 2011, 28 members of the putative class had accepted the Company’s settlement offer.  During the quarter ended May 31, 2011, the Company recorded $1.2 million of expenses for legal fees incurred in connection with the defense of the lawsuit and the settlements described above.  The Company may enter into additional discussions regarding settlement of the lawsuit with the named plaintiffs and other members of the putative class, and may enter into settlement agreements, if it believes settlement is in the best interest of the Company’s shareholders.

 

If the Company is not successful in its defense against the claims asserted in the lawsuit and if there is an adverse verdict on the merits from which there is no successful appeal, or in the event of a negotiated settlement of the litigation, the resulting liability could be material to the Company’s financial condition or results of operations.  However, because of the uncertainty of the outcome of the lawsuit, including whether the class will be certified and the amount of damages, if any, any class member may be able to prove, and because the Company’s liability, if any, arising from the litigation, including the size of any damages awarded if plaintiffs are successful in the litigation or any negotiated settlement, could vary widely, the Company cannot estimate the reasonably possible losses or range of loss that may arise from the litigation in excess of the amounts offered in settlement to current employees as described above.

 

**6. RESTRUCTURING CHARGES**

 

During fiscal year 2010, *Restructuring Charges* recorded within our *Consolidated Statements of Operations*totaled $8.2 million and**reflect (1) the consolidation of our logistics branch network, (2) the further streamlining of our organizational structure, which resulted in the reduction of non-sales headcount, and (3) the continued integration of Zep’s and Amrep’s manufacturing capabilities.

 

In the nine months ended May 31, 2011, we recorded a pretax restructuring charge of $1.5 million for costs associated with facility consolidations and reduction of non-sales headcount. The fiscal 2011 changes to our restructuring reserve (included within *Accrued compensation* and *Other accrued liabilities* on the *Consolidated Balance Sheets*) are summarized as follows:

 
| ** **                                        | ** ** | **Severance   Costs** | ** ** | **Facility Exit   Costs** | ** ** |
|---------------------------------------------------|------------|-----------------------|------------|---------------------------|------------|
| **Balance as of August 31, 2010**                 |       | $                     | 2,567      |                      | $          | 3,433 |   |
| Restructuring charges recorded during fiscal 2011 |       | 1,096                 |       | 373                       |       |
| Payments made from restructuring reserves         |       | (2,573                | )          | (773                      | )          |
| **Balance as of May 31, 2011**                    |       | $                     | 1,090      |                      | $          | 3,033 |   |

 

We listed a facility in the Boston, Massachusetts area for sale during fiscal 2010 in conjunction with previously disclosed restructuring programs.  We sold this facility during the second quarter of our fiscal 2011, and we have reflected the related gain of $0.7 million as *Gain on Sale of Building* within our*Consolidated Statements of Operations*.  We lease the majority of our selling branch and warehouse locations, and the sale of owned facilities occurs infrequently.

 

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**7. EARNINGS PER SHARE**

 

On September 1, 2009, we retrospectively adopted an accounting pronouncement that provides that unvested share-based payment awards that contain nonforfeitable rights to dividends or dividend equivalents (whether paid or unpaid) are participating securities and should be included in the computation of earnings per share.  This guidance is applicable to us due to a dividend protection feature inherent within certain of our historical equity awards.  Awards issued under the fiscal 2011 annual grant did not include a dividend protection feature, and we do not currently intend to reinstate this provision.  Therefore, we expect the impact of this guidance on our earnings per share calculations to diminish over time.

 

Basic earnings per share is computed by dividing net income adjusted for presumed dividend payments on unvested shares by the weighted average number of common shares outstanding during the period. We exclude unvested shares of restricted stock from basic shares outstanding. Diluted earnings per share is computed similarly, but reflects the potential dilution that would occur if dilutive options were exercised and restricted stock awards were vested.

 

The following table reflects basic and diluted earnings per common share:

 
| ** **                                                               | ** ** | **Three Months Ended   May 31** | ** ** | **Nine Months Ended   May 31** | ** ** |
|--------------------------------------------------------------------------|------------|---------------------------------|------------|--------------------------------|------------|
| ** **                                                               | ** ** | **2011**                        | ** ** | **2010**                       | ** ** | **2011** | ** ** | **2010** | ** ** |
| Basic earnings per share:                                                |       |                            |       |                           |       |   |   |   |   |
| Net income                                                               |       | $                               | 6,243      |                           | $          | 5,234 |   | $ | 13,332 |   | $ | 11,392 |   |
| Less: Allocation of earnings and dividends to   participating securities |       | (71                             | )          | (126                           | )          | (151 | ) | (243 | ) |
| Net income available to common shareholders -   basic                    |       | $                               | 6,172      |                           | $          | 5,108 |   | $ | 13,181 |   | $ | 11,149 |   |
| Basic weighted average shares outstanding                                |       | 21,603                          |       | 21,324                         |       | 21,502 |   | 21,247 |   |
| Basic earnings per share                                                 |       | $                               | 0.29       |                           | $          | 0.24 |   | $ | 0.61 |   | $ | 0.52 |   |
| Diluted earnings per share:                                              |       |                            |       |                           |       |   |   |   |   |
| Net income available to common shareholders -   basic                    |       | $                               | 6,172      |                           | $          | 5,108 |   | $ | 13,181 |   | $ | 11,149 |   |
| Add: Undistributed earnings reallocated to   unvested shareholders       |       | 1                               |       | 1                              |       | 2 |   | 3 |   |
| Net income available to common shareholders -   diluted                  |       | $                               | 6,173      |                           | $          | 5,109 |   | $ | 13,183 |   | $ | 11,152 |   |
| Basic weighted average shares outstanding                                |       | 21,603                          |       | 21,324                         |       | 21,502 |   | 21,247 |   |
| Common stock equivalents (stock options and   restricted stock)          |       | 468                             |       | 533                            |       | 473 |   | 469 |   |
| Diluted weighted average shares outstanding                              |       | 22,071                          |       | 21,857                         |       | 21,975 |   | 21,716 |   |
| Diluted earnings per share                                               |       | $                               | 0.28       |                           | $          | 0.23 |   | $ | 0.60 |   | $ | 0.51 |   |

 

For the three month periods ended May 31, 2011 and 2010, we excluded from our earnings per share calculation 0.2 million and less than 0.1 million common stock equivalents, respectively, because of their anti-dilutive effect on this calculation. For the nine month periods ended May 31, 2011 and 2010, we excluded from our earnings per share calculation 0.2 million and 0.7 million common stock equivalents, respectively, because of their anti-dilutive effect on this calculation.

 

**8. COMPREHENSIVE INCOME**

 

Comprehensive income includes all changes in equity that result from recognized transactions and other economic events other than transactions with owners in their capacity as owners. We currently intend to indefinitely reinvest all undistributed earnings of and original investments in foreign subsidiaries, thus the foreign currency translation adjustments presented in the below listed tabular disclosure are not affected by domestic income taxes. The components of our comprehensive income are as follows:

 
| ** **                                                                                                                        | ** ** | **Three Months Ended   May 31** | ** ** | **Nine Months Ended****May 31** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------|------------|---------------------------------|------------|
| ** **                                                                                                                        | ** ** | **2011**                        | ** ** | **2010**                        | ** ** | **2011** | ** ** | **2010** | ** ** |
| **Net income**                                                                                                                    |       | $                               | 6,243      |                            | $          | 5,234 |   | $ | 13,332 |   | $ | 11,392 |   |
| Foreign currency translation adjustments (net of   tax of $0 in all periods)                                                      |       | 1,307                           |       | (2,452                          | )          | 5,743 |   | (3,012 | ) |
| Change in unrealized loss on hedges (net of tax of   $59 and $110 for the three and nine months ended May 31, 2010, respectively) |       | —                          |       | 94                              |       | — |   | 275 |   |
| **Comprehensive income**                                                                                                          |       | $                               | 7,550      |                            | $          | 2,876 |   | $ | 19,075 |   | $ | 8,655 |   |

 

Foreign currency translation adjustments for the three months and nine months ended May 31, 2011 resulted primarily from fluctuation of the U.S. Dollar compared with the Canadian Dollar and the Euro.

 

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**9. FAIR VALUE DISCLOSURES**

 

Our financial instruments consist primarily of cash and cash equivalents, trade receivables, trade payables, and debt and related derivative instruments. The book values of cash and cash equivalents, trade receivables, and trade payables are considered to be representative of their respective fair values due to their short-term nature. We estimate that the carrying value of all of our outstanding debt obligations approximates fair value based on the variable nature of interest rates associated with the indebtedness.

 

In September 2006, accounting guidance was issued that establishes a single authoritative definition of fair value, establishes a framework for measuring fair value, and expands disclosure requirements pertaining to fair value measurements. This guidance is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. Accordingly, we adopted this pronouncement effective September 1, 2008. The adoption did not affect our results of operations or financial condition. We applied the provisions of this guidance to non-financial assets, such as our property and equipment, goodwill and certain other assets, which are measured at fair value for impairment as required beginning September 1, 2010. The application of this guidance did not affect our results of operations or financial condition.

 

**Item 2.****                                 *****Management’s Discussion and Analysis of Financial Condition and Results of Operations***

 

The following discussion should be read in conjunction with the *Consolidated Financial Statements* and related notes thereto. References made to years are for fiscal year periods.

 

The purpose of this discussion and analysis is to enhance the understanding and evaluation of our results of operations, financial position, cash flows, indebtedness, and other key financial information as of and for the three and nine month periods ended May 31, 2011 and 2010. Also, please refer to our Form 10-K for the fiscal year ended August 31, 2010 for additional information regarding Zep, including our audited consolidated and combined financial statements as of and for each of the three years ended August 31, 2010 and the related notes thereto.

 

**Overview**

 

***Company***

 

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 we were founded in 1937. 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 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, and, as a result of recent acquisitions, have established a strong presence in the distributor market.

 

Due to the seasonal nature of a portion of our business and the number of available selling days, sales in the second-half of our fiscal year have historically outpaced those generated in the first-half of the fiscal year. Additional discussion of trends and expectations related to the remainder of fiscal year 2011 and beyond is included within the *Results of Operations* and *Outlook* sections of *Management’s Discussion and Analysis of Financial Condition and Results of Operations.*

 

***Acquisitions***

 

On January 4, 2010, we acquired Amrep a specialty chemical formulator and packager focused in the automotive, fleet maintenance, industrial/MRO supply, institutional supply, and motorcycle markets. Amrep was acquired for approximately $63.5 million. Amrep’s products are marketed under recognized and established brand names such as Misty®, Next DimensionTM, 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. We borrowed under our credit facilities to finance the purchase price of Amrep.

 

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On September 2, 2010, Amrep and certain other of our subsidiaries acquired certain brands and assets and assumed certain liabilities of the North American operations of 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(R), TimeWick®, MicrobeMax(TM), Country Vet(R), and Konk(TM). We did not acquire Waterbury’s manufacturing facility. Waterbury entered into a transition services agreement with us pursuant to which it is continuing to make products for us until we have completed the transfer of related manufacturing operations to our facilities.  We will complete this transfer during the fourth quarter of fiscal year 2011. We acquired the Waterbury brands and assets for a cash purchase price of approximately $66 million. Of the approximately $66 million purchase price, $62 million was funded through borrowings under our 2010 Credit Facility (discussed further in Note 4 of *Notes to Consolidated Financial Statements*), and the remaining $4.0 million was funded through available cash.

 

On October 1, 2010, we completed the acquisition of the brands and assets of Atlanta-based Niagara National, LLC, a manufacturer of truck wash systems and products. The historical total assets and operating results of Niagara National, LLC 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 that includes the Zep, EnviroEdge, and Armor All Professional® brands.

 

***Strategy***

 

Our strategy is to further our position as a leading provider of innovative, environmentally sustainable cleaning and maintenance solutions for commercial and industrial end users. We seek to achieve financial performance in the top quartile of our peer group of companies by growing our share with existing and new customers and expanding our margins. To achieve this financial performance, we intend to:

 

·                  Profitably grow the sales and service business;

 

·                  Serve “pro” customers through a broad retail base;

 

·                  Grow sales with new and existing distributors;

 

·                  Build upon existing European capabilities; and

 

·                  Expand through selected acquisitions.

 

During the past three years, we streamlined our historical product offering by approximately 50%; we reduced our branch network from 42 locations to 17 locations; we reduced non-sales headcount by approximately 10%; and we reduced the breakeven point of our Sales and Service selling organization by almost one-third. These changes allowed us to increase our cash flows and to reduce our debt by 53% before we began pursuing acquisitive growth opportunities. We began to implement our acquisition strategy in fiscal 2010 with the January 2010 acquisition of Amrep followed by our acquisition in September 2010 of certain assets and the assumption of certain liabilities of Waterbury, including certain air-care brands. These two acquisitions gave us a strong presence in the distributor market and strengthened our position in the retail market. The acquisition of Amrep also allowed us to consolidate further our manufacturing operations. In October 2010, we acquired the assets of Niagara, which complements the strength of our direct-sales organization in the vehicle-wash market, specifically in the truck and fleet washing equipment markets.

 

***Liquidity and Capital Resources***

 

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 2010 Credit Facility, which, net of scheduled term loan repayments, provides for a maximum borrowing capacity of $314 million. As of May 31, 2011, 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 and supporting certain environmental obligations. These letters of credit were issued under the 2010 Credit Facility as of August 31, 2010, thereby reducing the total availability under the facility by such amount. As of May 31, 2011, we had $7.9 million in cash and cash equivalents of which $4.5 million was held by our foreign subsidiaries.  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.    As of May 31, 2011 we had approximately $168.4 million of available borrowing capacity under the 2010 Credit Facility and 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.

 

We intend to use our liquidity and capital resources to fund our working capital needs, capital expenditures, strategic initiatives, and other anticipated cash requirements, excluding acquisitions, over the next twelve months. In addition, subject to market

 

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conditions, we may also access our effective shelf registration to help fund these needs. The shelf registration provides for 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 the sale of any securities registered thereunder 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.

 

We were in compliance with our debt covenants as of May 31, 2011, 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 foreseable future, excluding acquisitions.

 

***Cash Flow***

 

We use available cash and cash flow provided by operating activities primarily to fund operations and capital expenditures. Net cash provided by our operating activities totaled $11.7 million during the nine months ended May 31, 2011, compared with $15.2 million of cash provided by our operating activities in the same prior year period. We used approximately $2.0 million of cash in the first quarter of fiscal 2011 to pay professional fees associated with the Waterbury acquisition that were accrued in the fourth quarter of fiscal year 2010. In addition, the funding of incentive-based compensation programs required more cash in fiscal year 2011 than in the previous fiscal year, and inventory levels are higher this year than in the prior fiscal year, each of which contributed to the decrease in cash provided by our operating activities in 2011.  Partially offsetting these uses of cash are higher net earnings generated in the first nine months of this fiscal year compared with the same period last year, as well as a reduction in comparable accounts receivable balances.

 

Cash invested in acquisitions during the nine months ended May 31, 2011, totaled $76.1 million compared with $63.5 million in the prior year-to-date period. We invested $5.2 million and $7.7 million in the nine months ended May 31, 2011 and 2010, respectively, primarily for building improvements, machinery, equipment, and information technology. Management believes that investing in assets and programs that will over time increase the return on our invested capital is a key factor in creating stockholder value. We expect to make capital expenditures of approximately $8 million in fiscal year 2011.

 

**Results of Operations**

 

***Third Quarter of Fiscal Year 2011 Compared with Third Quarter of Fiscal Year 2010***

 

The following tables set forth information comparing the components of net income for the three months ended May 31, 2011 with the three months ended May 31, 2010. Both dollar and percentage changes included within the tables below were calculated from our *Consolidated Statements of Operations*.

 
| ** **                        | ** ** | **Three Months Ended** | ** ** | ** **  | ** ** |
|-----------------------------------|------------|------------------------|------------|-------------|------------|
| ** **                        | ** ** | **May 31**             | ** ** | **Percent** | ** ** |
| **(Dollars in millions)**         | ** ** | **2011**               | ** ** | **2010**    | ** ** | **Change** | ** ** |
| Net Sales                         |       | $                      | 167.9      |        | $          | 153.0 |   | 9.7 | % |
| Gross Profit                      |       | 78.4                   |       | 75.6        |       | 3.7 | % |
| *Percent of net sales*            | * *   | *46.7*                 | *%*        | *49.4*      | *%*        |   |   |
| Operating Profit                  |       | 11.6                   |       | 9.2         |       | 26.7 | % |
| *Percent of net sales*            |       | 6.9                    | *%*        | 6.0         | *%*        |   |   |
| Income before Provision for Taxes |       | 10.0                   |       | 8.6         |       | 15.4 | % |
| *Percent of net sales*            |       | 5.9                    | *%*        | 5.6         | *%*        |   |   |
| Net Income                        |       | $                      | 6.2        |        | $          | 5.2 |   | 19.3 | % |

 

***Net Sales***

 

Net sales totaled $167.9 million in the third quarter of fiscal year 2011 compared with $153.0 million in the third quarter of fiscal year 2010, an increase of $14.9 million or 9.7%.  Our third quarter fiscal year 2011 sales performance included $13.7 million of revenues from companies acquired in fiscal years 2011 and 2010.  Excluding incremental acquisition-related revenues, we increased sales volume to customers accessed through the distribution and retail channels as well as to customers in the food processing, manufacturing, and automotive end markets.  Also, we were able to realize $6.6 million from higher selling prices enacted to mitigate the impact of rising raw material costs.  However, these gains were more than offset by the continued decline in volume sold through our direct sales and service channel, where sales to customers in the school and government and several other end markets remain soft.

 

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Finally, fluctuation in foreign currencies on international sales comprised $2.0 million of this quarter’s comparative $14.9 million increase in net sales.

 

***Gross Profit***

 
| ** **                | ** ** | **Three Months Ended** | ** ** | ** **   | ** ** | ** **     | ** ** |
|---------------------------|------------|------------------------|------------|--------------|------------|----------------|------------|
| ** **                | ** ** | **May 31**             | ** ** | **Increase** | ** ** | **Percent**    | ** ** |
| **(Dollars in millions)** | ** ** | **2011**               | ** ** | **2010**     | ** ** | **(Decrease)** | ** ** | **Change** | ** ** |
| Net Sales                 |       | $                      | 167.9      |         | $          | 153.0          |       | $ | 14.9 |   | 9.7 | % |
| Cost of Products Sold     |       | 89.6                   |       | 77.5         |       | 12.1           |       | 15.6 | % |
| *Percent of net sales*    | * *   | *53.3*                 | *%*        | *50.6*       | *%*        |           |       |   |   |
| Gross Profit              |       | $                      | 78.4       |         | $          | 75.6           |       | $ | 2.8 |   | 3.7 | % |
| *Percent of net sales*    | * *   | *46.7*                 | *%*        | *49.4*       | *%*        |           |       |   |   |

 

Gross profit increased $2.8 million, or 3.7%, to $78.4 million in the third quarter of fiscal year 2011 compared with $75.6 million in the prior year period. Gross profit margin was 46.7% in the third quarter of fiscal year 2011, representing an approximate 270 basis point decline from the same prior year period.

 

Gross profit margin declined during the third quarter of fiscal year 2011 due in part to the increase in the percentage of total sales sold through the distributor and retail channels.  As previously disclosed, in recent months we experienced an increase in the cost of our raw materials.  In addition to the change in our sales mix and product mix, increased raw material costs had a negative impact on our third quarter fiscal year 2011 gross profit and gross profit margin. Price increases implemented by the direct sales and service organization successfully mitigated the impact that higher raw material costs had on our overall gross profit, but were not sufficient to offset the degradation of our overall gross profit margin.  Further, we recently initiated price increases in the distribution and retail channels.  However, we do not expect to begin benefiting from these actions until the fourth quarter of fiscal year 2011.

 

We previously disclosed the expectation that operational milestones regarding the Waterbury integration would occur during the third quarter of fiscal 2011.  During this quarter, we successfully moved the majority of production from Waterbury’s manufacturing facility and incurred one-time charges totaling $0.3 million as a result of these efforts.  We expect to complete the move of production from Waterbury’s manufacturing facility during the fourth quarter of fiscal year 2011.

 

***Operating Profit***

 
| ** **                                         | ** ** | **Three Months Ended** | ** ** | ** **   | ** ** | ** **     | ** ** |
|----------------------------------------------------|------------|------------------------|------------|--------------|------------|----------------|------------|
| ** **                                         | ** ** | **May 31**             | ** ** | **Increase** | ** ** | **Percent**    | ** ** |
| **(Dollars in millions)**                          | ** ** | **2011**               | ** ** | **2010**     | ** ** | **(Decrease)** | ** ** | **Change** | ** ** |
| Gross Profit                                       |       | $                      | 78.4       |         | $          | 75.6           |       | $ | 2.8 |   | 3.7 | % |
| *Percent of net sales*                             | * *   | *46.7*                 | *%*        | *49.4*       | *%*        |           |       |   |   |
| Selling, Distribution, and Administrative Expenses |       | 66.3                   |       | 64.4         |       | 1.9            |       | 2.9 | % |
| Acquisition and Integration Costs                  |       | 0.4                    |       | —       |       | 0.4            |       | 100 | % |
| Restructuring Charge                               |       | —                 |       | 2.0          |       | (2.0           | )          | (100 | )% |
| Gain on Sale of Building                           |       | —                 |       | —       |       |           |       |   |   |
| Operating Profit                                   |       | $                      | 11.6       |         | $          | 9.2            |       | $ | 2.4 |   | 26.7 | % |
| *Percent of net sales*                             |       | 6.9                    | *%*        | *6.0*        | *%*        |           |       |   |   |

 

The shift in the mix of our sales from the direct-sales channel to sales through the distribution and retail channels that resulted from the Amrep and Waterbury acquisitions altered our margin structure. While the gross profit margin for sales through the distribution and retail channels is lower, sales through these channels are associated with lower selling and distribution costs.  Therefore, our selling, distribution and administrative expenses declined as a percentage of sales to 39.5% in the third quarter of fiscal year 2011 from 42.1% in the third quarter of fiscal year 2010.  The change represents an improvement of approximately 260 basis points.  During the third quarter of fiscal year 2011, we recorded an out-of-period adjustment in our *Consolidated Financial Statements*.  This adjustment corrected the improper accrual of certain compensation-related expenses that accumulated ratably over a three-year period.  The adjustment reduced selling, distribution and administrative expenses and accrued compensation in the third quarter of fiscal year 2011 by approximately $1.3 million.  Management undertook both a quantitative and qualitative assessment of this error pursuant to relevant authoritative literature. After performing this assessment, management concluded that the error was not material to our *Consolidated Financial Statements*.

 

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Since January 2010, we have executed the three acquisitions discussed above which has resulted in the recording of approximately $63.7 million of finite-lived intangible assets (namely customer relationships and intellectual property). On an annual basis, we expect amortization of these assets will result in approximately $4.0 million of amortization expense.

 

During the quarter ended May 31, 2011, the Company recorded $1.2 million of expenses for legal fees incurred in connection in the defense of the California lawsuit and related settlement offers described in Note 5 of *Notes to Consolidated Financial Statement*.   Relative to the same prior year quarter, incremental legal costs in the third fiscal quarter of 2011 totaled $0.6 million. Also, we recorded $0.4 million of severance-related costs in May 2011 due to the continued reorganization of the acquired Amrep organization.  We recorded a restructuring charge of $2.0 million during May 2010 related primarily to employee severance costs.

 

Operating profit increased $2.4 million in the third quarter of fiscal year 2011 to a profit of $11.6 million compared with $9.2 million reported in the third quarter of fiscal year 2010. Operating margins were 6.9% in the third quarter of fiscal year 2011 compared with 6.0% in the comparative prior year period.

 

***Income before Provision for Taxes***

 
| ** **                                   | ** ** | **Three Months Ended** | ** ** | ** **   | ** ** | ** **     | ** ** |
|----------------------------------------------|------------|------------------------|------------|--------------|------------|----------------|------------|
| ** **                                   | ** ** | **May 31**             | ** ** | **Increase** | ** ** | **Percent**    | ** ** |
| **(Dollars in millions)**                    | ** ** | **2011**               | ** ** | **2010**     | ** ** | **(Decrease)** | ** ** | **Change** | ** ** |
| Operating Profit                             |       | $                      | 11.6       |         | $          | 9.2            |       | $ | 2.4 |   | 26.7 | % |
| *Percent of net sales*                       | * *   | *6.9*                  | *%*        | *6.0*        | *%*        |           |       |   |   |
| Other Expense                                |       |                   |       |         |       |           |       |   |   |
| Interest Expense, net                        |       | 1.6                    |       | 0.6          |       | 1.0            |       | 184 | % |
| (Gain) Loss on foreign currency transactions |       | 0.1                    |       | —       |       | 0.0            |       | 36.8 | % |
| Miscellaneous expense (income)               |       | —                 |       | (0.1         | )          | 0.1            |       | 114 | % |
| Total Other Expense                          |       | 1.6                    |       | 0.5          |       | 1.1            |       | 213 | % |
| Income before Provision for Taxes            |       | $                      | 10.0       |         | $          | 8.6            |       | $ | 1.3 |   | 15.4 | % |
| *Percent of net sales*                       | * *   | *5.9*                  | *%*        | *5.6*        | *%*        |           |       |   |   |

 

Other expenses increased $1.2 million from the third quarter of fiscal year 2010. Our level of indebtedness, and, therefore our interest expense, has increased due primarily to debt incurred to fund our acquisitions. We expect total interest expense to range from $6.5 million to $7.0 million on an annual basis assuming current debt levels and interest rates.

 

***Provision for Taxes and Net Income***

 
| ** **                               | ** ** | **Three Months Ended** | ** ** | ** **   | ** ** | ** **     | ** ** |
|------------------------------------------|------------|------------------------|------------|--------------|------------|----------------|------------|
| ** **                               | ** ** | **May 31**             | ** ** | **Increase** | ** ** | **Percent**    | ** ** |
| **(Dollars in millions)**                | ** ** | **2011**               | ** ** | **2010**     | ** ** | **(Decrease)** | ** ** | **Change** | ** ** |
| Income before Provision for Income Taxes |       | $                      | 10.0       |         | $          | 8.6            |       | $ | 1.3 |   | 15.4 | % |
| *Percent of net sales*                   | * *   | *5.9*                  | *%*        | *5.6*        | *%*        |           |       |   |   |
| Provision for Income Taxes               |       | 3.7                    |       | 3.4          |       | 0.3            |       | 9.3 | % |
| *Effective tax rate*                     | * *   | *37.3*                 | *%*        | *39.3*       | *%*        |           |       |   |   |
| Net Income                               |       | $                      | 6.2        |         | $          | 5.2            |       | $ | 1.0 |   | 19.3 | % |

 

Net income for the third quarter of fiscal year 2011 increased $1.0 million, or 19.3%, to $6.2 million compared with $5.2 million reported in the third quarter of fiscal year 2010.

 

Diluted earnings per share generated in the three months ended May 31, 2011 totaled $0.28, which is a per share increase of $0.05 compared with the $0.23 earnings per diluted share reported in the prior year period. Net income in the third quarter ended May 31, 2011 included $0.4 million or $0.02 per diluted share of legal costs that were incremental when compared with the same year-ago period.  Net income in the third quarter of fiscal 2011 also included $0.4 million or $0.02 per diluted share of acquisition related costs pertaining to the continued Amrep and Waterbury integrations. Earnings in the third fiscal quarter of 2010 were negatively impacted by $0.06 per diluted share resulting from a restructuring charge and by $0.01 per diluted share due resulting from incremental costs associated with recording acquired inventory at estimated fair value in accordance with purchase accounting rules.

 

The effective tax rate for the third quarter of fiscal year 2011 was 37.3%, compared with 39.3% in the prior year period. We anticipate our effective tax rate will range between 36% and 37% for fiscal year 2011, which is consistent with effective tax rates of previous fiscal years.

 

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***Nine Months of Fiscal 2011 Compared with Nine Months of Fiscal 2010***

 

The following table sets forth information comparing the components of net income for the nine months ended May 31, 2011 with the nine months ended May 31, 2010. Both dollar and percentage changes included within the tables below were calculated from our *Consolidated Statements of Operations*.

 
| ** **                        | ** ** | **Nine Months Ended** | ** ** | ** **  | ** ** |
|-----------------------------------|------------|-----------------------|------------|-------------|------------|
| ** **                        | ** ** | **May 31**            | ** ** | **Percent** | ** ** |
| **(Dollars in millions)**         | ** ** | **2011**              | ** ** | **2010**    | ** ** | **Change** | ** ** |
| Net Sales                         |       | $                     | 472.2      |        | $          | 407.1 |   | 16.0 | % |
| Gross Profit                      |       | 225.0                 |       | 205.4       |       | 9.5 | % |
| *Percent of net sales*            | * *   | *47.7*                | *%*        | *50.5*      | *%*        |   |   |
| Operating Profit                  |       | 26.0                  |       | 19.6        |       | 32.7 | % |
| *Percent of net sales*            | * *   | *5.5*                 | *%*        | *4.8*       | *%*        |   |   |
| Income before Provision for Taxes |       | 20.9                  |       | 18.3        |       | 14.3 | % |
| *Percent of net sales*            | * *   | *4.4*                 | *%*        | *4.5*       | *%*        |   |   |
| Net Income                        |       | $                     | 13.3       |        | $          | 11.4 |   | 17.0 | % |

 

***Net Sales***

 

Net sales were $472.2 million in the nine months ended May 31, 2011 compared with $407.1 million in the prior year-to-date period, representing an increase of $65.1 million or 16.0%.  Revenues of approximately $68.5 million in the first nine months of fiscal year 2011 were generated by acquisitions closed in fiscal years 2011 and 2010.  Additionally, higher selling prices primarily realized in our direct sales and service channel and favorable foreign currency translation on international sales contributed to additional net sales of approximately $12.3 million and $1.8 million, respectively.  However, weakness in demand for our products sold through the North American direct sales and service channel continues, and the resulting decline in organic sales volume more than offset higher selling prices and the effect of currency fluctuation.

 

Separately, in the first quarter of fiscal year 2010, we executed a release agreement addressing historical business transactions with a third-party French licensee.  We received a one-time, $1.1 million payment in the first quarter of fiscal year 2010 pursuant to this release agreement.

 

***Gross Profit***

 
| ** **                | ** ** | **Nine Months Ended** | ** ** | ** **   | ** ** | ** **     | ** ** |
|---------------------------|------------|-----------------------|------------|--------------|------------|----------------|------------|
| ** **                | ** ** | **May 31**            | ** ** | **Increase** | ** ** | **Percent**    | ** ** |
| **(Dollars in millions)** | ** ** | **2011**              | ** ** | **2010**     | ** ** | **(Decrease)** | ** ** | **Change** | ** ** |
| Net Sales                 |       | $                     | 472.2      |         | $          | 407.1          |       | $ | 65.1 |   | 16.0 | % |
| Cost of Products Sold     |       | 247.2                 |       | 201.7        |       | 45.5           |       | 22.5 | % |
| *Percent of net sales*    | * *   | *52.3*                | *%*        | *49.5*       | *%*        |           |       |   |   |
| Gross Profit              |       | $                     | 225.0      |         | $          | 205.4          |       | $ | 19.6 |   | 9.5 | % |
| *Percent of net sales*    | * *   | *47.7*                | *%*        | *50.5*       | *%*        |           |       |   |   |

 

Gross profit increased $19.6 million, or 9.5%, to $225.0 million in the nine months ended May 31, 2011 compared with $205.4 million in the nine months ended May 31, 2010. Gross profit margin of 47.7% in the current year-to-date period decreased approximately 280 basis points from same period in the prior year. Sales in the first nine months of fiscal year 2011 included nine months of sales related to the Amrep and Waterbury acquisitions, whereas, during the same period in the fiscal year 2010, we only benefited from five months of sales from the Amrep acquisition.  The decline in gross profit margin percentage was primarily attributable to the impact on sales and product mix from the Amrep and Waterbury acquisitions.

 

During the second quarter of fiscal year 2011, we detected contamination within one of our manufacturing location’s waste streams, which caused a temporary increase in our wastewater disposal and overall operating costs.  Gross profit in the first nine months of fiscal year 2011 includes $1.4 million of costs associated with this occurrence, which represents approximately 30 basis points of gross profit margin.  The affected waste treatment facility is now fully functional, and we do not expect future cost associated with this event, if any, to be material.

 

Partially offsetting the above mentioned items responsible for a decline in gross profit are price increases implemented to address the increase of raw materials used in our production and improved manufacturing absorption.  While we are realizing the full

 

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benefit of price increases implemented in the direct sales and service channel, we expect to realize fully the benefit of recently initiated price increases in the distribution and retail channels during the next six months.

 

***Operating Profit***

 
| ** **                                         | ** ** | **Nine Months Ended** | ** ** | ** **   | ** ** | ** **     | ** ** |
|----------------------------------------------------|------------|-----------------------|------------|--------------|------------|----------------|------------|
| ** **                                         | ** ** | **May 31**            | ** ** | **Increase** | ** ** | **Percent**    | ** ** |
| **(Dollars in millions)**                          | ** ** | **2011**              | ** ** | **2010**     | ** ** | **(Decrease)** | ** ** | **Change** | ** ** |
| Gross Profit                                       |       | $                     | 225.0      |         | $          | 205.4          |       | $ | 19.6 |   | 9.5 | % |
| *Percent of net sales*                             | * *   | *47.7*                | *%*        | *50.5*       | *%*        |           |       |   |   |
| Selling, Distribution, and Administrative Expenses |       | 197.8                 |       | 182.0        |       | 15.9           |       | 8.7 | % |
| Acquisition and Integration Costs                  |       | 0.4                   |       | 1.6          |       | (1.1           | )          | (72.3 | )% |
| Restructuring Charge                               |       | 1.5                   |       | 2.4          |       | (0.9           | )          | (37.5 | )% |
| Gain on Sale of Building                           |       | (0.7                  | )          | —       |       | (0.7           | )          | (100 | )% |
| Operating Profit (Loss)                            |       | $                     | 26.0       |         | $          | 19.6           |       | $ | 6.4 |   | 32.7 | % |
| *Percent of net sales*                             | * *   | *5.5*                 | *%*        | *4.8*        | *%*        |           |       |   |   |

 

The Amrep and Waterbury acquisitions have significantly altered our margin structure due to the increased percentage of product sold through the distributor and retail channels. While gross profit margin associated with sales through distributor and retail channels is lower, sales through these channels normally result in higher operating margins given lower associated selling and distribution costs. Our selling, distribution and administrative expenses as a percentage of sales declined to 41.9% in the first nine months of fiscal 2011 from 44.7% in the first nine months of fiscal 2010, an improvement of approximately 280 basis points. This favorable trend is due to the inclusion of Amrep and Waterbury-related operating results as well as the success of previously enacted restructuring initiatives undertaken to reduce the breakeven point of the business. We have been able to use our reduced cost structure to invest further in sales and marketing resources, as well as fund employee incentive programs designed to reward profitable growth.

 

In the first nine months of fiscal year 2011, we recorded restructuring charges of $1.5 million, primarily for costs associated with the reduction of non-sales headcount and a facility consolidation. During the quarter ended May 31, 2011, the Company recorded $1.2 million of expenses for legal fees incurred in connection in the defense of the California lawsuit and related settlement offers described in Note 5 of *Notes to Consolidated Financial Statement*.   Relative to the same prior year quarter, incremental legal costs in the third fiscal quarter of 2011 totaled $0.6 million. Also, we recorded $0.4 million of severance-related costs in May 2011 due to the continued reorganization of the acquired Amrep organization.  In the first nine months of fiscal year 2010, we recorded restructuring charges of $2.4 million primarily for costs associated with facility consolidations.

 

We listed a facility in the Boston, Massachusetts area for sale during fiscal 2010 in conjunction with previously disclosed restructuring programs.  We sold this facility during the second quarter of our fiscal 2011, and we subsequently recognized the related gain of $0.7 million in our operating results.  We lease the majority of our selling branch and warehouse locations, and the sale of owned facilities occurs infrequently.

 

As previously stated, since January 2010, we have executed three acquisitions resulting in the recording of approximately $63.7 million of finite-lived intangible assets (namely customer relationships and intellectual property). On an annual basis, amortization of these assets will result in approximately $4.0 million of amortization expense. We incurred acquisition costs during the nine months ended May 31, 2010 associated with the purchase of Amrep totaling $1.6 million. Acquisition and integration costs in the first nine months of fiscal 2011 totaled $0.4 million.

 

Operating profit increased $6.4 million in the nine months ended May 31, 2011 to a profit of $26.0 million compared with $19.6 million reported in the nine months ended May 31, 2010. Operating margins were 5.5% in the first nine months of fiscal year 2011 compared with 4.8% in the comparative prior year period.

 

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***Income before Provision for Taxes***

 
| ** **                                   | ** ** | **Nine Months Ended** | ** ** | ** **   | ** ** | ** **     | ** ** |
|----------------------------------------------|------------|-----------------------|------------|--------------|------------|----------------|------------|
| ** **                                   | ** ** | **May 31**            | ** ** | **Increase** | ** ** | **Percent**    | ** ** |
| **(Dollars in millions)**                    | ** ** | **2011**              | ** ** | **2010**     | ** ** | **(Decrease)** | ** ** | **Change** | ** ** |
| Operating Profit                             |       | $                     | 26.0       |         | $          | 19.6           |       | $ | 6.4 |   | 32.7 | % |
| *Percent of net sales*                       | * *   | *5.5*                 | *%*        | *4.8*        | *%*        |           |       |   |   |
| Other Expense                                |       |                  |       |         |       |           |       |   |   |
| Interest Expense, net                        |       | 5.1                   |       | 1.3          |       | 3.8            |       | 294 | % |
| (Gain) Loss on foreign currency transactions |       | (0.2                  | )          | —       |       | (0.2           | )          | (100 | )% |
| Miscellaneous expense (income)               |       | 0.1                   |       | (0.1         | )          | 0.2            |       | 250 | % |
| Total Other Expense                          |       | 5.0                   |       | 1.2          |       | 3.8            |       | 305 | % |
| Income before Provision for Taxes            |       | $                     | 20.9       |         | $          | 18.3           |       | $ | 2.6 |   | 14.3 | % |
| *Percent of net sales*                       | * *   | *4.4*                 | *%*        | *4.5*        | *%*        |           |       |   |   |

 

Other expenses increased $3.8 million from the nine months ended May 31, 2010. Our level of indebtedness, and, therefore our interest expense, has increased due primarily to debt incurred to fund our acquisitions. Assuming current debt levels, total interest expense is expected to range from $6.5 million to $7.0 million on an annual basis.

 

***Provision for Taxes and Net Income***

 
| ** **                               | ** ** | **Nine Months Ended** | ** ** | ** **   | ** ** | ** **     | ** ** |
|------------------------------------------|------------|-----------------------|------------|--------------|------------|----------------|------------|
| ** **                               | ** ** | **May 31**            | ** ** | **Increase** | ** ** | **Percent**    | ** ** |
| **(Dollars in millions)**                | ** ** | **2011**              | ** ** | **2010**     | ** ** | **(Decrease)** | ** ** | **Change** | ** ** |
| Income before Provision for Income Taxes |       | $                     | 20.9       |         | $          | 18.3           |       | $ | 2.6 |   | 14.3 | % |
| *Percent of net sales*                   | * *   | *4.4*                 | *%*        | *4.5*        | *%*        |           |       |   |   |
| Provision for Income Taxes               |       | 7.6                   |       | 6.9          |       | 0.7            |       | 9.7 | % |
| *Effective tax rate*                     | * *   | *36.3*                | *%*        | *37.8*       | *%*        |           |       |   |   |
| Net Income                               |       | $                     | 13.3       |         | $          | 11.4           |       | $ | 1.9 |   | 17.0 | % |

 

Net income for the nine months ended May 31, 2011 increased $1.9 million, or 17.0%, to $13.3 million from $11.4 million reported in the first nine months of fiscal year 2010. The increase in net income resulted primarily from the increase in operating profit noted above. Net income in the first nine months of fiscal 2011 reflects charges totaling $1.6 million, or $0.07 per diluted share, related to restructuring efforts and incremental expense due to an increased basis in acquired inventories. The above mentioned wastewater contamination resulting in a temporary increase in manufacturing costs adversely affected year-to-date fiscal 2011 net income by $0.9 million or $0.04 per diluted share.  The Boston facility sale resulted in a gain that contributed $0.4 million or $0.02 per diluted share to year-to-date fiscal 2011 net income and earnings per share, respectively. Net income in the third quarter ended May 31, 2011 also included $0.4 million or $0.02 per diluted share of legal costs that were incremental when compared with the same year-ago period, and $0.4 million or $0.02 per diluted share of acquisition related costs pertaining to the continued Amrep and Waterbury integrations.

 

Net income for the nine months ended May 31, 2010, reflects charges totaling $1.0 million, or $0.04 per diluted share, of acquisition costs associated with last year’s purchase of Amrep.  Additionally, net income and earnings per diluted share in the first nine months of fiscal year 2010 included $1.5 million or $0.07, respectively, of charges pertaining to restructuring activities.  Also included in the comparative prior year period’s reported results is $0.5 million (after-tax) or $0.02 per diluted share of incremental expense due to an increased basis in acquired inventories.  Finally, in the first quarter of fiscal 2010, we executed a release agreement addressing historical business transactions with a third-party French licensee.  We received a one-time, $0.7 million after-tax payment pursuant to this release agreement, which contributed earnings per diluted share of $0.03.

 

The effective tax rate for the first nine months of fiscal year 2011 was 36.3%, compared with 37.8% in the prior year period. We expect our effective tax rate to range between 36% and 37% for fiscal year 2011, which is consistent with effective tax rates of previous fiscal years.

 

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**Outlook**

 

We are committed to transforming the business into a dynamic, market-driven enterprise that delivers superior products and customer service. Importantly, we believe we have made substantial improvements to our cost structure. In the near term, we will continue to invest in the business, organically as well as acquisitively, while leveraging our improved cost structure.

 

During fiscal year 2011, we intend to take certain of the following actions in pursuit of our strategic goals:

 

·                  Profitably grow the revenue of our sales and service organization by focusing on our key strategic end markets where the customers value the training and experience of our dedicated sales force. We will continue to invest in tools and training to enhance further the effectiveness of our Sales and Service organization. We also expect to develop new products and new marketing initiatives for targeted strategic end-markets;

 

·                  Diversify our business with retailers by utilizing a variety of owned and private label brands focused on the “pro” buyer;

 

·                  Expand our business in the distributor channel by offering industrial and specialty distributors a variety of owned and private label brands focusing on the category management strategies of the distributors. We will leverage our recently acquired assets and brands to penetrate further this channel;

 

·                  Improve and then expand our international operations leveraging the strengths of the Italian organization by more fully integrating our western European operations and evaluate acquisition opportunities to expand in other areas of Europe; and

 

·                  Grow through profitable, strategic acquisitions that will expand our access to markets and utilize the strength of our formulations and industry knowledge to accelerate our growth.

 

We believe that the success of our strategy in creating shareholder value will be measured by the following long-term financial objectives:

 

·                  Revenue growth in excess of market growth rates;

 

·                  Annualized EBITDA margin improvement of 50 basis points;

 

·                  Annualized earnings per share increases of 11 — 13%; and

 

·                  Returns on invested capital of greater than 15%.

 

These financial objectives are long term in nature and are expressed in terms of annualized improvement. We have previously stated that in the early phases of our transformation, we would likely experience inconsistency in meeting these objectives, and that we expect our financial results to fluctuate over time as we implement our strategy. Our progress towards these objectives was delayed by the deep and prolonged economic recession that began in December 2007 and worsened throughout the majority of our 2008 and 2009 fiscal years. However, as discussed in the previous sections, we made significant improvements to the business during the past three years, and we remain committed to achieving our previously stated long-term financial objectives.

 

We face potential execution risk with respect to accomplishing our strategic initiatives. We believe we are operating in a new economic reality following the broad economic downturn, and the full impact on our customers is not yet known. While economists have declared an end to the recession, its effects are widely predicted to be felt for many months to come. We believe markets reached through our direct-sales organization, which include transportation, food, industrial manufacturing, and government, are strongly correlated to seasonally-adjusted manufacturing employment, overall employment levels and, to some degree, new motor vehicle sales. Sales into this channel are expected to remain soft for the foreseeable future, and we intend to continue managing the business in a way that is not predicated upon a near-term recovery. However, as volume growth returns, we expect to realize significant financial leverage due to our efforts to improve productivity and streamline the business.

 

Volatility in the commodities markets had a negative impact on our margins and volumes during the third quarter of fiscal 2011 and could have a negative impact on margins and volumes in the future.  All this notwithstanding, we remain encouraged and believe the improvements to our cost structure should enable improvement in future EBITDA margins. We will continue to aggressively pursue each of the components of our strategic plan, and are committed to delivering long-term value to our shareholders as measured by our long-term financial objectives.

 

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**Critical Accounting Policies**

 

*Management’s Discussion and Analysis of Financial Condition and Results of Operations*addresses the financial condition and results of operations as reflected in our *Consolidated Financial Statements*, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and reported amounts of revenues and expenses during the reporting period. On an ongoing basis, management evaluates its estimates and judgments, including those related to: inventory valuation; share-based compensation expense, depreciation, amortization and the recoverability of long-lived assets, including intangible assets; medical, product warranty, and other reserves; litigation; and environmental matters. Management bases its estimates and judgments on its substantial historical experience and other relevant factors, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results could differ from those estimates. Management discusses the development of accounting estimates with our Audit Committee. For a detailed discussion of significant accounting policies that may involve a higher degree of judgment, please refer to our Form 10-K.

 

**Cautionary Statement Regarding Forward-Looking Information**

 

This filing contains, and other written or oral statements made by or on behalf of us may include, forward-looking statements, within the meaning of the Private Securities Litigation Reform Act of 1995. In addition, we, or our executive officers on our behalf, may from time to time make forward-looking statements in reports and other documents we file with the SEC or in connection with oral statements made to the press, potential investors or others. Specifically, forward-looking statements may include, but are not limited to:

 

·                  statements relating to our future economic performance, benefits of productivity improvements, business prospects, revenue, income, cash flows, and financial condition;

 

·                  statements relating to the tax-free nature of the distribution of our common stock to stockholders of Acuity Brands in the Distribution; and

 

·                  statements preceded by, followed by, or that include the words “expects,” “believes,” “intends,” “anticipates,” and similar terms that relate to future events, performance, or our operating results.

 

Forward-looking statements are subject to certain risks and uncertainties that could cause actual results, expectations, or outcomes to differ materially from our historical experience as well as management’s present expectations or projections. These risks and uncertainties include, but are not limited to:

 

·                  customer and supplier relationships and prices;

 

·                  competition;

 

·                  ability to realize anticipated benefits from strategic or planning initiatives and the timing of related benefits, including initiatives and benefits pertaining to acquisitions;

 

·                  market demand;

 

·                  litigation and other contingent liabilities, such as environmental matters; and

 

·                  economic, political, governmental, technological, and natural disaster related factors affecting our operations, tax rate, markets, products, services, and prices, among others.

 

A variety of other risks and uncertainties could cause our actual results to differ materially from the anticipated results or other expectations expressed in our forward-looking statements. A number of those risks are discussed in Part I, “Item 1A. Risk Factors” within our Form 10-K and in other documents we file with the SEC from time-to-time.

 

You are cautioned not to place undue reliance on any of our forward-looking statements, which speak only as of the date of this Quarterly Report on Form 10-Q. Except as required by law, we undertake no obligation to publically update or release any revisions to

 

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these forward-looking statements to reflect any events or circumstances after the date of this Quarter Report on Form 10-Q or to reflect the occurrence of unanticipated events.

 

**Item 3.*****                                   ******Quantitative and Qualitative Disclosures about Market Risk***

 

We are exposed to market risks that may affect the *Consolidated Balance Sheets*, *Consolidated Statements of Operations*, and *Consolidated Statements of Cash Flows* due primarily to fluctuation in both interest rates and foreign exchange rates. There have been no material changes to our exposure from market risks from those disclosed in Part II, Item 7A. within our Annual Report on Form 10-K for the year ended August 31, 2010.

 

**Item 4.*****                                    ******Controls and Procedures***

 

Disclosure controls and procedures are controls and other procedures that are designed to reasonably ensure that information required to be disclosed in the reports filed or submitted by us under the Securities Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the SEC rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to reasonably ensure that information required to be disclosed by us in the reports filed under the Exchange Act of 1934, as amended (the “Exchange Act”), is accumulated and communicated to management, including the principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure.

 

As required by SEC rules, we have evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of May 31, 2011. This evaluation was carried out under the supervision and with the participation of management, including the principal executive officer and principal financial officer. Based on this evaluation, these officers have concluded that the design and operation of our disclosure controls and procedures were effective at a reasonable assurance level as of May 31, 2011. However, because all disclosure procedures must rely to a significant degree on actions or decisions made by employees throughout the organization, such as reporting of material events, the Company and its reporting officers believe that they cannot provide absolute assurance that all control issues and instances of fraud or errors and omissions, if any, within the Company will be detected. Limitations within any control system, including the Company’s control system, include faulty judgments in decision-making or simple errors or mistakes. In addition, controls can be circumvented by an individual, by collusion between two or more people, or by management override of the control. Because of these limitations, misstatements due to error or fraud may occur and may not be detected.

 

Except as set forth below, during the quarter ended May 31, 2011, we made no change in our internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting:

 

On September 2, 2010 and October 1, 2010, we completed our acquisitions of Waterbury and Niagara, respectively. We are currently integrating policies, processes, people, technology and operations for the combined company. Management will continue to evaluate our internal control over financial reporting as we execute integration activities.

 

**PART II. OTHER INFORMATION**

 

**Item 1.*****                                   ******Legal Proceedings***

 

We are subject to various legal claims arising in the normal course of business.  Certain pending claims are described in Note 5 of *Notes to Consolidated Financial Statements* to the unaudited consolidated financial statements presented in this Form 10-Q.  We are self-insured up to specified limits for certain types of claims, including product liability, and are fully self-insured for certain other types of claims, including environmental, product recall, and patent infringement. Based upon information currently available and except as described in Note 5, it is the opinion of management that the ultimate resolution of pending and threatened legal proceedings will not have a material adverse effect on our results of operations, financial position, or cash flows. However, in the event of unexpected future developments, it is possible that the ultimate resolution of such matters, if unfavorable, could have a material adverse effect on our results of operations, financial position, or cash flows. We establish reserves for legal claims when the costs associated with the claims become probable and can be reasonably estimated. The actual costs of resolving legal claims may be substantially higher or lower than the amounts reserved for such claims. However, we cannot make a meaningful estimate of actual costs to be incurred that could possibly be higher or lower than the amounts reserved. The information in Note 5 under the caption “Britto and Cowan v. Zep Inc. and Acuity Specialty Products, Inc.” is incorporated by reference in this Item 1.

 

**Item 1A.*****                          ******Risk Factors***

 

There have been no material changes in the Company’s risk factors from those disclosed in Part I, “Item 1A. Risk Factors” of our Form 10-K.

 

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**Item 6.*****                                   ******Exhibits***

 

Exhibits are listed on the Index to Exhibits (page 26), which is incorporated herein by reference.

 

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**SIGNATURES**

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 
|                 | REGISTRANT                                         |
|----------------------|----------------------------------------------------|
|                 | Zep Inc.                                           |
|                 |                                               |
| DATE:   July 7, 2011 | /s/ John K. Morgan                                 |
|                 | JOHN K. MORGAN                                     |
|                 | CHAIRMAN, PRESIDENT, AND CHIEF EXECUTIVE   OFFICER |
|                 |                                               |
| DATE:   July 7, 2011 | /s/ Mark R. Bachmann                               |
|                 | MARK R. BACHMANN   EXECUTIVE VICE PRESIDENT AND    |
|                 | CHIEF FINANCIAL OFFICER                            |

 

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**INDEX TO EXHIBITS**

 
| EXHIBIT   3  |   | (a)    |   | Restated   Certificate of Incorporation of Zep Inc.                                                      |   | Reference   is made to Exhibit 3.1 of registrant’s Form 8-K as filed with the Commission   on October 26, 2007, which is incorporated herein by reference. |
|--------------|--------|--------|--------|----------------------------------------------------------------------------------------------------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------|
|         |   |   |   |                                                                                                     |   |                                                                                                                                                            |
|         |   | (b)    |   | Amended   and Restated By-Laws of Zep Inc. (effective July 7, 2011)                                      |   | Filed   with the Commission as part of this Form 10-Q.                                                                                                          |
|         |   |   |   |                                                                                                     |   |                                                                                                                                                            |
| EXHIBIT   10 |   | (a)    |   | Zep   Inc. Omnibus Incentive Plan Form of Performance Stock Award Agreement                              |   | Filed   with the Commission as part of this Form 10-Q.                                                                                                          |
|         |   |   |   |                                                                                                     |   |                                                                                                                                                            |
|         |   | (b)    |   | Zep   Inc. Omnibus Incentive Plan Form of Incentive Stock Option Agreement for   Executive Employees     |   | Filed   with the Commission as part of this Form 10-Q.                                                                                                          |
|         |   |   |   |                                                                                                     |   |                                                                                                                                                            |
|         |   | (c)    |   | Zep   Inc. Omnibus Incentive Plan Form of Non-Qualified Stock Option Agreement for   Executive Employees |   | Filed   with the Commission as part of this Form 10-Q.                                                                                                          |
|         |   |   |   |                                                                                                     |   |                                                                                                                                                            |
|         |   | (d)    |   | Zep   Inc. Omnibus Incentive Plan Form of Restricted Stock Award Agreement                               |   | Filed   with the Commission as part of this Form 10-Q.                                                                                                          |
|         |   |   |   |                                                                                                     |   |                                                                                                                                                            |
| EXHIBIT   31 |   | (a)    |   | Rule   13a-14(a)/15d-14(a) Certification, signed by John K. Morgan                                       |   | Filed   with the Commission as part of this Form 10-Q.                                                                                                          |
|         |   |   |   |                                                                                                     |   |                                                                                                                                                            |
|         |   | (b)    |   | Rule   13a-14(a)/15d-14(a) Certification, signed by Mark R. Bachmann                                     |   | Filed   with the Commission as part of this Form 10-Q.                                                                                                          |
|         |   |   |   |                                                                                                     |   |                                                                                                                                                            |
| EXHIBIT   32 |   | (a)    |   | Section   1350 Certification, signed by John K. Morgan                                                   |   | Furnished   with the Commission as part of this Form 10-Q.                                                                                                      |
|         |   |   |   |                                                                                                     |   |                                                                                                                                                            |
|         |   | (b)    |   | Section   1350 Certification, signed by Mark R. Bachmann                                                 |   | Furnished   with the Commission as part of this Form 10-Q.                                                                                                      |

 

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