Watts Water Technologies - Q1 2013

Transcript

Operator (participant)

Good day, ladies and gentlemen, and welcome to the Q1 2013 Watts Water Technologies Earnings Conference Call. My name is Alex, and I will be your operator today. At this time, all participants are in a listen-only mode. We will conduct a question-and-answer session towards the end of this conference. If at any time during the call you require assistance, please press star, then zero, and an operator will be happy to assist you. Please be aware that remarks made during today's conference call about the company's future expectations, plans, and prospects constitute forward-looking statements under the Private Securities Litigation Reform Act of 1995.

Actual results may differ materially from those indicated by these forward-looking statements as a result of various factors, including those discussed under the heading Risk Factors in the company's annual report on Form 10-K for the year ending December 31, 2012, and other reports the company files from time to time with the Securities and Exchange Commission. In addition, forward-looking statements represent the company's views only as of today and should not be relied on upon as representing its views as of any future date. While the company may elect to update these forward-looking statements, it declines any obligation to do so. During this call, the speakers may refer to non-GAAP financial measures. These measures are not prepared in accordance with generally accepted accounting principles.

A reconciliation of non-GAAP financial measures to most directly comparable GAAP measures is available at the press release dated Tuesday, the thirtieth of April 2013, relating to the company's first quarter 2013 financial results, a copy of which may be found in the Investor Relations section of the company's website at www.wattswater.com, under the heading Press Releases. Now I'd like to turn the call over to David Coghlan, Chief Executive Officer. Go ahead, please, sir.

David Coghlan (CEO and President)

Thanks, Alex. Good morning, everyone, and thanks for joining our first quarter earnings call. I'll start by providing you a brief overview of the quarter, then we'll go on and give you our latest view on market dynamics in each of our key geographies and a sense for where we see those markets trending as we move further into 2013. Finally, I'll update our high-level view on how we see our segments performing as 2013 proceeds, and then I'll hand the call over to Dean Freeman to review our financial performance in more detail. After Dean's discussion, I'll try and summarize, and then we'll open the call up to your questions. So let me start with an overview of the quarter, as you'll see highlighted on slide two of the presentation we posted on our website last night.

Consolidated sales in the first quarter were fairly flat with the previous year, with increases in North America and Asia being offset by a sales reduction in EMEA. We delivered an adjusted operating margin in the first quarter of 8.4%, or 50 basis points higher than our first quarter 2012 performance, and our adjusted earnings per share of $0.49 was approximately 14% ahead of Q1 last year. The net effect of last year's share buyback program was $0.02 accretive to this year's adjusted earnings per share. Dean will provide more color on our results in a moment. If you recall, during our February conference call, we talked about the risk that deteriorating market conditions in Europe could extend, affecting markets which have held up for us well to date. Unfortunately, that seems to have occurred in Q1.

Southern Europe continues to be affected by eroding markets. However, we saw France slow down significantly in the first quarter, and we also encountered some market softness and delays in shipments to some key OEM customers in Germany during the latter part of the quarter. However, our drains business in Europe continues to do well, and we continue to see solid growth in developing markets such as the Middle East. However, those gains were more than offset by softness elsewhere. As a result of the drop in volumes in the first quarter, EMEA's adjusted operating margins declined by 60 basis points as compared to last year's first quarter. In North America, after a slow January, we saw orders and sales pick up as the quarter progressed, driven primarily by the wholesale channel. Overall, our sales growth in North America was in line with the expectations we provided you in February.

With the added sales volume and solid cost controls enacted by the North America team, we were able to drive up our adjusted operating margins versus last year. One headwind we did encounter in North America in the first quarter was pricing pressure in the retail channel, and to a lesser extent, in our wholesale business, which served to restrict further operating margin expansion in the quarter. Our DIY customers are being very aggressive in line reviews at the moment, and we saw a more challenging competitive environment in certain regions within our wholesale channel. We also experienced costs from our lead-free transition program of approximately $600,000 in the first quarter, related principally to labor inefficiencies as our factories began the lead-free transition. These costs are part of the $2 million-$4 million in anticipated first half costs we provided to you previously.

We believe remaining lead-free related costs will be in the $2 million-$3 million range, with the bulk of these costs expected to be incurred in the second quarter. Operationally, our new lead-free foundry has started its initial trial, trial production runs, with expectations that we'll be up and running at normal capacity early in Q3. We have ceased production of leaded C and B inventory items as planned, and A production is currently coming to an end. From a customer perspective, we continue to work hard on the education process and on making their transitions as smooth as possible. In Asia, we continue to build out our plumbing and HVAC capabilities and to broaden our market coverage. The overall China economic environment remains positive, and our intercompany business was stronger during the quarter, which helped with plant absorption.

The end result is that our Asia team delivered another strong quarterly performance. Now, if you turn to slide three, let's discuss the current market conditions and where we see them trending. Let me first talk about EMEA. As I mentioned earlier, the macro headwinds in Europe have increased and affected our business more deeply in the first quarter than expected. We estimate French wholesale markets were down 10%-15% in the first quarter due to a softening economy. We also saw a slowdown in our German business, partially the results of a softening economy and partially due to weather-related delays with some key OEM customers. As you may know, this was Europe's worst winter in 50 years, and project work was affected across a number of countries.

Italy continues to be depressed, and the political instability there in the first quarter served to create even more uncertainty. We do expect that our drains business will continue strong, and emerging markets like the Middle East should continue on their growth path. But overall, I think our market outlook for Europe is now less positive than the flat growth we had projected at the beginning of the year. Let's now look at North America. We see the same trends today in North America as we discussed in February. Residential new construction is trending up, existing home sales will be steady, and the residential repair and replacement business, as tracked by the LIRA Index, remains positive. We have not yet seen a pickup in our commercial end markets, and we see others sharing that same view.

We realize the ABI index has been in positive territory for the last eight consecutive months, so we are hopeful that a commercial construction uptick may occur at some point later in 2013, but just when it may affect our top line is hard to gauge. Finally, let's discuss Asia. China GDP was up 7.7% year-over-year in the first quarter, so the overall economy continues to grow steadily. We are focused on bringing to bear our worldwide capabilities on the Chinese market, where high-end construction engineers and contractors are interested in European and U.S. technologies, and where consumers are increasingly focused on ensuring comfort and safety in their homes. As a result, not only are we seeing demand in China for our localized products, but also for our more highly engineered German, Italian, French, and U.S.-manufactured products.

We're expanding our sales footprint into tier two and tier three cities within the country. We expect to maintain our momentum in the China market as the year progresses. We're also working on some nice opportunities for growth elsewhere in Asia. If we move to slide four, I'll provide you our updated view of how we see 2013 shaping up. For EMEA, I think we've laid out the challenges there already, and we'll certainly endeavor to mitigate the downward market pressures where possible. However, our current outlook suggests that we'll experience a 2%-5% decline in sales for the full year of 2013 at constant FX rates. We see business volumes picking up in North America, with growth from residential new construction and from remodeling. As we mentioned earlier, we are still not anticipating commercial construction to provide any tailwind in the near future.

As a result, we continue to expect core business growth for all of 2013 in the 2%-5% range, and we estimate that the effect of expected lead-free sales may provide an incremental 1%-2% to our total North American sales for the year. Given our solid start in Asia this year, and our expectation that the team will continue to execute well on its sales plans, we've recalibrated our growth expectations up to 20%-25% growth for the full year. I've already provided the latest update on costs and timing regarding the lead-free program. As I mentioned, we do expect incremental costs in the $2 million-$3 million range in Q2, and suffice to say, the project continues as a major initiative for our North American business for the balance of the year.

In response to our evolving view of the year, we're now planning to accelerate certain operating footprint consolidation programs and SG&A improvements throughout the company that we had been contemplating. We also expect to initiate a realignment of our operations to further improve efficiencies where possible. Those plans have yet to be fully vetted and will require approval by the board of directors and other outside agencies prior to implementation. And so we'll keep you informed as these plans progress. Finally, I wanted to give you an update on our cash allocation priorities. First, we will retire $75 million of private placement notes in mid-May, and we expect to use existing cash to complete this transaction. Second, our board has approved a $90 million share repurchase program that we expect to execute over the next two to three years.

The purpose of this program will be to buy back the expected leakage from our various employee option programs, and we expect to spend approximately $22 million during the remainder of 2013 to buy back stock. Finally, the board authorized a dividend increase of $0.02 per share to $0.13 per share, effective in the second quarter. Incremental annual spend for this increase will approximate $2.8 million. This increase, along with the share repurchase program, will provide additional returns to our shareholders. Let me turn it over to Dean now, who will provide you with more insight into our operating performance in the first quarter.

Dean Freeman (EVP and CFO)

Thanks, David, and good morning, everyone. I'll keep my comments brief, and I'll apologize in advance if I repeat some of the comments that David made, but I will try to add some color. So on a consolidated basis, organic revenue was flat, with North America up organically 2.6%, offset with EMEA's decline of 5.5%, as David talked about. Asia having another very strong quarter with organic trade sales up 34%. We had a very slow January in North America, despite the fact that it saw an increase of 3% organically in its wholesale business and OEM channel. Retail was up slightly less than 1%. I would say that we did see an acceleration of growth in wholesale for the quarter, as March was up nearly 6% versus the prior year.

As David pointed out, Europe's economic decline was largely driven by continued economic malaise, particularly in France. France's overall regional markets were down about 10%-15%, with our sales affected on the lower end of that range. Declines in Germany, driven by OEM project delays, largely in the month of March. Overall, Europe saw declines across all major channels. Just talking about the margin for a moment. Year-over-year consolidated gross margin was essentially flat at 35.7% versus prior year, as EMEA volume declines, price challenges in North America in retail and wholesale, and product mix in North America and EMEA were offset with productivity gains. Our gross margin was also impacted by approximately $600,000 of lead-free conversion related inefficiency costs in the current quarter.

We now expect the lead-free conversion cost impact to be $2 million-$3 million for the remainder of the year. Again, as we talked about last time, primarily in the second quarter. Adjusted gross margin, excuse me, adjusted operating margin was up 50 basis points to 8.4% of revenue to $30.5 million, or 7.4% increase versus prior year, with the bulk of that coming from volume and lower SG&A in North America, as well as strong year-over-year growth, income growth in Asia. All offsetting the decline in Europe and increases in our year-over-year corporate expense related to certain legal costs, increased stock and incentive compensation accruals, and other personnel-related costs in the quarter. Our effective tax rate on GAAP basis was 27.8%, essentially flat with the prior-year GAAP tax rate of 28%.

Last year's lower effective tax rate was driven by certain one-off reserve releases, whereas this year we experienced a lower effective tax rate than our normalized structural rate of about 32%, largely due to earnings mix intra-Europe and in China. Again, as David talked about, looking at our adjusted EPS from continued operations of $0.49, this was $0.06 versus prior year, with overall earnings increase of close to 11%. The net effect of the dilution related to our 2012 share repurchase program positively affected EPS by $0.02. Turning to, slide 10, just looking at working capital. The entirety of the working capital increase was driven by inventory to support the lead-free transition in the balance of the year. We ended the quarter with $251 million in cash.

Overall, let me just make a couple comments regarding the outlook that David talked about. As we look at the balance of the year, we expect relatively stable and continued organic sales growth in North America of 2%-2.5%. Again, as David talked about, that's largely relying on the recovery of the residential construction market, and we've made no assumptions regarding the the commercial end markets. Again, as David talked about, another 1%-2% of incremental growth due to what we anticipate and estimate to be the lead-free pricing. Asia will continue to be a consistent performer, and we believe that while Europe had an unusual sharp drop-off in revenues in Q1, and there continues to be uncertainty, we do see potential for sales decline to moderate for the balance of the year.

We believe the announced cash return to shareholders, the debt paydown, and capital spending represent our continued balanced and disciplined cash allocation strategy. Finally, as David pointed out, we'll be updating you on our next call on the acceleration and improved regional restructure and realignment initiatives currently under review. I'll turn it back to David for final comments.

David Coghlan (CEO and President)

Okay, Dean, thank you. So let me try and summarize. During the quarter, we gained momentum in the North American wholesale market. Our key lead-free project continued on track, and Asia performed above expectations. North America and EMEA controlled operating costs well, but margins were impacted by volume reductions in EMEA and by some pricing and mix issues in North America and EMEA. Looking forward, we expect the market in EMEA to remain soft as the year progresses, and we expect to begin and/or accelerate various worldwide initiatives to rightsize our cost structure and improve our performance going forward. So with that, why don't we open up the line to your questions? Alex, would you mind opening up the lines, please?

Operator (participant)

...Certainly. Ladies and gentlemen, if you wish to ask a question, please key star, followed by one on your touchtone telephone. If your question has been answered or you wish to withdraw your question, simply key star, followed by two. Press star one to begin. Please stand by for your first question. Our first question comes from Kevin Maczka from BB&T Capital Markets.

David Coghlan (CEO and President)

Good morning, Kevin.

Kevin Maczka (Managing Director and Senior Equity Research Analyst)

Thanks. Good morning. I'd like to ask a couple of margin questions, I guess. First, in North America, Q1 last year was especially hard hit on lead-free. We dipped down just below 10% and then snapped back, and we're above 13% in the second half. I think the expectation wasn't that we would be higher sequentially in Q1, but that maybe that Q1 set such an easy comp, if you will, that we might be better than 11.4%. Is pricing the biggest issue here? Was that the delta, do you think, in terms of your own internal expectations?

David Coghlan (CEO and President)

Yes, Kevin. If we think about the first quarter last year, you'll recall on the gross margin line, we talked about a $2 million hit because of pre-production runs of lead-free, and obviously, that was reduced. We had about a $600,000 lead-free impact in the first quarter this year, and so a net benefit, if you like, of $1.4 million. As we've also talked about during the year, we started last year with a $2 million surprise due to non-commodity cost inflation, and we worked throughout the year to mitigate that and to push the water back behind the dam, so to speak, and we succeeded in that. So the main delta, as you mentioned, is price. And let me just talk about that for a second, if I may.

During our comments, we referred to two pricing issues. The first one relates to our DIY business. Our two largest DIY customers have been particularly aggressive in line reviews over the last 12 months. And that intensity has continued to pick up, and that has affected pricing in that channel. Then on the wholesale side, we saw some competitive dynamics in a couple of regions across the South, which hurt us. So on the retail side, we're working hard to drive productivity to offset those price declines. On the wholesale side, we will have some price increases coming out. In fact, they went out in April, and so we should see some benefits from that accrue over time.

Dean Freeman (EVP and CFO)

Kevin, this is Dean. We also, just to add to David's comment, we also had an unusually high lower margin mix shift in our wholesale business in the first quarter. As you think about sort of new construction and the product mix in new construction versus repair/replace, not that there's a huge margin differential there, but we did see a fairly dramatic increase in our backflow preventers versus our drains business, and that created some mix headwinds as well.

David Coghlan (CEO and President)

And then we also have lower margin items like PEX, which is a plastic alternative to copper pipe, which has been growing rapidly. So, you know, mix is smaller, but another factor.

Kevin Maczka (Managing Director and Senior Equity Research Analyst)

So if I try to summarize all that, I know you don't like to quantify margins sequentially quarter by quarter, but going forward into Q2, we've got some moving parts on price, where you'll take some increases in wholesale, but maybe some of these line reviews where it will be further pressures. And then you've got the incremental lead-free cost hitting. So should we be thinking that margins maybe are down sequentially in Q2, or is that not the way to think about it?

Dean Freeman (EVP and CFO)

Well, you know, I think, we wanna be careful about guiding forward, but really, you know, the big driver in the margin in the out years is gonna be the improvement in the top line, the revenue growth. I think the dynamic on lead-free will obviously have an impact that'll be incremental in terms of the dollar margin. But from a percentage basis, you know, from our perspective, we don't see a dramatic structural change from what we've seen in the past.

Kevin Maczka (Managing Director and Senior Equity Research Analyst)

Okay. And then, just maybe if I squeeze one more in. On Europe, on margin, it looks like if I just annualize the Q1 revenue run rate, that puts us in your guidance range for the year on the top line. We just did about a 9% margin at that rate. So is that kind of a sustainable rate we ought to be thinking about for Europe, given the top line pressures that we have here?

David Coghlan (CEO and President)

Yeah, I think that's right. But bear in mind that, you know, we are planning some response actions on a global basis as we seek to improve and right-size our footprint.

Kevin Maczka (Managing Director and Senior Equity Research Analyst)

Okay. Okay, thank you.

David Coghlan (CEO and President)

Thanks, Kevin.

Operator (participant)

Our next question comes from Derek Schmus, from Longbow Research.

David Coghlan (CEO and President)

Morning, Derek.

Derek Schmus (Analyst)

Hi, thank you. Hoping that you could provide a little bit more color on the lead-free rollout. Previously, you've been indicating that it's more of a Q2, Q3 transition with respect to your customers. Just wondering if anything has changed over the last quarter, if you're seeing customers starting to take on inventory here early in the second quarter, or do you think this might be a little bit more weighted towards the back half of the year now?

David Coghlan (CEO and President)

No, I think the conversion period of Q2 to Q3 is still right. Remember, the way this rolls out is that after December 31st, a contractor, a maintenance engineer, cannot use a leaded product. And so the wholesalers and retailers are anxious to transition their inventory well in time, so they're not caught with any leaded product. So Q2, Q3, I think, is still the transition period. And nothing's changed from that perspective. If anything, in the near term, we are seeing our wholesale customers be much more prudent in terms of their order patterns. And so they're certainly being very cautious about inventory and just ordering what they need to make it easier to go through the transition.

Derek Schmus (Analyst)

Okay, thank you. And then just a follow-up question on some of the pricing, issues that you cited in the first quarter in your attempts for an April price increase. I'm just wondering, what gives you the confidence that you'll be able to get some of this pricing, you know, at this point in time, it looks like raw material costs have pulled back. You know, what are you seeing in the marketplace on the pricing side? You know, number one, that gives you confidence on the increase. And then secondly, maybe if you could expand a little bit on some of the pricing pressure that you did see. You know, you mentioned it's regional. You know, is there a risk with lower raw material costs that, you know, some of these, items, pricing pressure might accelerate beyond the South?

David Coghlan (CEO and President)

Well, look, let's talk about it by the various channels. Let me start, if I may, by retail. If you look at the day-to-day strategies of some of the big players in DIY, there's been an evolution in those strategies, and now you've got the two biggest players who are very aggressive online reviews, and that certainly affected suppliers to that industry, and we've been hurt by that. One of the things that will benefit us is if you look at copper, copper has come down over the last quarter, and so we certainly hope that reduced copper prices will help to relieve some of that pressure, and we're also putting a lot of focus on productivity around those products.

But can I expect that the pricing challenges in DIY will lighten up? No. The two main players in that industry are aggressively rolling line reviews across a lot of their categories. If we switch to wholesale, I think there's some local dynamics in play. And you know, we've been responding to protect our market share position. I think as the industry moves forward and starts focusing on the lead-free transition, all of us will be faced with significantly higher costs. And our expectation is that the prudent players in the market will act accordingly to deal with that.

Derek Schmus (Analyst)

Okay, and then just one last follow-up on that. You mentioned previously that you're with the lead-free transition, you're expecting to maintain gross margin percentages on the new products. Anything changed in that outlook after the first quarter?

David Coghlan (CEO and President)

We're obviously watching it very carefully, but it's still too early to have a clear view. And so we'll start to see that as we progress through to Q2 and Q3. But, you know, we're working hard to make sure that we maintain our margins through that transition.

Derek Schmus (Analyst)

Okay. Thanks so much.

Operator (participant)

Our next question comes from the line of Jeff Hammond from KeyBanc Markets.

David Coghlan (CEO and President)

Good morning, Jeff.

Jeff Hammond (Managing Director and Senior Equity Research Analyst)

Hi, good morning, guys. You mentioned in the prepared remarks kind of the trend in North America wholesale and the nice March. Can you give us a sense of trend into April? Has that continued? And then similarly, in Germany, I think you talked about some delays. Is that kind of aberration in timing, or is that a function of demand weakness?

David Coghlan (CEO and President)

Okay, let me deal with each of them in sequence. If we look at North America, January was a soft month, and we saw a lot of our peers describe it similarly. There were weather issues, there were a bunch of different things. But it progressed nicely during the quarter, and we ended the quarter with some nice, solid mid-digit growth. As we move forward into April, we're seeing some solid orders continue. But I will say, Jeff, that you know, we mentioned two countervailing trends. We're continuing to see a nice increase due to resi new construction, but as we move nearer towards the lead-free transition point, it's natural that wholesalers are gonna be cautious about laying in inventory. So they're gonna live hand to mouth until that transition is done.

And so you've got two slight countervailing trends there, that we'll be living through for the next couple of months. But we still are very encouraged by the continued increase in resi new construction. As you no doubt saw, the latest forecasts are saying about a 25% increase in resi new construction for the year. We're also encouraged by the 5% or so increase in existing home sales projected for the year. And so that continues to point to a gradual improvement in the markets. And we continue to keep our finger crossed, fingers crossed, that the ABI index will convert into a commercial recovery later in the year.

Switching to Europe, I mentioned that the winter in Europe was the worst for 50 years, and so, a lot of project-related work was delayed because of snow, because of freezing temperatures, et cetera. We're, Dean mentioned that we expect our European sales decline to moderate as the year goes on, but there's an awful lot of moving pieces in Europe, so we certainly are hopeful that the sales decline we experienced in Germany will moderate, but we continue to watch the macroeconomics in France with concern.

Jeff Hammond (Managing Director and Senior Equity Research Analyst)

Okay, and then just kind of back to margin trajectory. I mean, I guess best case, you get some of this pricing through and you get lower copper. When do you start to see lower copper coming through?

David Coghlan (CEO and President)

... Well, copper, copper has been declining since the beginning of the year, and you know, traditionally, given the length of our supply chain, we typically talk about a quarter lag.

Okay, so-

That should say that as we head into the second quarter, you know, let's say midway into the second quarter, we should be seeing some relief.

Jeff Hammond (Managing Director and Senior Equity Research Analyst)

So if you get this price increase and you get the, you know, some of the copper deflation in a margin should lift nicely, you know, into the second half of the year.

David Coghlan (CEO and President)

And then, you know, the other thing from a dollar perspective is that the lead-free transition will be taking hold as we move through to the end of the second quarter into the third quarter.

Jeff Hammond (Managing Director and Senior Equity Research Analyst)

Okay. Thanks, guys.

David Coghlan (CEO and President)

Thanks, Jeff.

Operator (participant)

Our next question comes from Ryan Connors, from Janney Montgomery Scott.

David Coghlan (CEO and President)

Hey, Ryan. How are you?

Ryan Connors (Managing Director)

I'm well, thank you. I had a question on some of your competitors have been kind of making a lot of noise about market share shifts and making market share gains in specific product lines. I'm curious what your thought is on that. I don't hear you mention market share a lot in this discussion, one way or the other. So I'm curious what your thoughts or reaction is to those types of comments, and whether you think it might be playing a role on some level in the pricing issue, to the extent it exists on the wholesale side.

David Coghlan (CEO and President)

Ryan, without being privy to the comments that you're seeing, you've got one up on me there. But, you know, the thing that I would say is that, the areas where we see pockets of growth, such as resi new construction, we're focused intensely on those areas, and we're working hard to make sure we get our fair share, of that growth. And then when it comes to the, you know, the pockets of defense, if you like, where we've got, what we believe is a solid market position, we're working hard to make sure we defend.

And so, I mentioned the pricing pressures we saw in some regions of the country in wholesale, and that those are areas where people have been attempting to, you know, make some movements, if you like, and we've responded.

Ryan Connors (Managing Director)

Okay. But you don't feel that there's any from a technology and product standpoint, you don't feel like there's any areas where you're deficient and you know, playing catch up in terms of you know, the solution itself?

David Coghlan (CEO and President)

Look, any good sales team, any good marketing team is going to point to a new product rollout and really focus on the fundamental feature set, benefit set of those new products. If we look at the products that form the heart of our portfolio, have there been any technology breakthroughs which changed the game? No. Are our competitors rolling out evolutions? Yes. Are we rolling out evolutions? Yes. And so it comes down to, you know, incremental improvements in product sets, but no fundamental breakthroughs. And so, you know, that's the way we're looking at it, and I look with interest as to the competitors that you're talking about to see what they're saying and what they're doing. But that's the way we're seeing it.

Ryan Connors (Managing Director)

Okay. And then, just kind of, kind of a, a, a one-off, but there was a pretty big announcement during the quarter that a major player in the space was effectively on the block, referring to Zurn. And then there was really no follow-through there, and so everyone's left wondering what's happening to that pretty significant asset in the space. I wonder if you had give us any color from your perspective as a peer there in terms, and I guess, twofold. Number 1, you know, were you involved or are you involved in that process in any way that you're able to comment on, even just to editorialize? And then, B, has there been any impact on the underlying business, as they're sort of left hanging in the balance in that uncertainty?

David Coghlan (CEO and President)

Geez, Ryan, that's a question I really can't comment on. I do know that the Rexnord earnings call is coming up in a couple of days, and it might be a better place to ask it there.

Ryan Connors (Managing Director)

Okay. Well, I appreciate it. Thank you.

Operator (participant)

Just to remind you, ladies and gentlemen, if you wish to ask a question, please key star followed by one on your telephone. The next question comes from Jamie Sullivan, from RBC Capital.

David Coghlan (CEO and President)

Morning, Jamie.

Sid Panda (Company Representative)

Hi, this is Sid Panda, standing in for Jamie. Good morning.

David Coghlan (CEO and President)

Good morning. How are you?

Sid Panda (Company Representative)

Good. How are you?

David Coghlan (CEO and President)

Great, thank you.

Sid Panda (Company Representative)

My first question is on China, and just some could you provide some commentary on the sales and particularly the margin trends there? Seems like the margin was 40%, pretty high, it seems, this quarter. Just some idea about what's going on there.

David Coghlan (CEO and President)

Well, you know, remember, one of the things that you have to bear in mind in looking at our, Asia business, is that we've got a significant intercompany business, which gets eliminated on the top line, but provides some nice tailwinds, to the margin line. And so, if we look at the, the shifts in margin during the quarter, as we, as we finished up, our inventory ramp for lead-free and for the transition, there was some nice absorption gains, in our Chinese factories, as they helped us with that, ramp-up. And so that certainly provided some nice tailwinds, from an overall margin perspective.

Dean Freeman (EVP and CFO)

They've been benefiting from, obviously, the volume increases that we've been talked about. I think they're on their third sequential quarter of revenue growth over 20%, and as we talked about this quarter, over 30%. And they're just as focused as any of our other regions, with regard to productivity. So all those things have been big contributors to the margin, as well as the comments that David made.

David Coghlan (CEO and President)

And then if we switch to, I think, what was the other part of your question on Asia, which is the growth side. Look, you know, the Chinese economy, while it has moderated its growth, it's still growing at 7.5%. A level of growth we'd love to see replicated in many other parts of the world. And so we're obviously taking advantage of that. Growth is extending from tier one into tier two and tier three cities. And we've been building our capabilities to participate in that broadening growth.

And last but not least, we've identified some very attractive opportunities to gain share by participating in some macro trends within China, where the high-end architects, engineers, and contractors are increasingly interested in using Western green technology, and where consumers are looking for improved comfort and safety. And so, our Western technology leveraged into China is allowing us to take share in the plumbing and heating segment.

Sid Panda (Company Representative)

Thank you. The next question I had was on the—you earlier used to provide in the call, the breakout between wholesale, retail, OEM sales, by Europe, for Europe and U.S.. Could you do that for the quarter?

David Coghlan (CEO and President)

We're just pulling the numbers together. I think overall, at a high level,

Mm-hmm.

-while Nina's just zeroing in on the specific answer to your question.

Yeah.

You know, it's pretty much the same, right? , we're looking at about 60% of our business being in wholesale, approximately, on a global basis.

Sid Panda (Company Representative)

Okay. Okay. Thank you. That's all.

Operator (participant)

Our next question comes from the line of Stewart Scharf from S&P Capital IQ.

Stewart Scharf (Equity Analyst)

Good morning. Thank you. Could you just explain a little more about the timing of the lead-free conversion, or you were ahead of the curve in ramping up trying to get ready for 2014. And in hindsight, you know, based on customer inventories or as you're getting closer to that, do you feel that it was, you know, the right decision? And based on your competitors and their position on the timing of converting to lead-free, and where you stand and when you started that, do you feel that you know, looking back, you made the right decision at the time?

David Coghlan (CEO and President)

Well, I think, maybe the way I'd answer that is to say that we made a slightly different decision based on our manufacturing strategy versus some of our peers' manufacturing strategy. So as I look across the industry, you know, we decided to invest in a dedicated lead-free foundry and machining assembly lines in North America. And obviously, that required a significant CapEx investment and a significant time commitment to get it up and running. Some of our competitors outsource castings and machining, and some of them have decided to do it in a mixed model line fashion, where they'll pour, machine and assemble leaded and lead-free in the same process. And so I would argue that our strategy is different. I'm not gonna comment on whether it's better or worse. It's different.

In terms of timing, the law sets the ultimate constraint, which is December 31st , 2014. The law also sets a high bar for our customers in that previous transitions allowed them to work through existing inventories and transition as those inventories ran out. This law requires them to stop selling by a certain date, and there's very little they can do with any leaded inventory that remains. And so we simply work back from December 31st. We spent a lot of time talking to our customers, and based on their input, concluded that they were likely to shift in Q2 and Q3, and that's what we still expect to happen.

So, you know, were those decisions correct or incorrect? We still believe the market will transition in Q2 and Q3, and we believe we'll be ready to support that transition.

Stewart Scharf (Equity Analyst)

Okay. And, just on Asia, with the strength there, do you have a target of, would you like your percentage of sales to grow to?

David Coghlan (CEO and President)

Our target is to grow double-digit in Asia, and what we're saying for the rest of this year is we expect to lift our sales at 20%-25%.

Stewart Scharf (Equity Analyst)

Okay, thank you very much.

David Coghlan (CEO and President)

You're welcome.

Operator (participant)

We have no further questions in the queue at this time. I would like to hand the call back to David for closing remarks.

David Coghlan (CEO and President)

Okay, well, thanks, everybody, for joining, and thanks again for your continued interest in Watts Water. We appreciate you taking the time to join our call today, and we look forward to speaking with you again during our Q2 earnings call in late July. All the best.

Operator (participant)

Thank you for participating in today's conference. This concludes your presentation. You may now disconnect. Good day.