Watts Water Technologies - Q1 2019

Transcript

Operator (participant)

Good morning. My name is Mariama, and I will be your conference operator today. At this time, I would like to welcome everyone to the Watts Water Technologies, Inc Q1 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question-and-answer session. If you would like to ask a question at that time, please press star then one on your telephone keypad. If you would like to withdraw your question, please press the pound key. Thank you. I would now like to turn the call over to Tim MacPhee, Treasurer and Vice President of Investor Relations. You may begin your conference.

Timothy MacPhee (VP of Investor Relations)

Thank you, and good morning, everyone. Welcome to our first quarter earnings conference call. With me today are Bob Pagano, CEO and President, and Shashank Patel, our CFO. During today's call, Bob will provide an overview of the quarter and offer his opinion on the current state of the markets. Shashank will provide details on our first quarter performance and revisit our full year outlook. Following our prepared remarks, we will address questions related to the information covered during the call. Today's webcast is accompanied by a presentation which can be found in the Investor Relations section of our website. We will reference this presentation throughout our prepared remarks. Any reference to non-GAAP financial information is reconciled in the appendix to the presentation. Before we begin, I'd like to remind everyone that during the course of this call, we will be making certain comments that constitute forward-looking statements.

These statements are subject to numerous risks and uncertainties that could cause actual results to differ materially. For information concerning these risks and uncertainties, see Watts' publicly available filings with the SEC. The company disclaims any intention or obligation to update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise. With that, I will now turn the call over to Bob Pagano.

Robert Pagano (CEO)

Thank you, Tim, and good morning, everyone. Please turn to slide three and let me briefly provide an overview of the first quarter. 2019 began on a solid note, with the team delivering record Q1 sales, operating margin and EPS. Organic sales growth was favorable in the Americas and Europe, with some softness in APMEA. We expanded adjusted operating margin by 80 basis points, and adjusted earnings per share increased by 15% in the quarter. We continue executing on our strategy of delivering profitable top-line growth and driving productivity and cost discipline in the organization while continuing to invest for the future. Regionally, sales growth was largely in line with our internal expectations. The Americas had broad growth in a number of product lines, including connected products and a favorable pricing dynamic.

Europe delivered a solid top line that was driven by the Drains platform and an extra shipping day in the quarter over prior year. APMEA softness was hindered by a weak China residential heating market and softness in Korea. Shashank will review the quarter results in more details in a few minutes. The end markets performed in line with our expectations during the quarter. In the Americas, recent macro data like the ABI and Dodge Momentum Index have softened, which may be signaling slower growth later this year. Residential new construction data remains lumpy, and residential repair and replacement indicators see decelerating growth as the year progresses. Europe macro data continues to signal softness. This, together with the continued geopolitical concerns, provides a backdrop for sluggish growth as the year progresses, just as we had anticipated.

APMEA markets are growing at moderate levels, but we are finding that growth spotty by region. We continue to monitor the U.S. trade and tariff situation. For enacted tariffs, we instituted price increases in the second half of 2018. Recall, this issue mainly affects U.S. purchases as much of our intercompany activity into China is through Europe, which is not affected by the tariff regulations. Turning to our outlook, we are reaffirming our original full-year outlook for top-line growth and reaffirming margin expansion in line with the assumptions we provided in February. With that, let me turn the call over to Shashank to talk more about our first quarter's results and our outlook. Shashank?

Shashank Patel (CFO)

Thanks, Bob. Please turn to slide 4, which shows the first quarter's comparative results. Sales of $389 million were up 3% on a reported basis. Organically, sales were up 6%, with growth in the Americas and Europe. Foreign exchange, primarily driven by a weaker euro, decreased year-over-year sales by roughly $11 million, or 3%. Adjusted operating profit increased roughly 10% to $48 million. Adjusted operating margin of 12.4% was up 80 basis points. Price, volume, and productivity more than offset normal cost inflation, tariff increases and incremental investment spend of $3 million. Foreign exchange was a year-over-year headwind of $1.4 million to operating profit. Adjusted earnings per share of $0.94 increased 15% over last year. The increase was driven mainly by operational improvements.

Favorable below-the-line items mostly offset unfavorable foreign exchange, which was driven primarily by a weaker euro. The impact of the weaker euro was $0.03 a share. The adjusted effective tax rate of 27.5% is 70 basis points lower than the first quarter of 2018, and relates primarily to an increase in foreign tax reserves in the first quarter of last year. Now, turning to cash. As you know, historically, the first quarter is a slower period for cash flow, and that played out as expected.... Our free cash outflow for the quarter was $31 million, as compared to a $33 million outflow in the first quarter of last year. The cash flow improvement was due to higher operating income generated this year.

We expect our cash generation to improve as the year progresses and expect to achieve at least 100% cash conversion for the year. During the quarter, we repatriated approximately $11 million in cash, which was used to pay down our line of credit. In addition, we purchased approximately 74,000 shares of our common stock at a cost of $5.6 million. In total, we returned approximately $13 million in the first quarter to shareholders in the form of dividends and share repurchases as part of our balanced capital deployment strategy. Overall, a good start to 2019. We delivered record sales, adjusted operating margin, and adjusted earnings per share, and we continued to see organic growth trend positively. Turning to the regions, on Slide 5, let's review the Americas results for the quarter.

Sales were $259 million, up 7% on a reported basis and 8% organically. We saw strong performance from our core plumbing valves, drains, and water quality. Heating and hot water solution sales were up double digits, driven by both boiler and hot water heat products. Adjusted operating profit was $43.1 million, up 18% over the first quarter of last year. Adjusted operating margin was 16.6%, 150 basis points increase over last year, driven by price, volume, and productivity. Margin expansion was partially tempered by the impact of tariff costs, inflation, continued growth investments, and unfavorable product mix. A strong start for the Americas, with growth in a number of key products and platforms. Now on to Slide 6. Let's review Europe's results.

Sales of $116 million were down 5% on a reported basis and up about 3% organically. Foreign exchange negatively impacted sales by about $10 million or 8%. From a platform perspective, we saw growth in both Drains and Fluid Solutions. Europe benefited from one more shipping day during the quarter, which will be offset in the second quarter. In addition, Drains benefited from strong project sales into the hospital and industrial end markets, as well as stronger marine-based business sold into shipyards. Within Fluid Solutions, the sales increase was driven by valve products, including backflows and check valves, offset partially by softer electronic sales. Regionally, we saw solid growth in some of our key regions, such as France, Germany, Italy, and Scandinavia. France growth was driven by expansion in the wholesale market, with increases in valves and drain products.

Germany was up due to OEM growth and drains project timing. Italy grew from an expansion in wholesale, including drains and electronic products. This growth was partially offset by continued softness in the UK, which was down double digits due to weaker end markets resulting from ongoing uncertainties there. Adjusted operating profit for the quarter was $14.6 million, a decrease of 2%, which included a foreign exchange headwind of 8% year-over-year. Adjusted operating margin of 12.6% increased 50 basis points as compared to the first quarter of last year. Margin expansion was driven by higher volume, price and productivity, including restructuring savings, and was partially offset by unfavorable product mix, inflation, and incremental investments. For Europe, excluding the foreign exchange noise, a decent start to the year, aided by the extra shipping day in the quarter.

Moving to Slide 7, let's review APMEA's results. Sales were $13.5 million in the quarter, down 6% on a reported basis and down 3% organically. Sales outside of China, which represented over 70% of APMEA's sales in the quarter, decreased organically by 4%. Strength in the Middle East and Australia were more than offset by a slowdown in Korea due to a reduction in demand for products sold into the hospitality market. China's organic sales were down 2%, as continued demand for commercial valves sold into data center and semiconductor markets was more than offset by continued softness in underfloor heating products. Adjusted operating profit was $1.3 million in the first quarter, which translates to an adjusted operating margin of 9.7% or 30 basis points better than last year.

The drivers of the margin expansion were higher affiliate volume and a positive impact from foreign exchange favorability from affiliate activity, partially offset by lower trade sales and incremental investments. We expected APMEA to start the year slowly, given the China heating market's continued volatility. Our expectation is for a gradual pickup in APMEA's growth as the year continues. Now, just a quick update on our full-year outlook. Slide 8 provides the details, and I will highlight a few key points. Our current assumptions are mostly in line with the original outlook we provided in February. One change is corporate costs, which for the year have increased to $41 million and now incorporate the additional expense incurred in the first quarter. We expect operating margins should grow between 50 and 70 basis points, which includes incremental investments to support future growth initiatives.

We are currently maintaining our full year effective tax rate at approximately 28%. As I just mentioned, we anticipate free cash flow for the year converting at or above 100% of net income. Before I turn the call back over to Bob, a few items to keep in mind regarding the second quarter. We are expecting consolidated organic growth in the second quarter to be at the higher end of our full year expectations, and sequentially, we expect overall growth should be lower than the first quarter. A couple of items about organic growth to keep in mind from a regional perspective. First, we expect a tougher comp in the Americas in the second quarter.

If you recall, about $4 million, or approximately 2 percentage points of pre-buy sales, were shipped in the second quarter of 2018 in anticipation of the price increase that went into effect in July 2018. Second, the one extra day of shipping tailwind we experienced in Europe in the first quarter will reverse and be a headwind in the second quarter. We expect incremental investments of $4 million in the second quarter, approximately $3 million in the Americas, and approximately $500,000 each in Europe and APMEA. The investments will be partially offset by approximately $1 million in incremental restructuring savings, all in Europe. Quarter over quarter, consolidated operating margin in the second quarter should grow in line with our full year growth expectations.

Foreign exchange would be a headwind when compared to the second quarter last year, given the current euro-dollar exchange rate. As a reminder, the average Q2 2018 euro exchange rate was 1.19, and the current euro exchange rate is around 1.12. And finally, in the appendix, we provided a slide on the impact to Watts of the new lease accounting pronouncement, which took effect on January 1, 2019. For us, it's a balance sheet impact only, no effect on our P&L or earnings per share going forward. So with that, let me turn the call over to Bob before we begin Q&A. Bob?

Robert Pagano (CEO)

Thanks, Shashank. I'd like to summarize before we address your questions. The year started out on a positive note. We delivered Q1 record results in sales, adjusted operating margin, and adjusted EPS, and we continued to invest for the future. Overall, we expect to make sustained progress and look forward to another solid year of profitable growth. With that, operator, please open the lines for questions.

Operator (participant)

At this time, I would like to remind everyone, in order to ask a question, please press star then one on your telephone keypad. We'll pause for just a moment to compile the Q&A roster. Your first question comes from Nathan Jones with Stifel. Your line is open.

Nathan Jones (Senior Equity Analyst)

Morning, everyone.

Robert Pagano (CEO)

Good morning, Nathan.

Nathan Jones (Senior Equity Analyst)

Bob, some comments on the call about, you know, forward-looking indicators suggesting maybe slower growth in the back half of the year. Are you starting to see any of this slowdown in your order book, or is this just, you know, prudent caution, given some of the macro data out there and some of the uncertainties in the overall economies?

Robert Pagano (CEO)

Yeah, I think it's just prudent caution right now. We look at all the same indicators that I'm sure everybody did. I referenced them earlier, but, again, all of them are portraying, you know, portending, you know, slower growth in the, in the future. So, we watch those very closely and, are monitoring accordingly.

Nathan Jones (Senior Equity Analyst)

Okay, a follow-up question then on Americas margins. Really strong, 150 basis points year-over-year expansion there. I know you've been doing a lot of work on the operations over the last few years. Can you talk about maybe how much of that improvement is coming out of that operational improvement, maybe where you are on the price cost equation there? And are you seeing any pressure from customers to give back a bit on the pricing side as input costs have moderated?

Robert Pagano (CEO)

Yeah. So when you look at that, I would say half the growth in, you know, related bottom line, well, no, it, it was related to price. I mean, so that was part of the, the story, although we have been in front of the inflationary costs, so we have seen inflation increase, but our price to cost ratio, I think, is positive. As we look, as you remember, we put in price increases in the second half of last year, and we knew some of the first half comps this year would be positive as it related to price.

So as we see some of the tariffs and what's happening with inflation, you know, we're hearing some noise on pricing, but we're trying to be disciplined and, you know, we'll go as long as we can and drive, you know, pricing as long as we can.

Nathan Jones (Senior Equity Analyst)

I'll just slip one more in on the balance sheet. You know, despite the seasonal use of cash, you've still only got 0.8 times net leverage. How actionable is the M&A pipeline? If you can't find appropriate deals, what would be the alternative for capital, or would you just, you know, let it build on the balance sheet until you can find an appropriate avenue for it?

Robert Pagano (CEO)

Well, you know, we believe in a balanced and disciplined capital allocation, so our first priority is to invest in the business, you know, and to do disciplined M&A where it makes sense, and then return to shareholders. So we're in the middle of our strategic planning process. Our pipeline is very active, and, you know, it's a good problem to have, but we'll continue to monitor it, and we'll do the right thing for our shareholders.

Nathan Jones (Senior Equity Analyst)

... Fair enough. Thanks for taking my questions.

Robert Pagano (CEO)

Thanks, Nathan.

Operator (participant)

Your next question comes from Walter Liptak with Seaport Global. Your line is open.

Walter Liptak (Industry Analyst)

Hi, good morning, guys. Congratulations-

Robert Pagano (CEO)

Morning, Walter.

Walter Liptak (Industry Analyst)

on this quarter. I wanted to just stick with the first question about organic growth and, you know, some of the macro data points slowing down. And I wonder if you could just, you know, maybe dig into a couple of ideas like, you know, residential versus commercial. Are you seeing the same kind of potential slowing on the commercial side? And then, weather seems to have been an issue for some companies. I wonder if weather had impacted you guys or your channel partners in the first quarter?

Robert Pagano (CEO)

Yeah. So let's talk about the markets in general. If you recall, you know, 60% of our business is commercial, 40% is residential. And of that residential, as you know, two-thirds of that is really in multi-housing, which tends to act like a commercial building. When we look at, you know, the housing starts and some of that for residential, that doesn't concern us as much as commercial because, you know, we're more into the commercial side of that business. So, you know, when we look at the commercial indicators, as I said earlier, the good news is I believe they're still, you know, looking for growth, just not as fast as growth as what we saw last year. So I think that's positive.

Just always remember, as we've had many discussions with all of you on this, 65% of our business is repair and replace, and that tends to follow GDP. That's a nice, solid backdrop on our overall business. So when we look at that, I think that's, you know, how we're looking at the markets. They look okay. Our discussions with our channel partners are positive. So overall, we're just being cautiously optimistic and exactly what we originally started the year with, and our assumptions, I think, are coming out. So, we're aligned and our teams are driving, you know, for whatever share we can get in the marketplace and driving for growth.

Shashank Patel (CFO)

Yeah, just one thing to add on the second half slower growth that we've talked about, beyond the macro indicators, yeah, in addition to that, we've also got lapping of price. So as you all know, we had price increases in Q3 and Q4 last year, and we lapped those in the second half, so the compares become tougher in the second half versus the first half. So we factored that into our expectations when we did the plan for the year.

Walter Liptak (Industry Analyst)

Okay, great. You know, kind of along the same lines with price, have, you know, with the price increases having gone up, how are inventories in the channel? You know, and, you know, were there pre-buys on some of the products that are gonna impact, you know, second quarter? You know, where do you think the, the channel inventory is?

Robert Pagano (CEO)

I didn't answer your question on weather earlier. I apologize for that. The weather, you know, we didn't believe it had a material impact to us in the quarter. From a channel point of view, I think the inventories are okay. If you know, if we look at last year, though, in the second quarter, we had pre-buys related to our price increase from the prior year, about $4 million we estimated. So that'll be a headwind to us in the second quarter, as Shashank previously talked about. But you know, channels look okay. You know, so weather, it's very difficult. That's very difficult to figure out for us at this point in time, so I'm not gonna call any weather issues in the first quarter.

Walter Liptak (Industry Analyst)

Okay. Yeah, when you didn't answer that, I thought, that was probably your way of saying no, but, that wasn't it. Okay, thanks. I'll get back in queue.

Robert Pagano (CEO)

Thanks, Walter.

Operator (participant)

Your next question comes from Jeff Hammond with KeyBanc Capital Markets. Your line is open.

Brad Thomas (Managing Director)

Hey, good morning, guys. This is, Brad on for Jeff.

Robert Pagano (CEO)

Morning, Brad.

Brad Thomas (Managing Director)

Just digging into that 8% core growth in Americas, you know, and you've kind of touched on different moving pieces here, but, you know, I think you talked about 150-200 basis point pull forward headwind in 1Q, so maybe, maybe that's even closer to the 10% on a normalized basis. So I guess, just wondering if you could kind of split out how much of that was market driven versus share gains? I think you said price was maybe about half, but just clarifying just, you know, some of the market dynamics there.

Robert Pagano (CEO)

Yeah. So in the 8% growth in the Americas, about half of it was price, half is growth. We believe about 1% was related to our new product developments, primarily driven by our Connected Products inside of that. So, you know, I think that's really, you know, the dynamics of that.

Shashank Patel (CFO)

In your first statement on the 1.5%-2% headwind, that was for the second quarter, not the first quarter in the Americas.

Brad Thomas (Managing Director)

Oh, okay. I thought you talked about last quarter, you know, there was maybe some benefit in the fourth quarter of 2018.

Robert Pagano (CEO)

A small amount.

Shashank Patel (CFO)

Yeah.

Brad Thomas (Managing Director)

Okay.

Shashank Patel (CFO)

Not significant. Yep.

Brad Thomas (Managing Director)

All right. And then just in Europe, you know, I understand the directional commentary, but, you know, I guess going into the year, you talked about some headwinds in Italy, France, and Germany. So I guess a little bit surprised to see moderate growth in all those regions, you know, maybe a little bit of project timing in Germany. But can you kind of, you know, level set, you know, how that market performed relative to your expectations on a kind of a country-by-country basis in the first quarter?

Robert Pagano (CEO)

Well, yeah. So, it -- you know, each one of them, we had an extra day that we talked about. That's about 1.5% of the growth, overall growth in the quarter, and that's in essence, every one of those countries.... you know, so it rippled all the way across each one of those. So when we look inside of it, our drains business is performing very well in keys like the Nordics. We had some strong German OEM business in the quarter, which is our lower margin type business. That was positive. In electronics, it was slightly down because we're seeing some product shifts on different platforms, and that's just a timing issue. So generally, it performed basically in line with what we expected.

Shashank Patel (CFO)

Okay.

Robert Pagano (CEO)

There was no surprises for us on that. We're gonna see the negative impact of that, you know, day coming back inside of, negatively hitting us in Q2.

Shashank Patel (CFO)

You know, as we model the year, for our full year outlook for Europe was 0%-2% growth, with easier first half compares versus second half compares, 'cause second half last year, we actually grew Europe. Clearly, Q1, Q2 dynamic with that extra, the Easter timing. So it's playing out like we thought. Now, clearly, you know, Europe three months ago versus Europe today, things have moved around, but it's small. It's 0.2%, 0.3% by each of those countries you mentioned, so it's not significant enough.

Brad Thomas (Managing Director)

Okay, I'll leave it there. Thanks for the color, guys.

Robert Pagano (CEO)

Thanks.

Operator (participant)

Your next question comes from Ryan Connors with Boenning & Scattergood. Your line is open.

Ryan Connors (Managing Director)

Hey, okay, that's a new one. Hey, guys. I've heard a lot—I've heard a bunch, but that's a new one. So just you mentioned the somewhat softer outlook for really across the board in terms of the end markets and maybe some particular concern on non-resi commercial. Can you parse that for us in terms of you know how that impacts the mix outlook in terms of you know would that maybe that would have a negative effect on mix given if commercial's a little softer? Can you just kind of give us your view there?

Robert Pagano (CEO)

Yeah. Again, really no change from where we gave guidance for the year. I think we saw leading indicators were telling us it would slow in the second half, and I think it's playing out as we expected. What's interesting to us is, you know, if we look at what happened in the fourth quarter and early in the first quarter, I mean, this business, in general, is based on sentiment and what's happening in the market. So people decide to invest in new construction based on how the economy's going, et cetera. So I think there could be a lumpiness inside of, you know, the economics related to, let's call that one to three months negative period we had, that kind of made people rethink.

So, you know, if you look at where GDP is going, it's slowing, but, you know, it popped up a little bit here in the first quarter. But in general, you know, we feel good about the year in total, and it's not changed. All the indicators were, you know, coming down before, but they're still growing. So from a positive point of view, our teams feel good about what's happening in the channel, and the discussion is if there's a pickup in the second half, and some of the indicators start indicating that, you know, they may be a little bit more bullish. But we're a short lead time business. We have visibility really into the next three months, and that's really what where we're gauging. So the longer term is just the same indicators that we all look at.

Shashank Patel (CFO)

I think, Ryan, on the mix side, you know, between commercial and residential in the Americas, you know, from a margin standpoint, it's very similar. Where we get the difference is obviously in our heating, hot water solutions business. The margin profile is different. But where we get mix shifts is in APMEA, when we're selling in different regions within the APMEA market, and that's just market dynamics there.

Ryan Connors (Managing Director)

Okay. Now, my other one was, you touched on channel inventories earlier, and I just wanted to revisit that briefly. You know, you talk about given some of the data and also the fact that, you know, maybe raw materials moderating a bit, is there any what do you think is the likelihood that you do see some kind of a bit of a destocking in the next couple of quarters? Is that or is that not the right way to read that?

Robert Pagano (CEO)

You know, when we look at it, we're close to our channel partners. We don't have exact numbers on every one of their channels, but our discussions with our channel partners are, they're cautiously optimistic. We're not seeing any major trends in their inventory and their buying patterns. So right now, steady as they go right now.

Ryan Connors (Managing Director)

Got it. And then my last one, just, I guess, for you, Shashank. You know, you're buying back some stock, but if I'm reading it right in the proxy, you actually have a pretty sizable request for a pretty sizable increase in share authorization. Any color on what's driving that?

Shashank Patel (CFO)

I mean, it's just, I guess it's just a, you know, proactive move on our part. I mean, as Bob said, you know, we actively pursue the M&A pipeline, and you never know the timing of that, but this is just a proactive move to get ready for anything that could happen over the next several years.

Ryan Connors (Managing Director)

Got it. Okay. Well, look, thanks for, thanks for your time this morning, guys.

Robert Pagano (CEO)

Thanks.

Shashank Patel (CFO)

Thank you.

Operator (participant)

Your next question comes from Joe Giordano with Cowen and Company. Your line is open.

Rob Jamieson (Equity Research Associate)

Hey, good morning. This is Rob in for Joe this morning. Just had a quick question on your incremental investment spending this year. Just a little bit more detail on that and how much did that come through in the first quarter?

Shashank Patel (CFO)

Yeah, so as we had talked about three months ago, our incremental investment spend was approximately $12 million for the year. In Q1, we spent about $3 million, and our forecast for the second quarter is about $4 million. A good portion of that is basically on new product development, including our Smart and Connected strategy, so we continue to invest in that. And then there's a piece of that which is obviously driving our productivity initiatives, and that's within the factory and outside the factory walls. And a small portion is capability building, but right now we're on track for the $12 million we talked about.

Rob Jamieson (Equity Research Associate)

Okay, that's great. And then is there anything that you can provide in terms of detail on the restructuring actions in Europe, and the related savings to that?

Shashank Patel (CFO)

Yeah, so you know, we took an action last July, and we had approximately about $5 million of cost with an incremental savings of about $3-$3.5 million in 2019. As we true that, you know, as we looked at that and finalized the numbers, we had an incremental $1 million. So instead of $5 million, it's a $6 million cost. The savings is still in that same range, and the incremental savings in 2019 is in that same range. And in the second quarter, it'll contribute about $1 million of incremental, you know, quarter-over-quarter savings versus Q2 of 2018.

Rob Jamieson (Equity Research Associate)

That's very helpful. Thank you very much.

Robert Pagano (CEO)

Thank you.

Shashank Patel (CFO)

Thank you.

Operator (participant)

There are no further questions at this time. I will now turn the call back over to Robert Pagano for closing remarks.

Robert Pagano (CEO)

Thank you for taking the time to join us today. We appreciate your continued interest in Watts and look forward to speaking with you again at our second quarter earnings call in early August. Thank you very much.

Operator (participant)

This concludes today's conference call. You may now disconnect.