Watts Water Technologies - Q2 2015

Transcript

Operator (participant)

Ladies and gentlemen, thank you for standing by, and welcome to the Watts Water Technologies Second Quarter 2015 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will be given at that time. If anyone should require assistance during the conference, please press star then zero on your touch-tone telephone. I would now like to introduce your first speaker for today, Treasurer and VP of Investor Relations, Mr. Tim MacPhee. You may begin, sir.

Tim MacPhee (Treasurer and VP of Investor Relations)

Thank you, Andrew. Good morning, everyone, and thank you for joining our second quarter earnings call. Joining me today are Bob Pagano, President and CEO, and Todd Trapp, our CFO. Bob will begin by providing a summary of the quarter. He will offer some color on current market conditions and will update you on Phase One of the Americas/Asia-Pacific Transformation Initiative. Todd will discuss the financial results for the second quarter in more details and update our outlook. Bob will summarize, and then we will open the call to your questions. The earnings press release and earnings call presentation we issued last evening include some non-GAAP financial measures, and we have included in those documents the necessary reconciliations to GAAP measures. You can find a direct link to the webcast of today's conference call on our website at www.wattswater.com.

We will archive the webcast on the site for replay. I'd like to remind everyone that in the course of this call, to give you a better understanding of our operations, we will be making certain forward-looking statements. These statements are subject to numerous risks and uncertainties that could cause actual results to differ materially from such statements. For information concerning these risks and uncertainties, see Watts Water's 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. Now I will turn the call over to Bob Pagano.

Robert J. Pagano Jr. (President and CEO)

Thanks, Tim, and good morning, everyone. Please turn to slide 3 in the earnings call presentation, and I'll briefly provide an overview of our second quarter. Overall, I'm pleased with the progress we made in the quarter. Our transformation efforts are moving ahead nicely. We were able to drive operational margin expansion despite lower revenues, and we generated strong cash flow. Heading into the second quarter, we knew our top line would be challenged, as we signaled during the April call. Organic sales in the EMEA were down due to a tough macro environment, especially in some of our larger countries, such as France and Germany. In the past quarter, however, we did see the overall EMEA sales decrease moderate from Q1, as we expected. Americas organic sales were affected by the product rationalization effort and, to a lesser extent, rainy weather in the South Central U.S.

Overall, Americas' core product line sales were flat with last year, if you exclude the effect of the rationalization. Asia-Pacific performed very well during the second quarter, with solid double-digit growth. AERCO had another strong quarter. Year-to-date, AERCO's sales growth is over 10% compared to the prior year, as we continue to perform very well in the commercial high-condensing boiler marketplace. Also in the second quarter, the movements from the strength of the U.S. dollar, primarily against the Euro and Canadian dollar, negatively impacted our top line. However, despite the revenue headwinds, we were able to expand our adjusted operating profit and margin percentage and maintain a constant Adjusted EPS quarter-over-quarter. We also delivered strong cash flow in the quarter, driven mainly by better working capital management. Todd will provide more details in a few moments.

In Q2, we continued to execute on our various restructuring and transformation initiatives in EMEA and the Americas. A key milestone is our announcement last evening that we've reached an agreement to sell certain non-core product lines in the U.S. to Sioux Chief, a strategic buyer. I'll provide more information on the transaction in just a few minutes. We're still working through the details Phase Two of the U.S. transformation program as we execute on Phase One, and expect to provide more details for you during our third quarter call. Finally, the EMEA actions are progressing as planned, with savings initiatives on track for 2015 and beyond. Two other points of note. First, from a shareholder perspective, the board has approved a new $100 million share repurchase program. This program is in line with our balanced capital allocation strategy.

Second, in early June, we received a favorable determination letter from the IRS concerning our proposed pension plan settlement. We expect to formally settle all obligations related to the pension plan during the third quarter. Costs, both cash and non-cash, are still in line with the estimates we provided during our Q1 call. Moving to the markets, let's turn to slide 4. Let's begin with the Americas. In general, the U.S. economy continues to grow, but at a slower rate than was forecasted when we entered 2015. Certainly, the harsh winter and rainy spring affected many businesses tied to construction. Key residential indicators we watch, such as the Wells Fargo data on housing starts and builder sentiment and the LIRA Remodeling Index, continue to look encouraging and suggest steady growth. On the commercial side, the Dodge Momentum Index and the ABI Index have been trending positive.

Overall, we expect to see continued macro growth in the U.S., although at a more moderate pace. Now let's review the EMEA markets. Overall, the Euro area appears to be stabilizing as GDP expectations are holding firm. Quantitative easing may help stimulate incremental activity. However, it's difficult to correlate to our orders, but certainly, lower rates should trigger a more active construction market. Geographically, our markets are mixed. Construction data from France suggests both residential and commercial markets are down in the 8%-12% range. The boiler marketplace in Germany, where a majority of our OEM customers reside, is down mid-single digits this year. Eastern Europe remains fragile, with geopolitical issues and sanctions affecting the Russian economy, and the uncertainty increase is also driving tension in the region.

I think the mood in EMEA is getting better, but the region has a long way to go before we see sustainable growth. Finally, let's discuss Asia-Pacific. Economic growth in Asia-Pacific is moderate, particularly in China, where we see continued headwinds in the housing market. We think that the recent stock market volatility in China may be impacting customer or consumer sentiment. The Chinese government is taking steps to avert a market crash, but I think people still feel somewhat uneasy about their personal finances and wealth. GDP expectations in other parts of the region are holding firm. So overall, our markets are a mixed bag, with pockets of growth being offset by lagging economies and slow end markets. Now, I wanna update you on the Americas Phase One transformation exercise. So please turn to slide five.

You may recall, as part of Phase One, that we commenced a portfolio rationalization effort focused on removing products that are non-core. We then identified four sizable product lines, in particular, fittings, tubing, brass and tubular, and water connector products. We also identified other smaller product lines that will be discontinued. I'm happy to report that yesterday, we've entered into a definitive agreement to sell the first three product lines I mentioned to Sioux Chief. The sales price is $35.5 million. This is an asset deal and includes two U.S. manufacturing locations. Total product line sales for these four products were $105 million in 2014, mostly sold in the DIY market. We expect to close the transaction by the end of Q3.

We are winding down other product lines, the most significant being water connectors, which are manufactured at a dedicated facility in China. Manufacturing at this facility will be discontinued in the fourth quarter, and we are currently pursuing the sale of these assets. Water connectors represented approximately $75 million in sales in 2014. There are a few miscellaneous product lines that totaled approximately $10 million in sales in 2014, which will be discontinued by year-end. From a financial perspective, we anticipate that our second half 2015 sales reduction related to all product lines will be in the $65 million-$75 million range, with a loss in sales weighted a little more towards Q4.

Given we have lost approximately $15 million in year-to-date sales, we expect total lost sales for 2015 will be between $80 million and $90 million. In 2016, the total lost sales will approximate $190 million. Costs related to Phase One are trending to the midpoint of the range we previously provided. We'll provide a full accounting of all the costs once the product line sales are completed. Finally, the global sourcing program, as part of Phase One, is on track, providing savings at the $4 million annual run rate we discussed previously. Now, I'll turn this over to Todd to talk about our second quarter operating results in more detail and update you on our revenue outlook for the remainder of 2015. Todd?

Todd Trapp (CFO)

Thanks, Bob, and good morning, everyone. Let's turn to slide 6, and let me walk you through the financial results. In the second quarter, we reported sales of $387 million, down 2.3% on a reported basis and down 3.4% on an organic basis. During the April call, we signaled that the second quarter's top line would be challenged due to the foreign exchange headwinds, a continued softness in Europe, the effects of the Americas product line rationalization, and overall tougher comps in both Americas and EMEA. Foreign exchange, mainly related to the weaker euro, negatively impacted sales quarter-over-quarter by 7.1% or roughly $28 million. This substantially offset the upside from the AERCO acquisition, which contributed approximately 8% growth.

In the Americas, we also experienced some top-line headwinds from the flooding that occurred in the South Central U.S. region. As I mentioned, the product line rationalization also had an impact on our top line, and if you adjust for this initiative, our consolidated organic sales would have been down roughly 1%. Regionally, organic sales were down 3.8% in the Americas and down 4.1% in EMEA, which more than offset a 14.6% increase in APAC. Adjusting for the product line rationalization, Americas would have reported flat growth in the quarter. I'll provide more color on the regional performance in a few minutes. Adjusted operating profit increased 2.9% to $42 million, which translated into an adjusted operating margin of 10.9%, up 60 basis points on a year-over-year basis.

Favorable product mix, including AERCO, strong productivity, and other cost savings initiatives, more than offset the impact from the lower volume absorption and the higher anticipated SG&A spend. As we communicated back in February, and again in April, our SG&A costs are higher due to the addition of AERCO and an increase in stock compensation, pension, compliance, and other costs. Further, we are making investments in sales and marketing and product lines with strong margin profiles, like our Global Drains business. Adjusted net income of $24.3 million and Adjusted EPS of $0.69 were both flat with Q2 of last year. Adjusted EPS included a negative impact of $0.07 in the quarter for foreign exchange and a $0.03 headwind associated with the product line rationalization. AERCO contributed $0.09 in EPS in the quarter.

The effective tax rate was 33.8%, which is 100 basis points higher than in Q2 of last year, primarily due to the mix of earnings in the quarter being more heavily weighted to the U.S. Free cash flow in the second quarter improved by almost 9% year-over-year, driven by working capital, primarily inventory. Our inventory is significantly lower on a year-over-year basis due to the efforts to right-size safety stock levels in our distribution centers and by improving processes between sales, planning, operations, and logistics. So now let's turn to slide seven, and let's review the Americas results for the second quarter. Sales were $263 million, a reported increase of 8.7%, but down 3.8% on an organic basis. Again, adjusting for the product line rationalization, Americas would have reported flat growth.

There were several discrete items that impacted organic growth in Americas during the quarter. First, the timing of price increases at both-- from both last year and this year affected Q2 comparability. As you may recall, we introduced a price increase in June of last year, which accelerated approximately $3 million of sales into Q2 of 2014. Similarly, in 2015, we announced a price increase effective April first, which accelerated approximately $4 million of sales out of Q2 and into Q1 of 2015. Second, as mentioned earlier in the call, we were also impacted by the flooding in the South Central U.S. region, which saw sales declines in the 9% range for the quarter. Adjusting for both the price and weather headwinds, core organic growth would have been approximately 4% in the Americas during the second quarter.

AERCO continues to perform very well, led by strong boiler and aftermarket sales. As Bob mentioned, year-to-date growth exceeded 10%, in line with our full-year growth expectations. Also, it is worth noting that the integration savings are on track to what we communicated back in February. From a channel perspective, wholesale organic sales were down 1.9%. Our retail sales were down 15.2%, partially offset by a 7% growth in the OEM channel. As a reminder, the retail channel is where most of the rationalized products are sold. Adjusted operating profit for the quarter was $38.6 million, a 31% increase. This translated into operating margin expansion of 250 basis points to 14.7%, despite the volume reduction.

The margin expansion was due to favorable product mix, including AERCO, pricing, and strong productivity, which included improved performance at our Franklin, New Hampshire, site, which more than offset lower absorption. Overall, we were pleased with the Americas' ability to deliver operating margin expansion despite lower revenue during the quarter. And as I will discuss momentarily, we believe we should see improved top-line growth in the second half of this year. Turning to slide eight, let's review EMEA's quarterly results. Sales of $112 million were down $31.7 million on a reported basis, or approximately 22%, and down 4% organically. Foreign exchange, driven by the euro decline against the US dollar, accounted for $25.8 million or 18% of that sales decline. The organic decrease was concentrated in our larger countries, mainly France and Germany.

As Bob mentioned earlier in the call, the markets we serve in France are down in the high mid-single digits, and in Germany, the major OEM boiler manufacturers also continue to experience year-over-year sales declines. We are also seeing declines in Eastern Europe, primarily driven by the continued weakness in the Russian market, which is down double digits in the quarter. With that said, we did see some pockets of growth within EMEA during the quarter. Middle East sales were especially strong, up 51%, given the timing of drains projects shipped during the quarter. Overall, our European drains platform was up 5%. We also saw continued good performance in the U.K., as our sales were up 15% compared with last year. So we're seeing some growth in some of the other regions, but unfortunately, not enough to offset the difficult conditions in France, Germany, and Russia.

Regarding channel sales, wholesale sales was down 1.5%, driven by lower plumbing sales, primarily in France. In OEM, sales decreased 5.7%, mostly related to HVAC products sold into Germany. Adjusted operating profit for the quarter was $10.7 million, a decrease of $6.2 million or 37%, which translated into an adjusted operating margin rate of 9.5%. Approximately $2.3 million, or 37% of the operating profit decrease, was due to foreign exchange. Lower volume and absorption and stainless steel cost increases more than offset the benefit from our transformation and restructuring efforts. As Bob mentioned, we are executing on our restructuring plan in Europe and are seeing the expected benefits. As forecasted, in the first half, EMEA was a challenge.

We started to see some improvement in order rates as we exited June and expect to see sequential improvement in the second half as we lap some easier comps. Now, on slide 9, let me provide a summary of APAC results for the second quarter. APAC sales were approximately $12 million, a 14.6% organic increase over the prior year, driven by higher valves and underfloor heating volume. Sales have remained strong despite indications of slowing construction in China. We have expanded our distribution presence into tier two and tier three cities and have increased our focus on some key verticals, such as hospitals, data centers, and urban complexes, which are resulting in some incremental growth opportunities. Adjusted operating profit decreased 24% to $1.6 million in the quarter, and APAC's adjusted operating margin decreased 700 basis points to 13.4%.

The key driver of the decline was lower absorption due to a 20% reduction in intercompany sales in the quarter. This reduction was triggered by lower demand due to the exit of non-core products. So in summary, another strong quarter for the APAC team. Margins were and will continue to be affected by the intercompany volume drop related to the exit of non-core products. So on slide 10, let me highlight a couple items related to year-to-date free cash flow. Year-to-date free cash flow was $29.5 million, up over 250 basis points as compared to the first half of last year. Compared to June of 2014, we improved inventory turns in all regions, and DSO improved in both EMEA and Asia-Pacific. So we are making strides in working capital management, and we see further opportunities ahead.

Also, year to date, our capital investment increased 18%, mostly related to the addition of AERCO. In addition, our existing stock buyback program is on track, as we've purchased approximately 350,000 shares of our Class A common stock in the first half at a cost of roughly $20 million. So a strong cash performance in the first half for Watts. Finally, turning to slide 11, I'll provide a brief update on our revenue outlook for the second half of the year. Please note the growth rates on slide 11 equate to core organic sales, which excludes the impact of AERCO and non-core products. In the Americas, we reported 1% core organic growth during the first half of this year. But as I mentioned, there were some discrete items, such as weather and the timing of pricing actions, which affected core growth.

Excluding these discrete items, we believe our core organic sales growth grew in the 3% range in the first half. So as we look at the second half, we think our top line will grow in the 3%-5% core organic range. We believe the economic outlook in the U.S. remains positive. We will continue to realize some incremental pricing benefits, and we do have some easier comparisons, which all equate to a second-half improvement. In EMEA, organic sales declined approximately 5% in the first half of the year. We had some tougher comparisons, especially in the second quarter. However, the sales decline did decrease from Q1 to Q2, as we had forecasted. The euro economy is stabilizing, and the overall sentiment appears to be improving slightly.

With how we exited June and what we're seeing so far in July, we think EMEA sales will be flat to down 2% during the second half of this year, which is an improvement over the first half. In APAC, we had an exceptional first half, mainly due to the ramp-up of our valve and heating businesses. That ramp-up began in the second half of 2014, so comparisons will be a little more challenging in the second half. We are estimating sales growth between 10% and 15% in the second half for APAC. Again, very strong performance, especially when compared to the current challenges in China. So lots of puts and takes, but in summary, versus the last update, we are seeing stronger performance in APAC and AERCO. America-- I mean, EMEA, basically in line, and slightly lower growth projections in the Americas.

Now, let me turn the call over to Bob for a wrap-up before moving to Q&A. Bob?

Robert J. Pagano Jr. (President and CEO)

Thanks, Todd. If you would, please turn to slide 12 and let me give you an update on our top strategic priorities. I'd like to review with you our progress over the last 14 months since I came to Watts Water. There were certain priorities I felt were key to transforming the company.... I evaluated my management team to ensure we possess the skill sets needed to grow this business profitably. I have filled some key positions on my leadership team, including President of the Americas, CFO, and VP of Continuous Improvement, and we continue to look for opportunities to accelerate management and employee development and add key skill sets at all levels of the organization. The EMEA transformation and restructuring initiatives are on track, and the team is executing commendably against those plans.

They have made steady progress in driving savings throughout Europe, but their efforts have been more than offset by the overall market downturns in EMEA. We'll continue to assess our cost positions in this region given the overall market environment. We also made some hard decisions as part of the Americas Phase One transformation effort regarding people and product lines, but the end result is we'll focus our key resources on more profitable customer and product portfolios that drives innovation and is more solution-oriented. We're also delivering on our global sourcing saving commitments. Phase One transformation should deliver sustainable margin expansion in 2016 and beyond. At this point, we've also moved to settle some long-term obligations of the company, with the expected U.S. pension settlement being the largest to date, and we'll continue to look at other opportunities to settle other long-term obligations.

The Phase Two transformation continues to be refined as this process was impacted by the Phase One sale. As previously discussed, the focus will be on consolidating and optimizing our manufacturing and distribution footprint to better support the needs of our customers and improve our cost structure. Again, I'll provide more details in our Q3 call. As mentioned earlier, I do expect to invest a portion of our future savings into reinvigorating customer training, R&D, and our new product development pipeline. I noted this during our first quarter call, that commercial excellence, our ability to delight our customers with new and innovative products, is a key for us to continue to be able to differentiate ourselves in the marketplace. Finally, we'll continue to look for every opportunity to continuously improve performance in our company.

We are increasingly working together as one organization between businesses, countries, and regions to provide our customers with value-added products and solutions. We have our strategic priorities as an organization, and we are on track to complete what we said we would do. So with that, Andrew, please open the lines for questions.

Operator (participant)

Ladies and gentlemen, if you have a question or comment at this time, please press star, then one on your touchtone telephone. Once again, if you have a question or comment, please press star, then one on your touchtone telephone. And if your question has been answered or you wish to remove yourself from the queue, please press the pound key. I'm showing our first question or comment comes from the line of Jeff Hammond with KeyBanc. Your line is now open.

Jeff Hammond (Managing Director covering Industrial Machinery)

Hey, good morning, guys.

Robert J. Pagano Jr. (President and CEO)

Good morning, Jeff.

Jeff Hammond (Managing Director covering Industrial Machinery)

Hey, so just on the Americas, kind of the more moderate growth, I mean, if you talk about the indicators, they all seem pretty positive. So I'm just trying to understand, you know, what do you think is driving the lower growth rate, you know, thus far this year and into the second half? And, you know, if you could just talk about also the sustainability of the margin performance you had in Americas in Q2.

Robert J. Pagano Jr. (President and CEO)

Okay, Jeff, this is Bob. First of all, you know, the growth certainly was disappointing from our perspective. You know, as Todd said earlier, we had some tough compares with timing of our price increases that we had signaled. But certainly, you know, the South Central really was a disappointment in that, you know, we saw, you know, the timing, the rainy weather, and just the commercial impacts of construction related to the oil and gas business just in that area. So anyway, so that, you know, was moderated. I think we all saw GDP this morning come out, and it was lower than expectations. So I think just in general, it was softer than we've seen. In addition, you know, we're focusing not only on rationalizing our product portfolio in our, let's call it, the undifferentiated products.

We're also looking at our differentiated products to make sure, you know, we're capitalizing on the lower tail of that. So we're, we're doing market and channel rationalization as well as product rationalization, especially before we move the products Phase Two. so there's probably a little growth in there. It's difficult to watch it in all aspects, but, you know, we're feeling better about the second half because the second half doesn't have all the noise of the price increases, and hopefully, this weather will subside. So we thought that in the first quarter with the harsh winter, but now moving on, you know, hopefully, in the third and fourth quarter, we'll have better weather. So, you know, I think it's just more, you know, tepid growth, and, you know, I think we're not the only ones seeing that.

And, related to the second part of your question-

Todd Trapp (CFO)

Yeah, Jeff, I'll jump in on the second question in terms of sustainability of the Americas margins. I would say that, you know, in Q2, we saw, you know, 14, 14.7% margins. And from my perspective, you know, a lot of that's being driven by what we're seeing from a productivity standpoint, you know, material savings and commodities and plant productivity. And from my perspective, I see that going, continuing in the second half of the year. So I'd say the margin rates that we saw in Q2 for the Americas, you know, we should be somewhere in that range as we head into the second half of the year.

Jeff Hammond (Managing Director covering Industrial Machinery)

Okay. And then just quickly on the sale, can you know and maybe just talk to us about how you're thinking about dilution overall from this rationalization, you know, kind of given that you've now sold a piece?

... and then, you know, as we look for, you know, as we look out and we get the cost out, you know, how do you kind of make up, you know, for those lost sales and lost EBIT and make this kind of an accretive shift?

Robert J. Pagano Jr. (President and CEO)

Yeah. So I'll take that. What you saw with this rationalization, I'll go back to the original concept. You know, in the long run, we knew this product for us was a decreased focus, and it was decreasing both from a sales and a margin point of view over the long run. So we knew it was dilutive to our overall margins. So in a perfect world, without the euro, you know, AERCO acquisition would have been more from a bottom-line point of view, would have offset the dilution that would cause in 2016 or not. So we'll continue to look for both organic growth as well as acquisitive higher EBITDA growth, you know, with our acquisitions as we go forward.

In addition, when you look at the second part of this year, you know, as I said before, the absorption impact is gonna be heavier as we exit the year and wind down some of the operations. So I think you'll see more of that in China, will be tougher margins in the second half, even from the second quarter in China, because they're bearing the largest impact of the negative absorption in the China results, because they produce, you know, the products that were shipped to North America. So overall, though, I think, you know, selling this, it was faster than we expected. It allows my team to be more focused on our differentiated products and grow from that point of view.

So we're excited about this, you know, transition, and, you know, we're looking to moving forward and allocating our resources on our more profitable products.

Jeff Hammond (Managing Director covering Industrial Machinery)

Okay. Thanks a lot.

Robert J. Pagano Jr. (President and CEO)

Thanks.

Operator (participant)

Our next question or comment comes from the line of Jim Giannakouros with Oppenheimer. Your line is now open.

Jim Giannakouros (Executive Director and Senior Analyst)

Okay. Good morning, everyone.

Robert J. Pagano Jr. (President and CEO)

Morning, Jim.

Jim Giannakouros (Executive Director and Senior Analyst)

Just to clarify, as far as your absorption issues that you're citing in North America, I mean, is that isolated to the retail wind down, or is there some still that you're experiencing in the foundry? And if it is in the foundry, how long before that's no longer the case?

Robert J. Pagano Jr. (President and CEO)

I was hoping we'd not talk about the foundry. But, anyways, no, the foundry is doing real well. It's really related to the retail reduction as well as, as we've been reducing inventory, there's been some absorption impacts with that. So, you know, really, it's the wind down of the product. As we said before, as we wind this down, we have stranded fixed costs that we won't be able to completely exit till the end of this year. So, that's really driving it.

Jim Giannakouros (Executive Director and Senior Analyst)

Got it. Okay. And then, moving to Europe, I fully understand that, you know, you have, you know, lower volumes that are depressing margins. But when I look at a time like 2010, where you were at similar revenues, but at a much higher profitability, I'm just trying to... I can't get from your margin experience then, you know, fast-forward, you know, four to five years, where you've done a serious amount of restructuring in the region, and now you're at a similar revenue level, but at lower margins. Can you, I mean, are there mixed headwinds at play? Any color there would be helpful.

Robert J. Pagano Jr. (President and CEO)

Well, it's primarily volume driven, and I guess there's some mix in it. But also realize we've added some costs toward the end of last year and fully this year for our overall new organization, which is really a Pan-European organization. However, the benefit of that is really in our tax line, so you're not actually seeing it in the margins, but our effective tax rate in Europe has gone down, you know, quite a bit. So you gotta put both of those in perspective. But really, it's volume and absorption driven. We have a heavy fixed cost with our footprint in Europe, and as you know, that footprint is very difficult and costly to get out of. But we'll continue to look at that and monitor that and make sure, you know, we're optimizing that footprint for the future.

Jim Giannakouros (Executive Director and Senior Analyst)

Okay, thanks. And one more, if I may. A quick one on just your priority list as far as uses of cash. You announced another, you know, $100 million in share repurchases. I see that you do have, you know, 6% or so debt coming due early next year. You know, how should we be thinking about your priority list? Because I know that you probably have some M&A pipeline that's building as well. So if you can kind of just categorize, you know, your priority list as far as uses of cash, that'd be great.

Robert J. Pagano Jr. (President and CEO)

Yeah. So, Jim, the other thing, too, just to mention, is we do have this pension settlement that's gonna occur in Q4, I mean, in Q3, which is going to use some of our cash. But, you know, in terms of, you know, our track record of returning capital to shareholders in the form of dividends and share repurchases, and, you know, I think we have a good track record there, and we're gonna continue to do so in the future. And so as it relates to the share repurchase, we typically don't talk about the timing of it, but I can tell you that, you know, we're gonna be absolutely offsetting dilution from a share issuance associated with our employee plans at a minimum. And, you know, the share repurchase will continue to be an important part of our playbook going forward.

Jim Giannakouros (Executive Director and Senior Analyst)

Great. Thank you.

Operator (participant)

Our next question or comment comes from the line of Kevin Maczka with BB&T Capital Markets. Your line is now open.

Kevin Maczka (Managing Director and Senior Equity Research Analyst)

Thanks. Good morning.

Robert J. Pagano Jr. (President and CEO)

Good morning.

Kevin Maczka (Managing Director and Senior Equity Research Analyst)

Question on AERCO. I'm just wondering if that's exceeding your internal plan. They did $0.09 this quarter. I know it's seasonally heavy in Q2 and Q3. That's almost half the accretion you were expecting for the full year.

Robert J. Pagano Jr. (President and CEO)

...So we're real pleased, Kevin, with, you know, with AERCO's performance. They had a real solid Q2 and a solid first half, so we're excited about where they're going. So, you know, we want the team to keep it up and a little tougher comparison in the second half of the year for them. But, you know, we're excited about AERCO and the prospects with the company.

Kevin Maczka (Managing Director and Senior Equity Research Analyst)

Okay. Shifting over to the selling, you're very clear on the second half and full year top line impact of the sales that are coming out. But to bring that down to the bottom line, when you say the costs are trending to the midpoint, I think before you were talking about decremental margins this year on that in the kind of 15%-20% range. Is that what you mean by trending towards the midpoint?

Robert J. Pagano Jr. (President and CEO)

Well, we actually meant in the overall cost to implement the restructure. But, you know, going back to your, really, the 15%-20% is what we talked about before. We think that's still valid in the second half of the year as we start dropping those sales, really at the gross profit level versus what I call the operating income level, which you'll really see the benefit once we get rid of all these fixed costs in the second half of the year. You'll see the benefit coming into 2016.

Kevin Maczka (Managing Director and Senior Equity Research Analyst)

So still looks like 15-20 decrementals on that $80 million-$90 million reduction this year is good, and then that'll be much less than that because of the fixed cost takeout on the additional $100 million next year?

Robert J. Pagano Jr. (President and CEO)

Correct. Correct.

Kevin Maczka (Managing Director and Senior Equity Research Analyst)

Okay. And then just, just to be clear, all of this is coming out of the Americas, correct? Even though we're, we're manufacturing water connectors in China, that's, that's not coming off the Asia-Pac line.

Robert J. Pagano Jr. (President and CEO)

Yeah, there's a piece of the Asia-Pacific sales because they also sold, sold the product. So we'll see a reduction in the Asia-Pacific sales, certainly much less than the North America sales. But there's an absorption impact and a margin hit in... Their margins, we expect to be, you know, south of what we reported in the second quarter, in the second half of the year because of that significant—I mean, it was a large facility, and we're still in the wind down of that.

Kevin Maczka (Managing Director and Senior Equity Research Analyst)

So of the $75 million that's winding down, that's manufactured in China, just curious, how much of that is, would have been reported on that Asia-Pac line versus the Americas?

Robert J. Pagano Jr. (President and CEO)

About $15 million in the second half.

Kevin Maczka (Managing Director and Senior Equity Research Analyst)

15, okay. Okay, thank you.

Robert J. Pagano Jr. (President and CEO)

Thank you.

Operator (participant)

Our next question or comment comes from the line of Ryan Cassil with Global Hunter. Your line is now open.

Ryan Cassil (Analyst)

Hi. Thanks, guys. Wanted to ask about the transformation, Phase Two. i know, there'll be more details coming out, but any, you know, what hasn't been done? You know, what could be the targets and focus without getting into quantitative numbers?

Robert J. Pagano Jr. (President and CEO)

Well, I think our team continues to work Phase Two. you know, a lot of analysis is going on, as well as a lot of, you know, what I call preparation Phase Two is going on. So, you know, we're still making progress behind the scenes. What we're very careful of is the timing of the announcements, because it impacts our employees, and we wanna make sure, given the scope of Phase One, what we sold and what we're, you know, driving inside of Phase One, was a lot of resources. And Phase One, you know, with the sale, we're also providing transitional services. So that's taking some of our resources, that's slightly delaying Phase Two.

But in the long run, you know, we're real pleased with the outcome and what we think is the incremental cash flow associated with the sale, as well as the, it was a great thing for our existing employees, versus winding down the businesses. They'll have opportunities at Sioux Chief to continue with their careers.

Ryan Cassil (Analyst)

Okay, fair enough. Good luck with the transformation.

Robert J. Pagano Jr. (President and CEO)

Thank you.

Operator (participant)

Our next question or comment comes from the line of Joe Giordano with Cowen. Your line is now open.

Joe Giordano (Managing Director)

Hi, guys. Thanks for taking my questions here. Just wanted to just clarify on slide 5, the financial impact on 2016 from the Americas transformation. It's an incremental $100 off of 2015, right? It says $190. That's like, off of 2014, right?

Robert J. Pagano Jr. (President and CEO)

Yes, that's correct.

Joe Giordano (Managing Director)

Okay. And then just looking at AERCO, so it looks like 2Q margins were like 19% versus 9% in 1Q. I know that you could see the revenue, how it falls out, that it's 2, second quarter, third quarter weighted. Is that a pretty normal margin kind of shift that you would expect? And would you think like 3Q similar to 2Q and 4Q similar to 1Q is kind of roughly how we should look at that?

Robert J. Pagano Jr. (President and CEO)

Yeah, I think, Joe, you're spot on. I think, again, the big driver, the performance from Q1 to Q2 is really driven by volume-

Joe Giordano (Managing Director)

Yeah.

Robert J. Pagano Jr. (President and CEO)

Some favorable mix in terms of, you know, they saw some nice performance out of their aftermarket business. But, I would think that Q3 profile, margin profile, would be somewhat consistent, and then Q4 will be closer to Q1.

Joe Giordano (Managing Director)

Okay, fair enough. And then on EMEA, I guess margins there may be a little bit below what some were looking for. And I just was wondering if you can kind of quantify what you've seen so far in first half cost savings from the efforts that you've put in last year. What have you realized to date there, and what are you kind of building into the second half, and where do you kind of see margins shaking out there?

Robert J. Pagano Jr. (President and CEO)

Yeah. So in the first half, we saw about $4 million of cost savings associated with the restructuring and transformation efforts in EMEA, and we assume a similar type of performance in the second half of the year. So

... Again, the big driver is, is really just the volume and the absorption associated with that. And so, you know, if you look at their margin profile in, in EMEA, you know, they were at, you know, 7.5%, I think, in Q1. We, we said it was gonna get a little bit better in Q2, and it did at 9.5%, and we think it's gonna get continue to get better, and, and I would say in the second half of the year, as some of that volume stabilizes.

Joe Giordano (Managing Director)

Okay, fair enough. And then, lastly for me, it, when I think the, the impact of the lost sales from the transformation in 2015 is, it seems to be a bit more back weighted than probably a lot of people had modeled, certainly more towards 4Q. So is there any sort of margin implications that you would kind of guide us to in the second half, related to that? Those, like, the weighting of those sales and when that decline is gonna hit?

Robert J. Pagano Jr. (President and CEO)

Yeah, I still think it's in the 15%-20% range. It's difficult on the timing of Q3 and Q4. Certainly, Q4, you know, given that we're selling, you know, the Americas piece, that'll be done by Q3, so we'll see a large impact out of the Americas in Q4. So, as I said earlier in my comments, I think it's gonna be heavily weighted more towards Q4 as we wrap up and, you know, that business, both in the Americas and in Asia.

Todd Trapp (CFO)

Yeah, I just would add one comment, is that in Q3, we think it's somewhere between $25 and $35 million decline from a year-over-year perspective, as it relates to the sale of the undifferentiated products.

Joe Giordano (Managing Director)

Good. Thanks, guys.

Robert J. Pagano Jr. (President and CEO)

Thank you.

Operator (participant)

Our next question or comment comes from the line of Kevin Bennett with Stern Agee. Your line is now open.

Kevin Bennett (VP of Research Analyst)

Good morning, everybody.

Robert J. Pagano Jr. (President and CEO)

Good morning.

Todd Trapp (CFO)

Hey, Kevin.

Kevin Bennett (VP of Research Analyst)

Bob, if I go back to Asia-Pac real quick, I know you've talked about margins are gonna get worse in the third quarter than they were in the second quarter. If I look out, like, once all this is done, I mean, where do you think those settle out? I mean, are we looking at a new run rate in the low teens, or can we get back up to the high teens?

Robert J. Pagano Jr. (President and CEO)

I think it's gonna be, you know, more on that lower end because there was a lot of volume and absorption that they had as they transferred a lot of business to the U.S., so a lot of their intercompany margins. So the team there is focused on really developing and growing. You saw the large growth, let's call it, in the first quarter and the second quarter, and that's really, most of that growth is focused on what we call differentiated products. So, you know, you're gonna see a shift and, you know, it could, it could be more in the high single digits as we start off. You know, so as we're reallocating resources, adjusting our fixed costs, et cetera, it's gonna get, you know, substantially reduced from where it's been running without that intercompany volume.

Kevin Bennett (VP of Research Analyst)

Got it. Okay, that's helpful. And then if I think about price costs, I know you guys raised prices, but, you know, given what we've seen in just the commodity complex, can you talk about, you know, the benefit you may be seeing from lower material costs and, how you view that going forward?

Robert J. Pagano Jr. (President and CEO)

Yeah. So certainly, we're seeing benefits in the material cost side. Certainly, our customers are pushing for portions of that back. Pricing, you know, we're seeing in the 1-ish range in the Americas, but we're really seeing difficult price pressure inside of EMEA. You know, with the volume decreases, a lot of our customers are pushing real hard for price decreases, so we're actually seeing negative pricing inside of EMEA. So, you know, we're trying to hold our own on that, but certainly we're seeing the benefit of commodities. Europe isn't seeing the benefit of commodities because most of the commodities are bought in U.S. dollars, so with the depreciation of the euro, they're not seeing that benefit of commodities.

Overall, though, both of those, I believe, are positive for the whole company, and, you know, we believe we'll continue to see that in the second half of the year.

Kevin Bennett (VP of Research Analyst)

Got it. So net-net, we're looking at a positive impact from-

Robert J. Pagano Jr. (President and CEO)

Yeah.

Todd Trapp (CFO)

Yes.

Robert J. Pagano Jr. (President and CEO)

Absolutely.

Kevin Bennett (VP of Research Analyst)

Great. Then last question for me. I was wondering if you could talk about your order rates and maybe, you know, as the quarter progressed, and then what you're seeing, you know, into July.

Todd Trapp (CFO)

Yeah. So let's start with Americas. I think as we looked in Q2, we, you know, we got off to a pretty slow start in the month of April, and we saw orders progress, I would say, nicely in May and June. And what we're seeing so far in July is probably a little bit softer than we expected, but still, they're on forecast, and again, feeling pretty good about what we have in there for Q3. As it relates to Europe, we actually saw some really nice progression as we went through Q2, and early polling in July is that the order rates are actually stabilizing, and which from a year perspective is pretty positive.

So, I would say Americas is slightly lower than expectations in July, and May is probably in line with what we expected.

Kevin Bennett (VP of Research Analyst)

Got it. Thanks for that, Todd. Thank you, guys.

Robert J. Pagano Jr. (President and CEO)

Thanks.

Todd Trapp (CFO)

Thank you.

Operator (participant)

I'm showing no further questions at this time. With that, I would like to turn the conference back over to President and CEO, Mr. Bob Pagano.

Robert J. Pagano Jr. (President and CEO)

Thanks, Andrew. In closing, I'd like to thank you for taking the time to join us today for our Q2 earnings call, and we appreciate your continued interest in Watts Water. We look forward to speaking with you again during our Q3 earnings call in late October. Thank you.

Operator (participant)

Ladies and gentlemen, thank you for participating in today's conference. This concludes the program. You may now disconnect.