Watts Water Technologies - Q2 2017

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 second quarter 2017 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 during this time, please press star, followed by the number 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 VP Investor Relations. You may begin your conference.

Tim MacPhee (Treasurer and VP of Investor Relations)

Thank you, and good morning, everyone, and welcome to our second quarter 2017 earnings conference call. Joining me today are Bob Pagano, President and CEO, and Todd Trapp, our CFO. Bob will provide his perspective on our second quarter results in the global markets before turning the call over to Todd, who will address our second quarter results in more detail and offer our latest outlook for the second half of this year. 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 Investors section of our website. We will reference these slides throughout our prepared remarks. Any reference to non-GAAP financial information is reconciled in the appendix of the presentation.

Before we begin, 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' publicly available filings with the SEC. The company disclaims any intention or obligations to update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise. Now, let me turn the call over to Bob Pagano.

Bob Pagano (President and CEO)

Thanks, Tim, and good morning, everyone. Please turn to Slide 3 in the presentation, where I'll provide some commentary on the second quarter. Watts delivered another solid quarter, in line with our expectations and what we communicated back in April. For the second consecutive quarter, we reported a record adjusted operating margin and adjusted EPS, despite a muted top line. Operating margin expanded 60 basis points to 12.5%, which helped drive an 11% increase in adjusted EPS. We continue to execute on our various transformation initiatives, including portfolio rationalization, sourcing, and restructuring actions, which is driving our double-digit earnings growth. As expected, we did see a modest sequential improvement in organic sales growth. Excluding product rationalization, organic growth was 1% in the quarter.

Growth in both Europe and Asia Pacific was tempered by flat performance in the Americas, where an increase in our valves and drains products was offset by AERCO's expected headwinds and tougher comps. Todd will review the financial results in more detail shortly. Now, let me make a few comments on our end markets. In the Americas, we still expect low- to mid-single digits growth in both the non-residential and residential markets. As you recall, the market for condensing boiler products in the U.S. had softened in the first quarter. We saw that trend reverse in Q2, and now it is essentially flat for the year. In Europe, the overall macro environment is relatively stable, although there appears to be slightly more optimism in countries like France and Germany as we exit the second quarter.

In Asia, recent GDP and construction data remain positive, and we expect that trend to continue as well for the second half of the year. We continue to invest for growth with the goal to drive innovation, reinvigorate the front end of our business, and accelerate productivity, all with a focus on enhancing the customer experience with Watts. Incrementally, we invested approximately $2 million in the quarter. Also, in September, we will hold our third annual Innovation Summit in North Andover. This meeting will bring our sales and engineering teams from around the world together to understand our broad capabilities, share ideas, and identify new and innovative breakthroughs to drive further growth. Finally, we are reaffirming our full year outlook for 2017.

We expect organic growth rates will improve in the second half versus the first half, mainly due to improved market conditions, new product introductions, and geographic expansion. We expect our operating margin for the full year should approximate 12%. Now, I'll turn the call over to Todd to talk about our second quarter operating performance and provide a little more detail on our second half outlook. Todd?

Todd Trapp (CFO)

Thanks, Bob, and good morning, everyone. I'm on Slide 4, which shows the second quarter results. Reported sales of $379 million were up 2%, reflecting the impact of the PVI acquisition, which added approximately $14 million or 4% in the quarter. Foreign exchange, mainly driven by a weaker euro, negatively impacted sales by roughly $5 million or 1%. Organically, sales were flat, with growth in Asia Pacific being offset by a slight decline in the Americas. I will talk more about the regional performance in a few minutes. As expected, we saw about a $5 million negative impact in the quarter from product rationalization. Excluding this item, organic sales were up about 1%. Adjusted operating profit of $47 million increased $3 million or 8%.

This translated into an adjusted operating margin of 12.5%, up 60 basis points versus last year and a record quarter for the company. Excluding the dilutive impact of the PVI acquisition, adjusted operating margin grew over 80 basis points.

We attained this margin while continuing to invest in our growth initiatives. Productivity, restructuring, and transformation benefits were the main drivers of the record margin performance. Adjusted EPS of $0.83 was 11% better than last year. The $0.83 also represented a new record quarter for the company. This increase in EPS was driven primarily by strong operational performance and, to a lesser extent, a lower tax rate. The effective tax rate in the quarter was 32.1% , about 250 basis points lower than the prior year, mainly due to the mix of worldwide earnings. Turning to cash, on a year-to-date basis, free cash outflow was $2 million. This was a $9 million improvement over the same period last year, mainly due to the timing of capital spend.

We do expect that capital spend will pick up in the second half of the year as we increase investment at some of our manufacturing sites and IT tools, which will help drive future productivity improvements across Watts. Also important to note, and consistent with our history, we expect that our cash generation will improve in the second half, as we are focused on achieving 100% cash conversion for the year. So overall, we are pleased with our second quarter performance as we set new highs in adjusted operating margin and earnings per share. Turning to the region, on Slide 5, let's review Americas results for the quarter. Sales of $251 million were up about 5% on a reported basis, mainly driven by the acquired sales of PVI.

Organic sales were down 1% and flat when excluding approximately $2 million in anticipated product rationalization. Stronger sales in our valves and drains products were offset by anticipated softness in AERCO and water quality. AERCO was impacted primarily by tough comps and a softer repair and replacement sales in our tankless water heaters. AERCO's boilers product line was relatively flat in the quarter. At AERCO, we did see order rates improve as the second quarter progressed, partly driven by the success of our new Platinum boiler line. We also expect that the overall U.S. condensing boiler market will be better in the second half versus a flat first half. As a result, we expect the headwinds that we've seen at AERCO should subside beginning in Q3.

PVI also continues to perform well, as sales were up double digits in the quarter, driven by strong growth in our gas condensing water heaters. PVI's year-to-date growth is outperforming the overall market, and we expect that trend to continue. Adjusted operating profit in the Americas was $41 million, a 5% increase year-over-year. Operating margin was steady at 16.5%. Productivity and transformation savings offset the dilutive impact from the PVI acquisition and continued investments to fund future growth. So for the Americas, a marginal top-line improvement from what we saw in the first quarter and continued strong operating performance. Let's turn to Europe's results on Slide 6. Sales of $111 million were down 3% on a reported basis and flat organically. Excluding the impact of product rationalization, organic sales were up 1%.

Foreign exchange, primarily the euro, negatively impacted sales by about $4 million or 3% in the quarter. From a platform perspective, we saw solid growth in our drains business, which was driven by increased product releases within the commercial segment. In Fluid Solutions, sales were down slightly, with growth in electronics offset by softness in our water and plumbing products. By region, we saw strength in Germany, driven by new product introductions into the OEM channel within our electronics business, as well as some drains products. We also experienced solid growth in Eastern Europe, mainly in Russia, where there was a strong commercial demand for our Stout branded products. Conversely, we had softness in France, as increased sales in electronics from new products were being more than offset by product rationalization.

Adjusted operating profit for Europe in the quarter was $13 million, which translated into operating margins of 11.8%, an increase of 60 basis points versus Q2 last year. The strong margin expansion was driven by sales and product mix and productivity, including the benefits from prior restructuring actions. So for Europe, another quarter of continued stabilization with solid earnings and margin growth driven by our, our initiatives. Moving to Slide 7, let's review Asia Pacific's results. In the quarter, sales were approximately $17 million, flat on a reported basis and up 2% organically over the same period last year. Excluding product rationalization of $2 million, organic sales were up 15%. It's a similar story to what we saw in the first quarter, as strength in China more than offset flat performance outside of China. Excluding product rationalization, our China sales grew over 40%.

Due to the continued strong demand for our underfloor heating products used in residential applications and new products that we launched in our commercial valves business. Sales outside of China were flattish, mainly driven by timing of project releases in the Middle East, offsetting a strong performance in Korea. Adjusted operating profit in the quarter for Asia Pacific increased 47% to $2.2 million, which translated into adjusted operating margin of 13%. The key drivers of the 380 basis points margin improvement included an increase in intercompany sales, which drove favorable plant absorption, as well as continued productivity savings. In summary, Asia Pacific performed very well during the quarter, with increased organic growth, driven by sales within the China market. Finally, turning to Slide 8 and our outlook for the second half of the year.

On a consolidated basis, we expect organic sales growth in the second half to improve as compared with our first half performance. By region, the Americas should see consistent growth from relatively healthy end markets, with AERCO returning to growth after being down in the first half. In Europe, we expect modest improvement given the stable outlook for our end markets. In Asia Pacific, sales should pick up in the back half of the year as our China business continues to expand, and we see a rebound in activity in the Middle East and Southeast Asia. Our consolidated adjusted operating margins grew by 40 basis points in the first half of 2017. We expect slightly better year-over-year margin expansion in the second half, as productivity and cost savings continue to be realized, and we see more drop-through from anticipated incremental top-line growth.

We still expect operating margin to approximate 12% for the full year, up 60 basis points versus 2016. Finally, we are forecasting strong cash flow generation in the second half, consistent with our performance over the past several years. With that, I will turn the call back over to Bob before we begin Q&A. Bob?

Bob Pagano (President and CEO)

Thanks, Todd. To summarize, we experienced record adjusted operating margin and adjusted earnings per share in the second quarter and are reaffirming our full-year outlook. We continue to drive our various transformation programs and are investing in key areas to help drive our future performance and create shareholder value. So 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 followed by the number one on your telephone keypad. We'll pause for a brief moment to compile the Q&A roster. Your first question comes from the line of Jeffrey Hammond. Your line is open.

Jeffrey Hammond (Managing Director)

Hey, good morning, guys.

Bob Pagano (President and CEO)

Hey, Jeff.

Todd Trapp (CFO)

Jeff.

Jeffrey Hammond (Managing Director)

Hey, so just on North America second half, can you just talk about, outside of maybe just easy comps and AERCO and, you know, the abatement of product rationalization, you know, what else are you seeing outside of that that would support the acceleration and the growth rate?

Bob Pagano (President and CEO)

Yeah. So Jeff, as we look, you know, we look at Dodge Momentum Index, ABI Index, and just our channel checks, you know, our product pipeline and just the overall mood in the marketplace. So having just spent some time with all our rep organizations, they feel, you know, positive about the signs. As you remember, you know, last year, we had a lot of political uncertainty in the second half of last year, and I think some of these projects that were slowed down are starting to move forward. So we feel, you know, cautiously optimistic inside the Americas.

Jeffrey Hammond (Managing Director)

Okay, great. Then can you just talk specific to AERCO, some of those, you know, what you're seeing in terms of some of these projects breaking free and, you know, any feedback you're getting on some of the new product? Thanks.

Bob Pagano (President and CEO)

Yeah. So, you know, it was good to see AERCO's, we started to see the orders pick up in the boiler section and, you know, as we, you know, proceeded through the second quarter. The interesting thing, the Benchmark Platinum line is getting very positive feedback in the marketplace, and we're starting to close some orders. So our backlog's improving as well as, you know, our teams are seeing, the project pipeline improve, too. So we feel good about their ability to return to growth in the second half of this year.

Jeffrey Hammond (Managing Director)

Okay, great. Thanks, Bob.

Bob Pagano (President and CEO)

Thanks.

Operator (participant)

Your next question comes from Joe Giordano. Your line is open.

Joe Giordano (Managing Director)

Morning, guys.

Bob Pagano (President and CEO)

Morning, Joe.

Todd Trapp (CFO)

Joe.

Hey, just starting in the Americas again, can you just kind of square the commentary around AERCO with PVI and, like, what, what's driving those differences in near-term performance? Is it, is it comps? I don't, we don't have as much historical context for PVI. So if you could just kind of comment on that.

Bob Pagano (President and CEO)

Yeah, well, PVI, we acquired in November, so you know, we've been talking about organic growth. PVI, you know, we've seen double-digit growth year to date, so we feel good about that. You know, they're condensing commercial boiler line or water heater line, mainly in gas. We don't have an electric portfolio. AERCO is primarily a condensing commercial boiler manufacturer, and our sweet spot is 1 million BTU and above. So, also inside of AERCO is tankless water heaters, and we saw some softness in that in the second quarter, but we saw our boilers basically flattish in the quarter. So again, we're looking at the pipeline, we're looking at the activity, and you know, we feel good about both businesses. And you will start seeing PVI you know, in the fourth quarter, start moving over towards our organic growth.

Joe Giordano (Managing Director)

Fair enough. If I look at Europe, the data in France on just the macro data has started to improve pretty materially. You know, I know you mentioned in your comments that the rationalization is offsetting that, but absent that, do you expect kind of like an apples to apples organic acceleration in that market in second half?

Bob Pagano (President and CEO)

Yeah, if you remember, the elections, you know, happened later in the second quarter.

Joe Giordano (Managing Director)

Mm-hmm.

Bob Pagano (President and CEO)

Having been in Europe, you know, about 70% of our business is repair and replace. There's not a lot of booming construction going on in France right now, but our team over in Europe is very optimistic, you know, and, you know, we're expecting to return to growth in the second half of the year.

Joe Giordano (Managing Director)

Okay. And then how much are you embedding in your estimates for savings in the second half? And how much, and if you can comment maybe on, like, price cost that you're seeing right now.

Bob Pagano (President and CEO)

I'll grab the price cost, and I'll let Todd handle the savings. But price cost right now, certainly we've seen copper prices have increased and actually increased a lot more just recently in the last few weeks. But what we're seeing right now, we've been able to pass... You know, our price increase went into effect in March through the wholesale channel. We're seeing that stick. Some of our competitors have announced price increases. We've yet to see them implement that. But overall, we expect, you know, we saw a little under a point inside of our wholesale channel in the second quarter, and we expect that to continue as our agreements with our various customers start rolling that out.

So overall, we believe we'll be able to pass on price in the marketplace, and we're counting on our competitors to do the same.

Todd Trapp (CFO)

And Joe, your comment on, or your question on how much are we seeing in terms of transformation savings, we talked about a $10 million full year savings in 2017, and we saw about $6 million of that in the first half, and expect to see $4 million of that in the second half.

Joe Giordano (Managing Director)

Okay. And if I could just sneak in one more. If you could, any update on the operations of the new U.S. distribution center? How's that going right now?

Bob Pagano (President and CEO)

It's going very well. You know, our team is excited about that. Things are going very well. We continue to see improvements every single day in that group. So, as you know, the heavy lifting of our restructuring is behind us with the facilities. I think right now it's optimizing all of them, and we'll continue to optimize them. We'll never be done with that, right? We'll always be looking for continuous improvement. But the tough stuff, the heavy moves, all of that is behind us. So we're just now optimizing these new sites.

Joe Giordano (Managing Director)

Great. Thanks, guys.

Bob Pagano (President and CEO)

Thank you.

Todd Trapp (CFO)

Thanks, Joe.

Operator (participant)

Again, if you would like to ask a question, it is star one on your telephone keypad. Your next question comes from the line of Brian Lee. Your line is open.

Brian Lee (Clean Technology Analyst)

Hey, guys. Thanks for taking the questions. Maybe just specifically on PVI, I wanted to walk through a little bit of the puts and takes going forward. You mentioned it's outgrowing the market for you guys, so it sounds like you're taking share. Can you walk through what's, you know, what maybe some of the drivers are behind that, and then how sustainable you think that is going forward? And then secondarily, on PVI, just the margin impact, does that start to let up and lap the November acquisition timing, or is that something that could become more of a reversal and tailwind before that?

Bob Pagano (President and CEO)

Yeah. So regarding PVI and the product, we're having success because we have a premier product line that has one of the best warranties in the industry, and the product is performing very well. So they've had some new products. They're being successful and feel good about what they're doing. Again, the law of small numbers, it's a small business. You got small, you know, numbers. It's a $50 million business, so when you look at double digit growth, it's still on a small number. We need to continue that. We feel very good about that. We feel good about the new product pipeline inside of that. And then from a margin point of view, when you look at our margins, as in any acquisition, we have incremental integration costs. They're fully integrated at this point in time.

The teams are working there. So we feel that the drag on our margins will get better in the second half of the year, or will be less-

Todd Trapp (CFO)

Less.

Bob Pagano (President and CEO)

That less drag in the second half of the year.

Todd Trapp (CFO)

Yeah, we still expect their margins to be up high single digits for the year.

Bob Pagano (President and CEO)

Right.

Brian Lee (Clean Technology Analyst)

Okay. Okay, great. And then, just, on drains, I think you guys have said in the past that the drains tend to be a leading indicator for your new construction-driven volumes. Did you guys see steady growth in 2Q versus 1Q, or any sort of acceleration? And then, how are you thinking about the trends in that particular category as you move through the back half of the year? Thanks, guys.

Bob Pagano (President and CEO)

Yeah. So, yes, we saw growth in the second quarter, and we continue to see that playing forward. The other part of that is we have a new product line related to our stainless steel drains, really in the food and beverage and industrial type marketplace that we brought over from Europe. And the, you know, that also is in the craft brewery market. So we've seen some success in that area. That's part of our geographic expansion initiative here in the Americas. So again, drains looks good, and as you said, it is a positive early indicator, which also gives us, you know, some good momentum going into the second half of the year.

Brian Lee (Clean Technology Analyst)

All right. Thanks, guys.

Bob Pagano (President and CEO)

Thank you.

Todd Trapp (CFO)

Thanks, Brian.

Operator (participant)

Your next question comes from Jim Giannakouros. Your line is open.

Jim Giannakouros (VP and Head of Investor Relations)

Good morning, guys.

Bob Pagano (President and CEO)

Hey, Jim.

Todd Trapp (CFO)

Good morning, Jim.

Jim Giannakouros (VP and Head of Investor Relations)

AERCO, and I apologize if I missed it. I mean, I get that the market stabilized in the second quarter versus what you were seeing in the first quarter. Have competitive pressures there or aggressive pricing subsided there? Or was it really just volumes coming back relative to what you were seeing three months ago?

Bob Pagano (President and CEO)

Well, I think, from a market point of view, we saw some project delays. I think the whole market saw that. We saw them start being released in the second part of the second quarter, and that started making us feel a lot more positive. The projects were never canceled. But we have seen a lot of new competitors enter the marketplace from Europe, and the market is very competitive. So it's important for us to continue with our new product development, and deliver the most efficient boiler on the commercial boiler market. So we continue to do that. We believe our Benchmark Platinum is the great new product, and we're having good success with that early on. So we feel good about that.

Jim Giannakouros (VP and Head of Investor Relations)

Understood. Thanks. And I guess along those lines, as you think about your product portfolio, how that evolves over time, and obviously using acquisitions to move that along going forward. Just given the vision that you guys have for Watts, where you're gonna take it over, you know, longer term, should we be thinking you're isolating M&A to system sales? Or no, not exclusively, maybe there are some areas that you can beef up core and develop markets, or is there more fertile ground in Asia Pac, for example?

Bob Pagano (President and CEO)

Jim, we continue to look in all those areas. I think it's, you know, it's difficult to pinpoint timing on acquisitions. As you know, multiples are very high, so we continue to cultivate acquisitions in all of those areas. So you know, I don't wanna exclude any of those, but certainly we're looking at more, how we can more, provide more solutions to our customers. We're looking at technology, for, you know, to enhance our project and fill in gaps and regional exposure. So again, we're looking at all those areas, but, we'll be very disciplined as we move forward with that.

Jim Giannakouros (VP and Head of Investor Relations)

Got it. And one last one, if I may. Europe, the margin there, the way I understand it, kind of tough to do any kind of incremental restructuring that would move the needle and get that margin up from where you are. The way I understand it is that it's really gonna be top-line leverage. But are there areas where you can, outside of, you know, leverage, see margin expansion potential? And if you can isolate where, just so I can better understand, 'cause I know Europe is obviously a bunch of buckets and not just one.

Bob Pagano (President and CEO)

Yeah, I think our biggest focus is really investing in our, our higher-margin growth businesses, which are really drains and in our electronics businesses. So those are opportunities to outperform and, and handle the margins on that. So, you know, we'll continue with our normal, you know, our normal purchasing savings, our lean initiatives inside our, our organization to, you know, continue to take costs out of the process, let attrition impact that. But, you know, part of the goal is just to invest in new products in some of those higher margin, more growth-oriented businesses.

Jim Giannakouros (VP and Head of Investor Relations)

Thank you.

Bob Pagano (President and CEO)

Thank you.

Todd Trapp (CFO)

Thank you.

Operator (participant)

There are no further questions at this time. I will now turn the call back over to Bob Pagano for final comments.

Bob Pagano (President and CEO)

Thank you for taking the time today to join us for our second quarter earnings call, and we appreciate your continued interest in Watts. We look forward to speaking with you again in our third quarter earnings call in early November. Take care and enjoy the rest of your summer.

Operator (participant)

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