Watts Water Technologies - Q2 2019

Transcript

Operator (participant)

Good morning. My name is Brent, and I will be your conference operator today. At this time, I would like to welcome everyone to the Watts Water Technologies' second quarter 2019 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, simply press Star and the number One on your telephone keypad. If you would like to withdraw your question, press the Pound key. Thank you.

At this time, I would like to turn the call over to Mr. Tim MacPhee, Treasurer and Vice President of Investor Relations. Sir, please go ahead.

Timothy MacPhee (Treasurer and VP of Investor Relations)

Thank you, and good morning, everyone. Welcome to our second quarter 2019 earnings conference call. With me today are Bob Pagano, President and CEO, and Shashank Patel, our CFO. Bob will provide his perspective on our second quarter business results before turning the call over to Shashank, who will address the financial results in more detail and offer our latest outlook for the second half of this year. Following the prepared remarks, we will address questions related to the information covered during the call. Today's webcast is accompanied by a slide 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.

Let me remind everyone that during the course of this call, to give you a better understanding of our operations, we may be making certain forward-looking statements. These statements are subject to numerous risks and uncertainties that could cause our 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, I will turn the call over to Bob Pagano.

Robert Pagano (President and CEO)

Thanks, Tim, and good morning, everyone. Please turn to slide 3 in the presentation, and I'll provide our quarterly overview. Thanks to our dedicated team, we drove solid growth in the quarter, delivering record results for sales, operating margin, and EPS. We continued to execute on our strategy of driving profitable growth while also continuing to fund incremental investment opportunities. Organically, we saw a positive sales growth in the Americas and Europe, while APMEA's softness persisted in the quarter. The Americas continued to experience broad growth among a number of key product categories and channels, while Europe saw stronger than anticipated growth due to the timing of Drains projects. APMEA's growth was hindered by continued sluggishness in Korea and project timing in the Middle East. We addressed the latest round of tariff increase in the US with additional price increases, which went into effect on July first.

We'll continue to monitor market reaction to these enacted price increases as the second half progresses. Shashank will review the financial details with you in a few moments. Now, briefly, a quick view on the markets. During the second quarter, the end markets performed, for the most part, as we had anticipated. Looking forward, major indicators like the ABI and Dodge Momentum Index have been consistently flashing slowing growth signals over the next six to nine months. Europe macro data continues to signal softness, and market growth in APMEA remains spotty, depending on the region. We are maintaining our full-year organic sales growth outlook for 2019. We expect organic growth in the second half of the year will moderate in the Americas and Europe as compared to the first half, given the impact of some tougher second-half comps and the slowdown in overall market growth.

We continue to expect our adjusted operating margin for the full year should expand by 50-70 basis points. Now, I'd like to update you on our Smart & Connected strategy. Please turn to slide 4. If you recall, we introduced our global Smart & Connected initiative earlier this year. On our website, at trade shows, and on social media platforms, we have developed a comprehensive internal and external communication campaign around our customer promise of Connect, Control, and Conserve. So far, we have had very positive feedback. The pace of growth of our connected products is approximately 2 times the rate of growth of Watts as a whole. We have a strong pipeline of ideas and active connected products under development in all platforms as we continue to invest in expanding our capabilities to create value to our customers.

I'll speak to two examples of products recently launched. The first example is the Edge Controller for our AERCO Benchmark Platinum Boiler, one of the most advanced commercial condensing boilers on the market. Earlier this year, we launched the Edge Controller, a game-changing, connected touchscreen boiler controller that saves customers time and money, simplifies startups and maintenance, and strengthens system performance and efficiency. It features an iOS and Android-friendly mobile app with expanded functionalities. Customers now have the flexibility and freedom to move around the unit when configuring, diagnosing, and troubleshooting. The Edge Controller is the culmination of a true One Watts cross-platform team effort and is the epitome of our connect, control, conserve customer promise....The second example is the Watts Pro mobile application, which offers a full product catalog with access to valuable resources.

It provides product registration and asset management through QR codes, now placed on thousands of Watts products and product labels in North America. Once scanned, the mobile app records a product geolocation and allows users to store in the cloud, pictures and notes related to that installation or services performed. It also allows customers to visually place a 3D model of several Watts products in a real-life application. We'll continue to expand the Watts Pro mobile app product range as we integrate more of our product portfolio and brands into our Watts.com website. We are excited about what the future of Smart and Connected systems can bring to Watts and the industry. We'll continue to update you periodically on the progress of this initiative.

Now, let me turn the call over to Shashank, who will discuss our second quarter operating performance and provide more detail on our second half outlook. Shashank?

Shashank Patel (CFO)

Thanks, Bob, and good morning, everyone. Please turn to slide 5, and I will walk you through the second quarter results. Reported sales of $417 million were up 2%. Organically, sales were up 4%, with strength in the Americas and Europe being partially offset by softness in APMEA. Foreign exchange, mainly driven by a weaker euro, decreased sales by $9 million or 2% year-over-year. Adjusted operating profit was $56 million, an increase of $4 million or 7%. This translated into an adjusted operating margin of 13.3%, up 50 basis points versus last year and a record for the company. We attained this margin while continuing to invest approximately $4 million in our growth initiatives during the quarter.

Price and productivity were the main drivers of the record margin performance, more than offsetting general inflation and the growth investments. Adjusted earnings per share of $1.09 was 4% higher than last year and also represented a new all-time record for Watts. Operations drove an $0.08 increase that was partially offset by higher non-operating expenses and negative foreign exchange translation movements. The effective tax rate in the quarter was 28.4%, or 80 basis points higher than the prior year, mainly due to a mix of earnings. Year to date, free cash flow was a positive $5 million, as compared to a $14 million outflow during the first half of 2018.

The incremental improvement of $19 million in cash flow was due to higher income, reduced inventory levels, reduced tax payments, and slightly lower capital spending as compared to last year. We made progress in the second quarter and consistent with our historic seasonal patterns, we expect that cash generation should continue to improve in the second half. During the second quarter, we repatriated approximately $19 million in cash. Year to date, we have repatriated about $30 million in cash, using a majority of that to pay down debt. In the second quarter, we purchased approximately 56,000 shares of our common stock at a cost of $4.7 million. Year to date, we've returned a total of approximately $26 million to shareholders in dividends and share repurchases as part of our balanced capital deployment strategy.

Overall, we are pleased with our second quarter performance as we set new highs in sales, operating margin, and earnings per share. Turning to the regions on slide six, let's review Americas results for the quarter. Sales of $287 million were up about 6% on both a reported and organic basis. Similar to the first quarter, we saw broad strength across a number of product lines, including Plumbing, Water Quality, and Drains. This growth was partially offset by softness in Heating and Hot Water Solutions due to product timing and a competitive market environment. Similar to the first quarter, incremental price was a key contributor to the Americas top line growth. The pre-buy impact quarter on quarter was minimal, as pre-buy is approximated 2% in the second quarter of each year, both driven by July pricing increases.

Adjusted operating profit in the Americas was $50.7 million, a 9% increase year-over-year. Operating margin expanded by 50 basis points to 17.7%. Price, productivity, and volume offset increased inflation and incremental growth and productivity investments. In summary, a continued strong operating performance for the Americas in the second quarter. Let's turn to Europe results on slide 7. Sales of $113 million were down 3% on a reported basis, but up 3% organically. Foreign exchange, primarily the euro, negatively impacted sales by about $7 million or 6% in the quarter. We saw continued solid growth in our Drains platform, driven partially by product timing. Products sold into both the marine and land-based end markets performed well. Regionally, drains saw strong growth in Germany and in export sales.

In the Fluid Solutions platform, sales were up slightly, mainly due to increases in certain core Plumbing and HVAC products. By region, we saw growth in France, Germany, and Italy. In France, the sales increase was driven by Fluid Solution product sold into the wholesale channel. Germany's stronger performance included increases in HVAC, electronics products sold into OEMs, and drains products sold into the marine sector. In Italy, we saw strength in Fluid Solution product sales into both the wholesale and OEM markets. Conversely, we continued to see the UK slowing due to ongoing Brexit concerns, and Eastern Europe was slow, primarily driven by Russia. Adjusted operating profit for Europe in the quarter was $14.1 million, which translated into operating margins of 12.4%, an increase of 140 basis points versus the second quarter of last year.

The margin improvement was driven by price, productivity, including restructuring savings, and volume, offset partially by inflation, mix, and incremental investments. Overall, a good quarter in Europe, with stronger-than-expected organic growth and solid margin expansion. Moving to Slide 8, let's review Asia Pacific, Middle East, and Africa results. In the quarter, sales were approximately $17 million, down 12% on a reported basis and down 8% organically over the same period last year. Sales outside of China, which represented about 60% of APMEA's sales in the quarter, decreased organically by double digits. We saw growth in New Zealand and Southeast Asia, which was more than offset by weakness in Korea, Australia, and the Middle East. As Bob mentioned, we believe the softness in the Middle East is due more to project timing and expect sales should pick up in the second half of this year.

China sales were up organically by double digits as demand continued for our commercial valves sold into data centers and semiconductor markets, and we saw a pickup in the residential underfloor heating products as well. Adjusted operating profit in the quarter for APMEA decreased 25% to $1.2 million, which translated into adjusted operating margin of 7.4%. The key drivers of the margin reduction included third-party and affiliate volume reduction, inflation, and incremental investments, offset partially by productivity initiatives. Overall, APMEA continued to be soft in the second quarter. Most of the issue relates to project timing, and we expect the top line growth to bounce back in the second half of this year. Now please turn to Slide 9 and our growth outlook for the second half of the year.

We are maintaining our original expectation that sales growth should continue to moderate in the second half of the year due to slowing markets and much tougher comps, especially in the Americas and Europe. On a consolidated basis, we expect continued organic sales growth, with overall second half growth of between 2% and 3%. By region, we expect the Americas should see growth in the second half of 3%-4%, driven by a moderating price tailwind, offset partially by tougher second half comps and slower growth in underlying markets. In Europe, we expect sales should be up 1%-2% against some tougher comps with last year. In Asia Pacific, sales should pick up by 5%-7% in the second half as more Middle East projects come online and the markets in China continue to grow.

Our consolidated adjusted operating margins in the second half should grow by 50-70 basis points, in line with our original full-year expectation. This margin expansion includes an increase in our growth investments during the second half of approximately $5 million, which is consistent with our expected $12 million in incremental spend for the entire year. We are forecasting strong cash flow generation in the second half, consistent with our performance over the past several years. We are still focused on achieving 100% free cash flow conversion for the year. Before turning the call back over to Bob, a few items to keep in mind regarding the third quarter. We're expecting consolidated organic growth in the third quarter to be in line with our second half expectations, with the Americas at the lower end of our growth outlook, given the second quarter pre-buy impact.

We expect that consolidated operating margin expansion in the third quarter should be at the lower end of our full-year range. Regarding investments, we anticipate incremental investments of $3 million in the third quarter, $2 million in the Americas, and approximately $500,000 each in Europe and APMEA. These investments should be partially offset by approximately $1 million in incremental restructure savings, all in Europe. We expect our third quarter effective tax rate to be in line with our full-year outlook of 28%. Finally, based on current foreign exchange rates, the translation impact should be slightly negative when compared to the third quarter of last year. With that, I'll turn the call back over to Bob before we begin Q&A. Bob?

Robert Pagano (President and CEO)

Thanks, Shashank. To summarize, the business delivered record sales, operating margin, and earnings per share in the second quarter. This was driven by the Americas and Europe, both delivering a solid operating performance during the quarter. We are maintaining our full-year sales and operating margin outlook and are pleased with the progress to date around our Smart and Connected product strategy. So with that, operator, please open the line for questions.

Shashank Patel (CFO)

At this time, I would like to remind everyone, in order to ask a question, simply press star, then the number 1 on your telephone keypad. We'll pause for a moment to compile a Q&A roster. Your first question comes from Nathan Jones with Stifel. Your line is open.

Nathan Jones (Senior Equity Analyst)

Yeah, good morning. This is Adam Farley on for Nathan. Good morning.

Shashank Patel (CFO)

Good morning, Adam.

Nathan Jones (Senior Equity Analyst)

Hey, looking at the 2H organic growth guide, is the lower growth in 2A in the second half simply a function of tougher comparisons? Or, does it imply that Watts is potentially gaining share given some of the slowness in some of your end markets?

Robert Pagano (President and CEO)

Adam, thanks for the question. When we look at it, first of all, if you look at last year, in particular, the Americas had a comp in the second half of... It was up 10%. So we have difficult comps, and secondly, we do believe the market is slowing a bit. So it's still growing, but just slowing in the second half as compared to last year. So it's a combination of that, and, you know, I think, you know, the team is doing a great job in the current environment, and we continue to believe we're driving growth in this tough market.

Nathan Jones (Senior Equity Analyst)

All right. And then just turning to APMEA, you expect growth to pick up in the second half. I think you called out Middle East project timing and then also some pickup in China. You know, what, what kind of gives you the confidence there? And just any other additional color would be great.

Robert Pagano (President and CEO)

Yeah, sure. First of all, China, we saw growth come back in the second quarter, primarily in our valves under our valves for our data centers. And so that's positive, and we see the pipeline continuing in the second half. Middle East, the same thing, it's a timing issue. The political uncertainties that happened, let's call it in the first half of this year, we're beginning to build a backlog, and we're gonna see that come out in the second half of the year. So that gives us the confidence based on our backlog and what we see, and I think there's easier comps in the second half in that region.

Shashank Patel (CFO)

Yeah, and on that point, if you recall, in China, in the second half of last year, we were down double digits, so the comps do get easier in China in the second half.

Nathan Jones (Senior Equity Analyst)

Oh, that's great. Thanks. I'll pass it on.

Robert Pagano (President and CEO)

Thank you.

Operator (participant)

Again, if you would like to ask a question, press star and then number one on your telephone keypad. Your next question comes from Walter Liptak of Seaport Global. Your line is open.

Walter Liptak (Managing Director)

Hi, guys. This is Stephen Friedberg filling in for Walt.

Shashank Patel (CFO)

Hi, Steven.

Robert Pagano (President and CEO)

Hi.

Walter Liptak (Managing Director)

So I wanted to turn to the operating leverage. It looks like second quarter in a row looked good. You guys kind of, you know, call out the same thing, price, volume, productivity. You know, with a slower than expected growth in the second half, you know, I guess, can the level of, you know, 35%-40% of incremental margins be continued?

Shashank Patel (CFO)

Yes. Yes. So it's more in the range of 25%-30% as far as operating leverage. And based on what we've got in play from a productivity standpoint and our outlook on inflation, we expect that to continue in the second half.

Walter Liptak (Managing Director)

All right, great. And then, going back to the original question on the call, regarding second half growth. I know on the Q1 conference call, you guys kind of talked down expectations a little bit. You know, you said in recent housing data as well as housing affordability. And it looks like Q2, you guys pulled out a great, you know, 6% organic growth in Americas. I guess the question being is, you know, with the same current tone as of Q1, you know, as in this call, you know, has the second quarter growth rates caused you to rethink any of your, you know, I guess, comments on the market outlook?

Robert Pagano (President and CEO)

No, I, I think the market's playing out just like we thought. I mean, we began the year knowing that the first half we felt was gonna be stronger than the second half, number one, because of market conditions, but number two, because we had such a strong second half of last year relative to pricing increases, et cetera. So it's kind of playing out just like we had expected in the markets.

Walter Liptak (Managing Director)

All right, thanks. And then, if I could just ask one more. You know, I know, you know, in the earnings season, we've, you know, seen a couple companies call out, you know, stable, you know, housing, or, you know, even improving, you know, housing data. Are you guys seeing any, you know, thing, you know, an underlying market that, you know, that can confirm this, this notion?

Robert Pagano (President and CEO)

Well, when you look at it, if you recall, about 35% of our business is residential, and of the residential, two-thirds of that business is multifamily for us. So single family homes, in particular in the Americas, is a low part of our business, and we tend to be on the higher end of those homes. So, you know, with recent interest rates decreasing, you know, single family starts, especially the beginning ones, I think that's sounding like that's gonna go forward, but that's not a market that we heavily play in. So right now, the markets are playing, as I said earlier, in alignment with what our expectations are.

Walter Liptak (Managing Director)

Okay, great. Thanks.

Robert Pagano (President and CEO)

Thank you.

Operator (participant)

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

Jeff Hammond (Managing Director)

Hey, good morning, guys.

Shashank Patel (CFO)

Good morning.

Robert Pagano (President and CEO)

Good morning.

Jeff Hammond (Managing Director)

Just on Europe, I mean, that business seems to be holding in better, you know, given some of the macro worries. Where are you kind of most concerned as you look into the back half, either, you know, product or region-wise? And then, you know, margins, you know, really, you know, progressed nicely in the first half, just, you know, kind of sustainability.

... of that, you know, kind of margin improvement in Europe, should we just kind of stay in this low growth environment? Thanks.

Robert Pagano (President and CEO)

Yeah. Thanks, Jeff. When I look at Europe right now, we had a good quarter in our drains business. That was very positive for us. As we look into the second half, what we're seeing is we had, again, tough comps last year. As you know, our quarter was strong, you know, over 3% in the second half of last year, so we're comping against that. I mean, fundamentally, the European market, we're hearing, is slowing. We're seeing some of that. We had some strength in Germany. This quarter, we gained some share with a couple new customers in Germany, you know, small customers. So again, I think the market in general is about the same.

We've done a lot of margin improvement based on the restructuring that we've done, and you've seen in the fourth quarter and the first half of this year. So, you know, our goal is to keep driving margins and, you know, be cautious about the market as we have and keep on growing, in particular, our drains business, which is a global business and our global electronics business. And your second question was a margin question.

Jeff Hammond (Managing Director)

Yeah.

Robert Pagano (President and CEO)

I'll let Shashank grab.

Shashank Patel (CFO)

Yeah, in the margin question, I mean, beyond the normal productivity over cost, et cetera, we have done a better job on price. The price came in more favorable than we expected, so the teams have been working really hard on the value prop and driving more price out of the market, albeit under tougher market conditions. And then, so that's primarily been the drivers there, is that aspect of it, and then the drains business Bob talked about, and that's on the marine side. Obviously, that drives a slightly better margin profile as well, so that's helped the operating margin. And then the last piece is the restructuring.

You know, we did do an additional $1 million of restructuring, and we got some savings out of that, and that'll continue in the second half as well to help the op margin performance.

Jeff Hammond (Managing Director)

Okay, great. And then, a lot of your peers have kind of talked about weather being an issue. I don't think, you know, you guys really mentioned it. You know, how do you think weather's impacting or not impacting the business? And then, you know, maybe specifically to the AERCO PVI business, how those performed and if weather crept in at all there.

Robert Pagano (President and CEO)

Yeah. So when we look at it, we believe weather had a small impact, right? Especially in our South Central regions in particular. It's difficult to quantify because we had pull-ins a little bit, that Shashank talked about, but approximately 1%, I would believe, it impacted that. And I think that did have an impact with the HHWS platform in the quarter. But again, we're at our mid-single digit run with those guys on a year-to-date basis, and that's in alignment where we expect to end the year at.

Jeff Hammond (Managing Director)

Okay. And then, so can you just talk about what price was in the first half and what you think the contribution is in the second half, given kind of the new price increase?

Shashank Patel (CFO)

Yeah. In the second quarter, you know, slightly more than half of the growth was price related in the U.S. In Europe, obviously, a lot less, because obviously there's not the tariff impact that drove the price. As you look at the second half, I mean, look, it's too early to tell right now. We just announced the July 1 price increase. It's a very dynamic market and there's price elasticity. So, you know, we've tapered down our expectations based on what happens as we go through the second half.

Jeff Hammond (Managing Director)

So just on that follow-on price increase, what are the dynamics on the cost side that are driving a price increase? Because it seemed like, you know, most of the tariffs and inflation was through and some of the, you know, input costs are, you know, moderating.

Shashank Patel (CFO)

Yeah. So in, at the end of May, May 25th, I believe it was, the 10% tariff from, on the imports from China went to 25%. So the additional 15% that was supposed to be tacked on in January, finally got tacked on at the end of May, and that's what drove the July 1 price increases for the U.S.

Jeff Hammond (Managing Director)

Yeah. Then just final question, you know, it's been quiet on the M&A front. You know, just given some of the macro uncertainty, are you seeing, you know, valuations start to come your way on deals? And, you know, what does that mean for maybe actionability on the pipeline?

Robert Pagano (President and CEO)

Yeah, Jeff, it's always difficult to time acquisitions. And, you know, I think our pipeline continues to be full. We're cultivating and looking at acquisitions, like we always have, but in our balanced capital allocation strategy. So, you know, multiples, they're all over the place, so it's difficult to exactly say, you know, what, what's coming in or not. So again, I think it's, you know, something we keep on monitoring. We'll continue to cultivate and still deploy our balanced capital allocation strategy.

Jeff Hammond (Managing Director)

Okay. Thanks a lot, Bob.

Robert Pagano (President and CEO)

Thank you.

Operator (participant)

Again, if you would like to ask a question, press star, then the number one on your telephone keypad. Your next question comes from Joe Giordano of Cowen and Company. Your line is open.

Joe Giordano (Managing Director)

Hey, good morning. This is Robert in for Joe. I just have a quick question about the incremental investment spending. I see your guidance for $12 million this year. I just wondered how much came through in the first half this year so far. Thank you.

Shashank Patel (CFO)

Yeah. Yeah, out of the $12 million, roughly $7 million was in the first half, and the other $5 million will be in the second half.

Joe Giordano (Managing Director)

That's great. Thank you.

Robert Pagano (President and CEO)

Thank you.

Operator (participant)

There are no further telephone questions at this time. I would now like to turn the call back over to Bob Pagano, President and CEO.

Robert Pagano (President and CEO)

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

Operator (participant)

Ladies and gentlemen, this concludes today's conference call. You may now disconnect.