Watts Water Technologies - Q3 2013

Transcript

Operator (participant)

Good day, ladies and gentlemen, and welcome to the Q3 2013 Watts Water Technologies Earnings Call. My name is Glenn, and I will be your operator for today. At this time, all participants are in listen-only mode. Later, we will conduct a question-and-answer session. If at any time you require operator assistance, please press star followed by zero, and we'll be happy to assist you. Please be aware that remarks made during today's call about the company's future expectations, plans and prospects constitute forward-looking statements under the Private Securities Litigation Reform Act of 1995.

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

A reconciliation of the non-GAAP financial measures to the most directly comparable GAAP measures is available in the press release dated Tuesday, October 29, 2013, relating to the company's third quarter 2013 financial results, a copy of which may be found in the Investor Relations section of the company's website at www.wattswater.com, under the heading Press Releases. I would now like to turn the conference over to your host for today, Mr. David Coghlan. Please proceed.

David Coghlan (CEO)

Thank you, Glenn. Good morning, everybody, and thanks for joining our third quarter earnings call. I'll start by providing a brief overview of the financial results for the quarter. Then I'll speak to some highlights for the quarter before handing the call over to Dean Freeman, who will review our performance in more detail. Dean will also provide you with an update of our guidance for the remainder of 2013. After Dean's review, I'll try to summarize, and then we'll open the call up to your questions. Let's start by turning to slide three of the conference call presentation for a brief overview of our third quarter financial results. From a revenue perspective, we had overall growth of 5.4%, which was driven by solid organic growth in North America and China and offset by an organic decline in Europe.

The strengthening euro was a tailwind in the quarter. Adjusted operating margins declined 110 basis points versus Q3 2012, largely driven by two issues in North America: product liability costs and incremental lead-free transition costs. We'll discuss both of these in more detail shortly. EMEA had a decent operating result as they expanded adjusted operating margins by 70 basis points, despite a 4.2% drop in organic sales. Although with solid sales growth in the quarter, we continued to experience pricing pressures in the North American DIY market. Adjusted earnings per share was $0.58 in the quarter versus $0.62 in Q3 last year. But product liability and lead-free issues negatively impacted the current quarter by approximately $0.10.

As previously announced, we completed the disposal of Austroflex in the quarter and recorded a loss of $2.2 million as part of that disposal. Finally, we spent $10 million in the quarter to repurchase our shares on the open market as part of our ongoing repurchase program. Dean will provide you with more details on our performance in a few minutes. But now let's review the business and market highlights in North America for the third quarter, and you can see some details on page four of the presentation. Based on recent information we've reviewed, which we got from Reed Construction Data, U.S. housing starts in recent quarters have stalled somewhat at just under 900,000 starts on an annualized basis.

The pullback likely relates to interest rates increasing, to subpar employment growth, and more, more recently, to the government shutdown, which caused, we believe, unease in the markets. Current consensus suggests that by year-end, housing starts should total about 950,000 units, which is about a 22% increase over last year. So all in all, new residential construction in the U.S. has been a solid tailwind for us during 2013. But we believe we're likely still years away from getting back to the 1.4-1 million units per year, which were the average through the eighties and nineties. The U.S. remodeling and repair market grew steadily during 2013. The latest data suggests that the remodeling market will increase about 11% this year. This spend includes money invested in owner-occupied units as well as investments in rental units.

We expect the remodeling market to continue its steady growth for the foreseeable future. Non-residential construction spend in the U.S. has still not turned around, with information available on non-residential spend through July, suggesting an overall decline in the market of about 2.1% versus last year. There have been sectors that are growing. For example, lodging is up, and signs point to more upside there. The ABI index has also been positive for 13 of the last 14 months, and that's certainly a good trend. However, loan demand for developers is still being constrained by high lending standards. Having said all of that, the anecdotal evidence we're seeing suggests that the non-residential construction market is likely to turn sometime next year. On Slide five, let's review EMEA's market and business highlights for the quarter.

Although the macro headwinds in Europe continued, current sentiment in Europe seems to suggest that we may have hit bottom and that things may start to improve over time. For example, market confidence, as measured by the Purchasing Managers' Index for the Eurozone, has trended up now for four consecutive months, which we see as a positive sign. And certainly, when speaking to our colleagues and our customers, they're more optimistic than they were six or even three months ago. Our results in EMEA were spotty, depending on the markets involved. We still estimate that French wholesale markets remain down double digits due to a softening economy there, but yet our French business managed to deliver relatively flat sales in the quarter. This is the first time that we haven't seen a reduction in comparable quarters since Q2 last year.

Germany was down 8.2% versus Q3 last year, but sequentially, sales declined less than in Q2. Furthermore, the German boiler manufacturers are reporting end user sales improving, and this should have a direct impact on our HVAC business. Drains and Middle Eastern sales were down against Q3 last year, but Q3 2012 is a tough comp for drains, as two large projects were completed in the Middle East last year, which didn't recur again this year. The drains business is reporting a solid project pipeline heading into the fourth quarter. Lastly, our Italian business still remains soft. Exiting the quarter, we saw a fairly stable order entry pattern, and so we'll be watching market sentiment closely in Q4, while we continue to focus on trying to outperform the market through customer service, sales force effectiveness, and new products.

If we turn to Slide six, let's briefly discuss our Asia business. In Asia, we continue to build out our plumbing and HVAC capabilities and to broaden our market coverage. The overall China economic environment remains positive, and our third-party sales growth was driven by new product introductions and a focus on specific regional growth, most notably in the northeastern part of China, where heating products would be in demand. The Asia team is also focused on expanding our business in Australia, and we have changed distribution partners within Australia and New Zealand to strengthen our presence there. The team continues to market our Watts brands to the higher-tiered markets throughout Asia, where we can differentiate ourselves from local producers.

With that, I'd ask Dean to discuss our results for the quarter in more detail and then to provide you our updated guidance for the remainder of 2013.

Dean Freeman (CFO)

Thanks, David, and good morning, everybody. So I'll start my comments on Slide nine and walk you through some of the financial highlights for the quarter and year to date. So on a consolidated basis for the quarter, organic revenue was up 3.6%, with North America up organically 8.6%, offset with the EMEA declines of 4.2%. Asia had another strong quarter, with growth organically of trade sales of 15.1%. Looking at North America, we did see an increase in the wholesale channel of 9.6% organically, very strong. Same with OEM channel, up 9%, and retail up 4.7%, despite headwinds related to pricing. And this is driven primarily by increased sales in our ResCom commercial flow control products.

And as David pointed out, we're clearly seeing the momentum, and strengthening trends in the North American residential, commercial construction, and repair, replace end markets. The U.S. lead-free initiative continued to dramatically ramp up during the quarter, with lead-free sales double that of what we saw in the first quarter, with retailers stocking of lead-free products accelerating as expected, and we expect our major retail customers to be completely transitioned by the end of the year. Larger wholesale customers are on a similar path. However, I think as we've talked about in the past, the smaller wholesalers have not yet ramped up their purchases of lead-free products as much as we'd anticipated. So we still see some lag there, but we do expect an increase in the transition process amongst those wholesalers as the year comes to a close.

Looking at EMEA for the quarter, organic sales declined 4.2%, resulting from OEM sales decline of 9.1%, offset by a slight uptick in the wholesale market of 1%. And again, while markets are still down, we do see continued signs of strengthening potential recovery, particularly, particularly in the large OEM HVAC end markets, and I think David covered it more comprehensively by country. So we remain hopeful of the sustained recovery. However, I will point out that we remain cautious and continue to be focused on driving our cost productivity initiatives, and I'll talk a little bit more about that in a minute. Asia continues its strong performance, 15% organic growth, as it continues to build out its plumbing and HVAC market coverage.

Looking at adjusted operating margin for the quarter, it was $34.9 million, and as a percentage of sales, decreased 110 basis points year-over-year to 9.4%.... As is mentioned, the decrease is principally driven by 210 basis point reduction in North America to 11.2%, as product liability costs increased $3.5 million year-over-year, and lead-free transition costs added $2.4 million. Notably, when you look at adjusting for lead-free and product liability impact, North America would have been nearly 14% operating earnings for the quarter, so structurally still on track. So let me just make a couple of comments regarding the two items impacting North America.

First, regarding product liability, over the last few actuarial review periods, we did see an inflection in reported claims, largely related to legacy products that were not consistent with our claims history. Accordingly, the actuary made an adjustment as a result of the increased claims activity that we reflected in the product liability reserve. We have not referred to these items as one-off or special because, frankly, over time, these types of actuarial adjustments may occur again. Secondly, regarding our lead-free transition costs, as demand volumes of lead-free production have dramatically increased, we saw a greater impact related to foundry disruption due to furnace shutdowns, and as a result, we saw increased logistics costs and under absorption. We now believe that the production issues have been rectified, and as a result, we've seen October production lows ramp up toward normal capacity, and they've sustained that for some time now.

As a result of the third quarter issues, however, we have had to push our normal production schedule back, and we now expect additional manufacturing inefficiencies, which we believe should be final, associated with foundry and transition costs of approximately $1 million in the fourth quarter. So look, overall, we're pleased that the lead-free product, the pricing, the cost of margins in the third quarter were consistent with expectations, but candidly, we saw further shutdowns that obviously impacted our overall number. Year-to-date, we expect that number to be $4.4 million, and now for the full year, expect that number to be $5.4 million.

So moving back to the presentation and looking at EMEA adjusted operating margins, we did see an increase of 70 basis points to 11.5% as production efficiencies and tight cost controls offset margin loss for the sales volume reduction. Notably, EMEA's gross margin improved 120 basis points versus prior year and sequentially as a result of these cost improvement actions. So let me just make a couple of comments on the restructuring efforts to date. The team is now executing on the plans we announced in July. We've recorded charges of, in Q3, of approximately $3 million related to the various plans, mostly for expected severance that we are legally required to provide. There's a lot of work to be accomplished, including meeting with various works councils and government agencies to have redundancy plans agreed and approved.

Savings to date, as you can expect, have been minimal, as social plans will take some time to execute on. So still a lot of heavy lifting to be done, but we definitely believe that we're aligned with our original guidance regarding the timing of costs and savings as we outlined in last quarter's conference call. Just a quick comment, Asia's margins were largely affected by sales mix and volume. Our adjusted tax rate was 30.7% versus 31.1, largely different by earnings mix between North America and EMEA and a reduction in the Danish tax rate. Adjusted EPS of $0.58, which includes less than $0.005 benefit from share repurchases in the quarter, decreased $0.04 or 6.5% versus prior year.

This includes approximately $0.10 of impact related to lead-free and product liability. Just looking at slide 10. On a year-to-date consolidated basis, revenue was up 1.3% year-over-year organically, with North America up 4.7%, EMEA down 4.6%, and Asia up nearly 24%. Year-to-date adjusted operating profit of $103.3 million, improved 10 basis points year-over-year to 9.4% of sales, driven largely by improvement in gross margin, while organic SPNA, as a percentage of sales, was flat. The year-to-date adjusted tax rate was essentially flat to prior year. Year-to-date adjusted earnings per share, $1.65 or 5% growth versus prior year, including $0.03 of benefit from the share repurchase. You can read the slides on the regional performance, so I'll, I'll turn to slide 17.

Primary working capital, as we've talked about in the last couple of quarters, primarily affected by the inventory build of the lead-free conversion to about $28 million. Receivables are increasing as a result of North American revenues. Free cash was impacted primarily by the higher operating and capital spend on our lead-free foundry. So we also spent about $10 million in share repurchases for the quarter under our authorized 2013 share repurchase program. We expect to purchase an additional $3 million worth of shares in the fourth quarter. Overall, we ended the quarter with $227 million in cash. So looking at slide 19, just looking at the guidance for 2013, FX constant, really no significant changes in the balance of the year.

We expect full-year North American revenue, again, on track to 4%-7%, including the lead-free impact, EMEA being down 4%-5%, and Asia between up 20%-25%. We do, as I mentioned earlier, expect additional costs of no more than $1 million for the lead-free transition. Lastly, just making a comment on the CapEx. We expect total CapEx to be $32 million for the year. With that, I'll turn it back over to David. David?

David Coghlan (CEO)

Thank you, Dean. So let me try and summarize the way we look at the quarter. We saw improved sales momentum in North American wholesale, OEM, and DIY markets. We think Europe performed well, and we believe Europe delivered a solid result given the macro issues in play there. As we discussed, North America's results were impacted by two developments: lead-free transition costs and the product liability adjustment. We are starting to see more optimism as key markets like North American residential remain solid, as North American commercial move towards a turn, and as European markets appear to be moving in a more positive direction. Also, we expect the EMEA team to continue to execute on its realignment plan and deliver on the benefits we've committed to. So with that, why don't we open up the line to your questions? Glenn, can you open up the lines, please?

Operator (participant)

Ladies and gentlemen, if you would like to ask a question, you may do so by pressing star one on your phone. If your question has been answered or you would like to withdraw your question, press star two. Questions will be taken in the order received, and you may press star one to begin. Your first question comes from the line of Jeff Hammond with KeyBanc Capital Markets. Please proceed.

Dean Freeman (CFO)

Good morning, Jeff.

Jeffrey Hammond (Managing Director and Equity Research Analyst)

Hey, hey, good morning, guys. Hey, so just on the 8.8 and 8.6 core growth in North America, can you talk about what was, you know, price, what would have been, you know, maybe just ramp and lead-free versus kind of, you know, real demand improvement? And then within the real demand improvement, you know, where are you seeing it within the commercial piece?

Dean Freeman (CFO)

So, hey, Jeff, this is Dean. So of the 8.6, we think as we talked about in lead-free, 1-2 points for the year, we think we saw a similar trend in the third quarter. And when you kind of look at the breakdown of the growth, primarily in three areas, we saw very strong growth in regulators, which is, as I think we've talked about earlier, sort of a leading indicator of core structural growth in participating in the end markets. Fittings, we saw, again, strong growth there and backflow preventers. So from a product perspective, we're growing, you know, in the areas that we would expect as we participate more meaningfully in the growth trends in ResCom.

From a lead-free perspective, again, 1-2 points could be associated with that.

Jeffrey Hammond (Managing Director and Equity Research Analyst)

So, was there any kind of inflection in your commercial-based products, or your comments about commercial or more perspective?

Dean Freeman (CFO)

Yeah, David, do you want to...

David Coghlan (CEO)

Well, you know, I think we continue to execute on some programs on the commercial side that we're pleased with the returns on. But I think if you really look to links to markets, we continue to benefit from the growth that we're seeing in residential new construction and from increased investment in existing residential buildings.

Jeffrey Hammond (Managing Director and Equity Research Analyst)

Okay. And then just on the, the inefficiency, I mean, what, what gives you confidence that those are kind of largely behind us moving into 2014? And, and should we think of this, you know, 5, 4, and 3.5 product liability as, you know, completely going away into 2014?

David Coghlan (CEO)

Well, let me try and deal with the lead-free issues, and then maybe Dean will deal with the product liability issues. So if we look at the lead-free transition costs, a lot of it was driven by the fact that in our new foundry, we continued, during the quarter, to work to get used to the behavioral characteristics of the new alloy. And that new alloy did cause a couple of furnace downs, which cost us money to take them back up and also cost us money as we tried to expedite product in to ensure we didn't disappoint customers.

And so we're now comfortable that we understand the drivers of the furnace downs, and we've put a lot of work into mitigating the effect of those drivers and trying to ensure that they won't recur in the future. So can we guarantee that nothing will happen in the future? No, but we have a much more thorough understanding as to how the alloys are behaving in our furnaces, what some of the issues were, and we're much more comfortable with the mitigation plans that we've implemented to deal with it.

Dean Freeman (CFO)

Yeah, so let me just make some comments about the product liability. I know that's on everyone's mind. Look, it, as I mentioned in the comments, it's certainly not consistent with our historical trends. Certainly, as a function of what we did see, we were required to true up our reserve. We think we're adequately reserved at this point. And so, you know, again, as we mentioned, not consistent with our history and a full true-up of our reserves.

Jeffrey Hammond (Managing Director and Equity Research Analyst)

Do you have an ongoing, you know, higher warranty run rate as a result, or is this just a one-time catch-up?

David Coghlan (CEO)

I think the way to think about it is that, first of all, it relates to some legacy products. And so, you know, we're not looking at an across-the-board lift in warranty rates. And you know, we really believe that the driver for these specific products were some bulk claims that came in from some specific law firms who reviewed their inventory of claims with their clients, and that was a substantial contribution to the spike in claims. And so again, what we'd say is that the spike and the bulk reporting isn't really consistent with our past experience or our general practice.

Jeffrey Hammond (Managing Director and Equity Research Analyst)

Okay, thanks, guys. I'll get back in queue.

Operator (participant)

Your next question comes from the line of Garik Shmois with Longbow Research. Please proceed.

Dean Freeman (CFO)

Garrick, good morning.

Garik Shmois (VP of Senior Research Analyst)

Hi, good morning. I have a question, a follow-up question on some of the anecdotes that you're starting to hear on the commercial construction side. Just wondering if you could help us understand a little bit better the lag between when commercial project breaks ground and when you start to see it? So if some of this commercial improvement does end up playing out in 2014, when realistically should you start to benefit?

David Coghlan (CEO)

Well, one of the advantages, I guess, of our product line on the commercial side, is that we see some reasonably quickly, and then we see a lot more as the project gets to the finishing stages. So let me try and explain that. And so once a commercial project physically starts, i.e., construction starts, one of the first things that goes in is the underground drainage systems, and we participate in that. And then the rest of the building gets constructed, the frame goes up, and then they start to put in the systems that will ultimately form behind the walls.

There's a sort of a valley period where not a lot of our stuff is going in while the frame of the building is going up, while they're finishing out the outside of the project. But then when they start to move inside and put in fire protection systems, hot water systems, plumbing systems, et cetera, then our products start to participate. It's sort of in the early stages of physical construction, and then it's in the later stages as they fit out and complete the building.

Garik Shmois (VP of Senior Research Analyst)

Okay, thanks for that. I guess just a quick follow-up to that. This year, at least the data points have showed a nice actual growth on some commercial categories like retail, but the institutional piece, you know, education, healthcare, has significantly lagged. Do you have a preference as to what commercial category shows growth? You know, meaning, are you, you know, more preferable to some of the institutional work that hasn't come back this year, that maybe, you know, just maybe, will end up returning in a year or two?

David Coghlan (CEO)

Well, the vertical markets that are important to our industry are largely vertical markets that are associated with large numbers of people who are going to use large volumes of water. So for example, hotels, that vertical is an important one to us. The commercial office market, multifamily. If we think about distribution centers, which has been another area that's been pretty hot, A, you don't have a lot of people, and B, you don't have a lot of drivers for the water needs for those people. And so that type of vertical, industrial manufacturing plants, those types of verticals are not hot ones for us.

The hot ones for us are where you've got large groups of people, and they need, they make use of, plumbing systems, hot water systems, et cetera.

Garik Shmois (VP of Senior Research Analyst)

Okay. Then I guess, switching to North American retail pricing, you mentioned it continues to be competitive. Would you say the competitive landscape has accelerated in Q3, or is this just a continuation of recent trend?

David Coghlan (CEO)

Well, I don't know that the trends have accelerated, and I think a lot of it is really driven by the number of line reviews which the DIY chains themselves are holding. So, you know, if you really want to understand the developments in that arena, a good thing to do might be to look at the sort of the earnings calls for the major DIY retailers, and you get a sense for their focus. So it's less driven by proactive, competitive behavior and more driven by the rate at which the DIY chains call line reviews.

Garik Shmois (VP of Senior Research Analyst)

Okay, thanks. And then just lastly, on the North American margin, if you strip out the products manufacturing cost inflation and the liability reserve cost, you know, we're getting an incremental margin somewhere around 19%-20%. I think it's a little bit below your recent run rate, which you had very impressive incrementals in the first half of the year. Is there anything else going on within the cost side in North America or within the mix, that worked down the incrementals on a like-for-like basis? And how should we be thinking about that going forward?

Dean Freeman (CFO)

Yeah, no, the only other thing I think, as we mentioned, was the growth in the retail, which both has a lower margin mix, but also, obviously, the impact of the pricing that we talked about.

Garik Shmois (VP of Senior Research Analyst)

Okay, great. Thanks so much.

Dean Freeman (CFO)

Yeah.

Operator (participant)

Your next question comes from the line of Todd Vencil with Sterne Agee. Please proceed.

David Coghlan (CEO)

Good morning, Todd.

Todd Vencil (Managing Director of Equity Research)

Hey, thanks. Good morning, guys. How are you?

David Coghlan (CEO)

Good, thank you.

Todd Vencil (Managing Director of Equity Research)

Good. Just to sort of continue beating this mostly dead horse a little bit, but I am interested on the commercial side and the fact that you're sort of seeing what you think are early signs that you're gonna see a turn next year. I appreciate this sort of high-level color on how you think that plays out. Can you talk about what you're actually hearing? I mean, are you tracking new project awards, or are you just hearing chatter from your customers? I mean, what are you actually hearing at this point?

David Coghlan (CEO)

So, you know, we think that the ABI Index is a really good indicator. And as we mentioned, that's been positive now for a long, long time. And so the next thing that we're trying to track from a data perspective is the actual lending that's being provided. So I can put a project in with an architect, design a building, start through the permitting process, but if I don't get financed for that project, it's not gonna go ahead. And so we're touching base with our customers, architects, engineers, and contractors. We're trying to get a sense for what's going on in terms of the lending environment. And, you know, construction is a multi-local industry. It's not a national industry, and so conditions vary region by region, locality by locality.

And so we are hearing that, you know, lending standards are easing a little bit. Our personal beliefs are, that as, you know, mortgage refinancing opportunities start to go away, the financial institutions are gonna start to look elsewhere, to improve their loan book. And so we're starting to feel a little bit more confident, that the, amount of lending to, commercial projects is going to improve. Now, are there any facts that lay that out? No, but that's the sense we're getting as we touch base with, the architects, the engineers, and the contracting firms around the country.

Todd Vencil (Managing Director of Equity Research)

Got it. That's exactly what I was looking for. And then just to sort of pivot off something that you just said, it is a multi-local industry, and you mentioned the regionality. Are there any particular regions where you're seeing, you know, more or less of that kind of dynamic developing?

David Coghlan (CEO)

I'm not sure I'll get into a laundry list of regions where we're seeing it. I'm sure there's others who'd love to get that list. But you know, you can look across the country, and there is data that would suggest that, for example, there are parts of California that there's certainly increased activity. Texas has been pretty strong, you know, the Northeast. So there are certain areas that we're starting to see pockets, but you know, there's a lot of people who'd love to get their hands on that data.

Todd Vencil (Managing Director of Equity Research)

Fair enough. Turning to the North American DIY, you know, you mentioned that the greater sort of frequency or number of line reviews. I mean, does that seem to be developing on the parts of those customers as a way to maybe push back on, you know, some price increases they're seeing in a variety of areas? Or is there anything else particularly driving that you know about?

David Coghlan (CEO)

Well, I think, first of all, over the last couple of years, the DIY, the major DIY chains, have been adjusting their strategies, and they have been looking at ways of improving their price points, as well as improving their selection. And, you know, you get some really good insights on that from listening to some of their earnings calls. But, the sense we get is that, at least for the biggest, you know, they've been moving through that process. So the future tendency is probably gonna be less line reviews than the past tendency has been. And that's based on what they're saying.

Todd Vencil (Managing Director of Equity Research)

Got it. That's, that's really helpful. And then final one for me, you know, as you look at the sort of high level, particularly of wholesale sales, but also on the DIY side, too, when you have a sense of where the, you know, the inventories of the customer stand and what the channel looks like, is it up, down, or flat?

David Coghlan (CEO)

I think it varies, and it goes back to the comments that Dean made on the lead-free transition. We are seeing our larger wholesale customers work hard to transition their inventory and to be prepared for the January 1 transition. And so, you know, they've been putting in lead-free stock. Now, are they dramatically increasing their inventories? No. It's largely a phase in, phase out process. We also see a very organized approach on the DIY side to phase out and then phase in lead-free, and they've done it reasonably early, and they're well organized. We do see a reluctance on the part of the smaller wholesalers, A, to invest in inventory, and B, to transition. And so they've transitioned later than we might have expected.

But we are now in the fourth quarter, and the law does take effect in January first. And so I think the, that part of the industry are gonna have to rush to transition over the next several weeks.

Todd Vencil (Managing Director of Equity Research)

Got it.

David Coghlan (CEO)

But is there a major shift in terms of, you know, taking inventories down any further? You know, they're pretty darn lean. Is there a major shift to invest in inventory? I don't think there's a broad-scale shift.

Todd Vencil (Managing Director of Equity Research)

And not a lot of sort of absolute build in that, you know, 8%+ growth that you guys saw in the quarter?

David Coghlan (CEO)

Uh, yeah.

Todd Vencil (Managing Director of Equity Research)

Got it. Okay. Thanks very much.

Operator (participant)

Your next question comes from the line of Ryan Connors with Janney Montgomery Scott. Please proceed.

David Coghlan (CEO)

Ryan, good morning.

Ryan Connors (Managing Director of Water and Agriculture Research)

Great. Good morning. Thank you. David, I wonder if you could talk about a little bit about this issue of the competitive situation on lead-free. Specifically, earlier this year, you talked about the fact that your scale and your R&D, you know, prowess would enable you to build a better mousetrap, and that some of the smaller players might have a tougher time engineering these products around, you know, the new, compliance, initiative. So, can you talk about that a little bit and how that's evolved and what the competitive front is looking like? Is the market starting to coalesce around some standard, or is it still kind of a Wild West, where everyone's offering different types of compliant products?

David Coghlan (CEO)

Well, Ryan, I might word your introduction a little bit differently in terms of what we had been saying. We think the larger manufacturers in our industry are high-quality companies, and that they've gone through the transition from what we can see, in a very professional and very technically skilled way. And so our position is that the larger players in the industry can stand behind the products associated with this transition and make the customer feel comfortable that they're providing a quality product that meets the requirements of the new law. I think in terms of alloy selection, in terms of assuring quality in a multi-standard world, it's tougher for smaller companies, for moms and pops, and for importers.

So I wouldn't be so bold as to say that there's a lot of daylight between the standards that Watts can offer and the other large professional companies. I would say, though, that there's daylight between what the large guys can do and what some of the importers and the moms and pops can do. As a customer sits there and looks at the law and says, you know, he who introduces it into commerce, i.e., sells it to a contractor, installs it in a building, is responsible under the law. I think that is getting customers to look at the quality standards of their providers and how well they can rely on those standards.

Dean Freeman (CFO)

I'd also just add, it's very early in the process, though. And so in terms of any discrete sort of analytics or behaviors that we can sort of point to, I think it's still too early in this cycle to call out any specifics.

Ryan Connors (Managing Director of Water and Agriculture Research)

Okay. I mean, that would seem, David, to me, that would seem like something where, to the extent there was a market share opportunity, it would materialize sooner than later because the initial jump over to lead-free for a contractor is sort of the scariest moment. So, if they were gonna go with a larger player who could give them a better assurance of quality and compliance, that would happen right away and not a couple of years down the line. So, you know, I guess, Dean, you've already answered that, saying there's no evidence of that, but why wouldn't we be seeing evidence of that kind of right off the bat?

David Coghlan (CEO)

Look, there's, there's a whole bunch of variables that, you know, wholesalers, retailers, and contractors are trying to get used to. You know, we've talked about the fact that, for the industry, these new alloys drive cost increases. And so our customers are looking at double-digit price increases for their products. And obviously, you know, if they're on a, an aggressive job or a competitive job, they're gonna look at, Well, what are my alternatives? And so they'll have to get used to and feel out and get a sense for, what are the consequences associated with that, right? So I, I think there's so many variables in play that this is gonna take some time to play out.

Ryan Connors (Managing Director of Water and Agriculture Research)

Okay. And then just an update on the other side of this, which is, you kind of alluded to it, but the passing the higher cost through in pricing. Can you just kind of give us an update, any kind of color around where that's tracking, and where you see that tracking next year relative to your expectations? And maybe, you know, do you expect to be able to get most of the majority of that right away, or will that be a process that you think takes a little while?

Dean Freeman (CFO)

Okay, so there's a, there's a couple questions in there. I think, you know, as we've said consistently, and certainly as we're pleased by, we, we are seeing, you know, the, the pricing profile that we talked about, 10%-20% price increases, and the cost profile that we talked about, consistent with holding our margins percentages constant, we're seeing that play out as expected. Obviously, how that flows through going into next year will be a function of volumes, will be a function of a number of dynamics. We're not necessarily seeing anything, you know, as I've said in the past, irrational or, or in any way, unusual in terms of the competitive dynamic. And so I think, as we've said, it's consistent with our expectations.

Ryan Connors (Managing Director of Water and Agriculture Research)

Okay. And then, you know, I guess, one of the silver linings of this lead-free is that it's actually taken copper away as such a prominent topic. I know for years that was, you know, a prominent topic. But how does copper impact that whole discussion around pricing? Because copper is obviously lower than it was a year ago, and some of these customers may be conditioned to expect, you know, maybe even a price concession, let alone an increase against that. So how do you manage—how are your sales teams managing those, you know, kind of disparate expectations?

David Coghlan (CEO)

Well, you know, first of all, there's really no change in terms of copper and how it plays through our business. You know, the lead-free clearly affects the lead content of the alloy, but it doesn't really affect the copper content. And then secondly, I think, you know, the market is struggling to deal with a multivariable calculus. And so you've got some changes in the copper markets down, and then, you know, more recently, back up. And then you've also got the changes associated with products moving from leaded to lead-free.

And so, you know, one of the things that we believe is occurring with the smaller guys is they're trying to figure out where should pricing be, and they're wondering, you know, whether the sort of increases they've seen from all of the companies thus far will hold up. And the point we're trying to make to them is, you know, lead-free, we're trying to hold our margins percentage-wise, and that's what we and the rest of the industry are doing. And so I think, you know, it's difficult for people to sort through all the different variables to see what's going on.

And so they're looking at the prices they're seeing, they're looking at their other options, and so far, as Dean said, we're very comfortable that we're able to achieve what we laid out in terms of holding percentage margins.

Ryan Connors (Managing Director of Water and Agriculture Research)

Okay. And then one last one for me, kind of a bigger picture question. You know, lead-free has kind of been such a dominant topic this year, but, but just as we look beyond the lead-free and once, you know, six months from now, this will now be, you know, the deadline will have passed, and get back to sort of focusing on the underlying operating leverage potential in, in the business, what can you tell us about how you feel about your ability to generate leverage as the volumes improve toward, you know, you mentioned the 1.4, 1.5 million start run rate in, in residential and so forth? I know you probably can't give us a specific quantitative number, but if you can kind of characterize-

... your view on the leverage in the model over the next couple of years?

David Coghlan (CEO)

Well, look, I'd try and point to a couple of things, and then I'll ask Dean to add in anything that I may have missed. I'd point to three things. First of all, we're very proud of the work that the team in Europe has done in very difficult circumstances to expand our margins. And we point to that as evidence of the sort of capabilities that we're building in our business to drive operational excellence. The second point that I'll make is, for our business, there was a huge reallocation of sourcing professionals, sourcing quality professionals, manufacturing, engineering, design engineering to getting through the lead-free transition.

And what we're really excited about is the resources that we've got to reallocate towards new product development, operational excellence, as those resources come off lead-free. And the third thing I'd point to is that we've said in the past that we believe that this business is capable of delivering leverage on incremental volume in the 30%-35% level. So if you sort of add those three points together, hopefully, it gives you a sense for what we believe this business is capable of and what our priorities are gonna be as we move past lead-free. Dean, anything you'd add?

Dean Freeman (CFO)

No, I, I think that's exactly right. I think we are—we have a strengthening business model, commercially. We have a strengthening business model operationally, as David pointed out. You know, many of you heard me talk about building the muscularity that lead-free has provided us, both operationally, from an engineering perspective, from a sourcing perspective, and we're gonna leverage that moving forward. And I think, I think you said it exactly right.

Ryan Connors (Managing Director of Water and Agriculture Research)

Great. Well, that's all very helpful. Thanks for your time this morning.

David Coghlan (CEO)

Hey, Ryan, thank you for good questions.

Operator (participant)

Your next question comes from the line of Nick Prendergast with BB&T Capital Markets. Please proceed.

David Coghlan (CEO)

Hi, Nick, how are you?

Nick Prendergast (Analyst)

Hey, I'm doing well. Good morning. Just a quick question, on the North American margin performance, last quarter, you had about 14%, and it looks like it would have been about the same if we kinda strip out those two charges. How should I possibly be looking at this going forward? Is that about sustainable?

Dean Freeman (CFO)

Well, look, you know, we talk about that level roughly, as, you know, as sort of the structural profile. Mix, volumes, obviously, will impact that, but yeah, I think that's about right. I mean, you look at gross margins, gross margins on an adjusted basis, you strip out the, the, the effect of the, of the, of the lead-free transition would have been about, you know, 50 basis points better than, than, prior quarter. And, to your point, operating income would have been close to 14%. So yeah, I think, I think that's a good place to start, and then you can, you know, obviously, think about volumes and mix as a function of adjustments from there.

Nick Prendergast (Analyst)

Got it. All right. And, regarding Europe, France and Germany are still looking pretty, pretty weak. Do you see that possibly returning to growth anytime soon as the comps get easier?

Dean Freeman (CFO)

So, you know, I think as David pointed out, and as I highlighted, we're encouraged by the signs that we're seeing. We're hearing a lot of good news. We are seeing recovery. I mean, if you recall and look at the presentation materials, many of the countries that we talk about that we operate in are in fact down. So we're encouraged, but we're being cautious. Eventually, like all things, of course, Europe will eventually come back. But I think it'd be, you know, I'd be very hesitant to sort of call a timeframe when we see that happening. But clearly, we're optimistic, and we're very pleased with what seems like a recovery.

We're gonna, you know, stay focused on, continuing to realign the business and focus on our commercial strategies to take advantage of areas of growth that we do see, which is, you know, emerging markets, our electronics business, our drains business. We have a number of platforms that continue to grow despite, you know, sort of the broader, macroeconomics in the region.

David Coghlan (CEO)

Nick, I think it's just worth maybe going back to something that we said earlier in the call. If you take the economy that's been most troubling to us in Europe, it's an important market for us, that's France. We believe the market is down double digits, but our team there has done a phenomenal job for us. You know, we were effectively flat in the quarter, and so that's great performance. We're very excited by the project backlog that our drains team is building. They had a really tough comp in the quarter because of some of two big jobs that they had last year in the Middle East, and those jobs didn't, you know, don't reoccur. We're very excited by that.

To steal a phrase from Dean, you know, we're also very excited by the improving muscularity that we've got around emerging markets capability throughout the EMEA region. So look, you know, we think the market's bottoming in Europe, but we continue to be encouraged by the self-help programs that we've identified in our driving.

Dean Freeman (CFO)

Yeah, that's what I said.

Nick Prendergast (Analyst)

Okay. If I could just ask one more. On the working capital front, your inventory has been coming up in anticipation of this whole lead-free transition. Do you see that coming down as we move into 2014?

Dean Freeman (CFO)

Yes.

Nick Prendergast (Analyst)

All right. Short and sweet. Okay, thank you very much.

Dean Freeman (CFO)

Thank you, Nick. Thank you.

Operator (participant)

Ladies and gentlemen, if you would like to ask a question, you may do so by pressing star one. And your next question comes from the line of Jamie Sullivan with RBC Capital Markets. Please proceed.

Jamie Sullivan (Managing Director and Equity Research Analyst)

... Good morning. Question on the lead-free transition and the impact to revenues, based on, you know, full year, 1%-2%, you've been kind of running it there, you said, in the third quarter. So sounds like you're expecting a pretty big jump in the fourth quarter. Have you seen, you know, sort of an acceleration there on the adoption as we go into the fourth quarter? Just wondering how to think about that.

David Coghlan (CEO)

But Jamie, first of all, I'd just point out that the biggest players have been transitioning, and it's the smaller wholesalers that have yet to transition. And so, you know, we've seen the build-up through the year occur nicely and smoothly. We were a bit surprised by the fact that the smaller guys seem to be transitioning a little bit later. But, you know, the big players in the industry, the big wholesalers, the big retailers, they've all been transitioning, and they're finishing up their transition. So, you know, we still say that in the aggregate, we're looking at between a $200 million-$300 million piece of business being affected by lead-free. We've had a nice, relatively smooth build through the year, and we're on track to see that sort of revenue convert.

Jamie Sullivan (Managing Director and Equity Research Analyst)

That's helpful. And then on the DIY front, when you talk about the line reviews and sort of the impact there, you touched on how that was somewhat impacting the incrementals in North America. Does that... You also reiterated the 30%-35% overall capacity of the business on the incremental line. Does the DIY channel make you a little bit cautious on still hitting that number? Or once we stabilize with the line reviews, should be able to deliver on that level?

David Coghlan (CEO)

Yeah, we had higher levels of growth in DIY earlier in the year than we did in wholesale. That position is now reversed. But we are seeing line reviews that have yet to lap, if you like.

Jamie Sullivan (Managing Director and Equity Research Analyst)

Mm-hmm.

David Coghlan (CEO)

And so, you know, I'd point to a couple of different things in terms of why we feel confident 30-35 is still relevant. You know, the first one is that we're seeing the sort of growth that we were working towards appear in wholesale. Second, you know, the next couple of quarters, we're coming up to the lapping of some of the most significant number of line reviews. And then the third factor is that if you look at what the big DIY chains are themselves saying, they seem to be coming to the end of a pretty substantive period of line reviews. And so put all those factors together, and we still feel comfortable with, you know, in the aggregate, 30-35.

Jamie Sullivan (Managing Director and Equity Research Analyst)

That's helpful. Then just last quick one on commodities. You touched on it a little bit. Maybe just the impact in the quarter on price cost.

David Coghlan (CEO)

Yeah. So, total supply chain, if you will. We saw about 100 basis points of total improvement year-over-year in margins, and only about a third of that was commodity driven. So about 30 basis points.

Jamie Sullivan (Managing Director and Equity Research Analyst)

Thanks very much.

David Coghlan (CEO)

Yep. Thanks, Jamie.

Operator (participant)

Your next question comes from the line of William Bremer with Maxim. Please proceed.

William Bremer (Partner, Senior Industrial and Infrastructure Analyst)

Good morning, David. Good morning, Dean.

David Coghlan (CEO)

Hey, Bill, how are you?

William Bremer (Partner, Senior Industrial and Infrastructure Analyst)

I'm fantastic, gentlemen, fantastic. Question for you. David, you mentioned $200-$300 million business to be affected. I guess that's at the onset. What are you projecting as your underlying capacity, and where are you manufacturing this capacity?

David Coghlan (CEO)

Well, first of all, capacity for lead-free is not a concern from our perspective. The biggest piece of capacity that we've got comes from the large investment that we made in our Franklin, New Hampshire facility. And that's a fully integrated facility where we've put a lot of dollars into building a state-of-the-art lead-free foundry, and that foundry feeds into dedicated machining and assembly cells for lead-free. We do also manufacture lead-free products in a couple of other facilities in North America, and we do also manufacture and source some lead-free products in Asia. But one of the things that we're really pleased about, you know, how do you take lemons and make lemonade, is that we've actually onshored a lot of capacity for lead-free.

And so we're in a position to serve our customers quickly and efficiently, and we're really pleased with what we're seeing in terms of the productivity that we're going to be able to get out of this investment in Hampshire.

William Bremer (Partner, Senior Industrial and Infrastructure Analyst)

Okay. And what has been, David, the inquiry from, say, your foreign customers on this?

David Coghlan (CEO)

The inquiry in terms of foreign customers wanting to buy lead-free?

William Bremer (Partner, Senior Industrial and Infrastructure Analyst)

Yes.

David Coghlan (CEO)

You really can't look at it that way because Europe moved to a lower lead product standard 10, 15 years ago.

William Bremer (Partner, Senior Industrial and Infrastructure Analyst)

Mm-hmm.

David Coghlan (CEO)

And so this is a specific standard for the US, and it's not so much customer driven as code and legally legal driven. And so the way you need to think about it is, this requirement is largely US driven.

William Bremer (Partner, Senior Industrial and Infrastructure Analyst)

Mm-hmm.

David Coghlan (CEO)

We do have the regulatory and code authorities in Canada looking at it, and we do expect that over the next months and years, there'll be a transition in Canada. But many other parts of the world previously had requirements for products with a lower lead standard than the old requirements in the U.S.

William Bremer (Partner, Senior Industrial and Infrastructure Analyst)

Okay, that's all I have.

David Coghlan (CEO)

And so you sort of look at this as a catch-up.

William Bremer (Partner, Senior Industrial and Infrastructure Analyst)

Mm-hmm. Right. Right. Okay, gentlemen. Thank you.

David Coghlan (CEO)

Thanks, Will.

Operator (participant)

At this time, we have no further questions. I will now turn the call back over to David Coghlan for closing remarks.

David Coghlan (CEO)

Well, first of all, I'd really like to thank the folks on the call for some very good questions, and hopefully, that gives you all a better sense for what's going on in our business. But, we're very grateful for you for taking the time to join us on the call, and we're very grateful for your continued interest in our company. And we look forward very much to talking to you again during our fourth quarter earnings call, which will be sometime early February of next year. So thanks for your time. Thanks for your interest.

Operator (participant)

Ladies and gentlemen, that concludes today's conference. Thank you for your participation. You may disconnect.