Watts Water Technologies - Q3 2015

Transcript

Operator (participant)

Good day, ladies and gentlemen, and welcome to Watts Water Technologies, Inc. third quarter 2015 earnings conference call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will follow at that time. If anyone should require assistance during the conference, please press star then zero on your touchtone telephone. As a reminder, this conference is being recorded. I would like to introduce your host for today's conference, Mr. Tim McAleer, Treasurer and Vice President, Investor Relations. Sir, you may begin.

Tim MacAleer (VP of Investor Relations)

Thank you, Teresa. Good morning, everyone, and thank you for joining our third quarter earnings call. Joining me today are Bob Pagano, President and CEO, and Todd Trapp, our CFO. Bob will begin by providing a summary of the quarter. He will offer some color on current market conditions and will update you on the Americas, Asia Pacific transformation initiatives. Todd will discuss the financial results for the third quarter in more detail and provide some commentary on the fourth quarter. Bob will update you on our progress concerning our key organizational initiatives, and then we will open up the call to your questions. The earnings press release and earnings call presentation we issued last evening includes some non-GAAP financial measures, and we have included in those documents the necessary reconciliations to GAAP measures.

You can find a direct link to the webcast of today's conference call on our website at www.wattswater.com. We will archive the webcast on the site for replay. I'd like to remind everyone that in the course of this call, to give you a better understanding of our operations, we will be making certain forward-looking statements. These statements are subject to numerous risks and uncertainties that could cause actual results to differ materially from such statements. For information concerning these risks and uncertainties, see Watts Water's publicly available filings with the SEC. The company disclaims any intentions 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 earnings call presentation, and I'll provide a quick overview of the third quarter. Overall, I'm pleased with the progress we made during the third quarter on many fronts, despite the more muted global economic environment. Our transformation efforts continue to move ahead. We were able to drive sequential operating margin expansion despite lower revenues, and we continue to generate strong cash flow. We are focused on portfolio growth and are making strides in reshaping our portfolio with a Sioux Chief sale and the announced purchase of Apex, which I'll discuss momentarily. We also addressed some long-term obligations, most notably the pension, which I'll speak to as well.

Our top line continued to be a mixed bag, with softer end markets and foreign exchange challenges in EMEA, some timing issues in Asia Pacific, and the exit of non-core products more than offsetting a strong contribution from AERCO and higher U.S. core sales. Americas reported sales were impacted by the sale of our non-core products to Sioux Chief. Organically, Americas sales were up 2% in the quarter. We continue to focus on pricing discipline and driving profitable sales growth within our core markets, which is demonstrated in our operating margin profile. AERCO had another strong quarter. Year to date, AERCO has delivered double-digit sales growth as the market continues to migrate to condensing boiler solutions. Organic sales in EMEA remain challenged.

Continued tough market environments in some of our larger countries, like France and Germany, and slower Eastern Europe markets more than offset gains made in the Middle East and the Benelux regions. Asia Pacific sales were down due to project delays as well as some early-in-the-quarter destocking by distributors, given the uncertainty in the China markets. We are expecting core product sales to rebound in Q4. We settled some long-term obligations in Q3, mostly related to our defined benefit pension plan. In total, we took a one-time charge of approximately $65 million, which we have classified as a special item, and paid out approximately $49 million to settle the obligations. The settlement should provide profit tailwind in the future. We sequentially expanded our adjusted operating margin percentage, and our margin profile was fairly consistent with the third quarter last year. We did this despite reduced sales in both periods.

Cash generation continues to be a good story, and Todd will provide more details in a few moments. In Q3, we continued to execute on our various restructuring and transformation initiatives. As expected, we finalized the sale of certain non-core U.S. products to Sioux Chief. We also entered into an agreement in principle to sell the manufacturing location in China that is dedicated to non-core products. We expect that sale should be consummated during the first half of 2016. Today, I'm pleased to provide more color on phase two of the U.S. transformation program. I'll speak to that in a few minutes. Yesterday, we announced that we've entered into a definitive agreement to purchase 80% of the outstanding shares of Apex Valves Limited for approximately $22 million. We are committed to purchase the remaining 20% of Apex within three years.

Apex is a leading plumbing product supplier, specializing in the manufacture and sale of control valves for hot water and filtration applications, primarily in the New Zealand market. The incremental Apex sale should help replace Asia Pacific lost trade sales as part of the phase one product rationalization. We expect to close the Apex purchase during Q4. The ongoing transformation efforts, the Apex acquisition, and the pension settlements are all actions taken to help us reshape our portfolio and become a more profitable enterprise in the future. Now on to the market, so please turn to slide four. Not a lot has changed in the market since our last update, so let me briefly comment on a couple of items. First, we expect to see continued macro growth in the U.S., although at a more moderate pace. The commercial market is improving and the residential markets continue trending positive.

In EMEA, the overall outlook is more stable, but geographically, our markets still remain mixed. Construction data from France suggests the residential market is down high single digits. The boiler marketplace in Germany continues to be down, where a majority of our OEM customers reside. Depressed oil prices have curtailed spending in much of the Nordic region, and emerging markets are mixed, with Russia down considerably and the Middle East trending up. Geopolitical issues and sanctions continue to impact the Eastern Europe and Middle East economies. In China, the soft housing market, continued uncertainty in the equities market, and slower GDP are all driving volatility that is impacting consumer sentiment. The Chinese government is taking steps to stimulate the economy, but people are still uneasy about their personal finances and wealth. Outside China, we still continue to see moderate growth.

So overall, our markets remain mixed, with pockets of growth being offset by lagging economies and slower than expected end markets. On slide 5, we have provided an overview of the Americas, Asia Pacific transformation effort. Recall that under phase one, we undertook a portfolio rationalization and a global sourcing initiative. Global sourcing savings are on track to deliver the planned $4 million of annual benefits. The portfolio rationalization effort focused on removing products that we considered non-core. We identified four sizable product lines and a few other small product lines to be discontinued. We finalized the sale of three product lines to Sioux Chief in September for roughly $33 million. As just mentioned, we have also entered into an agreement to sell our China facility, which makes connectors for the U.S. and China markets.

We expect to close on that sale in the first half of 2016. We expect final phase one costs to be approximately $10 million, below the midpoint of the original range we provided back in February. Now, having addressed our product portfolio, we've turned our attention to an infrastructure needs to support the new streamlined portfolio. We've done an exhaustive review of our manufacturing and distribution capabilities throughout the Americas. We engaged third-party logistics experts, evaluated potential plant synergies, and validated our assumptions through various scenario reviews. Once the Americas transformation efforts are complete, we expect to reduce our net operating footprint by approximately 30%. We believe the footprint optimization will allow us to shed underutilized capacity and help the region leverage its cost structure. When completed, we expect to reduce working capital, improve our planning process, and realize savings from redundant operations.

More importantly, by streamlining our operations, we believe we should provide a better experience for our customers by increasing on-time delivery and eliminating multiple shipments. We currently estimate that total phase two costs should be in the range of $30 million-$35 million, which includes approximately $5 million in non-cash charges, principally inventory and other asset write-downs. We also expect to incur approximately $3 million in capital spending at certain remaining sites for new equipment and some expansion. Cash costs would consist of severance, shutdown, relocation, site preparation, IT, and consulting charges. From a timing perspective, we estimate that about 20% of the costs will be recognized in 2015, 65% in 2016, and the remaining in 2017.

Although we anticipate an inventory reduction over time, near term, we expect to build approximately $20 million of inventory to support the many moves involved with this endeavor. We expect gross savings for phase two should approximate $10 million. We expect to reinvest a portion of that savings to help drive commercial excellence, including investments in marketing and sales, product innovation, customer and channel training, and R&D, along with other infrastructure needs. This is consistent with my previous message that we need to reinvest in the business to help drive future profitable growth. Most of the net savings will be realized in 2017 and 2018. Todd will now provide more details about the quarterly results and give you an overview of how we see the fourth quarter shaping up. Todd?

Todd Trapp (CFO)

Thanks, Bob, and good morning. I'm on slide 6, which shows the third quarter results. Sales of $366 million were down 2.6% on a reported basis and down just under 1% on an organic basis. As Bob mentioned, our top line continued to be challenged by foreign exchange headwinds, a continued softness in Europe, and the effects of the Americas' non-core product divestiture. These headwinds were offset to some degree by the addition of AERCO and growth in the Americas' core product lines. Foreign exchange, mainly related to the weaker euro, negatively impacted sales quarter-over-quarter by 6.5% or roughly $24 million. The year-over-year impact of lower non-core product sales was roughly $20 million, which was about $5 million-$10 million better than our original expectations.

These two discrete items substantially offset the upside from the contribution from the AERCO acquisition. Regionally, organic sales increased 2% in the Americas, declined 3.5% in EMEA, and we're down about 5% in Asia Pacific. I will provide more color on the regional performance in a few minutes. Adjusted operating profit decreased 4.8% to $41.7 million, which translated into an adjusted operating margin of 11.4%, down 20 basis points versus prior year. Lower volume absorption and a higher anticipated SG&A spend more than offset favorable product mix, strong productivity, and other cost savings initiatives. As we've communicated in the past, our SG&A costs are higher due to the addition of AERCO, an increase in stock compensation, pension compliance, and other costs.

Also, it is important to remember that in the third quarter of 2014, as we called out during that call, our operating margins were positively impacted by approximately 40 basis points for net reserve adjustments. So if you factor in these items, we would've actually expanded margins in the quarter despite the lower volume. So overall, solid performance in this area. Adjusted net income of $23.6 million and adjusted EPS of $0.67 were both approximately 4.5% below last year. Adjusted EPS included a negative impact of $0.06 in the quarter for foreign exchange and a $0.05 headwind associated with the exit of non-core products, which basically offset the $0.12 of positive contribution from AERCO.

The effective tax rate was 35%, which is 80 basis points higher than in Q3 of last year, primarily due to the mix of earnings in the quarter being more heavily weighted to the U.S. and a reserve established for a recent tax audit. Free cash flow continues to be a bright spot for the company as we delivered another strong quarter, and I will take you through more details on cash in a few minutes. Now, moving to Slide 7 in the Americas results. Sales for the third quarter were $245 million, up 7% on a reported basis and up 2% on an organic basis. We saw organic growth in our core products in the wholesale and DIY channels, especially in our backflow and valves.

However, we did see softness in other areas, including our industrial products that serve the oil and gas markets and our specialty drains that serve the education market. AERCO continues to perform very well, led by strong boiler, water heater, and aftermarket sales. And as Bob mentioned, year to date, we've seen double-digit growth in this business, and it is in line with our full-year growth expectations. Also, it is worth noting that the integration savings are on track to what was previously communicated. Adjusted operating profit for the quarter was $36 million, a 7.5% increase. Operating margin expanded ten basis points to 14.7%. The margin expansion was due to favorable product mix and strong productivity, which included continued improved performance out of our Franklin, New Hampshire foundry.

Partially offsetting these positive factors were lower absorption from the loss of non-core sales, higher anticipated costs, including personnel, product liability, and compliance costs, as well as more difficult comps. It is important to note that most of the third quarter 2014 reserve adjustments that I mentioned earlier impacted Americas' financials. Excluding these adjustments, Americas would have expanded 100 basis points on a year-over-year basis. So overall, the Americas delivered a solid quarter, despite the effect of lost sales and continued investment in SG&A. So turning to Slide 8, let's review EMEA's results. Sales for the third quarter were $111 million, down $26 million or 19% on a reported basis, and down 3.5% on a constant currency basis.

Foreign exchange, driven by the euro's decline against the US dollar, accounted for $21 million, or 15% of the sales decline. Geographically, the organic decrease was concentrated in our larger countries, mainly France and Germany. As Bob mentioned earlier in the call, the markets we serve in France are down in the high mid-single digits, and in Germany, the major OEM boiler manufacturers also continue to experience year-over-year sales declines. We continue to see softness in Eastern Europe, primarily driven by the weakness in the Russian market, which is down over 35% in the quarter. This was the largest decline we've seen so far this year in Russia. We also saw some softness in our European drains business, as we've encountered some project delays, especially in the Nordic region, related to offshore activity.

It is important to note that to date, we have not seen any project cancellations, and our backlog in the drains business is up nicely on a year-over-year basis. On a positive note, we are seeing pockets of growth within EMEA in the quarter. Middle East sales were especially strong, up 40%, driven by valve sales. We also saw good performance in the Benelux region, as our sales were up approximately 20% compared with last year, also driven by stronger valve activity. So seeing some growth in other countries, but not enough to offset the continued difficult conditions in France, Germany, and Russia. Regarding channel sales, wholesale was up about 1%, driven by water and plumbing, while OEM decreased 7%, mostly related to HVAC products sold into Germany for the domestic and export markets.

Adjusted operating profit for the quarter was $12 million, a decrease of $4 million or 26%, which translated into an adjusted operating margin rate of 10.8%.... approximately $2 million, or half of the operating profit decrease, was due to foreign exchange headwinds. Lower volume, absorption, and foreign exchange more than offset the benefit from our transformation and restructuring efforts. As Bob mentioned, we are executing on our restructuring plan in Europe and seeing the expected benefits. Unfortunately, it is not enough to overcome the continued top line softness. Now, moving to slide nine, let me provide a summary of Asia Pacific's results for the third quarter. Asia Pacific sales were $10.4 million, a 5% decline over the prior period. As mentioned earlier, we saw some delays for heating-related products early in the quarter.

We also attribute some of the softness to distributor destocking, caused to some extent by uncertainties in the China real estate and equity markets. We believe the delays are temporary in nature, and it's really more of a timing issue than anything else. With that said, we saw a strong order intake during the month of September, which should help drive sales in the fourth quarter. Adjusted operating profit of $1.7 million was flat versus last year, which translated into operating margins of 16.3%, an increase of 80 basis points. Margins expanded despite lower trade sales and intercompany sales for a couple of reasons. First, the team was aggressive in driving manufacturing headcount reductions, along with reaping benefits from sourcing and other productivity efficiencies.

Second, Asia Pacific's third quarter of 2014 operating margin included a charge for bad debt, which did not repeat this year, so some favorable comps. So in summary, a lower than expected top line for Asia Pacific, really more time than anything. We believe the top line should bounce back in Q4 again, supported by the strong order intake in September. On slide 10, a few items to mention related to free cash flow. Excluding the long-term settlements of $49 million, year-to-date free cash flow increased 25% as compared to the first nine months of 2014. A big driver of the performance is working capital, primarily inventory. We improved inventory turns by 10%, which has led to an operating reduction in inventory of approximately $35 million since last September.

So we continue to make strides in working capital, and we further see further opportunities ahead. Year to date, our capital investment increased 22%, mostly related to the addition of Aerco. Also, during Q3, we received the proceeds from the asset sale to Sioux Chief in the amount of $33 million, which helped partially fund the pension settlement. In addition, our stock buyback program remains on track, and we purchased approximately 235,000 shares in the quarter at a cost of $12.5 million. So again, free cash flow continues to be a real bright spot for the organization. Finally, turning to slide 11, I'd like to say a few comments on Q4. First, we expect to close the Apex acquisition during the quarter and begin the integration process.

In Q4, we estimate the top-line organic growth rates should be marginally higher than what we saw in Q3. As compared to Q3, we see Americas growth up modestly, EMEA in line with Q3, and we expect Asia Pacific to deliver growth in the mid- to high-single-digit range. Also, as a reminder, recall that Q4 is seasonally slower for AERCO, with sales activity more in line with Q1 versus what we did in Q2 and Q3. Looking at operating margins, we believe margins should expand on a year-over-year basis, but will be down sequentially, primarily due to lower volumes. Finally, a couple of discrete items. We expect the Q4 tax rate should be between 32% and 34% for the quarter, with capital spend for the year between $25 million and $30 million.

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

Bob Pagano (President and CEO)

Thanks, Todd. If you would, please turn to slide 12 and let me update you on our top priorities. I'd like to update the scorecard we shared with you during our second quarter call in July regarding our top near-term priorities of the business. We have hired a new Chief Human Resources Officer, Deborah Oxton, who started about 2 weeks ago. Deborah is a seasoned HR executive with substantial experience at some leading organizations like Johnson Controls and Pepsi. Deborah will help drive our talent and performance culture. She will also look for opportunities to accelerate management and employee development and help to add key skill sets at all levels of the organization. The EMEA transformation and restructuring initiatives are on track, and the team is executing against those plans.

They have made steady progress in driving savings throughout Europe, but unfortunately, their efforts have been more than offset by the overall market downturns. We continue to assess our structural costs in this region, given EMEA's results, the current market environment, and the muted outlook. That assessment may drive additional actions to rightsize our cost structure. We'll update you with any plans during our Q4 earnings call. Phase one of the Americas Asia Pacific transformation effort is going very well. We finalized the sale of the U.S. assets and are in process of selling our China manufacturing plant and have identified and executed on sourcing initiatives. Completing phase one will allow our key commercial resources to focus on a more profitable customer and product portfolio that drives innovation and is more solutions-oriented. Today, we announced the framework for phase two of the transformation program.

The focus will be on consolidating and optimizing our Americas operating footprint to better support the needs of our customers and improve our cost structure. We successfully resolved certain long-term obligations during Q3, including the settlement of our legacy defined benefit pension plan. This will alleviate an administrative burden and improve our future operating performance. As I mentioned earlier, I plan to make incremental investments in reinvigorating customer training, R&D, and our new product development pipeline. A key for us will be to continue to be able to differentiate ourselves in the marketplace. Finally, we'll continue to look at every opportunity to continuously improve performance in our company. We are increasingly working together as one organization between businesses, countries, and regions to provide our customers with value-added products and solutions.

We have our strategic priorities as an organization, and we are on track to complete what we said we would do. We are building momentum within the organization. So with that, Taria, please open the lines for questions.

Operator (participant)

Ladies and gentlemen, if you would like to ask a question at this time, please press star, then one. If your question has been answered or you wish to remove yourself from the queue, please press the pound key. And once again, if you would like to ask a question, please press star, then one. We'll give it one moment for questions. And our first question comes from Kevin Bennett of Stern Agee. Your line is now open.

Kevin Bennett (Equity Research Analyst)

Well, hey there. Good morning, guys.

Bob Pagano (President and CEO)

Good morning.

Kevin Bennett (Equity Research Analyst)

Bob, first question on the Apex deal, which certainly seems like a good one. I was wondering if you could comment some more on the margin profile of that business, as well as kind of get into, you know, what was the thinking in terms of expanding in New Zealand?

Bob Pagano (President and CEO)

Well, when we looked at our portfolio and we looked at our, our growth, you know, the New Zealand market, this is a market leader in New Zealand. They have high, mid-single digit, you know, operating margins, which is a nice portfolio add, and they have, you know, 40-some patents inside their business. So we believe we can take some of their products and leverage it throughout Asia. So we're really excited about it. It gives, our Asia Pacific team the ability to, you know, have a new product to offset their various undifferentiated products that they lost. So the team's real excited about it and believe they can grow that business.

Kevin Bennett (Equity Research Analyst)

Gotcha. So you said high single-digit operating margins. Is that - was that correct?

Bob Pagano (President and CEO)

Hi, I'm sorry. It's high, you know, to mid double digits. I'm sorry.

Kevin Bennett (Equity Research Analyst)

Got it. Got it. Okay. That makes more sense. Perfect. And then the other question for me, I was wondering about new product development. You know, we've talked about this before, but I was wondering if you could provide some more information there and if you guys have a target for kind of what that should contribute to growth over the longer term?

Bob Pagano (President and CEO)

Yeah. Well, certainly, we're slightly below our industry in spending as R&D as a percentage of sales, where our goal is to get similar to everybody. AERCO spends a lot more on R&D, and we see the benefits of that. So that's an area you'll see us increasing our investments, you know, over time. So I think it's a, it's a great opportunity. We continue to get our teams together. We've had an innovation summit just recently, where we brought a lot of our engineers from all over the world to meet with our electronics team, and the team just has a, a, a real, you know, a, a multitude of ideas that we need to fund as an organization. So we're really excited about it, and it's an area we're gonna take some of our savings and reinvest for the long run of the company.

Kevin Bennett (Equity Research Analyst)

Gotcha, but you... No targets as of right now of kind of what, you know, percentage growth this could add? Again, just thinking longer term.

Bob Pagano (President and CEO)

Yeah, we'll provide more details, you know, on our next call about our future forward-looking information. But as of now, suffice it to say that it's a key growth initiative for us in the out years.

Kevin Bennett (Equity Research Analyst)

Sure. Thank you.

Bob Pagano (President and CEO)

Thank you.

Operator (participant)

Thank you. Our next question comes from Joe Giordano of Cowen. Your line is now open.

Joe Giordano (Analyst)

Hello, guys. Can you hear me?

Bob Pagano (President and CEO)

Yes. Good morning, Joe.

Joe Giordano (Analyst)

Hi, guys. Thanks for taking my question. And apologies if this has been asked. I'm kind of, I'm bouncing around a little bit, but I just wanted to confirm with you the impact of the non-core loss, like, going through 2016. So it was a little bit lighter in 3Q to see your expectations for 4Q. Are we still expecting about $100 incremental in 2016?

Todd Trapp (CFO)

Yeah, Joe. Hey, this is Todd. I would say the really only thing that's changed from our previous guidance is that we saw higher sales due to the Sioux Chief closure, which happened a few weeks later than expected. So again, it was about $20 million of headwind in Q3. We expect Q4 to be somewhere in that $40 million range. And then, as we think about 2016, I'd say $90-$100 million is still probably a pretty good, pretty good number at this point in time.

Joe Giordano (Analyst)

Okay. Okay, great. And then, what were the margins for AERCO for the quarter?

Todd Trapp (CFO)

Yeah, I would say they were in the high teens for AERCO, you know, in that 18%-20% range were the margins-

Joe Giordano (Analyst)

Okay.

Todd Trapp (CFO)

-for AERCO quarter.

Joe Giordano (Analyst)

Okay, great. And then last, on China, on the margin, I know it's not a huge impact to the overall here, but the commentary on the last call suggested margins in, like, a single digit range, and then wound up being up. So just curious as to what I'm... If I'm missing something there.

Todd Trapp (CFO)

Yeah, no, I think it's more of a timing issue. So in Q3, we still saw some activity from our intercompany sales perspective, but we expect that to wind down in Q4. And I think in Q4, you would see operating margins in that, what I'd say, in that low, mid single digit for the Asia Pacific region.

Joe Giordano (Analyst)

Okay.

Todd Trapp (CFO)

It's just more, it's more time than anything.

Joe Giordano (Analyst)

Okay, that, that makes more sense. All right, thanks. I appreciate it, guys.

Bob Pagano (President and CEO)

Thanks, Joe.

Todd Trapp (CFO)

Thanks, Joe.

Operator (participant)

Thank you. At this time, I'm showing no further participants in the queue. I would like to turn the call over to Bob Pagano, President and CEO, for any closing remarks.

Bob Pagano (President and CEO)

Okay. No, there's no more calls? Okay. All right. Well, in closing, I'd like to thank you for taking the time to join us today for our Q3 earnings call, and we appreciate your continued interest in Watts Water. We look forward to speaking with you again during our Q4 earnings call in February. Thank you very much.

Operator (participant)

Ladies and gentlemen, thank you for your participation on today's conference. This concludes the program. You may now disconnect. Everyone, have a great day.