Watts Water Technologies - Q3 2019

Transcript

Operator (participant)

Ladies and gentlemen, thank you for standing by, and welcome to the Watts Water Technologies third quarter 2019 conference call. At this time, all participants are in a listen-only mode. After this speakers presentation, there will be a question-and-answer session. To ask a question during the session, you will need to press star one on your telephone. Please be advised that today's conference is being recorded. If you require any further assistance, please press star zero. I would now like to hand the conference over to your speaker today, Tim MacPhee, Vice President, Investor Relations. Please go ahead.

Timothy MacPhee (Treasurer and VP of Investor Relations)

Thank you, and good morning, everyone. Welcome to our third quarter 2019 earnings conference call. Joining me are Rob Pagano, President and CEO, and Shashank Patel, our CFO. Rob will provide a business overview of the quarter, and Shashank will address the financial results and offer our latest outlook for the fourth quarter. 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, may 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 our publicly available filings with the SEC. The company disclaims any intention or obligation to update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise. Let me now turn the call over to Rob Pagano.

Robert Pagano (President and CEO)

Thanks, Tim, and good morning, everyone. Please turn to Slide three in the presentation, where I'll provide an overview of the quarter. We delivered a solid performance in the third quarter. As anticipated, top-line organic growth moderated due to tougher comps and slowing market expansion. However, we were able to drive record quarterly sales, operating margin in EPS. Regionally, the Americas' continued broad growth was partially impacted by softer heating and hot water platform sales due to project timing. Europe continued on a steady pace, and APMEA returned to nominal growth while continuing to be challenged by Middle East project delays. Shashank will review the financial details in a few minutes. Now, let me make a few comments about the markets. We expect to see mixed growth in the fourth quarter in the Americas non-residential end market.

More recent indices that we follow, including the PMI and ABI, have recently touched multiyear lows, and the Dodge Momentum Index has been trending downwards year-over-year. The institutional end market is also mixed, with growth in healthcare spending being offset by lower educational spend. On the residential side, year-over-year changes in new housing starts and existing home sales have stabilized recently and have shown a slight uptick in Q3. Lower interest rates may help the residential side to some extent, but that could take time. So we see market moderation continuing in the Americas for the remainder of this year and as we head into 2020. Global policy uncertainty, rising protectionism, and other geopolitical factors have become prominent backdrops in Europe. In the U.K., economic activity is expected to remain muted in the coming quarters.

The ECB recently revised its GDP expectations for the euro area to 1.1% for 2019 and 1.2% for 2020. So in general, we remain cautious regarding Europe. In APMEA, we see a continued mixed bag with the market spotty, depending on the region. Macro issues like China trade, oil refinery bombings in Saudi Arabia, and the Turkey-Syria conflict only create additional uncertainties in those regions. Now, let me provide some more background on our latest acquisition. In late August, we purchased the assets of Backflow Direct, a California-based company that designs and manufactures large-diameter stainless steel backflows, primarily used in commercial fire protection applications. Backflow Direct was established about 7 years ago, and the founder is well-known in the backflow prevention industries and to Watts as well.

Strategically, Backflow Direct provides some innovative products in fire protection applications that broaden our offerings to meet customers' requirements. We are also excited that the former owner, a well-respected professional in backflow prevention, is joining our team to aid in future backflow development opportunities. We're excited to add Backflow Direct to our portfolio. Finally, our outlook for the second half of 2019 has not changed from the guidance we provided in August. We still expect growth in the second half to be 2%-3% on a consolidated basis, with Americas growing 3%-4%, Europe 1%-2%, and APMEA in the 5%-7% range. Now, I'll turn the call over to Shashank to talk about our third quarter operating performance and provide more color on our fourth quarter outlook. Shashank?

Shashank Patel (CFO)

Thanks, Rob, and good morning, everyone. Please turn to Slide four, and we'll discuss the third quarter consolidated results. Reported sales of $395 million were up 1%, as organic growth of 2% was partially offset by a foreign exchange headwind of approximately $6 million, or 1%, during the quarter. Consolidated organic growth was in line with our expectations, and I will address our regional performance in a few minutes.

...Adjusted operating profit was $52 million, an increase of 4%. This translated into an adjusted operating margin of 13.3%, up 40 basis points versus last year, and an all-time quarterly record for the company. Price, productivity, including restructuring savings and higher volume, partially offset by investments and inflation, were the main drivers of the record margin performance. We continued to invest in growth and productivity initiatives. In fact, in the third quarter, we spent approximately $4 million on investments, about $1 million more than we had anticipated. More than half of the total investment spend was focused on our smart and connected initiatives. Adjusted earnings per share of $1.04 was a 5% increase over last year and a new third quarter record for the company. The adjusted earnings per share increase was driven by operations.

Negative foreign exchange and positive share dilution were each 1one cent and were net neutral. The adjusted effective tax rate in the quarter was 28.5%, consistent with the prior year. Turning to cash on a year-to-date basis, free cash flow was $76 million, a 77% increase as compared to the same period last year. The increase was mainly due to higher income, reduced inventory levels, lower tax payments, and reduced capital spending. Historically, the fourth quarter is a strong cash flow quarter for the company, and we expect that trend to continue this year as well. Our goal is to attain 100% free cash flow conversion for the year. During the third quarter, we repatriated approximately $7 million in cash. Year to date, we have repatriated about $37 million, using a majority of that to pay down debt.

In the third quarter, we purchased approximately 48,000 shares of our common stock at a cost of $4.5 million. Year to date, we've returned a total of $38 million to shareholders in dividends and share repurchases as part of our balanced capital deployment strategy. We also incurred some costs at corporate this quarter, which have been classified as special items. First, we incurred $2.3 million of professional fees, including legal and tax costs, to optimize and simplify our European legal structure from a pan-European perspective and align with previous restructuring initiatives. We also incurred other professional fees in order to obtain a much deeper understanding of our product, country, and customer profitability, which should help guide our future new product development and other investments. We expect to complete this review in the fourth quarter.

The second special item of $0.9 million related to acquisition costs incurred for the Backflow Direct acquisition and costs of other acquisition efforts that did not come to fruition. So to reiterate Rob's comments, a solid third quarter performance, setting new quarterly highs in sales, adjusted operating margin, and adjusted earnings per share, while continuing to invest for the future. Now to the regions. On Slide five, let's review Americas results for the quarter. Sales of $270 million were up approximately 3%, both on a reported and organic basis. The organic growth was driven by price realization and volume increases in plumbing valves, drains, and water quality products. Growth was partially offset by softness in heating and hot water products from project timing delays and continued competitive pricing.

As expected, price was a smaller contributor to growth as compared to the first half. Also, the pre-buy during the second quarter, ahead of the previously announced July 1 price increases, negatively impacted the Americas sales growth by about 2% in the third quarter. Adjusted operating profit in the Americas was $48.9 million, a 9% increase year-over-year. Adjusted operating margin increased 100 basis points to 18.1%, driven primarily by price and productivity, which more than offset incremental growth investments and inflation. To summarize, a good quarter for the Americas. Moving to Europe, please turn to Slide six. Sales of $108 million were down 3% on a reported basis and up 1% organically. Foreign exchange, mainly the euro, was a headwind of about $5 million or 4% in the quarter.

The organic sales increase was driven by solid growth within our drains platform and, to a lesser extent, growth within core plumbing and HVAC products in the fluid solutions platform. Drain sales into marine applications continued to be strong. By geography, we saw strength in France, Italy, and the Nordic regions. We saw softness in Germany and the UK. France was driven by increases in core plumbing and drains products. Italy and Scandinavia were both stronger due to growth within our plumbing product lines. Sales in Germany were down as both plumbing and drains products were soft. Finally, the UK was down amid Brexit uncertainties in the market. Adjusted operating profit for Europe in the quarter was approximately $12 million, a 5% decrease as compared to last year. Operating margin of 11.2% decreased 30 basis points versus the third quarter of last year.

The benefits of incremental price and productivity, including restructuring savings, were more than offset by incremental investments and the timing of certain costs. So for Europe, steady top line growth with a slightly lower operating margin performance. We expect adjusted operating margin should expand in the fourth quarter. On Slide seven, let's review APMEA's results. In the quarter, sales of $16.5 million were down 1% on a reported basis and up 1% organically. The third quarter was a continuation of APMEA's first half performance, with strong growth in China offsetting weakness in other regions, especially the Middle East, where projects continued to be delayed. Sales in China were up double digits organically, mainly driven by commercial valves. Sales outside China decreased by double digits due to the Middle East and Korea.

Adjusted operating profit and adjusted operating margin were significantly affected by a decrease in intercompany sales volume, unfavorable country sales mix, and additional investments, which were only partially offset by additional productivity savings. Recall that last year, the Americas purchased additional product from our Chinese sister companies in anticipation of the higher tariffs. In summary, APMEA returned to growth during the quarter, with solid growth continuing in China, but profits were negatively affected, primarily by unfavorable intercompany volume and Middle East project timing. Finally, turning to Slide eight, I'd like to make a few comments on the fourth quarter. On a consolidated basis, we expect year-over-year fourth quarter organic sales growth of approximately 3%. Growth rates should increase sequentially from the third quarter in the Americas and APMEA, while Europe's growth should be fairly consistent as compared to the third quarter.

Adjusted operating margin in the fourth quarter should expand versus the prior year, supported by price, volume growth, continued execution of our productivity and restructuring initiatives, partially offset by inflation. We expect incremental growth investments of $2 million-$3 million in the fourth quarter versus last year. Excluding special items, we anticipate total corporate costs in the quarter to be $10 million-$11 million. Expected restructuring savings are $1 million in Europe. We expect full-year adjusted operating margin expansion should be at the high end of the 50-70 basis points range that we provided during our February outlook. Our adjusted effective tax rate should approximate 28.5% in the fourth quarter. The FX impact should be negative as compared to the fourth quarter last year. Our average euro exchange rate last year was 1.14.

Our current expectation is 1.10 for the fourth quarter of this year. We are expecting strong cash flow generation in the fourth quarter, consistent with our performance over the past several years. We estimate capital spending will approximate $30 million for the year. Finally, we anticipate incremental costs of $1 million-$2 million in the fourth quarter, including additional costs to finalize the European project I discussed earlier. We'll highlight these costs as special items. With that, I'll turn the call back over to Rob before we begin Q&A. Rob?

Robert Pagano (President and CEO)

Thanks, Shashank. To summarize, the quarter played out as we had expected, with solid earnings and margin expansion, along with tempered top line growth. We acquired the assets of Backflow Direct to extend our product range and meet our customers' needs, and we expect our second half sales and margin expectations to be in line with our previous outlook. So with that, operator, please open the line for questions.

Operator (participant)

Certainly. As a reminder, to ask a question, you will need to press star one on your telephone keypad. To withdraw your question, press the pound key. Please stand by while we compile the Q&A roster. Our first question comes from the line of Nathan Jones, Stifel. Your line is open.

Speaker 5

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

Robert Pagano (President and CEO)

Morning, Adam.

Speaker 5

Morning. You guys have been very consistent with your strategy of organic investment and driving growth and margin expansion. So I'm going to focus first on growth. Your comments on the macro were helpful. I was wondering, though, if you could talk about, you know, some of your strategies of penetrating some of your international markets, like the Middle East. What does that look going forward? Are you seeing traction there? And then also, if you could talk about some of your connected solutions and maybe an update there.

Robert Pagano (President and CEO)

Yeah, thanks, Adam. Certainly, we believe there's opportunity and growth inside the Middle East region. Right now, our quoting activity is very high. We are continuing to invest there, but we're being very cautious, from a, let's call it, a collection point of view. There's a lot of jobs out there. We're really tight with our terms because it's really important we remain disciplined and get our cash. So a lot of activity, and we're seeing some projects being delayed with some of the uncertainty that I talked about previously. So again, we believe in the long run, though, that we have low market share there, and it's a huge opportunity for us to grow, so we'll continue to invest there. On the connected products, they still remain very strong.

We're driving, you know, those continue to grow double the rate that our existing portfolio is growing, and we plan on being in the double digits as a percentage of our overall sales by the end of this year. So again, great opportunities. Our continued investment is in that area, and we believe that will be opportunities for growth in the future.

Speaker 5

All right, great. And then just switching over to the margin side, maybe talk about moving into 2020, there's a lot of uncertainty how you guys are gonna balance growth investments and then also margin expansion. So, you know, where are you guys in the lean transformation journey? And then just, you know, any other color there would be great.

Robert Pagano (President and CEO)

... Yeah, so, when we look at margins next year, obviously dependent on how far the top line grows, you know, that will determine, you know, how far we expand. But we, as you know, we have many opportunities for lean in our organization, both in our factories and on our front end. And that's really our focus, because we believe we need to continue to drive productivity to allow us to invest in the future. So, you know, margin increases, you know, that's our continued goal. As we've always stated, we believe we have the opportunity to, to do that. But in the face of that, we've also been looking at our overall corporate investments and where, you know, in our global investments, on where we believe we can drive overall shareholder value by investing in growth opportunities.

So we haven't done a lot of M&A, and we believe investing in ourselves is the best value for our long term for our shareholders. So again, we'll be reviewing that as we get closer to 2020, but I still believe we have ample opportunity to grow our margins.

Shashank Patel (CFO)

All right, great. Thank you.

Robert Pagano (President and CEO)

Thanks.

Operator (participant)

Our next question comes from the line of Jeff Hammond, KeyBanc. Your line is open.

Jeffrey Hammond (Managing Director and Senior Equity Research Analyst)

Hey, good morning, guys.

Robert Pagano (President and CEO)

Good morning, Jeff.

Jeffrey Hammond (Managing Director and Senior Equity Research Analyst)

Hey, just on the Americas commentary, you know, outlook, can you just kind of bifurcate what you're seeing in the business, specifically in terms of, you know, areas that might be weakening versus kind of the, the high-level macro data which might be, you know, pointing to more caution, but, you know, maybe you're not seeing yet in the business?

Robert Pagano (President and CEO)

Yeah. So our first issue is the comparison against last year. If you recall, in the Americas, in last year, we grew about 10%. So some of that was related to the tariffs, and, but overall, we see very good activity. But we look at the leading indicators. As you know, those are something we look at on a forward basis as predicting our future. So, you know, activity still is strong. We did see in our heating and hot water, some of our business got pushed into the fourth quarter. Some delayed funding happened. A lot of quotation activities are still out there. So again, we see growth, but just probably slower growth, because a lot of growth has been driven by pricing increases. Those, you know, as a result of tariffs, that'll slow down as we go into next year.

And then again, our leading indicators are, you know, saying that, in particular, in the, you know, commercial area, that they should be slowing in the future. But our teams are optimistic we'll get our fair share in more of the market that's out there.

Jeffrey Hammond (Managing Director and Senior Equity Research Analyst)

And then this or I guess, delays and timing issues, does that reverse in 4Q, or, or is that something that's pushing into 2020?

Robert Pagano (President and CEO)

I would say both. We are seeing we have a strong backlog on the heating and hot water solutions group into the fourth quarter. So, you know, our orders were up double digits in Q3. It just, the shipping was in Q4. Some educational institutions just delayed the timing of the funding of those projects. Normally, they seasonally are in Q3, and it moved out into Q4. So again, we should have a solid Q4 in that business.

Shashank Patel (CFO)

Just a note on the heating hot water side, our lead times are longer, so those projects came in. That's why Rob talked about orders were good, but they'll be shipping in Q4. On the other side of the business, it is book and ship business primarily.

Jeffrey Hammond (Managing Director and Senior Equity Research Analyst)

Okay, great. And then, can you give us any more on Backflow Direct? What's the annual revenue? Is there a revenue contribution you to think about for 4Q, and anything around, you know, kind of the multiple you paid for the business?

Robert Pagano (President and CEO)

Yeah. So Jeff, they've been running about $2-$2.5 million per quarter. And, again, we've, the owner has asked us to not talk about the details of the transaction, but you obviously can read our cash flow statement. But, anyways, we believe it's a great opportunity for us in the long run, from an R&D point of view. It saves us about three years of development. They have a unique product that, is, you know, smaller and lighter than our existing product, so it fills a need, that we have in our portfolio, and I think it's, in the long run, will aid in our new product development. So we're really excited about this acquisition.

Jeffrey Hammond (Managing Director and Senior Equity Research Analyst)

And then maybe one last one. Shashank, you talked about some professional fees and looking at your European business strategically and from a tax. Any, any kind of early observations from that on how maybe you're thinking about the tax structure differently or, or, you know, strategically, or, or any opportunities that are coming out of that? Thanks.

Shashank Patel (CFO)

Yeah, and, you know, so as you know, you know, we did restructuring in our Amsterdam office last year, and as a result of that, as well as the tax law changes within the Eurozone, we decided to do an assessment of our legal entity structure, and we incurred some legal and tax fees. As we gained further insights from that effort, from that analysis, we also hired consultants to actually do a deeper dive of our product and customer profitability by country to help guide us in future investments. So I think we're still in the middle of that. We're gonna complete that in the fourth quarter, but it'll certainly help us, you know, drive better investment decisions as we go forward. So more to come on that in the next call.

Robert Pagano (President and CEO)

Jeff, just to add-

Jeffrey Hammond (Managing Director and Senior Equity Research Analyst)

Okay.

Robert Pagano (President and CEO)

You know, we set up a principal company inside of Amsterdam, and again, a lot of billing and centralized activity was going through that. So we wanted to break that back up because we're really more focused on the countries at this point in time, and we believe it's a better opportunity to do that. So that's why we needed to break that up and allocate the right cost to the right places.

Jeffrey Hammond (Managing Director and Senior Equity Research Analyst)

Okay, thanks, guys.

Robert Pagano (President and CEO)

Thank you.

Shashank Patel (CFO)

Thank you.

Operator (participant)

Our next question comes from the line of Brian Lee, Goldman Sachs. Your line is open.

Speaker 6

Hey, how's it going? This is Alex on for Brian.

Shashank Patel (CFO)

Morning, Alex.

Robert Pagano (President and CEO)

Morning, Alex.

Speaker 6

Hey, just a quick one for me. Appreciate the macro color in the prepared remarks. So in light of those trends that you mentioned, have you, are there any changes to the business model or the markets that you're targeting going into next year? Or is it just a bit of cyclicality that you're seeing?

Robert Pagano (President and CEO)

I think it's a bit of cyclicality. I mean, you know, we're gonna continue on our investments, our new product development, our connected strategy. All of that, we believe, will allow us to have above market growth opportunities. So, you know, that's really important. And I always remind everybody that, you know, 60%-65% of our business is repair and replace. That tends to follow GDP, and as we all see, GDP is continuing to be positive, although slightly, you know, moderating. But overall, you know, the business model is sound. We'll continue to invest in emerging markets also, because we have low market shares there. But right now, there's a little political turmoil in some of those countries that we've been investing in. But again, we're in it for the long run, and we believe there's opportunities in the long run.

Speaker 6

Great. Appreciate that. And just to follow up there, would you say those trends that you were referring to are occurring in Europe as well?

Robert Pagano (President and CEO)

Well, yeah, certainly in Europe. I mean, I think, you know, with the Brexit, the uncertainty in that whole region, you know, in the... let's call it, the trade impacts that are, you know, going on as a result of that. So, you know, there was a report out yesterday that France is coming back. We had a strong growth in France, so that's an opportunity for us. So again, you—as you followed me, you know I've always been very conservative in Europe, just to make sure our costs are, structure are in alignment. But our two other businesses that are growing in there, both our drains and electronics, those are global growth businesses, and we believe there's opportunities to continue to grow in those markets.

The other areas, I think there'll be more slower growth, and we'll make sure our cost structure is aligned to that.

Speaker 6

Excellent. Thanks a lot.

Robert Pagano (President and CEO)

Thank you.

Operator (participant)

Our next question comes from the line of Joseph Giordano of Cowen. Your line is open.

Speaker 7

Hey, guys. Good morning. This is Francisco in for Joe.

Shashank Patel (CFO)

Morning, Francisco.

Robert Pagano (President and CEO)

Morning.

Speaker 7

Morning. So you guys called out some of the momentum in U.S. institutional building that seems to be weakening. We've seen the things like the Dodge Momentum Index slowing down. Are you guys seeing anything notable that you could be calling out in that part of the business, specifically?

Robert Pagano (President and CEO)

Not really. I mean, again, quoting's up. We've seen some project delays, and, and that's normal, right? In our business, when there's uncertainty, projects just get pushed out and stuff, but we've not seen any cancellations, and, hopefully, some of this uncertainty will go by. But there-- we still see good spending, but some of those indicators are longer leading indicators, and I think, that's what we're very cautious on. So again, we're gonna be watching that carefully. We've, you know, talking to our sales team, they still, still feel, you know, bullish, but, we're also very cautious in watching around the corner to make sure we're prepared if there's any significant downturn. But right now, steady as it goes, and, again, but remember, our compares and tariffs and all that are also impacting our growth into the future.

Speaker 7

Okay, great. And then in terms of German OEMs, have you guys seen any positive signs on that side?

Robert Pagano (President and CEO)

Not really. I think it's. Again, and we all read about the German economy, and, you know, potentially they've been in recession, and I think there's just muted spending right now. I mean, you know, so that, that's something we're gonna watch cautiously. It's not been horrible, but it's, we've not seen growth there, and that's an area we just will remain cautious on.

Speaker 7

Okay, great. Thank you.

Robert Pagano (President and CEO)

Thank you.

Operator (participant)

There are no further questions at this time. I'll turn it back over to Rob Pagano for closing remarks.

Robert Pagano (President and CEO)

Thank you, everybody, for taking the time to join us today for our third quarter earnings call, and we appreciate your continued interest in Watts. We look forward to speaking with you again in our fourth quarter call in February. Thanks again.

Operator (participant)

This concludes today's conference call. You may now disconnect. Have a good day.