Watts Water Technologies - Q4 2013

Transcript

Operator (participant)

Good day, ladies and gentlemen, and welcome to the Fourth Quarter 2013 Watts Water Technologies Earnings Conference Call. My name is Zhaneta, 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 will 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, February 18th, 2014, relating to the company's fourth 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. Dean Freeman, Chief Executive Officer and Chief Financial Officer. Please proceed.

Dean Freeman (CEO and CFO)

Thank you, operator. Good morning, everybody, and thank you for joining our fourth quarter earnings call. We have a lot of ground to cover, and I've got some help here with me. Joining me today are Ken Lepage, our General Counsel and Chief Administrative Officer, Ken Korotkin, our Chief Accounting Officer, and Tim MacPhee, our Treasurer and VP of Investor Relations. I'll begin by providing a high-level overview of our fourth quarter results. I'll talk briefly about the financials for the full year as well. I'll talk about market conditions in our key regions, update you on our key initiatives, and give you a sense at a high level of how we are viewing our expectations for 2014. Tim will then walk us through quarterly and full year performance in more detail, and some relevant financial points related to 2014.

After Tim's discussion, I'll summarize and open the call to your questions. Let me start by providing a brief overview of the fourth quarter results. Just flipping to slide three. Our sales were $376 million in the fourth quarter, 6.1% increase over Q4 2012. Our adjusted EPS was $0.57, $0.03 below our adjusted earnings for the same period last year. I'd like to point out a couple of items that affected our adjusted earnings during the quarter. First, rebate costs were adjusted in Q4 to reflect the achievement of annual volume incentive targets for certain large customers. $3 million of these costs related to catch up of our rebate reserves. The second item related to manufacturing inefficiencies we've experienced as part of our lead-free conversion project.

In Q4, we incurred approximately $1.4 million of costs, including furnace repairs, excess scrap, professional services, and other costs related to the new foundry. We expect that these inefficiencies are now substantially behind us. In the two items, the rebates and the lead-free costs impacted our adjusted EPS by about $0.08. I'd like to also provide you a little bit more color on the Trabakoolas legal settlement. The suit was brought for alleged failures of legacy toilet connector products, as we disclosed in our 8-K filing in December. The settlement amount totals $23 million, of which Watts will be responsible for $14 million. We have preliminary approval from the courts, and we expect will be completed by the end of the second quarter of 2014.

As a result of the final settlement, we believe that a significant current source of volatility and variability impacting the product liability accrual will be eliminated. The total toilet connector outstanding claims is about 40% of our total product liability claims. Also, during the fourth quarter, there were approximately $6 million of additional special items, which you can see in Table 1 of our Q4 press release. Turning to slide four, just looking at full year. We delivered solid top-line performance during 2013 as we achieved record worldwide sales result for the company. This happened despite a year-on-year reduction in EMEA. We continued to grow sequentially in Americas, and China consistently delivered double-digit growth during the year. However, our adjusted operating profits were mixed, with different economic and business dynamics in each of our key segments, providing unique challenges and opportunities.

In the Americas, after a slow first half, we're able to see—we were able to grow sales organically for the full year by 5.5% as we participated in growing residential construction market, a solid repair and replace end market, and sales of lead-free products took hold in the marketplace during the second half of the year. As we anticipated, the Americas adjusted operating results were impacted by the ramp-up of our lead-free foundry operation, which caused production inefficiencies for much of the year, as we talked about.

We estimate that these efficiencies added up to about $5.8 million of expense to our expense base in 2013, but we do not expect these additional costs to remain going forward as we continue to increase our efficiencies in the foundry. Adjusted margins were also impacted by higher than historic product liability costs, as we talked about, which we estimated added approximately $3.5 million in expenses for the year. Margin expansion was also hindered throughout the year by competitive pricing, especially in the retail channel. In EMEA, a weak Pan-European economy drove year-over-year organic sales down by 3.6%, or about $21 million. Regionally, sales were down in our French plumbing business almost 6% for the year, but we did see stabilization starting to return in the second half of 2013.

As sales were essentially flat in the second half of 2013 when compared to the same period of 2012. German sales were down, or sales in Germany were down for the year, approximately 8%, but sequentially, the sales reductions moderated as the year progressed. Overall, our EMEA team was able to mitigate the effects of the sales volume reduction on adjusted operating earnings and generated adjusted operating margins that were slightly better than 2012. This result was achieved by focusing on productivity initiatives, SG&A cost reductions, just doing an exceptional job with the overall cost structure. EMEA also did an exceptional job in generating cash flow in 2013. Asia Pacific, our team made great progress in building the foundation for a continued growth platform based on our global plumbing and HVAC capabilities.

The Asia Pacific team grew sales organically over 20% in 2013, on top of an 18% sales increase in 2012. On a consolidated basis, in 2013, we delivered an adjusted operating margin of 9.5%, or 10 basis points below 2012 performance, again, mostly driven by the net volume declines in EMEA, lower margin retail business in Americas, lead-free conversion costs and product liability costs I talked about earlier. Our lead-free conversion and excess product liability costs reduced our adjusted operating margins by 65 basis points for the year. Our adjusted EPS for the year at $2.22, is $0.05 higher than 2012. Included in adjusted EPS, again, are the items I talked about with regard to lead-free and product liability, totaling about $0.16 for the year.

The net effect of FX and share buyback resulted in $0.06 of incremental EPS in 2013 as compared to 2012. So in summary, we expected somewhat of a choppy year, given the disruptions on lead-free, you know, that we thought would be created in 2013. We were concerned about the European economy. Our core business results in Europe were affected, as we talked about many times, the macroeconomic issues, and we were hopeful for some stabilization, and I think we actually saw that in the second half of the year. In the Americas, we delivered solid sequential sales growth, but again, we had headwinds and margins impacted for the reasons that we previously mentioned. We also made great strides in our target emerging markets, especially in China, Eastern Europe, and in Australasia.

Now let's look at slide five, and I'll take us through some current market conditions for each of the regions. After a 24% gain in 2013, new housing starts are expected to remain robust, with 19% growth for 2014 being forecast. Existing home sales are expected to track positively in 2014, with approximately 4% growth after gains of 9.1% in 2013. The growth in 2014 would equate to about 5.3 million existing unit sales, which is obviously helpful for our repair and replace business. And the LIRA Index, which tracks trends in remodeling activity, recently forecasted double-digit growth expectations for Q1 and Q2. We're starting to see more constructive signs regarding commercial construction expansion.

In 2013, the commercial end markets was somewhat muted, but there is more optimism for 2014, although timing of the pickup is still somewhat opaque. Dodge is predicting an 8% overall commercial pickup, with some sectors like institutional still lagging. But there's still verticals like hotels and office space that we participate in, that are forecasted to grow by double digits this year. So we're more hopeful that a commercial construction uptick may occur in 2014, but it's just difficult to say right now what the effect on our top line will be. Moving to slide six. Just looking at EMEA, as we mentioned during our Q3 call, we're hearing anecdotal information that our customers and markets were getting more optimistic about future expectations.

The latest expectations that Euro area GDP will grow 1% in 2014, which would come after two consecutive years of decline. The Euro PMI index has shown positive trends for the last six months. During 2013, the sales shortfall against the prior year, which we saw in Q1, moderated as the year progressed, so that by year-end, our EMEA sales were almost flat with Q4 2012. This is an encouraging sign. Still, our markets continued to be uneven, and as I mentioned, French plumbing sales flattened out in the second half of 2013, again, which is positive. However, our German business continued to decline, albeit at a lower rate as the year went on. Our drains business was steady in the second half. It was more challenged as some large drains projects in the Middle East were not repeated.

In Eastern Europe, showed consistent progress with nice growth in countries like Turkey and Saudi Arabia, as our order rates were steady as we exited 2013. Now, let's review market conditions in Asia on slide seven. As we've consistently mentioned, we believe that our long-term growth prospects in Asia Pacific are bright. We anticipate a significant opportunity for us to grow in the domestic China marketplace, and we're making some nice progress in laying the foundations for sustained growth there.... China's economy grew by roughly 7.7% in 2013, and expectations currently are that 2014 will have similar GDP growth. We expect to grow our heating products business in Tier One cities, where we're expanding middle class is looking for more comfort. Our focus, however, will be on the higher-end markets, where we expect to sell importer products.

We believe our valves business should grow in the China 50, those cities being the, in the tier two, tier three cities, that should offer substantial construction expansion over the next decade. Now let me talk about two of our ongoing initiatives, so please turn to slide eight. Our lead-free conversion in U.S. has been substantially completed. As expected, we experienced downtime getting acclimated to new furnaces, new machinery processes involved in the lead-free alloys. But as of year-end, our foundry was running at about expected capacity and downtime has been minimized. We estimate that the production inefficiencies and related costs total about $5.8 million in 2013, as I mentioned earlier. On the customer side, we converted most of our customers over to lead-free products by year-end, and we're able to maintain our gross margin percentages despite the higher cost of the new alloys.

The restructuring program for Europe that we announced last July is proceeding as expected. Recall, we announced a plan to reduce approximately 10% of our existing European manufacturing footprint, with total expected costs of $14 million, plus approximately $2 million of capital spend. Those estimates have not changed, and for 2014, we are forecasting full-year restructuring charges of approximately $5.8 million, which will bring our total charges since the project inception to approximately $10 million, or about 70% of the total expected cost. The remaining $4 million costs we expect to incur in 2015. Savings are on track with our original estimates, with total savings forecasted to be $7 million on a run rate basis. We expect to realize savings in 2014 of about $4 million and to have the savings fully realized by 2015.

The plans are in various stages and have not all been finalized with works councils or government approvals, so that's still pending, but we hope the approval process can be completed by the end of 2014. If you turn to slide nine, just to provide you a little bit more information related to a new initiative which has begun in Europe. In the fourth quarter, we began a program that we refer to as a European transformation. This program is designed to realign our European operations from a country-specific strategy to a more Pan-European operating strategy. This program is in line with our most recent five-year strategic plan. Under this initiative, we want to develop a more efficient and broader sales capabilities through improved product management, Pan-European marketing, and enhanced product cross-selling efforts, and uncover more emerging market opportunities.

Also, as part of the transformation, we want to drive European sourcing, logistics, shared services, and IT. We'll have a focused effort on rationalizing products that deliver little incremental margin to our business. We expect to review our business model with the express goal to drive common business processes and systems and reduce our SG&A. And lastly, we will align our legal and tax structure to drive significant incremental tax efficiencies. We anticipate this effort will ultimately increase and sustain our EMEA after-tax cash flows and help drive better return on invested capital and earnings power consistent with our strategic plan. Overall, we expect this to be a four-year effort. We anticipate total nonrecurring spend of between $12 million and $13 million, with approximately $9 million anticipated to be spent in 2014.

Total annual savings and profit enhancements are forecasted at $18 million by 2018, with approximately $3.5 million realized in 2014 and approximately $10 million realized in 2015. We expect that we will need to eventually add about $4 million of structural costs to maintain the program. We anticipate that we will add about $3.5 million of that in 2014. Much of the incremental nonrecurring costs will be from one-time transitional costs, professional services to help execute the project and get it off the ground as we build our own internal capabilities. Finally, if you turn to slide 10, I'll provide a high-level overview of how we see 2014 shaping up from a top-line perspective. We see business volumes picking up in the Americas, with growth from residential new construction and remodeling.

Commercial construction still needs to gain traction, but we're hopeful by the second half of 2014 that there will be a discernible uptick. In 2013, our Americas top line grew organically by about 5.5%. We anticipate that we can grow 2014 by between 6% and 9% range. Included in that range is about 1.5% of incremental top-line growth due to the final rollout of lead-free product sales. In EMEA, our organic decline for 2013 was about 3.6%. For 2014, we're assuming the European markets will slowly start to recover from the two-year recession, but the recovery may be uneven, it may be uncertain, and it will be fragile.

As we mentioned, we expect that our overall markets are choppy, and so where we see growth, perhaps in one region, we see potential decline or flat performance in others. From a Pan-European perspective, we expect flat organic sales growth for 2014. We do expect our Middle East and Eastern European businesses will grow modestly, but not enough to move the EMEA sales dramatically. As part of the European transformation, as I mentioned earlier, one of the key projects is product rationalization program, with an express goal of rationalizing low-margin products from our existing product portfolio. We're gonna take a deep dive into all of our product lines, and we expect to potentially rationalize as much as 3% of our total sales in Europe as a result.

Blending our organic expectations with the rationalization effect, we expect the total EMEA sales on a constant currency basis may decline by 1%-3% in 2014. The upside to the sales rationalization exercise is that EMEA's remaining sales should delever overall higher margins, which have been built into the transformation savings for 2014 that I discussed previously. We expect our growth trends in Asia will continue to 2014 and to expand geographically within China and external to China, and therefore, we anticipate that we should grow our top line in that region 15%-20% in 2014. And finally, we'll remain active in the acquisition market.

We continue to progress in developing a pipeline of targets as part of our overall strategic plan, and we anticipate doubling the rate of our organic growth through acquisition over the next several years. So now let me turn it over to Tim, who'll provide a little bit more detail on the operating performance. Tim?

Tim MacPhee (Treasurer and VP of Investor Relations)

Thanks, Dean, and good morning, everybody. I'll start by walking through the highlights for the quarter in the full year slides on slides 11 and 12, and then make some general comments about 2014. So looking at slide 11, on a consolidated basis, organic revenue for the quarter was up 4.6%. By segment, the Americas was up 7.9%, offset partially by EMEA, which had a small decline of 0.7%. And Asia had another strong quarter with organic growth up about 12.5%. FX provided a tailwind for us in the quarter as well. The Americas saw an organic increase in its wholesale channel of 8.7%.

OEM channel was up about 4%, and retail channel was up almost 7%, driven primarily by increased sales in our residential and commercial flow products. As Dean pointed out, we are continuing to see results of strengthening trends in the North American residential new construction in repair and replacement markets. Looking at EMEA for the quarter, organic wholesale sales declined 3.5%, offset for the most part by an uptick in the OEM market of 3.7%. While certain markets within EMEA were down to flat in the quarter, we continued to see signs of potential stabilization. EMEA, in the quarter, had an adjusted operating margin of 11.1%, which expanded by ninety basis points over Q4 2012.

EMEA reaped some early benefits of the restructuring effort, as you may have noticed on slide eight, plus other productivity and cost initiatives that have been ongoing for much of 2013. We will continue to drive our productivity efforts through both the restructuring and transformation initiatives that Dean mentioned earlier. Asia Pacific's strong performance in the quarter was driven largely by continued growth of plumbing and HVAC market sales. Adjusted operating profits for the quarter were $36.7 million, as a percentage of sales decreased 60 basis points to 9% year-over-year. The decrease was principally driven by a 130 basis point reduction in the Americas to 12.3%, as the segment incurred the customer rebate adjustment and the manufacturing inefficiencies related to the lead-free conversion that Dean discussed earlier.

The reduction was partially offset by EMEA's increased adjusted operating margin, as I previously mentioned. The adjusted tax rate for the quarter was just a little over 34% versus about 29% in the prior year. The increase was primarily due to a Q4 France tax law change on interest deductibility that was retroactive to the beginning of 2013, and partially from a Q4 adjustment to true up some of our U.S. tax-related reserves. Adjusted EPS in the quarter, $0.57, decreased $0.03 or 5% versus the prior year, and as mentioned, included about $0.08 of costs related to the rebate and lead-free transition costs. We spent $3 million to repurchase our shares during the quarter, which had a negligible effect on adjusted EPS versus Q4 of last year.

So if you move on to slide 12, on a full-year basis, consolidated basis, revenue was up 2.1% organically year-over-year, with the Americas up 5.5%, EMEA down 3.6%, and Asia up a little over 20%. Full-year adjusted operating profit was $140.2 million, with adjusted operating margins declining 10 basis points year-over-year to 9.5% of sales, driven largely by the lead-free transition costs and the higher product liability costs that we incurred earlier in the year. Margins were also impacted by unfavorable pricing in the retail channel throughout the year.

The full year adjusted tax rate was 32%, about 120 basis points higher than the prior year, and related, again, to the retroactive tax increase in France that I had mentioned earlier. 2013 adjusted earnings of $2.22 per share, a little, little over 2% growth in the year. And since we've already touched upon a lot of the regional highlights on slides 13 through 18, I'll just turn to slide 19 now. We'll talk about the primary working capital. And the comment I'll make there is our primary working capital is mainly affected by inventory builds to support the lead-free conversion, and receivables are increasing in, in Q4 of 2013, a result of higher sales in the Americas, especially during November, December time period.

So now if you turn to slide 20, I'll give you a quick, quickly discuss some of the cash highlights for 2013. We had another strong cash year, as our cash flow conversion rate was approximately 151%. That's the sixth year in a row now that we've had, a cash conversion rate greater than 135% for the company.

During 2013, we spent approximately $23 million to buy back $454,000 of our own stock in the open market, and this represents approximately 25% of the $90 million buyback program that was approved by our board last year. And if you recall, back in May, we repaid $75 million in private placement debt that was due, and we used available cash on hand to take care of that and to retire that debt. So overall, at the end of the year, we ended the year with $268 million in cash. Now, if you turn to slide 21, just a few points on 2014, I'd like to make you aware of.

As we announced last night in last night's press release, we have entered into a new $500 million line of credit agreement that will be used for general corporate purposes, acquisitions and debt repayments. The new agreement extends through February 2019, increases our available liquidity to $475 million, while reducing the interest spreads we paid on any borrowed funds. We expect to spend approximately $40 million in 2014 on our repurchase program, and that's in line with our existing plan. We anticipate spending approximately $25 million-$30 million in capital spend for the year. Most of the spend will be for maintenance-type capital.

Finally, as you can see on slide 21, we put some estimates there for depreciation and amortization, and also giving you a range of our effective tax rate for 2014. With that, I'll turn it back over to Dean.

Dean Freeman (CEO and CFO)

Thanks, Tim. So in closing, in the fourth quarter, we saw sales growth in the Americas and Asia, and better sequential performance in EMEA. As we talked about, adjusted operating profits in the quarter included a couple of items related to rebates and lead-free costs, which dampened our margin results. For the year, our Asia team delivered very solid results. EMEA worked diligently to negate some strong macro headwinds to deliver a very respectable performance in 2013. The Americas delivered on improved top-line performance and executed in the challenging lead-free conversion. Full-year adjusted operating profits, again, were negatively impacted by the items mentioned earlier. But we believe that the issues related to lead-free conversion and product liability costs have been largely mitigated with the proposed class action settlement.

As I mentioned earlier, we believe much of the lead-free issue conversion issues are in our rearview mirror. Looking ahead at 2014, the market dynamics are positive in continued growth in Americas and Asia Pacific, and some emerging positive signs in Europe. Our European team will still be busy executing both the restructuring program and the transformation process, which will require incremental investment, but will drive significant benefit to us both in the medium and in the long term. Overall, for 2014, we expect to deliver healthy operating profit growth through continued focus on growth, operational excellence and One Watts. So with that, why don't we open up the line for questions, operator?

Operator (participant)

Thank you. Ladies and gentlemen, if you have a question, please press star followed by one on your phone. If your question has been answered or you would like to withdraw your question, press star followed by two. Please press star one to begin. Your first question comes from the line of Mike Halloran with Robert W. Baird. Please proceed.

Mike Halloran (Senior Research Analyst and Associate Director of Research)

Good morning, guys.

Dean Freeman (CEO and CFO)

Hey, Mike, how are you?

Mike Halloran (Senior Research Analyst and Associate Director of Research)

Good, thanks. Just to make sure we're on the same page on the European restructuring, these are two separate initiatives, and the announcement today is incremental to the announcement that you made mid-year, correct?

Dean Freeman (CEO and CFO)

That's right.

Mike Halloran (Senior Research Analyst and Associate Director of Research)

Okay. And then, could you talk a little bit about the competitive pricing dynamics on the retail side of North America? It doesn't sound like it's impacting the business all that much based on the growth rates the last couple quarters, but I wouldn't mind hearing what the win rate looks like from your perspective, and then how disciplined you guys have been from your perspective as well.

Dean Freeman (CEO and CFO)

Well, look, I don't think we're necessarily calling out, you know, specific win rates. I'm not sure we've done that in the past. But I think what we can talk about, and what we have talked about, is that we had a fair number of line reviews in the year. Certainly in the first half of the year, the environment got very competitive. We continued to see, you know, a high volume of line reviews throughout the balance of the year, although they have started to moderate in the second half of the year. And I think all we're pointing out is that we had a, you know, historically high number of line reviews, which drove pricing down in some cases, as we tried to capture market share.

So broadly, I think that, you know, we believe that many of those line reviews are behind us. We think that, you know, the environment continues to be tough, but, you know, we've come out of it, I think, in a, in a way that, you know, allows us to continue to be competitive, but at the same time, you know, maintain discipline moving forward. So retail, you know, continues to be tough. On the wholesale side, I think we've been very balanced in our approach, both in pricing. In some cases, we continue to try to capture market share with price. In other cases, we've been able to hold price.

Certainly, we've been fortunate that on the lead-free side, we've been able to hold price consistent with our expectations, and so we've really tried to be very balanced about that.

Mike Halloran (Senior Research Analyst and Associate Director of Research)

And then, on the rebate side of the equation, any sense some of that was pull forward in demand? And you got a pretty healthy outlook for North America growth in the next year into 2014, so I suspect you're saying not a lot, but just curious.

Dean Freeman (CEO and CFO)

No, no, none of that was necessarily related to pull forward in demand. It was really more the basis of historical growth trends, and then obviously the inflection point in growth that we saw in the fourth quarter.

Mike Halloran (Senior Research Analyst and Associate Director of Research)

Thank you. Appreciate the time.

Operator (participant)

Your next question comes from the line of Jeff Hammond with KeyBanc Capital Markets. Please proceed.

Jeff Hammond (Managing Director and Equity Research Analyst)

Hey, good morning, guys.

Tim MacPhee (Treasurer and VP of Investor Relations)

Hey, Jeff.

Dean Freeman (CEO and CFO)

Hi, Jeff.

Jeff Hammond (Managing Director and Equity Research Analyst)

Hey, so just to kind of walk through the. So the $5.9 lead-free, you know, doesn't repeat the $3.5 million of a product liability doesn't repeat. The rebate true-up, I guess, you would have rebates next year, it would just be more smooth?

Dean Freeman (CEO and CFO)

Yeah, the rebate does not affect the year. We only call it out for the quarter.

Jeff Hammond (Managing Director and Equity Research Analyst)

Okay. And then it looks like you're gonna get $3 million or so of incremental savings in Europe from your first plan. The other one's a push. So I guess if we kind of pull all those out, you know, what, how should we think about, you know, maybe one, a normal incremental, you know, outside of those moving pieces? And then two, any other kind of headwinds to think about, you know, that would, you know, that would temper some of the, you know, some of the margin expansion?

Dean Freeman (CEO and CFO)

Well, look, we still think that, if there was a concern, to answer your first question, I think if there's any incremental headwinds that at least we're certainly thinking about, I think it's exactly what we said, which is Europe. I think that, while we're obviously all very hopeful, I think we've learned lessons about being overly optimistic with regard to any recovery. I mean, there's news out today, as a matter of fact, that I think is rattling markets a little bit. So, I mean, I think it's a tenuous recovery. I think it's fragile, but obviously, we're hopeful. So I think that's kind of the one area that we're flagging with regard to concerns.

I think the numbers, as you laid them out, are sort of exactly how we think about it in terms of normalizing margins for Americas and on a consolidated basis. So I think you got the numbers right.

Jeff Hammond (Managing Director and Equity Research Analyst)

Okay. And then, just real quick, what do you think of price in the 6%-9%? And maybe just update us on the CEO search and when you think you'd have an announcement there.

Dean Freeman (CEO and CFO)

Yeah. So I guess what I'll say on the 6%-9%, sort of normal pricing environment as we've expected. I think things will continue to be competitive, but we do see, again, healthy end markets, and that should be positive for price overall. And in that number, I think, as I mentioned, there's about 1-1.5% of lead-free pricing in there.

Jeff Hammond (Managing Director and Equity Research Analyst)

Okay, and CEO search?

Dean Freeman (CEO and CFO)

Oh, CEO search. It's underway. The committee is active, and I think as we announced, it's a 4-6-month process.

Jeff Hammond (Managing Director and Equity Research Analyst)

Okay, thanks.

Dean Freeman (CEO and CFO)

Yep.

Operator (participant)

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

Kevin Maczka (Managing Director and Senior Equity Research Analyst)

Thanks. Good morning.

Tim MacPhee (Treasurer and VP of Investor Relations)

Good morning, Kevin.

Dean Freeman (CEO and CFO)

Kevin.

Kevin Maczka (Managing Director and Senior Equity Research Analyst)

Dean, it looks like lead-free, for the most part, has played out about like you thought it would. I'm just wondering, I know we're early in the new year, but have you been able to see any signs of any share opportunity actually materializing there?

Dean Freeman (CEO and CFO)

No, not specifically that I would call out, Kevin. I think, you know, our focus has been to get the capacity in that foundry up to our own expectations, to normalize our production flows, to, you know, make sure we've got good, good harmonized delivery flows, both with our supply chain and with our distribution centers. And, you know, obviously, as we move forward and we get our production ramped up, we can have more thoughts on any incremental volume coming from, you know, third parties or otherwise.

Kevin Maczka (Managing Director and Senior Equity Research Analyst)

Okay. Now that we're beyond that, that was such a big initiative throughout most of 2013. I guess, you've made some strides elsewhere on productivity and cost and things like that. I'm just wondering, to the extent that, that any, any focus was diverted away from those other things because lead-free was so big in 2013, is there an even bigger productivity opportunity now away from the restructuring that you've called out as, as we look at 2014 and beyond?

Dean Freeman (CEO and CFO)

I think there is. I think you've heard us talk about, and I think the quote is, you know, building up of the muscularity of the organization around lead-free, both in terms of engineering capability, supply chain capability, our manufacturing capability. And our thinking was as we wind down lead-free, we would obviously divert those resources, lift and shift, as I like to say, toward enhanced productivity, enhanced supply chain efficiencies. And in fact, we have, you know, a number of initiatives underway to incrementally drive productivity in other places other than what we talked about in Europe. So it's perfectly consistent with some of the things that we've talked about in leveraging those resources to drive more productivity across the Americas and obviously in support of what we're doing in Europe.

Kevin Maczka (Managing Director and Senior Equity Research Analyst)

Yeah. And I may have missed it, but because of all of that, is it still fair to think about a 30% plus type incremental margin on the 6%-9% in North America?

Dean Freeman (CEO and CFO)

Yeah, absolutely. It's a great, it's a great, call-out. Yeah, we're still in the 30%-35% incremental flow through.

Kevin Maczka (Managing Director and Senior Equity Research Analyst)

Yeah. Okay, great. Thank you.

Dean Freeman (CEO and CFO)

Yep.

Operator (participant)

Your next question comes from the line of David Rose with Wedbush Securities. Please proceed.

David Rose (SVP of Equity Research)

Good morning. I was wondering if you could go into the incremental cost for lead-free. I think you called out $1 million in the last quarter, and it was $1.4 million. Was there anything, you know, operationally that sort of stood out?

Dean Freeman (CEO and CFO)

No, no, David. I think it was exactly as we called it. Obviously, through a transition like this, you don't have perfect clarity on sort of what's on the horizon, what costs may come up. You know, I think the one thing that we're clear about is that we see, and we have seen, that through this process, consistent improvement, both in terms of capacity, flow rates, production efficiencies. It's not where we want it to be yet. You know, obviously, we went through a lot in the year, but consistent improvement is certainly one of the key things that we look for, and we saw that through the fourth quarter.

David Rose (SVP of Equity Research)

... Okay, and so to be clear, in Q1, we're not going to hear anything about lead-free?

Dean Freeman (CEO and CFO)

That's what we're hoping.

David Rose (SVP of Equity Research)

Okay. And then as we look at Asia, is the product mix impact a trend, or is it just a one-off event?

Dean Freeman (CEO and CFO)

I think it's a one-off event. I don't see it necessarily a full year trend there or motion.

David Rose (SVP of Equity Research)

Okay. Great. Then lastly, if you could, on the European transformation, can you provide us a little bit more color in terms of the specific buckets? I mean, how we're going to be looking at the $18 million in annual savings, how much of it is from severance? How much of it from materials and maybe back office?

Dean Freeman (CEO and CFO)

Yeah. You know, I wish I could, David. I think it's still very much in the planning stages, and we haven't finalized all of that quite yet. I think we'll, you know, what we wanna do is update you know on a quarterly basis as we develop our plans further. So, not prepared to break that out at this point beyond what we've already communicated.

David Rose (SVP of Equity Research)

Okay, I may, I may have missed it. Could you repeat where we're starting to see the biggest costs incurred then, as we get through the year, in which quarters?

Dean Freeman (CEO and CFO)

We haven't broken it up by quarter. We did call out-

Tim MacPhee (Treasurer and VP of Investor Relations)

I can give you halves, David.

David Rose (SVP of Equity Research)

Okay.

Tim MacPhee (Treasurer and VP of Investor Relations)

It's about $9 million of non-recurring costs in 2014, and on a half-to-half basis, it's about 50, 50/50.

David Rose (SVP of Equity Research)

Okay. Thanks, Tim.

Tim MacPhee (Treasurer and VP of Investor Relations)

Okay.

David Rose (SVP of Equity Research)

All right. Okay, thanks, gentlemen. I appreciate it.

Tim MacPhee (Treasurer and VP of Investor Relations)

Thanks, David.

Operator (participant)

Your next question comes from the line of Joe Giordano with Cowen. Please proceed.

Dean Freeman (CEO and CFO)

Hey, Joe.

Joe Giordano (Managing Director)

Just quick question on the growth rate for revenue in the Americas. Is that predicated on that 19% Dodge estimate for new starts?

Dean Freeman (CEO and CFO)

Not necessarily. I mean, if you look at our business and, you know, I think the mix of our business between new residential and repair-replace, we're much more weighted on the repair-replace side of growth-

Joe Giordano (Managing Director)

Sure.

Dean Freeman (CEO and CFO)

and not necessarily on the starts. But obviously, starts are a leading indicator for the overall health of the industry, so we obviously look at that very closely.

Joe Giordano (Managing Director)

But it, I mean, I guess more is like when you're coming up with a number, is that something that's almost plugged into, like, you're kind of the way you're looking at it, or is that just to, you know, for our benefit to see what others are kind of thinking in terms of the market? Like, if that came in at 10%, for example, would that have... Would you guys be basing it on 19% and then have to shift towards 10%, or are you using a more conservative number internally when you're, when you're coming out with your growth expectation?

Dean Freeman (CEO and CFO)

Well, I can answer the question this way. They're not directly linked in terms of how we look at our growth rate.

Joe Giordano (Managing Director)

Okay, okay.

Dean Freeman (CEO and CFO)

Secondly, but they are, they are a key indicator of how we view the end markets.

Joe Giordano (Managing Director)

Yeah.

Dean Freeman (CEO and CFO)

So as we see changes in the health of the general construction market, obviously, you know, we evaluate our business on the same level.

Joe Giordano (Managing Director)

Okay. Then, one last thing. I think David might have hinted at this. In terms of lead-free, I know you said it's substantially behind you at this point, but is there anything left to, like, get over, or is there any potential... What would you say the potential for, like, leakages into, into 2014?

Dean Freeman (CEO and CFO)

Well, look, it's a complex foundry with a lot of technology. You know, we look at the conversion costs very discreetly as isolated to exactly the conversion.

Joe Giordano (Managing Director)

Mm-hmm.

Dean Freeman (CEO and CFO)

It is always possible that we continue to have productivity issues. It's always possible that you have issues with supply chain or material cost increases or any of the things that any normal foundry has to deal with, given the level of complexity we have there. I think what we're calling out is that the discrete items related to the transition are behind us, and we're continuing to ramp up our production and our efficiencies in the foundry on a you know, go-forward basis.

Joe Giordano (Managing Director)

So, there's nothing you'd call out on the efficiency side for that, that made up that 1.4%, that kind of stood out or any one aspect?

Dean Freeman (CEO and CFO)

No, no, I think it's, it was very much similar to what we saw, you know, earlier in the year.

Joe Giordano (Managing Director)

Okay, great. Thanks, guys.

Operator (participant)

Your next question comes from the line of Kevin Bennett with Sterne Agee. Please proceed.

Kevin Bennett (Equity Research Analyst)

Hey, guys. Good morning.

Dean Freeman (CEO and CFO)

Good morning.

Kevin Bennett (Equity Research Analyst)

First off, on the non-residential market here in the U.S., you know, I know we're hoping for some decent growth this year. Can you guys dig a little deeper on, you know, what you're currently seeing, and then maybe talk about what areas within that may be stronger than others and what may be weaker?

Dean Freeman (CEO and CFO)

Yeah. So look, from a residential perspective, as I mentioned earlier, we're encouraged by the housing starts data. We're encouraged by the overall momentum that we see in new construction. We're encouraged by the LIRA information, which obviously points to, I think, what's more closely correlated to our growth rates, which is the repair-replace end markets, which is expected to be up about 11% next year. So I mean, from our perspective, it is about, you know, the health of the repair-remodel market, the health of the overall new construction market. Where the opportunity lies is, as those markets get healthier, obviously, you know, small commercial, multifamily, the broader commercial verticals like hospitality and office space also have a pull-on effect, and that's where we see really the incremental opportunity in the second half of the year.

Kevin Bennett (Equity Research Analyst)

Okay, thanks. And then in terms of, you know, inventories in the channel, how are you feeling about those right now?

Dean Freeman (CEO and CFO)

... Well, look, if demand has increased and our fulfillment performance continues to improve, and, you know, we had very, very solid fulfillment performance in the second half of the year, despite, you know, what we were going through on lead-free, we think we're fairly well balanced, and we feel like we're meeting customer requirements. At the same time, we're getting a lot more efficient on our inventory. We obviously had to invest significantly, both in leaded and lead-free inventory, as buffer stock through the conversion, but we think that we're getting back on track at levels that we would have, you know, we think are normalized.

Kevin Bennett (Equity Research Analyst)

Got it. Thanks for that, Dean. And then two more quick ones. First, on the buyback, should we think about that $40 million being evenly spaced throughout the year, $10 million a quarter? Are we gonna be opportunistic, or how should we think about that in 2014?

Tim MacPhee (Treasurer and VP of Investor Relations)

Right now, Kevin, I would think about it at $10 million a quarter.

Kevin Bennett (Equity Research Analyst)

Okay, perfect. Thanks, Tim. And then last question for me on the M&A pipeline. Can you just, Dean, talk about what you're seeing, and is there anything close or anything you can talk about?

Dean Freeman (CEO and CFO)

No. Nothing close.

Kevin Bennett (Equity Research Analyst)

All right.

Dean Freeman (CEO and CFO)

We're seeing a lot of opportunities out there, but nothing imminent. Obviously, we're working through a number of priorities here, internally. We're keeping a very healthy pipeline and an active pipeline, but nothing imminent.

Kevin Bennett (Equity Research Analyst)

Got it. Thanks, guys. Appreciate it.

Tim MacPhee (Treasurer and VP of Investor Relations)

Bye, Kevin.

Operator (participant)

As a reminder, ladies and gentlemen, if you would like to ask a question, please press star one on your phone. Your next question comes from the line of Jim Giannakouros with Oppenheimer. Please proceed.

Jim Giannakouros (Managing Director and Senior Analyst)

Good morning, guys.

Dean Freeman (CEO and CFO)

Hey, Jim.

Jim Giannakouros (Managing Director and Senior Analyst)

As far as if you can give us any update on the timeline for achieving your previously stated 12% operating margin goal, I know that it was formerly in the out years, but just given the improved visibility you're getting to leverage opportunities in North America and obviously your cost takeout in Europe, any update there would be great.

Dean Freeman (CEO and CFO)

Yeah, Jim, I'd be loathe to call out a specific date because we hadn't done that in the past. I mean, I think what we've talked about is in the next, you know, two to three years, probably closer to the two years. But I think the range we've talked about is two to three years, and I don't think there's a big change in that.

Jim Giannakouros (Managing Director and Senior Analyst)

Okay, fair. I apologize if I missed it, but when you were talking about your sales rationalization in Europe, does that have more to do with duplicative SKUs in certain geographies or just low performers? Can you give us some specifics around where you're culling your offerings?

Dean Freeman (CEO and CFO)

Yeah, it's difficult for us to get into the specifics on that, given the early stages we are in the program. But it is a top to bottom, comprehensive assessment of SKUs, products, categories, and the discrete margin profiles across those categories. And then, obviously, taking a rationalization view of do we keep it, do we sell it, do we increase pricing? How do we rationalize across that portfolio to ensure that we've got the optimal product mix with the optimal margin profile that we're targeting? And, you know, over the years, I mean, it's one of the issues, if you think about the acquisitions and the integration of acquisitions over the years, there's just a lot of components, a lot of SKUs that generate low, or in many cases, no margin whatsoever.

And so that's all a part of this effort to better integrate as we leverage our Pan-European capabilities, as we try to leverage more cross-selling. Rationalizing SKUs is just a good, good, way to affect those, those initiatives, but also to expand margins.

Jim Giannakouros (Managing Director and Senior Analyst)

Understood. Thank you.

Operator (participant)

At this time, we have no further questions. I would now like to turn the call back over to Mr. Dean Freeman for any closing remarks.

Dean Freeman (CEO and CFO)

Okay, well, look, thanks, everybody. I know there was a lot to cover. I appreciate your interest. Thanks for the time, and we look very much to thank you for your continued interest in Watts and look forward to talking to you again on the first quarter earnings call in late April. Thanks, everybody.

Operator (participant)

Ladies and gentlemen, that concludes today's conference. Thank you for your participation. You may now disconnect. Have a great day.