Watts Water Technologies - Q4 2014

Transcript

Operator (participant)

Good morning, ladies and gentlemen, and welcome to the fourth quarter Watts Water Technologies Earnings Conference Call. My name is Corinne, and I will be your event manager for today. At this time, all participants are in listen-only mode. We will conduct a question-and-answer session towards the end of the conference. If at any time during the call, please key star zero if you require assistance, and we will be happy to help you. Just as a reminder, the call is being recorded for replay purposes. I have a safe harbor, which the company has asked me to read out to you. Please be aware that remarks made during today's conference 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 ending December 31, 2013, 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, as of today and should not be relied upon as representing its views of any future date. While the company may elect to update these forward-looking statements, it disclaims any obligation to do so. During the call, the speakers may refer to non-GAAP financial measures. These measures are not prepared in accordance with generally accepted accounting principles.

A consolidation of the non-GAAP financial measures to the most directly comparable GAAP measures is available in the press release dated Tuesday, February 17, 2015, relating to the company's fourth quarter, 2014 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 of Press Releases. Now, I would like to hand over to Tim MacPhee, Treasurer and Vice President of Investor Relations. Please go ahead, sir.

Timothy MacPhee (VP of Investor Relations)

Thank you, Corinne. Good morning, everyone, and thank you for joining our fourth quarter earnings call. Joining me today are Bob Pagano, our President and CEO, Ken Lepage, our General Counsel, and Ken Korotkin, our Corporate Controller and Chief Accounting Officer. Bob will begin by providing an overview of the year and provide color on the current market conditions. I will then discuss the financial results for both the full year and the fourth quarter. I will also update you on EMEA's transformation restructuring efforts. Bob will then provide an overview of our expected phase one actions regarding the Americas, Asia Pacific transformation project, and I will offer an initial outlook for 2015, highlighting some financial items to consider for this year. Bob will summarize, and then we will open up the call to your questions. Let me turn the call over to Bob Pagano.

Bob Pagano (President and CEO)

Thanks, Tim, and good morning, everyone. Turning to slide 3 in the deck, let me briefly provide an overview of this past year's performance. First, I want to recognize that in 2014, Watts celebrated its 140th anniversary. Quite an accomplishment. I believe the company's longevity is principally due to its people, customer focus, and history of innovation. Those foundations will remain a cornerstone of our efforts as we move ahead for the next 140 years. In 2014, we delivered record sales of just over $1.5 billion and record adjusted EPS, which was up 14% versus 2013 on a comparable basis, excluding the AERCO acquisition.

Our adjusted operating margins expanded by 70 basis points, again, on a comparable basis, and the team delivered strong free cash flow, which exceeded 2013 by 21%. This was accomplished despite a second-half sales decline in EMEA, driven by macro market forces, continuing pricing pressures both in Europe and in the Americas DIY channel, and continued inefficiencies encountered in our lead-free foundry. The lead-free foundry did begin to stabilize in the second half of 2014, as we got a better handle on the many potential manufacturing variables that could affect this unique foundry operation. We continued to execute on our various restructuring and transformation initiatives in EMEA, which helped to offset a broad sales reduction during the year. The cost savings realized by these actions and efforts helped expand adjusted EMEA operating margins despite a difficult market environment.

Our EMEA team has been extremely proactive in driving for results. In response to the recent market conditions, the team has initiated additional restructuring programs to better match our internal cost base with the external market environment. Tim will provide more details on those initiatives in a few minutes. As we've alluded to in our prior calls, we wanted to emulate the success of our EMEA transformation efforts in the Americas as well. Much of the data analysis is completed, and we are now in a position to start implementing the Americas transformation plan. This plan also affects our Asia Pacific operations because of captive production and sourcing initiatives undertaken for the Americas. I'll provide the highlights of this important effort in a few moments. Finally, in 2014, we maintained a balanced capital deployment strategy.

From a shareholder perspective, we increased the dividend payout by 16% and continued executing our share repurchase program, buying back almost $40 million in our Class A common stock during the year. In December, we purchased the shares of AERCO to expand our offering to include heat source products, a key platform adjacency to our existing portfolio. With respect to AERCO, integration is going very well. We've been very pleased with the way the teams are working together. It is still very early, but all indications are very positive. Moving to the markets, let's turn to Slide 4. Let's begin with the Americas. In general, the economy looks strong, consumer sentiment is high, and key indicators we look at for residential, like Wells Fargo data on housing starts and building sentiment, look encouraging.

On the commercial side, we see positive trends in the Dodge Momentum Index, ABI, and lending activity. In total, we saw solid growth in the Americas in 2014, and we believe this trend will continue in 2015. Now let's turn our attention to the EMEA markets. As we noted in our Q3 conference call, we saw the markets within Europe take a step backwards, and that trend continued during the fourth quarter as well. Although 2014 Eurozone GDP is forecasted to be positive for the first time in several years, we saw further contraction in France in the construction markets and market instabilities that affected our OEM HVAC customers in Germany, where we still are seeing wholesalers and OEMs sitting on excess inventories. The signs continue to be mixed into 2015.

Quantitative easing may help stimulate incremental activity, but instabilities in Greece, continued tensions in Ukraine, sanctions on Russia, and falling energy prices make forecasting difficult. We believe EMEA emerging markets will continue to be a good source of growth as infrastructure investment in the Middle East and Eastern Europe continue to grow. For the full year, emerging markets were down slightly, with prior year driven by the softness in the Middle East and Eastern Europe. Eastern Europe is driven by political unrest. The Middle East is project-driven, so we normally will experience lumpy growth quarter over quarter. With recent oil and currency swings, we believe there could be an impact on the project funding and the expected timing of those projects in the Middle East. Finally, let's discuss Asia Pacific. We had strong growth in Asia Pacific, albeit from a relatively small base.

This growth was through channel and territory expansion in China, despite some significant headwinds in the housing market. As everyone has observed, while China's economy has been slowing, it still remains one of the most active economies in the world. Most concerning from our standpoint is that the housing market in China appears to be contracting, with both home values and new housing projects declining. Despite the subdued macro environment, our market strategy has not changed. We continue to see demand in China for our localized products and our more highly engineered European and US-manufactured products. In addition, we see continued growth in Tier 2 cities, especially in key verticals such as hotels, office space, and data centers. We also see the heating market, which for us is about 70% retrofit, doing well.

Now I'll turn it over to Tim to talk about our operating results in more detail. Tim?

Timothy MacPhee (VP of Investor Relations)

Thanks, Bob. Moving to the financial highlights for the year, please turn to Slide 5. As Bob mentioned, consolidated revenue for the year was $1.5 billion, an increase of 2.7% over 2013. Organic growth was 2.6%, with increases in the Americas and Asia Pacific being partially offset by a reduction in EMEA. The effect of FX on sales year on year was negligible. AERCO sales, which represent only the month of December, were $5.3 million. December is seasonally a very slow period for AERCO, so the December sales result does not represent a good gauge for AERCO yearly sales.

Adjusted operating profit for 2014 on a comparable basis, excluding the AERCO acquisition, was $153.6 million, a $13.4 million increase, or 9.6% over 2013. Adjusted operating margin, again, excluding AERCO, was 10.2% for 2014, a 70 basis point improvement over last year. The Americas operating margin increased 110 basis points on solid operating leverage from incremental sales, some net wholesale pricing, and cost containment actions. EMEA's margins expanded 70 basis points over 2013 from savings derived from its continued transformation and restructuring efforts. Corporate costs increased during the year by $2.2 million, as both people-related costs, compliance and professional fees increased year over year.

The incremental increases in foundry costs in 2014 were mostly offset by a reduction in product liability expenses year-over-year. Adjusted EPS, excluding AERCO, for the full year 2014, was $2.52, a record and an increase of about 14% over 2013. The effect of the share repurchase program and the effect of FX essentially offset one another during the year. GAAP earnings for the year included approximately $48 million in restructuring special items that reduced GAAP EPS by $1.09. The details are highlighted in Table 1 of our press release.

The bigger items include restructuring costs in EMEA, in the Americas relating to both new and legacy actions, and a $12.9 million goodwill write-off in Asia Pacific that was triggered by the expected impact of the transformation exercise. Please note that we could not provide the tax benefit against the goodwill charge, hence part of the reason for the higher tax rate recorded in 2014 versus last year on a GAAP basis. Also last year, the effective tax rate was reduced by a positive change in Denmark's statutory tax rate. Now, turning to Slide 6, let's review some of the highlights for the fourth quarter. Revenue was $376.5 million, essentially flat with Q4 of 2013.

Organic growth was 2%, with increases in the Americas and Asia Pacific being substantially offset by a reduction in EMEA. FX was negative as compared to Q4 last year by 3.2%, and AERCO acquisition was a positive 1.3% to sales. In the Americas, quarterly wholesale sales were up 7.5%, OEM was up about 16%, and DIY was down 3.7% as compared to Q4 last year. In EMEA, wholesale edged up 1.7%, but was more than offset by an OEM decline of 12.8%. Asia Pacific sales were driven by valve and heating product sales. Adjusted operating profit for 2014, for the fourth quarter, and excluding the AERCO acquisition, was $35.5 million, a decrease of 3.3% versus last year.

Our consolidated adjusted operating margin of 9.6% was 20 basis points lower than Q4 last year. EMEA's operating margin dropped 100 basis points to 10.1%, mainly on the reduction in sales volume quarter-over-quarter and from some incremental bad debts. The Americas operating margin, excluding AERCO, expanded by 100 basis points to 12.6% against Q4 2013. Recall that we had a $3 million rebate charge in Q4 2013 to adjust the results last year. Excluding the rebates, Americas operating margins would have declined quarter-over-quarter by approximately 10 basis points. This lower margin was driven by lower plant absorption as we drove inventories down in Q4, where inventories were actually increasing in Q4 last year, and from incremental E&O, excess and obsolete inventory charges. Corporate costs also increased quarter-over-quarter.

Adjusted EPS, excluding AERCO, was $0.59 in Q4, a $0.02 or 3.5% increase over Q4 2013. Foreign exchange was a $0.03 headwind this quarter related to the strengthening of the US dollar against both the Euro and the Canadian dollar. Our adjusted tax rate was favorable in the quarter, as this included some benefits from the EMEA transformation, along with a positive one-off benefit. In last year, the effective tax rate included some one-off charges for a tax law change in France and various negative corporate provision adjustments. GAAP earnings in Q4 included $34.6 million in restructuring costs and other special items, which equates to $0.80 in EPS. Again, the details of these items are highlighted in Table 1 of our press release.

The bigger items in the quarter include the restructuring costs in EMEA, relating mainly to a new set of initiatives that I will discuss shortly, and the $12.9 million goodwill write-off in Asia Pacific. As mentioned, we could not provide a tax benefit against the goodwill charge, so that is why, on a GAAP basis, a tax charge has been recorded despite having a pretax loss in Q4. Slide 7 provides a snapshot of our primary working capital as compared to last year. Please note the 2014 balances exclude AERCO to provide a comparable analysis. Working capital as a percent of sales has decreased, and primary net working capital is down in 2014 due to better collection efforts and a concerted effort in Q4 to reduce inventories in both the Americas and Europe.

Payables decreased as a result of the inventory reductions and timing related to some purchases in CapEx. FX fluctuations decreased net primary working capital by about $19 million year-over-year. Now, in Slide 8, a few points on cash flows for the year. First, free cash flow was approximately $112 million, a 21% increase over last year, driven by lower working capital and reduced capital spending. This translates into a free cash flow conversion rate of 222.5% for 2014. Secondly, we repurchased $39.6 million of our common stock in the open markets during the year. About 670,000 shares were repurchased. This repurchase spend is in line with our current program. The net effect of the share buyback program was minimal for the year.

As Bob mentioned, we increased our dividend payout by 16% year-over-year as part of our capital allocation strategy. Finally, if you move to Slide 9, let me update you on our transformation and restructuring initiatives in EMEA. For the ongoing transformation and restructuring efforts, both are moving ahead as planned. 2014 savings of $4 million for the restructuring plan are in line with the expectations, and all costs are now fully spent. The transformation net savings increased about $1 million in 2014 for accelerated tax savings that were realized. Forecasted net savings in 2015 for both programs have been reduced by a total of $2.2 million, mostly related to a weaker Euro. Recently, the EMEA team proactively initiated a series of cost-saving measures to address the current market environment.

Total costs for the 2015 programs will approximate $12.1 million, of which about $10.7 million are P&L charges and $1.4 million will be for capital spend. The P&L charge includes $9 million for expected severances and the remainder for non-cash asset impairment charges and accelerated depreciation. When completed, the program will save approximately $4.7 million annually. That'll be in 2016. But 2015, the savings are estimated to be about $1.2 million. These initiatives are broad-based across Europe. The savings is smaller this year because of the expected time required to coordinate and vet the plans with local workers, councils, and government agencies.

For GAAP purposes, in Q4 2014, we took a $7.8 million restructuring charge for these programs, mainly related to severance costs. With that, I'll turn it back over to Bob.

Bob Pagano (President and CEO)

Thanks, Tim. So turning to slide 10, I wanna update you on the Americas and Asia Pacific transformation efforts. As I conveyed during our last call, in September, we began an assessment of our Americas business platform in order to explore different commercial and operational improvements that could be made to drive both near-term and long-term shareholder value. This process was similar to the efforts we undertook in our EMEA transformation initiative last year. Based on our assessment, we have now developed an action plan, which will be executed in two phases. The first phase will focus on driving both commercial excellence and global sourcing. Phase two involves a broader review of our existing operational footprint in the Americas. We are finalizing the data related to phase two, and we'll update you at our Q1 earnings call.

Recall, by commercial excellence, I mean, we want to invest in product innovations that meets the wants and needs of our customers and our end markets. We want to focus on differentiated products that will provide greater opportunity with ourselves in the marketplace and migrate away from products that we cannot add value to. We want to strive to be a solutions provider, not merely a component supplier. As part of the assessment, we performed an exhaustive review of our existing Americas product portfolio. Based on that review, we have commenced a portfolio rationalization effort focused on removing products that are not considered value-added by the markets, and in turn, do not add value to our operating margins. Our retail customers will be most affected by this effort. We certainly will work with all our affected customers to ensure a smooth transition.

Given that we are just announcing this decision today, I'm not going to go into the finite details of our plans, as we are now in the process of discussing this decision with our customers and our employees that are affected. As we transition from this business, we are reviewing different strategic alternatives to minimize disruption to all of those involved. In addition, we initiated an incremental Americas sourcing program to drive efficiencies in our supply chain. Included in the initiative was a comprehensive review of our existing processes and resources. The team reviewed many of our existing programs and made recommendations for purchase decisions, ranging from castings, to machine parts, to filtration products. On slide 11, you'll find a summary of the expected financial impact of phase one.

We expect that between $175million-$200 million of low-margin product sales will be eliminated from our portfolio by the end of 2016. We have already rationalized approximately $23 million in annualized sales to date, and we expect by the end of 2015, between $80million-$100 million in sales will have been eliminated from our 2014 run rates. We then expect an incremental $75million-$120 million of sales will be eliminated in 2016. Regionally, most of these sales reductions will affect the Americas. These estimates represent our best estimate right now, and the timing of the lost sales certainly can and likely will be affected by how customers react to the news and how quickly they are able to transition.

One thing to bear in mind, the legacy fixed costs supporting these sales will take time to remove, especially since we expect to support customers through this year. For 2015, we anticipate that losses generated from the sales reduction will be higher due to the lag in eliminating the related fixed costs. We estimate that the losses from existing sales for 2015 will drop through it between 15%-20% of sales. We anticipate that in 2016, that loss drop-through will be less, in the mid-single-digit range. We will have exited the majority of those stranded costs by the end of 2015. Total costs expected to be incurred regarding phase one will approximate $40 million-$50 million.

Cash costs, which include severances and other transitional costs, are estimated at $15million-$20 million. Non-cash costs, which include asset impairments, accelerated depreciation, and write-downs, are expected to total approximately $25million-$35 million. We recognized $13.4 million in Q4 for the write-down of goodwill and other intangible impairments related to the transformation. The remainder of the costs, both cash and non-cash, are expected to be incurred in 2015. All these costs will be identified as special items when we report future results. Global sourcing initiatives are expected to provide about $4 million in incremental savings in 2015, and incremental $4 million in 2016, and ultimately provide $10.5 million in run rate savings by 2017. Hard savings related to the product rationalization effort is minimal.

The real effect of the rationalization exercise should change the margin profile of our businesses, helping to expand our margins by allowing our teams to focus on core products and solutions where we can bring the most value to the marketplace. We estimate our efforts in phase one, by itself, should expand our consolidated operating margins in 2017 by approximately 150 basis points over 2014's adjusted operating margins of 10.2%. We expect to realize approximately 100 basis point expansion on a consolidated basis by 2016, again, over 2014 consolidated adjusted margins. Near term, we anticipate 2015 will be a transition year.

Our expectation is that any phase one product mix benefits and sourcing savings will be significantly offset by incremental costs to help transition customers and inefficiencies in both manufacturing and distribution fixed costs. The phase one decision was critical in our overall transformation efforts. Now that we know the businesses we're staying in, we can now move into phase two, which will allow us to optimize our future footprint. I'd like to now turn it back over to Tim to give you an overview of how we see 2015 shaping up.

Timothy MacPhee (VP of Investor Relations)

Thanks, Bob. Now, if you turn to slide 12, let me give you an overview of how we see 2015 going. Looking at sales, we expect organic growth in the Americas of between 4% and 6% over 2014, excluding AERCO and excluding the effects of the sales of the transformation effort and potential negative FX related to the Canadian dollar. At this point, we estimate the Canadian dollar will negatively impact overall Americas sales between 0.5% and 1% year-over-year. In EMEA, where the markets are much more uncertain, we estimated organic reduction in sales year-over-year between 1% and 3%. We're conservatively planning for our markets to be down 1%-3% overall, and we are also assuming approximately a 1% sales reduction due to product rationalization efforts.

With the introduction of some new products, cross-selling efforts, and the expansion of our drains platform, we expect to offset the rationalization effect. From a phasing perspective, we expect tougher sales comps in EMEA in the first half of 2015, as the first half last year was fairly strong for the region. In Asia Pacific, we are expecting organic top-line growth of around 20%, excluding the effect of any transformation exercise. We expect AERCO sales to increase by 10% from its 2014 run rate of approximately $100 million. Note that AERCO's Q1 and Q4 are typically slower periods. In fact, AERCO typically earns about 80% of its profits during the second and third quarters of the year. So please keep that in mind when you're adjusting your models.

To reiterate, we anticipate eliminating between $80 million and $100 million in sales over this year as part of the transformation effort. As Bob mentioned, we have already exited $23 million of the $80 million to $100 million in sales, all related to the Americas segment, but with operational impacts to Asia Pacific. So that sales loss is already in the Q1 run rate of the business. Other items to consider, FX will negatively impact our 2015 operating results. Our current estimate is EPS will be impacted between $0.25 and $0.30, including both translation and estimated transaction costs. Our analysis assumes current market foreign exchange rates and also assumes that those rates hold for the year.

As we have mentioned before, we estimate that every point movement in the Euro rate will affect our EPS by approximately $0.01. We anticipate spending between $30million-$35 million in capital in 2015, an increase over previous years, which includes a broad upgrade of our existing equipment with a focus on improving productivity and supporting our strategy. Depreciation and amortization charges are expected to be between $55million-$60 million. We expect our global tax rate for 2015 will be between 31%-33%, similar to 2014. We expect tax savings from the EMEA's transformation process will be offset by the mix in global earnings weighted toward the U.S., which is a higher tax jurisdiction.

During our last call, we discussed some expected incremental costs to stock compensation, pension, and bonuses that could be a headwind in 2015. Having recently completed our 2015 operating plans, we have finalized those costs. Recall, we had identified about $11 million of incremental costs to our 2014 run rate. We have refined that number to about $13 million, which includes the three components previously discussed, plus some additional recruiting, relocation, and compliance costs we need to undertake in the first half of 2015, related to the hiring of a new CFO and to meet the latest COSO and SOX requirements. We are finalizing our CFO search process and hope to have someone on board within the next two months.

We anticipate completing our existing share repurchase program through the third quarter of 2015. We will update our expectations about further repurchases during the Q1 conference call. Interest expense on the AERCO acquisition debt will approximate $5.5 million-$6 million for the full year, and we hope to settle our pension liability during the latter half of 2015. The gating factor is the final IRS approval. Once approval is received, we have up to 120 days to liquidate our obligations. We estimate that we will incur a one-time special settlement P&L charge of between $55 million and $65 million, with estimated cash costs of $40 million-$45 million. Our best guess now is that we will recognize the accounting charge and related cash expenditures in Q4, but timing could be accelerated or delayed.

It depends on when the IRS provides its approval. So the takeaway is we expect 2015 to be another good year. However, it will be a transition year, especially from a reporting perspective. With the announcement of the Americas transformation effort, 2015 quarterly results may fluctuate significantly. The rate at which we lose the undifferentiated sales is intrinsically tied to the affected customer's ability to transition to other suppliers. And as Bob mentioned, the net margin effect in 2015 on the product mix enhancement and sourcing savings will be more than offset by stranded costs related to the transitioning out of these products. So let me turn it over to Bob, who will provide his summary.

Bob Pagano (President and CEO)

Thanks again, Tim. To summarize, we were able to deliver a solid year-over-year performance. We did this through increased sales volumes in the Americas and cost savings driven by the various initiatives in EMEA and general operating cost controls. We completed a strategic acquisition by purchasing AERCO, which provides us a new avenue for growth and expansion. The foundry operations started to stabilize in the second half of 2014. Delivering a solid year is only the start. We want to expand our product offerings, be innovative in the marketplace, and drive operational efficiencies throughout our organization. Our key next focus will be to execute on the Americas and Asia Pacific business transformation program. This will reshape our business, enhance our margin profile, and focus our efforts on our core value-added products.

The actions we have taken and will take this year will serve to drive shareholder value by allowing us to significantly improve operating margins and ROIC. So with that, operator, can you open the lines for questions?

Operator (participant)

Thank you. Ladies and gentlemen, if you wish to ask a question, please press star, followed by one on your touchtone telephone. If your question has been answered or you wish to withdraw your question, please press star followed by two. So star one to begin. Please stand by for your first question. Your first question comes from Kevin Maczka of BB&T Capital Markets. Please proceed.

Kevin Maczka (Managing Director and Senior Equity Research Analyst)

Thanks. Good morning.

Bob Pagano (President and CEO)

Good morning.

Timothy MacPhee (VP of Investor Relations)

Hey, Kevin.

Kevin Maczka (Managing Director and Senior Equity Research Analyst)

Can I ask a couple of questions on this, on this sales elimination? I guess, first question is: You're going to do $80 million-$100 million this year. Did you say you'll be at that full run rate in Q1? Or is this something that gets phased in over the course of a year, and it's more back-end weighted?

Bob Pagano (President and CEO)

I think it's going to be phased throughout the year. What we did say is, of that run rate, we know that, we've already rationalized $23 million of that already.

Kevin Maczka (Managing Director and Senior Equity Research Analyst)

Okay. And then I mean, I would assume that these are lower-margin products that you don't make much, if any, money on, but I think I heard you say expect a 15%-20% decremental on those sales, which would mean this is about a $0.30 or so earnings hit this year. Can you just talk about why those decrementals would be as much as 20%?

Bob Pagano (President and CEO)

Sure. I mean, you're right that it's low-margin business at the start, and if we exited 100% of it immediately and all the costs associated with it, you know, it would drop much less. But, what's happening is because the timing of when we can shed the fixed costs, as well as support our existing customers during that transition, you know, it's dropping more at the gross profit level versus the operating income level. So, you know, it's going to impact us more. But the whole goal is to transition all the costs out by the end of this year. So that's why I said, as you look into the following year, in 2016, you're going to see less of an impact on the operating margin drop.

Kevin Maczka (Managing Director and Senior Equity Research Analyst)

Okay, got it. And then just one on the phase one, Americas and Asia Pac. I guess, is the $10.5 million savings, is that all coming on the sourcing side? And the sourcing benefit that you expect in 2015, the $4 million, I mean, it doesn't seem like a huge number for a company with almost a billion-dollar cost of goods line. And I would think maybe, maybe things like lower copper alone could, could give you some pretty material savings next year. Can you just address that point?

Bob Pagano (President and CEO)

Yeah, Kevin. So we look at sourcing in three buckets, right? You know, we have normal sourcing that's tied to commodity prices, and, you know, that's excluded from this decision. We've also had a transformation effort in Europe that also has included sourcing. So you're correct, we do have a large focus on global sourcing, but, you know, this initiative, all by itself, was to look at consolidating our capabilities and look at different sourcing. So it takes longer to implement. So, you know, we have all three of them built inside of our numbers, but this was incremental to what we've done in the past, and hopefully, that answers your question.

Kevin Maczka (Managing Director and Senior Equity Research Analyst)

Okay, great. Thank you.

Bob Pagano (President and CEO)

Thank you.

Timothy MacPhee (VP of Investor Relations)

Thanks.

Operator (participant)

Thank you. Your next question comes from Jeff Hammond, KeyBanc Capital Markets. Please proceed.

Jeff Hammond (Managing Director and Senior Equity Research Analyst)

Hey, good morning, guys.

Bob Pagano (President and CEO)

Good morning, Jeff.

Timothy MacPhee (VP of Investor Relations)

Hey, Jeff.

Jeff Hammond (Managing Director and Senior Equity Research Analyst)

Hey, so just to follow on the sales transformation, why not sell the business versus kind of exit? And, you know, it looks like you're, you know, kind of just going through the math, you're losing kind of $15 million in op profit as you transition out. Yeah, how do you see yourself, you know, replacing that through other means?

Bob Pagano (President and CEO)

Well, yeah, we've looked at all alternatives, and we're continuing to look at it. It's a low-margin business, and when you look over the history, we look for the last five years, and what we've seen in this business and margins continue to deteriorate. So we made the strategic decision to take the action now, and, you know, we'll look at all alternatives. But, given the disparity of the business in all the different locations, we believe that it may be difficult to do that, so we may be selling assets at that point in time, Jeff. When we look at replacing that, certainly through acquisitions such as Aerco, as well as really focusing the team internally on organic developments and leveraging our talent, you know, to look on creating our own differentiated products, which was really the core of our business.

So we'll continue to do that, but now is the time to exit this business where we could take control of it, make the decisions, and drive the changes in our organization. And as I said, you know, it was critical for us to make the strategic decision on which businesses we wanted to be in. Because once you do that, you then can now begin optimizing your footprint and distribution channels.

Jeff Hammond (Managing Director and Senior Equity Research Analyst)

Okay, great. So, and then just on FX, struggling a little bit with the, with the drop through or the, the earnings impact. Can you just walk through what you think the revenue headwind is, and then, you know, maybe how to think about translation versus transaction?

Timothy MacPhee (VP of Investor Relations)

Yeah, sure. The way we're looking at it, Jeff, is from an EPS perspective, maybe it's an easier way to look at it, is with the Euro, right now, we think we have about a $0.20 headwind. And that's the difference between, you know, the current rate that I used was about 1.14, versus our average rate in 2014 was about 1.34. So to us, as we mentioned before, it's about, you know, for every one point movement in the rate, it's about $0.01 to us in EPS. So it's about $0.20 on the Euro. There's probably another $0.03-$0.04 relating to the Canadian dollar year-over-year.

Then finally, within the $0.25-$0.30 is transaction effect year over year. We think we'll have some transaction effect to the tune of, you know, a few pennies year over year. So that's why we're in the $0.25-$0.30-cent range on an EPS—from an EPS perspective.

Jeff Hammond (Managing Director and Senior Equity Research Analyst)

What do you think is the rev-FX revenue headwind all in?

Timothy MacPhee (VP of Investor Relations)

Probably, from a percentage perspective, probably 13%-14% year-over-year.

Jeff Hammond (Managing Director and Senior Equity Research Analyst)

On the Euro, on the Euro business?

Timothy MacPhee (VP of Investor Relations)

Yeah, on the Euro business.

Jeff Hammond (Managing Director and Senior Equity Research Analyst)

Okay, and then just finally, back to Kevin's question on sourcing. Can you just maybe, Bob, let us know what, all in, you know, as you look at kind of the three ways you've kind of gone after sourcing, what kind of the total savings is where, you know, as you kind of incorporate this new $10.5 million piece? Thanks.

Bob Pagano (President and CEO)

Well, all in, you know, we don't give specifics in total by each, you know, commodity and every item because it's a net cost number. One of the things I will tell you, though, that from a copper perspective, we are seeing favorability there, especially in the Americas, offset by steel a little bit. But the unique thing of copper inside of our EMEA, it's actually a slight headwind or headwind in that, you know, the copper commodity is, you know, done in US dollars, and with the, you know, copper has come down, but the Euro's come down even further, so it's actually a small tailwind or a headwind for them. So when you look at overall, you know, we shoot for world-class purchasing savings inside our organization.

That's what our teams are driving for, and we'll continue to drive for those gross cost savings, offset by the net inflation.

Jeff Hammond (Managing Director and Senior Equity Research Analyst)

Okay, thanks, guys.

Bob Pagano (President and CEO)

Thanks.

Timothy MacPhee (VP of Investor Relations)

Yeah.

Operator (participant)

Thank you. Your next question comes from the line of Joe Giordano from Cowen and Company. Please proceed.

Joe Giordano (Managing Director and Senior Equity Research Analyst)

Hi, guys. Thanks for taking my question. Just one quick clarification on the, on what you said on the Euro. Is it every penny of Euro decline is a penny of EPS, or every, like, 1% decline is a penny of EPS?

Timothy MacPhee (VP of Investor Relations)

Every penny of Euro decline is a penny to our EPS.

Joe Giordano (Managing Director and Senior Equity Research Analyst)

Okay. Okay, that's what I thought. Okay, great. And then can you guys kind of talk a little bit about management bandwidth to handle... I mean, there's, like, four programs going on now. You're looking to, for a, you know, full-time CFO. How do you guys look at handling everything that's on the plate right now?

Bob Pagano (President and CEO)

So, Joe, you know, we look at that before we start any initiative. The EMEA team is well staffed to handle their transition and transformation. We have strong project management capabilities. We even relocated the project management PMO officer from EMEA to lead our North America efforts. So we're bringing in outside help where we need it, but we believe we're fully staffed to do this. We have brought in a new supply chain person on board. He's been on for almost a year now, and he's developed a new team to implement our global sourcing initiatives and all around the world. And finally, on the CFO search, as Tim alluded to, we're real close to finalizing our search.

You know, and we hope to have someone on board in the next couple of months, and I think you guys will be pleased with the individual who we're thinking about. So stay tuned for that. So all in all, I feel confident in our ability to execute this. Teams are focused, they're all organized and deployed and ready to go, and we'll bring in outside help where we need to supplement that. But right now, all the action plans are loaded, and we're ready to implement beginning at 11 o'clock today.

Joe Giordano (Managing Director and Senior Equity Research Analyst)

Okay, great. And then two kind of, like, housekeeping ones. One is the $13 million in incremental spend, that's off, like, that $35 million corporate number for 14, right?

Timothy MacPhee (VP of Investor Relations)

You have to spread that out. About $6.5 million is corporate, Joe. Now, the $5 million would be in the Americas, $1 million is in EMEA, and then about $0.5 million is in Asia Pacific.

Joe Giordano (Managing Director and Senior Equity Research Analyst)

Okay, great. And then lastly for me, you, you mentioned EMEA on the, on the guidance for 1%-3% organic decline, and then I thought I heard you mention 1% of a rationalization also. So is that like a 1% rationalization decline on top of a 1%-3% organic decline of the go-forward business?

Timothy MacPhee (VP of Investor Relations)

Yes.

Joe Giordano (Managing Director and Senior Equity Research Analyst)

Okay.

Bob Pagano (President and CEO)

But offsetting that is our new product development and new innovations that have been launched. So-

Joe Giordano (Managing Director and Senior Equity Research Analyst)

Right.

Bob Pagano (President and CEO)

You know-

Joe Giordano (Managing Director and Senior Equity Research Analyst)

Which you think will offset those percent?

Bob Pagano (President and CEO)

Yeah, the two offset.

Timothy MacPhee (VP of Investor Relations)

The two offset.

Joe Giordano (Managing Director and Senior Equity Research Analyst)

Okay. Great. That does it for me. Thanks, guys.

Bob Pagano (President and CEO)

Thank you.

Timothy MacPhee (VP of Investor Relations)

Thank you.

Operator (participant)

Thank you. Your next question comes from the line of David Rose, Wedbush Securities. Go ahead, please.

David Rose (VP and Senior Equity Research Analyst)

Good morning. Just a couple of housekeeping items. Should we expect any, you know, inventory obsolescence, going forward? I mean, did you have any write-down in Q4 for the product rationalization? And should some of that go into 2015?

Bob Pagano (President and CEO)

So when we look at, we had some small E&O write-offs inside of Q4. I think Tim talked about that. As we look in our overall rationalization approach, we've covered some feeling of some E&O inside of the numbers we provided, but our goal is to sell all of it, as much of it as we can during the process, so or sell it as part of the product or asset set.

David Rose (VP and Senior Equity Research Analyst)

Okay, that's helpful. And then, you know, I don't. It sounds like we're pretty much finished on the foundry, but what are the remaining challenges you have left on the foundry, so we don't talk about it anymore?

Bob Pagano (President and CEO)

Well, I was hoping to get away again, another meeting without talking about the foundry. But I must tell you, you know, the fourth quarter was our best performance of the year. It's stabilized. I really think the next step of the foundry is really beginning to add volume and, you know, continue to drive future growth inside of there. So the teams are working. Now that we've stabilized the process, which we've done for several months now, just we have seen the steady improvement, we can throw more volume inside of that and start leveraging it. But again, we're doing it slowly and cautiously because we don't want to disrupt what we've already accomplished. So we've stabilized it. We have backup capabilities now in all our processes and the teams moving slowly but surely, and I think that's what it's gonna take.

Anytime we throw large volumes in it, it disrupts the process. So we're slowly gearing it up, and that's what we'll continue to do for the rest of the year. So as far as we're concerned, you know, that's a non-issue, let's hope, at least, internally for us. We're just focused on the continued improvement, more of a continuous improvement process.

David Rose (VP and Senior Equity Research Analyst)

Okay. And then that's helpful. And then lastly, can I assume that the byproduct of all this rationalization, apart from enhanced margins, is better working capital?

Bob Pagano (President and CEO)

That's all part of the whole structure. The whole structure, you know, again, as we move into phase two, that's another part of how we distribute our whole distribution strategy. And yes, inventory, inventory turns is a key focus of our initiative as we drive and grow our ROIC.

David Rose (VP and Senior Equity Research Analyst)

Do you have a goal for us for 2015 or 2016 on that front?

Bob Pagano (President and CEO)

Stay tuned, because I really want to talk about phase two and the impact of that on it. So, certainly, we have our stated goals that you're well aware of, 12 and 12, 12% operating margin and 12% ROIC on an adjusted basis, but our goals are certainly north of that.

David Rose (VP and Senior Equity Research Analyst)

Okay, great. I'll stay tuned. Thank you.

Bob Pagano (President and CEO)

Thank you.

Operator (participant)

Thank you. Your next question comes from the line of Jim Giannakouros from Oppenheimer. Please go ahead.

Jim Giannakouros (Managing Director and Senior Analyst)

Good morning.

Bob Pagano (President and CEO)

Morning, Jim.

Timothy MacPhee (VP of Investor Relations)

Hi, Jim.

Jim Giannakouros (Managing Director and Senior Analyst)

Just not to focus too much on the near-term earnings reset as you transition, what appears to be primarily your retail exposure. I know you don't give guidance, Bob, but can you speak to your longer-term vision, whether it be a three or five year plan, as far as, like, a sales margin, earnings target? Basically, you know, thinking, just trying to think about where you think the underlying earnings power of what you're trying to create at Watts will be. Appreciating, of course, you know, that you've captured some of that in your phase one detail.

Bob Pagano (President and CEO)

Yeah. Well, David just asked that question, I mean, in a different way. But really, look at, you know, we're a premier company. We're number one or two in most of the markets and brands we serve, and I believe we need to command a premier operating margin in our ROIC. So that's our focus, that's our goal, and this is a critical step. This business that we're exiting has been an anchor on us, and it's been slowly eroding, and it's really had the, you know, it's really defocused our organization on our core and what makes us great. So we wanna refocus on that core. I said our 12% operating margin goal that we talked about, we see that in the future very soon. And we believe we should have the opportunity to significantly increase that going forward.

So we need it's real critical that we transform this portfolio. We'll continue to look at doing and deploying our capital in a disciplined way and look for acquisitions such as AERCO, that has high EBITDA margins, and, you know, that's what we're focused on.

Jim Giannakouros (Managing Director and Senior Analyst)

Okay, understood. And, and just so I understand, your phase two correctly, that will be primarily or all on the expense side, and, and you've identified the sales impact, predominantly in your phase one. Is that, is that the way to think about it?

Bob Pagano (President and CEO)

Yeah. Phase one is the sales and the product rationalization. Phase two really gets in more about our footprint. You know, what is the proper footprint now to serve the businesses we're in, and the proper distribution channels and strategies inside of that with our warehouses and distribution channels. So that's what the next step is, and, before you could make that decision, we had to make the first decision to make, you know, determine what business we're, we were gonna be in.

Jim Giannakouros (Managing Director and Senior Analyst)

Got it, okay. And then one last one, if I may. In Europe, you've been at it now for a couple of years on the transformation. I know that some or many of the benefits there have been on the tax line, with more to go. Could you just give us an idea of, at this point, where your tax rate is in the region versus what I imagine is a mid- to high thirties in North America?

Timothy MacPhee (VP of Investor Relations)

Yeah, I think right now, Jim, we're probably in the 28%-29% range.

Jim Giannakouros (Managing Director and Senior Analyst)

Okay, thank you.

Bob Pagano (President and CEO)

Thank you.

Operator (participant)

Thank you. Your last question comes from the line of Kevin Bennett of Sterne Agee. Thank you. Go ahead, please.

Kevin Bennett (Equity Research Analyst)

Hey, good morning, guys.

Bob Pagano (President and CEO)

Morning, Kevin.

Kevin Bennett (Equity Research Analyst)

Bob, first question, I wanna ask about your EMEA guidance for a sales decline of 1%-3%. You know, we've been down 5%, I guess, the last couple of quarters, and I'm just wondering, what gives you confidence that it'll only be down 1%-3% next year?

Bob Pagano (President and CEO)

Well, I think, because it was down five in Q3 and Q4, the team is, you know, really... You know, I think we're gonna have a tough Q1 and Q2 comps, because really what we saw at that point in time was a lot of building of inventory for an assumption of a, you know, a growth inside of the third and fourth quarter, which never materialized. So I think there's inventory adjustments going on. I think some of the inventory adjustments, you know, happened in Q4 in particular. So I think now that, you know, I think we'll probably see that in Q1 again this year. But the goal really here is, you know, we believe that there's opportunities to grow internally.

We're assuming a conservative marketplace, so we don't get our cost structure, and that's why we took the additional actions just in case it doesn't materialize. So we're watching it closely. I'll tell you, we feel good about our drains business. That's starting to grow. We see orders in the pipeline. Some of our emerging market stuff is starting to break. So the core concern, as you can imagine, is Germany, Italy, and France. Those are our key areas. We're focused real tight on those areas and watching that very closely. So all in all, you know, we netted the pluses and minuses, and we think we'll be in the 1%-3% range, considering all those things.

Kevin Bennett (Equity Research Analyst)

Okay, that makes sense. And then, you know, in terms of M&A, you know, how high would you guys be willing to go on the leverage side if another AERCO came along?

Bob Pagano (President and CEO)

Well, you know, we don't speculate on things like that. We certainly will look at all opportunities that come our way that make sense to us from a strategy point of view. That's the first gate. Does it make sense? Does it tie to our overall strategy in the company? Does it add value added, and how does it fit into the overall structure of the company? So, you know, we'll look at any and all acquisitions, but I can assure you we're gonna be disciplined in making sure you know, that we have the bandwidth to manage an acquisition and integration, given all the things that we have going on right now.

So our key focus right now is to integrate the acquisition we have, which is going very well, and, you know, implement, in particular, this North America transformation plan, which I think has significant value to be had on that. So that's our key focus right now, Kevin.

Kevin Bennett (Equity Research Analyst)

Okay, that makes sense. I guess a different way to ask it, I mean, you know, in terms of, you know, debt to cap or net debt to cap, I mean, do you have a range that you'd like to be in or that you're comfortable with?

Timothy MacPhee (VP of Investor Relations)

Right now, Kevin, I think we're between... We'd like to be between 35% and 45% debt to cap.

Kevin Bennett (Equity Research Analyst)

Okay.

Timothy MacPhee (VP of Investor Relations)

Right now-

Kevin Bennett (Equity Research Analyst)

Got it.

Timothy MacPhee (VP of Investor Relations)

We're probably high 30.

Kevin Bennett (Equity Research Analyst)

Okay, thanks, Tim. And then last question for me. On the pension settlement, you know, how much do you guys expect to save in the future by doing this?

Timothy MacPhee (VP of Investor Relations)

If it gets settled this year, which we hope it does, you know, we expect to save approximately $4.5 million-$5 million.

Kevin Bennett (Equity Research Analyst)

Is that per year or just overall?

Bob Pagano (President and CEO)

Yeah, our costs go down starting in 2016.

Timothy MacPhee (VP of Investor Relations)

Costs go down in 2016, yeah, by $4.5 million.

Kevin Bennett (Equity Research Analyst)

Gotcha. Okay, perfect. Thank you, guys.

Bob Pagano (President and CEO)

Thank you.

Operator (participant)

Thank you, ladies and gentlemen. I would now like to turn the call over to Bob Pagano for closing remarks.

Bob Pagano (President and CEO)

In closing, I'd like to thank you for taking the time to join us today for our Q4 earnings call, and we very much appreciate your continued interest in Watts Water. We look forward to speaking with you again during our Q1 earnings call. Thank you very much.

Operator (participant)

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect and have a good day.