Watts Water Technologies - Q4 2016

Transcript

Operator (participant)

Good morning. My name is Lindsay, and I will be your conference operator today. At this time, I would like to welcome everyone to the Watts Water Technologies Incorporated fourth quarter 2016 earnings conference call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question-and-answer session. If you would like to ask a question during this time, simply press star, then the number one on your telephone keypad. If you would like to withdraw your question, press the pound key. Thank you, Mr. Timothy MacPhee, you may begin your conference.

Timothy MacPhee (Head of Investor Relations)

Thank you, and good morning, everyone, and welcome to our fourth quarter and full year 2016 earnings conference call. Joining me today are Bob Pagano, CEO and President, and Todd Trapp, our CFO. Bob will discuss our key accomplishments in 2016, provide an overview of our fourth quarter results, discuss our 2017 goals, and address the macro markets. Todd will offer his detailed analysis on our fourth quarter and full year results and provide our initial outlook for 2017. Bob will then summarize our discussion, and following our prepared remarks, we will address questions related to the information covered during the call. Today's webcast is accompanied by a presentation which can be found in the investor relations section of our website. We will reference these slides throughout our prepared remarks.

For purposes of today's call, all references to key performance metrics will be on an adjusted basis unless otherwise indicated, and non-GAAP financial information and metrics have been reconciled and are included in the appendix section of the presentation. Before we begin, I'd like to remind everyone that in the course of this call, to give you a better understanding of our operations, we'll be making certain forward-looking statements. These statements are subject to numerous risks and uncertainties could cause actual results to differ materially from such statements. For information concerning these risks and uncertainties, see Watts Water's publicly available filings with the SEC. The company disclaims any intention or obligation to update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise. Now, let me turn the call over to Bob Pagano.

Robert J. Pagano Jr. (CEO and President)

Thank you, Tim, and good morning, everyone. We're on slide 3 in the earnings call presentation, where I'll provide an overview of this past year and initial thoughts on 2017. 2016 was a transformational year for Watts. We made excellent progress on many initiatives that we identified as important to our future success. Financially, our efforts delivered a record performance in Adjusted operating margin and adjusted EPS for the full year. Now, let me briefly comment on our quarterly results. Our fourth quarter performance was in line with the outlook we provided in November. We expected and achieved marginal sequential improvement in organic growth. Adjusted for shipping days, our consolidated sales were flat as compared to down 1% in Q3. In the fourth quarter, growth in Asia Pacific was offset by some softness in EMEA, while the Americas were flat.

Notably, we achieved strong adjusted margin expansion again this quarter, up 100 basis points, driven by our focus on portfolio enhancements and continued cost savings initiatives. Cash flow also continued to be a very good story for the company. Todd will provide additional color on the financial results in a few moments. Now, let's discuss our accomplishments for the year. First is putting the right people in place to drive our strategy forward. As you'll recall, we initiated several key senior-level management changes to drive a One Watts mindset. Munish Nanda took over responsibilities for Europe, including Eastern Europe, while Elie Melhem assumed responsibilities for the Middle East and Africa. We made these changes to simplify our organization and employ a more global business approach. Munish realigned platforms and leadership in both Europe and the Americas and created some global product platforms like drains, water quality, and electronics.

This enabled us to focus on the voice of our customer, implement global new product development, and promote more cross-selling opportunities within EMEA and around the world. In addition, with the acquisition of PVI in November, we established a new Heating and Hot Water Solutions platform led by Jim Dagley, a recent addition from Johnson Controls. We expect this alignment to foster customer-centric solutions in commercial boiler room applications. We also took meaningful steps to foster a One Watts culture. This past November, we held the first-ever Connect conference, bringing together our top 140 leaders from around the world. The focus of this senior leadership meeting was on growth and accountability, and feedback from the attendees has been extremely positive. Second, we continue to drive customer and commercial excellence.

In April, we reestablished our position as a leader in training the industry when we opened our Watts Works Learning Center in North Andover. The learning center provides customers, distributors, sales representatives, and our associates a hands-on experience with the company's products and technologies and provides us invaluable feedback on customer needs. In the U.S., we trained approximately 4,300 people, including 3,700 online courses during 2016. We also established a learning center in Dubai as part of our Middle East expansion, and we've invested in our existing learning centers in Italy and California as well. Third, a principal focus for the team has been executing on our transformational and restructuring efforts, and we delivered on that goal.

Phase two of the Americas' transformation, launched in the second half of 2015, addresses our infrastructure requirements to streamline the product portfolio and is expected to be completed in mid-2017. We anticipate the phase two effort should improve our planning process, realize savings from redundancy, reduce working capital, and improve our customers' overall experience. We'll continue to drive new and existing programs in 2017 and beyond to generate further efficiencies as part of our normal operations. Fourth is discipline and effective capital allocation. The PVI acquisition, which closed last November, enhances our portfolio, enabling us to address more customer solutions in the growing commercial heating and hot water space.

As a reminder, our capital deployment strategy is balanced as we seek to invest organically through CapEx and in internal projects and inorganically through M&A, and we also continue to return cash to shareholders. Finally, we remain acutely focused on controlling what we can, and our operational efforts yielded strong financial results in spite of tepid top-line growth. Those efforts drove record adjusted operating margin and adjusted EPS in 2016. If you recall, we anticipated 2016 consolidated adjusted operating margins would increase by 100 basis points. We're proud to have exceeded our goal, delivering 130 basis points increase over last year. And this margin increase included incremental investments in sales and marketing, R&D, training efforts, as well as systems to help seed future growth.

Further, free cash flow conversion exceeded 120% of net income this year, so a great performance turned in by the entire team. In summary, 2016 was an eventful and exciting year for Watts. As we move into 2017, our top priority will be profitable growth. 2016 was about building and strengthening our foundation, including implementing various transformational actions and seed planning for future growth. To improve our organic growth trajectory in 2017, we expect to introduce new products, expand geographically, drive solution selling, and concentrate on key account management. We'll also continue to rationalize lower-margin products from our portfolio. We expect adjusted operating margins will continue to expand as we realize incremental savings from our transformation and restructuring actions.

Consistent with last year, we expect to continue to reinvest a portion of the anticipated savings in selling and marketing, R&D, and systems. All investments are focused on the long-term viability of the company. We expect to complete phase 2 of the Americas transformation by midyear and should reap more of the benefits we previously discussed. Now, let's talk about the market. So please turn to slide 4. Let me share some macro data and some regional observations for 2017. In the U.S., we expect to see continued growth, with GDP forecast to expand to 2.3%, above the 1.6% 2016 estimate.

Based on information we derive from IHS, total residential spending in 2017 is forecasted to increase low single digits, but below 2016 numbers, as student debt, higher mortgage rates, and lower refinancing activity weighs on new homebuyers. Non-residential spending in 2017 is forecasted to increase in the low single digits, with growth in office and institutional offset partially by an expected decline in the commercial submarket. Keep in mind that we typically do well in the institutional submarket, where there tends to be more complex plumbing and HVAC content. Obviously, a big unknown that could affect the US markets in 2017 is the new administration's ability to achieve its policy agenda. The proposals are far-reaching, and timing and final regulations have yet to be determined.

We're monitoring the landscape closely and will continue to keep you apprised of how any developments affect our company. Turning to Canada, which is about 8% of the Americas business, we expect conditions in the construction markets to remain under pressure. Both residential and non-residential spending is forecasted to decline slightly in 2017. In the Eurozone, the overall outlook is generally stable, with GDP growing at about 1.6%, nominally lower than 2016. We are forecasting flat to low single-digit growth for both residential and commercial construction spending in our larger markets like France, Germany, and Italy. Other factors that may affect Europe are FX volatility and continued geopolitical events, such as Brexit and upcoming elections in Germany, the Netherlands, and France. The overall outlook for Europe is somewhat muted given the degree of uncertainty.

Emerging markets GDP expectations are moderating, as Russia is forecasted to be marginally positive for the first time in three years, and the Middle East is expected to remain lumpy. As we've noted before, geopolitical issues are likely to continue to have an impact. In China, GDP is expected to remain robust at 6.5%, while GDP in the greater Asia Pacific region is expected to remain stable at 2016 levels. Residential and non-residential spending in China is expected to grow, but at slightly lower levels than 2016. As a reminder, our Asia exposure is only 5%. Overall, the macro data suggests our markets will remain mixed and somewhat uncertain. I'll now turn the call over to Todd, who will review our results for the quarter and full year and offer our initial outlook for 2017. Todd?

Todd Trapp (CFO)

Thank you, Bob, and good morning, everyone. I am on slide five, which shows the fourth quarter results. We delivered sales of $342 million, down 5% quarter-over-quarter, both on a reported and on an organic basis, which was in line with our expectations. The organic sales decline was primarily driven by a reduction in shipping days in the quarter. As you recall, we mentioned back in early 2016 that because of the way our fiscal calendar fell, we gained approximately four shipping days in Q1 and lost a similar number of days in Q4 when compared to 2015. Excluding the effect of fewer shipping days in Q4, organic sales were flat. We also had several puts and takes, which offset one another.

The 2015 exit of undifferentiated products and the negative impact of currency was a headwind of $13 million or 4% in the quarter. Fully offsetting these reductions were the acquired sales of PVI and Apex. adjusted operating profit of $37 million increased 5% despite the lower sales. This translated into an adjusted operating margin of 10.9%, up 100 basis points versus Q4 of last year. Favorable sales mix, including the exit of undifferentiated products and continued benefits from productivity and restructuring actions, more than offset incremental investments in sales and marketing, R&D, and IT. Adjusted EPS of $0.64 was 8% higher than last year, and a Q4 record for the company, driven by strong operating performance. The effective tax rate in the quarter was 32.9%, consistent with last year.

So overall, a similar result to Q3, as we delivered strong operating margin in EPS performances despite a sluggish top line. As Bob mentioned, we focused on those aspects of the business that we could control and executed accordingly. Moving to the regions, let's turn to slide six and discuss the Americas results. Sales were $223 million, down 4% on a reported basis and flat on a days adjusted basis. The reported sales reduction was driven by the exit of undifferentiated products of $8 million and $3 million from the retail sales erosion that we communicated on the Q3 call. The recently acquired PVI contributed about $9 million in sales during the quarter. Growth in backflow, mixing valves, and drains were offset by softness in some of the specialty products in the aforementioned retail sales erosion.

We are also seeing pressure in Canada as well as from products that serve the industrial markets. AERCO was relatively flat, rebounding from the softness that we saw in Q3. AERCO is still experiencing some project delays and pushouts given the uncertainty in the marketplace. Adjusted operating profit for the quarter was $34 million, a 3% increase year-over-year. Operating margin expanded 100 basis points to 15.3% due to favorable mix, including the impact from the exit of undifferentiated products and continued strong productivity, including benefits from sourcing and lower commodity costs. So another record operating margin performance in the quarter by the Americas. Turning to slide 7, let's review EMEA's results. Sales were $104 million, down $9 million or 8% on a reported basis. Foreign exchange, mostly related to the euro, accounted for $3 million of the sales decline.

Excluding the shipping days impact, organic sales were down 1% in the quarter. So let me provide some more color by platform. On a shipping days adjusted basis, Fluid Solutions sales were flat organically. Sales of our electronics products continued to make solid gains, but were offset by lower demand of our water and plumbing products, mostly in the French marketplace. Sales on our drains platform were down approximately 3% compared to Q4 last year, as we saw some destocking activity in the Nordic region at some of our wholesalers, as well as continued project delays in the U.K. By geography, our performance was mixed. We saw growth in Italy, where our energy-efficient products remained strong. On the other hand, sales declined in France due to a softer refurbishment market, and in Germany, due to slower HVAC sales into boiler manufacturers.

Adjusted operating profit in EMEA for the quarter was roughly $9 million, a decrease of $1.4 million from last year. Operating margin of 8.5% contracted 50 basis points, primarily due to lower sales, which more than offset the benefits from our transformation and restructuring efforts. So for EMEA, a somewhat softer quarter due to volume declines in some of our larger markets and continued sluggish spending given the current political environment. Now, moving to slide 8, let's take a look at Asia Pacific's results for the fourth quarter. Asia Pacific's reported sales were roughly $15 million, an increase of 26% over the prior year. The reported increase was driven by acquired sales of $3.7 million. Adjusted for shipping days, organic sales increased by 18% compared to the fourth quarter of 2015.

Residential sales of our underfloor heating applications within China remained very strong, which is being offset by a decline in China valve volume due to lumpiness in the commercial end markets. We continue to see growth outside of China of double digits in the quarter, driven by demand from our water and plumbing products in areas such as Australia and Southeast Asia. Adjusted operating profit of $2.1 million increased by $1.4 million as compared with the same period last year. Operating margin of 14.4% was significantly higher than last year due to volume, acquisition benefits, and sourcing savings. In summary, Asia Pacific delivered another good quarter, led by performance outside of China.... I am now on slide nine. Let me speak briefly about the full year results.

Sales for the full year were $1.4 billion, down $69 million, or 5% on a reported basis, and up 1% organically. The decline was primarily a result of the strategic exit of undifferentiated products, which was roughly $96 million or about 7%. Organically, Americas and Asia Pacific sales were up 1% and 12%, respectively, while EMEA's sales were essentially flat year-over-year. Operating margin was a record 11.4% for the year, or 130 basis points higher than 2015. We are proud to have exceeded our margin expansion goal by 30 basis points. Sales mix, transformation, and restructuring benefits, and continuing productivity, including sourcing initiatives, were the driving factors. Also important to note, the margin expansion included incremental investments during the year, consistent with our guidance.

adjusted full-year EPS of $2.67 was up $0.26 or 11% versus the prior year. Again, another record result for Watts, primarily driven by improved operational performance. Let's move to slide 10, where I'd like to make a couple of comments on cash. Free cash flow continues to be a very good story for Watts. We delivered $102 million of free cash flow in 2016, which was up 25% versus the prior year. This translated into a conversion rate of 121%. Working capital performance was fairly neutral to cash flow this year, mainly impacted by our 2015 transformation activities.

Recall, we had strong cash collections in 2015 from divested product lines, and in 2016, we temporarily increased inventories to minimize customer disruptions as part of rationalizing our distribution and manufacturing footprints. CapEx increased 30% in 2016, driven by incremental investment in our facilities to support our growth and productivity initiatives. Our reinvestment ratio was 118%, up significantly from 2015, reflecting our commitment to reinvest back in the business. During 2016, we expanded our credit facility by $300 million to $800 million, using a portion of the proceeds to retire private placement debt and to help fund the PVI acquisition in the fourth quarter. This facility provides us with ample liquidity and flexibility as we prioritize capital allocation in the future.

In 2016, we also returned $51 million to shareholders in the form of dividends and share repurchases. Our stock repurchase program remained active as we purchased 500,000 shares for almost $27 million during the year at an average price of $53. Now turning to slide 11, let's discuss the general framework we considered in preparing our 2017 outlook. First, let's look at expected headwinds. Consistent with our ongoing strategy, we are going to reinvest in the business. Commodity costs, especially copper, increased during the second half of 2016, and the forecast from IHS is that it will remain at higher levels in 2017. We anticipate that the euro will be under pressure this year.

In our plan, we have pegged the euro at 1.05, which is about $0.06 lower than the 2016 full year average. As a reminder, we estimate that for every point move in the euro-US rate, there is an impact to full year sales and EPS of $4 million and $0.01, respectively. The US DIY erosion that began in the third quarter of 2016 will continue into the first half of 2017. Also, as part of our ongoing initiative to strengthen our portfolio, we are planning to rationalize a small portion of low-margin products in both Europe and Asia Pacific. In the middle column, you can see some of the items that are more uncertain. No surprise that it is centered more around the political environment in both the US and in Europe.

The quicker we have clarity and resolution around some of these unknowns, obviously, the better it is for everyone. At this point in time, we think our markets may be cautious, at least through the first several months of 2017, as the events unfold. Finally, on the tailwind side, we expect to reap incremental benefits from our transformation and restructuring efforts, especially in the Americas and Europe. Acquisitions, primarily PVI, will be incremental to our results. Growth in Asia Pacific should continue, given our small base and our recent investments. Lastly, we expect pricing to be positive in 2017 to help mitigate most of the commodity inflation. With that framework in mind, please turn to slide 12, and I'll provide details on our 2017 outlook. Starting with our sales, we estimate that Americas should grow low single digits.

Growth in our traditional plumbing products may be tempered during the first half of the year due to the continued market sluggishness as we exited 2016, as well as tougher comps. As you recall, we had a fairly strong first half last year. We expect AERCO should return to solid growth through new product and geographic expansion, and PVI should add roughly $45 million in sales year-over-year, which will more than offset the $6 million of DIY erosion that we will see in the first half of 2017. For EMEA, we are forecasting sales to be flat. While we believe our business has stabilized over the course of 2016, we remain cautious given the broader macro and the political uncertainty. The flat sales forecast also includes approximately $5 million of lower margin sales we anticipate rationalizing during the year.

In Asia Pacific, we expect organic sales to increase high single digits in 2017. We also expect to be rationalizing approximately $9 million of certain OEM-directed, undifferentiated product sales this year. Again, this is part of our continuing effort to enhance our portfolio. So for overall Watts, organic sales are estimated to grow low single digits for 2017, and growth is expected to pick up more in the back half of the year. Turning to margins, we are targeting a full year operating margin in the 12% range, roughly a 60 basis points margin expansion versus 2016. Included in that assumption are savings from transformation and restructuring efforts, as well as some incremental investment. We are also expect PVI's margins to be in the high single digits during the integration phase. A couple of comments on Q1.

We expect the year will start off slowly, in line with the general business environment we experienced in Q3 and Q4 of 2016. Our top line will also be challenged by some tougher comps, given the strong start we had last year, and further portfolio rationalization, which we expect to be more weighted toward the first half. So, flattish is slightly down on the top line. From an operating margin perspective, Q1 2017 margins may also be fairly flat, given last year's tougher comps. Also, PVI's margins should negatively impact consolidated margins by 20 basis points each quarter until our integration programs take hold, which will likely be late in 2017 and into next year. Finally, a few housekeeping items.

We estimate capital spend for the full year of $36 million-$40 million as we continue to reinvest in our manufacturing facilities and systems, which will support future growth and productivity. Depreciation and amortization should approximate $50 million-$52 million, while the effective tax rate should be in the 34% range. Regarding capital deployment, we expect to repurchase shares at a rate that at least offset option dilution, and we will continue to pay a competitive dividend. Now, let me turn the call over to Bob before moving to Q&A. Bob?

Robert J. Pagano Jr. (CEO and President)

Thanks, Todd. Please turn to slide 13 and let me summarize our discussion. We've continued to execute on our transformational strategy that we outlined in 2015. Our team has worked diligently to focus on the customer, drive a One Watts culture, and align our businesses. Operationally and financially, we delivered on our 2016 commitments. We are approaching 2017 with some caution, given what we saw in the second half of 2016, and uncertainty associated with the new administration's ability to translate campaign promises into policy and new legislation, the pace and timing of which is unknown at this point. We are currently seeing a pause in the marketplace as customers are delaying projects until there is more clarity on proposed legislation.

Therefore, we think our growth in the first half of 2017 will be marginal and will accelerate in the second half of this year. As Todd mentioned, we plan to deliver continued margin expansion in 2017, while continuing to invest for future growth. And finally, we'll continue to be disciplined in capital deployment, expecting to spend wisely on CapEx, strategic M&A, and returning excess cash to shareholders. Over the last two years, we have made substantial progress in our journey to become a leaner, customer-centric organization. These years were about stabilizing our foundation, driving transformation, and seed planting for the future. This year, we'll be keenly focused on growth through solution selling, geographical expansion, new product introductions, and key account management. I'm confident our team will continue to deliver on its commitments for 2017 and beyond.

With that, operator, please open the line for questions.

Operator (participant)

At this time, ladies and gentlemen, if you would like to ask a question, please press star, then the number one on your telephone keypad. We'll pause for just a moment to compile the Q&A roster. Our first question comes from the line of Ryan Connors with Boenning & Scattergood. Your line is now open.

Ryan Connors (Analyst)

Great, thanks for taking my question. Thanks for the detailed outlook for 17. Very helpful. I had a bit of a bigger picture question on the policy side, Bob. You know, I know there's not too much you can say in detail about the direction this will go, but can you at least kind of give us some quantification of the company's presence in Mexico as it relates to assembly and/or, you know, manufacturing, and how material that is and how that's shifted in the last few years with the realignment, and how you look at the different scenarios about what's being talked about there in terms of a border tax, adjustment tax, and how that could or could not impact Watts?

Robert J. Pagano Jr. (CEO and President)

Thanks, Ryan. Yeah, so, when we exited undifferentiated products, a lot of that was produced in Mexico. So, our exposure in Mexico is very limited. Our bigger exposure is imports from China. We are a net importer, but I would say it's not as material as maybe some of our other competitors would have. So we, as you know, have a foundry in the local area here in the US, as well as our boilers are mainly produced in the US. So, again, we have some, you know, exposure, but I would say it's not as much as, maybe others would have.

Ryan Connors (Analyst)

Okay. And is that exposure, is it manufacturing, or are you exporting components, say, from the U.S. for assembly in Mexico? Is that-

Robert J. Pagano Jr. (CEO and President)

... It's primarily we're importing products to be assembled in the U.S.

Ryan Connors (Analyst)

Got it. Okay.

Robert J. Pagano Jr. (CEO and President)

We do export some products out, but it's primarily import. And we're reviewing alternatives. We do have the ability to bring more stuff to our local foundry, as well as we'll look at other capabilities inside the U.S. So we're reviewing all alternatives at this point in time until we... there's more clarity on this.

Ryan Connors (Analyst)

Got it. Okay. And then the other was just kind of a housekeeping update from last quarter. You talked about, you know, kind of some distinct kind of dealer disruption related to some of the product realignment, and that, that was pretty discrete and isolated in nature. But can you just update us on, on that, on that topic as well?

Robert J. Pagano Jr. (CEO and President)

Yeah, we're seeing similar, just like we thought. You know, that's carrying over, carried over to Q4, and it's gonna carry into the first half of next year, and we put that in our guidance assumptions. And, you know, the second thing we're doing is continuing to look at our product portfolio, which is in EMEA, we're getting rid of about $5 million worth of DIY, and also related to our exit of undifferentiated products, we have the same issue inside of China at this point in time. So again, we're continuing to watch our portfolio. As you know, we have many, many SKUs, and we continue to look at the tail end of those SKUs.

Ryan Connors (Analyst)

Got it. Okay, that's helpful. Thanks for your time this morning.

Robert J. Pagano Jr. (CEO and President)

Thanks, Ryan.

Operator (participant)

Our next question comes from the line of Jeff Hammond with KeyBanc Capital Markets. Your line is now open.

Jeffrey Hammond (Analyst)

Hey, good morning, guys.

Robert J. Pagano Jr. (CEO and President)

Hey, Jeff.

Ryan Connors (Analyst)

Good morning, Jeff.

Jeffrey Hammond (Analyst)

I wanted to dig in a little bit here on, on slide 11, particularly some of the headwinds. What, you know, first, can we talk about commodity inflation? Maybe just to remind us, you know, your inputs, how big is copper, copper-based products? How big do you think that, you know, gross headwind, I think, on commodities and then what you're doing on pricing actions to kind of mitigate that?

Robert J. Pagano Jr. (CEO and President)

Sure. As Todd mentioned, you know, copper is going up. We're seeing that, but, you know, we don't give out the details of our copper exposure for competitive reasons. But I'll tell you, we are planning a price increase to mitigate that. We believe it'll stick, and, we're implementing that in February as we speak. So, we're on top of that. We believe our pricing actions will mitigate the copper increase.

Jeffrey Hammond (Analyst)

Okay. And then is there a way to quantify what the incremental year-on-year benefits are for both the transformation and then, you know, the offset on the investment side as you look at 2017?

Todd Trapp (CFO)

So, yeah. So, Jeff, this is Todd. So I think in 2017, it's gonna be very similar to what we saw in 2016, and so most of the restructuring transformation benefits are gonna be in that, and I would say, in that $10 million range. And from an investment perspective, I would say we're gonna make similar types of investments in those, you know, let's call it $6 million-$7 million range in 2017 as well. So pretty similar to what we saw in 2016.

Jeffrey Hammond (Analyst)

Okay. And then just finally, you know, Europe has kind of been a, you know, tough market to grow. It seems like, you know, more broadly, you know, a lot of my other companies have been seeing at least some modest growth. And, you know, just help me, you know, understand what you think really needs to happen there to, you know, just to start to, you know, kickstart the growth. Thanks.

Robert J. Pagano Jr. (CEO and President)

Yeah, I think it's really centered around the political uncertainty with all the elections going on. You know, we're strong in France, and you know, that's where most of the political uncertainty is at this point in time. We have seen some positives in Italy, so we're optimistic in that regard. But, you know, Germany is... For us, we primarily sell to the German boiler OEMs, and they've had difficult times. So when you look at it, you know, we're being somewhat conservative in our outlook until more things are known based on these elections. So I think France is the one I'm probably most concerned about. The UK, we do a little bit business there, and there were some timing issues in the fourth quarter with our drains business there.

But again, you know, it's nice to see a little growth from Italy, and, you know, from a Russia point of view, that's been down. We think it's gonna be, you know, relatively, you know, stable at this point in time and maybe even a tick up.

Jeffrey Hammond (Analyst)

Thanks, guys.

Robert J. Pagano Jr. (CEO and President)

Thank you.

Operator (participant)

Our next question comes from the line of Mike Halloran with Robert W. Baird. Your line is now open.

Michael Halloran (Analyst)

Hey, good morning, guys.

Robert J. Pagano Jr. (CEO and President)

Hey, Mike.

Ryan Connors (Analyst)

Morning, Mike.

Michael Halloran (Analyst)

So just a quick clarification on the 1Q comment. Was that flat to slightly down revenue comment, was that organic, or was that an all-in revenue number?

Robert J. Pagano Jr. (CEO and President)

It was an all-in number.

Michael Halloran (Analyst)

Right. Great. And then second question on the heating and hot water solution side. It's good to see some progression from 3Q levels. Maybe talk about what the competitive environment looks like, how you think that business is performing relative to the environment. And, you know, as you get through this year, what do you think it'll take to get back towards that normalized long-term growth rate that you guys have talked about?

Robert J. Pagano Jr. (CEO and President)

Yeah, Mike, we believe, you know, 2017, we're gonna get back to that normal run rate, which is at the high single digits. We did see competitive pressure. In particular, when there's lumpiness in projects, it gets very competitive out there, and we've seen some new entrants trying to come in. But we were excited at the recent ASHRAE show to unveil our brand-new product that we believe is a differentiator in the marketplace. So we believe we have the, you know, ability to put that new product out there, and, which differentiates us from our competition. But we are planning a return to high single digits, in the Heating and Hot Water Solutions group.

Michael Halloran (Analyst)

Great, appreciate that. And then, last one. Just on the capital deployment side, maybe just some thoughts on how the pipeline looks like today, how valuation levels look like in the market, and how actionable things are from your perspective.

Robert J. Pagano Jr. (CEO and President)

Yeah. So, you know, I can't comment on any specific transaction, as you know, but clearly, you know, our pipeline remains full. We keep on looking at them. You know, valuations are similar to what I think we're seeing in the current marketplace and no real change. But, you know, we keep on looking and developing our relationships at this point in time. So other than that, I'm not sure any more details I can comment on that at this point.

Michael Halloran (Analyst)

Okay, appreciate it. Have a good one.

Robert J. Pagano Jr. (CEO and President)

Thanks, Mike.

Michael Halloran (Analyst)

Bye.

Operator (participant)

Your next question comes from the line of Jim Giannakouros with Oppenheimer. Your line is now open.

Jim Giannakouros (Analyst)

Good morning, Bob. Todd, Jim.

Robert J. Pagano Jr. (CEO and President)

Hey, Jim.

Jim Giannakouros (Analyst)

On the statement that you're pivoting towards growth, I think that, you know, I take that as an investment statement. Is that more of a North America statement, or does that apply in EMEA as well?

Robert J. Pagano Jr. (CEO and President)

It's primarily North America and Asia Pacific, but we are investing in Europe, and particularly in our electronics platform and other differentiated products like Drains, where we believe we have a competitive advantage. So, you know, it's growth in all areas. And as you know, in our business, you know, we, as we said earlier, we're planting a lot of seeds. Those seeds may take multiple years to go forward. But, you know, again, we believe it's important that we continue to plant those seeds. We're spending more in R&D, sales and marketing, and looking at continued geographical expansion.

Jim Giannakouros (Analyst)

Got it. And thank you. If we can get a little more granular as far as your expense base in 2017. You know, appreciating that you're still doing a little bit more of, you know, growth investments. You know, you talk about expanding sales, marketing, IT, you're stepping up R&D. How are those buckets comparing versus 2016? And are we at a run rate, or are any of those kind of step-ups temporary or non-recurring in nature?

Robert J. Pagano Jr. (CEO and President)

Well, Todd can give more specifics, but I know in R&D in particular, we plan on spending more in that area than we have in the past. You know, probably 2.1% of sales at this point in time, as well as investing in sales and marketing. Plus the run rates, you know, our training facility, as an example, wasn't started till April, you know, so we'll continue to have those run rates into next year. But, you know, we're continuing our focus in those areas as well as with the new acquisition. Certainly, our operating expenses, you know, in particular, sales and SG&A, will continue to go up.

Jim Giannakouros (Analyst)

Got it. Okay. And just to be clear on the 1Q commentary, I mean, the tough comps. Should we be thinking about that as weather-related? We obviously had barely a winter last year, very mild. Is that what we should be thinking about? It's really just weather, or was there something going on specifically in North America that we should be factoring? Thanks.

Robert J. Pagano Jr. (CEO and President)

So, so, Jim, if you think about Q1 last year, I mean, from a top-line perspective, we had a strong start, I think, across all regions. And when you turn to the margin, from a margin rate perspective, I think every region in Q1 last year expanded margins in excess of 200 basis points. So I think it's more of just a, an overall comp issue than it has anything to do with weather at this point in time. I think the other thing just to, you know, important to keep in mind is, you know, some of the DIY and product rationalization will impact Q1 somewhere in that $7 million-$8 million range. The Americas will also benefit from approximately $13 million in acquired sales of PVI during the quarter. And the other thing I think that's a headwind a little bit is, is FX.

So FX last year was about 1.10, 1.11. You know, today it's at, you know, the euro rate's at 1.06, so that could be a little bit of a headwind from a top-line perspective as well. But I think it's more of a comp issue than I'd say anything about weather.

Jim Giannakouros (Analyst)

Appreciate it. Thank you.

Robert J. Pagano Jr. (CEO and President)

Thank you.

Operator (participant)

And again, ladies and gentlemen, if you would like to ask a question, please press star one on your telephone keypad. Our next question comes from the line of Ryan Cassil with Seaport Global. Your line is now open.

Ryan Cassil (Analyst)

Good morning.

Robert J. Pagano Jr. (CEO and President)

Good morning, Ryan.

Michael Halloran (Analyst)

Good morning, Ryan.

Ryan Cassil (Analyst)

Just, could you, you know, flesh out, you know, what you're thinking on the boilers business? I think, you know, that's kind of seen the biggest change in growth dynamics over the last couple quarters. Are you thinking this is more of a short-term issue, or, perhaps, you know, is it a bit of a turning point in the commercial non-res cycle?

Robert J. Pagano Jr. (CEO and President)

No, we don't believe that it's a turning point at all. We believe there's opportunities. I think just with the uncertainty and the stimulus and what was happening, projects just got pushed out and delayed. And, you know, we remained disciplined in our pricing because we didn't want to give up margins. So I think it's a pause. Our, you know, our projects that we see in backlog, you know, they haven't been released, but it's just been more lumpy. But, as I said earlier, I believe, you know, that business is gonna grow high single digits again this year. So that's what our planning. We've introduced a whole slew of new products in that segment, so, we're pretty excited about it.

Ryan Cassil (Analyst)

... Okay. And sort of the front log of that business, any color you could give there? I mean, are you seeing sort of a healthy pipeline of, you know, new work, you know, for that business? You know, thinking-

Robert J. Pagano Jr. (CEO and President)

Yeah, the project-

Ryan Cassil (Analyst)

behind the backlog.

Robert J. Pagano Jr. (CEO and President)

Yeah, sure. The project pipeline looks strong. What we did is, if you recall, the first half of last year, that business was strong. We saw a big dip in the Q3. It was flattish in the fourth quarter, and so we got some tough compares in the first half of this year, and I think it'll be more smoother in the second half of next year. But overall, projects visibility, and remember, a large portion of our business, of that business, is retrofit, where we believe, you know, we have high paybacks to convert, you know, to more efficient condensing boilers. So there's also a payback to people for switching their boilers to do that. So overall, we feel confident that we'll get back on track with that business.

Ryan Cassil (Analyst)

Okay, great. And then you mentioned new products and introducing, you know, products in new geographies. I know boilers, you've talked about that in the past. Just from a timing standpoint, do you think, you know, that's a benefit to 2017, or you introduce those products in 2017, really, the bigger sales uptake is an 2018 story?

Robert J. Pagano Jr. (CEO and President)

Yeah, I think it's a bigger impact in 2018. I think 2017 is, again, we see- we're seeding that. We did get some approvals just recently on some of our boilers, but some of these markets, in particular, China as an example, the condensing market is new, so it's gonna be slow to adopt, but they're clearly looking for more higher efficiency products. So that's an opportunity for us, but again, we've got to work with, policy and, and drive some of that. So it's not gonna be an instantaneous, we, but we believe over the long run, it's the right seed to plant.

Ryan Cassil (Analyst)

Okay, and then last one for me, just going back on the, on the price increase for February, is this... You know, are you expecting to get any net pricing, so outside of labor and raw material inflation? And then could there be, you know, just given the rise in raw materials as quickly as we've seen for products like copper, is there a period in the short term where you get squeezed and then that, you know, you put through that price increase and it kind of all works itself out? Any kind of color on the cadence there would be helpful.

Robert J. Pagano Jr. (CEO and President)

Yeah, you know, we don't believe it's gonna be a net negative squeeze at all because, you know, we had purchased product in advance of some of these increases, so we're a little in front of it, not through hedging, but just pre-buying. So we believe net-net, it's, it should be even. You know, we're certainly gonna drive towards positive price this year, but, again, it, it all depends on the environment and how competitive it is out there.

Ryan Cassil (Analyst)

Great. Thank you.

Robert J. Pagano Jr. (CEO and President)

Thank you.

Speaker 10

Thanks, Ryan.

Operator (participant)

Our next question comes from the line of Joe Giordano with Cowen. Your line is now open.

Joe Giordano (Analyst)

Hey, guys. Thanks for taking my questions.

Robert J. Pagano Jr. (CEO and President)

Hey, Joe.

Speaker 10

Morning, Joe.

Joe Giordano (Analyst)

So, on M&A, when you look across your geographies and, you know, I guess some of the market uncertainty, it's tough to tell if some markets break up or down from here. So how does that kind of guide your outlook in terms of what you're willing to pay when it's, you know, kind of uncertain which direction some of these businesses are going? So how do you move forward from there, and how does that, like, impact your discussion?

Robert J. Pagano Jr. (CEO and President)

Well, Joe, the first thing we look at is what is the strategic potential, and how does that fit into our overall strategy? And, you know, we sometimes, I don't want to get caught up in some of the noise. We're clearly looking at the long term. So, you know, we would put valuation differences based on some of those certainty, but the first criteria is what is the strategic implication to our business, and do we believe that'll make a stronger portfolio for us? So that's our first criteria, and then, you know, some of the uncertainty, you know, that all turns into valuation at this point in time related to that. So again, we're focused on the strategy and then, valuation, and clearly, we're gonna be disciplined in this environment.

Joe Giordano (Analyst)

Okay, great. And then, a little bit more on the AERCO delay that you've been seeing. Is there any specific, like, sub-market that you'd call out there?

Robert J. Pagano Jr. (CEO and President)

Not really. I mean, we've seen it across the board. That's why it's been widespread, from that perspective. So again, it's competitive out there, but again, we believe we have a superior product and a value differentiator from our competitors. So again, timing, lumpy, and, you know, just driven by uncertainty.

Joe Giordano (Analyst)

Okay. Then one clarification, Todd. On the realized savings and the investments, you mentioned, like, $10 million in savings and then $6 million-$7 million in investments. I assume that the $10 million in savings is an incremental ten versus last year. Is the $6 million-$7 million in investment spending, like, the same level as from last year, or is that $6 million-$7 million, like, incremental, so you're really looking at a net, like, three?

Speaker 10

Yeah, so I would say the from the restructuring side, $10 million is incremental year-over-year, from 2016 to 2017. On the investment side, that $6 million-$7 million that we talked about is incremental investments.

Joe Giordano (Analyst)

Okay, fair enough. And then last clarification: Are the organic outlooks that you guys presented for across the segments, are those inclusive of the rationalizations in those, like, low single digit or whatever you... By segment?

Robert J. Pagano Jr. (CEO and President)

Yes, it is. I mean, all the growth rates we talked about have the product rationalization included in there.

Joe Giordano (Analyst)

Great. Thanks, guys.

Robert J. Pagano Jr. (CEO and President)

Thank you.

Speaker 10

Thank you, Joe.

Operator (participant)

There are no further questions in queue at this time. I'll turn the call over to Mr. Bob Pagano for closing comments.

Robert J. Pagano Jr. (CEO and President)

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

Operator (participant)

This concludes today's conference call. You may now disconnect.