Watts Water Technologies, Inc. (WTS) Q2 2015 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by and welcome to the Watts Water Technologies Second Quarter 2015 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will be given at that time. [Operator Instructions] I would now like to introduce your first speaker for today Treasurer and VP of Investor Relations, Mr. Tim MacPhee. You may begin sir.

Thank you, Andrew. Good morning everyone and thank you for joining for our second quarter earnings call. Joining me today are Bob Pagano, President and CEO, and Todd Trapp, our CFO. Bob will begin by providing a summary of the quarter. He will offer some color on the current market conditions and will update you on Phase 1 of the Americas Asia-Pacific transformation initiative. Todd will discuss the financial results for the second quarter in more details and update our outlook. Bob will summarize, and then we will open the call up to your questions. The earnings press release and earnings call presentation we issued last evening include some non-GAAP financial measures and we have included those documents – in those documents the necessary reconciliations to GAAP measures. You can find a direct link to the webcast of today’s conference call on your – on our website at www.wattswater.com. We’ll archive the webcast on the site for replay. I’d like to remind everyone that in the course of this call, to give you a better understanding of our operations, we will be making certain forward-looking statements. These statements are subject to numerous risks and uncertainties that could cause actual results to differ materially from such statements. For information concerning these risks and uncertainties, see Watts Water’s publicly available filings with the sec. The company disclaims any intention or obligation to update or revise any forward-looking statements whether as a result of new information, further events, or otherwise. Now I will turn the call over to Bob Pagano.

Thanks, Tim and good morning everyone. Please turn to Slide 3 in the earnings call presentation and I’ll briefly provide an overview of our second quarter. Overall, I am pleased with the progress we made in the quarter. Our transformation efforts are moving ahead nicely. We’re able to drive operational margin expansion despite lower revenues and we generated strong cash flow. Heading into the second quarter, we knew our top-line will be challenged as we signaled during the April call. Organic sales in the EMEA were down due to a tough macro environment, especially in some of our larger countries such as France and Germany. In the past quarter, however, we did see the overall EMEA sales decrease moderate from Q1 as we expected. Americas organic sales were affected by the product rationalization effort and to a lesser extent rainy weather in the south central U.S. Overall, Americas core product line sales were flat with last year, if you exclude the effect of the rationalization. Asia Pacific performed very well during the second quarter with solid double-digit growth. AERCO had another strong quarter. Year-to-date AERCO sales growth is over 10%, compared to the prior year as we continue to perform very well in the commercial high condensing boiler marketplace. Also in the second quarter, the movements from the strength of the U.S. dollar, primarily against the euro and Canadian dollar, negatively impacted our topline. However, despite the revenue headwinds we were able to expand our adjusted operating profit and margin percentage and maintaining the constant adjusted EPS quarter-over-quarter. We also delivered strong cash flow in the quarter, driven mainly by better working capital management. Todd will provide more details in a few moments. In Q2, we continue to execute on our various restructuring and transformation initiatives in EMEA and the Americas. A key milestone is our announcement last evening that we have reached an agreement to sell certain non-core product lines in the U.S. to Sushi, a strategic buyer. I’ll provide more information on the transaction in just a few minutes. We are still working through the details of Phase 2 of the U.S. transformation program, as we execute on Phase 1 and expect to provide more details for you during our third quarter call. Finally, the EMEA actions are progressing as planned, with savings initiatives on track for 2015 and beyond. Two other points of note. First from a shareholder perspective, the board has approved a new $100 million share repurchase program. This program is in line with our balanced capital allocation strategy. Second, in early June we received a favorable determination letter from the IRS concerning our proposed pension plan settlement. We expect to formally settle all obligations related to the pension plan during the third quarter. Costs both cash and non-cash are still in line with the estimates we provided during our Q1 call. Moving to the markets, let's turn to Slide 4. Let's begin with the Americas. In general, the U.S. economy continues to grow but at a slower rate than was forecasted when we entered 2015. Certainly the harsh winter and rainy spring affected many businesses tied to construction. Key residential indicators we watched such as the Wells Fargo data on housing starts and builder sentiment and the LIRA Remodeling Index continue to look encouraging and suggest steady growth. On the commercial side the Dodge Momentum Index and the ABI Index have been trending positive. Overall we expect to see continued macro growth in the U.S., although in a more moderate pace. Now, let’s review the EMEA markets. Overall the euro area appears to be stabilizing as GDP expectations are holding firm. Quantitative easy may help stimulate incremental activity, however, it’s difficult to correlate to our orders, but certainly lower rates should trigger a more active construction market. Geographically, our markets are mixed. Construction data from France suggest both residential and commercial markets are down in the 8% to 12% range. Our boiler marketplace in Germany, where a majority of our OEM customers reside, is down mid single-digits this year. Eastern Europe remains fragile with geopolitical issues and sanctions affecting the Russia economy and the uncertainty increases also driving tension in the region. I think the mood in EMEA is getting better. But the region has a long way to go before we see sustainable growth. Finally, let’s discuss Asia Pacific. Economic growth in Asia Pacific is moderate, particularly in China, where we see continued headwinds in the housing market. We think that the recent stock market volatility in China maybe impacting customer or consumer sentiment. The Chinese government is taking steps to avert a market crash, but I think people still feel somewhat uneasy about their personal finances and wealth. GDP expectations in other parts of the regions are holding firm. So overall, our markets are a mixed bag with pockets of growth being offset by lagging economies and slow end markets. Now, I want to update you on the Americas Phase 1, transformation exercise, so please turn to Slide 5. You may recall as part of Phase 1 that we commenced a portfolio rationalization effort focused on removing products that are non-core. We identified four sizable product lines in particular fittings, tubing, brass and tubular and water connected products. And we also identified other smaller product lines that will be discontinued. I am happy to report that yesterday we’ve entered into a definitive agreement to sell the first three product lines I mentioned to Sushi. The sales price is $35.5 million. This is an asset deal and includes two U.S. manufacturing locations. Total product line sales for these four products were $105 million in 2014, mostly sold in the DIY market. We expect to close the transaction by the end of Q3. We are winding down other product lines, the most significant being water connectors, which are manufactured at a dedicated facility in China. Manufacturing at this facility will be discontinued in the fourth quarter and we are currently pursuing the sale of these assets. Water connectors represented approximately $75 million in sales in 2014. In our few miscellaneous product lines that totaled approximately $10 million of sales in 2014, which will be discontinued by year-end. From a financial perspective, we anticipate that our second half 2015 sales reduction related to all product lines will be in the $65 million to $75 million range with a loss in sales weighted a little more towards Q4. Given we have lost approximately $15 million in year-to-date sales; we expect total loss sales for 2015 will be between $80 million and $90 million, and in 2016 the total loss sales will approximate $190 million. Cost related to Phase I are trending to the mid-point of the range we previously provided. We’ll provide a full accounting of all the costs once the product line sales are completed. Finally, the global sourcing program as part of Phase 1 is on track, providing savings at the $4 million annual run rate we discussed previously. Now, I’ll turn this over to Todd to talk about our second quarter operating results in more detail and update you on our revenue outlook for the remainder of 2015. Todd?

Thanks, Bob, and good morning everyone. Let’s turn to Slide 6 and let me walk you through the financial results. In the second quarter, we reported sales of $387 million, down 2.3% on a reported basis, and down 3.4% on organic basis. During the April call, we signaled that the second quarter’s top line would be challenged due to the foreign exchange headwinds, a continued softness in Europe, the effects of the Americas product line rationalization and overall tougher comps in both Americas and EMEA. Foreign exchange mainly related to the weaker euro negatively impacted sales quarter-over-quarter by 7.1% or roughly $28 million. This substantially offset the upside from the AERCO acquisition, which contributed approximately 8% growth. In the Americas, we also experienced some top line headwinds from the flooding that occurred in the south-central U.S. region. As I mentioned the product line rationalization also had an impact on our top line and if you adjusted this initiative, our consolidated organic sales would have been down roughly 1%. Regionally organic sales were down 3.8% in the Americas, and down 4.1% in EMEA, which more than offset a 14.6% increase in APAC. Adjusting for the product line rationalization, Americas would have reported flat growth in the quarter. I’ll provide more color on the regional performance in a few minutes. Adjusted operating profit increased 2.9% to $42 million, which translated into an adjusted operating margin of 10.9%, up 60 basis points on a year-over-year basis. Favorable product mix including AERCO, strong productivity, and other cost savings initiatives more than offset the impact from the lower volume absorption and the higher anticipated SG&A spend. As we communicated back in February and again, in April, our SG&A costs are higher due to the addition of AERCO, and an increase in stock compensation, pension, compliance, and other costs. Further we are making investments in sales and marketing, and product lines with strong margin profiles like our global drains business. Adjusted net income of $24.3 million and adjusted EPS of $0.69 were both flat with Q2 of last year. Adjusted EPS included a negative impact of $0.07 in the quarter for foreign exchange and a $0.03 headwind associated with the product line rationalization. AERCO contributed $0.09 in EPS in the quarter. The effective tax rate was 33.8%, which is a 100 basis points higher than in Q2 of last year, primarily due to the mix of earnings in the quarter being more heavily weighted to the U.S. Free cash flow in the second quarter improved by almost 9% year-over-year driven by working capital primarily inventory. Our inventory is significantly lower on a year-over-year basis due to the efforts to right size safety stock levels in our distribution centers and by improving processes between sales, planning, operation and logistics. So now let’s turn to Slide 7 and let’s review the Americas results for the second quarter. Sales were $263 million, a reported increase of 8.7%, but down 3.8% on an organic basis. Again, adjusting for the product line rationalization, Americas would have reported flat growth. There were several discrete items that impacted organic growth in the Americas during the quarter. First, the timing of price increases from both last year and this year affected Q2 comparability. As you may recall, we introduced a price increase in June of last year, which accelerated approximately $3 million of sales into Q2 of 2014. Similarly, in 2015, we announced a price increase effective April 1, which accelerated approximately $4 million of sales out of Q2 and into Q1 of 2015. Second, as mentioned earlier in the call, we were also impacted by the flooding in the south-central U.S. region which saw sales declines in the 9% range for the quarter. Adjusting for both the price and weather headwinds, core organic growth would have been approximately 4% in the Americas during the second quarter. AERCO continues to perform very well, led by strong boiler and aftermarket sales. As Bob mentioned, year-to-date growth exceeded 10%, in line with our full year growth expectations. Also it is worth noting that the integration savings are on track to what we communicated, back in February. From a channel perspective, wholesale organic sales were down 1.9%, our retail sales were down 15.2%, partially offset by a 7% growth in the OEM channel. As a reminder, the retail channel is it where most of the rationalized products are sold. Adjusted operating profit for the quarter was $38.6 millin, a 31% increase. This translated into operating margin expansion of 250 basis points to 14.7%, despite the volume reduction. The margin expansion was due to favorable product mix, including AERCO pricing and strong productivity which included improved performance out of Franklin New Hampshire which more than offset lower absorption. Overall we were pleased with the Americas ability to deliver operating margin expansion despite lower revenue during the quarter. And as I will discuss momentarily we believe we should see improved top line growth in the second half of this year. Turning to Slide 8, let’s review EMEA’s quarterly results. Sales of $112 million were down $31.7 million on a reported basis or approximately 22% and down 4% organically. Foreign exchange driven by the euro’s decline against the U.S. dollar accounted for $25.8 million or 18% of the sales decline. The organic decrease was concentrated in our larger countries mainly France and Germany. As Bob mentioned earlier in the call, the markets we serve in France are down in the high mid single-digits. And in Germany, the major OEM boiler manufacturers also continue to experience year-over-year sale declines. We’re also seeing declines in the Eastern Europe, primarily driven by the continued weakness in the Russian market, which is down double-digits in the quarter. With that said, we did see some positive growth within EMEA during the quarter. Middle East sales were especially strong, up 51%, given the timing of drainage projects shipped during the quarter. Overall, our European drainage platform was up 5%. We also saw continued good performance in the UK as our sales were up 15% compared with last year. So we’re seeing some growth in some of the other regions, but unfortunately not enough to offset the difficult conditions in France, Germany, and Russia. Regarding channel sales, wholesales was down 1.5% driven by lower plumbing sales primarily in France, and OEM sales decreased 5.7%, mostly related to HVAC products sold into Germany. Adjusted operating profit for the quarter was $10.7 million, a decrease of $6.2 million, or 37%, which translated into an adjusted operating margin rate of 9.5%. Approximately $2.3 million or 37% of the operating profit decreased was due to foreign exchange. Lower volume and absorption, and stainless steel cost increases more than offset the benefit from our transformation and restructuring efforts. As Bob mentioned, we are executing on our restructuring plan in Europe and are seeing the expected benefits. So as forecasted in the first half, EMEA was a challenge. We started to see some improvement in order rates as we exited June and expect to see sequential improvement in the second half as we lapse on easier comps. Now on Slide 9, let me provide a summary of APAC results in the second quarter. APAC sales were approximately $12 million, a 14.6% organic increase over the prior year, driven by higher valves and under floor heating volume. Sales have remained strong despite indications of slowing construction in China. We have expanded our distribution presence into Tier 2 and Tier 3 cities, and have increased our focus on some key verticals such as hospitals, data centers, and urban complexes, which will result in some incremental growth opportunities. Adjusted operating profit decreased 24% to $1.6 million in the quarter and APAC adjusted operating margin decreased 700 basis points to 13.4%. The key driver of the decline was lower absorption due to a 20% reduction in intercompany sales in the quarter. This reduction was triggered by lower demand due to the exit of non-core products. So in summary, another strong quarter for the APAC team. Margins were and will continue to be effected by the intercompany volume drop related to the exit of non-core products. On Slide 10, let me highlight a couple of items related to year-to-date free cash flow. Year-to-date free cash flow was $29.5 million, up over 250 basis points as compared to the first half of last year. Compared to June of 2014, we improved inventory turns in all regions and DSO improved in both EMEA and Asia-Pacific. So we are making strides in working capital management and we achieved further opportunities ahead. Also year-to-date, our capital investment increased 18% mostly related to the addition of AERCO. In addition, our existing stock buyback program is on track as we purchased approximately 350,000 shares of our Class A common stock in the first half at a cost of roughly $20 million. So a strong cash performance in the first half for Watts. Finally, turning to Slide 11, I’ll provide a brief update on our revenue outlook for the second half of the year. Please note, the growth rates on Slide 11 equates to core organic sales, which excludes the impact of AERCO and non-core products. In the Americas, we reported 1% core organic growth during the first half of this year, but as I mentioned there were some discrete items such as weather and a timing of pricing actions, which affected core growth. Excluding these discrete items, we believe our core organic sales growth grew in a 3% range in the first half. So as we look at the second half, we think our top line will grow in the 3% to 5% core organic range. We believe the economic outlook in the U.S. remains positive. We will continue to realize some incremental pricing benefits and we do have some easy comparisons, which are great to a second half improvement. In EMEA, organic sales declined approximately 5% in the first half of the year. We had some tougher comparisons especially in the second quarter. However, the sales decline did decrease from Q1 to Q2 as we had forecasted. The euro economy is stabilizing and the overall sentiment appears to be improving slightly. With how we exited June and what we’re seeing so far in July we think EMEA sales will be flat to down 2% during the second half of this year, which is an improvement over the first half. In APAC we have an exceptional first half, mainly due to the ramp up of our valves and heating businesses. That ramp up began in the second half of 2014, so comparisons will be a little more challenging in the second half. We are estimating sales growth between 10% and 15% in the second half for APAC. Again very strong performance especially when compared to the current challenges in China. So lots of puts and takes but in summary versus last update we are seeing stronger performance in APAC and AERCO, America, I mean EMEA basically in line and slightly lower growth projections in the Americas. Now let me turn the call over to Bob for the wrap up before moving to Q&A. Bob?

Thanks, Todd. If you would please turn to Slide 12, and let me give you an update on our top strategic priorities. I’d like to review with you our progress over the last 14 months since I came to Watts Water. There are certain priorities I felt were key to transforming the company. First, I evaluated my management team to ensure we possessed the skill sets needed to grow this business profitably. I’ve filled some key positions on my leadership team, including President of the Americas, CFO, and VP of Continuous Improvement. And we continue to look for opportunities to accelerate management and employee development and add key skill sets at all levels of the organization. The EMEA transformation and restructuring initiatives are on track and the team is executing commendably against those plans. They have made steady process in driving savings throughout Europe, but their efforts have been more than offset by the overall market downturns in EMEA. We will continue to assess our cost positions in this region, given the overall market environment. We’ve also made some hard decisions as part of the Americas Phase 1 transformation effort regarding people and product lines, but the end result is we will focus our key resources on more profitable customer and product portfolios that drives innovation and is more solution oriented. We’re also delivering on our global sourcing saving commitments. Phase 1 transformation should deliver sustainable marked expansion in 2016 and beyond. At this point, we’ve also moved to settle some long-term obligations for the company, with the expected U.S. pension settlement being the largest to-date. And we will continue to look at other opportunities to settle other long-term obligations. The Americas Phase 2 transformation continues to be refined as this process was impacted by the Phase 1 sale. As previously discussed, the focus will be on consolidating and optimizing our manufacturing and distribution footprint to better support the needs of our customers and improve our cost structure. Again, I will provide more details in our Q3 call. As mentioned earlier, I do expect to invest a portion of our future savings into reinvigorating customer training, R&D and our new product development pipeline. I noted this during our first quarter call that commercial excellence, our ability to delight our customers with new and innovative products, is a key for us to continue to able to differentiate ourselves in the marketplace. Finally, we will continue to look for every opportunity to continuously improve performance in our company. We are increasingly working together as one organization between businesses, countries, and regions to provide our customers with value-added products and solutions. We have our strategic priorities as an organization. And we are on track to complete what we said we would do. So with that Andrew, please open the lines for questions.

[Operator Instructions] And I'm showing, our first question or comment comes from the line of Jeff Hammond with KeyBanc. Your line is now open.

Hey, good morning guys.

Good morning, Jeff.

So just on the Americas kind of the more moderate growth, I mean if you talk about the indicators, they all seem pretty positive so I’m just trying to understand what do you think is driving the lower growth rate thus far this year and into the second half? And, you know, if you could just talk about also the sustainability of the margin performance you had in the Americas in Q2?

Hey, Jeff, this is Bob. First of all, the growth certainly was disappointing from our perspective. As Todd said earlier, we had some tough compares with timing of our price increases that we had signaled, but certainly the south-central really was a disappointment and that we saw the timing, the raining weather, and just the commercial impacts of construction related to the oil and gas business just in that area. So anyways, so that was moderated. I think we all saw GDP this morning come out and it was lower than expectation. So I think just in general, it was softer than we’ve seen. In addition, we’re focusing not only on rationalizing our product portfolio in our, let’s call it the undifferentiated products. We’re also looking at our differentiated products to make sure we’re capitalizing on the lower tail of that. So we’re doing market and channel rationalization, as well as product rationalization, especially before we move the products in Phase 2. So there’s probably a little growth in there, it’s difficult to watch it in all aspects. But we are feeling better about the second half, because the second half doesn’t have all the noise of the price increases and hopefully this weather will subside so we thought that in the first quarter with a harsh winner, but now moving on, hopefully in the third quarter and fourth quarter, will have better weather. So I think it’s just more tepid growth and I think we’re not the only one seeing that. And related to the second part of your question.

Yes, Jeff I’ll jump in on the second question in terms of sustainability in the Americas margins. I would say that in Q2, we saw 14.7% margins and from my perspective, a lot of that’s being driven by lower [indiscernible] from a productivity standpoint. And material savings, and commodities, and planned productivity and from my perspective, I see that going – continuing into the second half of the year. So I’d say the margin rates that we saw in Q2 for the Americas, we should be somewhere in that range as we headed to the second half of the year.

Okay. And then just quickly on the sale. You know, and maybe just talk to us about how you’re thinking about dilution overall from this rationalization, you know, kind of given that you’ve now sold a piece. And then, you know, as we look out and we get the cost out, how do you kind of make up, you know, for those lost sales and lost EBITDA and make this kind of an accretive shift?

Yes. So I’ll take that, what you saw with this rationalization, I’ll go back to the original concept. In the long run, we knew this product for us was a decreased focus and it was decreasing both from a sales and a margin point of view over the long run. So we knew it was dilutive to our overall margins. So in a perfect world without the euro, AERCO acquisition would have been more from a bottom line point of view would have offset the dilution that would cause in 2016 or not. So we’ll continue to look for both organic growth as well as acquisitive higher EBITDA growth with our acquisitions as we go forward. In addition, when you look at the second part of this year, as I said before, the absorption impact is going to be heavier as we exit the year and wind down some of the operations. So I think you’ll see more of that in China, it will be tougher margins in the second half even from the second quarter in China because they’re bearing the largest impact of the negative absorption in the China results because they produced the products that were shift to North America. So overall though I think selling is - it was faster than we expected. It allows my team to be more focused on our differentiated products and grow from that point of view. So we’re excited about this transition and we’re looking to moving forward in allocating our resources on our more profitable products.

Okay. Thanks a lot.

Okay.

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

Good morning, everyone.

Good morning, Jim.

Just to clarify as far as your absorption issues that you’re citing in North America, I mean is that isolated to the retail wind down or there some still that you’re experiencing in the foundry? And if it is in the foundry, how long before that’s no longer the case?

I was hoping we would not talk about the foundry, but anyway, the foundry is doing really well. It is really related to the retail reduction as well as, as we’ve been reducing inventory, there has been some absorption impacts with that. So really, it’s the wind down of the product as we said before, as we wind this down, we have standard fixed cost that we won’t be able to completely exit till the end of this year. So that’s really driving it.

Got it. Okay. And then moving to Europe, I fully understand that, you know, you have, you know, lower volumes that are depressing margins but when I look at a time like 2010 where you were at similar revenues but at a much higher profitability, I’m just trying to, I can’t get from your margin experience then, fast forward four to five years where you’ve done a serious amount of restructuring in the region and now you’re at a similar revenue level but at lower margins. Can you, I mean, are there mixed head of winds at play? Any color there would be helpful.

Well, it’s primarily volume driven and I guess there is some mix in it. But also realize, we’ve added some costs before the end of last year and fully this year for our overall new organization which is really a pan-European organization. However, the benefit of that is really in our tax line. So you are not seeing it in the margins but our effective tax rate in Europe has gone down quite a bit. So you got to put both of those in perspectives. But really its volume and absorption driven, we have a heavy fixed cost with our footprint in Europe. And as you know that footprint is very difficult and costly to get out of. But we’ll continue to look at that and monitor that and make sure we are optimizing that footprint for the future.

Okay. Thanks. And one more if I may, quick one. On just your priority list as far as uses of cash, you announced another $100 million in share repurchases. I see that you do have 6% or so debt coming due early next year. How should we be thinking about your priority list because I know that you probably have some M&A pipeline that’s building as well so if you could kind of just categorize your priority list as far as uses of cash, that would be great.

Yes, so Jim the other thing too just to mention is we do have a pension settlement that’s going to occur in Q4, I mean in Q3 which is going to use some of our cash but in terms of our track record of returning capital to shareholders in the foreign dividends and share repurchases, I think we have a good track record there and we’re going to continue to do so in the future and so. As it relates to the share repurchase we typically don’t talk about the timing of it, but I can tell you that we’re going to be absolutely offsetting solution from a share issuance associated with our employee plan at an minimum and that the share repurchase will be continue to be a important part of our play book going forward.

Great. Thank you.

And our next question or comment comes from the line of Kevin Maczka with BB&T Capital Markets. Your line is now open.

Thanks. Good morning.

Good morning.

Question on AERCO. I’m just wondering if that’s exceeding your internal plans? They did $0.09 this quarter. I know it’s seasonably heavy in Q2 and Q3. That’s almost half the accretion you were expecting for the full year.

Yes, so we are real pleased, Kevin with - AERCO’s performance they had a real solid Q2, and solid first half. So we’re excited about where they’re going. So we want the team to keep it up and little tougher comparison in the second half of the year for them, but we’re excited about the AERCO and the prospects with the company.

Okay. Shifting over to the [indiscernible] you’re very clear on the second half and full year top line impact of the sales that are coming out. But to bring that down to the bottom line when you say the costs are trending to the mid point, I think before you were talking about decremental margins this year on that in the kind of 15% to 20% range. Is that what you mean by trending towards the mid point?

Well, we actually meant in the overall cost to implement the restructure, but going back to your - really the 15% to 20% is what we talked about before, we think that’s still valid in the second half of the year as we start dropping those sales really at the gross profit level versus what I call the operating income level, which you’ll really see the benefit once we get rid of all these fixed costs in the second half of the year. You’ll see the benefit coming in the 2016.

So still looks like 15% to 20% decrementals on that $80 million to $90 million reduction this year is good and then that will be much less than that because of the fixed costs take-out on the additional $100 million next year?

Correct, correct.

Okay. And then just to be clear, all of this is coming out of the Americas, correct, even though we’re manufacturing water connectors in China, that’s not coming off the Asia PAC line?

Yes, there’s a piece of the Asia-Pacific sales because they also sold the products. So we will see a reduction in the Asia-Pacific sales, certainly much less than the North America sales, but there is an absorption impact and a margin fit in their margins. We expect to be south of what we reported in the second quarter and in second half of the year because of that significant - I mean it was a large facility and we’re still in the wind down of that.

So of the $75 million that’s winding down, that’s manufactured in China, just curious how much of that is, would have been reported on that Asia PAC line versus the Americas?

About $15 million in the second half.

$15 million okay. Okay, thank you.

Thank you.

And our next question or comment comes from the line of Ryan Cassil with Global Hunter. Your line is now open.

All right, thanks, guys. I wanted to ask about the transformation to Phase 2. I know there will be more details coming out but what hasn’t been done? You know, what could be the target and focus without getting into the quantitative numbers?

Well, I think our team continues to work on Phase 2; a lot of analysis is going on as well as a lot of what I call preparation for Phase 2 is going on. So we are still making progress behind the scenes, what we’re very careful of is the timing of the announcements because that impacts our employees and we want to make sure given the scope of Phase 1 what we sold and what we are driving inside of Phase 1 with a lot of resources and Phase 1 with the sale we are also providing transitional services. So that’s taking some of our resources that’s slightly delaying Phase 2, but in the long run, we’re real pleased with the outcome and what we think is the incremental cash flow associated with the sale as well as, it was a great thing for our existing employees versus winding down the businesses. They will have opportunities that Sushi to continue with their careers.

Okay, fair enough. Good luck with the transformation.

Thank you.

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

Hi, guys. Thanks for taking my questions here. I just wanted to clarify in slide 5 the financial impact on 2016 from the Americas transformation, it’s an incremental 100 off of 2015, right? It says 190. That’s off 2014, right?

Yes, that’s correct.

Okay. And then just looking at AERCO, so it looks like 2Q margins were like 19% versus 9% in 1Q. I know you can see the revenue how it falls out that it’s second quarter, third quarter weighted. Is that a pretty normal margin kind of shift that you would expect and would you think, like, 3Q is similar to 2Q and 4Q is similar to 1Q is kind of roughly how we should look at that?

Yes, I think Joe, you are spot on, I think again the big driver of the performance of Q1 to Q2 is really driven by volume, and favorable mix. In terms of - we saw some nice performance out there aftermarket business. But I would think that Q3 profile, margin profile to be somewhat consistent and then Q4 to be closer to Q1.

Okay, fair enough. And on EMEA, I guess margins there may be a little bit below what we’re looking for and I was wondering if you could kind of quantify what you’ve seen so far in the first half cost savings from the efforts that you’ve put in last year, like, what have you realized to date there and what are you kind of building into the second half and where do you kind of see margins shaking out there?

Yes, so in the first half we saw about $4 million of cost savings associated with the restructuring and transformation efforts in EMEA. And we assume a similar type of performance in the second half of the year. So again the big driver is really just the volume and the absorption associated with that. And so if you look at their margin profile in EMEA, they were 7.5% I think in Q1, we said it was going to get a little bit better in Q2 and it did at 9.5% and we think it is going to get continue to get better and I would say in the second half of the year as some of that volume stabilizes.

Okay, fair enough. And then lastly for me, I think the impact of the lost sales from the transformation in 2015, it seems to be a bit more back weighted than probably a lot of people had modeled, certainly more towards 4Q. So is there any sort of margin implications that you would kind of guide us to in the second half related to that? Like, the weighting of those sales and when that decline is going to hit?

Yes, I still think it is in the 15% to 20% range. It is difficult from the timing of Q3 and Q4, certainly Q4, given that we’re selling the Americas piece that will be done by Q3. So we’ll see a large impact out of the Americas in Q4. So, as I said earlier in my comments, I think it’s going to be heavily weighted more towards Q4 as we wrap up and - that business both in the Americas and in Asia.

Yes, and I would add one comment is that in Q3, we think it’s somewhere between $25 million and $35 million decline from a year-over-year perspectives that relates to the sale of the undifferentiated products.

Good. Thanks guys.

Thank you.

And our next question or comment comes from the line of Kevin Bennett with Stern Agee Capital. Your line is now open.

Good morning, everybody.

Good morning.

Good morning, Kevin.

Bob, if I go back to Asia-Pac real quick, I know you’ve talked about margins are going to get worse in the third quarter than they were in the second quarter. If I look out once all this is done, I mean where do you think those settle out? Are we looking an at new run rate in the low teens or can we get back up to the high teens?

I think its going to be more on that lower-end, because there was a lot of volume and absorption, that they had as they transferred a lot of business to the U.S. so a lot of their company margins, so the team there is focused on really developing and growing, you saw the large growth, let’s call it the first quarter and second quarter, and that’s really most of that growth is focused on what we call differentiated products. So you’re going to see a shift and it could be more in the high single-digits as we start off. So as we are reallocating resources, adjusting our fixed cost, et cetera, it’s going to get substantially reduced from where it’s been running without that intercompany volume.

Got it, okay that’s helpful. And then if I think about price cost I know you guys raise prices but given what we’ve seen in just the commodity complex, can you talk about the benefit you may be seeing from lower material cost and how you view that going forward?

Yes, so certainly we’re seeing benefits in the material cost side. Certainly our customers are pushing proportions of that back. Pricing, we’re the one-ish range in the Americas. But we’re really seeing difficult price pressure inside of the EMEA, with the volume decreases lot of our customers are pushing real hard for price decreases. But we’re actually seeing negative pricing inside of EMEA. We’re trying to hold our own on that, but certainly we’re seeing the benefit of commodities. Europe hasn’t seen the benefit of commodities because most of the commodities are bought in U.S. dollars. So with the depreciation of the euro, they’re not seeing that benefit of commodity. So overall though both of those, I believe are positive for the whole company. And we believe we will continue to see that in the second half of the year.

Got it. So net, net, we’re looking at a positive impact.

Yes, absolutely.

Okay, great. And then last question from me, I was wondering if you could talk about your order rates and may be as the quarter progressed and then what you’re seeing into July?

Yes, so let’s start with Americas. I think as we look in Q2, we got off to a pretty slow start in the month of April and we saw orders progressed I would say nicely in May and June. And what we’re seeing so far in July is probably a little bit softer than we expected, but still there are on forecast and again feeling pretty good about what we have in there for Q3. As it relates to the Europe, we actually saw some really nice progression as we went through Q2 and early pulling in July is that the order rates are actually stabilizing, which from a euro perspective is pretty positive. So I would say Americas slightly lower than expectations in July, and EMEA is probably in line with what we expected.

Got it, thanks for that Todd. Thank you guys.

Okay.

Thank you.

And I’m showing no further questions at this time. So with that I’d like to turn the conference back over to President and CEO Mr. Bob Pagano.

Thanks Andrew. In closing I’d like to thank you for taking the time to join us today for our Q2 earnings call. And we appreciate your continued interest in Watts Water. We look forward to speaking with you again during our Q3 earnings call in late October. Thank you.