Watts Water Technologies, Inc. (WTS) Q1 2017 Earnings Report, Transcript and Summary

Good morning. My name is Scott and I will be your conference operator today. At this time, I would like to welcome everyone to the Watts Water Technologies, Inc., First Quarter 2017 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. [Operator Instructions] Thank you. Tim MacPhee, Treasurer and VP, Investor Relations, you may begin your conference.

Thank you. Good morning, everyone. And welcome to our first quarter 2017 earnings conference call. Joining me today are Bob Pagano, CEO and President; and Todd Trapp, our CFO. Bob and Todd will provide their perspective and analysis of what first quarter 2017 results. Bob will offer some color on the market, update you on our key initiatives and in our latest acquisition PVI. Todd will also update you on our full year outlook. 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 Web site. 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 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, future events or otherwise. Now let me turn the call over to Bob Pagano.

Thanks Tim and good morning everyone. Please turn to Slide 3, let me briefly provide a run down of the first quarter. Watts delivered another quarter of solid operating margin expansion and EPS growth despite a muted top-line. Overall, the first quarter was in line with our expectations and what we communicated during our last call in February. Sales excluding product rationalization were essentially flat. A continuation of what we experienced in the second half of 2016. Top-line growth in Europe was more than offset by softness in the Americas, mainly attributable to AERCO. Despite the top-line pressures, we were able to expand adjusted operating margins by 30 basis points to 11.1%, a first quarter record for the company. We delivered adjusted EPS of $0.65 or 14% increase over last year another Q1 record. We are executing on our strategy to transform the portfolio, restructure operations and drive cost and pricing discipline and these efforts are reflected in our financial performance. Todd will review the quarter's results in more detail in a few minutes. Overall, the end markets are performing inline with our expectations. In the Americas much of the construction data remains lumpy, but we sill expect both the non-resi and resi markets to grow moderately for the year. Europe continues to show signs of stabilization. Recent elections have quelled some anxieties with the final French elections still to come. Asia Pacific markets are growing but at more modest levels. Our key initiatives are also progressing as planned. The Americas transformation program continue to deliver results. Our efforts regarding phase two are substantially complete, in total we will exit five manufacturing sites in addition to two distribution centers and we expect to achieve our goal of reducing our footprint by approximately 30%. By final project cost and expected full year run rate savings for phase two are inline with our previous discussions. Our significant restructuring actions in Europe primarily in France are complete and we are beginning to see the expected savings in our P&L from this action. We also continued what I call seed planning or investing in new product development, geographic expansion, solution selling and key account management to drive future organic growth. We are making inroads in new territories most recent wins in Mexico and expanding our BLÜCHER Drain solutions into the growing U.S. craft breweries market. In Q1, we created a leadership position reporting directly to me for key strategic account management. This will ensure we introduce our entire portfolio of products to strategic customers with the goal to make it easier to do business with Watts. And we are beginning to drive more solutions for commercial customers including bundling our Watts AERCO and PVI products for boiler room applications. Lastly, the PVI acquisition is performing well and inline with our expectations. PVI drove solid growth during the quarter. And we are starting to realize the anticipated cost synergies although we are still early in the execution phase. So, overall, a solid start to the year inline with our forecast and expectations. Now, I will turn the call over to Todd to talk about our first quarter operating results in more detail. Todd?

Thanks, Bob and good morning, everyone. I'm now on Slide 4, which shows the first quarter results. Sales of $347 million were up 1% on a reported basis. This increase was mostly driven by the PVI acquisition, which delivered about $14 million in sales in the quarter. Organically, we were down 1%, but as Bob mentioned flat excluding product rationalization. Recall that we expected about $20 million for the full year in DYI erosion and other product rationalization and we had about $5 million of that impact in the quarter. Also, foreign exchange primarily driven by the weaker euro lowered sales by roughly $4 million or 1%. Adjusted operating profit increased 3% to $38 million. This translated into an adjusted operating margin of 11.1% up 30 basis points versus Q1 of last year. In terms of operating margin, the 11.1% represents a first quarter record for Watts. Strong productivity including savings from restructuring was the main driver of the record Q1 margin. Adjusted EPS of $0.65 was 14% better than last year another Q1 record for the company. The increase was driven by operational improvements, lower interest expense and a favorable tax rate compared to last year. The effective tax rate of 33.4% is basically inline with our full year outlook. It is about 400 basis points lower than Q1 last year primarily related to a reserve that we booked in 2016 associated with a tax audit. So, overall, just as we signaled back in February, Q1 played out like we thought. We delivered strong operating margin expansion in EPS growth despite a sluggish top-line. Before discussing the regions, I want to mention a minor change to our segment reporting. Recall that last year, we reorganized operational responsibilities between Munish Nanda and Elie Melhem. Munish took over Europe, while Elie assumed responsibility for the Middle East and Africa. Beginning this year, we aligned our management and financial reporting to reflect this change. In the 8-K filed last week, we restated 2016 quarterly information for comparison purposes. That 8-K is also included in the appendix of this presentation. This change does not affect the Americas segment and the financials included in this presentation have been restated accordingly. Now, turning to the regions on Slide 5, let's review the Americas results for the quarter. Sales approximated $229 million, up 3% on a reported basis driven by the PVI acquisition. Organically sales were down 2%. Solid performance from our core plumbing products like drains, back flows and valves were more than offset by headwinds in AERCO product line into our lesser extent the anticipated retail sales erosion, we have discussed during previous calls. AERCO sales were down due to softness in the overall condensing boiler market, continued project delays and competitive pricing pressures. As discussed last quarter, we are seeing some very aggressive pricing actions in the marketplace. At the same time, we have remained disciplined with our commercial strategy forgoing short-term gains for longer term profitable growth. We are also very excited about our new platinum boiler line, which was launched in the first quarter. We believe that this innovative new product will give us a competitive advantage that will allow us to differentiate ourselves in the marketplace. Early indications from our customers in the platinum are positive. We expect sales of platinum to pick-up in the second half of 2017 as the new product gets specified into commercial buildings. PVI delivered $14 million of sales in the quarter, which represents mid-single digit growth over Q1 of 2016. So, a good start to the year for PVI. We are very excited to have PVI in our portfolio and the integration with AERCO is on track. Adjusted operating profit was roughly $34 million. This translates into an adjusted operating rate of 14.7%. The year-over-year margin performance was driven by strong productivity and transformation savings, which basically offset the volume decline in AERCO, lower operating margin at PVI and continued growth investments. It should be noted that PVI negatively impacted Americas margins by roughly 50 basis points versus prior year, which is inline with our expectations. So, overall, a mix start for the Americas with growth in core plumbing products being muted by AERCO headwinds. Now, on to Slide 6, let's review Europe's results. Sales of $105 million were down 3% on a reported basis and up 1% organically. Excluding product rationalization, organic sales were up 2%. Foreign exchange negatively impacted sales by about $5 million or 4%. From a platform perspective, we saw a strong growth in drains offset partially by a reduction in fluid solutions. Drains had some nice project wins in Mexico and in Germany along with strong growth in the Nordic region. Within fluid solutions, our electronics product line was up double digits which was more than offset by softer HVAC sales and known headwinds associated with product rationalization. We saw low to mid-single digit growth in some of our key countries and regions, such as Germany and Scandinavia. By contrast, we saw weakness in France in both the residential and commercial markets due to political uncertainty with the ongoing election as well as continued softness in the U.K. Adjusted operating profit for the quarter was $12.6 million an increase of 24%. Operating margin of 12% increased 260 basis points as compared to Q1 last year. The strong margin expansion was driven by higher volume, favorable product mix, productivity and restructuring savings. So, all in all, a good start to the year for Europe. Moving to Slide 7, let's review Asia Pacific results. In the quarter, sales were approximately $14 million, flat on a reported basis and down 10% organically over the same period last year. Excluding product rationalization, organic sales were up 6%. With the addition of the Middle East into the Asia Pacific reporting segment, sales outside of China now represent over 65% of the total regional sales. Organically, sales outside of China were fairly flat due to some tough comps and timing of projects in the Middle East. China sales excluding product rationalization were up 23% driven by continued strong demand for our under floor heating products. We continued to expand our presence in this market as the growing middle class in China demands more comfort in their living arrangements. Adjusted operating profit was $1 million, was translated into an adjusted operating margin of 7.4%. The key drivers of the margin decline were at 22% reduction in affiliate sales in support of the 2016 Americas transformation, negative product mix and some growth investments. So, as expected a little bit of a slow start to the year for Asia Pacific. I would categorize it more timing than anything else as we expect growth to accelerate in the out quarters. On Slide 8, a couple of comments, I would like to make on cash flow. As you know, historically, Q1 is a slow period for us. Our free cash outflow for the quarter was $15 million as compared to a $31 million outflow last year. The year-over-year improvement was driven by higher net income, less inventory build and lower capital spending. As you recall, in 2016, we increased inventory to support the opening of our new distribution center in Columbus into established buffer inventory for other Americas phase two transformation activities. This quarter, we spend less than capital versus prior year. However, we believe this is just timing and we still feel like the full year range of $36 million to $40 million is intact. Repurchased approximately 69,000 shares of our common stock at cost of $4.4 million. Overall, we returned $11 million to shareholders in the form of dividends, in share repurchases as part of our continued balanced capital deployment strategy. While the first quarter is seasonally slow, we fully expect our cash generation will improve as the year progresses and are focused on achieving 100% cash conversion for the year. Before, I turn it over to Bob, just a quick update on our full year outlook. Slide 9 provides the details and I will highlight a few points. Generally, not much as changed since our February call. At a consolidated level, we continued to expect full year organic sales growth in the low single digits, with sales by region falling in line with our previous guidance. We expect operating margins should grow by roughly 60 basis points despite the incremental investment to support future growth initiatives. Currently, we expect to invest between $1.5 million to $2 million per quarter for the remainder of 2017. Lastly, as I just mentioned, we anticipate free cash flow converting at or above 100% of net income. So with that, let me turn the call back over to Bob before we begin Q&A. Bob?

Thanks, Todd. Let me summarize our discussion before we address your questions. The year started out in line with our expectations. Despite a muted top-line, we delivered Q1 record adjusted operating margins in EPS. We continued to drive our various rationalization and transformation programs as well as continued seed planning for further organic growth. We expect to make continued progress as the year unfolds and look forward to another solid year of profitable growth. With that operator, please open the line for questions.

[Operator Instructions] And our first question comes from the line of Ryan Connors with Boenning & Scattergood. Your line is open.

Great, thanks. Thanks for taking my question. I wanted to get your perspective on the pricing environment, Bob, and why it's not better. It seems like we've -- raw materials are up. There has been some consolidation both by yourselves and others. So supply or capacity seems to be maybe down, demand environment is not great, but it certainly workable. I mean why do you think it is that price increases are having a hard time -- harder time going through?

I really think, Ryan, if you look at it, what's happening is in the commercial market I think the projects are being a little more lumpier. And I think when projects get lumpier people are playing the price game. So I think that's a big piece of it. When we look at passing through, we announced our price increase at the beginning of March, it's too early to tell, but all signs right now are looking like we're going to be able to pass that along into the channel. So we feel good about our prospects are getting that. I think the competitive pricing level is really in the AERCO environment, which is really we're seeing larger commercial projects just be pushed out and I think that's where some of the pricing gets full, people want to fill their factories at any cost and we're just going to be disciplined in that area.

Okay. And then, as it relates to AERCO, you've talked a lot about the kind of tepid demand environment there, but what's your sense of how long that lasts, I know you mentioned -- Todd mentioned there is expectation of some return to growth on a consolidated basis, maybe in the second half, but speaking about AERCO specifically, can you give us some more detailed flavor on where do you see that heading near-term?

Yes. So, when we look at the condensing boiler market, our data shows that it was down 6% in the first quarter. So as we look at that, our project pipeline what we're coating on and what we're seeing in the marketplace is continuation of growth really in the second half. So the projects are going on and they are being coated and architect, everybody is really busy at this point in time. They just hadn't released all these projects. So, people are scrambling to get those. But, we feel good about the prospects, I was just out -- out on the field with the AERCO team and again and the reps and they feel good about the second half of the year because new projects are starting to move forward. As you know we have a real tough comp in Q2 with AERCO. We were up double digits last year in the quarter, so we believe we're going to have another tough quarter with AERCO in the second quarter and then it's going to return in the second half of the year.

Got it. Okay. That's helpful. And then last one from me. Just to revisit this issue which we've touched on a couple of times in the last couple of calls about kind of the impact of the product realignment on your distributor channel relationships and so forth. I mean, anything to report, any kind of update there on whether that has impacted anything, whether it would be channel inventories or line cards being moved around and anything you can give us on that?

No. We haven't seen anymore movement from that. When we exited the undifferentiated products, some of our DIY channel was a little upside maybe with us and reacted in the fourth quarter. Since then, we've not seen any further actions, but as you know that's not our most profitable part of the market anyway. So again, I think inventory levels are in line, we don't see any issues with inventory in the channels.

Got it. Super. Thanks for your time this morning.

Thank you.

Thanks.

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

Hey, guys, thanks for taking the questions. I had two of them. Hi, morning. The first one -- the follow-up on Ryan's question just on AERCO, the pricing in competitive issue, it sounds like there is some rationale players in the market as you talked to, but could you give us some sense, is there anything that whether it's historical precedent or other signpost that gave you the general confidence that this is temporary? And then to any degree if you can quantify how many more quarters you think you may see this play out for? And then I have a follow-up.

Yes. So a little bit about the market. We believe the condensing boiler market is and it has been very positive. People are moving to higher efficiency condensing boilers. Overall, we think this is a temporary glitch in the market. We saw it in the third and fourth quarter. We believe we're going to see the same thing in the first and second quarter. Primarily just because some of these projects are being pushed out, we're in the first half of last year, we saw some more robust activity. The political uncertainty slowed everybody down, slowed these projects down, and but overall, we believe the trend towards more high efficient boilers is going to happen. And we think it's going to -- we believe it's going to happen in the second half of the year is the turning point.

Okay. Great, thanks. And then, Bob, you alluded to some of the political uncertainty in your prepared comments. I know you guys talked about that in the February call when you outlined guidance for the year. And the guidance is unchanged, but directionally would you say that the trends you're seeing in Europe, either more cautious or maybe more optimistic versus your original view from February with the ebbs and flows that we're seeing real-time in the political environment out there.

We're feeling a little bit better. I think Sunday's elections will really tell us what's going on. I think everybody is waiting and seeing what that is, hopefully there is no surprise there. But we're cautiously optimistic, I mean, we had a good first quarter that was driven by double-digit gains in our drain business which drove the operating margins favorable. But, the general environment as Todd talked about in France is still a lot of uncertainties or not a lot of construction spending going on in the France at this point. So, hopefully would that behind us on Sunday, we can move forward with that. But again, I think everybody is kind of wait and see mode. And then, if that's starts ramping up, it will take a while. So we're staying with our full year flat forecast for Europe, only because the drains business was very -- that's a lumpy business that was strong in the first quarter and we can't comment on that every single quarter. So, we're going to be cautious, and then, let's hope that the elections -- the uncertainty goes away and it becomes more positive for the rest of the year.

Okay. Fair enough. Last one from me and I'll pass it on -- again, when you guys provided the 2017 outlook, you gave us some directional feel for how Q1 was going to shakeout, given some of the subtle re-segmentation here in Asia-Pac and EMEA, any directional feel you can provide for what we should be thinking about key trends across the different segments? Thanks guys.

Sure, Brian. This is Todd. From a top-line perspective, we expect Q2 to be marginally better than Q1, flattish versus down on a top-line perspective. I think a few items worth mentioning his -- as Bob alluded to Q2, we did have some tough comps. And so recall last year that we had -- I think close to 4% growth in Q2. Product rationalization will impact Q2 by about $6 million and I'd say it's about $2 million in each of the regions. In the Americas, we'll continue to benefit from the acquired sales of PVI somewhere in that $14 million to $15 million range. And also we have to continue taking account foreign exchange and as you recall last year the euro rate went up to about 1.13%. Today, it's a little over 1.09%. So, could add some more headwinds in the -- from a top-line perspective associated with foreign exchange. From an operating margin perspective, we still expect to see some nice growth year-over-year, really driven by productivity and restructuring benefits, which will offset some higher incremental investment spend. But, we still see better margin expansion in Q1. And PVI's margins should negatively impact the consolidated margins by 10 to 20 basis points in Q2 on a year-over-year basis and probably 40% basis points at the Americas margins. So that's a little bit off color how we see Q2 playing out.

Okay. Super helpful. Thanks guys.

Thanks Brian.

[Operator Instructions] Your next question comes from the line of Jim Foung with Gabelli &Company. Your line is open.

Hi, good morning guys.

Hi, Jim.

Yes. We can just kind of talk a little bit more about AERCO, could you kind of size the -- maybe dollar value number of projects that have pushed out because revenues became double digits and then whose cutting prices in an industry [ph]?

Well, Jim, look at the project activity, there are many projects and some are larger and other and it just depends on the various projects. But we've seen them pretty much across the board in all the territories projects being pushed out or delayed, where we thought we're going to shift some in Q1 and it moved out to Q2. Regarding pricing, we don't talk about competitors specifically on that, but it looks like there is both public and private companies in that space and I think a lot of them are going after whatever share they can grab. But we're being disciplined and we spend a lot of time over the last three years focusing our teams on profitable growth and we're not going to change that.

Okay. Fair enough. And then, I know you completed your Phase II in the Americas transformation and I know your outline margin improvement when you started the transformation plan and could you -- now that you've completed, are you able to see if you could get more margin lift from exiting the manufacturing sites and distribution locations?

Jim, clearly I think in our results, we're seeing the impact of that.

All right.

As Todd alluded to in the first quarter, our margins in North America were muted by the PVI acquisitions by 50 basis points. So, when you look at overall restructuring, we're on track with all our commitments, as I said in my prepared remarks, the brands restructurings done in Europe. So, we're seeing the impact of that, what's somewhat offsetting that is our investments that were really focused on growth. So, we are seeing the impact of it. The teams are aligning around that and I think you will continue to see that. We're now moving on to what I call the more sustaining part which is driving lean and productivity inside of the plants, but now have been consolidated. So, we'll continue to do continuous improvement in each one of those areas.

Okay. And then when you see PVI being accretive?

I think as we get into next year, I think that's the piece of it. Their margins and the integration is going very well as we've talked about. But as we move into next year, I think that's what we're driving towards.

Okay, great. Okay, thank you.

Thanks, Jim.

Thanks, Jim.

There are no further questions at this time. Mr. Pagano, I'll turn the call back over to you.

Okay. I think we have one participant…

I'm sorry. I just received a question from the line of Ryan Cassil with Seaport Global. Your line is open.

Hi, thanks for squeezing me in guys.

Hi, Ryan.

Hi, Ryan.

I wanted to just talk about the re-segmentation a little bit. I was wondering if you could expand on the -- just the rationalization a little bit there is -- our Europe and the Middle East and Africa at sort of different points here in their transformation journey or are there additional actions you maybe thinking about and that's why you separated these out and changed the management up or any color you could give there, it would be great. Thanks.

Yes. Last year we made the change to create the focus. And Ellie and his team have experience in the Middle East. We believe it's a growth market for us. We believe we're under-penetrated. And so we have a key focus in that region. So, there is nothing more really to read into that and also what we try to do is realign our internal reporting to our external reporting because internally we hold Ellie and his team accountable for both Middle East and Africa and Asia Pacific and he has dedicated teams in those regions. And we just didn't want to have two separate books, one internally and one externally. We felt it was more appropriate to have in the same, so that's all there is inside of that.

Got it. Okay. Thanks for the color. And then, one of the things has been addressed your leverage still isn't too aggressive. I was wondering if you could talk about your thoughts on M&A here really focused on what you already have or if you're still in the M&A market and what you're seeing there probably would be helpful. Thanks.

Sure. Well, certainly we've been internally focused. We did the PVI acquisition. We're moving forward and integrating that well. But, we're always looking and cultivating acquisitions and potential acquisitions in, if they are out there, the pipeline is full, we actively continue to look at that, but it's very difficult to say when in timing of any of those things at this point in time. So, we'll continue to look for once that make sense and that have their appropriate returns for our shareholders, but we're always looking and if that makes sense, we'll take a look at it.

Okay. Still very U.S. focused and more commercial product focused, is that fair to say or has that changed?

Yes. I think that's a fair statement, absolutely. That's a fair statement because we believe the margins in the commercial side are stronger than the residential side.

Make sense. Thanks very much.

Thank you.

Thanks Ryan.

There are no further questions at this time. Mr. Pagano, I'll turn the call back over to you.

Okay. Well, thank you, everyone, for taking the time to join us today for our first quarter earnings call and we appreciate your continued interest in Watts. We look forward to speaking with you again during our Q2 earnings call in August. Thank again.

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