Watts Water Technologies, Inc. (WTS) Q3 2017 Earnings Report, Transcript and Summary

Good morning. My name is Krista, and I will be your conference operator today. At this time, I would like to welcome everyone to the Watts Water Technologies Third Quarter 2017 Earnings Conference Call. [Operator Instructions]. Thank you. Mr. Tim MacPhee, Treasurer and Vice President of Investor Relations, you may begin your conference.

Thank you, and good morning, everyone, and welcome to our third quarter 2017 earnings conference call. With me on the call today are Bob Pagano, President and CEO; and Todd Trapp, our CFO. Bob will provide his perspective on our third quarter results in the global markets. Before turning the call over to Todd, we'll address our third quarter results in more detail and offer our latest outlook for the remainder of 2017. 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 sections of our website. We will reference these slides throughout our prepared remarks. Any reference to non-GAAP financial information is reconciled in the appendix of the presentation. Before we begin, I'd like to remind everyone that during the course of this call, we will be making comments that constitute forward-looking statements. These forward-looking statements are subject to numerous risks and uncertainties that could cause actual results to differ materially. For information concerning these risks and uncertainties, see Watts 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. I will now turn the call over to Bob Pagano.

Thanks, Tim, and good morning, everyone. Please turn to Slide 3 in the presentation where I'll provide some commentary on the quarter. Overall, I was very pleased with our performance in the third quarter. Organic sales, excluding product exits increased 2% year-over-year. As anticipated, our top line growth rate improved as compared to the first half of this year. We also continued the earnings momentum from the first half and delivered another record quarter. Operating margin at 12.6%, was an all-time record for Watts. We delivered $0.80 of adjusted EPS, a record for Q3 and another quarter of double-digit growth. These results reflect the continued execution of key strategic initiatives, including the many transformation and restructuring actions and operational excellent focus and our commitment to profitable growth. Based on the results, the strategy is working. Now let me make a few comments about the regions. In the Americas, the residential and nonresidential markets remained healthy and we saw AERCO's boiler market continued to improve. We delivered strong organic sales growth in the Americas, as plumbing and drains product continue to grow and we saw recovery in AERCO's growth as well. As I'd mentioned many times, we continue to plant seeds to reinvigorate growth through new product development, geographic expansion and key account management. Let me illustrate with some examples. We've improved our capabilities in Latin America, by adding new sales and marketing resources. We've successfully introduced our European stainless steel drains offering into the Americas markets. And our enhanced new product development process drove the recent introduction of SmartSense, a gas connector kit, which automatically shuts off gas flow at a prescribed temperature range and provides protection against gas leaks, should a gas line be compromised. SmartSense has many applications in both the residential and commercial settings. These are just a few examples of the early benefits of seed planting, taking hold in the Americas. Regarding commodities, we've addressed the latest spike in copper by announcing a mid-single digit price increase in the Americas, that goes into effect in Q4. We've seen a number of our competitors who are also dealing with higher input costs announced price increases as well. Now let me touch upon the series of natural disasters that affected the Americas this past quarter. Certainly, our first concern was for the welfare of our employees and I'm happy to report that all employees are safe. Our facilities in those regions sustained minimal damage, were back online quickly. We also are working with our suppliers and reps to ensure the right inventories in place to meet future demand. The negative impact to our growth in the third quarter was minimal. We believe these regions will recover over the medium to long term, but timing is difficult to predict. We expect continued softness that may affect our near-term business with potentially some upside as we head in to 2018. Turning to Europe, we saw continued stabilization in the markets and sentiment is fairly positive. With regards to our performance, we experienced sales headwinds due to known product exits and lower HVAC demand, especially in Italy, which more than offset solid growth in Drains. We saw pockets of growth in certain regions, but the larger European countries like France and Germany were flat to down. Even with the softer top line, the team delivered a record operating margin in Q3, as our focus continues to be on profitable growth. Todd will provide more color in just a few moments. In Asia-Pacific, we see the market is somewhat mixed. China's construction market continues to grow albeit at a slower pace. GDP in China is still solid, but there are concerns about the country's high debt levels. Outside China, we see reasonable GDP growth in Korea and Australia, offset by softness in the Middle East as the latest GDP estimates have been revised down for that region due to oil market volatility. During the third quarter, Asia-Pacific top line performance was impacted primarily from known product exits and top comps. We believe this is a timing issue and are expecting more robust growth in the fourth quarter. Similar to the Americas, Asia-Pacific is also benefiting from our key growth initiatives, including geographic expansion. Our business in Korea, which previously only sold boiler products, is now selling a broader Watts offering. Sales In Korea are up double-digits this year. In the Middle East, we made our first sale of water heaters into that region during the third quarter. So again, more example of our strategy beginning to drive growth. With just over 2 months left in the year, we are confident in our ability to close out 2017 on a positive note and in achieving the outlook we've provided back in August. At a consolidated level, we expect the second half top line growth rate to generally be in line with the August guidance with some puts and takes at the regional level. We expect our operating margin for the full year should approximate 12%, which would be a record for the company. And free cash flow should also be a good story and convert at 100% of net income for the year. Now I'll turn the call over to Todd, to talk about our third quarter operating performance and provide some color on our fourth quarter outlook. Todd?

Thanks, Bob, and good morning, everyone. I'm on Slide 4, which shows the third quarter results. Reported sales of $365 million were up 7% mainly driven by the PVI acquisition, which added approximately $14 million or 4% in the quarter. Foreign exchange positively impacted sales by $6 million or 2%. Organically, sales were up 1%. As expected and communicated, we saw a negative impact of about $3 million or 1% in the quarter from product rationalization in both Europe and Asia-Pacific. Excluding the rationalization, organic sales were up 2% with strong growth in the Americas, being offset by a decline in Europe. I'll talk more about our regional performances in a few minutes. Adjusted operating profit was $46 million, an increase of 11%. This translated into an adjusted operating margin of 12.6%, up 50 basis points versus last year, and an all-time record quarter for the company. Excluding the dilutive impact from PVI, adjusted operating margin grew over 70 basis points. We attained this margin while continuing to invest in our growth initiatives. Volume, productivity, restructuring and transformation benefits were the main drivers of the record margin performance. Adjusted EPS of $0.80 was a 13% improvement over last year and a new third quarter record for the company. This EPS increase was driven primarily by strong operational performance. The effective tax rate in the quarter was 32.9%, slightly lower than last year, mainly due to the mix of worldwide earnings. Turning to cash, on a year-to-date basis, free cash flow was $57 million, this was a 31% improvement over the same period last year, mainly due to the timing of capital spend. We do expect the capital spend will pick up in the fourth quarter, as we remain committed to fund future productivity improvements across Watts. Historically, Q4 is a strong cash flow quarter for the company and we expect that trend to continue this year as well. To reiterate Bob's comments, we are very pleased with our third quarter performance. Setting new highs and adjusted operating margin and adjusted EPS while continuing to invest in the future. Turning to the regions on Slide 5, let's review our Americas results in the quarter. Sales of $239 million were up 11% on a reported basis, largely driven by the acquired sales of PVI. Organic sales were up a healthy 4% in the quarter. We saw continued strong demand in our valves, drains and HVAC products, both in the U.S. and in Canada, as we are starting to see some early benefits from our key growth initiatives. AERCO's business was up mid-single-digit as well. As anticipated, the convincing boiler market continued to improve after a slow first-half. PVI also performed well. Our sales were up mid-single digits in the quarter driven by demand for our gas condensing water heaters. Adjusted operating profit in the Americas was $40.5 million, a 12% increase year-over-year. Operating margin increased 10 basis points to 16.9%. Excluding the dilutive impact from PVI, adjusted operating margin grew over 70 basis points. Margins were driven by higher volume, productivity and transformation seasons, which more than offset the dilutive impact from PVI, incrementals growth investments and some top comps. Just as a reminder, last year's Q3 operating margin included a one-time benefit of approximately 70 basis points for absorption associated with the inventory build to support the transformation initiatives. So to summarize, a very good quarter for the Americas on both the sales and profit lines. Now let's move to Europe. Please turn to Slide 6. Sales of $109 million were up 2% on a reported basis and down 3% organically. Excluding the impact of product rationalization, organic sales declined to 2%. Foreign exchange, mainly the Euro, was a tailwind of about $5 million or 5% in the quarter. Looking at the platforms, we saw some softness in fluid solution driven by the impact of product rationalization and lower HVAC sales. Our HVAC business was affected by a slowdown in demand associated with a directive to use more energy efficient products in Italy. On the positive side, our Drains business had another solid quarter, driven by increased product releases within the commercial segment. Drains continue to perform well through its efforts in key account management, geographic expansion and sales and marketing initiatives. By geography, we saw strength in the Benelux and Nordic regions due to new product introductions and stronger electronics demand. Sales in France were essentially flat in the quarter with some growth in electronics offsetting product rationalization. Conversely, we saw some softness in Germany from lower OEM business and in Italy for the reason I just mentioned. Adjusted operating profit for Europe in the quarter was $14 million, a 10% increase over last year. Operating margin of 12.8% increased 90 basis points and was a new record for Europe. The strong margin expansion was driven by productivity, restructuring benefits, favorable sales mix and a bad debt recovery, which more than offset the volume loss. So for Europe, the team delivered a record operating margin in Q3, despite the top line headwinds. We expect the region will return to growth in the fourth quarter. Moving to Slide 7, let's review Asia-Pacific's results. In the quarter, sales of $16.6 million were down 10%, both on a reported and organic basis. Excluding product rationalization, organic sales were up 1%. Keep in mind, we also had a top comp sales in Q3 of 2016 were up 22%. Q3 was a continuation of Asia-Pacific's first-half performance, with strong growth in China offsetting weakness in Australia and the Middle East. Excluding product rationalization, China's sales grew 8% due to strong demand in our valve products, sold into commercial applications. Our residential underfloor heating products also performed well in the quarter, however, we are starting to see some demand softness in the retail channel. Sales outside of China were down 3%, mainly driven by some de-stocking in Australia, and the timing of project releases in the Middle East, which more than offset another strong performance in Korea. As Bob mentioned, the investments we have made in Korea are starting to pay dividends, which is great to see. Adjusted operating profit and adjusted operating margin were impacted by lower volume, unfavorable sales mix and incremental growth investments. In the quarter, Asia-Pacific also saw a significant decline in intercompany volume, which negatively pressured margins as well. In summary, a soft quarter for Asia-Pacific. However, we attribute most of this to timing and we expect the region will deliver solid, top line growth in Q4. Finally, turning to Slide 8. I'd like to make a few comments on Q4. On a consolidated level, we expect the organic sales growth rate should improve on a sequential basis over Q3. And we expect in both Europe and Asia-Pacific to rebound from the Q3 growth rate performances. Product rationalization in the quarter should approximate $3 million. It's also important to note that PVI will be included in our organic calculation in Q4. As a result, there will be only 1-month sales considered acquired, which we estimate to be about $4 million. Operating margin in Q4 should expand versus the prior year, supported by volume growth and continued execution of our productivity and transformation initiatives. We expect growth investments will be higher in Q4 versus Q3 and we anticipate more material cost headwinds as well. And we'll continue to be prudent and review our fixed cost structure to ensure it is aligned with our volume expectation, as we head into 2018. Finally, we are expecting strong cash flow generation in Q4, consistent with our performance over the past several years. As I previously mentioned, we are anticipating higher capital spend in Q4. We estimate capital spend will be in the $30 million range for the year. With that, I will turn the call back over to Bob, before we begin Q&A. Bob?

Thanks, Todd. To summarize, the positive momentum from our many initiatives continued as we delivered another record quarter. We're expanding margins and driving double-digit earnings growth, while continuing to invest in new products, technologies and new geographies. The investments will help drive our future performance in 2018 and beyond. So with that, operator, please open the line for questions.

[Operator Instructions]. Your first question comes from the line of Ryan Connors of Boenning and Scatter.

So I wanted to talk a little bit about this pricing initiative that you mentioned and how much of that is really truly driven by the raw materials and how much of that is more business as usual and opportunistic in nature. And if you can kind of talk through, I know you mentioned it on the top down level mid-single-digit, but talk through some of the various products lines and where would you expect that to kind of sail through pretty nicely and where you might expect to see some more challenging uptick?

Thanks, Ryan. Let me try to put that in perspective. So given the copper prices going out, we looked at probably about half of the price increase is really related to that and half is normal pricing. The issue we always have to remember is that whether our competitors follow suit or not. So it was nice to see that they followed suit and let's hope that they continue to do that. When I look at where we realize our price, usually in the wholesale channel, that's our best opportunity to do that. When you look at OEM in retail, that certainly is tougher, a lot of that is based on contracts, a lot of our OEM deals are based on LME pricing. So we're able to just with that, but that's really how we look at it. Wholesale usually we can pull that through and so, we believe it's the right prudent thing to do. And as I said, let's hope our competitors follow suit.

Okay, and then my related follow-up there would be, in terms of the channel situation, you mentioned wholesale. Obviously, channels are evolving more online, distribution and then dealer consolidation continues and I wanted to get your take, Bob, on that issue in general and then specifically as it relates to how that evolution of the channel impacts a major pricing initiative like this?

When I look at the channel, we've exited a lot of our undifferentiated products, which were more commoditized in nature. When you look at some of our larger project, backflow or IntelliStation or some of those items, they are not as easy to be susceptible through an online retailer type initiatives. So when I look at it, we're always watching that, but I think the products that be exited were more susceptible to that. So as we go forward, it's a really our initiative around providing solutions to our customers, bundling components into solutions and that's where we believe we'll differentiate ourselves and that's where we believe we'll make a difference and allow us to push price through.

Got it and just a final one just on cash flow has been -- cash balance is now significant. Todd, you mentioned expectation of continued strong cash generation. I mean you've talked about buybacks, but really the share count hasn't really budget much. I mean is there -- what's your view going forward on cash deployment? And then specifically, whether you may or may not get more aggressive on the buyback side?

Yes. So, again we believe in a balanced capital allocation strategy, focus on our internal growth and M&A opportunities and continue to return to shareholders via dividends and stock purchases. When I think about our share repurchase and consistent with our past communications, our goal at a minimum is to offset share creep associated with option issuance and we're doing that. We spent $14 million this year and bought back over 200,000 shares and our share count is flat. And I think we're just going to continue to have that approach going forward. Obviously, we'll be opportunistic in the marketplace where we see dislocations, but I think going forward, we are going to remain with this capital deployment approach.

Your next question comes from the line of Nathan Jones of Stifel.

Just a follow up to Ryan's question. Historically, is there kind of an average that you realize when you put through a pricing increase? Like if you put through an x percent pricing increase, do you get 0.5x, do you get 0.8x, do you get 1x?

Well again it varies by channel. When we look at it, normally it's probably half of what we put out we usually see, but again that varies by channel, right? So you have to look at each one of those channels differently. I would say the wholesale is more of that 50% of what we put out usually comes through. So that's the better way to look at it. The -- but I keep on cautioning everybody, it depends on what our competitors do. So if they are offering promotions and stuff, unfortunately we have to follow suit, so we don't lose market share. So it's always that balance.

Okay, got you. And could you quantify the impact that increased copper and other raw material prices had on margins in the third quarter?

We don't normally talk about that because of the competitive nature on it. Certainly, it was a headwind, but our global sourcing initiatives as well as our pricing initiatives more than offset that. So we've been able to mitigate that. But certainly, we're seeing it. We're seeing it more in the second half of the year than the first half and that's why we wanted to put in a price increase, which is about 4 months earlier than we normally would do.

Okay, got it. And then maybe just a little more strategically discussing the growth initiatives here. You've clearly been investing in growth initiatives that will probably begin to see more evidence of next year. Are there plans for further growth investments? Would you plan on increasing the level of growth investments in 2018 over 2017 and how should we think about that?

Yes. Well we're probably looking at about the same investments. We're just starting our 2018 budget process. But I would think as you've heard me talk about planting seeds. A lot of these seeds and new product development, expanding geographically, are really starting to -- we're just starting to see them in the second half here. So we'll continue that focus on new product development. We're getting better at it and we're gaining some traction on some of these initiatives. So it makes us feel confident as we move forward for the remaining half of -- part of this year and into next year.

And your next question comes from the line of Jeff Hammond of KeyBanc.

This is James Picariello. My line did drop so I apologize if this question was already asked. Did you quantify the bad debt recovery in Europe?

It was actually about a 50 basis points headwind or I should say tailwind in the quarter versus what we reported. So probably about $0.5 million impact.

Okay, got it. And then just in Europe, you called out that HVAC trend in Italy. Does that headwind correct itself in the fourth quarter? Or is that a regulatory issue that doesn't go away? And then what gives you the confidence that growth returns in the fourth quarter?

Let me give you a little bit of background on that Italian directive. So there's a specific European energy directive that was supposed to go into effect in Italy in December of 2016 and what that directive called for was that all multidwelling units had to have some sort of heat cost allocator installed in order to better manage energy consumption. And the deadline for the regulation was extended by the Italian government to June of 2017. And at this point of time, there still seems to be a lot of confusion around the directive in terms of noncompliance. So for us, we did definitely saw a direct impact on our sales in this product line in Q3 and we expect the same headwind in Q4 until there's more clarity on this directive going forward. It's isolated in Italy, but also had a significant impact on fluid solutions growth rate in the quarter. Your second question is how do we get more comfortable with Europe as we get into Q4. I would say, if you look at our order rates as we exited September and what we're seeing so far in October, it gives us comfort that it supports I would say, our return to growth in Europe in Q4.

Got it. And just on the -- on Italy once more. So the regulations and building codes that typically works in your favor, does that position you guys well once the uncertainty clears out? Do you guys have the right product for that?

Well, we clearly have the right product, and we had robust sales last year, based on that code change. What happened was is they started slowing down that code and people stopped buying our product and that's where we really see in the hole in Q3 and Q4. We're hopeful that they will reinstitute that code because it's a code that makes sense. And we're continuing to push for it. But again, we can't control that. We can control our margins, and our cost but from a market point of view, we can push and push the codes, and we'll continue to do that. But as we look forward here, we're hopeful that the codes will go into effect and will help us next year. But again, based on what we're seeing right now, it's not clear that even next year they'll push it. So we're watching it very closely.

Understood. And then just on AERCO and PVI, PVI has been strong all year. Looks like AERCO saw a nice pick up in the quarter. What's your outlook for these business in fourth quarter, early next year? And then how would you just assess the general competitive backdrop for AERCO specifically?

Yes, we saw a nice mid-single-digit growth in these businesses and we see that on a go forward basis for sure. The competitive position, it's very competitive out there. And when you look at it, in particular in the condensing water heater business, that market is actually down. So we've been gaining share. But you look at the AERCO side of the business, the boiler market is very competitive and our new product is starting to gain traction and the teams are executing on that.

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

This is actually Jacob Seide on for Joe. Most of our questions have been answered already, but i have a few for you guys. So on the Drain growth, I just wanted some more color on what you're seeing in end-market health as a rethrough? And then just follow-up on the last one about the sort of order strengthening in Europe. Is that broad-based or are you're seeing renewed strength in certain products or regions?

Yes. So when we look at the drain business, there's 2 pieces of it, where we've been really executing is on bringing our stainless steel drains into the U.S. market. So that's been very positive. Our regular Drains business, our traditional cast iron drains business, we're seeing positive momentum and that gives us a good feeling, as we look at our normal plumbing business, because as we all know the drains are positive and that leads later on in the cycle on that. When you look at Europe. Really when you look at where we're seeing the positive impact, it's in the French orders. We're seeing positive nature in that and you know my feelings on Europe. I'm always very cautious given the political uncertainty and the timing and the belief that a lot of new construction is not happening. So we're cautiously optimistic. But we are seeing positive orders that we believe will translate into positive revenue in the fourth quarter for Europe.

And there are no further questions at this time. I'll turn the call back over to Bob Pagano, for closing remarks.

Thank you for taking the time to join us today for our third quarter earnings call, and we appreciate your continued interest in Watts. We look forward to speaking with you again in our fourth quarter call in February. Thank you, again.

And this concludes today's conference call. You may now disconnect.