Ladies and gentlemen, thank you for standing by, and welcome to the Watts Water Technologies Fourth Quarter 2019 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. [Operator Instructions] I would now like to hand the call over to Tim MacPhee, Treasurer and VP, Investor Relations. Please go ahead.

Thank you, and good morning, everyone. Welcome to our fourth quarter and full year 2019 earnings conference call. With me today are Bob Pagano, CEO and President; and Shashank Patel, our CFO. Bob will discuss our key accomplishments this past year and touch upon our 2020 priorities in the macro markets. He will also offer insight into the estimated coronavirus impact to Watts and update you about our smart and connected initiatives. Shashank will offer a detailed analysis of our fourth quarter and full year results and provide our initial outlook for 2020. Following our prepared remarks, we will address questions related to the information covered during the call. Today's webcast is accompanied by a presentation, which can be found in the Investor Relations section of our website. We will reference this presentation throughout our prepared remarks. Any reference to non-GAAP financial information is reconciled in the appendix to the presentation. Let me remind everyone that during the course of this call, to give you a better understanding of our operations, we may 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 our 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.

Thank you, Tim, and good morning, everyone. Please turn to Slide 3 in the earnings presentation, which summarizes our accomplishments for this past year. I will also provide some initial thoughts on 2020. I'm very pleased with our performance in 2019. The team delivered another year of record results as solid organic sales growth, combined with our One Watts performance system, drove record adjusted operating margin and adjusted earnings per share. Last February, we mentioned we expected to see more tempered organic growth in 2019 as compared to 2018. 2019, pricing tailwinds were expected to abate and moderating end markets were anticipated, especially in the second half of the year, and that is how the year played out. For the year, we saw solid organic growth of 4% driven by a number of factors, including decent end market demand in the Americas, a positive price/cost dynamic in the first half of the year and benefits from our new product development efforts. We introduced new smart and connected solutions and expanded our traditional mechanical plumbing product offerings this year. Full year sales also increased due to the late August acquisition of Backflow Direct, which expands our backflow product offering in fire protection applications to help meet our customer needs. The acquisition also brings some respected talent in backflow technology. Another 2019 goal was continued expansion of our adjusted operating margin. This year, we increased consolidated adjusted operating margin by 60 basis points driven by price realization, volume growth and productivity initiatives. Margin expansion was in line with our original expectations for the year despite an incremental $3 million of investment spend above our original plan as we accelerated funding for growth and productivity. In total, we invested an incremental $50 million in 2019 to benefit the future. We estimate about 80%…

Thank you, Bob and good morning everyone. Please turn to Slide 7 which highlights our fourth quarter results. Reported sales of $400 million were up 3% with organic sales up 4%, offset partially by 1% foreign exchange headwind. The organic increase was driven by growth in all three regions. Acquired sales approximated $2 million in the quarter. I will review regional performance momentarily. Adjusted operating profit of $50 million, a 10% increase translated into an adjusted operating margin of 12.5%, up 80 basis points versus last year and a fourth quarter record for Watts. Benefits from price, volume, productivity and restructuring savings, more than offset higher inflation and incremental growth and productivity investments. Investments totaled $4 million in the quarter. Adjusted earnings per share of $1 increased 14% versus last year and was another fourth quarter record for the company. Earnings per share growth was driven by $0.11 from operations. Net positive below-the-line items were $0.02, mainly lower interest charges and foreign exchange translation was a headwind of $0.01 in the quarter. Adjusted effective tax rate in the quarter was 27.2%, marginally lower than last year. Free cash flow for the full year was $165 million, an increase of 22% over 2018, driven by higher income, inventory reductions, lower income tax payments and reduced capital spending. Free cash flow conversion was 125%. Over the course of the year, we paid down debt by $45 million. We invested $29 million in capital expenditures, which equates to a 94% reinvestment ratio. During 2019, we also returned $51 million to shareholders in the form of dividends and share repurchases. Our net debt to capitalization ratio declined to 8.4% at year-end as compared to 14.3% in the prior year due to the debt reduction and cash generated by operations. Our balance sheet continues to…

Thanks, Shashank. Please turn to Slide 12, and let me summarize our discussion. We were pleased to deliver record results for the company in 2019. Our outlook for 2020 anticipates moderating growth and continued margin expansion. Smart and connected products are gaining momentum, and we expect they should continue to drive growth in 2020. Productivity and efficiencies gained through our One Watts performance system should expand operating margins. We plan to deliver strong free cash flow, and as always, we’ll remain disciplined in our capital deployment. We have provided our current assumptions of the expected Q1 impact of the coronavirus. We will be closely reviewing how this development and other potential macro headwinds could affect customer sentiment and the construction markets. We intend to continue to focus on becoming a leaner, more customer-centric organization. I’m confident our team will work through the near-term issues as we focus on and execute what we can control. With that, operator, please open the line for questions.

[Operator Instructions] Your first question comes from Nathan Jones with Stifel.

Good morning, everyone.

Good morning.

Bob, I’d like to start with a discussion on some of these investments, $13 million incremental coming up in 2020 on the back of $15 million in 2019 and, I think, a number somewhere in that area in 2018 and maybe 2017 as well. So we’re starting to invest fairly heavily in the business. We’re talking 300, 400 basis points of margin that you’ve increased the investments over the last few years. So I’m wondering if you could talk about what benefits you’ve seen from that in terms of, I don’t know, a vitality index, kind of new product revenue generation. What are the tangible results that you’re seeing from these investments? And what are the tangible results you expect to see in the future from these investments?

Yes, thanks, Nathan. I mean, look at – one of the things when I got here a little over five years ago was we reviewed our pipeline of new product development products – projects and they were very low, and a lot of them were me-too-type products. We really needed to reinvigorate our new product development process and look for breakthrough-type products and investments. So what’s exciting now is we have a bunch of new ideas, both in research and what I call, execution stages in our pipeline. So the exciting thing is, Shashank earlier talked about, 80% of our investments are really related to growth investments and the remaining are driven by productivity and regional expansion. So a lot of our Smart and Connected initiatives, which are really revitalizing our portfolio, is what we’re focused on. We had an older portfolio of products, and now we’re reinvigorating them. We’re looking at solutions versus components and all of that we believe is driving above-market growth. So we don’t give out vitality, but I’ll tell you, we’ve now started tracking it internally and we’ve been seeing improvements, significant improvements over the last several years. And again, the team is motivated. And we’re also looking at incremental operating margins, as you see, we’re doing both investments and driving incremental operating margins at the same time, which is a great balance.

Yes. And so Nate, I’ll just – as you said, over the last three, four years, we’ve invested over $45 million. And when you look at that, the R&D spend has gone up from 1.5% of sales to about 2.5% of sales. But it’s not only NPD but also market expansion because we’ve put feet on the street as well as invested in training centers, et cetera, and also invested in resources to drive the productivity, which is funding a lot of this as well.

Okay. My follow-up question, despite having put these investments in, you guys have continued to deliver kind of this 50 basis points of margin expansion a year, which really means that core operating performance is up more like 100, 150 basis points each year over the last two, three, four years. You were talking about product – getting productivity this year inside the four walls and also out of SG&A. Can you talk a little bit about what those plans are and how far into the future that you think you can continue to deliver this kind of productivity that you guys have produced here over the last four or five years?

Yes. As you said, over the last three, four years, it’s been productivity within the factory walls. There’s still more work to do around that in the Americas but more so in Europe and other regions. And over the last year, we’ve now started focusing with the One Watts Performance System and productivity outside the factory walls and also a big focus on indirect material spend, which started, like in the back half of last year. So we think there’s a lot more legs to go, there is a lot more opportunity over the next three to five years, which is going to drive the op margin improvement as well as continued funding investments we’ll need for, for example, on the smart and connected side.

Do you guys see further incremental investments in growth here? Or have we reached the kind of plateau level? Are you continuing to find good investments to make that – could see that this investment in R&D go from 2.5% to 3%, 3.5%? Where do you think we should end up at?

Well, we continue to look at our pipeline and the great thing is the pipeline. We have to draw a line in the sand with our team. So we have more ideas that we can fund right now, which is a great problem to have right now. So again, it’s all about balance. We’d certainly like to improve our R&D spending and get it up into the 3%, 3.5% over the long run. But again, it’s going to be focusing on the quality of those type projects. And again, we look at internal rate of return and making sure that these projects will generate the future. So again, the momentum is building and the teams are excited about it.

That’s helpful. I’ll pass it on. Thanks very much.

Thank you.

Thank you.

Next question comes from Ryan Connors with Boenning & Scattergood.

Great, thanks, good morning.

Good morning.

I actually wanted to – you mentioned the positive momentum in housing, and obviously, we see that in the macro data, it makes sense, given that you’ve got a strong job market, mortgage rates et cetera. But are you seeing anything specifically in your order boards, in your channel inventory situation, anything specifically that tells you that’s beginning to actually play out on the ground in terms of an acceleration in resi?

Well, I think it’s important that we back up a little bit and talk about like 60% of our business is commercial, 40% of our business is residential. Of that residential, two-thirds of that is multi-family and one-third is residential. And then when you break that, 65% is repair and replace, which tends to follow GDP and 35% new construction. So about 4% or 5% of our business as a company is in new construction residential. So it’s hard to really see at that granularity, at that level, but the orders, the stocking levels, we believe, stocking levels were sound by our channels at the end of the year. We didn’t think there was any pull-backs on that. And we had a slower start in January, that was due to the holidays and one less workday. And then certainly with the Chinese New Year that impacted that, but we’re seeing some pickups in February here. So overall, I think what we’re seeing in the start of the year is in line with our overall guidance here.

Okay. And then I wanted to talk about pricing. You go back about a year and a half, when the tariffs went in, you had a pretty sizable set of price increases, I recall it was something like upwards of 15% depending on the product line. And obviously that was a bit of a shock to the system for customers. And Shashank, you mentioned how it’s too early to say what this Phase one trade deal does. But in terms of the price cost dynamics and market customer expectations, I mean, how – what’s the pricing outlook and situation in terms of price cost management, now that it looks like we may be in a different chapter in this whole tariff situation?

Yes. We’ve been maintaining that – our price has been ahead of cost. And we think pricing, as we said earlier, will start moderating in the second half of 2019 and into 2020. So again, we continue to believe we’ll be in front of that. It’s just lower pricing, probably a little less than 1% is in our assumptions for 2020.

And Ryan, so – and last year, if you look at the whole of last year, we did have more tariff induced price, so to speak, in Americas and about half of total growth was priced this year, it’s about 1%, so a lot less. And most of that is in the first half, because we lap in the second half. But on the tariff situation, where we got impacted was on list one, two and three was our components and that 25% tariff is still there, nothing has happened with that. It’s only the list 4a that the tariff went down from 15% to 7.5%. But on that list, our impact was minimal.

Okay. And then last one was, I had a kind of a bigger picture question. It’s water quality is not a huge business for you, but it’s material enough that you do mention it in the press release as being a tailwind. And if we think about coronavirus, we think about things like PFAS in the U.S., it seems like with a lot of these health contamination type scares that, that would be a tailwind for kind of residential and commercial level at the tap-type treatment products, which I know your premier product line, for example. Is that something that’s driving that strength in water quality? Or is that something else?

Really a lot of the growth is in our HF scientific business, which is really being driven based on ballast water testing that is now required in the coast guard. So we’re seeing a lot of strength in that area, and that’s some of our growth. But your comments are actually true and something that we’re watching. Residential, as you know, water quality is not the bigger portion of our business. We’re really focused more on commercial growth with our One Flow and some of our other products. But again we are seeing some growth in each one of our product lines in water quality and your point is well taken and that’s the areas that we’re focused on.

Okay. Thanks for your time.

Thank you.

Next question comes from Jeff Hammond with KeyBanc.

Hey, good morning, guys.

Good morning, Jeff.

Good morning, Jeff.

Hey, just wanted to – good color on the coronavirus impact. Just wanted to clarify, what did you say on APMEA sales in the first quarter?

We said in the – of the $10 million to $20 million range, about half was APMEA in the first quarter.

Okay. Okay, and then just moving over to Europe, I mean that you’ve kind of had this consistently kind of low growth, no-growth market, but this year 2019, I think you had significant margin improvement and just want to see what’s in the pipeline for kind of margin expansion in Europe if you continue in this kind of muted environment.

Yes. So when you look at Europe, we’ve seen growth in our Blucher drains business and our electronics, and the other businesses have grown just at a more moderate pace. And the two businesses that are growing have a higher margin than the other two businesses, as well as last year, we did substantial amount of restructuring. So we got a little restructuring and I think Shashank mentioned about $0.5 million of incremental restructuring savings we’re seeing. But the big restructure was last year. So each one of our businesses, we focus on improving margins all the time and that’s our focus with our One Watts Performance System. So I think there is opportunities, but as you said, we had big margin improvements in 2019. I think as you saw in our guidance, that will moderate a little bit.

And we did get – the team did a nice job driving price as well in 2019. And obviously we’re going to continue with that. Just on the restructuring though, the incremental savings from restructuring in Europe in 2020 will be approximately $2 million.

Okay. And then do you expect that mix dynamic to continue where Blucher and the controls business continues to outgrow?

Yes, that’s the plan. What we don’t know, in particular, you’re seeing some negative readings out of Germany right now. And as you know, we do a lot of OEM business in that area and that’s an area of concern, because we have a lot of fixed costs, and that volume impact on us will hit us hard. So again, we got to balance both of those discussions so – and that’s kind of really what the Europe numbers I’ve been doing over the past several years is we focus on low growth, controlling our costs, driving those two other growth businesses. And the other two businesses, we’re investing slightly to begin looking at growth opportunities, but again we’re cautious of our German OEM business at this time.

Okay. Can you just talk about what your heating and hot water solutions business grew in 2019? What you’re seeing there from a market perspective into 2020?

Yes. So overall, I think we are in the – about 3%, a little over 3% for that business year-over-year. They had a really strong fourth quarter. We had some project timing issues in the third quarter. So again, we believe there’s opportunities to grow in that business, in that 3% to 4%, 5% range, somewhere in that. That’s our focus in that area. Again, it’s highly competitive, but we’re focused on the niche part of that in the commercial market, one million BTU and above. And we had a lot of new product developments in that and we will have continued new products. At the recent AHR show, that I know you attended, you saw some of those products. And again, that’s a key focus and it really is part of our overall solutions strategy as a company.

Yes, absolutely. The booth showed really well this year, so congrats on that. Just final one, M&A, certainly the balance sheet kind of continues to improve with the cash flow generation. Just maybe update us on pipeline. And just really how much time do you think – how much time do you guys spend considering like a larger type deal that would push up your leverage a little bit? Thanks.

Yes. I mean, the M&A front, we’re always looking, cultivating relationships. And as I’ve always said, we’re going to be disciplined. And as you know, in the last quarter, we’ve walked away from some deals. So from our point of view, it’s hard to predict. It’s got to tie to our overall strategy. And again, we evaluate small, medium and large deals all the time and we’ll continue to do that. So in total, I can’t predict that, Jeff, as you know, but our pipeline is full and we continue to look for opportunities, where it makes financial sense.

Okay, thanks guys.

Thanks, Jeff.

Thanks.

Next question comes from Joe Giordano with Cowen.

Hey, guys. Good morning.

Good morning, Joe.

Good morning, Joe.

Just curious, I mean, a lot of companies are talking about coronavirus in the first quarter. And I’m just curious, it seems like there is risk of things may be extending longer than people are giving credit for or slower ramp ups. And I’m just curious as to how you thought that process through in like the rest of your – like the nine months after first quarter outlook. Like, what’s kind of built in for the pacing of getting back to normal?

Yes. So the way we’ve been looking at, we’ve had extensive meetings. I talk to my Head of Asia Pacific daily, as well as our entire organization is focused on this. So this – what’s nice about this is, we can leverage our global footprint from a manufacturing point of view, but we’re looking at key components, where we might have bottlenecks or a large sourcing of that is inside of China. So we’re looking at it, we’re putting contingency plans, but a lot of our suppliers are beginning to come back to work and that’s why we kind of felt that the beginning of March is where we’re going to see it. And when we looked at the numbers, the range of $10 million to $20 million, half of that, as Shashank said, was really in the APMEA region, the other is the other side based on supply chain slowdowns. Now we believe, other than APMEA, because right now in China, they’re not doing any construction right now, everything is at a standstill and it’s difficult at this point to assume that that’s going to come back. But the rest of the world, we believe, is just a timing issue, and it’ll come back from that demand. So again, we’re putting all our resources, the teams, as we speak, are looking at all the potential bottlenecks that we’re leveraging our – all our global resources are on this.

Fair enough. And then do you have any kind of – I apologize if you said this initially in your prepared comments, I had to join a couple of minutes late. But can you talk about momentum in the U.S. commercial market, just from a – maybe like an institutional building standpoint, what you’re seeing there?

Yes. From an institutional market, I think that is the best part of the market that’s still holding up at this point in time. As you know, 65% of our business is repair and replace that tends to follow GDP. The new construction that we talked about, we’re seeing growth, but just at a slower growth. And in particular in the Northeast, we see some slowing and that’s one of our stronger markets and some of that is slowing right now. But overall, we see growth. It’s just at a slower growth with the institutional markets obviously, being the biggest opportunities for us and a key focus area.

Thanks, guys.

Thank you.

Thank you.

[Operator Instructions] We have a question from Bryan Blair with Oppenheimer.

Good morning, everyone. Thanks for taking my questions.

Good morning, Bryan.

Good morning, Bryan.

I was hoping you could offer a little more color on the early days of owning Backflow Direct and how it’s affected your R&D efforts and maybe any initial feedback from customers having those assets in the Watts portfolio.

Well, the integration has gone really well. We’ve fully integrated that into our facility. So it’s out of their facility and they’re performing as we expected right now. So there is not much comments and the teams are executing, and it’s giving us a new product line. And R&D, that’ll be a longer-term discussion at this point in time, but the teams are working really well together and we’re really excited about this acquisition.

Yes, fair enough. And it looks like the deal was modestly accretive at the outset. How should we think about 2020 EPS contribution?

I think, look, it’s – the incremental sales are not significant. So when you look at incremental EPS, it’s minimal in 2020 after amortization.

Got it. And you commented on overall funnel, you clearly have a strong balance sheet, solid cash flow. If the right opportunity or opportunities came along, Shashank, what do you view as near-term dry powder?

Sorry, say that again. Near time – near-term what?

Near-term dry powder or overall balance sheet capacity if the right opportunities came along.

Sure, sure. So based on where we stand on the balance sheet and leveraging up to a comfortable 2.5, 3 ratio, I think about $800 million of dry powder is what we have.

Got it. Appreciate the color. Thanks.

Thank you.

[Operator Instructions] And we do not have any telephone questions at this time, I will turn the call over to Mr. Pagano.

Thank you. And in closing, thank you again for taking the time to join us today for our fourth quarter earnings call. We appreciate your continued interest in Watts and look forward to speaking with you during our first quarter earnings call in May. Have a great day.

Ladies and gentlemen, this concludes today’s conference call. Thank you for participating. You may now disconnect.