Ladies and gentlemen, thank you for standing by and welcome to the Watts Water Technologies' First Quarter 2020 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 conference over to your speaker today, Timothy MacPhee, Treasurer and Vice President of Investor Relations for Watts Water. Thank you. Please go ahead.

Thank you and good morning, everyone. Welcome to our first quarter earnings conference call. With me today are Bob Pagano, CEO and President; and Shashank Patel, our CFO. During today's call, Bob will offer insight into our response to the COVID-19 pandemic and discuss the current state of the markets, our operations in liquidity. Shashank will discuss details of our first quarter performance and provide assumptions about the outlook for the second quarter. Following the 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'll reference this presentation throughout our prepared remarks. Any reference to non-GAAP financial information is reconciled in the appendix to the presentation. Before we begin, I'd like to remind everyone that during the course of this call, we will make certain comments that constitute forward-looking statements. These 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. Company disclaims any intention or obligation to update or revise any forward-looking statement, whether as a result of new information, future events or otherwise. With that I will now turn the call over to Bob.

Thank you, Tim, and good morning, everyone. Please turn to Slide 3 to begin. Before we get started, I'd like to commend the healthcare and first response workers for their amazing efforts during the COVID-19 crisis. Their unwavering commitment to help people and their time of need is truly heroic. We also would like to thank those people that are behind the scenes, the plumbers, the maintenance teams and so many others as the work they do has never been more essential and we salute their efforts. Finally, I want to thank my Watts colleagues around the world for their unwavering support in meeting our customers' critical needs during this extraordinary period. COVID-19 is appending every aspects of our lives and throughout this ordeal, our team has been committed to ensuring that the essential water and heating products we manufacture are available for our customers. The markets have been significantly affected by the pandemic and our operations have been impacted to different degrees. I'll provide an update on both the markets in our operations in just a minute. Our response to COVID-19 has been timely and comprehensive. As the pandemic spread, we were able to incorporate many of the early learnings from our China operations to the other regions. In February, we established a COVID-19 Task Force made up of a cross-section of functional leaders. One of the key focus areas of the task force was to ensure we addressed employees' safety, which is our number one priority. The task force enacted global policies and procedures around social distancing including working from home, the use of personal protective equipment, temperature monitoring in other recommended protocols by the CDC and local country governments. There are several other important facets of our COVID-19 response that I'll speak to in more depth momentarily.…

Thanks, Bob. Please turn to Slide 8, which shows the first quarter's consolidated comparative results. Obviously, underlying markets have changed dramatically over the last two to three months and therefore I will only make some brief comments about the quarter as the results are no indication of how the remainder of 2020 could play out. Sales of $383 million were down 2% on a reported basis and down 1% organically. Organically, the estimate sales were impacted by a $10 million to $15 million headwind due to COVID-19. Foreign exchange primarily driven by a weaker Euro decreased year-over-year sales by roughly $4 million or 1%. As mentioned in February, both the Americas and Europe were impacted by one less workday which negatively impacted sales by approximately 1% as compared to the first quarter of last year. Acquisitions accounted for $2.6 million of incremental sales year-over-year. Despite the sales drop adjusted operating profit was flat as compared to last year and adjusted earnings per share were up 1% to $0.95. Adjusted operating margin of 12.6% was up 20 basis points as price productivity and recent cost actions more than offset volume loss incremental investments and inflation. As Bob mentioned, we took some timely actions to reduce our cost base, which are reflected in the results. The adjusted effective tax rate of 28.2% is 70 basis points higher than the first quarter of 2019 and relates primarily to the greater impact from non-deductible tax items in 2020. Our free cash flow for the quarter was negative $8 million as compared to negative $31 million in the first quarter of last year. The cash flow improvement was due to better working capital management. Our goal is to drive free cash flow conversion at 100% or more of net income for the year. During the…

Thanks, Shashank. On Slide 11, I'd like to summarize our discussion before we address your questions. COVID-19 is certainly causing enormous disruption around the globe. The speed of which the pandemic has affected our lives and commerce has been unprecedented. Our company has reacted with decisiveness in urgency, focusing on our people's safety, our customers' needs and being fiscally responsive to changing market demand. With our experienced management team, we have recalibrated our cost structure to help navigate through these turbulent times. While COVID-19 uncertainties make predicting the future, more difficult, we will continue to monitor developments daily and proactively take necessary measures based on underlying market conditions. The company is well capitalized and well positioned to make it through these challenging economic conditions. We are taking actions to optimize our cash flow to further enhance our strong balance sheet. Finally, we are a market leader. We know we must address the many near-term challenges, but we won't lose focus on our long-term strategy by continuing to invest for the future, especially in our smart and connected product portfolio. We expect to come out the other end of this crisis, a stronger company. With that, operator, please open the line for questions.

Thank you. [Operator Instructions] Your first question comes from Jeff Hammond with KeyBanc. Your line is open.

Can you hear me?

Yes, we can.

We can now.

Okay, great. You gave a really good color in your presentation. You gave the 25% to 30% expectation. Can you just talk about what you actually saw in your April sales run rates? And if there is any big disparities between North America and Europe?

Yes. When you look at quarter-to-date, we've seen about 30% reduction in the Americas and about 40% in Europe and Asia Pacific about 30%. However, inside of Asia Pacific's number, actually China was up 2% which is good. However, New Zealand and Middle East were basically close for the month. So that's what brought down the overall APMEA numbers. You could see a little worse in Europe and they hit the virus, it hit them harder. So I think that's why we're seeing that activity.

Okay. And then just on the decrementals, I think if you kind of run the math, it's in that 30% range. As you start to go through the year, is that kind of the right decremental to think about Q2 and beyond?

Yes. It's in that 30% to 35% range in the second quarter. It's closer to that 35% range, but as the year progresses. And hopefully, the volume declines are less, it's closer to that 30% decrement range.

Okay, great. And then just finally, can you just talk about what you're seeing in terms of deferrals beyond mandatory work stoppages or any cancellations in your kind of order book on the non-res side?

Yes. We've not seen cancellations. What we've seen is deferrals push out. So I think a lot of uncertainty is out there just because of the social distancing requirements that is happening out there. And as you know, places like the Northeast and the West Coast were basically shut down from a new construction point of view. So that's kind of the activity we're seeing in the marketplace.

Okay. Thanks so much guys.

Thanks, Jeff.

Thank you.

Your next question comes from Nathan Jones of Stifel. Your line is open.

Good morning, everyone.

Good morning, Nathan.

I apologize if I ask something you covered in your opening comments, Bob. I was a little bit late getting on. So you guys have 30-odd percent decline here in the second quarter. Is there any color you can give us on what you think the split is between inventory destocking in the channel, the decline in replacement revenue, and the decline in new construction revenue?

Yes, that's really difficult to see because we saw a lot of activity. I think again, when you look at our portfolio, 65% is repair replace. When we talk to local plumbers, etc., in our channels, the discussion is emergency work is continuing, and on a repair and replacement. But a lot of the plumbers, as well as people in multifamily homes, they don't want anybody in there unless there's a material error, a big issue going on right now. So I think given the shock to the system, that's why we're seeing this uncertainty. But we can tell, especially from our smaller wholesalers, they're smaller. They're ordering less and less. So again, I think it's pretty much across the board at this point in time, and we think the destocking will end in May. So we're seeing it in April and May, and we'll come out of the other end of that in June, once everybody starts opening up all these construction markets.

Okay. I guess part of my point here is on the replacement market. I mean, with these kinds of level of revenue decline, and given the two-thirds of the portfolio's replacement, that has to be a fairly significant decline in replacement revenue here. I would think that snaps back fairly quickly once we get the economy open again and things running again at a more normalized rate. Is that a reasonable expectation?

Yes, I think it is. I mean, look at, you can only put off repair and maintenance. Whether a building has one occupant or a hotel is 95% full, you still need to make sure they have good plumbing and code-driven is going to be even more important right now. So again, I think your assumption is accurate.

And did you quantify what the cost out number is going forward?

So the total here is approximately $55 million. A piece of that is obviously the same reductions we talked about, which at the end of Q3. So there is a larger portion of that $55 million that happens in the second quarter.

Okay. Thanks very much. I'll pass it on.

Thank you.

Your next question comes from Ryan Connors of Boenning & Scattergood. Your line is open.

Great, thanks for taking my question. Hope everyone's well. Wanted to kind of follow on with that prior question on repair replace and just kind of clarify and better understand the buckets here. So you talk about new construction, being a third, and then sort of repair replace being the remainder. Where does sort of remodeling fit into all that where you've got a restaurant or a hotel, or even a household, they're not - it's not a new construction, but it's not an emergency repair. It's some sort of remodeling. Which bucket would that fall in and how have you seen that type of business impacted?

Yes. So again, it's early on, right, with April just being - just happening here. We saw it across the board. But just if you look strategically inside of that, that would fall under depending on if it's a brand new addition, maybe in the new construction repair replacement, if it's fixed. So it's a combination of both of those. But if you just look at some of the markets that we think that are probably more apt to get hit, restaurants, some hotels in the short term, and let's call it just office buildings, I mean that's less than 10% of our business. But still, as I said earlier, they'll still need to be repaired. It doesn't codes are going to be more in force than ever before. And I think there is an opportunity for people to continue to upgrade. So when you look at our core strategic things of safety and regulation, energy efficiency, and water quality and conservation, all of those are going to be critical in this new world. So as we go forward also - I also look at our connected product strategy, how important that's going to be. Because, monitor and making sure there is - what I call less people requirements to determine whether there's issues in the system, right? So that's going to be really important going forward. So again, that's where we're looking at, and we're watching very closely.

Yes. Just on that point, Bob, you talked about the connected strategy. I guess there's been a lot of talk about reopening these buildings, offices and hotels and whatnot and if the water's been stagnant in those systems, that there has been talk about Legionella concerns and things like that. I know that is part of the connected strategy, kind of monitoring for some of those things Legionella in particular. Is that - I mean, that's we could spend that as a positive, but is that just a longer term thing? Or are you just seeing it more demand for those type of things even now?

Well, we're doing a lot of seminars exactly on that with our customers, engineers, et cetera. So you know how to start up buildings, et cetera. And we believe when buildings sit idle for a while, and restaurants and everything else, once they start up, they're going to have some issues, and they need to do with the proper way to prevent Legionella and other diseases in their pipes and systems. So again, that could be an opportunity for us. But again, we're monitoring it very closely.

Got it. And then one last one from me, if I could. You made a comment in the press release about sort of renegotiating materials contracts. Can you please elaborate on that? Or is a mechanics of that to the extent you can?

Yes. Look, so Ryan, it's Shashank. So on as we all know, commodities have gone down, especially comp a little bit stingless and we typically go long on those. So we got contracts over the next, let's say, three months, six months, nine months. And also, the challenge we have is the volume is going down. It's harder to negotiate price decreases with volume reductions, but that's in fact we're in a unique place, so we're going to back and we are having some luck in negotiating lower prices as we go forward on those material contracts, as well as even on some freight contract as well, because at the lower prices on oil.

Got it. Okay. Thanks for your time.

Thank you.

Your next question comes from Bryan Blair with Oppenheimer. Your line is open.

Good morning, everyone. Hope you're staying safe.

Good morning.

Same to you, Bryan. Thanks.

Thank you. Following up on your second quarter mid to high-single-digit margin guide. Can you break that out by region, what we should expect across your segments?

So the margin performance we are up 20 basis points. America was strongest of the region, so we had good and we had relatively good price performance there as well. And some of the actions, we were proactive in our cost action. So that helped to the first quarter as well. So that drove the margin expansion in the Americas. In Europe, we were actually soft in the first quarter. And then obviously, the third - and then we got affected in APMEA. Now, as we think about the second quarter though, we basically said mid to high-single-digits on the operating margin. With the volume declines, we're talking about 25% to 30%. We expect to see margin decline across all regions. APMEA will be the most affected, because their volume's going down, as well as they get affected with the intercompany volume piece. But the margin decline will pretty much be similar in the Americas and in Europe.

Got it. And any additional color you can offer on expected cost savings by region? I think you said $55 million for the year in total. And also the variable versus structural breakout there would be helpful.

Yes. Just to take the second piece first, the structural piece is about 15% of the total approximately $55 million we talked about. The structural piece, which is head count, that does have annual savings related than what we realized in 2020. As far as the regional split of the cost savings, for the most part, we're about 75% of that's going to be in the Americas, and then about 20% in Europe, and the other 5% in APMEA. Rough split. We do get a little bit more savings in the Americas versus Europe.

Okay. And what are the key metrics you're tracking to determine if additional action is needed? And what would come next if further action's warranted as we move through 2Q and into the back half?

Well, we certainly watch orders. We watch that daily, and we continue to look for leading indicators, talking to our channel partners, understanding permits, and all the normal things that we've all been looking at for a while. I think what's more important, as we see this country come back up and running, to see whether there's some surge of pent-up demand, et cetera. But we're looking at all our costs. Every single piece, we're asking our teams to review every single thing in every single region. So it's across the board. We're continuing to look. We went aggressive right out of the gate, and we have detailed contingency plans when we start the year. We triggered those immediately, and we'll continue to watch these leading indicators. And most importantly is the shutdowns come back online. We want to see how quickly they think in.

Got it. Appreciate the color.

Thanks, Bryan.

Thank you.

Thank you. Your next question comes from Mike Halloran with R.W. Baird. Your line is open.

Good morning, guys.

Good morning.

So it's kind of a two-fold question here. You've got very strong market leadership and some fragmentation. Obviously, some sizable scale advantages. Your liquidity's in a very good spot strong balance sheet. So the two-fold question is, one, how are you thinking about the potential to widen that disparity versus some of the comp group with how you're thinking about your R&D spend, the connected products, et cetera? And then the second piece of it is, how are you guys balancing the need for short-term management with continuing to invest and play offense, and how should we think about kind of all those things wrapped together?

Well, Mike, as you know, we've been investing a lot over the last several years. And I think as I said earlier, what we've been doing is focusing our time and attention on new products with safety and regulation, energy efficiency, water quality and conservation. All of those are going to be really important in this new economy. And like you said, the smart and connected products are going to be even more critical because we just need to monitor things and not rely on people and maintenance organizations to really react. So as we look at our investments in R&D, we're going to slightly ratchet down our investments. We had a plan of about $13 million. We were very aggressive on that. But when you take that down, we're probably going to cut that by 40%. And really where we're cutting is areas like emerging markets. Right now, it's probably not we need the emerging markets to come back on that. But our smart and connected product, we are not cutting any costs at all on that because that's more important than ever. So that's how I look at that from an overall strategic point of view.

And just a note on the R&D. As you all know, R&D spend in 2019 was 2.5% in the first quarter. We're actually at about 3%. So we're continuing that focus on the smart and connected side.

Thank you.

Thanks, Mike.

There are no further questions at this time. I will now turn the call back over to Bob Pagano for closing remarks.

Thank you for taking the time to join us today. We appreciate your continued interest in Watts, and look forward to speaking with you again at our second quarter earnings call in early August. Have a great day, and stay safe and healthy. Take care.