Ladies and gentlemen, thank you for standing by and welcome to the Watts Water Technologies' Second 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 turn the call over to Timothy MacPhee, Vice President of Investor Relations. Please go ahead.

Thank you. And good morning, everyone. Welcome to our second quarter 2020 earnings conference call. With me today are Bob Pagano, President and CEO, and Shashank Patel, our CFO. Bob will provide an overview concerning various aspects of our business before turning the call over to Shashank, who will address the financial results in more detail and offer our outlook for the third quarter. Following the prepared remarks, we will address questions related to the information covered during the call. Today's webcast is accompanied by a slide presentation, which can be found in the Investors section of our website. We will reference these slides throughout our prepared remarks. Any reference to non-GAAP financial information is reconciled to the relevant GAAP measure in the appendix to the presentation. Before we begin, I'd like to remind everyone that, during the course of this call, we may be making 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, 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. Now, I will turn the call over to Bob.

Thanks, Tim. And good morning, everyone. Please turn to slide 3 in the presentation and I'll provide an overview of the quarter. I'd like to start with the COVID-19 update. Our highest priority continues to be the health and safety of our employees. Fortunately, confirmed COVID-19 cases within our workforce has been very low. Since early April, all our manufacturing locations have remained open. The safety protocols we established during the first quarter have continued, and we've actually enhanced measures as government requirements have started easing. We have recently implemented new travel and back-to-the-office policies as we move into the next phase of the pandemic recovery. We will remain diligent in ensuring workplace safety is a top priority. I again want to acknowledge the efforts of our employees who continue to maintain a customer focus as we transition into the new normal, ensuring our essential products are manufactured and delivered in a timely fashion. Thanks to our dedicated team, we delivered results in the second quarter that exceeded our internal expectations. The second quarter sales reduction was less than we had anticipated and decrements in operating profits came in lower than expected as well. Overall, we maintained our focus on productivity and cost management, preserving cash and controlling what we can. Shashank will provide more financial details in a few minutes. Orders trended positively during the second quarter and into July. Monthly orders were down as compared to the prior year from April through June, but sequentially, order rate declines improved as the quarter progressed. Order rates on average for the quarter declined more in Europe as compared to the Americas, with Europe substantially softer in April and May, but recovering in June. Now, let me provide a view on the markets. During the second quarter, the end markets performed…

Thanks, Bob. Please turn to slide 6 to review second quarter consolidated comparative results. Sales of $339 million were down by 19% on both a reported and organic basis and were primarily driven by the impact from COVID-19. Foreign exchange impact was minimal and acquisitions accounted for approximately $2 million of incremental sales year-over-year. Adjusted operating profit and adjusted earnings per share were both down 32% as compared to last year. Adjusted operating margin of 11.1% was down 220 basis points as price, productivity and recent cost actions were more than offset by volume loss, incremental investments and inflation. The reduction in revenue resulted in a 23% decrement to the adjusted operating margin, which was better than our expected 30% to 35% decrement. The improvement was driven by higher-than-anticipated sales volume, and we booked a one-time reduction in corporate long-term incentives. The adjusted effective tax rate of 26.3% is 210 basis points lower year-over-year. The reduction is discrete to the quarter and relates primarily to the foreign exchange impact of repatriations made during the second quarter. Our year-to-date free cash flow was $25 million as compared to $5 million for the same period last year. The increase was due to improvements in accounts receivable, more than offsetting lower income and inventory increase and higher capital spending. Our goal remains to achieve free cash flow conversion at 100% or more of net income for the year. We retired $75 million of private placement notes using both existing cash and additional revolver borrowings. The interest rate on the retired notes was approximately twice the rate we now pay on revolver debt. The balance sheet remains strong. Our gross and net leverage ratios at the end of June were 1.2 times and 0.5 times, respectively. Our net debt to capitalization ratio at June…

Thanks, Shashank. To summarize, here are a few key themes from today's call. We continue to take employee safety very seriously and have expanded our protocols as more employees return to the office. Second quarter results were better than expected as activity improved during the quarter. Markets are returning slowly. We aggressively implemented the cost actions discussed last quarter, and we're continuing to review our cost base for other opportunities. We continue to invest in long-term growth opportunities, especially in smart and connected solutions, productivity-enhancing technology in our manufacturing facilities and bolt-on acquisitions that support our long-term strategy. Our balance sheet remains strong, which is providing us flexibility while we navigate through the pandemic. We expect to see sequential improvement in the third quarter. The path of COVID-19 remains a concern and could impact our results, so we were watching developments closely. With that, operator, please open the line for questions.

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

Just starting on the top line here. You started the 2Q guide at down 25% to 30%, took that up to down 20% to 25% as the US construction industry got back. I think they're coming in better than the down 20% and sounds like it was primarily Europe opening up that you hadn't seen in May. You've got 8% to 12% for the third quarter. Can you talk about what are the kinds of things that could surprise you either to the upside or the downside that could get you the top end or better or the lower end or worse as you view the markets at the moment?

Sure, Nathan. When you look at it, the quarter we changed – if you recall, we weren't sure when – particularly the Northeast, New York, Massachusetts, Pennsylvania and even the West Coast when they were going to start-up. So, they ended up starting mid-May and things started to progress. So that was in May. We were surprised with retail. Retail was very strong, up double digits for us in the quarter. So, we don't expect that to continue because some of our contractors were going to the big box stores to get products, while the wholesalers were beginning to still be closed than opening up. So, the high end of your discussion, I guess, would be if retail continued and the construction markets kept on moving faster than they were before. We also got a surprise in the second quarter where our German OEM partners ordered more business, ordered more products because of some energy efficiency subsidies that were happening in Germany. So, we had some strong performance out of our German HVAC OEM. So, that was positive in the second quarter. So, again, we're not expecting that to be as high as it was, but if that continued, that would be at the higher end. But we think we're more balanced. We have a little bit more clarity than we had at the April time frame when we originally gave guidance. So, things are opening up. And as long as they stay open – what concerns us is really if there's a shutdown, things go back to where COVID outbreaks are even more concerning, and that begins to have more lockdowns in various countries and/or states. So, that's kind of how we're looking at it.

It was a tough time to go out in April. I think the connected solutions business is interesting at the moment. You're starting to hear a lot of people, a lot of folks in a lot of industries want remote monitoring capabilities, those kinds of things. I'm sure it's been too early in the [indiscernible] to probably say concrete orders coming out of that. But have you seen increased interest from customers, maybe requests for quotes or anything like that, that would lead you to think that the penetration of those connected solutions might accelerate from here relative to what you were thinking previously?

I think, early in April, we expected that to happen and we did see – there is a lot of inquiries around that. Like you said, I think it's too early. But I would tell you, as we look at what's decreased, our decrease in our connected products is substantially lower. And we're actually running as a percentage of sales in the mid-teens on some of our business. So, a lot higher as a percentage of sales and more towards our goal towards 25%, as you know, by 2023. So, clearly, remote monitoring is really going to be important for the future.

Do you have any kind of idea when you think that you might be able to convert some of that interest into orders, into revenue?

I think we already are. When you see some of the – our new products that we've introduced, some of the ones I just talked about, we're seeing growth in some of those key markets. I think as we continue to expand our portfolio and connect the systems, I think that will only continue to go forward. I think what you're seeing is, everybody went through a shock in Q2 and some of this just takes time to materialize as we go into the retrofit cycle. I think people will be thinking more of it. And our sales team will be pushing more of it, obviously, because of this.

Your next question comes from Ryan Connors with Boenning & Scattergood.

My question actually had to do with the operating margins. You did talk about it a little bit, but the resiliency there does seem pretty remarkable, given the magnitude of the top line hits you took in the quarter. So, I know you kind of laid out a few of the drivers, but can you just drill down on that a little bit? What exactly were you able to cut without getting into bone to sustain margins pretty well and maybe discuss kind of the variable versus fixed cost structure going forward?

I'll let Shashank answer that in detail. But I just want to commend our team for a great job of controlling costs. The teams took it very seriously and we're really cost conscious. So, Shashank, if could get into some of the details.

Ryan, look, as we talked even in Q1 earnings call, right, we took actions early. So, we implemented actions early in the March time period. And I think we saw results because of that. So, when you think about the $55 million of cost-out we targeted, about half of that was people cost and then about – of the balance, 33% of the 100% is discretionary, things like T&E, mar/com, additional spend. And then about 17% was variable, manufacturing supplies, things like that. That's kind of the breakdown of the $55 million. As to what is long-term, short term, we had said about 15% of that is long-term structural, i.e. headcount restructuring. So, annualized, it's about a $13 million benefit as we go forward. This year, we'll see $8 million of the $13 million. And that $8 million is included in people cost reduction of $27 million, which is 50% of the $55 million. Some of that was temporary pay cuts, et cetera, which ended at the end of September.

Okay. So, if we take a relatively bullish view and we think things are going to continue to rebound sequentially, will some of that start to creep back in or do you get some cost leverage on that going forward?

Yes. Some of that does creep back in mostly in the fourth quarter. But then, obviously, our hope is that the volumes do come back and continue progressing in a positive trajectory. Although negative, but less negative.

And then, just one last one, more on the balance sheet. I appreciate the rationale for paying down debt early on in the crisis. Things were obviously very uncertain there for a time. But now, if we look at where interest rates are, we look at what the Fed is doing in terms of actually buying corporate debt, it seems like the government is practically goading companies into levering up. Would you think about going the opposite direction at some point and actually taking on some debt on the balance sheet now in this environment, now that things have kind of stabilized a bit?

It's funny you said that. I've been challenging Shashank on that. But, obviously, look, our balance sheet is healthy, we believe interest rates are going to stay low for a while, but it's certainly an option we'll continue to look at.

Your next question comes from Bryan Blair with Oppenheimer.

I was hoping if you could drill down a little more on the Q3 sales guide, specifically how we should think about your outlook by region. It's actually a little tighter band of organic decline than we expected last quarter, although you mentioned Europe in terms of order rates trailed a bit. So, should we expect a little more disparity in Q3 decline by region?

I'll give you our planning assumptions. Right now, we're looking at Americas down 6% to 10%; Europe, 14% to 18%; and APMEA, down 10% to 14%. In those ranges.

And how about expected margin by region and corporate expense netting to the 11% to 13% guide? It sounds like consolidated decrementals will remain in a pretty attractive range for the quarter. Just curious how that shakes out by region.

As you noted, the consolidated decrementals are similar to what we experienced in the second quarter, roughly 23%. Americas will be better from a margin performance than, for example, Europe and APMEA for a couple of reasons. Europe, we did get government subsidies in the second quarter, which helped the margins there. And then, in APMEA, we had higher intercompany volume in the second quarter, but the margins in APMEA won't be as good as they were in the second quarter, still low double-digits, but not as good. So, Americas will be better margins versus the other regions as far as performance versus Q2.

And then, any additional color you can offer on the AVG deal? We know run rate revenue, $10 million range. Any detail on the multiple paid, current margin profile of that business, expected accretion would be helpful.

Because we made the acquisition in middle of COVID, we actually put 30% of the purchase price subject to hitting certain performance milestones over the next couple of years. So, that $10 million is a net number. There could be additional money based on how they perform over the next couple of years. So, there's about $3 million of money at risk there. As far as multiples, it's a 7 times to 9 times EBITDA. So, it's a pretty decent multiple that we paid for the business. EPS accretion year one is going to be almost 0. It's close to 0. And then we'll get EPS accretion in year two and on.

Your next question comes from Brian Lee with Goldman Sachs.

This is Alex on for Brian. Wondering if you could just provide a bit more detail on the recent order trends. Can you bifurcate by segment there? And how has it trended incrementally over the past few months?

Well, every month, it got better in every one of the regions, every single month and continued into July. So, that's what gave us the confidence to give you our Q3 guidance. So, overall, April was by far the worst. As I said in my prepared comments, Europe was slower to rebound. We had steeper declines in April and May, but started rebounding in June and in July. So, sequential improvement in pretty much in every one of the regions.

Obviously, you're not providing full-year guidance, but how much of this recent backlog creeps into the fourth quarter as of now?

We're pretty much a book-and-ship business. So, we don't have a lot of detail, especially into the fourth quarter, right? So, we don't have any visibility into the fourth quarter as of right now. In the third quarter, we have July behind us. And what we're seeing in the book and ship and from what we're hearing from the sales team gives us the confidence to give you the range we gave in our Q3 guidance.

Your next question comes from Joe Giordano with Cowen and Company.

This is Robert in for Joe. Just a couple on the end markets. Just with what we've been seeing with COVID-19 and some of the urban exodus that's been driving housing performance recently, I just wondered how sustainable you think this tailwind is? And kind of additionally, what's your view on multifamily? Do you think it's more challenged in a socially distanced world as we move forward?

Well, you mentioned tailwind. I'm not sure whether there's any tailwind right now in the market because every market is down, unfortunately. So, I think there's some tailwind in residential single family, but there's also a shortage right now. So, as I look at multifamily, look at – in a movement – they said that in 9/11, right, in New York City that everybody is going to move out of the city. And guess what? Everybody came back. So, I think it takes multi-generations. And right now, as we all know, the single-family homes availability, there's just not enough inventory out there to do that. So, I think it's a longer transition here. What we're seeing in the marketplace right now is any new construction that has started is continuing. And if anything, they're behind schedule because of the lockdowns in some of the key market areas in the Northeast and the West Coast, so they're trying to get them going and moving as fast as we can. So, I think as we look at multifamily for the future, like I said, we have visibility to Q3. We don't have visibility for the rest of the year, and we're watching it very closely.

Can you talk a little bit about the impact from [indiscernible] like the office market, universities, things like that to your commercial business?

So, office buildings, stores, malls, retail and lodging, that represents in our new construction about – in total, for the whole company, 10% of our overall business for overall Watts. So, those are the key areas we're watching just like you and making sure and watching the trends. Like I said, what started is being finished. It's just a question of where they haven't broken ground, what's going to happen. And that's where we all have a lot less visibility at this time. But we're watching and keeping close with our customers and watching what's going to transpire for the fourth quarter and the rest of the – into next year.

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

I just want to follow-up with a question on growth investments. You certainly cut those this year. Bob, can you talk about how you're thinking about the balance between investing for long term, protecting short-term margins. I know some of the growth investments you deferred were in Middle East where there's no demand, which makes sense. So, maybe you can just talk about where they've been reduced and why it makes sense to reduce them at the moment?

You know my feeling on long-term investments. I want to move forward longer term and continue, especially in the smart and connected. But where we've been prudent is where we've needed voice of customer. It's been very difficult to get voice of customer and install new products in new locations because they're very paranoid about doing that. So, we're being very – we want to spend efficiently and moving forward. And like you said, areas like expanding sales force in Latin America, Middle East, we've cut back on that. That just doesn't make sense, and that was in our original plan. Same with some IT investments. Again, given everybody working remotely, we focused our investments on that and the security around that versus new ERP implementations, which would allow – would require us to be on-site, do a lot of in-person training, et cetera. So, we pushed that out. We continue to invest in our manufacturing capability and leveraging new technology. Recently, we have automated core boxes in our Franklin facility and our foundry. We're pretty excited about that. They're just getting that up and running right now. So, again, we're investing in technology to improve efficiency where we can. But being prudent to make sure it's cost-effective and not wasting money.

Fair to say that you haven't and are not planning to cut any of the growth investments into connected solutions?

That's correct. We have not done that at all and we continue to focus on that where it makes sense. Now, there's been some delays on some of those investments. It's just that we couldn't get products installed from a test point of view as soon as – as fast as we wanted to. So, again, the general spending, the focus on that continues.

Okay. There are no further questions queuing up at the time. I'll turn the call back over to Bob Pagano for closing remarks.

Well, thank you, everyone, for taking the time to join us today for our second quarter earnings call. We appreciate your continued interest in Watts and we look forward to speaking with you again in our third quarter earnings call in early November. Enjoy the rest of your summer and stay safe. Thank you.

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