Ladies and gentlemen, thank you for standing by and welcome to the Watts Water Technologies Third Quarter 2020 Earnings Conference Call. [Operator Instructions] Please be advised that today's conference is being recorded. [Operator Instructions] I would now like to hand the conference over to your speaker today, Timothy M. MacPhee, Treasurer and Vice President, Investor Relations of Watts Water Technologies Inc. Thank you. Please go ahead.

Thank you, and good morning, everyone. Welcome to our third quarter 2020 earnings conference call. Joining me today are Bob Pagano, President and CEO; and Shashank Patel, our CFO. Bob will provide a business overview for the quarter and offer his preliminary views of the 2021 markets. Shashank will address the third quarter financial results and discuss our outlook for the fourth 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 refer to 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. Let me now 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. First, I must again applaud the efforts of all our employees for adjusting to the challenges of the pandemic. Our employees have remained deeply engaged with our customers whether working on site or remotely, delivering our products on time and with the quality they have come to expect in the Watts' solutions. The teams have worked diligently while adhering to safety protocols to ensure we maintain close customer contact through order fulfillment, training and responding to inquiries. And while travel is restricted, we've expanded virtual plant tours which allows local leaders a chance to update senior management on their most recent customer and operating initiatives. These virtual tours are also promoting greater employee engagement and helping to drive productivity during these difficult times. Our third quarter operating performance was solid as we again delivered results that exceeded our internal expectations. Our seasoned management team has played a critical role in taking proactive actions that have optimized the performance of the business despite challenging underlying market conditions. The sales decline in the quarter was less pronounced than we had anticipated, both in the Americas and Europe. Despite the tough macro environment, we maintained our focus on driving our smart and connected strategy. We also increased adjusted operating profit and expanded adjusted operating margin versus Q3 last year despite the lower sales volume. This was driven primarily by the aggressive cost actions we've undertaken in response to the pandemic. Cash also remains a focal point and year-to-date, we've increased free cash flow by 25% as compared to the same period last year. Operationally, we've now instituted all cost-out programs we discussed earlier this year. During the third quarter, we estimate…

Thanks, Bob. Please turn to Slide 4 to review the third quarter consolidated results. Sales of $384 million were down 3% on a reported basis and down 5% organically driven primarily by the continued impact of COVID-19. Foreign exchange had a favorable year-over-year impact of $5 million and acquisitions, net of divestitures, accounted for $4 million of incremental sales year-over-year. Adjusted operating profit and adjusted earnings per share both increased by 1% as compared to last year despite lower sales. Adjusted operating margin of 13.8% increased 50 basis points as cost actions and productivity more than offset the impact of volume loss and incremental investments. Incremental cost action savings of $20 million in the quarter were the main driver of the adjusted operating profit and adjusted margin improvements. The adjusted effective tax rate of 27.3% is 120 basis points lower year-over-year. The reduction is due to final regulations being issued in the U.S., allowing for higher tax exceptions on foreign-sourced income. For GAAP purposes, we recorded a charge of $3.4 million, primarily related to the previously announced and expanded restructuring initiatives, most of that being severance. Savings from these expanded programs should approximate $3 million annually. We expect to book $1 to $2 million of additional cost for asset relocation and asset write-offs in the fourth quarter that also relate to these programs. These costs will be classified as special items when incurred. As Bob noted, year-to-date free cash flow is up 25% to $95 million as compared to the same period last year. We have been laser-focused on working capital optimization including improvement in accounts receivable, and the teams' efforts have resulted in strong results as our DSO declined by 9% year-over-year. Year-to-date, we've invested an incremental $15 million or 77% in capital expenditures versus last year. That CapEx…

Thanks, Shashank. To summarize, I'd like to leave you with a few key themes. Employee safety, engagement and customer service remain top priorities. We continue to expand our protocols to maximize employee safety while simultaneously meeting our customer needs. Third quarter results were better than expected as activity improved when compared to the second quarter. Cost actions provided significant benefits in our third quarter and year-to-date results. We continue to review our cost base for further opportunities. Our balance sheet remains solid and provides flexibility to execute our balanced capital allocation strategy. Our ability to generate cash during these turbulent times has been critical. We continue to invest for the long term in both smart and connected solutions and in productivity-enhancing capital spending. We expect year-over-year margin improvement in the fourth quarter on reduced volume. Our outlook is mixed and cautionary, especially in certain commercial markets, given leading indicators and continued market uncertainty due to COVID-19. We will continue to keep a close pulse on our markets. And finally, we are prepared to react quickly to market changes with mitigating actions and remain focused on positioning Watts to capture opportunity as our markets recover with our diversified portfolio and by executing our smart and connected strategy. With that operator, please open the lines for questions.

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

This is Adam Farley on for Nathan. Just on the restocking event that took place in the Americas, could you provide a little more color on that? And then going into the fourth quarter, do you expect to see any further restocking? And could that possibly go into 2021 as well?

Yes. So we saw a restocking in North America in July, and most of that was a result of construction restarted up in late May, middle to late May, and completed some of their inventory. We saw a big restocking in July. We saw that bleed down. And as of now through October, we didn't see them -- we saw steady -- just steady sales with that channel versus that big stock-up in July. So that's what we're seeing in the market. And heading into 2021, I think it's -- what we see in the fourth quarter, I think the wholesalers will look what's on their shelves. So I think restocking, from that point of view, it's too soon to tell at this point in time. With the COVID-19 still continuing here, I think there's continued uncertainty in the market as we've previously discussed.

Okay. And then turning to water quality, I know it's a smaller piece of the portfolio, but you did highlight it in the presentation. Were you seeing any favorable trend there? We've heard from other companies water quality improvement, home improvement as a favorable trend.

Yes, we're seeing very positive as related to our residential piece in that marketplace as well as some of our commercial piece of that. But water quality has been favorable so has our most of our residential market. We actually saw our residential market up double digit in the quarter. So we believe that will continue with the focus on renovation and the single-family homes growing. As I've said, we're more cautionary about the commercial markets at this point in time. That's the one we're watching very closely.

Your next question comes from Jeff Hammond of KeyBanc.

So second -- third quarter second half decrementals look really impressive. I'm just trying to unpack, I don't know if you can quantify for the year how much temporary cost savings are going to be, how much of this is kind of mix and structural versus temp costs. And then just as you think about that into '21, how should we think about incrementals versus normal as some of that, I think you mentioned Bob, some of the temp cost creep back in?

Yes. So Jeff, it's Shashank. So as we had talked 3 months ago and we're pretty much on the same basis, we had about $55 million of cost-out in 2020. Year-to-date through the third quarter, we're at $42 million, as Bob noted, and $20 million of that was in the third quarter. We get another $12 million, $13 million in the fourth quarter. Out of that $55 million, roughly $8 million, $9 million was permanent in nature, which was restructuring activities. And that was $8 to $9 million. And as we look into next year, with the additional actions we took, that's going to be approximately $10 million of permanent cost-out. And when you look at the rest of the rest of the $55 million beyond restructuring, things like travel and mark-on and things like that, right now we're in the planning stages of 2021. Clearly, with the fact that the vaccine might not be available for a period of time, some of those costs will not be coming back, especially in the first 6 months, but we're in the early planning phases. So by February, we'll know exactly what that cost savings number is for 2021.

Would you think incrementals look a little bit lower than normal just as temp costs come back in or not necessarily?

I think overall, obviously, we still got the long-range target once we get beyond COVID of expanding the op margins, right? So when you look at the incremental drops, we're still looking at 25% to 30% on volume. Our decrementals, with the cost actions, we've done a nice job of managing the decrementals.

Okay. Great. And then just as we look to 2021, I mean if you look here, I mean outside of 2Q, your business has been pretty resilient. You speak to the replacement and, certainly, res. So I'm just trying to -- as we look into '21, kind of balance, like, snap back from easy comp versus kind of this lingering commercial uncertainty and how much you think you snap back in some of these businesses into '21.

Yes, Jeff, that is something we've been analyzing a lot. And we just completed our strategic planning process where we engaged an external support, did a lot of voice of customer, analyze the activity. And what we're seeing here is, this March, we're actually seeing an air pocket, right? Like, we look at our Drains business which has steadily gone down as an early indicator. So what's been happening is people have been completing existing construction and -- in commercial buildings. However, they were not doing any new buildings. And we're seeing that continue to push out. Including October, we saw Drains down double-digit. So that's the area we're getting most concerned. And as we're looking into next year, because of the COVID continuing to extend longer than I think everybody thought and going into next year, overall, North America, honestly, we believe, will be overall flat at best for next year. We believe Europe is going to be down, and APMEA is going to be up. So we're not seeing that rebound in commercial construction. Residential is doing fine. That's offsetting multifamily which is also projected to be down and focused on that. So from a residential, those kind of net. But the basic commercial building is soft and it's going to continue to be soft into next year.

And so -- and those are market commentary for each of the markets versus, like, your business, right? So I mean I just -- if you balance that with the replacement side of the business and maybe outgrow, it's like -- how much better can you do than those kind of market projections?

Yes, well, I think it's both our market and our projection. But I think the other thing is repair and replacement right now in -- traditionally, overall, that has followed GDP. What we're seeing is when we dug down deeper recently here, we're seeing that, of our repair and replacement, about 40% is break/fix where they repair it right away. The other 60% is preventative maintenance and renovation. And what we're seeing is, because COVID-19 has hit some of these troubled markets very hard, they're delaying that and pushing that up. Now at some point, that's going to catch up with them. And again, long term, we still hold the case that our repair and replace should hold GDP. But right now, with COVID and no stimulus, no health and all of that, that's pushing that out. And we're now seeing a bifurcation of that as we head for the rest of this year and into next year. So again, we think that will be difficult to compare us to.

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

I wanted to actually drill down, a little bigger picture topic, on just the channel situation. And I realize you had a destocking, which is encouraging. But just from a bigger picture perspective, can you talk about how the channels to market are evolving to the sort of new normal? Is there any evidence of wholesalers, or at least the marginal ones, being disintermediated, more of a virtual selling model, direct to customer? I mean how is all this impacting your channel to market, if at all?

I mean we're not seeing any of our smaller wholesalers go under in any regard. I think that market has -- the smaller ones have been consolidating into the larger ones. I think that continues. I think the larger ones do have a lot more online capabilities and are capitalizing on that. But we have not seen any bankruptcies within our smaller wholesalers at this point in time. But again, I think that will be a longer-term opportunity for the larger ones to consolidate with the smaller ones.

Okay. And I guess the restocking kind of supports that, right, because if there were balance sheet issues and so forth, there would be a limited capability to sort of take in inventory and they'd be on more of [ an adjusting ] model? Is that a good way to read that?

Yes. I agree.

Okay. And then I guess my other -- just as a follow-on to that, I mean I know it was a smaller deal, but Backflow Direct, they obviously, as their name suggests, had more of a direct online, more of a virtual distribution model, which would seem to be pretty timely, on the one hand, a deal that may be not timely, more commercial driven into all this, but timely in that sense. So can you give us an update on how that's gone, how that product line has been integrated? Then how the distribution side of that, has that just been folded into your regular distribution? Or are you still maintaining that online selling model there?

The answer to your question is all of the above. So first of all, Backflow Direct is performing very well, fully integrated into our business, and we are offering that product line to our traditional build business as well as we're offering it through online capabilities given the various channels. So the answer is we are capitalizing that. We continue to add products to that website in capabilities, and we'll continue to leverage that for the parts of the market that want to go direct like that. But overall, we're very pleased with that acquisition.

Your next question comes from Bryan Blair of Oppenheimer.

I was hoping you can provide a little more color on October order rates. I'm trying to gauge how much caution you're baking into the Q4 outlook of 48% organically.

Yes. So October order rates were basically flat which -- traditionally, what we're seeing is people restock at the beginning of the quarters so -- and then it gets softer after that. And with the COVID-19 spike-up, we're concerned, in particular in Europe, and then what usually happens is Americas follows 3 to 4 weeks later. And when you have the upcoming holiday season, I think there's concern in the marketplace. So right now, it's aligned with where we expect it to be. We expect November and December to get a little softer as we come out of this.

Okay. That all makes sense. And if you're willing to drill down a little bit more on regional planning assumptions, how are you thinking about top line trends across Americas, Europe and APMEA for the fourth quarter? And then any color on margin expectations and the sources of the year-on-year expansion you're guiding, that would also be helpful.

Yes, so for the fourth quarter, what breaks up the top line, as we're looking at it, we're expecting overall to be down 4% to 8%. Americas will be down 3% to 6%, Europe 6% to 10% and APMEA down 5% to l0%. So that's our internal planning assumptions. And again, it all depends on what's going on with COVID and the continued market uncertainty.

Okay, very helpful detail. And then Shashank, APMEA margins were quite a bit better than we expected in the third quarter. I was wondering if you could parse out the impact of AVG contribution and how much of a lift, if any, you've seen so far from the transition through a distribution model versus direct sale in Korea.

Yes, Korea sales -- to take the last one first, Korea sales a year ago were pretty immaterial, so nothing significant there, quite frankly, but it will be margin accretive as we go forward. The rest of the margin improvement, the APMEA story, part of it is the intercompany volume. And the intercompany volume obviously drives absorption as well as productivity. So we've got a lot of favorability from the intercompany volume that went through our factory in Ningbo. And then the rest of it was really margin expansion on third-party sales. So we did see margin expansion. As you know, in China, we target data centers which tend to be typically higher margin overall. So we had margin favorability there. And then lastly, our business in Middle East-Africa was down year-over-year as well, and that was margin accretive as well. So it's a combination of those that really helped. AVG is our higher-margin business as well, so that contributed a little bit. As we noted, there was about $3.5 million of inorganic sales in the third quarter from AVG, and those came in at higher margins as well.

Your next question comes from Walt Liptak with Seaport Global.

I wanted to ask a follow-on question with that geographic look. That was helpful. It sounded in your prepared remarks, like, some of the government subsidies were helping you guys a little bit. And I think Europe has been a little bit, because of maybe the political situation, able to come up with government programs to support businesses. So I wonder if you could talk a little bit about that. And the outlook for the Americans for the fourth quarter looks a little bit more stable than Europe, I wonder why that is. And do you think there may be more government support in the U.S.?

Yes, so Walt, to answer your first question, in Germany, they have some energy efficiency subsidies going on. And as you know, a lot of our business in Germany is related to OEMs, boiler -- residential boiler manufacture, so that's been helping those German manufacturers, and we've been supporting that, so that's helped. The biggest overall why things were better in Europe than we expected is they worked through the summer months, and we didn't expect them to do that, right? So they worked through that. That will subside. And right now, we're a little concerned with the breakouts, the shutdowns. The current shutdowns are not shutting down manufacturing at this point in time. It's mainly restaurants, bars, et cetera. But we are seeing -- obviously, they're seeing wider spread and uncertainty in that marketplace, and we think that's going to slow that down. So I think there has been some more government stimulus in that area. However, the COVID outbreak is what leads us to be cautious in the fourth quarter. In the Americas, certainly residential, as I said before, has been doing well. And I think some of the subsidies that were happening on into, let's call it, the hospitality market, et cetera, may have helped on some of the repair and replacement type stuff. But now that that's not been in there and we're not seeing that, we're starting to see a slowdown and people pushing out normal repair and renovations, as I said earlier, and we're watching that very closely. But again, uncertainty in the market, as I said in my prepared remarks, when there's uncertainty, people aren't building. And our Drains, which is a leading indicator, was down double digits in October and steadily got worse out of Q3. So that means they're not building new buildings at this point in time, finishing what they complete. And then we got that air pocket, and the question is how long will that air pocket go, and we believe it's going to go at least into the second half of next year.

Okay. Understood on that. With the smart technology, it sounds like you're continuing to make investments there. What is the voice of the customer saying about smart technology? And is there a digital trend where buildings -- where your customers are looking for digital solutions to reduce employment or just have better control over their water systems?

Yes, I think there is a clear trend in the industry. As we've said before, there's a shortage of plumbers, there's a shortage of maintenance people and anything we can do to monitor and identify issues before they become big issues is going to help building owners in this environment. So we're getting more and more focused on that. So I think that strategy is right on and more important than ever in this current environment.

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

Okay. Thank you, everyone, and for taking the time to join us today for our third quarter earnings call. We appreciate your continued interest in Watts, and we look forward to speaking with you again in February to discuss our fourth quarter and full year 2020 results. So enjoy the upcoming holidays, and please stay safe. Thank you.

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