Ladies and gentlemen, thank you for standing by, and welcome to the Watts Water Technologies Fourth Quarter 2020 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speaker's presentation, there will be a question-and-answer session. [Operator Instructions] Please be advised that today's conference is being recorded. [Operator Instructions] I would now like to turn the conference over to your speaker today, Timothy MacPhee, Treasurer and Vice President, Investor Relations. Thank you. Please go ahead.

Thank you, and good morning, everyone. Welcome to our fourth quarter and full year 2020 Earnings Conference Call. Joining me today are Bob Pagano, President and CEO, and Shashank Patel, our CFO. Bob will provide an overview of the past year, review our 2021 priorities as well as update you on our market expectations for this year. Shashank will provide a detailed analysis of our fourth quarter and full year financial results and discuss our outlook for 2021. Following our 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 Investor 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 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. With that, I will turn the call over to Bob.

Thank you, Tim, and good morning, everyone. Please turn to slide 3 in the earnings presentation, and I'll offer some reflections on 2020, and provide our updated thoughts on 2021. I want to start out by expressing my deepest gratitude to our employees around the world. Their dedication since the start of the pandemic has been unwavering to ensure our customers' needs were being met and our business continued to move forward. This past year has tested everyone's endurance and patience. I'm so grateful to our experienced team that was able to nimbly adapt to the dynamics of this constantly changing global environment, and I'm confident the team will continue to proactively manage our business to meet our customer expectations in 2021 and accelerate Watts' strategy. I'm also pleased to report that we continue to make progress in our environmental, social, and governance efforts and in diversity, equity, and inclusion initiatives this past year. Our sustainability performance improved following evaluations from several leading ESG rating agencies, and we supported our customers and local communities that were impacted by the pandemic. As you know, our product portfolio is aligned with three macro themes. Safety & Regulation, Energy Efficiency, and Water Conservation. We believe this focus dovetails well with the ESG framework. In 2020, we launched our first diversity, equity, and inclusion survey, which identified key focus areas, and we formed working groups to lead our global diversity initiatives. We've also deployed employee training and development programs relevant to this effort. As a company, we enacted a comprehensive response to COVID-19 challenges. First, employee safety was and remains our priority. Through our COVID-19 taskforce, we emphasized safety protocols in the workplace that met or exceeded CDC and other country-specific requirements. Secondly, given we are an essential business, we maintained a customer focus.…

Thank you, Bob, and good morning, everyone. Please turn to slide 6, which highlights our fourth quarter results. Reported sales of $403 million were up 1% year-over-year. Organic sales were down 2%, but were more than offset by net acquired sales and a foreign exchange tailwind. While each region experienced lower organic sales, America and Europe sales were better than anticipated. Acquired sales, net of divestiture, approximated $1 million in the quarter. I will review regional performances momentarily. Adjusted operating profit of $55 million, a 10% increase, translated into an adjusted operating margin of 13.6%, up 110 basis points versus last year. Benefits from cost actions, including restructuring and productivity savings, more than offset lower volume and incremental growth and productivity investments. Investments totaled $3 million in the quarter. Adjusted earnings per share of $1.15 increased 15% versus last year. EPS growth was driven by $0.08 from operations and $0.07 primarily from a lower adjusted effective tax rate and positive foreign currency translation. The adjusted effective tax rate in the quarter was 24.6%. The rate declined as compared to last year as new regulations provided an opportunity to benefit from a favorable tax election, and we received tax benefits related to foreign exchange on cash repatriation. GAAP reporting included a net tax charge of $9.7 million or $0.29 a share, primarily driven by increased income tax expense, resulting from recently issued final tax regulations, which reduced the reliability of foreign tax credits. In summary, aggressive cost controls and a higher American and European top line drove the better than anticipated operating results. Moving to the regional results, please turn to slide 7. In the Americas, reported sales decreased by approximately 1% to $264 million. Organically, sales were down by approximately 2%, with growth in certain plumbing and electronic products being…

Thanks, Shashank. Please turn to slide 11 and let me summarize our discussion. The team successfully navigated through a very trying year. We were able to adapt to the many challenges caused by the COVID pandemic, delivering strong results by controlling what we could, given the economic environment. Our market outlook for 2021 remains guarded. Timing for broad dissemination of the vaccine is critical to reduce uncertainty and restore some normalcy to the markets. We see a challenging year starting in the second quarter, given current industry indicators and the lack of new non-residential and multi-family construction starts in 2020. Smart and Connected products continue to gain momentum, and we expect they should continue to grow in 2021. Productivity and efficiencies gained through the one watch performance system will continue and help fund investments. We plan to deliver strong free cash flow. As always, we'll remain disciplined in our capital deployment, prioritizing reinvestment in bolt-on acquisitions that strengthen our core, further expand our geographic reach and add technology to build scale. We'll be closely monitoring how the COVID vaccination process develops and how that affects customer sentiment and the construction markets. Given our 2020 performance, I'm very confident in our experienced team will work through the near-term COVID issues and execute on what we can control in 2021, while still focusing on our long-term growth strategy. With that, operator, please open the line for questions.

Thank you. [Operator Instructions] Your first question comes from Nathan Jones with Stifel. Your line is open.

Good morning, everyone.

Good morning, Nathan.

Hi, Nathan.

Thanks very much for all of the color on your end market expectations there, Bob, that's very helpful. Maybe just a few questions on the cost side to start with. Shashank, you made a couple of comments during your remarks, $15 million of costs returning in 2021, $14 million incremental cost savings in 2021. Can you talk just in a little bit more detail about what the level of temporary costs that you took out in 2020 that are returning versus carryover savings from structural elections, just to put a finer point on that? And then given the expectations that revenues are going to be net down low-to-mid-single digits here in 2021, whether you need to take more cost actions or more planning to maintain capabilities for a potential rebound in 2022?

So on the cost actions that are coming back, it's about $15 million of headwind, primarily starting from May onwards. And what that $15 million is made up of is, there was temporary pay cuts we had from the April through September time period, which is about $3 million. We got government subsidies, primarily in Europe and in China, which is about $3 million, which again were one-time. Travel and MARCOM is about another $6 million, and that's the one we're going to meter. Obviously, in the first six months, it's going to be light again because of COVID. But in the second six months, once things hopefully open up, those costs will be coming back and we'll be metering that based on what the top line is. And then there are some miscellaneous other costs of $3 million, and that's the $15 million of cost headwind that we've kind of included in the budget. And obviously, we'll be metering the variable pieces of that like travel and MARCOM. On the restructuring side, of the $55 million cost out in 2020, about $14 million were restructuring savings. Now -- and that was partially a restructuring savings. So the actions we took saved us $14 million last year, and then there's another incremental roughly $14 million, $15 million that we get in 2021 on top of the $14 million that we had.

Okay. So net temporary versus restructuring, you're about even in 2021?

That's a fair statement, yes.

Just one more on the repair and replace side of this, Bob. I know you talked last quarter about not seeing the typical correlation between GDP recovery, repair and replace and there was some concern there that potentially customers' balance sheets were a bit wounded, and maybe you wouldn't see that typical correlation. Any updated thoughts with another three months under your belt there?

Yes. I think the troubled markets, which are really the hotels and restaurant side of the business; I think their occupancy is 10% in some of the hotels, et cetera. So I think, they're continuing to defer as much maintenance as they can. Certainly, the break/fix side of that is happening, but overall they're cash constrained, and I think that continued in the quarter. Overall, we saw positive residential side. And everybody is trying to complete their existing projects that they started because builders want to get paid and get going. So I think we're seeing that continuing as expected. And our biggest concern is really in the -- primarily in the second half of the year, given the starts, the lack of starts in the multifamily and nonresidential part of our business.

Do you believe this might create some pent-up demand? Or does this just permanently shift that demand curve to the right?

Yes, it's tough to tell on that. That's a great question because I think in some parts, there'll be pent-up demand that's willing to be spent. But others, and again, those troubled markets, I think it is just going to be pushed to the right until they get their cash flow back. So I think, again, that's mixed.

Thanks very much. I'll pass it on.

Thanks.

Thanks.

Your next question comes from Jeff Hammond with KeyBanc Capital. Please go ahead.

Hey, good morning guys.

Good morning, Jeff.

Good morning, Jeff.

So just a clarification on multifamily. What are you looking at or what are you assuming for multifamily? I know, it's not going to be as robust certainly as single-family, but I thought it would be fairly stable.

Well, multifamily, overall construction, as I said in my prepared comments, is going to be -- they're forecasting to be down 6%. What we're most concerned about is, when we look at loan originations, and I'm looking at a Q3 document that basically said, the origination volume index for multifamily is down 31%. And that was in Q3, expecting similar in Q4. So again, everybody is completing, Jeff, what they started, but new construction is really slow at this point in time. Permits are down. You see the ABI, the Dodge Momentum index, all those are portending a softness in that air pocket that we're talking about. Talking to channel partners, they're also discussing that they're seeing some air pockets, and for the first time in a while, there's some trades, plumbers, et cetera, unionized labor that's sitting on the bench and not employed right now, in particular in New York City. So those are the things that we're most concerned about. A lot of stuff that started is being finished. And I think that's mixed up into that overall minus 6%. But I think the second half of the year in particular is going to be really challenged.

Okay. And then, so if I look at your bridge, it seems like at the midpoint of guidance, EBIT is down $13 million, and you've got $28 million of headwind from investments and temp costs coming back, $15 million of structural savings. And then I guess you had some volume baked in. So, I don't know if I'm missing something else in the bridge, other savings, or favorable mix or –

Yes. So Jeff, mix is not -- it's insignificant. The other big piece is inflation, right? So we talked about inflation from commodities and freight and packaging and all sorts of stuff. So inflation is a significant headwind this year. Now obviously, we got some price to try to combat that, so that's the other piece of it. But the point you made, which is the margins, the 50 to 90 basis points of margin degradation is probably driven by the decrements on the volume.

Okay. And then in an inflationary year like this, what kind of price do you typically realize?

We implemented price increases of 3% to 5% in January. And we plan on realizing 1% to 2%, and we're pushing the team to get even more aggressive on that. So that's an area that we're pushing hard, and that's what we're looking at.

Okay. And then last one on connected products. It looks like if I take your 15% now to 25% and put a little growth on the total business, you are kind of high teens to the 20% kind of growth CAGR. How are you thinking about that in terms of organic versus these kind of bolt-on technology acquisitions?

I think it's going to be a combination of both. We're first focused on organically transforming our products. And again, that will cannibalize existing products. But the whole digitization strategy has become more and more important. So we'll do small bolt-ons right now, but I think the majority of it is our focus and what's driving our significant investment is to take our existing products and electronify them.

Okay. Thanks a lot.

Thanks.

Your next question comes from Bryan Blair with Oppenheimer. Please go ahead.

Thanks. Good morning, guys.

Good morning, Bryan.

Good morning, Bryan.

You've given a lot of color on expectations in terms of the moving parts and then what's billing to impact the margins throughout the year. Is that level set on quarterly or first versus second half progression and thinking about the down 50 to 90 basis points for the year?

Yes. I think – so Bryan, a lot of the cost actions we took obviously started – we actually got early, so we started March, but the bulk of them happened in the second half. So therefore, when you think about margin degradation, not expansion, a lot of that is in the second half. The first quarter, and that's why when we gave the first quarter guidance, we kind of said flattish from an operating margin standpoint, because we're still getting the benefit of the actions we took in Q1, and we didn't have the benefit of that last year in Q1. So to your point, the second half is going to be more weighted around – with lower operating margins versus 2020.

Got it. Appreciate the color. Anything more you can offer on AERCO and PVI trends through the fourth quarter and into early 2021? And I guess given current visibility in market reads, what's your base case expectation for boiler sales this year?

Well, our complete HHWS platform, which is boilers and water heaters, they were down mid to high-single digits in the quarter, and we see similar as we're coming into the first quarter of this year. So that's an area they were most hit by restaurants, hotels, et cetera. That was their strength. And if you recall last year, in the first quarter we saw a lot of education spending in the first quarter last year, which surprised us. There was some pent-up demand. So we've got a tougher comp in particular in our AERCO boiler side in the first quarter.

Got it. And you have US government transition/policies in the monitoring section of 2021 planning framework. Outside of tax policy, which I assume is more of a 2022 watch item, what's on the team's radar there?

Well, we're certainly watching the stimulus proposal and what happens on that, especially if there's energy efficiency type discussions with that on infrastructure. So that's a key area. I mean, again, it's an unknown right now at this point in time, but a lot of talk on roads and bridges. And certainly, we would rather have social infrastructure, really focused on healthcare, education and airports, but they're not talking about that. Obviously, that's an area we, with other industry participants, are focused on pushing where we can. But that's an area we're hopeful. But right now, I think there's a lot of talk, and we haven't seen much action at this point in time.

That definitely makes sense. If in an optimistic case scenario, we do have a package come through over the near term, is there the potential that that could meaningfully lift your back half expectations? Or should we assume that the spending would take place into 2022 and reset our thinking in that direction?

I would think it'd be very late in the year and then definitely more into 2022. But again, I don't think it's significant at this point in time.

Okay. Thank you.

Thanks.

Your next question comes from Brian Lee with Goldman Sachs. Please go ahead.

Hey guys. Good morning. Thanks for taking the questions. Maybe just a follow-up from an earlier one around price actions. Just as you think about the base case for 2021, price/cost dynamics, you're out to the market with 3% to 5%, you're maybe targeting 1% to 2%. If you base case the 1% to 2%, is it sort of net neutral price/cost for the balance of 2011? Or are you actually able to get a point or two? Just trying to understand what's baked into your model for price cost.

Yes. So look, with the price and productivity, we offset inflation. That's usually the way we go at it. And that's the way we're thinking about this one. Obviously, on the inflation side though, because it's commodities and we have locks in place as you guys know, and those take us through the end of June, depending on how commodities progress through the rest of the year, we might be looking at price again. But for now, it's that 3% to 5% that Bob mentioned, with a 1% to 2% realization rate.

Okay. And then that gets you to net neutral on the price/cost dynamic?

Collectively, yes.

Fair enough. All right, that's helpful. And then I guess maybe a bit more color on the air pocket. You guys have been pretty detailed around the drivers here and sort of the timeframe, but can you give us a sense of what percent exposure you have to multifamily and non-res new construction? And then in terms of timing, you're calling out Q2 and a weaker back half, but any visibility as we stand here today as to kind of how that air pocket might normalize as you move through 2021? Or is this – are you kind of even shelving that for a 2022 discussion at this point?

So taking your second question first, right, on the length of the air pocket, if you go back to ABI, Dodge momentum, all these indices, they started turning negative in the second quarter. And usually, they have a 9 to 12-month lag. So if you take that point, that's where we come up with our second quarter, and we expect that to continue throughout 2021. As to when that turns in 2022, we don't know yet. We'll just have to see how those indices progress through the rest of this year. But we have factored in that we'll have that air pocket through 2021. As to the challenged markets, when we look at all of our challenging markets, right, so residential, multifamily, office buildings, stores, lodging, food services, recreation, commercial and marine, that represents approximately 20% of our total Watts business, and that's what we say will be impacted by the air pocket that we expect in the Americas.

Yes. And that's on the new construction portion of that. Brian, one of the key things, and I think you guys have all heard me talk about this in the past, it's confidence, right? It's confidence from the builders to invest their cash at this point in time. So I think there's money on the sidelines just waiting for some stability in the markets. You're hearing shortages of supply chains with builders, lumber prices are up double. So I think we're looking -- they're just waiting for supply chains to normalize, vaccines to be rolled out. There's low interest rates, so at some point, this will be released. So the timing of this is it will be very interesting to watch. So we see things happening in the marketplace, a lot of discussions. But look, when you're not doing loans and you're not doing starts, obviously, at some point, that's going to catch up with us and that's why we're talking about the air pocket the way we are.

Thanks guys.

Your next question comes from Joe Giordano with Cowen. Please go ahead.

Hey guys, good morning.

Good morning, Joe.

Can you talk about, as you continue on the Smart & Connected path here, what that means from a margin standpoint and like the uplift associated with the percentage ratcheting higher over the next couple of years?

Yes. I mean, look, as we look at our Smart & Connected solutions, so we continue to try to bundle a value proposition to our customer, higher than our existing value proposition with our standard products. So in general, the standard margins tend to be higher. But as you know, we're investing significant amounts in SG&A and R&D, right now as we scale up and build those capabilities. But, at the standard margin, they tend to be higher, given the value propositions we're offering to our customers.

And then, as we think longer term, you've made big strides in Europe on the restructuring end. How should we think about the normalized margin potential of Europe versus Americas?

I think, as we said, we have significant footprint, inside of Europe. So I think structurally, margins are going to be lower there. We continue to take small restructuring actions. And we have headcount freezes in place and let turnover take its course. But it's very expensive, as you know, to take out a lot of people through social plans, et cetera. It's only gotten harder during the pandemic, at this point in time. So, we continue to monitor that, look at that. But in general, it will be structurally lower. And remember, there's a big, about 1/3 of our business or a little less than 1/3 of Europe business is OEM related. So that in general is lower-margin business.

Joe, I would say that, over the last 12, 18 months, the teams have done a nice job with the whole value proposition and driving price. And that's helped on margins. And they're going to continue working on that.

Thanks a lot guys.

Thanks, Joe.

Thanks.

Your next question comes from Walter Liptak from Seaport. Please go ahead.

Hey, Thanks. Good morning guys.

Good morning, Wal.

Good morning, Wal.

I wanted to stick with the discussion of Europe. And I just wanted to clarify, that the air pocket that we're talking about is largely North America. And I wonder, if you could talk a little bit more just about, that growth rate in Europe and what could go well or are the headwinds to get to the low-end of the range for 2021?

Yeah. The air pocket that we're talking about is, in North America, so that's what we've been talking about. In Europe, I think Shashank talked about it, our commercial Marine business is what's challenging us. In general, Europe has been slow growth for us over this time. But our drains business, which is one of our more profitable businesses, is getting hurt, abnormally hard at this point in time. So we always plan lower growth in Europe, to keep our cost structure down, et cetera. But the team, as Shashank said, it's done a nice job managing those costs, and driving change. But low growth and offset by our drain business, is why we're giving the guidance the way we are.

Okay. Got it. And I wanted to go back to the discussion of restructuring and productivity. Understanding the $15 million of savings comes to an end, is there another phase of restructuring that you can do? Or -- and I think my understanding was there was productivity going on, on the factory floor, with machinery. I wonder what kind of benefits you'll get in 2020, from productivity.

Well, look, first of all, you know, we're always driving productivity in our factories, and that will continue. When we look at restructuring, our teams are always looking for opportunities for restructure. We went pretty hard in 2020, and went after it. Any other restructure is longer, more difficult, requires plans, et cetera. So we're always looking at that, we'll continue to look at that option. But we're in it for the long run here, right? We believe there will be a recovery coming back. We want to be ready to be able to capitalize on that. And hit the ground running. That's why we're continuing our investments. And the teams will continue to get leaner inside of our factories. But we've decided strategically to go after $13 million of incremental investments, primarily driving both, productivity and most importantly, our Smart & Connected strategy to get us to 25% connected by 2023.

Okay. Got it. Thank you.

Thanks, Wal.

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

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. And stay safe. Thanks.

Ladies and gentlemen, this concludes today's conference call. Thank you for participating.