Thank you for standing by, and welcome to the Watts Water Technologies Second Quarter 2021 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] 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, sir.

Thank you, and good morning, everyone. Welcome to our second quarter earnings conference call. We're glad that you could join us. With me today are Bob Pagano, CEO and President; and Shashank Patel, our CFO. During today's call, Bob will provide an overview of the second quarter and discuss the current state of our operations and markets. He will also update you on our smart and connected and sustainability efforts. Shashank will discuss the details of our second quarter performance, provide an initial outlook for the third quarter and offer a revised outlook for the full year 2021. Following our remarks, we will address questions related to the information covered during the call. Today's webcast is accompanied by a presentation, which can be found in the Investor Relations section of our website. We will reference this presentation throughout our prepared remarks. Any reference to non-GAAP financial information is reconciled in the Appendix to the presentation. Before we begin, I'd like to remind everyone that during the call, we will 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. I will now turn the call over to Bob.

Thanks, Tim, and good morning, everyone. I want to start the call by thanking our 4,500 global employees for their continued dedication and hard work during these challenging times. They've been navigating a robust demand environment and at the same time, managing through persistent supply chain constraints and the emergence of COVID-19 variants. I'm proud of our team's efforts to support our customers while remaining safe in the workplace. With that, please turn to Slide 3 in the presentation and I'll provide an overview of our Q2 performance. We anticipated a strong second quarter performance as the economy improved. However, demand was even better than we expected and our team delivered record results. As we guided last call, the February U.S. weather freeze provided a revenue tailwind in Q2 and we also benefited from our announced price increases. Adjusted operating margin exceeded our estimate, driven by incremental volume and our focus on productivity and cost management. Year-to-date, free cash flow is strong despite additional working capital needed to meet the current demand. In late June, we successfully completed negotiations to exit our manufacturing facility in Mery, France. This action will help to simplify our manufacturing structure and provide the incremental productivity. We've taken a charge for GAAP reporting in the second quarter. We expect to realize the full savings by 2023. Shashank will provide more financial details in a few minutes. Now, let me provide a view on the markets. In general, the markets continue to move in a positive direction during the second quarter. GDP expectations for 2021 have trended up in many of our key global regions since the first quarter. So, we expect that should continue to drive repair and replacement activity. In the Americas, single-family residential new construction remained strong in the second quarter in both…

Thanks, Bob, and good morning, everyone. Please turn to Slide 6 to review our second quarter consolidated comparative results. Sales of $467 million increased 38% on a reported basis and 32% organically, driven primarily by the global economic recovery. Sales benefited from a 5% foreign exchange tailwind and acquisitions added 1%. Adjusted operating profit increased 85% and adjusted operating margins expanded 380 basis points to 14.9%. Both measures were driven by increased volume from easier compares to last year, price, productivity and cost actions. This more than offset incremental investment spend, inflation and the return of expenses related to business normalization. Adjusted earnings per share increased 100% as compared to last year from the better operating result as well as favorable below the line items and our foreign exchange benefit. Our adjusted effective tax rate was 27.1% compared to 26.4% in the prior year period. As a reminder, last year included a benefit from a discrete item related primarily to the foreign exchange impact of repatriations. As Bob mentioned, we have completed negotiations to exit our facility in Mery, France. Total pretax exit costs approximate $26 million, which includes approximately $2 million in non-cash charges. Most of the costs are severance-related and are expected to be incurred through 2022. For GAAP purposes, we booked approximately $18 million of those costs in the second quarter and expect approximately $2 million in additional restructuring charges in the second half of 2021. Full year pre-tax run rate savings should approximate $5 million, which should be fully realized in 2023. We expect about $0.5 million in savings this year, largely in the fourth quarter. Free cash flow was $65 million through June 30th, up 160% from the same period last year. The increase was due to improvements in net income and lower net capital…

Thanks, Shashank. To summarize, let me leave you with a few key themes. Second quarter results were better than expected as activity improved during the quarter, helped by the global economic recovery, a strong repair and replacement market and the U.S. weather freeze tailwind. We have announced a third price increase in the Americas as inflation and supply chain costs continue to rise. Markets are supportive and the leading indicators for non-residential new construction are positive entering 2022. We continue to invest in long-term growth opportunities, especially in smart and connected solutions and in productivity-enhancing technology in our manufacturing facilities that support our long-term strategy. We have also increased our full year investment spend. During the second half, we expect to see increased costs on necessary investments, such as in-house training as business normalizes from pandemic levels. Still, we continue to closely monitor expenses. We expect to see improvement in third quarter results versus last year. Our full year outlook has been raised for both sales and adjusted operating profits, given the stronger than anticipated second quarter results and expectations for Q3 in the second half. With that, operator, please open the lines for questions.

[Operator Instructions] And your first question comes from the line of Nathan Jones with Stifel.

Good morning everyone.

Hi Nathan.

I'd like to start off just focusing on a comment you made during your prepared remarks, Bob, about high demand from channel anxiety. I think that was a specific comment about some European markets. Maybe you could comment more broadly on your feeling about your customer distributors potentially over ordering a little bit here, trying to get to the front of the line. Everybody is trying to lock in their own supply chains. Any color you have on what kind of your sell-in versus sell-through is?

Yes. Nathan, I think we are seeing some of that inside of the channels all over, in particular, in North America and Europe. Europe, I commented on that because of our electronics business in Europe. And we actually were pushing our customers to give us their orders so we could understand how much they really needed, so we could lock in our supply chain from an electronics point of view. So, again, I think there are some buys out there. I think people are beating price increases, but we are seeing sell-through in the channel. So, people want inventory and when we get the inventory, it's pushing through right now. So, again, there's some pent-up demand as we saw GDP and opening up of the economy has been strong. So, we're watching it very closely. But we believe based on our July results so far that it's all in line with our forecast for the third quarter.

Yeah. It seems like the markets are getting much better as well. You announced another price increase for September. Obviously, inflation continues to go up, freight costs continue to go up. Can you talk about where you expect to be on price cost for the full year? And what maybe the price carryover into next year would be?

Yeah. So, look, in the first half, if you think about price and material cost, net of the two were slightly positive. As we've talked about, we always try to stay ahead of the curve and that's why we're looking at that our third price increase in the Americas. The second one went into place through July 1 between Americas, Europe and the rest of the world. As we think about how much of that goes into 2022, I mean, it's a little early for that because we still got to get to the realization of the second and third price increase. But we'll give more color on that in the next call. But certainly, on a year-over-year basis because of the timing, there will be incremental benefits in 2022.

Got it. And you said you're slightly positive on first half. Do you expect to be neutral or slightly positive in the second half or some lag as pricing catches up to inflation?

We always expect to be ahead, Nathan, you know how we run this business. So, we're in front of it.

Not surprising. Thanks for taking the questions.

Thanks, Nathan.

Thank you.

Your next question comes from the line of Jeff Hammond with KeyBanc Capital Markets.

Hey, good morning guys.

Good morning Jeff.

Good morning Jeff.

Hey, so the European results are very impressive, particularly on the margin side. And I know this has been kind of an ongoing effort, but just trying to unpack the margin improvement here over the last couple of quarters and how much you think is mix versus kind of structural improvements?

Well, I think it's a combination of both. Look at the freeze - I'm sorry, the France, in France in particular, I think there was some pent-up demand, we're strong in residential there. So, we're seeing some of the same patterns we saw in North America, just delayed a little bit, and people are staying home and doing DIY and various things in their local houses. So, in addition, we talked about the energy incentives in Germany and Italy, which has helped some of our OEM business. And in the previous comment I made around electronics, we're seeing people put in orders quickly on that. And those between the France and the electronics, that was favorable mix for us for sure. When we look at our fixed cost structure, we continue to look at that. We announced the Mery, France closure that's taken us a while to do, and we've been taking out costs all along in this platform. But I think we're be as you know with higher volume in our strong fixed cost there. So, it's volume related. And I think it's going to taper off a little bit as we get going, but we're always focused on improving. But I'm really proud of the team's effort to hit that record operating margin and take advantage of the volume opportunities where we could.

Okay. Great. And then can you quantify price, how much price was in the quarter? And how you think price plays out in the second half?

Yeah. So, in the second quarter, on a global basis, our price was about 2%. And then as we talked about, we got the second price increase that went into effect from, let's say, the end of May to the end of June time period. And that will benefit us in the third quarter. And then the Americas price increase, the third one will benefit us in the fourth quarter. From a quantification of the second and third price increases, the second price increase is in the 5% to 10% range. And obviously, typically, our realization rates are about 50% and that's the closest one to us. So, 5% to 10% is the price increase, about half of that realization. The third one in the Americas, it's kind of its early days on that one.

Okay. And then just last one. Bob, you still seem a little less certain on kind of new commercial construction recovery. Can you just talk about what you're seeing from an order activity standpoint? And what does that tell you about kind of timing for an inflection there?

Yeah. So, again, we have to estimate that based on because we sell-through the wholesale channel. But certainly, our market intelligence, what we're hearing, et cetera, still lodging, stores, office buildings, recreation, et cetera, those have been still slow to do it. But we look at the same reports that all of you are looking at, the ABI, the Dodge Momentum, et cetera. And they're all pretending more positive growth. So, we've seen some pickup in the education markets, from the institutional side, some healthcare also. So, again, we're starting to see that. There is still labor shortages out there. We're hearing a lot of that discussion, and it's regional. Every region is a little bit different. But again, we're still watching that closely. We look at loan data for new construction and that's starting to move in the right direction. We're looking at big quotes on new projects and stuff. So, I think things are starting to move in the right direction. And our significant bump in repair and replacement has been nice to offset some of that. But it's nice to see the new construction indicators starting to move forward.

Okay. Thanks, Guys.

Thank you.

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

Great, thanks for taking my questions. First off, just a bigger picture one. If we assume that at least part of what's going on in the markets is the impact of just increased money supply, just general inflation on a monetary basis and that driving not only the raw material costs higher, but driving demand in the end markets as well, what are your thoughts about the potential unraveling of that in the future as the Fed steps back and contracts money supply? What's the scenario analysis in terms of how that impacts, not only the markets, but the margins and the price cost as all that maybe gets walked back in the next 12, 18 months, if in fact that kind of happens?

Yeah. Well, look, I still think we're in a low interest rate environment going forward here. So, although they might raise it a little bit, I still think it's still going to be lower interest rates, et cetera. I think a lot of this depends on the virus, how fast some of these variants could potentially, if another lockdown happens, et cetera, let's hope that's not the case. But overall, as I said earlier, labor shortages, too. So, there's a pent-up demand. There are some projects that are out there. I don't think we're going to see the boom that we've been seeing right now, because I think some of this tends to be some pent-up demand. But if you step back 10,000 feet, our repair-replace which is 60% of our business tends to follow GDP and then the 40% tends to follow new construction trends. So, we watch that very carefully. And certainly, GDP has gone up significantly. Overall, I think, for the world this year it's 5%. So, that makes sense. But I think that's going to taper down a little bit. But I think construction will continue to happen as things continue to open up. And if some of these bills' pass, there might be some investments, especially in healthcare and institutional type areas. So, again, we're watching very closely, but I think that's how we're looking at the world right now.

Okay. And I guess, I mean, specifically, what I'm trying to drive out there is price cost. I mean, if some of this liquidity gets sucked out of the economy in general and that has an obvious effect on commodity prices and things like brass, do you believe you can hold a significant amount of the price you've gotten and then realize the benefit of that in the margin? Or do you think in that kind of scenario, you'd be just sort of the market would force you to give some of that, most of that back?

I think we're going to have to give some of it back. It will be our goal and our team's goal to keep as much of that as we can in leveraging our differentiated product that offers a solution to our customers versus a commodity product and that's why our smart and connected initiative is really focused on that. So, we look at what value are we providing to our customer, not necessarily a cost plus. We don't do that. So that's not our focus. But we're watching that. And again, that's why we continue to provide higher value to our customers.

Got it. And then one last one, just to follow-up on the prior question there on non-resi. How important is office to watch longer term? I mean, that does seem like the one market where we've maybe got a structural change. I mean, I'm talking to you from a fully opened office, where about 5% of people have elected to actually to be here. So, it seems like maybe we are in just a new normal in terms of remote work and so forth. How important is that market? And if it never really does come back, what impact does that have on you longer term, in terms of growth of business?

It's not significant, less than 5%. So, again, we'll focus on the markets that are going well. Our product doesn't care what end market it goes into. So, we'll take advantage of the markets that are moving and offset some of that. So,

So, Ryan, just to qualify that 5%, less than 5% is the new construction piece of our office sub-segment.

Okay. Yeah, that makes more sense if a little low. Okay. Thanks for your time.

Thank you.

Your next question comes from the line of Bryan Blair with Oppenheimer & Company.

Thanks, good morning.

Good morning.

You've called a strong momentum across the repair, replace side of your portfolio, and all that makes sense at a high level. Drilling down a bit more, can you offer color on break fix versus retrofit activity and what your team is expecting differentiating between the two for the back half?

Yeah. I think it's a combination of both. It's hard to determine what is what at this point in time because we're seeing the demand. I think we talked about break fix is about 40%, renovation 60%, somewhere around there. So, it's across the board and I can't distinguish between the two. So, just solid opening up. People are adjusting and renovating. And as we said before, look, there's only so long you can hold off your plumbing repairs before you really have to do it. And I think we saw some of that in Q2 and some of that happening in Q3.

That's fair, and good to hear. Just a level set on the revised guide, Shashank can you walk through some of the pricing dynamics? But if we think of the 7 to 8 points that you've lifted the full year outlook, what's baked in for incremental volume versus price?

Yeah. It's approximately half now, because some of those price increases, some of them going to effect July 1 and then the Americas one is really effective October 1. But if I were to break it out, it's roughly about half of that is incremental price and the other half is some of the incremental volume we've already seen in the second quarter.

Got it. Thanks again.

Thanks, Bryan.

Thanks, Bryan.

Your next question comes from the line of Joe Giordano with Cowen & Company.

Yeah. Good morning.

Morning Joe.

When I just think about the growth guide for the full year, the raise here, was the previous guide more just maybe a little unwillingness to extrapolate what you saw a couple of months ago into the rest of the year and now we're just like about three months later and we're still there or do you feel like something structurally changed for the better over the last three months?

Well, I think, look when we gave guidance the last time, there was still a lot of uncertainty. How things were growing, could there be slowdowns, et cetera. I think we feel more confident now and that's why we're more aggressive with our third quarter forecast and outlook at this point in time. And remember, the second quarter last year was an easier compare globally for us because the world kind of shut down in the second quarter. So, again, I think our leading indicators, what we're seeing, what we're hearing from customers gives us the confidence to bring some of that forward for the rest of the year. So, again, it was too early when we gave guidance before, we're still hearing mixed signals in the market. We just wanted to clarify what was happening.

Yeah, fair enough. And then on the balance sheet, just thoughts there on capital deployment priorities. I mean, I know you guys want to - you're always looking and you have a pipeline, but if things don't - if prices are not where you need them to be, your thoughts on other sorts of usage of the balance sheet?

Well, look, our first priority is investing in ourselves and we continue to do that. That's our first. We believe in a balanced capital deployment strategy as we always have. And as you said, we'll look at alternatives. We're not willing to give up at this point in time. We think there's opportunities for capital deployment out there, and we just have to be patient, and we're going to be disciplined like we always have. So, we'll be watching, we're looking, but you never can predict timing of any M&A. But our first priority is investing in ourselves, organic growth as well as in our factories from an automation point of view we've increased our dividends and again, the rest from an M&A point of view. But we continue to monitor and look at that.

Thanks guys.

Thank you.

[Operator Instructions] Your next question comes from the line of Michael Halloran with R.W. Baird.

Hey, good morning guys.

Good morning Michael.

Hey, so, could you just go through on how the uptake is going on the innovation and the connected strategy? Obviously, incremental spend is happening on the R&D side, which we always like to see. Just curious if that receptivity is still gaining momentum, what the clients are saying and any kind of context behind it?

Yeah Mike, we're getting very positive comments from our customers on our innovation strategy, especially as it relates to smart and connected. And really, smart and connected really allows us to offer solutions to our customer. And we look at the various things and the pain points. And as we've talked about it in the past, I mean there's a shortage of plumbers and there's a shortage of maintenance personnel. And for us to have more connected products that will allow them to anticipate issues or see issues before their catastrophic valuers, everyone is seeing the benefit of that, so especially in this labor shortage market right now. So, again, very positive results, as I said in my opening comments that, we're continuing to increase our percentage as a percentage of our total sales. And that's actually, if you think about it, the freeze had a lot of increases in our, let's call it, traditional sales, but our overall percentage keeps on going up, even though we sold a lot of, let's call it, non-smart and connected products in the second quarter. So, we continue to increase our percentage. The pipeline is very full. And our team is excited about that.

Thanks. And then outside of some of the pre-buy activity you talked about in Europe, how do you think channel inventories are sitting here today? Thanks.

So, it's interesting. We continue to have dialogue with our customers and it's interesting. I would say, believe it or not, the channel inventory from a year ago is probably flattish. However, the channel wants more inventory given the current demand and volume out there. So, I think it's a mixed bag. People want more because of the supply chain concerns and they're demanding more. So, overall, they would tell you if they want more.

And is that a challenge from a capacity perspective for you to meet at this point where inventory, I mean, where supply chains are, where your channel is and what the capacity looks like?

It's been a challenge only because of the supply chain issues, but our team has worked tirelessly at looking at alternative sources and we've stayed in front of this thing as best we could. So, they're doing a great job. I think we're doing - I would say the team is excelling in that area. And I would tell you our strong supply chain is helping us continue to grow. So, we'll continue to push. The team is watching very closely. But like everybody, we have labor shortages and supply chain issues. So, we're continuing to work real hard on that and building capacity where we need it.

Great. Appreciate it, Bob. Great quarter. Thanks.

Thanks, Mike

Thanks, Mike

Your next question comes from the line of Walter Liptak with Seaport Research.

Hi. Thanks guys. Just as a follow-on first to the last one. Do you think you're getting market share because of supply? Are your competitors able to meet their channel partners' inventory needs?

I think we're holding our own or doing better. That's the best I can say.

Okay. All right, fair enough. I think in your commentary, you talked about some costs coming back in. I wonder if you could talk a little bit more about what those costs were that are coming back and maybe quantify them?

Yeah. So, for the full year, we had talked about business normalization costs and those are things like travel, marcom, training, all those things that we cut back starting last March. And that was about $15 million of headwind in 2021. In addition to that, obviously, last year, we got benefit of government compensation incentives, primarily in Europe and a little bit in China. Obviously, those are not this year. And last year also, we got the benefit. We had some pay cuts, et cetera. We got the benefit of that last year for a few months. So, that all kind of goes away and that's kind of headwind. And then incremental investment spend. For this year, we got about $17 million of incremental investment spend. About half of that is in our smart and connected strategy. And the rest of it is, whether it's product expansion or global market expansion, et cetera. But those are the headwinds this year.

Okay, all right. And I think you mentioned some expenses from travel and so forth. Have you lifted any kind of travel bands or are you allowing people to travel to and from your locations?

So, there's limited travel out there. Travel has begun. I've been out to our sites and met with our sales team, has gotten together, et cetera. International travel is still not there. I think it's more internally. So, we're starting to visit customers, but again, very limited and but it's starting to ramp up, and these variants we'll be watching very closely. So, again, we're balancing all of that right now.

Okay. And I guess the reason I ask this, is it important now, have you been able to figure out ways of selling to get around that travel or do you think it's important to have your channel partners coming into your facility for training on new products or are you able to get around that through digital ways?

Yeah. So, we've been doing digital training, but I've got to tell you, the field is really pushing us to start offering our in-house training, which is hands on training, where you take a part products. You troubleshoot them. Great beginner training. So, we're getting a lot of pressure to open that back up, and we're looking to do that. Right now, it's scheduled for the fourth quarter and we're being pushed to open it up even sooner. So, if we did that, it certainly would have to be vaccinated people before we allow external people to come inside of our facilities. So, anyways, there's a pent-up demand. We've been doing great digitally in Zoom. But at some point, with our long list of new product developments and innovation, we need to get out there and do more training and show everybody what we have. So, it can only last so long, and I'm sure everybody in the industry is excited to see that starting to come back.

Okay, Great. Okay. Thanks for the color on that.

Thanks, Walt.

Thanks, Walt.

[Operator Instructions] We have no further questions at this time. I would like to turn the call back over to Bob Pagano for closing remarks.

Thanks, 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 on our third quarter earnings call in early November. Stay safe and enjoy the rest of your summer.

Thank you for participating. This concludes today's conference call. You may now disconnect.