Ladies and gentlemen, thank you for standing by. My name is Brent, and I will be your conference operator today. At this time, I would like to welcome everyone to the Second Quarter 2022 Watts Water Technologies, Inc. Earnings Call. It's now my pleasure to turn today's call over to Diane McClintock, Senior Vice President, FP&A and Investor Relations. Please go ahead.

Thank you, and good morning, everyone. Welcome to our second quarter earnings conference call. Joining me today are Bob Pagano, President and CEO; and Shashank Patel, our CFO. During today's call, Bob will provide an overview of the second quarter and discuss the current state of the markets and our operations. He will also update you on our Smart and Connected product initiatives and our sustainability efforts. Shashank will discuss the details of our second quarter performance and provide our outlook for the third quarter and for the full year. 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 this presentation. Before we begin, I'd like to remind everyone that during 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. With that, I will now turn the call over to Bob.

Thank you, Diane, and good morning, everyone. Please turn to Slide 3, and I'll provide an overview of our Q2 performance. Firstly, I want to thank our employees around the world who have executed through the challenges of record inflation, the effects of the Ukraine war on Europe's economy, COVID lockdowns in China and the continuing supply chain disruptions. Our success is a result of the dedication of our team to serving our customers. We continued our strong start to the year with our second quarter results significantly better than we expected. During the quarter, we benefited from incremental sales due to our decision to invest in inventory, which allowed us to better serve our customers. Our Americas team delivered another quarter of double-digit growth despite the difficult prior year comparisons due to the impact of the freeze in the South Central U.S. in the first half of last year. We were able to deliver mid-single-digit organic growth in Europe despite the impact of the Ukraine war, the exit of Russia business and escalating inflation. And in APMEA, while lockdowns impacted several of our key markets, the team still delivered top line growth in the quarter. Adjusted operating margin exceeded expectations supported by price, volume and productivity, which more than offset inflation, incremental investments and cost normalization. We benefited in the quarter from our proactive investment in inventory at lower cost in parallel with increased price. This favorable dynamic subsides in the second half of the year when the pricing costs become more balanced. Year-to-date free cash flow has been seasonally slow due to additional working capital needed to meet the current demand and our investment in inventory. We anticipate sequential improvement through the second half due to normal seasonality. Our supply chain and sourcing teams have done a great…

Thanks, Bob, and good morning, everyone. Please turn to Slide 6, and I will review the second quarter's consolidated results. Sales of $527 million were up 13% on a reported basis and up 16% organically. We had a very strong quarter in the Americas and saw mid-single-digit growth in Europe. We saw double-digit growth despite the tough second quarter 2021 comps that included a 3% benefit from the freeze in the South Central United States. Foreign exchange, primarily driven by a weaker euro, reduced year-over-year sales by roughly $18 million or 4%. Acquisitions accounted for $2 million of incremental sales year-over-year. Adjusted operating profit was $98 million, up 40% compared to last year and adjusted EPS was up 43% to $2.11. Adjusted operating margin of 18.5% was up 360 basis points as price, volume and productivity more than offset inflation, incremental investments and normalized spend. As Bob indicated, our margins benefited in the quarter from our proactive investment in inventory at lower cost combined with higher price. The adjusted effective tax rate was 26%, 110 basis points lower than the second quarter of 2021. The decrease relates primarily to the restructuring of our Mexican supply chain operations. Our free cash flow year-to-date was $33 million as compared to $65 million in the second quarter of last year. The cash flow decrease was due to our proactive decision to invest in inventory, higher employee and customer incentives and restructuring payments and higher net capital spend, which more than offset higher net income. We expect sequential improvement in our free cash flow, and our full year goal is to drive free cash flow conversion of approximately 90% of net income. The balance sheet remains strong. Gross leverage was 0.6x, and net leverage was negative 0.1x. Our net debt to capitalization ratio at…

Thanks, Shashank. On Slide 9, I'd like to summarize our discussion before we address your questions. The second quarter was stronger than we anticipated, with double-digit organic growth and strong drop-through as a result of our proactive investment in lower cost inventory. We are staying on top of the price/cost dynamic and expect tougher second half compares. We expect a solid third quarter, although sequentially down from Q2. We are increasing our full year outlook based on our strong start, which should be able to offset headwinds from the war in Ukraine and softening GDP. We are monitoring our markets and are confident in our ability to execute in this uncertain environment. We continue to execute against our strategic framework, including focusing on innovation and profitable growth by investing for the future and driving our Smart and Connected strategy. With that, operator, please open the line for questions.

Your first question is from the line of Jeff Hammond with KeyBanc.

So just on this price cost gap into the second half. Is the largest delta that you had some low-cost inventory working through in 2Q and you won't have that? Or it seems like inputs are normalizing a bit and you continue to push price. Just more color there.

Yes, Jeff, and that was it. It's the -- in parallel with the price we got -- we had the lower cost inventory. The net amount is about $6 million to $8 million that we got the benefit of in the second quarter.

Okay. Great. And then just on the full year revision, can you just isolate how you're looking at EMEA and Asia differently or same? Or is it just all a revision on the Americas?

Well, look at, Jeff, when you see inside of our numbers, for Q3, we think North America is going to be up double digits. We believe Europe is going to be down low single digits. And APMEA up mid-single digits. For now in Q4, we're being cautious, really because of Europe right now. As you know, we're a short lead time business and the visibility for Europe is a concern for us right now. So the team is doing a good job of managing it, but it's something we're watching closely. So we're being cautious in Q4 based on that. But overall, Americas is doing well and APMEA is coming back given the lockdowns.

So you -- so on par, you're kind of lowering the Europe forecast a bit versus the previous quarter?

Yes. Correct.

Okay. And that's showing up in the order rate since May?

Yes. Yes. Shashank talked about. We started seeing declines in order rates in May. I think some of it is destocking of inventory that's going on in the channels right now and just the cautious nature because of the significant energy increases and everybody just being cautious given there's a potential recession in front of them.

Okay. And then just last one. Maybe talk about inventories in the channel and need to restock or destock in North America.

Yes, North America is holding its own. I think there's some discussion. People are beginning to talk about inventory. So we're watching that closely. But I think we benefited also in the second quarter because we did have the inventory. And as you know, it's a book and ship business. Whoever has the inventory gets the order. So I think the -- we're watching that closely. But I think it's decent inventory levels in North America.

Your next question is from the line of Joe Giordano with Cowen.

This is Michael on for Joe. Thank you on the color for the inventory build and price cost. Perhaps you can just dive into a little bit on the sustainability of the Americas margins, if you're contemplating any volume declines in your guide for that particular segment.

Yes. So in the second quarter, we talked about, and I basically said there was about $6 million to $8 million because of lower cost inventory position. And obviously, that balances out in the second half. As well as in the Americas, we've got tremendous volume leverage in the second quarter. The volume leverage is less in the second half as the volumes come down. And then from a margin standpoint, we do have incremental investments coming through in the second half as well versus the first half.

Your next question is from Nathan Jones with Stifel.

I'm going to go back to the margin in the second quarter here because, obviously, it was extremely high. That $8 million would be 110 to 150 basis points of margin upside. And you came in at 300 to 350 basis points, quite better than where you had guided the second quarter. I guess what I'm really wondering is why would -- the guidance for the second half implies that you pretty much dropped back down to where you were guiding the second half before, which is back down more like 300 to 350 basis points. If that price cost imbalance was only 130 of the 300, 350 that you beat the quarter by, the guidance by, why would we drop back down that full 300 to 350 in the back half of the year?

Yes. So part of it, Nathan, was we got tremendous volume leverage in the second quarter. That volume leverage isn't as much in the second half. As well as when you think about pricing, right, and the pricing dynamic, we had -- from a pricing perspective, the first half was best from a year-over-year comp perspective. And so we got approximately 10% price realization in the second quarter. Obviously, we don't talk about Q3, Q4 until it happens because there's elasticity out in the marketplace. But the expectation is it is tougher comps in the second half versus second half last year from a pricing perspective. So you bake some of that in as well. And the last point, the point I made earlier about investment spend is higher in the second half versus first half.

Is it higher than it was -- than what you were planning previously, the investment spend in the second half?

It's about the same.

Okay. And then I just wanted to talk about the balance sheet and capital allocation here. You're in a slight net cash position, the company hasn't executed much in the way of M&A over the last few years here. Just your outlook on what to do with the balance sheet here, if it's patience waiting for maybe some larger acquisitions or how you intend to get that cash off the balance sheet?

Well, Nathan, we -- as you know, we always have a balanced allocation strategy, right? So we look at dividends, CapEx, et cetera. But on the M&A, we're disciplined. Our pipeline is full. We look at it, but as you know, we're disciplined. We can never predict the timing of when acquisitions will happen. So we'll maintain discipline and that's how we look at our capital allocation strategy. So we'll be patient and look for what is out there.

And the last point, Nathan, I mean, people never talk about investment in inventory as cash allocation. But in the last year, it's been over $100 million, and that certainly helped us in the second quarter.

Your next question comes from the line of Michael Halloran with Baird.

So Bob, you talked about some of the leading indicators and the deck certainly had it on the new construction side. Maybe you could just dig into what some of those are? And whether that's what your customers or channel saying or just some of the kind of larger macro stuff?

Yes. So Mike, ABI, Dodge Momentum, all of those are positive. That's good. I think we're all seeing single-family housing starting to come down, but we're also seeing multifamily, that's positive. So I think North America is balanced. As I said earlier, Europe is the biggest wildcard for us right now. We just don't know the impacts -- the full impacts of the war and the implications of their significant energy costs and in particular, in Germany, if they shut off the gas at that point in time. So that's where we're watching. I think their mix. Some of these signals are coming down. Normally, our repair and replace, which is about 60% to 65% of our business, that holds up well. That ties to GDP. So we're watching that. We're also watching -- in general, supply chains are starting to get more balanced. So I think the fear of people having a bunch of inventory to offset supply chain issues with lead times coming down. I mean I think we're watching all of those things and how they come together. But in general, we feel positive about North America and APMEA. It's -- Europe is the biggest concern for us.

Yes. No, that makes a lot of sense. I should have been clear. I was more curious about the Americas, but you certainly touched on that. So are you actually seeing the weakness in the single-family business today, more of a prospective comment?

Yes, we're seeing that. But like I said, we're seeing some offset in multifamily.

No, makes sense. And then from a channel partner perspective, are they seeing -- where is their head at? And then maybe a thought on inventory levels in your main channels? And that question is focused on Americas.

Yes. Channel, when you talk to the channel, especially when you get into the contractors, they're all still busy. So they're cautiously optimistic, but they're certainly hearing the same things we're all hearing, so they're more concerned about their future, later on and stuff. But look, I don't think, for the most part, nobody believes it's going to be a potential -- if there's a recession in North America or a downturn, nobody believes at this point it's going to be very long. So they're optimistic. Their biggest issue right now is labor. It continues to be labor issues, getting the right labor to fulfill it, which I think helps extend this cycle over a longer period.

And then just to comment on the inventory levels?

Inventory levels, I think, are stable inside of North America. We've heard rumors of people beginning to think about that or reducing inventories because they're seeing commodities starting to come down, and they don't want to be caught with higher inventory. So -- but it's not -- we have not seen a significant shift at this point in time, but we're monitoring it.

Great. And I won't ask the question, but Americas margins even though they were pretty spectacular. So thanks, guys, really appreciate the time.

Your next question is from the line of Ryan Connors with Northcoast Research.

I wanted to kind of step back and look at the margin question from a bigger picture perspective, Bob. And I think it's pretty remarkable. We think back just a few years ago, you were talking about a margin -- operating margin target of 12%, which I think we interpreted it's like that's the reasonable margin the market will bear for this industry. So if we look at it from that perspective, I mean, do you think -- you're, obviously, going to try to hold price if in fact, raw materials come down. But do you believe that there's been a structural upward shift in sort of the natural equilibrium cross-cycle margin for this industry? Or not? Do you think gradually, things will revert back? I'm just curious on your big picture perspective of what all this has done to the run rate margin for this space.

Yes. Ryan, we've always talked about mid-teens. So in our mind, it was always 14 to 15, not 12, but it's just a question of timing. Every year we talk about growing margins 30 to 50 basis points while still investing for the future. But in general, I think a couple of things. We've driven productivity. We've got great supply chain. And we focused on automation in our factories. So I think -- and as you know, we're continuing our lean journey. So I think all of those contributed to our ability to take out costs and drive higher margins overall. But we try to add value to our customers and differentiate our products, especially in the smart and connected area, which we believe commands higher margins.

All right. I mean -- and maybe a related follow-up to that would be, you made a comment earlier that whoever has the inventory gets the order. Do you believe that there's been any market share shifts because of some companies maybe yourselves handling the supply chain issues more effectively and just head above water and others not faring as well and maybe suffering some reputational damage in the process? And has there been any share shift over the last couple of years that you think could hold going forward?

Yes. I think shares bounce around, right? It depends on who has the inventory and the timing of that inventory. I think certainly, our vertically integrated strategy of manufacturing where we ship has paid off, especially in an environment like this where lead times supply chains from overseas are much longer. So I think that benefited us, and we really saw the benefit in Q2 because there was shortages of inventory in the market, and we believe we took our fair share of what was out there. But supply chains are coming back to levels -- normal levels with all our competitors. So I think that great performance we have in Q2, we're going to do our best to continue that. And -- but I think it was abnormal because we pushed it, and we had the inventory and our strategic investment in inventory really paid off.

Your next question is from the line of Brian Lee with Goldman Sachs.

This is Miguel on for Brian. I just had two questions. The first one was just I wanted to touch back on the conversation around channel inventories. Just wanted to hear a little bit more commentary on your visibility into the channel, specifically wondering how much destocking do you think has occurred so far? How much inventory is out there, if there's a way to measure that in months or weeks? And what are your expectations on how those channel inventories work their way through the rest of the year and next year? And if there's a way to talk about that on a regional basis, if possible?

Miguel, that's very difficult. We have thousands of customers, right? And we do not have that visibility. So we have to do channel checks, et cetera. As I said earlier, I think Europe is the biggest place that we're seeing -- beginning to see channel destocking, which makes sense, especially in the smaller wholesalers, cash is king, as you can imagine. And I think that's important. I think that also holds true in North America. But again, visibility is limited from our point of view. I think a general comment would be as supply chain get better, leads times come down. I think the channels, the wholesalers and contractors will hold less inventory because they'll be relying on the wholesalers and the manufacturers to ship it to them. So timing of that, it's difficult to predict. But in general, I would say, over a longer term, a year or 2, I think that will begin coming down.

Okay. That's very helpful. And then second question, I'll pass it on. Just on the guidance for adjusted operating margins. The guidance suggest that 4Q is the low point on operating margins this year. Is that the right way to think about it? And I know you're not guiding to 2023, but just hoping to get more commentary on how you think about the general cadence of margins beyond this year as the balance of those pricing actions and also the lower inventory costs normalize?

We're not talking about 2023 at this point in time. But I would just say in general, when you look at margins, as I stated earlier in one of the previous questions, we're being cautious about Q4 given European margins and in European volume. I think the thing, as you can imagine, we've had a lot of discussion regarding we have high fixed costs in Europe, and it takes a while to take those costs out. So if volume deleverages, it abnormally hurts our margins. And we've been benefiting over the last 2 years with really strong volume inside of Europe, and we're starting to see from an order point of view, that's slowing. So again, we're cautious about that because, again, we're a book and ship business. We don't have a significant visibility to the future. So we'll update you. We'll take it a quarter at a time, and we'll update you at the next quarter and give us -- our better guidance into the future.

Your next question is from the line of Walt Liptak with Seaport Global.

I wanted to ask about if you can help us with selling prices, some of the commodities costs are a bit of a mixed bag. Are you still taking up prices? Did you take them up in the quarter? Like what was the cadence of some of the price increases?

Yes. Look, so Walt, as we've talked before, we do an evaluation every 90 days of our total cost inflation on all cost of goods sold. And the last analysis we did, which was in the May time period, price increases before that was based on that. We'll be updating our numbers at the end of August. So we'll take a look at it again. That's something that we do routinely every 90 days.

Okay. Great. That sounds good. And when I'm looking at some of the materials costs, there are some copper and piping and things like that, they're clearly deflating and others that might be out. But I wonder if you could just talk about some of your inputs and what that means for the back half?

So well, one of the things we pride ourselves on is staying in front of this. So we'll see the benefit -- we always stay in front of cost and price with cost. But one of the things we will see the benefit of that fall through with our inventory turns, et cetera in 2023. But look at -- there's many other costs, overhead, labor, et cetera, we're still seeing inflation on. So overall, net-net, we'll take a reading on it, but we're watching it very carefully, and we'll put the appropriate pricing in, as Shashank said. So we're continuing to drive price and -- because in this inflationary market, we need to do that.

There are no further questions at this time. I will now turn the call back over to the CEO, Mr. Bob Pagano.

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

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