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 Watts Water Technologies Second Quarter 2023 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question-and-answer session. [Operator Instructions]. Thank you. I will now turn today's call over to Diane McClintock, Senior Vice President, Financial Planning Analysis 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 the 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 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 the quarter. First, I'd like to thank the entire Watts team for their hard work and dedication to diligently serving our customers worldwide. Together, we delivered another better than expected quarter despite tough comparisons to a very strong second quarter in 2022. We finished the quarter with record sales, operating margin and earnings per share, leading to the decision to raise our full year 2023 outlook. The Europe and APMEA regions were resilient as organic sales grew at a mid-single digit pace, primarily due to price. Sales in the Americas region were down low single-digits as we expected due to a tough comparison to a very strong second quarter in 2022 where organic sales were up 22%. Strong growth in our nonresidential core valve products was more than offset by double digit declines in our gas connectors, radiant heating applications, and commercial marine instrumentation. Adjusted operating margin exceeded expectations supported by solid price realization, favorable mix and productivity, which more than offset inflation, lower volume, and incremental investments. Year-to-date free cash flow has been strong and is added to the strength of our balance sheet. We expect to generate strong free cash flow into the second half of 2023 which will afford us ongoing flexibility in our balanced capital allocation strategy. To that end, our board approved a new $150 million share repurchase program. This program will follow on our existing plan as stock repurchases remain an important part of our capital allocation strategy. As a reminder, stock buybacks along with high ROI CapEx investments, competitive dividends and strategic M&A such as our recent Enware acquisition remain our top capital allocation priorities. Moving to operations. The integration of our Enware acquisition is…

Thanks, Bob, and good morning, everyone. Please turn to slide 6, and I will review the second quarter's consolidated results. Sales of $533 million were up 1% on a reported basis and flat organically. Mid-single-digit organic growth in Europe and APMEA were offset by a low single-digit organic decline in the Americas. Sales from our indoor acquisition totaled approximately $8 million and are reported within the APMEA region. Unfavorable foreign exchange movements had an immaterial impact in the quarter. Adjusted operating profit was $104 million, up 7% compared to last year, and adjusted EPS was up 11% to $2.34. Adjusted operating margin of 19.5% was up 100 basis points as price, mix and productivity more than offset inflation, lower volume and incremental investments. We were able to deliver 100 basis points of margin expansion despite a tough comparison to the second quarter of 2022, which benefited from approximately $7 million of onetime price cost favorability and the dilution of the Enware acquisition in the quarter. The adjusted effective tax rate was 24.7%, 130 basis points favorable to the second quarter of 2022. The decrease relates primarily to the reduction of foreign taxes associated with the repatriation of funds. Our free cash flow year-to-date was $89 million as compared to $33 million in the first six months of last year. The cash flow increase was primarily due to higher net income and a lower amount of working capital investment. We expect sequential improvement in our free cash flow, and our full-year goal is to achieve free cash flow conversion of 100% or more of net income as previously communicated. During the quarter, we repurchased approximately 24,000 shares of our Class A common stock for $4 million and year-to-date, we have repurchased approximately 47,000 shares of our Class A common stock for…

Thanks, Shashank. Please turn to slide 9. I'd like to summarize our discussion before we address your questions. The second quarter was better than we anticipated with record sales, operating margin and earnings per share supported by price and favorable mix. Due to our strong first half performance, we are increasing our full-year outlook. We continue to monitor the slowing economic indicators in Europe and are staying close to our customers. We are confident in our ability to execute in this uncertain environment. We are prioritizing investment in our smart and connected and sustainability initiatives and are increasing our full-year investments from $20 million to $23 million. We believe we are on-track to hit 25% of total revenues coming from smart and connected enabled products by the end of 2023. Our strong free cash flow generation and balance sheet provides us flexibility to execute our balanced capital allocation strategy. We announced a new $150 million stock repurchase program to ensure we maintain repurchase flexibility over the coming years. With that operator, please open the line for questions.

[Operator Instructions]. Your first question comes from the line of Ryan Connors with Northcoast Research. Your line is open.

Good morning. Thanks for taking my question. So I want to start on the gross margin. Obviously, gross margins look really, really good. And I wanted to, just kind of step back and look at the big picture on that. Can we kind of interpret that one of these big debates about how well would price hold relative to raw materials and would we be able to hold price and lock-in some of that margin longer term as input costs moderate. I mean, is that kind of what's happening here on the gross margin line and is that something that's going to be sustainable going forward?

Well, good morning, Ryan. the first part of that. First of all, it was favorable mix, right? Residential is down, commercial's up and our OEM business is down. which are our lower margin businesses. So that's good. that's good from a margin point of view. From a pricing point of view, we've been able to hold pricing so far. And, in that backdrop, we've also seen some reductions in our input costs. So that altogether, favorable mix, as well as favorable cost at this point in favorable price is holding up.

And is there any sign that that's any early evidence that that's changing or is the price environment is there no real evidence of any major crack in that pricing? It looks pretty solid going forward.

Yeah. We don't comment on forward looking price usually, but as of now, as I said, it's holding up in the quarter. It held up in the second quarter.

Got it. Okay. And then just one last one. If you could just -- I didn't hear much from you on kind of the channel inventory situation in your prepared remarks. So, if you could just kind of give us an update on the channel inventory situation, that would be helpful as well. Thanks.

Yes. I think, the channel inventory is healthy, but we've seen some destocking with continued residential destocking with OEMs in North America. And I think there's a big, focus on inventory in Europe right now from the wholesalers, which we've been seeing them starting to destock as well as the OEMs in Italy. So, we're starting to see more destocking in Europe. We've seen it last year, but we're continuing to see it, especially with the order trends in Q2 in Europe.

Got it. Okay. Thanks for your time.

Thank you.

Your next question is from the line of Nathan Jones with Stifel. Your line is open.

Good morning. This is Adam Farley on for Nathan Jones.

Good morning, Adam.

Hey. Good morning. With global GDP still positive, should we expect, repair and replace volume to be modestly positive?

Yeah. We expect that. Repair and replacement's been holding up. I think you've seen some -- we talked about in our prepared comments that specialty market, which was really around gas connectors, radiant heating, and then a niche of commercial instrumentation, which is really related to our ballast water. Those areas have been declining and we expect them to continue in the third quarter that way.

Okay. That's helpful. And then looking at your non-residential businesses. Can you provide a little more color on which end markets within non-resi are still showing strength? Which ones are still showing weakness? And would you expect strength in institutional to continue into 2024?

Yeah. I think, similar to the first quarter, the commercial market's been holding in there. Strength in institutional has been there. And I think the normal offices, hospitality, but hospitality is coming back a little bit, albeit off a really low comps from last year. So, in general, it's holding up at this point in time. And as in my prepared remarks, we talked about the Dodge and ABI index is also supporting that. So, so far so good, and it's holding in there. But as you can imagine, we're watching that very carefully. And again, we have some tough comps we're comparing against, in the second half of this year.

Okay. Thank you for taking my questions.

Thank you.

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

Hey, good morning, guys.

Good morning, Jeff.

Good morning.

Hey, just want to unpack the decrementals, I guess, first half to second half. May I understand there's some seasonality in there, and maybe you can quantify the incremental investments. And if there's anything else, year on mix or otherwise that would be impacting that.

Yeah. So, Jeff, part of it is seasonality, right? Typically, first half, second half, we see a decline of a 100, 150 bps first half to second half. The other part this year, we got some volume deleverage, right? So, the volume deleverage affects not only at the standard margin line, but you got some absorption impacts as well there. The third thing is the incremental investments. We have about $5 million of incremental investments, H2 versus H1. And lastly, Enware is dilutive by about 20 bps. And then the other point, Bob had talked about, which is Europe, we've got negative growth in Europe. And with our high fixed cost base, we see some, deleveraging there.

Okay. Great. Have you guys seen any destocking in boilers? I don't know if you mentioned that, but one of the competitors had called that out. Can you just clarify what the specialty channel is? Is that DIY or something else?

Yeah. On the -- I think our HHW, heating hot water platform, is holding up. I think there might have been some destocking in the commercial water heater side of that business. But overall, that team is doing a nice job. The specialty channel is a combination of we call it in residential, our gas connectors and radiant heating in particular. So those are gas connectors and grills, generators, etcetera. So that's being impacted by, that part of the market, which is residential, same with radian heating. And we had some tough comps last year in that area. So, again the specialty channel, we also have what we call our commercial marine instrumentation which is our ballast water where there was a movement over the last several years to have all of the ships, the large ships measure their ballast water. And there was that requirement. All the ships got pretty much done by the end of last year, probably a year earlier than we expected and we're seeing that tail off. But again, all of that, our specialty product is less than 10% of our overall business. But some of this we expected, obviously, with the residential side of this decreasing in a big – a part of that gas also goes through OEMs.

And then just finally on Europe, I guess the moving pieces are you're starting to see destocking that's showing up in orders. think you mentioned in Italy regulatory change, dynamic. But that's a business that I think you've been worried about for some time but continues to kind of put up in a better growth.

Yeah. I mean, it surprised us both in the first quarter and second quarter. It's held up, but as expected, given the leading economic indicators and some concerns especially in the residential side of that market, we are seeing -- starting to see that tip over a little bit. But we were expecting that. It just, happened a little later than we expected. So, the team's done a nice job of getting more than our fair share of the market there. And I expect them to continue to do that.

Okay. Thanks.

Thank you.

Your next question comes from the line of Mike Halloran with Baird. Your line is open.

Hey, thanks. Good morning, everyone.

Good morning.

Good morning.

So, a couple of questions. First on the non-res side of things, maybe, Bob, could you talk to the project funnel or the funnel of the backfill, some of the projects out there. I know in the past, we've talked about working off of what was a backlog of activity and curious what you guys are seeing as far as replenishing that funnel and replenishing that opportunity out there and any level of variance as you look across some of the sub verticals within that non-res base.

As I've said in the prior quarter, institutional is still holding up as well as like data centers and some of that area has been holding up strong. Our teams are out in the field. It depends on which country, like or part of the country, like anything. But in general, I would say it's still healthy backlog out there. And I think some of it continues to be a result of the shortage of labor inside of those markets and there was some backlog out there. So again, we're cautiously optimistic, but we're watching it closely.

And how should I think about the North America margins from here? I mean, it feels like every quarter there's a new high that you're reaching. I certainly understand a lot as commentary on mix and other headwinds as you look to think sequentially in the back half. But when we're thinking on a little longer horizon, what’s that right base to build off of for that segment? I mean, it feels like you just established a new high here.

Yeah. I would say, so beyond the mix, which was very favorable in the second quarter, and obviously the mix adjusts over time. But our goal, as we've talked about before, is long-term to continue expanding that in the 30 to 50 basis point range going forward, including in the Americas because that's 70% of our business.

Mike, do you have any other questions?

Oh, I'm good. I said thanks. I might have been on mute. I apologize for that. I appreciate it.

Okay. Thank you.

Your next question comes from the line of Joe Giordano with Cowen and Company. Your line is open.

Good morning. This is Michael on for Joe.

Good morning.

Good morning.

Apologies. I’d joined the call late. So, apologies if this has already been asked, but previously you mentioned OEM related sales are roughly a third of your European business. So, I was just curious on how this has trended in the first half. And what are your thoughts sequentially for OEMs on a global basis? And then if you have any margin color there, it would be very helpful. Thank you.

Yeah. I mean, OEM business, which is usually is really tied to the residential markets, both in North America and Europe, has continued to be soft and we continue to see destocking in that area given the residential nature of that business. So, we're expecting that to continue through the rest of this year. And, as you can imagine, OEM business is our lowest margin business. So, with that being down, that obviously helps our margins in total from a mix point of view. So again, our guidance assumes that will continue in the third quarter.

Great. Thank you.

Thank you.

[Operator Instructions] Your next question comes from the line of Walt Liptak with Seaport Global. Your line is open.

Thank you. Good morning, guys.

Good morning.

Good morning.

I wanted to ask about the incremental spend on the new products. And I want to make sure that we're not like, underappreciating what you're doing with smart products. And so, I wonder if you could help us maybe with some data points about how many products you've developed, what the categories might be a product that might be a best seller, the kind of incremental growth that you might be getting from these investments.

Yeah. So, we talked in 2022 that we developed 20 new product developments in smart and connected. And we're continuing on that journey to get that 25% of our products smart and connected. So that's a key initiative for us. We continue to highlight those products. So, it's nice to see Enware, also is in that overall quest to be smart and connected. So, we'll continue to invest in there. We believe that's the future of all of our products into the future. And we'll continue to invest in those differentiated products to the marketplace.

Okay. Great. Are these going through -- do they require more training or are they going through the same channels as you're doing now? Like how's the commercialization of them calling?

Yeah. They definitely require both training from a customer point of view as well as our rep network and our channels. So, we continue the training. Our Watts Works training initiative, as you know, is very strong. We continue to grow that, and we'll continue to do that. So, what we always say is we have to make sure that it's we're easy to do business within regard to smart and connected, how it's connected, the data it produces, etcetera. So those are key areas. Training is a key part of that. but it's a shift. And I think everybody's realizing the shift is here. And I think during the COVID outbreak, everybody realizes that it's an important part in, of the future of, plumbing.

Okay. Yeah. It seems very excited. It seems like, an obvious progression for your products. Are you able to measure yet? How much? I guess you I'm sure you do. You measure the incremental sales, but at what point do you think it's going to or maybe it's showing up already? At what point do you think it's quantifiable, what is adding to your revenue?

So, we are taking our existing products and cannibalizing them, right, and making them smart and connected. So, it's -- I would just say in general, I think we're growing faster than the market. And I think having new products that are smart and connected gives us a continued differentiation that we're still capitalizing on. So, yeah, that's how we see it.

Okay, great. Thank you.

Thank you.

There are no further questions at this time. I will now turn the call back over to 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, thank you for participating. This concludes today's conference call. You may now disconnect.