Watts Water Technologies Inc (WTS) 2003 Q4 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Watts Water Technologies earnings conference call for the fourth quarter of 2003.

At this time, all participants are in a listen-only mode.

My name is Mike, and I will be your conference coordinator today.

If at any time during the call you require assistance, please press star followed by a 0, and a conference coordinator will be happy to assist you.

The presenters for today's call are Mr. William C. McCartney, CFO, and Mr. Patrick O'Keefe, CEO.

I would now like to turn the program over to your host for today's conference, Mr. Ken [LePage], who will give an introductory statement.

Please proceed, sir.

Thank you.

Before Pat and Bill begin their presentation, I want to inform you that various remarks they may make about the Company's future expectations, plans, and prospects constitute forward-looking statements for purposes of the Safe Harbor provisions under the Private Securities Litigation Reform Act of 1995.

Actual results may differ materially from those indicated by these forward-looking statements as a result of various important factors, including those discussed under the heading "Certain Factors Affecting Future Results" in our annual report on form 10K for the year ended December 31, 2002, which is filed with the Securities and Exchange Commission, and in other reports we file from time to time with the Securities and Exchange Commission.

In addition, any forward-looking statements represent our views only as of today and should not be relied upon as representing our views as of any subsequent date.

While we may elect to update forward-looking statements at some point in the future, we specifically disclaim any obligation to do so, even if our estimates change and, therefore, you should not rely on these forward-looking statements as representing our views of of any date subsequent to today.

During this call we will refer to non-GAAP financial measures.

These non-GAAP measures are not prepared in accordance with Generally Accepted Accounting Principles.

The reconciliation of the non-GAAP financial measures to the most directly comparable GAAP measures is available in the Investor Relations section of our web site, www.wattswater.com under the heading news releases, in the press release dated February 10, 2004, relating to our year and fourth quarter 2003 financial results.

I will now turn the presentation over to Pat.

Thank you, Ken.

My name is Pat O'Keefe, I'm President and CEO, Watts Water Technologies, and with me today is Bill McCartney, our Chief Financial Officer.

What I would do is I'm going to walk you through some prepared statements and some information that we have prepared.

Then we will open up the lines and accept any and all questions you may have.

Overall, if you look at the fourth quarter of 2003, sales increased from 161 million to 191 million over the prior year; that's an increase of $30 million or 19%, a pretty robust sales increase.

When you take the 19% and you look at it in terms of how we accomplished that, I want to walk you through some numbers that will help you understand our sales increase.

Internal growth represented approximately 12 million or 7.4% increase.

Acquisitions contributed an additional 3 million or 2.4%.

Foreign exchange represented approximately 11 million or 7%.

And the inclusion of Jameco International LLC represented an additional 4%, 4 million or 2.4%.

Now, when you take the business apart and you look at the segments, the first thing I want to say is I'm overall very pleased with the results of our North American operation as well as our European operation.

When you look at the North American operation, you will see that we had an overall sales increase of 10%.

Now, getting into those numbers, you look at the internal growth rate in North America was 6% for the quarter, with retail having an internal growth rate of 9%.

Now, that's an interesting number because we're comparing to the fourth quarter of 2002, where we had the ramp-up of a number of new SKUs that were being provided for the first time to Home Depot.

So, relatively difficult quarter-to-quarter comparison, but we still achieved a 9% internal growth rate.

When you look at the products across the board that contributed to that, we had a wide variety of products.

It wasn't concentrated in one product area.

We had significant increase in our brass and tubular, had significant increase in our under-the-floor radiant heating products.

We had a very broad across-the-board participation in that upswing.

In terms of the wholesale channel of distribution, the wholesale channel of distribution in North America increased by 6%, the majority of that being -- almost the entire amount of that is an internal growth rate, which is roughly taking sales from 83 million to 88 million.

In terms of plumbing and heating products, we saw an improvement in the overall economy, so we saw some pretty robust improvements across the board there.

But the vast majority of our improvement came from a product line that we're very excited about, which is our backflow prevention product line, both the Hunter product line and the existing Watts brand, and Ames product line, as well.

So, we saw pretty robust growth in the fourth quarter in our wholesale channel.

Now, one of the things I want to point out to you: This is the third consecutive quarter of positive growth in the North American wholesale business.

So, we've had three quarters in a row with positive growth.

We feel pretty positive about the progress we're making in the North American wholesale channel.

Now, turning over to Europe, Europe currently in this quarter represents 32% of our entire revenue, compared to 27% in the prior year.

When you look at an internal growth rate in Europe, the internal growth rate was roughly 12%.

Looking at the OEM market segment, we had an increase of 16% and the European wholesale market, which has been -- we have suffered with a negative economy in the plumbing wholesale channel in Europe for the last couple of quarters, but for the first quarter here -- for the fourth quarter of this year, we had an increase of 5%.

So, you add to that some foreign exchange contributions and some contributions from acquisitions that we made in Europe, and we had a pretty robust European segment during the fourth quarter.

In terms of earnings per share, our earnings per share, if you exclude the restructuring charge, we're reporting 36 cents for the quarter compared to 30 cents a year ago.

However, with inside of those numbers, I want to point out a couple of unusual items.

One is, we provided an additional $1.7 million to cover potential product liability costs.

The second, is that we recorded a $600,000 charge in the fourth quarter to cover potential and experience scrap in our start-up of our joint venture -- of our wholly owned subsidiary in Tianjin, China.

The other thing I want to point out is, our tax rate went from 36% a year ago to 38% in the current quarter, which is primarily due to the nondeductibility of certain costs involved in our Chinese operations.

So, we had a negative impact as a result of nondeductibility in terms of the effective tax rate.

I'm particularly pleased looking at the results in terms of cash generation.

If you look at the cash flow for the 12 months ended December 31, 2003, we had $24.9 million in free cash flow.

That compares to the prior year where we recorded 28.5 million in free cash flow, and more importantly, during the year we provided for pension costs of 6.8 million versus 0 in 2002.

So we had similar free cash flow, although we funded our pension plan to the extent of $6.8 million.

In terms of capital expenditures, they were consistent with the prior year at approximately 20 million in each year.

And I want to point out, at December 31, we had $140 million worth of cash on hand.

This is primarily the result of the stock offering which we did in mid-December where we raised $82 million.

Secondly, it's a result of the private placement we did in May of that year, in which we raised $125 million and paid off $75 million of notes that came due on December 1.

The other thing I want to point out is that we also closed on the acquisition of Flowmatic, which was effective as of January 5, 2004.

Flowmatic is an exciting new acquisition to us, and I just want to point out, Flowmatic designs and distributes high quality reverse osmosis components and filter components.

In summary, I would categorize the fourth quarter as a very positive quarter.

We saw positive sales growth in four out of four of our major market segments, with the North American wholesale business up 6%, the North American retail segment up 9%, the European OEM segment up 16%, and for the first time in quite some time, the European wholesale market up 5%.

In the fourth quarter, sales were achieved through: one, healthy internal growth; two, some positive impacts from foreign exchange; and three, the contributions from companies that we acquired throughout the year.

We also continue to make progress in developing our low-cost manufacturing capabilities in China, Bulgaria, and Tunisia.

Net income for the quarter was 26 cents per share for the fourth quarter of 2002, going up to 34 cents for the fourth quarter of 2003.

If you look at a earnings per share excluding restructuring charges, they increased from 30 cents per share in the fourth quarter of 2002, to 36 cents in the fourth quarter of 2003.

We were also able to increase our cash dividend to 7 cents per share during the quarter, and last but not least, we come out of the year with a very strong balance sheet, in large part due to a successful offering we completed in December, the refinancing of our debt in May, and continued strong generation of positive cash flow.

With those comments, I'll now open it up and accept questions.

Operator?

Ladies and gentlemen, if you wish to ask a question, please press star 1 on your telephone.

If your question has been answered or you wish to withdraw your question, please press star 2.

Once again, please press star 1 to ask a question.

And the first question comes from Michael Schneider with Robert W. Baird.

Please proceed.

Good afternoon, guys.

Hey, Mike.

First, maybe we can address the European wholesale market.

Pat, as you know, this is the first increase we've seen in a while.

Any particular market or product line that explains it?

Or is it, indeed, probably a broad-based recovery that you've witnessed at least for one quarter?

Mike, it's pretty well broad-based.

I think it's led, however, by our backflow prevention line.

We've seen pretty much across-the-board increases in our backflow prevention line, but we're also seeing it across the board in a multitude of both our plumbing and our heating products.

So I'd say it's relatively broadbased.

Bill, you may want to add comments.

Mike, just for clarification, were you speaking of North America or Europe with that question?

Europe.

Europe.

Oh, okay, excuse me, Mike.

The -- the primary driver of Europe, interestingly enough, was the wholesale business in our German operations.

Okay?

And they have been -- I think we had hired a new sales manager there approximately a year and a half ago, and I think he's beginning to have his presence felt ,so we had a relatively good quarter.

Some of it may be timing, in terms of things falling in the right place in the right time, but we seem to be -- we've been -- as you know, Mike, we've been languishing in the European market, particularly in Germany, where I would consider the conditions to be close to recessionary.

So, this is a very positive development for us.

Although, I think it's premature to think that it may continue into future quarters.

Okay.

Yeah, Mike, we think that we've picked up a little market share there in Germany.

Really it's -- at this point we're not -- we don't want to send a signal that the European wholesale market is returning.

This is the first quarter where we're seeing some positive movement there.

Sure.

Okay.

And then on the North American side, Hunter has obviously been a big driver for you,.

First, maybe you could tell us what the run rate of revenue is now, exiting the fourth quarter?

And then secondly, has it begun to cannibalize the core backflow lines?

Yeah, Mike, the run rate on Hunter, at this point in time, for the year 2003, we completed the year with $6 million, all of which was incremental sales.

We didn't see any cannibalization of our other backflow prevention lines whatsoever.

We're looking conservatively in terms of a goal for 2004, someplace in the neighborhood of $10 million, all of which we would consider to be incremental.

Okay.

And final question.

Just, Bill, on the product liability reserve, $1.7 million was set aside all this quarter?

Yes it was, Mike.

Okay.

And now that is not excluded from your 36 cent calculation?

No, it's not.

Okay.

Maybe you could run through, Bill, just the litany of items, I guess, that maybe hit you this year in terms of product rollout expenses, obviously the liability reserve, the JV expenses, just so we can at least in our minds start to model from a clean number for 2003 into 2004.

Okay.

I don't know if you have that build-up or if you can get to it maybe later in the call?

We can talk about it now, if you like, for a moment.

We had a -- quite a few what we consider to be unusual, hopefully one-time charges there.

The first one would be our interest.

We refinanced our $75 million public notes in May of this year with $125 million private placement, but we were unable to pay those notes off until December 1 of this year, so, we -- we felt we wanted to do that.

We had a -- we hit the bottom of the treasury yield curves in May.

So it was good long-term decision, however, we did pay about 7 cents in, you know, in interest expense; it decreased our EPS by 7 cents because of the duplicate interest expense that.

Now that's behind us.

We also had 5 cents of accounting adjustments that came out of our joint venture in Tianjin.

We've had a lot of disclosure on that.

I don't think we need to go into that -- any additional disclosure on that.

It's all out there.

So that's 5 cents that was predominantly the second and third quarter.

We've also had about 7 to 8 cents of start-up expenses in our wholly owned subsidiary in China.

We had another probably 2, 2.5 cents that hit us in the fourth quarter.

We saw a lot of those absorption variances start to decrease in the fourth quarter, but we did take some scrap charges there, so we still had the same effect, if you will, on the EPS.

We are anticipating that that variance will start to decrease as we continue to increase the production levels at that facility next year.

The $1.7 million, Mike, that we booked this quarter, that was -- we had switched insurance carriers, and as we started to do our analysis with all the year-end reports from our new carrier, we came to the conclusion that we needed to book that as a result of additional information that we had.

I'm not going to characterize that as -- as -- I think it's -- I think it's a one-time adjustment so we -- we did have to book that this quarter.

I think those are the main issues when you talk about unusual charges in the year.

Okay.

And all of those are -- are still included in the $1.36 that you reported for the year?

Yeah.

Okay.

That's it.

I'll get back in line.

Thanks, guys.

Thank you.

And the next question comes from Devlin Lander with Morgan Joseph.

Please proceed.

Hi.

Hi, Devlin.

In the quarter your gross margins improved pretty significantly.

Is that something that you think you can sustain?

Well, we would expect that as we go forward into next year our gross margins would improve year-over-year.

We did have some excellent results in our North American operations on inventory control and inventory variances, so we had an improvement there.

We had some of the product cost reductions that we've been working on here in the past, you know, two to three years, have started to come through during the fourth quarter.

We also saw an increase in the gross margin in Europe, and that is predominantly due to leveraging our fixed expenses.

We held our fixed expenses in the manufacturing portion of the business, and that volume went through, so, we're hopeful as we go forward that year-over-year we should see an increase in the margin for these reasons.

Okay.

And can you update us a little more on how China's going?

And at what point in 2004 you think it will be, you know, up to full capacity?

And then also comment on the commercial construction market and what kind of improvements you're seeing there?

And how much you think the improvement in wholesale was due to the commercial market.

Okay.

Okay.

I think, Devlin, because you're so soft-spoken, I'm going to repeat the question.

The first issue is, she asked us to comment in terms of how we are doing with regard to, particularly, our joint venture in China.

And the second one was, really was, could we comment on how -- how the development of the commercial marketplace is coming along?

In regard to the first question, we put a lot of time and energy in 2003 into bringing up our operation in Tianjin, China.

It's been an arduous process, and you can see that from the fact that we took a $600,000 charge for scrap and start-up issues in the fourth quarter.

We think we're continuing to make progress.

We've put some additional people into that operation who have long experience with the kind of technical issues that we have been facing throughout the year.

We think that the majority of those problems are substantially behind us.

Now we're looking to ramp up production levels so that we begin to see some positive absorption.

So, overall, I'm pretty optimistic with regard to the progress we're making there.

I think, Devlin, just to remind you, that one of the issues we struggled with is, we sort of had a hiatus in 2003 when we couldn't move people in and out of China because of the SARS illness.

So, at this point in time, I think we feel pretty good about the progress we're making, and we believe the majority of the significant problems are behind us.

With regard to the commercial marketplace, we think the commercial marketplace has been on the decline for three straight years.

We seem to think that now we've been bumping along in the last couple of quarters, sort of at the bottom, maybe what we saw in the fourth quarter was the beginning of an uptick in that marketplace.

We believe, and we're forecasting that the commercial marketplace will be on a road to slow recovery, not a quick recovery.

So the positive influence of that, though, is if the market comes back stronger, those product lines, because they're more highly engineered, tend to be higher margined products for us.

So, I think the way I would describe that is we're "cautiously optimistic."

I think we saw improvement in the commercial marketplace in the third quarter.

We saw continued improvement in the fourth quarter, but that's only two points.

You can make a line with two points, but generally, you're not too secure of where it's going to go from there.

Okay, great.

Thanks very much.

Devlin, the other thing I wanted to comment on, you had asked some questions with regard to -- your previous question.

The gross margins.

The gross margins -- and I just want to point out one thing there.

One of the issues we are dealing with is a rapid movement in base commodity price -- costs to us.

And we're in the process now of reacting to that with price increases and trying to get price increases out there effectively.

I think one of the things I'm concerned about here in the near-term is our ability, in terms of a timely basis, of being able to react to those commodity cost increases.

So, that's an unknown at this point in time in terms of the margins going forward.

But to date, it looks like you've been able to raise your prices along with the rising commodity prices.

I think that's been true the last couple of quarters.

The rate of increase in those commodity prices has actually accelerated in the latter part of the fourth quarter and the first part of the first quarter of 2004.

So, we have more work to do.

Okay.

Great.

Devlin, we also have five months of material in our inventory, so we have a hedge to that extent.

Okay.

So, you know, it gives us a little bit of timing -- relief on timing before it hits the P&L.

So, you have to build that into your thinking, as well.

Okay.

Great, thanks so much.

Okay.

Thank you.

And the next question comes from Jeff Hammond with McDonald Investments.

Please proceed.

Hi, good afternoon.

Hi, Jeff.

I was wondering if you had available the operating profit details by -- by geographic segment?

Yes, we do.

And if you could give us corporate expense, as well.

You want just the op profit?

Yeah.

Okay.

North American operating profit is 17,432 this year as compared to 14,487 last year.

European op profit this year, 6969 as compared to 3133, 2002.

China, this year, a loss of 980,000 compared to a loss of 1,364,000.

Corporate expenses, total expenses of 3,608,000 this year versus 3,830,000 last year.

So, that should total this year 19,813 versus 12,426 last year.

So, that's inclusive or exclusive of the -- the charges?

That's inclusive.

Inclusive?

Okay.

Where would have the -- the charges have fallen out, the 2 cents?

You're talking the -- which charges?

I think the 600,000 -- the difference between your 34 cents --

Oh, the restructuring?

Yeah.

Okay.

Do I have that?

Oh, thank you.

You have 41,000 in Europe, above the line.

We have 162,000 in China, above the line.

And we had -- below the line is -- we had some below the line, about 400 -- how much?

That would go under the other expense line?

Yes, it would.

It was 444,000, other expenses, which is in Europe, below the line.

Okay.

Great.

And -- and as you look at your balance sheet, you're pretty overcapitalized at this point.

Can you just comment on acquisition pipeline, you know, how are valuations?

Do you have a lot in the pipeline currently?

We -- I'd say the pipeline is fairly active.

We do see the pricing on these things creeping up somewhat.

I mean we, historically, have paid 4 to 5 times EBITDA for most of our -- if you look back over the past, you know, three to four years, I'd say the pricing now is -- is higher than that.

Since we haven't done a deal higher than that, I don't want to quote a specific ratio at this point in time.

But we have a very active pipeline right now.

Does that valuation -- rising valuation keep you on the sidelines?

Or, you know, are you looking at better properties that might warrant --

I think the drivers of some of that valuation are that some areas of those business see an improving economy and want to capture some of that in the sale price.

So, part of that is the fact you are dealing with three-year trailing earnings that have a low economic period in them.

I think the other part of that is that -- I don't think we're going to stay on the sidelines.

I think, as we see good properties become available we're -- we will be an active bidder.

Doesn't mean we're -- don't get me wrong, because I think you know that we have relatively disciplined approach in terms of financial objectives, in terms of the discipline we use, in terms of the fit with the business and, you know, we pretty much stick to those, although I think what you're seeing is you're seeing the band of multiples move up.

Okay.

Great.

And then finally, in your North American wholesale market, you said the big driver was backflow prevention.

Can you try to differentiate the best you can between -- what you think you're gaining in terms of market share versus maybe what the market is doing?

Yeah, I think the majority of that is market share gain at this point in time.

We don't believe that the backflow prevention market has grown as significantly as we have, so what we're seeing there is we're seeing a continuation of our existing backflow lines, but we're seeing the volume coming out of the Hunter product line as being pretty much purely incremental.

There are some competitors in the marketplace who have older designs, and the features and benefits of some of our products are far superior to some of the designs that have been in the market for some time.

So, I think you're seeing market share erosion on behalf of our competitors.

Okay.

Great.

Thank you.

Thank you.

And the next question comes from Stewart Scharf with Standard and Poor's Equity Group.

Please proceed.

Good afternoon, gentlemen.

Hi, Stu.

Hi.

I have several questions.

Firstly, could you breakdown the sales for the regions?

Certainly.

Okay.

Sales.

North America: this is the quarter now, $124,192,000, so, 124192, compared to 112540.

Europe is 61,505 compared to 43,624.

China: 5241 compared to 4726.

And that should come to the totals that we've issued.

Okay.

So annually you're still around -- close to 70%, North America?

I'm sorry, could you repeat that, Stewart?

Still pretty much close to 70% of total sales in North America? -- for the year?

It would be close to that, yeah.

We didn't figure it out for the year -- well, actually I have it right here.

Okay.

By percentage, I'd appreciate it.

476 divided by -- It's 67.5% of sales are North America, for the year.

Okay.

And do you have the percentage of sales to Home Depot?

We -- we haven't figured that out yet, Stewart, but it'll be somewhere -- I would expect it to be between 10 1/2, 11%, but we will -- we will release that as soon as we have it.

Maybe -- probably on the high end of that.

Okay.

And overall your top 10 customers, will you release that, also?

Or do you have an approximate -- maybe 25% --

We will release it.

We haven't done that level of analysis on that information yet, but we've -- we will share that with everyone.

Okay.

And do you see your D&A staying about the same levels going forward?

The fourth quarter?

D&A in the fourth quarter...

Do you have that?

We will look that up, Stewart, do you have another question while we're waiting for that?

Sure, the higher tax rate --

Yep.

-- 38%.

What do you see it for '04?

Going forward?

Yes.

I would say in t would be in the 37 range, high -- between 36.5, 37.

Okay.

Let's see, on the D&A in the quarter, it's 4.3 million.

You see that as a good figure, quarterly, going forward?

Yeah, yes, I do.

And the U.S. plant that's -- that you're going to be closing, which one is that?

We have not told our employees yet so we would prefer not to announce it here.

Hope you understand.

Okay.

And one other thing, the -- the shares outstanding going forward, those dilution -- approximately 20 cents, is that right, for the stock offering?

16 -- I think it was 17%.

17 cents?

Percent.

Percent.

Yeah.

And that's for '04, do you have a share count or projected?

What's the projected share count? $32.1 million.

That's going forward?

Yes.

For '04 -- I mean '04.

Right.

For '04.

Okay.

Thank you very much.

Thank you.

Thank you.

And the next question comes from Steve Tusa with J.P. Morgan.

Please proceed.

Hey, guys, how you doing?

Hi, Steve.

Looks like a solid quarter.

I just wanted to start out on the restructuring that you announced, the 6 million to come this year.

Right.

Could you just kind of maybe dig into that a little bit more?

Are -- you know, do we expect to continue to see you guys, you know, announcing this kind of restructuring that we're going strip out of results or, you know, how -- how much part of ongoing operations is this?

I mean is this part of your move to offshore, you know, lower cost locations, or is this truly kind of extraordinary in nature?

You know, should we expect to see more restructuring in '05, I guess is -- is the baseline question.

Well, right now we've disclosed everything that we know about relative to restructuring.

Okay.

These are all of our known plans.

You know, we -- the Company is in a significant transition as we move a lot of our plans -- our production to these lower-cost regions.

We have grown the Company over the years through acquisitions, so, you know, you wind up having some excess plants as you consolidate, which is the mode that we are in at the moment.

We have disclosed everything that we know about right now, so I don't want to sit here in 12 months, we read the transcript of this call, I made a mistake!

Yep. [ Laughter ]

Okay?

Yep.

I understand, you know, I understand that.

But I mean, you know, it comes to the point where this stuff becomes ongoing, and, you know, I would think that if it is part of the ongoing move low-cost regions, which is really a part of your business strategy as opposed to, you know, we need to take some cost out here because, you know, markets are down, you'd -- you know, would you think about maybe just taking the stuff pay as you go, you know, above the line?

It is above the line.

Well.

It is in our GAAP numbers. [ Laughter ] We're -- we're --

So, we should treat it as we please.

Yeah, I think everyone has to make their own decision on it, but we're disclosing it for the sake of full disclosure and I know that different people do look at it differently and that's why we try to provide the information.

Okay, what are the savings from this?

What's kind of the --

What we're estimating here is that the -- first of all, the charge itself, of the $6 million, more than -- will touch more than $5.35 million as accelerating depreciation.

Okay.

That's associated with the -- obviously, the assets that we're going to take out of service prior to the end of their useful lives.

The other 500,000 would be some anticipated severance costs and some expenses for moving equipment around, okay?

Okay.

So on an after-tax cash basis, this actually will generate positive cash flow about 1.7 million as we accelerate the tax benefit versus the cash we'll pay out for the cash charges, okay?

Okay.

That's one aspect of this.

Secondly, we are anticipating that the projects -- there's three separate projects that are contained inside of this, a plant closure and a closure of two departments in existing plants.

We will start to realize savings for this in early 2005, and by the end of 2005, the run rate of expense reduction is 3.5 million pretax on this set of projects that we're discussing.

Okay.

Cash flow.

Above the operating line, was there anything extraordinary?

I mean it was a great result this quarter.

You know, you guys had been seeing some working capital pressure all year.

Was there anything in deferred taxes or, you know, could you just talk about some of that?

Yeah, as far as the quarter goes, we did fund a pension during the quarter, $3 million.

We had a $6.8 million year-to-date but 3 in the quarter.

Okay.

So that's a bit unusual.

We were pleased with the accounts receivable that came in favorable on cash flow.

We did much better there than we thought.

So, that really helped the cost.

On inventories, we were positive cash flow, as well, about a million dollars for the year.

We consumed 8.4 million of cash, and that's really for two reasons.

One is, our Europeans needed to increase inventories on the -- to serve the OEM business.

That OEM business has grown nicely for us, but the service levels are higher than our average wholesale, where these manufacturers, dealing with another manufacturing companies, are demanding almost just-in-time-type of delivery.

So, we increased the inventories there for that purpose.

And then we increased inventories in North America a little bit to cover some of the production that we're sending over to China.

So increased safety stocks.

So, those are the -- the major --

So, is fourth quarter -- was a solid working capital performance?

It was.

Yeah.

Okay.

[inaudible] rate is $82 million. [ Laughter ]

Yeah, the balance sheet is not really a concern, right? [ Laughter] So, I guess that goes to my next question.

Given that, you know, a large water consolidator is probably, you know, a little bit hand strung right now, they have a lot on their plate, can you just talk about maybe how that changes the dynamics of the acquisition environment?

And maybe there are some properties out there that would have been a little bit more of a competitive bid and now -- you know, do you see the landscape changing at all by the transaction that was announced recently?

Yeah, this is Pat.

I think because of that particular consolidator, I think they've probably eaten their fair share of acquisitions.

I think that they were a driver of the escalating pricing.

I don't know if they were deliberately doing that or they were just doing it by their participation, but I think as a result, you're going to see a lot of buyers recognizing that the competitive process has been changed significantly.

So, you know, we haven't seen it yet, but we're hoping that as properties become available, you're going to see much more reasonable -- you won't see the continued escalation that we saw in the last six months in terms of the purchase price expectations.

Okay.

And lastly, just looking out to 2004.

You know, if we look at this quarter, I know there are a lot of pluses and minuses going on, some one-timers that hit results this year that maybe won't be there.

There's some raw materials pressures.

You know, what do you see maybe in the first quarter?

I mean, you know, as much as you can kind of provide us general commentary, hard numbers would be great, but, you know, what do you see for next year, maybe using this quarter as -- quarter's run rate as, you know, a barometer?

Any kind of commentary there, on the EPS line?

Well, our board has advised management that we really should not be providing EPS guidance.

So management will follow that, too. [ Laughter ]

So, that's a no, I guess.

No.

Sorry to disappoint you, Steven.

That's okay.

We can do our own work, I guess, on that one! [ Laughter ] Thanks, guys.

Good quarter.

Thanks a lot, Steve.

And the next question comes from [Jim Fong with Cavelli and Company].

Please proceed.

That's too bad.

It would make our work much easier, huh?

We were fully aware of that!

Our discussion involved how much easier it was for you to do your work versus the other aspects of that decision.

Ah, okay.

Good quarter.

Pat, let me just go back to this wholesale distribution business in North America.

Yes.

I guess I'm trying to get a hand on -- from your comments, you know, I guess is that market still pretty flat?

Because, I mean -- I know over the years it's kind of been down 1% every year, but with your Hunter, you've been able to grow some shares.

So, when I look into 2004, do you expect more market share gains?

And has the -- kind of the industry in wholesale distribution still pretty much flat?

Yeah, we -- our -- if you look forward in terms of the goals we've established for ourselves, we clearly believe that as we rolled out our new backflow prevention line, the Hunter line --

Right.

-- that it -- you got to remember that this is a product line that's subject to approvals by various approval authorities, and for most of 2003 we were in the process of obtaining those approvals.

Now we have a wide variety of approvals in place, so we are in the process of motivating our sales organization to go out there and make presentations because the majority of the product line is now available to them with the approvals.

So, we would expect that we would continue to gain market share with our backflow prevention lines.

The other thing I want to mention, though, is that if you look at the wholesale business, we saw some pretty robust growth in the fourth quarter, in the plumbing and heating products.

We also saw some pretty robust growth in terms of some acquisitions that we didn't make in 2003 but we made in 2002, where, for example, the underfloor heating products, we've seen some pretty significant growth in terms of that particular product line.

So, we're -- we're really seeing growth in more than just the backflow prevention, but that is the lead product.

Okay.

Could you kind of give us an idea of how big this whole distribution market is?

And what your share is today?

Where it was last year in '02, and where it is today kind of thing?

Or just --

I wouldn't be able -- at this point here, based on the numbers I have in the room, I wouldn't be able to give you a reliable number.

Okay.

Maybe I can follow up later.

Let us do work and we can disclose that to everyone at the same time.

Okay.

Okay.

So, basically, bottom line, you expect a little more share gain in '04, and would it be kind of the same order of magnitude as we saw in '03?

Yeah, Jimmy, remember in '03, the first quarter was a -- we were -- we were in a very poor economic environment.

Right, there was no gain [action] in the first quarter.

In our business, if you remember right, I think we had -- in the wholesale channel, we probably saw negative growth.

That's correct, you were down, actually, in the first quarter.

And then we started to see some growth in the second, continued into the third, and the results we just reported, which are pretty robust in the fourth quarter.

So, I think, you know, we're -- I guess if you were to look at our planning horizon, we're not -- we're not thinking that the market's going to continue as robust, or I should say it's not going to continue to grow from the fourth quarter, but we're pretty positive.

And then can you talk about price increases as a way of offsetting material costs?

How should we look at the whole distribution channel?

Or should we just kind of see it as a -- there is some gain where you will be able to raise prices to offset higher material costs in that distribution business?

Yeah.

Just so you know what we've done so far, Jimmy, we have -- in many of our markets, we already have announced price increases.

There is a lag between the time you announce price increases and you actually see them effective.

Okay.

Partially because, in some cases, your competitors are -- haven't reacted at the same time frame you are so that you have some slippage.

But we're working very diligently to try to force pricing up because we believe these commodity cost increases we've seen are more permanent than they are temporary.

Right.

And that they are impacting us and our competitors in equal proportions.

What would you say is your average price increase today?

Just kind of general terms, across the board?

Price increases that we put out range in the 3 to 5% range.

Okay.

Okay.

And just moving to the retail side of business, you talked early in the call about you introduced some new SKUs in the year and in the quarter.

Could you kind of expand a little bit on that in terms of these new products coming on board in -- in '04?

Yeah.

The -- the -- the comments that I made were actually pertaining to -- in the fourth quarter of 2002, we introduced a wide variety of new SKUs to Home Depot.

Generally, when you introduce SKUs, it's somewhat lumpy.

So, in the fourth quarter of 2002, there was a number of products that were introduced to the DIY market, and as a result, the fourth quarter of 2002 had higher sales than normal because you were filling the pipeline in terms of filling the shelves in -- in some of these major retailers.

Now, throughout the year we have been successful in terms of adding incremental products.

One of the areas that we, for example, have introduced incremental products is are under-the-floor tile warming systems, where we've been successful in introducing that product to a number of different retailers, and it appears to be a successful launch.

It's selling through the wholesalers -- or through the retailers, and there is a good example where, you know, each year we add more SKUs to our total mix with a Home Depot, with a Lowe's, with an Ace, with a Costco, et cetera.

And that's our strategy continuing forward.

Now, one of the comments I want to make on this call is that if you were to look at the information we've made public in the past, our growth rate in the past has been pretty robust.

In terms of our goal going forward, we're still looking at double-digit growth rates but we're looking in the -- in the low double-digit growth rates versus some historical rates, which were much higher, due to the fact that we're coming off of a low base.

Okay.

And that's helpful.

And then I guess in terms of the pension, you funded your pension plan, but was there pension income or expense in the P&L in '03?

And -- and what are you expecting in '04?

Yeah, we had pension expense of about $3.5 million, I think it was in '03.

Okay.

And we would expect that to be approximately the same for '04.

Okay.

All right.

And then, can you speak a little bit about the Euro?

In terms of what -- I guess -- what was the average Euro where you ended -- I guess in the first part of '04 I believe you should get some Euro gain, right, versus a year ago?

Could you just give us a benchmark in terms of how we look at the quarter with the Euro?

Our -- the average for -- let's see here.

The full quarter, the average rate that we translated at was $1.21, compared to $1.01 last year.

Right.

And on the year it was $1.14 versus 94 cents the prior year.

Okay.

Those are the weighted averages of how our numbers fell.

Right.

And what about the first quarter of '03 versus the first -- yeah, what was the -- what was the average Euro in the first quarter of '03?

Well, I -- I don't have that in front of me, Jim.

Okay.

But you should get some gains in the currency, right?

Because it's --

We would still expect some -- some gains on currency in '04.

I don't have that figured out, but I mean we should get some bang on that.

But again, the average rate --

Right.

-- for the year at a dollar twenty --

-- one.

Yeah, $1.21 is the quarter.

Yeah, you're ending at $1.21, but you probably started a year ago at $1.10 or something like that.

Yeah, for the year I'm $1.14, and right now the Euro is at $1.25 or so; right?

So, we have 10 or 11 cents, if the Euro holds.

Right, right, right.

So, at least in the first quarter you should get [inaudible].

Yeah, that's right.

Okay.

Okay.

And then I -- I didn't quite understand the insurance carrier.

I don't think that was in your press release.

You said you switched insurance carrier and there was a $1.7 million charge, is that correct?

$1.7 millions in the quarter.

How much in the quarter?

$1.7 million as of -- is a one-time charge, if you will.

Okay.

And that came to our attention because we had changed insurance carriers, and we were doing some year-end analysis as part of our audit, and we ran some -- we had some information from our new carrier, and it came to our attention that this was a -- that we were underaccrued in a certain area of product liability, so we had to take a charge on that.

And where was the charge?

Where was it taken, corporate expense?

In other?

In North American operations, SG&A.

Okay.

So, it's $1.7 million.

And that's just for -- that's all you expect to take, right?

You don't expect to take anything in '04?

No.

And one last question, When I look at your business, as you reduce these costs, you know, with your manufacturing thing, what's your variable margin today and your gross profit line?

For each incremental dollar that you get, what kind of variable margin, across profit margin increase, would you see?

Well, that a tough one, Jim.

I think depends on retail versus wholesale and all that sort of thing.

Right.

But I think on an incremental contribution basis, after freight, commissions, 30 -- 30ish, 35.

In the 35% level?

Okay.

Yeah.

Pretax.

And where do you think you can get that to after you complete your manufacturing part?

Well, the thing is -- it's difficult to answer that, Jim, because there's so many variables between, you know, where we're trying to go with all of this offshore production and where we are now.

Okay.

The biggest variable is going to be, you know, what type of pricing impact this is going to have.

As we have lower cost production, will we be able to retain all of that in terms of profit?

Or will we just be able to gain market share with it because we have better pricing power and we're more competitive.

Right.

So, you know, it's a very difficult question to -- too much guess work to give the answer to that.

Right.

Invariably you have to give some of that back to the customer.

That's right.

All right, good.

Thank you, gentlemen.

Thanks a lot, Jim.

Appreciate it.

Thank you, Jim.

And the next question comes from David Kurzman with Needham and Company.

Please proceed.

Hi, folks.

Hi, David.

Hi.

A quick question on the pension.

Can you give us the status of how underfunded it is here?

And what assumptions you're using?

Yeah.

Right now -- at year-end we'll be $16 million underfunded.

We were $16 million underfunded at the end of last year, and the reason we stayed flat is because we have dropped our assumptions on a discount rate, and my trusted is assistant is looking that up right now.

No problem.

Do you want me to go to the next question?

No, hold on, I got them here.

Okay.

Where are they?

Okay.

Yeah, our discount rate was 6 3/4.

It is now 6.

Uh-huh.

And our -- let's see, what else?

I think that's the big one, right?

That's the big one.

And then increase in salaries and stuff like that?

Assumptions?

Yeah, the compensation increase rate dropped from 4 1/2 to 4, and our long-term rate of return went from 9 to 8 1/2.

9 to 8 1/2.

Now, in that compensation number, do you guys assume that that half percent decrease is solely due to moving stuff offshore to lower cost?

Or is there other stuff we need to be thinking about in there?

No, that's really just the -- the assumption on people who are employed here, participants in our pension plan, which is just the United States.

Right.

And we look at the types of raises that we've given our employees, four might be a generous number, even at that.

That's kind of what I was thinking.

But, okay.

Enough on that.

Let me ask on the swap.

You had a 20 million Euro swap --

Right.

-- in place.

How much would it cost you to unwind that at this point, now that the Euro is so strong?

Is that something that's a possibility?

We haven't looked at that, but I'm not sure that that would be to our advantage because it was a -- I thought it was $25 million notional amount, which we fixed for two years at 2 1/2%.

And it is based on our -- on debt in Europe.

Right.

So, we haven't really looked at -- or considered unwinding that.

We're just going to leave that there and let it play out.

Okay.

All right.

And it sounded like from Jimmy's question before, you said you'd have to give back a little bit in pricing if things came back down.

Can you give us sort of a framework to think about how much historically you've had to give back?

Well the last time we were able to give price increases because of commodity run-ups was probably 10 years ago. [inaudible] much for the model is meaningful at this point.

That's fair.

All righty.

And you said you have about five months worth of inventory -- of raw materials and inventory.

Yeah.

Can you give a sense in terms of what your practice is right now?

Are you replenishing that pretty quickly?

Not so quickly?

How fast do you think?

Well, we're replenishing it based on our normal practices.

We're not trying to go out and hoard metals or -- or free -- you know, or load up on them in excess of our normal requirements.

We're really trying to manage this situation through, you know, staying on top of what -- what our costs are doing, trying to analyze what we need for price increases from our customers, you know, and staying on top of it that way.

I mean the most important thing we have to do is to, you know, make sure that we're delivering this -- the right stuff to our customers at the right time and -- and we'll manage the margins through pricing.

Got it.

Thank you, gentlemen.

Okay, thanks, David.

And we have two questions left in the queue.

So, again, if you wish to ask a question, please press star 1.

And our next question is a follow-up from Michael Schneider with Robert Baird.

Please proceed.

Guys, could you give us a sense what's in store in '04 as far as the Home Depot rollout goes?

I think you did something in the order of 23, 25 SKUs at Home Depot this year.

Do you have a comparable comparison for '04 as to what we can expect?

Just -- Mike, it's sort of too early for that because there are a number of line reviews that are coming up here in the first quarter.

We might be able to give you -- answer your question probably at the end of the first quarter, not at this point.

Is it fair to say, though, that you've gained probably the lion's share of the shelf space you have an opportunity to sit on?

At this point?

Or are there substantial portions left?

No, there's some -- there's some substantial chunks still left, where we have major competitors who, quite honestly, are larger than we are in certain categories that we participate in.

Okay.

And similarly, Wal-Mart remains an opportunity for you guys.

Any update from the line reviews that have gone on there, and their interest and consolidating vendors?

No, we continue to pursue them, but nothing material to the report at this point.

Okay.

And switching gears to the filtration lines.

Can you just give us a sense of how much momentum you've got with the premier line, both in the retail and pulling it through to the wholesale channels?

Yeah, the -- you know what it is, you know we're a leader in the retail channel with that particular product line, being, you know, a -- a good supplier to some customers like Costco and Sam's Clubs and others like that.

We have not been as successful in terms of penetrating the wholesale market, and a portion of the reason that we think that's true is because the wholesale market, the larger buyers of those are water treatment dealers who traditionally do not buy from the traditional distribution for Watts Regulator, which is wholesale plumbing distribution.

We are working to try to access some of those viewers now that we have acquired premier -- or Flowmatic, so that we're looking at the opportunity to expand in terms of the penetration of our reverse osmosis systems into that channel, working in cooperation with the people at Flowmatic.

Okay.

And then final question, the Tianjin operation.

Can you give us a sense where you are in the learning curve there, what the daily production rate is, whatever metrics you use to monitor the ramp over there, and I guess your confidence in the pace of the acceleration?

Yeah, I think, Mike, if you were to look at 2003, it was a bumpy road.

We ran into some technical difficulties, and then we ran into a time delay, which was predicated based on the spread of SARS and the inability to move our own people in and out of China, and the inability to move vendors who supported us in terms of bringing machine tools and bringing manufacturing processes online.

I think since -- I would say since July we have been on a relatively steady course.

We believe that most of the technical problems are being solved on a reasonably timely basis.

We are seeing a ramp-up in production.

I'm planning on visiting China in -- in the next few months to see for myself what -- as of today we have a gentleman on his way over there, a top-level manufacturing guy, to give us an assessment on that.

But all signs are positive in terms of absorption.

I think the worst is behind us, quite honestly.

I think the technical difficulties are behind us.

The one thing I worry about is, you know, a disruption due to some of these flu-kind-of illnesses that you're reading about now.

But the good news is, you know, the -- we're not dependent on people coming in from machine tool manufacturers and things like we were a year ago, so, once our people are on site, which they are, we feel we'll continue to make progress no matter what happens in terms of people being restricted as to travel.

Okay.

And the -- the 6 million in sales this year in China, how much of that is produced locally and sold locally?

Or is most of that coming from the U.S.?

In that particular operation --I think you're referring to the [Woofy] -- most of that is coming to the U.S.

The other operation, which is a joint venture, we refer to it as TWT.

It's interesting because yesterday we had a conversation with a gentleman who is involved in China, and he tells us that he's seen a dramatic demand for TWT branded products within China on a domestic basis.

So, he's actually having -- he's having problems getting his production rates up to speed to fill domestic demand for some of those products.

Okay.

Thank you.

Okay.

And the next question is a follow-up from Steve Tuso with J.P. Morgan.

Please proceed.

Sorry, guys, two more quick ones.

First, on seasonality.

Is there anything inherent in your numbers as far as seasonality is concerned?

I mean, you know, should we look are for the quarters next year to be choppy?

It doesn't seem like there's any historically?

We do have a bit of seasonality, Steve, in that, you know, come March time frame we have the construction season and irrigation season that kicks in.

And then somewhere usually around late September through October/November we have the heating season that kicks in.

And in certain product lines, you know, we'll see a significant increases in demand.

That being said, though, they don't affect our numbers to the extent that they used to.

So, I don't -- I think from the investors' standpoint we're not really a seasonal business.

Maybe to the extent of a -- at the most, a penny per quarter or something.

Okay.

It's a very small number these days.

And lastly, as far as the share count for next year is concerned, you said something like 32.3?

32.1.

That's a little bit higher than I was -- than was I expecting.

Is there some options creep in there or something like that?

Or did I just do my calculation wrong on the offering?

If I go back to my advanced accounting, my -- I believe that the higher our share price goes, it's going to have more of an impact on common stock equivalents in terms of the impact because of options.

Okay.

We haven't had any -- other than the share offering that we did in December, there's been no significant activity.

Of course, all of -- as the share price goes up, all the options go into the money, and it costs more to purchase them back on -- on the way you have to do the EPS calcs.

Yep.

Gotcha.

Thanks.

Okay?

And the next question is a follow-up from Jim Fong with [Cavelli and Company].

Please proceed.

Hi, one last question here.

I guess over the next two years, are there any regulations or codes that are coming that could be a big benefit to your business?

Yeah, there are I'm not prepared at the moment to give you a comprehensive answer on this, Jimmy.

But, for example, this morning at 8:00 we were talking with our guys in England, and the market in England is very, very concerned about thermostatic mixing valves because of -- they recently had an outbreak of Legionnaire's disease, legionella.

As a result, they are putting in place codes that require people to have thermostatic mixing valves at the point of use.

You're also seeing that across the U.S.

I think the other major influence on Watts, particularly, is the fact that we are, and have received a significant number of approvals on products that we had in development or products that were acquired as part of the Hunter Innovation line.

So, I think, you know, we see an ongoing stream of products where we have received approval in products that we think we have features and benefits that are superior to those of our competitors.

So, I think generally positive, but I can't -- at the moment I can't give you a comprehensive answer in terms of having in front of me a piece of paper that shows those codes that are coming in.

Okay.

Is there a way you can try to quantify or put some numbers around that?

How would you look at that in terms of either market share or the -- the size of the market?

And, you know, do you have a way we can kind of -- kind of quantify that in our models?

Yeah, I think that goes with your previous question, which is, maybe we can do some homework here and give everyone guidance -- give everyone some insight on that at the same time.

Okay.

Okay.

Thank you.

Thank you.

And there are no further questions at this time, Mr. O'Keefe.

Please proceed.

Well, I just want to thank everybody for participating in this call.

I just want to give you some notes in terms of marking your calendar.

We expect to report our first quarter 2004 earnings on or about May 4, and we expect to have a conference call similar to the one you were involved in today on or about May 5.

So you can mark your calendar for the 4th for a press release on our earnings and for the 5th for a potential earnings conference call.

We will, however, put out press releases in advance so that you understand the details of how to -- how to participate in that conference call.

Thank you.

This concludes your Watts Water Technologies earnings conference call for the fourth quarter of 2003.

Thank you for your participation today.

You may now disconnect.