Watts Water Technologies Inc (WTS) 2004 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to your Quarter 3, 2004 Watts Water Technologies earning conference call.

My name is Jean.

I'll be your conference coordinator.

At this time, all lines are on a listen-only mode and we will be taking questions towards the end of the conference call.

If you ever need operator assistance, please key star, 0.

At this time I'll turn the call over to your host, Ken Lepage.

Sir, over to you.

Thank you.

Good afternoon.

My name is Ken Lepage.

I am the Assistant General Counsel of Watts Water Technologies.

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 10-K for the year ended, December 31st, 2003, filed with the Securities and Exchange Commission, and 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 as of any date subsequent to today.

I will now turn the presentation over to Pat and Bill.

Thank you, Ken.

First of all, thank you for joining us on our third quarter conference call.

With me today is Bill McCartney.

And the way I'd like to conduct the call is I'm going to make some opening comments about results for the third quarter and year-to-date.

I am going to turn it over to Bill, who will give you more color with regard to segment information and the performance in various components of our organization, including some significant transactions impacting our numbers in the third quarter.

Let me first start out by saying this is a very strong quarter for us.

Pretty much across the board improvement in operating earnings from a number of different operations across Watts.

I would consider it to be a broad-based improvement.

With regard to revenue, we increased revenue by 39.3% over the same quarter a year ago, which is a 22% increase.

That leaves us year-to-date with an increase of 103 million, or 20% increase for the 3 months -- for the 9 months ended September 28th.

When you look at the net income numbers, we're showing an increase in net earnings of 54%, which represents 4.8 million for the quarter, compared to a year ago.

Year-to-date basis we're showing an increase in net income of 64%, which is an increase in dollars of 15.1 million.

So you can see both revenue and net earnings are up considerably.

When you look at earnings from a continuing operations point of view, they're similarly, for the 3 months they're up 4.8 million, or 53%.

For the 9 months, they're up 12.3, or 46%.

Earnings per share.

If you look at the total earnings per share, they come in at 42 cents, which is 10 cents above the number of a year ago, which was 32 cents, or a 31% increase year-over-year.

If you look at the numbers for the 9 months, you see that we're coming in at 100 -- $1.18 versus 86 cents for the same 9 months a year ago.

So 32 cent improvement or 37%.

Those numbers include, roughly, 4.6 million shares that were issued in our secondary offering, which was completed in December 2003.

Now, in terms of the improvement that we saw, we basically saw improvement in our North American operation, our Asian operation, and our European operation, all three had strong performance.

So, now I'd like to turn it over to Bill, who will give you some color on the performance.

Okay.

Thanks, Pat.

Looking at the consolidated revenue in the quarter, we were up 39 million, which is 22%.

The components of the 22% are as follows -- organic growth was 10.2%, which is 17,987,000; the foreign exchange represents 3.4%, which is 5,938,000; acquired revenue, 10,756,000, or 6.1%; and then the consolidation of 1 of our entities under the new FIN 46 rules, which is 4,653,000, or 2.7, which is, again, you total that up and get your 22%.

Just to read the numbers quickly for the year-to-date -- increase in revenue was 103.5 million; the organic growth is 8.3% year-to-date; the foreign exchange, 3.5%; acquired revenue was 5.4; and the FIN 46 rules impacted us 2.9%, and that totals 20.1% increase in consolidated revenue for the 9 months ended September.

What I'd like to do now is just give you some of the information on the 3 segments -- North America, Europe, and China.

And you will notice that in this quarter's press release we have included our information for our sales and earnings for our geographic segment.

So we don't need to read those to you, but they are in the press release for your information.

But now, we look at North America.

North America's revenue increased $24 million in the quarter, which is 20%.

Looking at the components, internal growth was 10.5 million, which is 8.6%.

The foreign exchange was 580,000, which is a half a point.

Acquired revenue, which is our Orion and Flowmatic acquisitions, which we completed during the course of the year was 8,358,000, or 6.9%.

And then, the FIN 46, here, is 4,653,000, or 3.8%.

On a year-to-date basis the North America is up 18%, or $63 million in total.

Looking inside of North America the retail portion of our business was up 8.3% from an organic standpoint.

The reason for the growth is we have the additional store counts with the expansion of Home Depot and Lowes.

Our SunTouch product line, which is our underfloor electric tile warming product, which continues to be well-received, was up 47% during the quarter.

And that continuing to through, predominantly the retail portion of our business.

We also had the beginning of our hot water recirculating product, which we rolled that out during the quarter.

So that contributed several hundred thousand dollars of revenue.

And that rollout will continue into the fourth quarter.

So as we've been discussing during the course of the year, Pat and I have been suggesting to you that we'll have a high single-digit growth for the full year.

We still feel comfortable with that forecast.

And we're going to continue to see the additional store counts in Q4.

The remaining rollout of the hot water recirculating product line.

And we'll be rolling out our presorted fitting line -- presorted fittings.

And we have that inventory in-house now, and that rollout is about to start.

Looking at the wholesale side in North America, we had 9.4% organic growth.

We continued to do very well on our backflow product line, which you've been hearing that story now for about 4 quarters, and that story is continuing.

So the backflow was up 13% in Q3.

Basically, most of our backflow product lines were up.

Hunter was up as well.

Hunter provided $3 million of revenue in the quarter, versus 2 million in last year's third quarter.

Some of our other commercial lines were up, but predominantly our automatic control valve line was up about 19%.

And our underfloor radiant heating products were up 19%, as well.

So we look at the combination of the backflow and the control valve market being up as indicating continuing strength in our commercial product lines.

On a year-to-date basis in North America, the retail was up 6% and the wholesale 9.5% I'd like to just move on to -- oh, and just 2 more comments on North America.

Orion, which we acquired in May, we acquired Mccoy Industries, and we're going to market under the trade name of Orion, was on target and has met our expectations for the 5 months ended September.

And the reverse osmosis filtration company, Flowmatic, which we acquired in January of this year is actually exceeding some of our expectations.

While they were not in our numbers last year, if we compare Flowmatic to their performance last year, their revenue is up about 30% over last year, and their earnings are up about 60% over last year.

So that they are making a very nice contribution.

We're getting some synergies as we combine some of the manufacturing activities of Flowmatic with our premiere division, which also manufactures these reverse osmosis filtration.

And we're getting some cross-fertilization on the distribution side as well.

Moving on to Europe.

On the quarter, sales were up $12,175,000, which is 24.2%.

We look at the components of that.

Organically, Europe grew at 8.8%, that's $4,421,000.

The impact of the strengthening euro increased our revenue by 5,356,000, that's 10.7%.

And acquired revenue in Europe was $2,398,000, which is 4.7%, that totals 24.2.

On a year-to-date basis the organic growth is 5.4%.

The foreign exchange is 10.8.

And the acquired revenue is 6.8.

So that's 23% increase in revenue in Europe on a -- for the 9 months ended September.

When we look at the reasons for the increase on the organic growth in Europe in the quarter, we had a 10% increase in both our wholesale side and our OEM side.

And right now our wholesale represents about 45% of our total sales in Europe.

And the OEM represents about 55% of our total sales in Europe.

We believe that on an overall basis we are gaining market share in Europe, because all of the reports from our operating people there indicate that, while there is some economic improvements occurring in some of the markets, they don't really see that economic improvement resulting in increases in our end markets, which would be the commercial residential construction market.

Though we know that, for instance, we feel strongly that in Germany we've been able to gain share on the wholesale side.

We have some new sales management there.

And we don't have a predominant position in the wholesale market there.

So we're gaining market share, with being more aggressive with our marketing programs.

You'll recall that last year -- beginning -- excuse me, 2 years ago we bought ADEV Electronics, which had a distribution unit in Sweden.

And we feel that we're gaining market share in the Swedish market as we continue to introduce our products into that marketplace through that existing distribution unit.

Now, even though the organic growth was 8.8% and our 2 segments grew at 10, the reason for the difference between the 10 and 8.8% is that we have done, during the course of this year, some product pruning, if you will.

Where we are exiting some smaller markets that have unsatisfactory gross margins and replacing that with some of our more traditional products.

So that, even though we grew the markets at 10, consolidated we've only grown at 8.8%.

We've also -- another reason for our growth in Europe is that our Tunisian sourcing strategy seems to be working well for us, as it is now supplying cost-reduced products into our European distribution channels, particularly with the safety unit, which is a temperature and pressure safety valve, and some of our thermostats as well.

So basically a good story in Europe.

The acquisition of TEAM, which we completed in June of this year, is on target relative to our expectations.

When we look at our Asian segments, if you -- those of you who follow us will recall that last year we had some accounting adjustments.

So if we adjust for those accounting adjustments, if you will, revenue in China from an operating standpoint was up 30%.

The reason for that is that we have some strength, significantly strengthened managements in our Chinese Companies now.

They have gone through -- our new managers have gone through and upgraded the sales management teams in China.

We feel that we have some better distribution network there, some better agents, if you will.

We've done a very good job, I think, of eliminating some counterfeit product in China.

And they are also exporting more backflow and automatic control valve products back to the United States.

So we are sourcing some of those products in our Chinese factories, and they're the beneficiary of the stronger commercial marketplace that we're seeing in the United States.

When we look at our operating earnings, we were up in the quarter 4.8 million.

And that's an increase of 27%, and an increase of 40 basis points as well.

On a year-to-date basis, we were up by 16.9 million, or 34%, which is an increase of 110 basis points.

The reason for the increase in the operating earnings, obviously, is the sales volume is up, which creates opportunities for leveraging our fixed expenses.

But most importantly is the gross margin.

If you look at the consolidated gross margin in the quarter, we are up 110 basis points versus last year -- last year's third quarter.

So our gross margin was 34.9% in the quarter.

On a year-to-date basis, we went from 33.8 to 35.1%.

The reasons for the increase in the gross margin, first of all, the major Number 1 reason would be the improvements in our Chinese operations.

About half of the improvement in China is a result of some of those accounting adjustments that we made last year.

We don't have to have those charges, thank goodness, in the third quarter of this year.

We also have some operating improvements there.

Our wholly-owned subsidiary in Tianjin, which last year was in a start up mode, has left that.

We've discussed this during the course of the year, and we said that during the year we would have continued improvement in that subsidiary.

And that is what is happening now.

We have all of our small regulators being manufactured at that facility.

And they are absorbing their expenses.

And we have the significant operating improvements at our joint venture in Tianjin as well, with the increased revenue and the improved performance there.

In North America, we saw the contribution to the margin from North American operations is the result of low-cost sourcing programs, as well as the increase in the wholesale revenue.

If we look at Europe, the gross margin is flat compared to last year.

But what we have there is, we have the offshore cost reductions, as well as some of our restructuring programs, which are contributing to improved margins.

But those are being offset in the quarter with product mix, where the German wholesale is up and the Italian wholesale is down because of weak economy in Italy.

And that creates an unfavorable sales mix, if you will.

We look at the operating expenses.

They're up approximately $10 million -- excuse me, $11 million in the quarter.

Some of the major issues there is we did record $1.2 million of expenses associated with Sarbanes-Oxley implementation.

And as you saw in our press release, we are planning on an increase of 3 million -- or, we are planning on recording 3 million additional dollars in the fourth quarter.

We also had $2.5 million of expenses associated with acquisitions that we didn't have last year, and we have them this year.

And foreign exchange increased our operating expenses by $1.1 million.

We then we had some variable selling expenses, commissions, freight, and we are seeing quite a bit of fuel surcharges in our freight expenses as well.

The major issues inside of the SG&A really is the Sarbanes-Oxley, inclusion of the operating expenses of acquired companies, and foreign exchange.

Looking at the tax provision, our tax provision in the quarter was only 32%.

We had -- that's compared to 40.1% last year in the third quarter.

We had a 1-time recording of $875,000 of favorable state tax credits that we booked.

We had some upgrades in our tax department, and these people dug in and found an opportunity that we were not availing ourselves of previously.

And they booked these state tax credits associated with some enterprise-owned credits for employment in certain states that we operate in.

So that was 5.8% of the 8% reduction in the tax rate in the quarter.

We're also utilizing our net operating losses in China.

That reduced the rate by 1.5 points.

And then the mix of income is about 0.7 of a point, which total -- those 3 items total 8%.

And as we look forward, we would anticipate a tax rate of 36.4 to 36.2, in that range, depending on the mix of income.

Just some overall comments as we look at the operations of the Company.

We believe that we are continuing to cover our raw materials cost increases with our price increases.

We continue to see increasing commodity cost.

We warned during the last call and in our 10-Q that we anticipated we might see some increases in plastics because of the price of oil.

And we are continue -- and that is exactly what we are experiencing now.

We did have a price increase.

We will have a price increase to cover some of that during the fourth quarter.

And there's another price increase being planned now for some time during the first quarter.

These aren't price increases that cover the entire gamut of product, but they're price increases in selected markets and with selected customers as we -- our plan is to attempt to make sure that we're covering these commodity increases with appropriate and selected price increases.

When we look at the comparison to the second quarter into the third quarter, we did see a bit of a drop in our gross margin.

Many of you had inquired of us how much arbitrage leverage had we created because of the timing of price increases versus cost increases.

And right now, after comparing Q2 and Q3, we're estimating that we probably did have some favorable arbitrage there of about $900,000.

And that, obviously, did not occur in the third quarter, as the higher costing caught up with some of the price increases.

As we start to look forward at the fourth quarter, you know, we're going to continue looking at commodity prices, monitoring them, anticipating price increases where necessary.

We are looking at our inventory.

We did have an inventory increase during the third quarter.

Management here feels that this is a problem which we have to focus our management group on.

There's a lot of programs and projects underway now.

So we are anticipating that there will be, during the fourth quarter several cut backs in production in certain areas to offset some of these inventory increases.

We had, during the course of the year, made some deliberate decisions relative to inventory, as we wanted to ensure that we did not miss any deliveries to our customers.

So, therefore, we did increase a lot of our inventories that were being sourced from overseas.

In certain cases, we probably put a little bit too much on, but at the same time, part of the reason for our sales increases is that we were able to service the customer and not miss those opportunities.

But now that we're starting to feel a little bit more comfortable with our supply chain, we're going to look at selected inventory reductions, which means slowing down some of our production in the fourth quarter on these product lines.

So we also saw, during the third quarter, what we felt was a little bit of nervousness surrounding our business, particularly as a result of the Presidential election.

So we're anticipating that in the fourth quarter, you know the -- some of the consensus estimates out there should be reviewed.

We would suggest that -- they should be reviewed for a number of reasons, because we do expect to under-absorb some of our factories because of the production issues I just mentioned.

And some of the uncertainties from the Presidential elections might be carried into the beginning of the fourth quarter.

So just a suggestion to everyone is to look at some of the historical relationships that we've had in the past between third and fourth quarter, and consider the fact that the third quarter, without the tax -- the 1-time tax adjustment and our earnings per share was a shade over, about 39.5 cents, if you will.

So, that's sort of the direction we're pointing people in right now.

And I think Pat wanted to have a few other comments as well.

Yes.

The one thing I want to bring people up to date on is, you often ask questions regarding significant litigation.

So rather than have the question be brought up by one of you, I thought I'd handle it right up front, which is there's a couple of things that have happened in the quarter with regard to our litigation on the James Jones litigation.

The first is that we did receive an order requiring Zurich Insurance Company to reimburse us $11 million, which was the settlement cost in the Phase I claims.

So we have been awarded that $11 million and Zurich has paid us that during the quarter.

That award -- that decision came down on August 6th of this year.

The second is, is that we had the California Court of Appeals affirm the decision of the lower court, which is that Zurich is obligated to pay Watts' defense cost in the James Jones lawsuit as well.

So on August 24th we received an opinion from the California Court of Appeals that was in our favor.

So the other thing is, in the basic case itself, there had been a number of motions made by Watts which have been ruled on.

The most prominent one being one where the judge ruled in our favor, and he, essentially, limited the claims of the plaintiffs to the cities that were directly involved in receiving and purchasing product from Watts.

And what he did is, he, basically, excluded all claims from subcontractors and from developers and others who are not the direct municipalities who purchased product from Watts.

So that helps us, in terms of limiting the scope of our exposure.

The other thing that happened is that the plaintiff's lawyer has filed, sort of, a secondary suit, which is a civil suit, where he has filed -- it's similar to the suit that was filed originally, but, however, he filed a, sort of, a lookalike civil suit.

We expect that that suit will be reassigned to the complex litigation court where our primary litigation is taking place.

And we suspect that those suits will be, sort of, over time, consolidated in some way, shape, or form.

We're not exactly sure at this point in time.

The other thing that's occurred is, and this just recently occurred, but the judge has ordered us, being Watts, Zurich, the insurance company, and the basic plaintiff in the suit, which is known as Armenta, to sit down and enter into settlement negotiations.

We had our first preliminary meeting on Friday of last week.

Those really haven't developed into anything at this point in time, but we are under court order to sit down and try to see if we can't come to a global settlement of all the issues, including the base case, as well as the insurance issues.

So that's pretty much wraps up where we are in terms of significant litigation.

The other comment I want to make before we open up the line is, I think Bill did a good job of describing how broad-based the improvement was in this particular quarter.

I'm just going to quote some numbers.

The retail had organic growth of 8.3%.

The wholesale had organic growth of 9.4%.

Both those are North American operation.

Europe had a 10% organic growth rate in its wholesale.

Similarly, it had a 10% organic growth rate in its OEM.

And China had a 30% organic growth rate across the board, when you take out the adjustments from the prior year.

So you can see that this is a broad-based improvement.

We feel very comfortable with the results in this quarter.

Although, the quarter that's in front of us has its natural challenges.

And with that I'm going to open up the line and allow you to ask any questions you might have.

Operator, would you please open up the lines for questions?

Thank you, sir.

Ladies and gentlemen, if you'd like to ask a question, please key star, 1 on your touch-tone phone.

If you'd like to withdraw your question, please key star, 2.

Your questions will be taken in the order they are received by.

We'll take our first question, from Curt Woodworth of J.P. Morgan.

Hi.

Good afternoon.

I have a few questions, you know, surrounding, you know, the nervousness for the election, can you, sort of, talk about what you're seeing thus far into the quarter?

And it seems like you're getting a little more conservative on demand, are you seeing that on the wholesale side, the retail side?

And then also, in terms of the inventory reductions and the production cuts, can you quantify that at all, in terms of where you think your utilization rates may go?

And is that only going to be a fourth quarter issue?

Could that, you know, extend into '05?

Thank you.

Okay.

This is Pat.

Let me just express what I'm seeing in terms of general market condition.

We are seeing that the retail marketplace continues to do well.

And I think we told you that we were forecasting for the entire year a low double digit -- or low single-digit improvement in terms of sales growth.

And we still believe that that's on course.

It's particularly helped by the introduction of several product lines that we recently are in the process of rolling out. 1 being the recirculation system.

And 2 being the presoldered fitting.

When you look at the retail market, we continue -- that doesn't seem to be affected by any concerns over what's happening in the general economy or what's happening in the electoral process.

When you go over and you look at the commercial lines, earlier in the year, we felt pretty bullish about the growth that was occurring in the -- in, particularly, in the commercial segment.

And what we saw in the late summer was a little bit of a hesitation in that continued growth.

Now that the Presidential election has been conducted and we have the same President in place, we think that that's going to resume.

But we did see a, sort of, a flattening, in terms of the growth chart during the period, really, from probably about July 15 up to the present time.

So what we're -- what we're hoping is that we'll see renewed vigor, in terms of improvement in the commercial marketplace.

The people who are deferring decisions are those who are making commitments of major capital on a longer-term basis, not the -- not the -- those people who are making home improvements and people who are doing it yourself.

With regard to plant utilization, we have plenty of capacity.

And the reason we have plenty of capacity is, don't forget, we're bringing on our capacity in China.

So by bringing on our capacity in China and moving products from our U.S. plants to our Chinese plants, we are opening up capacity.

The good thing about our problem is, this year, because the demand was so strong, we actually, in some cases, had to defer some plans that we had in place to downsize our domestic operations and curtail our operations in the United States.

So we're not bumping up against any utilization factors whatsoever.

We have -- what we have, instead, is a challenge of simultaneously bringing up our Chinese operations and downsizing our domestic operations in a smooth and fluid fashion without impacting our customers.

Does that answer your question, Curt.

Yeah, I guess, I just want to get a sense for, you talked about the fixed cost absorption being -- could be an issue on margin in the fourth quarter.

I just want to try to get a feel for how to quantify that, you know, how much are you going to take production down to, kind of, sell through some inventory?

With don't have an exact number for you right now.

If you look at our inventories, you know, we probably have a, rough estimate, $15 million of stuff we should be getting out of there.

Some of that, you know, being -- some of that production is going to be reduced at factories that have very low labor and overhead content, as in China.

Some of it's buy/sell inventory.

So it's I don't think it's a huge issue but it's an issue that we're just alerting you to that we have a couple things happening here in the fourth quarter.

We're bringing them up now.

And then, on Sar-Box, is that an incremental 3 million, or a total of 3?

No.

That's an incremental -- well, it's 3 in the quarter in total.

That'd be, like, a sequential increase of 1.8?

Yes.

Okay.

Thank you.

Okay.

And we'll take our next question Jeff Hammond of KeyBanc Capital Markets.

Hi.

Good afternoon.

On the Sarbanes-Oxley expense, it looks like, I guess, from your previous guidance that number is going up.

Maybe remind us coming out of Q2 what you were thinking there, versus what looks to be about 6 million for the year?

Yeah, I think, I don't know the exact number, Jeff, but your point is correct in that the guidance that we gave on that for the year, we have increased it quite a bit as the year has progressed.

The issue we have there is that, if you look at companies on a Sarbanes-Oxley scale, we are going to be far to the side of complexity.

Because we have grown up through acquisitions.

We have a decentralized management structure.

We have decentralized computer systems in Europe.

So as a result, of all those we're actually having to do, you know, 6 or 7, sort of, mini-Sarbanes-Oxley exercises inside of Watts.

So we're high on the complexity level.

And the other thing that's impacted us, to be honest about it, is that from the beginning of the year until where we are right now, these rules have been constantly changing and management and the auditors are learning as we go.

So compared to were where we are now, we definitely underestimated the task, versus the beginning of the year as did, I believe, the auditing community.

And part of the reason for the increase is that our audit fees came in on this much higher than we were planning as well.

So there's a number of issues happening there.

But your point is correct.

I mean, I guess I just wanted to make sure there's not any, you know, issues you've encountered, in terms of complying that's, you know, increasing the cost.

I mean, you feel -- ?

No, I mean the issues we are facing, really, is, basically, the workload and the risk we have is the same risk that I think any company has, which is, you know, can we get the work done?

And as we change our organization to be Sarbanes compliant, will we be successful there?

You know, we have to change a lot of the way we do things internally.

It's not a lot of cost, but it's a lot of training.

So we are not uncovering any major internal control flaws, though, but it is a lot of little things that we're changing.

Okay.

And then moving over to China, and I guess, particularly, focusing in on the margins.

I know you had some issues last year and, you know, it was kind of a transition year.

But you look at '02 and '03, you lost money.

All of a sudden you come in with a 17% margin.

I guess I wanted to get a sense of, you know, going forward, is that sustainable or, you know, is even double-digit margins stainable in that Chinese business?

You know, well, I think that, a couple of things you got to look at.

Our objective from the factories that we own 100% and that are sourcing back to the States, our objective is to keep them at a relatively low level of profitability, keep the cash and everything over here, okay, in the States.

So there might be adjustments on transfer of pricing, if appropriate.

Okay?

When we look at our joint venture, there's significantly improved management there and it's a very vibrant water market in China.

So we would anticipate that that Company should continue to make a nice contribution to Watts.

So I think that the contribution China is making will continue over the longer term, maybe you'll have some bumps on a quarterly basis, but, longer term it's there.

But there's -- I guess is there anything 1-time in the quarter that made those margins maybe a little bit higher?

You know, in other words, you talked about transfer of pricing.

Do you see, you know, perhaps, higher margins in North America from an export basis, but lower margins in China going -- I guess I just wanted to understand that better.

I don't see any one time things.

I see some structural things that are changing that we've been telling everyone about.

You know, we're exporting backflow and control valve products from China to the States.

So we're manufacturing those in our joint venture so we're getting, you know, margin and revenue there.

We see an improved management team at that joint venture going after a market that's vibrant.

And then we start to see, you know, more of our wholly-owned subsidiary there coming off of a learning curve.

I don't see that it's any sort of 1-time things.

But a lot of things came together in the quarter, though, I guess.

Good.

No, no.

It looked -- it looked very good.

I guess, you know, last question moving over to the raw material issue.

Can you maybe give us a sense of, you know, what you saw, in terms of price realization, you know, this quarter?

And then on the flip side, you know, maybe do you have a sense of, you know, what the impact on the margins were as a result of, you know, the inflationary cost you're seeing?

Well, I think, in terms of price realization, if I'm understanding what that means in the question, is that we are covering our cost -- our cost increases right now.

And we did have, as I mentioned earlier, favorable, I'm calling it arbitrage, you know, in the second quarter that we didn't have in the third quarter.

It's really timing differences.

Timing.

That's right.

So our price increases were a little bit ahead of our cost increases.

I'm not sure if I'm answering your question or not, though, Jeff.

Well, I mean, I guess you're offsetting the cost with price, so you're getting, you know, the top -- the additional top-line volume from the price realization, but you're realizing the additional cost, which is having a negative impact on your margin.

So I'm just trying to get to the -- you know, what the negative impact, you know, was from the, you know, inflationary costs.

In terms of dollars, there's no negative impact that's being covered.

In the third quarter we covered that off.

Right.

Okay.

Okay.

Maybe I'll follow-up off-line.

Okay.

Thanks, so much.

Your next question comes from Mike Schneider of Robert W. Baird.

Hi, guys.

Nice quarter.

Thank you.

First, I guess, I want to just visit the issue we talked about last quarter about a pre-buy.

You cautioned us last quarter that you thought you benefited in the second quarter as a result of people buying ahead of the price increases that were going in, yet you had an extremely strong quarter.

Just any reflection on that now?

Because it doesn't seem to have been an impact, unless this quarter would have been even stronger?

This quarter would have been stronger, Mike because our calculations show that there's a $900,000 impact.

So how much of that -- we're thinking that 900,000 was, sort of, the positive impact on the second quarter, cost of goods sold and gross profit on a pre-buy, which really comes through as a better mix, Mike.

Okay.

And that's why in the second quarter, Mike, you saw a pretty significant boost in margin percentage.

I look at the 2 quarters together and say what we've done here is put 2 excellent quarters back-to-back.

Right.

You know, and because of the way the accounting rules work, we have to record revenue in the period in which the product shipped.

The customers made choices because they got spooked at the end of the second quarter as to where price increases were going to end, so that they did some pre-buy.

But the impact at this point in time we quantify it as roughly $900,000 of gross margin impact.

Okay.

And on pricing, why do you believe you've been successful in offsetting the cost of goods increases that you've seen?

Because many of the companies in the sector have certainly made attempts to, but have fallen short in some amount.

Yet you seem to be one of the few companies who has, essentially, been able to stay neutral, or even a little better?

I think, Mike, the answer is, is that last year when we were out making the offering, last December, we started seeing prices moving when we were literally on our road show, okay?

And we came back and we acted pretty quickly.

We had made, we had already put plans in place by the time Christmas came last year.

And I think that first price increase was a difficult one, because it was following on 3 years of deflationary pricing.

But once we were successful in going out and selling the first price increase, I think our competitors recognized that they were being impacted by the same things we were.

And there was a lag but they, in essence, saw fit to raise their prices.

Not always an equal amount, but they effectively supported the leadership role that we took in the marketplace.

The other thing I think that happened, Mike, is that we have a lot of salespeople in our organization who have never gone through an inflationary period like we've seen in the last year.

We spent a lot of time training people on the -- on how to sell a price increase, and how to explain a price increase to wholesalers, and how to explain it to the other parties in the channel.

And the necessity for them to pass on those price increases to their customers.

So, in some regards, I think we were lucky in that we recognized the problem a little bit earlier than others did, jumped on it, and as a result, our market segments have probably been a little bit more receptive than some of the other markets that you're seeing.

Okay.

Thank you for that color.

And specifically in the backflow market, growth there now has, essentially, been double digits for several quarters.

And yet commercial construction isn't up double digits year-over-year.

Can you give us some sense, is it market share gains still?

Because one of your competitors is having delivery problems?

Is it Hunter?

Is there a different product adoption cycle underway?

Give us any explanation as to why this market is so strong vis-a-vis the commercial construction numbers?

It's a combination, Mike.

Okay.

First of all, we -- when we bought the Hunter product line, all of the products in the Hunter product line, although they were designed, did not have USC approvals on them.

So we have benefited this entire year, and really over the last 2 years, of putting in the effort, and we, in essence, every quarter have a host of new products that come out of USC approval.

So our sales organization has got something new to sell.

So there's nothing a salesperson likes better than something brand new to sell.

And we've had a continuous quarter after quarter after quarter arsenal-worth of products for them to introduce to their customers.

The second thing, Mike, is that there are several of our competitors who have had some problems with deliveries, particularly those who have chosen to go overseas and haven't done it as carefully as they might have wanted to.

So it's a combination of us having brand new products.

It's a sales organization that hyped-up because of the ability to go out and sell something new.

And it is missteps by our competitors combining to give us this growth.

The majority of it is, you know, Mike, if the -- if you look at the market, I would say -- I'd say 2/3 of this is market share gain.

Okay.

That's helpful.

And, in terms of where you are in this approval cycle, are you half way done with the approvals on a local level?

Or do you have any sense of where you lie?

We are about 3/4 of the way, I would guess, at this point in time.

I'm going to review that with my guys next week, but, there's -- the last time I looked, we were about 2/3 of the way.

So I'm thinking we've since then, which was almost, you know, 3, 4 weeks ago, we have another slug of approvals coming out.

So we're probably close to 70%, let's say.

So by year-end or first quarter, you're done?

No, it'll take -- these things take more time than that.

I would say we probably have the majority of that product line out into the market by mid-next -- midpoint next year.

This is a laborious process, and an expensive one, Mike.

Right.

Right.

And then in the retail side, again, good numbers, obviously.

Housing has seemingly hit a wall, recently, and is bouncing around at these elevated levels.

Wondering where you are in the new product cycle, as well, because, clearly, the growth is being driven by strong housing, but also your new product introductions.

What's in store for '06?

Is there any major big bangs to come, in terms of product introductions?

Well, I think there are.

We have a number of new products that we're looking at.

Let me just tell you the areas.

We haven't gone through our business -- we haven't completed our business-planning process, Mike, so some of this is, I'll just talk about generalities.

So, if you look at, we continue to introduce a number of backflow prevention product.

Okay?

Not only the Hunter, but others under the Watts label and the Ames label.

So we will have a whole arsenal-worth of new product introductions throughout next year in the backflow prevention field.

The second is, we will have an arsenal of new products in the underfloor heating business.

Okay?

We have a management team in that business who is extremely creative.

They have a good sense for what the market needs are.

They do basic kind of research, in terms of identifying the needs of the users and the preferences of the contractors.

And we feel pretty comfortable there's a number of new product introductions that are sort of in the queue that will come out over the next 15 months or so.

The third area which we have a lot of faith in is the thermostatic mixing valves, where we bought Powers Process Controls from Crane Co., roughly, 2.5 years ago.

Have introduced a number of new design products.

I was as our factory in Franklin, New Hampshire yesterday, and they were manufacturing, for the first time, the first batch of new products on 3 different SKUs.

So those products are being manufactured here in the fourth quarter.

We'll probably start seeing sales of those some time in the first quarter of next year.

So -- and then, you know, there's a number of products coming out of Watts Regulator.

There's a number of products coming out of most of our opportunities.

So, I sort of see it as a, sort of, way of life for us.

So, growth in 2005, is high single-digit organic still reasonable, assuming, call it, static housing?

I don't know if I can answer that question because I have to go -- I've got to do some more -- I've got to do some -- I have to go further into my planning process.

Okay.

Well, and maybe another way to look at it is, just in your gut, was this year an exceptional new product rollout year, or when you look out over the cycle, was this an average year for you, be it good, I'm not criticizing you, but is this an average, above-average year in new products within retail?

It was above average, but, hopefully, we're going to duplicate it next year.

Okay.

Fair enough.

And then, finally guidance.

Bill, you made clear your discomfort with that our estimates for the fourth quarter.

I'm sorry, could you run through the 39.5 cents is your adjusted number for what quarter in your -- ?

Well, if you take the third quarter, Mike, we just completed, and just take -- back off that tax adjustment, it gets to you 39.5.

Okay.

But then again, there was an extraordinary charge in there of about a penny.

So something over 40 cents.

And last year you were up sequentially by 3 cents.

You've got better momentum now.

Is there any reason to expect similar magnitude?

I think, Mike, I look at my numbers --

I've scrubbed mine of the charges so we may have slightly different numbers.

Well, I mean, we -- last year we went 33 to 34.

So we were up a penny from third to the fourth quarter.

Now, that's a straight GAAP numbers.

Right.

And I'm just basing my comments, Mike, on we see a big Sarbanes number coming in there.

We don't have a tax situation again.

Just sort of our feeling on the quarter.

I just, I don't see -- I think the consensus estimate --

42.

42.

And, you know, I don't see a couple of pennies going that way.

And we just sort of --.

Can you hold the line flat, even with added costs and under-absorption?

Well, it's going to be a challenge.

Okay.

I'll get back in line.

Thanks, guys.

And, again, great quarter.

Thanks, Michael.

We'll take our next question from Ian Fleischer of Friedman, Billings, Ramsey.

Good afternoon, Pat and Bill.

Hi, Ian.

Just going back to demand, and I know this is kind of difficult for you guys to look at it this way.

Your internal growth was very strong, it was 10% year-over-year.

Can you provide some color on the contributions from the residential versus the commercial end markets?

Well I think the -- you know, if you look at our lines that were up.

You know, the backflow and the control valves being up.

Those are all commercial.

Those are all commercial.

The retail being up at 8%.

And that's a combination of, you know, market share gains and new product offerings, et cetera, so it's not necessarily an 8%, you know, increase in residential activity.

It's additional sales.

It's not indicative of the strength of the market, I don't believe.

If you look at the European side, and again, we believe we're gaining market share.

In Europe, it's a very weak wholesale market and we've made progress there because of new programs, new management and same situation on the OEM market in Europe.

We are, we've consolidated a bunch of companies over there.

Our customer base is consolidating.

And that customer base is consolidating their vendor base.

We feel very comfortable that we are making the cut as they reduce the number of their vendors, because we're more important to those people than we were a couple years ago, because of the acquisition strategy that we've undertaken and the products that we're able to offer them.

So I don't -- I think it's -- I don't think the end -- outside of the commercial, you know, we look at our commercial lines, and they all seem to be up.

And we sense a strengthening overall in the commercial marketplace, not for big projects, but a lot of the smaller projects.

But we don't see as much of the residential.

We think it's more programs and projects that we have.

Okay.

And on China, you mentioned that the water market in the Chinese market is very strong.

And I've always looked at that more as a sourcing opportunity for product back to the U.S.

Are you considering investing new capital to focus on the demand in China?

Yeah, we have, sort of, rebalanced our strategy.

I think, I'd say 2 years ago, we thought of China as almost exclusively a sourcing strategy.

And then once we got into some of the issues that we ran across, in terms of difficulties we experienced in China, in that process, we had, for example, had people who were counterfeiting our product and selling it.

We went through a process of working with our joint venture partner to get those counterfeiters shut down, and one of the things we learned in that process is there was real demand for our branded product.

So one of the things that came with the joint ventures that we bought in China is pre-existing channels of sales channels into the Chinese market, which we're now committing resources to exploit.

So we think there's a good opportunity for Watts on 2 sides. 1 is, the water market is a strong market in China.

The building market itself -- the market in China is a little different than the United States.

It's high-rise residential and commercial buildings, where that's our soft spot.

That's most of the products that Watts makes, you know, is the core parts of our product line that we think over the next 5 to 10 years, we should be able to use some of the tactics we've used in the United States to create a good market position within China.

The predominant one is working with code authorities to get codes developed and use Watts products that already have pre-existing codes in the United States as the model code to establish those codes.

So we're, at the moment, thinking that we have quite a -- we're in a unique position that we can use China as a low-cost sourcing strategy and we can use it as a sales and margin expansion opportunity.

You think that you would need to do an acquisition to fully support that market?

We'd probably have to do some acquisitions to complement our product lines, yes.

Okay.

And on acquisitions, how is the pipeline and pricing looking at this point?

And where do you see opportunity geographically?

And, maybe, if you're looking at some bigger size acquisitions, or your more traditional 10 to $20 million-type acquisitions?

Right now, the pipeline's pretty good.

Although the size of the deals that are available at the moment are not that substantial.

There's a deal that's just about to come to market here, shortly, that is one that we've been interested in for awhile, of fairly good size.

But we are talking more in the 10, $20 million type of deals.

There are a number of deals out there.

We are active on a number of deals at the moment.

Whether they will come to fruition I don't know, and I would tell you that we're relatively indifferent as to buying companies in the United States, Europe, or China at this point.

Great.

Thank you.

Thank you.

We will take the next question from Richard Rossi of Morgan Joseph.

Good afternoon, everybody.

Just a couple of follow-ups on things you already commented on.

First, on the Sarbanes costs, how much of those costs might not be re-occurring, the training costs, the set up costs, versus costs that are going to be imbedded in your operations permanently?

Yeah, I would say, as a rough estimate, Rich, is probably half go away next year.

You know, we'll spend $6 million this year. 1 million of that is audit fees, and, you know, the rest has been consulting and internal fees.

We'll probably have $1 million a year for audit fees on just Sarbanes.

And, you know, we'll have a couple million for salaries and consulting fees to keep current with it.

We've had to outsource a tremendous amount of work to get this done.

So we are paying some pretty high hourly rates.

And as we bring that in-house and develop our own people, the cost will start to come down.

All right.

And back to China once more, you mentioned strong markets.

Obviously growth economy.

But in talking to a few other industrial companies this quarter, they've also seen very strong results in the third quarter.

But a few have mentioned a bit of an inventory build up in China during the third quarter, a little excessive inventory relative to what they are comfortable with.

Are you seeing any of that at all?

Well, our inventory position really -- it's not that it has anything to do with the Chinese market or China in particular, it's just that we had deliberately, in most cases built up excess inventories because we weren't completely sure of the delivery -- of our ability to deliver.

We're gaining more confidence there, so we're going to be cutting back.

So, it's -- you know, we have some of that going on in the U.S. and China.

I don't think it's a Chinese issue.

Okay.

All right.

That's about it for now.

Thanks.

Thank you.

And we'll take our next question from Rick Natole of Columbia Management.

Actually, several of my questions have been answered.

Just in rethinking your business, I know you mentioned earlier why you're taking it on the chin, relative to maybe some others on the Sarbanes-Oxley issue.

Does it make sense to rethink the decentralized -- or is there anything you can do about, you know, having this be a catalyst to, maybe, refocus or put some of these things under a common system?

Or has that been given any thought?

Yeah, this is Pat.

I think there's a couple of things that are coming out clear in this, which is, 1, you know, we grew by acquisition.

But there's a point in time, which, particularly, in Europe and in China, where we're now going to go ahead over the next couple of years and install a unified computer system, information technology system.

You know, what we're seeing in Sarbanes-Oxley is that, for example, we go out and we audit computer controls.

We have to audit computer controls in 6 or 8 or 10 different computer environments in Europe.

Where we think there's significant benefits, particularly now that you have a common currency across a good part of Europe.

So the other thing I think that -- you know, you're talking about Company that grew up with an entrepreneurial flare.

And, to a certain extent, we use to look at things and say, we'll take the 20% of things that give you 80% of the benefit and will leave the 80% that give you 20% of the benefit alone.

Well, under Sarbanes-Oxley that becomes a costly proposition.

So we're -- now we're starting to apply some best practices and starting to consolidate on common practices across the enterprise.

We have to be careful, though, because one of the things that drives this Company is new product development and entrepreneurial behavior.

So, we don't want to kill the golden goose, but on the other hand, we have to go ahead and now pull the trigger, in terms of standardizing on computer systems, standardizing on certain operating controls, et cetera.

Okay.

And you don't -- what kind of time period do you think you can accomplish what you're seeking to accomplish.

I think it's going to take us probably 2 years.

Okay.

All right.

That's all I had.

Thank you.

Thank you.

We will take our next question from Curt Woodworth of J.P. Morgan.

Hi.

Just a few quick follow-ups.

I think, entering the year, in terms of your low-cost sourcing, you were talking a number around 50 million.

What is that number now, and given that you're more comfortable with your supply chain in those areas, where do you think that number could get to in '05?

Curt, this is Bill.

If you look at '03, we sourced about 50 million.

Right into 2004, our estimates right now say that we will source about 100 million.

Bit if you look at our run rate now as we come to the end of the year, the run rate is about 125 million.

And we have plans in the works for next year.

I think it's very reasonable to think that we'll source 175, at a minimum, next year.

In aggregate?

Yeah.

Yeah.

And then, in terms of trying to quantify the cost benefit, can you provide any help there, in terms of what are the cost savings?

I mean, typically, what you have is a savings of about 25% versus -- you know, landed in the U.S. versus manufactured in China.

Wow.

Okay.

And, but the issue you have, though, is as you send over more and more of your stuff to get the next level of savings, you really have to aggressively attack your fixed cost in the United States or in Europe.

Right.

[Multiple speakers] and your sourcing, where you were sourcing it.

So it doesn't mean that you can take 50 million times 25% and drop that to the bottom line.

Right.

You can't do that.

But it -- it is a significant issue for us, in terms of, you know, opportunity.

And you're going to see -- I still think we have a couple of years of this to go through.

And then just quickly on China, in terms of your acquisition strategy.

Can you talk about what exactly the type of assets you think you need or would look to buy?

Well, we basically look and view ourselves as being in the water business.

So all of the companies would fit that strategy, in terms of being water related.

Okay.

There's 2 primary markets for water products in Europe -- or in China. 1 is, what I would consider the building market, which is high-rise residential commercial.

You're talking about things, products that would you sell into those are typically a number of control valve applications.

You could sell, for example, I did a hotel with the thermostatic mixing.

You could sell the backflow prevention.

You could sell the automatic control valves.

You could -- you could sell a host of products that we manufacture which are used in the heating and air conditioning and ventilation marketplace.

So we see products and companies that make products like that to be, sort of, in our target zone.

Okay.

The other, which if you look at our joint venture, TWT, TWT makes a number of products that are sold into the water market, but it's more of a municipal water market where you're talking about valves that are used in either municipal systems.

And that's a market that in the United States we left several years ago when we sold Pratt and we sold James Jones and other companies.

And the reason we left it in the United States is because it was mature market.

It was becoming commodity-oriented.

But in China you're at the other end of the spectrum, where that's a growth market.

It has strong margins, strong growth potential, and we already manufacture products in China for that particular market sector.

So, that's really the 2 sectors that we see as most immediate.

Okay.

Great.

Thank you, very much.

And then just a quick question on some of the raw materials.

Do you have any contracts in place for your various raw materials this year that are going to get rolled over next year?

And that could be, you know, significant inflation issue for you?

The contracts that we have in place that are fixed are relatively minor.

Okay.

Most of our contracts are linked to an index that move, you know, pretty quick.

Okay.

Great.

Thank you, very much.

We'll take your next question from Stewart Scharf from Standard & Poor's Equity.

Good afternoon.

Hi, Stewart.

Hi.

Could you first talk a little about free cash flow?

Do you have a projection or numbers for a D&A and CapEx for the third quarter?

When it comes to free cash flow, are you talking for the year, here?

Yes.

Yeah.

I think, based on the inventory situation we have, we'll -- you know, we will have positive free cash flow for the year.

But it will be significantly less than what we've seen in the past.

Right now, for instance, for the 9 months ended September 30th, we had negative free cash of 26 million.

Now we are looking at going into the fourth quarter.

We will be, with some inventory reductions in mind, so we will, I believe, be able to take that into the positive territory.

But it's not going to be a big number for us this year.

If we look at the year-to-date for the 9 months, depreciation and amortization, it's about $21.5 million for 9 months.

You can just annualize that and get the full year number.

I don't know what it is, exactly, in the quarter, Stewart.

I have a year-to-date cash flow in front of me.

And CapEx?

CapEx for the year should be approximately 19 million, which is the budget that we established at the beginning of the year.

It's 16.8 for the 9 months ended.

And the weighted-average cost of capital?

About 10%.

Okay.

Could you quantify the percentage of organic revenues from new products?

We don't really track that on a quarterly basis like that, Stewart.

You know, if we -- if we look at our overall organic growth, 10%, you know, you'd have to say maybe half of it is unit pricing.

The other half is units.

And I'm not sure, most of that 5% of units would be existing product.

Some would be new product.

But I -- we don't have that breakout right now.

Okay.

And at what point would the -- would you not be able to offset the higher resin costs and other raw material costs with price hikes.

Is there a point where if they continue to rise significantly, would you not be able to do the pass the costs through?

Well, I think as long as our competitors are somewhat rational we would be able to do that.

Stewart, our customers are wholesalers, primarily.

Okay?

They're also, you know, the big-box retailers.

And the answer to that question is, are they willing to pass on the price increases to their customers?

So far, we have seen them being willing to do that, particularly the wholesalers.

The wholesaler -- you know, most wholesalers are looking at it as, they can get a price increase out ahead of a cost increase, it will result in higher profitability for them as well.

So they tend to support cost increases where there's a good rationale, where they have a good argument to going -- for going to the contractor and explaining to the contractor why prices went up.

So that's one of the important factors is making sure you give your customer the ammunition to resell the pricing -- the cost increase onto his customer base.

So, you know, I think in our industry, if you continue to what we're doing, you should be able to pass along cost increases.

You're going to have some timing differences.

People are going to push back on you, but I think in the long-term, you should be able to recover them.

Okay.

Thank you, very much.

Thank you, Stewart.

And again, if you would like to ask a question, please key star, 1 on your touchtone phone.

And there're no questions at this time.

I'd like to turn the call back over to Mr. O'Keefe for closing remarks.

Thank you, very much.

I just want to thank everybody for joining us on our call.

I think this was a very robust quarter.

We're very proud of it.

I think it's a back-to-back with the second quarter, which, also, was very robust.

And we look forward to having you on the call in early February.

Thank you.

Thank you.

Ladies and gentlemen, thank you for joining us on the conference call.

You may now disconnect.