Watts Water Technologies Inc (WTS) 2004 Q4 法說會逐字稿

Good day ladies and gentlemen and welcome to the 4th quarter Watts Water earnings conference call. My name is Michelle and I will be your coordinator for today. [OPERATOR INSTRUCTIONS] I would now like to turn the presentation over to your host for today’s conference Mr. Kenneth LePage, Assistant General Council.

Before Pat and Bill begin their presentation, I need 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 Litigations 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 ending December 31, 2003 filed with the FCC, and other reports we file from time to time with the FCC. 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.

During this call, we will be referring to non-GAAP financial measures. These non-GAAP measures are not prepared in accordance with generally accepted accounting principals. A reconciliation of the non-GAAP financial measures to the most directly comparable GAAP measures is available in the Press Release dated February 23, 2005, correlating to our 4th quarter 2004 financial results, a copy of which may be found in the Investors Section of our website, www.wattswater.com, under the heading, Press Releases. I will now turn the presentation over to Pat and Bill.

Pat O’Keefe: Thank you, Ken. Good morning, ladies and gentleman. Thank you for joining the Watts Water Technology 4th Quarter call. I’m going to start the call by making some general comments, and them I’m going to turn the call over to Bill McCartney, our CFO, who will give you some more details in terms of breaking out the details of the numbers, and then we’ll open up the lines and let you ask any and all questions that you may have.

Let me start us out by talking about the Sales numbers. In the 4th Quarter, we came in with sales of $221,406,000, which is an increase of $34,260,000, or 18%, so sales were generally strong across the board. Bill will talk to you about the various segments and were the sales came in, but I think in terms of strong sales in terms of organic growth rate, strong sales in terms of overall growth rate, so I think in terms of revenue, we are doing fine. The only area of concern, if there is one, is in Europe, where organic growth was a roughly 1% in the quarter, but we have been experiencing a tough economic environment in Europe for the last four quarters, so that is nothing unusual.

Now, when you look at the year, we came in at $824,558,000, which is up $122,999,000, or roughly 17.5%, again continued strong story in terms of both year-to-date and quarterly sales.

Now, looking at the 4th quarter, net income came in at $8,161,000, which is down 16%, and I want to sort of walk you through the top level numbers, but the first is, included in the net income, is a loss from discontinued operations of $1,688,000, or $0.05 per share, and Bill will talk to you about the details about that later. That brings you down to income from Continuing Operations at $0.30, and if you look at that number, basically what you have inside that number, you have income from Continuing Operations which includes our costs incurred for our manufacturing restructuring plant of roughly $0.01, or $408,000 for the quarter. Then, if you look again, you will see that we made an accounting adjustment necessary to correct errors of $0.07 per share in the quarter, so you really have within the income from Continuing Operations, you have sort of two unusual items, one is the loss incurred on manufacturing restructuring of $0.01 and the $0.07 from the accounting error.

That is sort of the top line story in terms of earnings per share. Overall, I am very happy with the quarter. I think that there are a couple of things that happened in the quarter that need to be pointed out. One is that we did struggle in the quarter with absorption issues. We deliberately brought our manufacturing volumes down in order to reduce our inventory levels because we were producing at higher levels than necessary going in to the quarter, so we saw some pull-back in terms of our absorption in the quarter. The other important factor is that we are going through the process of complying with the Sarbanes-Oxley Rules, and as a result of that, we have installed, sort of what I would consider to be an enhanced control environment, and out of that effort came several adjustments which were the direct result of Management’s effort to enhance their control environment. Overall, I think that is a good thing, although in this particular quarter, we had to recognize some additional expenses and losses as a result of the thoroughness of our Sarbanes Oxley effort.

With that, I’m going to turn the call over to Bill who will take you through some of the details, particularly in terms of the growth story in terms of where we experienced internal growth, and secondly where we stand in terms of some of the details behind the numbers. Go ahead, Bill.

Thank you, Pat. What I want to do is walk you through the very detailed explanation of all line items on the CNL, we’ll talk about the cash flow a little bit, and give you all a detailed understanding here.

As Pat said, revenue was up $34 million, which is 18%, and we’ll talk about the segments in a minute. Earnings from Continuing Operations on that 18% increase in revenue were flat at $9.8 million. Now because of the share dilution that we have, because of the offering last year, the earnings per share on that flat income was down $0.05, so we went from $0.35 earnings per share from Continuing Ops to $0.30, and the shares outstanding went from 28.5 million last year to 32.9 million, so we have about 15% dilution on the shares.

I thought what I would do first of all is talk about the accounting adjustment, and then as we go through the numbers we can focus on the numbers from an operating standpoint. We charged ahead at $0.07 earning per share impact in the quarter. There are three different issues inside of that. The first was about an $0.11 charge, which was about $5.3 million which was charged to G&A expense. The situation there is that when we did the acquisition of Heatway, which is now doing business as Watts Radiant, back in the year 2000, we did that deal through and earn-out. We bought the assets out of bankruptcy, so the purchase price will be provided to the shareholders through and earn-out, and that earn-out will be paid in 2005 during the 4th quarter. Now that earn-out was originally reviewed and determined to be the purchase price under the accounting rules, and we have treated it as a capitalized item. As a result of the review done by some of our new accounting people here at Watts at year end, we made a determination that that really should be expensed, so we are taking a charge to recognize that of $5.3 million pre-tax, and that is about $0.108 impact on an after-tax basis. We anticipate that that earn-out, if the Watts Radiant Division hits their budget for 2005, will require us to book $0.01 per quarter in compensation expense during the first three quarter, so that is $0.01 in each quarter.

The other adjustment, one is an excess accruals in our books, and these go back for many, many years, and we reversed those two incomes to offset some of this other charge, so we recorded about $700,000 of income that was charged or recorded in other income and expense, and we credited the Taft Division about $450,000. So those two items created about $0.04 of income, so the $0.11 minus the $0.04 gets you to the net $0.07.

The two accruals, the $700,000 and the $450,00 were tax affected. And basically, these are both one-time issues, and as Pat mentioned earlier, as we’ve gone through our Sarbanes Oxley implementation, we have made some, shall we say, investments in our internal control system and we’ve hired some new people in the Accounting group here at the Corporate office, upgraded our staff, and that is the fall-out of those activities. So again, these are one-time charges, with the exception of the 3 pennies we are estimating the additional earn-out.

Pat O’Keefe: So let’s go back to some of the detail on the revenue. 18%, or $34.2 million in the quarter. Internal growth was $18.8 million.

That’s the 10% internal growth in the quarter, and we’ll provide some detail on that. The foreign exchange was $5.6 million that is 3%. Acquired companies contributed $9.9 million that is 5.3%, so those add up to 18.3%. On the year-to-date, organic growth was 8.7%. The foreign exchange was 3.3% and acquired companies contributed 5.4%, for a 17.5%, or a total of $122.7 million.

Now one issue that we addressed during the quarter is our minority interest, Gimacol, LLC. We had been recording that as revenue, and we have been reporting to you under this caption of SIM 46-R. Now this quarter, the 4th quarter, we made a decision to divest ourselves of that company. That was a small division, approximately $16 million in revenue that was operating at a break-even. The business of Gimacol, LLC was to import victrious china and faucets and sell them into the home-improvement market, and we made a decision that this did not have a long-term strategic fit to Watts, so we are in the process of divesting that unit. As a result, we took a charge in discontinued ops, and we are treating it as a discontinued operation, and that is why, if you try and reconcile some of our prior revenue numbers to this quarter, you are going to be missing what we had reported as the Sim-46 revenue.

Looking at North America, the total increase in revenue was 21%, that is just shy of $25 million, and we have included the geographic segment information in the Press Release. But internal growth in North America was $16.6 million, or 14% in total. Foreign exchange, which is the Canadian dollar, was 0.6%, about $700,000. Acquired companies contributed 6% of the growth, that is $7.2 million, so again total growth $24.6 million or 21%. So total revenue in North America in the quarter went from $120 million to $145 million.

Looking inside of that internal growth number in North America, our retail group posted a very strong quarter, with 21% organic growth in the quarter, and that is just about 10% for the year. You’ll recall that in our previous conference calls, Pat and I were forecasting that the retail would do high single digits for the year. We knew that we had a strong 4th quarter that would be coming up. The 4th quarter did turn out to be a bit stronger than we had expected, and that is why we went from 9 to 10% on the year. Some of the contributing factors there, as we were rolling out three product lines during the quarter, we have our pre-sorted fittings, our hot water re-circulating product and our hot water heater accessory kits, all of those are being rolled out in the quarter. We’ve also continued to have some nice success with our sun-touch product line, which is our under-floor electric heating product, and that went from $2 million to $3 million in the quarter, and we would have had some small contribution from pricing as well. So a strong quarter on retail, again we don’t believe that this is a 21% growth type of product line. We are still thinking of this as high single digits, and that is what we did for 2004.

Looking at the wholesale side in North America, the organic growth was 12%, 20% with the acquired companies. The organic growth continues to be driven by our backflow prevention type of products. Thirteen percent increase in the backflow continues to receive nice contributions from the Hunter product line. Hunter was $3 million, and increase of $1 million from last year’s 4th quarter. Generally, most of the product lines inside the backflow showed nice increases.

Our overall plumbing group was up 10%. That went from $48 million to $53 million in the quarter. And our under-floor radiant heating, the hydronic portion was up about 40%. It’s a small base, but we went from $3.8 to $5.4 million in the quarter. Overall the radiant division did very, very well, because that is where the electric sun-touch product line comes out of as well, so a strong quarter from the radiant group.

Year to date, the organic growth in wholesale was about 10% and with very similar numbers as I just mentioned overall, but $400 million of revenue in the wholesale side North America.

We saw some of the same trends in our Canadian markets that we saw in the United States, with good performance in the retail, the backflow, and the under-floor radiant heat products as well. The acquired companies, Orion and Floormatic, Orion for the year contributed $11 million, so that is pretty much on our expectations, and Floormatic, which was acquired in January, was about 20% ahead of last year’s run-rate prior to the acquisition, and they have done very well for us also.

Looking at Europe, the total growth was $8.3 million that is an increase of 13.5%. The organic growth there was about $800,000, which is about 1.3%. The foreign exchange, which is the change in the dollar to the Euro, was $4.8 million that is 7.8% contribution. Acquired companies, which is our Team UK acquisition we did in May, or maybe it was June, that contributed $2.7 million this quarter, or 4.4%, so that totals 13.5%. The organic growth was off from the year-to-date. Year-to-date Europe was 4.2%, or $8.8 million. Foreign exchange year-to-date was 10% and the acquired companies 6%, so 20% growth in Europe for the full year. Revenue in Europe, as you see from the geographic footnote, was about $70 million.

When we look inside of the European organic growth numbers there, we break it down between wholesale group and our OEM group. The wholesale group was up 7%, and again, wholesale and OEM are approximately evenly split inside of our European numbers, so the wholesale group was up 7%. We continued to make nice progress in the German wholesale market. We have some new management that we put in place during the middle of 2003, so we are seeing the results of the new managers. We’ve also signed out many new wholesalers, and we’ve also been successful in expanding some of our sales into eastern Europe, with adding a couple of new sales offices in eastern Europe and signing up additional distribution as well. We continue to see soft wholesale markets in Italy and France, which is consistent with what we’ve told you in the past.

On the OEM side, sales were down 6% in the quarter, and they were up 7% on the year-to-date basis. The wholesale was up 3% year-to-date. So again, a soft quarter on the OEM versus what we had previously seen on the year-to-date, and we’ve gone through a detailed review of our OEM customer base and we feel its predominantly due to some timing issues. We’ve had several large orders that went out in the 4th quarter 2003, and we think that the inventory situation of our OEMs was strong as they close the year, and we don’t necessarily think that change in our overall trend in the OEM business.

Looking at China, small base, but our revenues are up nicely at 26% in the quarter and 40% year-to-date. In the quarter, we closed our revenue at $6.6 million in China. The main issues there would be with shipping. Many more of our water connectors out of our southern China plant, the one that we purchased 100% of early in the year, and we’ve also during the 4th quarter, introduced our new line of low-lead water pressure regulating valves. In our inter-company activity, which is not included in the revenue numbers, is up significantly and that helps a lot with our profitability. We’ve now seen 3 consecutive quarters of profitability in our Chinese segment, and our operating earnings in China of $1.9 million for the year, versus a loss of almost $4 million the prior year. So, our Chinese operations are settling down nicely, as a result of getting our [woofie] up and running. The path to utilization is higher, the scrap rates are lower, and the shipments are increasing.

When we step back and look at the gross margin of the company in total, the margin did drop versus last year’s 4th quarter. We were reporting 34.2% versus 35.3%. On the year-to-date basis we are down as well. Year-to-date we are at 35.2%. So again, we are down a point, versus the year-to-date, and last year’s 4th quarter. The main issues there, we addressed. We did take a period expense for our fixed costs and our factories of $900,000. This is part of our program to reduce our inventories. We did reduce our inventories almost $10 million in the quarter. Part of the effect of that is some absorption variances. We also took some write-downs in our European companies associated with some obsolete inventory and some software we wrote off that went against cost of goods sold. Those are the primary reasons why are gross margin dropped by a point.

On our SG&A, it went from $46 million to $60 million, that is and increase of $14 million. The major components of that 14, we have a $5.4 million earn-out charge that we recorded in GNA expense. We also recorded $3 million for Sobane Oxley expenses in the quarter. The impact of acquisitions, which we did not have, last year, was $2.4 million. Foreign exchange has $1 million impact, and that leaves you with about $3 million associated with ongoing operations of the company. $1 million of that is increased selling expenses associated with increased volume, and then there is $2 million of other miscellaneous expenses.

When we look at the operating earnings, we are reporting a decline from 19.8 to 15.5 in the quarter. If we exclude our restructuring and exclude the 5.4 million charge from Watts Radiant, we are looking at an increase from last year. Last year would have been reported under 20 million excluding restructuring. This year, $21.8 million excluding restructuring and the charge from Radiant. On the year-to-date basis, if you look at the year-to-date, excluding the Radiant charge, we would have expanded our operating earnings percentage to sales from 10.2 to 11.1%, so that is about 90 basis points.

Looking at the tax rate in the quarter, last year our tax rate in the 4th quarter was 38%, this year is 23%. A couple of different items are going on there. First of all, we did value a net-operating loss in China. We are now comfortable that our Chinese operations will be profitable as we go forward, and that allows us to value the losses that we had lost in 2003, which you might recall, we were not tax affecting those losses at that time. So that has an impact of 3% on the tax rate, and then according to Sales 109 as you go through and value and NOL, you are also required to value any differed tax assets that you can now recover because you are profitable, so that had an impact of 4 points. So that one activity of going through a review and valuing the NOL and the differed tax assets, we credited the Taft division and that lowered our tax rate by 7 points in the quarter, so again, that is a non-recurring item. We have some favorable state tax planning programs that we implemented this year, and that had a 1.6% reduction in the rate. The accrual adjustment that we discussed earlier, that we credited the Taft Division with, that had a 4% reduction in the rate, and then the rest of the difference, which is 1.5 points, is associated predominantly with the mix of where we earned our income and the area that has some lower effected tax rates. So that takes the tax rate from 38 to 23%, there’s quite a few numbers in there. On the year-to-date, it takes it from 38 to 33%, when we go from 03 to 04. When we step back and look at it, though, we do feel that 36% is a normal tax rate if we are not valuing NOLs and running some of those adjustments through our division.

So, when we look at our earnings from Continuing Ops, again Flax at $9.8 million, excluding the Radiant charge, it would have been $13.4 million, or an increase of 36%. On a full year basis, our earnings had an increase of 43% at $52 million, versus the $48.7 million we are reporting, again, excluding that Radiant charge.

A brief comment on our discontinued operations. We booked a charge of $1.7 million in the quarter. There are two components of disc ops. First of all, we booked $800,000 after-tax charge to write off our investment in Grimace, LLC, which again, is a divestiture which will be taking place early this year, and then we had $900,000 in legal expenses associated with the California case, which we are treating as a gain contingency. We feel that we have a good chance of recovering those funds at some point, but we are taking a conservative position from an accounting standpoint and treating those as a gain contingency.

Just like to step back a minute, there’s a lot of numbers we just talked about, but how do Pat and I view the quarter, if we take a 50,000 foot view? From a continuing ops standpoint, we are reporting $0.30, and that is the GAAP accounting. If we want to add in the $0.07 of adjustments that we discussed, that takes you to $0.37. There is about $0.02 impact from the absorption hit that we took to expense the period expenses to reduce our inventory. You have to subtract 2 pennies out of the tax rate because that NOL is not going to be an ongoing piece of income for us, and then the Sobane Oxley expenses, we took $0.05 worth of hits there, and you have to think that that is a couple of pennies more than normal, that is not an ongoing rate. So what that tells us is that from kind of a normalized operating standpoint, you had a quarter that was somewhere around $0.40 per share, and again, we though that that was an important part of the message to communicate, because there is a lot of noise in these numbers this quarter.

Just one other brief comment if I could. The cash flows were very strong. Those of you who have been following us for a while know that we have a lot of seasonality in our cash flow, and the 4th quarter tends to be a strong cash producing quarter. What happened, we had a $36 million of free cash flow in the quarter, that gives us $12 million on the year-to-date basis. The major contributors to the cash flow in the quarter was a reduction in inventory of approximately $10 million. Accounts receivable had a decrease of about $16 million, and other changes in working capital predominantly in Accounts Payable contributed about $5 million, so again, a strong cash flow quarter, predominantly because of improved working capital.

So those are our kind of detailed comments, and at this point in time, Pat and I would be happy to answer any questions.

Thank you sir. [OPERATOR INSTRUCTIONS]. Our first question comes from the line of Ian Fletcher of Friedman, Billings, Ramsey. Please proceed.

The question on the absorption issue you brought up. You say its $0.02 that you EPS. Is that roughly 50 basis points on the margin line?

Yes, it would be close to that. The revenue was 220, so 1% of that is about 2 million, 2.2, so that is a correct statement.

Okay and with all the noise do have a sense as to what you think the normalized sort of operating margin was for the quarter.

Let’s see. Let me look at something here. I am looking at, well if you back out the Radiant charge and the restructuring it puts you at about 10%. So, you would have to back off about $1 million dollars, no excuse me about $500,000 from this. So, I think you are looking at in the mid nines to high nines. I don’t have the exact figure calculated.

Right and going forward through this year you would expect that to improve obviously. And, on the restructuring charges for you manufacturing consolidation what do expect those numbers to be in 2005 or is that generally complete at this point.

Well we haven’t disclosed that yet. We are in the process of finalizing our business plan and when we have that finalized we will disclose that but I — we are looking at some numbers but we don’t have them final yet.

You note in your release that you are not yet complete with your assessment. Can you talk about that a little bit and what the timeline is for when you think that will complete and what the implications would be for a material weakness.

Hey Bill, let me answer this and then you can add to it.

Pat O’Keefe: We are in the process and during that process we have identified a number of, what are considered to be significant deficiencies. For example, one of them is the fact that we went back and reviewed this contract on radiant heat waves and determined that we had incorrectly accounted for that as purchase price rather than as expense. So, it is something we discovered because of the enhanced environment that we had put in place. So, additional controls were put in place but it clearly represents a significant deficiency in terms of the fact that we probably should have identified that earlier than we did rather than at this point and time.

There are other significant deficiency. The process that we are going through is you need to evaluate the significant deficiency in terms of whether they individually or collectively amount to a material weakness. The reason we made the statement we did is because the numbers that we are coming out with aren’t going to be signed off by our auditors until probably March 13th. Phil is that about correct.

Yeah that is about right, yeah.

Pat O’Keefe: So we are seeing here — We know where we have a number of significant deficiencies at this point and time. There might be one or more additional identified between today and the 13th when the auditors sign off and until we get to that date we really don’t have the ability to determine whether collectively these could result in a material weakness. I think if you look at Watts in general we probably have a more complex process of trying to comply with Sarbanes-Oxley because of the fact that we are a company that was put together through a number of acquisitions and as a result, we are a number of different computer systems and a number of different accounting systems. For example, Europe is pretty much a fairly good size operating unit on its own. North America tends to be on one operating system but the results of that is from complex issues when it comes to implementing Sarbanes-Oxley.

The reason we put that statement in is because we have this gap between reporting our numbers and when the auditors are going to sign off. Do you want to add anything to that Bill?

I think that we look at what we are doing from the Sarbanes standpoint. We are doing what we feel is about 12 mini Sarbanes inside a lot because of the diverse operating systems and what not. So, it is a very complex project, more complex than most companies and that is why we put that note in the press release just to give a sense of caution. The auditors aren’t going to position to finalize until the very last minute. We have to file our K on March 15th. Then they will let us know their opinion a day or two before that.

If there were material problems, you would have it on that timeline, March 13th?

That is right.

Are the issues that you are looking at more on the operational control side or are they accounting related?

I think you have kind of a mixture there because basically we have always tried to present our numbers and calculate our numbers on a very conservative basis and value our assets conservatively and try to err on the side of too much disclosure. So, we don’t have those types of problems, issues. We have issues that are more related to allowing our accounting system just to catch up with the growth of the company. And we are not thinking that there are any areas in our numbers that haven’t been flushed out but Sarbanes sets such a hard standard that if there is even a remote possibility of an error they consider it a significant deficiency. So, it is like trying to prove a negative sometimes. It is very difficult.

So we have made a big investment in the company over the past 12 months. We have upgraded our staff. We are going to continue to upgrade the staff. So, we are committed to making sure that we are a company with the best practices as possible in this area.

Pat O’Keefe: Okay one other thing you need to understand is the adjustments that we are taking in the 4th quarter are a direct result of us putting additional control procedures in place. So, for example if we were in fact to look at the radiant contract, we want back and looked at other accrual adjustments etc. So, these are adjustments that are coming out of an enhanced control environment that we have created here.

So Sarbanes-Oxley within Watts is working in that we have embellished on our control structure and as a result we are making some minor adjustments. You know none of which — you can see that in total these aren’t substantial adjustments. They end up being .07 cents a share.

Our next question comes from the line of David Smith of Smith Barney, please proceed.

I am just wondering if we could dig a little deeper under the gross margin issue. You know stripping away the several one times issues that seem to be hitting your operating margin number but just really looking at the absorption issue and really kind of drilling down maybe into what you see in ’05 and on the gross margin side. And I know that the low cost sourcing strategy is going to play into that but if you could maybe just talk around where you see gross margins playing out in ’05 and kind of talk maybe about where channel inventories are. It sounds like you turned back on those with this production cutoff, but where we see things moving as we go into ’05 there.

Pat O’Keefe: Yeah let me make some comments in terms of; if you look at the 4th quarter you have the absorption issue but you also have something else, you have the mix. If you look at the numbers the numbers in our retail sector is substantially less profitable than our commercial sector, as an example. The fact that we had such a strong quarter from the retail point of view significantly influenced those numbers as well as the lack of absorption because of a hold back in our production schedule.

So within the quarter you have the mix and you have the absorption hitting you in the same quarter.

Got you.

Pat O’Keefe: Okay. When you look forward, we don’t make predictions but let’s just talk about something that could influence the number. One is that the 4th quarter, from my point of view was sort of a flat spot in the development of an increase in the commercial market space. I think we talked about this on the last conference call. We were concerned that the growth rate in the commercial market place seemed to have hit a little spot that flattened out in anticipation of determining who was going to be the President of the United States. That is in fact what I think we saw.

We saw the commercial place; the growth in the commercial market place had a flat spot in it. I think it is going to continue to grow and we are going to see expansion, which should have a substantial impact on our margins going forward. You take that plus our sourcing programs and we are counting on those two things to basically help us boaster our margins as we go forward and those are the two factors that I would point out.

What do see then on the mix side? I guess retail is sort of unusual this quarter isn’t it?

Pat O’Keefe: Yeah I think you are going to go back to a more normalized mix. If you take the mix for the whole year that is probably a better mix to use in some kind of modeling than it is to use the 4th quarter. The 4th quarter was an unusual mix.

I think we had three major product launches into the retail sector. I would also say that if I were to look forward I would say we go back to our estimate that we look at retail as sort of a high single digit, low double digit growth opportunity for us in the near term.

Okay.

Pat O’Keefe: So, and then we grow about 21% in this quarter. So double the average rate in this particular quarter. Good things happen. You know we introduced a number of new products, we were awarded the vendor of the year again at Home Depot. There was a lot of good things happening in the retail sector. They are all good but the margins in that business because of the commodity nature of the products we sell to those accounts is just lower.

What DIY then is percentage of the total sales in the quarter and then for the year?

I don’t have the exact percentages Dave, but the DIY would be — Well let’s see DIY was $40 million in the quarter so that is about 18% and then, let’s see year-to-date, just looking up the number here. Year-to-date would be, it is about 18% in the quarter end in the year but you know when you are doing somebody’s rollouts, okay, you have some inefficiency’s involved there and sometimes you are giving a little bit of a discount on that stuff as you roll it out. So the mix does, that high activity level when you have a 21% growth like that, does affect the margin. Okay for the quarter.

Just in the last three months. You mentioned new products a bunch of times, can you talk maybe around what percentage of total sales were new products in this quarter and where you see that in ’05.

Pat O’Keefe: Well I don’t have a new product report calculated yet but I mean the products that we have that we rolled out in the retail with the hot water recirculating pump, the pre soldered copper fitting line, and the hot water heater accessory kit, and those are going to be somewhere around $4 million.

Okay.

Pat O’Keefe: Rough, that is a rough estimate.

And they are kind of the average margin or are they slightly above.

Pat O’Keefe: Those would be, well because they are going through a rollout they are going to be slightly below the average.

Right.

They are expected to be pretty normal though when the rollout is complete.

Our next question comes from the line of Jeff Hammond from KeyBanc Capital Markets, please proceed.

I guess to go back to the absorption issue. If I look at inventory levels in the 4th quarter relative to the 3rd it doesn’t look like a whole lot of change, actually it looks like it is just down slightly. I want to get an understand of what period of time, because I know you have been working on trying to get inventories down, but you have that absorption issue kind of lingering.

Well if you are looking at the balance sheet Jeff it is tough to compare because you have foreign exchange and all that in that number. If you strip out the foreign exchange from an operating standpoint, you have a $10 million reduction in inventory. Okay so you might not be seeing that, just comparing it.

If I look at ’05 you expect inventories to kind of hold the line, go down from here, giving something of the things that you are working on.

Well I am not sure we are ready to forecast our inventory levels at this point. What we are doing right now is we are really focusing the organization on inventory management, okay. At the same time we have a lot of opportunities for additional profits and programs if you will. Some it if is related to sort things, changing the way we distribute and procure material from China etc. that will put some pressure on inventory levels. So, we have our senior logistic and manufacturing people going through that now and we are asking them to make this a major focus. So, I don’t want to give you a number because I am just not ready to do that but it is a major focus for us and well feel that we have some improvements in our inventory levels that can be achieved and we are going to do our best to get them.

Okay.

Pat O’Keefe: One other comment I want to make about inventory, you can look at inventory from a number of different points of view. One of the ways we look at them is kind of turn basis. The other way we look at them is a gross margin return on inventory. And when you look at them from a gross margin return on inventory basis in 2004 the process of doubling up on inventory that was coming in from Asia was a good move for us because we had inventories available when the market —. The market last year was an awkward market. You know one quarter you would have substantial movement in commercial activity and in the next quarter you would have a flat spot.

But I really do think from a gross margin return on inventory we did very well because we had inventory available fulfill customer requirements when our competitors did not have it. So, you can look at inventory in terms of saying, our inventory is high than we would like it to be but strategically it was a valuable resource to have in place last year.

So, that is why we are not willing to committee in terms of where we are going to end up on this number because to a certain extent we believe that we were beneficiaries of economic value drive by having higher than normal inventory last year.

I guess I am just trying to get a sense of the time frame where perhaps you under produce demand to kind of work those inventories back down.

It was all 4th quarter. Going into 3rd quarter we were still running pretty hard and then we made a severe correction. I wouldn’t consider it to be a severe correction in the 4th quarter. It is probably going to bounce back and we are not going to be operating at those same levels. You know depending on how demand kicks out here going into the spring we are probably going to see some what of a correction to that where our manufacturing variances will come back to more of a normalized basis.

Then the wholesale side, it looks like organic revenues were up 11% and I think you mentioned the back core prevention, the radiant heat, but I guess help me understand the 11% organic growth versus the commercial being flat commentary. I mean was that all residential or all market share gain.

Pat O’Keefe: A lot of that was in our backlog coming into the quarter and then when I talk about the flat spot I talk about incoming order rate. So what you saw is a little bit of that was in our backlog coming into the quarter. Coming into the — The 3rd quarter was a pretty good quarter in terms of the way I see the commercial market place. The 4th quarter showed a little bit of a breather in the commercial market space. But I mean those numbers are still good numbers. And we are believing, it is our belief at the current time that we are going to see continued growth in the commercial market space as we go forward in 2005 and 2006.

Okay and then Bill I don’t know if I missed this. Did you quantify what your Sarbanes-Oxley I guess direct or indirect was in ’04 and then perhaps talk about what the continuing portion of the expense is our any added cost to kind of bolster your internal controls going forward.

Sarbanes in the quarter was 3 million and for the full year it was 6 million and as we drove forward, I would estimate that we would have a slight reduction in sort of Sarbanes related expenses. It will be composed a little bit differently. We think and hope that our [inaudible] fee from the auditors will be done a lot more efficiently and effectively. So we will have a pickup there but we are going to have to invest in some staff to comply so that will offset some of the other savings. I think what you will see is a number that is spread a lot more evenly over the course of the year as apposed to this big choppiness we had particularly at the last half of the year. So I think it would be a slight reduction Jeff.

Okay. And then finally —

Pat O’Keefe I am stopping this Jeff just so you know, is because half of the detail requirements for Sarbanes-Oxley weren’t really released until late into the year. So, I think everybody had a problem with back ended activities.

Sure. On the, I guess the accounting charge, the 5.3 million. Am I assuming correct that all would hit the North American business?

Yes.

Our next question comes from the line of Stuart Sharp of Standard and Poors Equities, please proceed.

Most of my questions on inventory have been answered but could you give a little perspective on the areas of acquisitions that you would be looking at and free cash flow for ’05.

Pat O’Keefe: Yeah and let me cover the acquisition side and then Bill will cover the cash flow part of it. We, at the moment, have a pretty active pipeline of potential acquisitions. Some of those acquisitions are typical bolt down acquisitions to existing business units that we already have and some of them are expansions into the water filtration, water purification market place. We are also looking at, in somewhat related, but the instrumentation portion of the water treatment, water purification market as well. We recently acquired a company called HF Scientific. We look at that as sort of sticking our toe in the water on the instrumentation side of the business as well. At the moment we are not having trouble with finding activity in terms of acquisitions. So, we think our pipeline is fairly robust at the moment.

And Stuart on the cash flow, you know one big driver of that obviously is our inventory levels. So, Pat and I will be pushing all of our managers for improved performance there. With that being said I don’t have an exact promise from them, forecast from them yet but I would expect that cash flow to be equal or slightly more than they have been this year.

Up slightly from —

Yeah, I mean I am — We still had a net growth in inventory for the course of the year but we should have an improvement in our tax roles in ’05. I am not expecting inventories will grow at the rate they did this year. We are hopeful for much, much better performance. So short of having a definitive answer on inventory at this point and time I am expecting to have kind of a worse cash scenario would be cash flow equal to this year but realistically we are going to be pushing from much improved performance on inventory. So we should have you know that air free [ph] cash flow numbers. But I can’t give you a forecast yet.

According to the Institutional Shareholder Services, which ranks companies based on corporate [revenues] practices. You ranked well below average according to there industry group and the main reason is, well two of the categories that you ranked low on was auditing and take over defensives. And especially with some of the areas that you discussed the looking into for acquisitions that might be something to think about as far as GE acquiring Osmotics and an so forth. How do you feel about corporate governance?

Pat O’Keefe: When you say the issues that they are pointing out in terms of take over defense. I mean we basically, at this point and time, we have — you know first of all you have significant shareholders, right. Who have both the Gabelli Group and the Horn family who are significant shareholder, right. We don’t have traditional other kind of things that would really be an inhibitor for somebody to look at us. I mean it is really a decision on the part of the shareholder in terms of if someone where to approach us.

In terms of the other things in the corporate governance. You know I think a lot of the things we were ranked low on had been corrected. For example we had an affiliated insider on our audit committee and on our compensation committee and he has stepped off of those committees. And we have an affiliated insider as a director only not on the committees. So we made a number of changes to enhance or corporate governance scores as ISS views them. And you might want to make some comments on this.

Yes. We made several changes in the fall of 2004 and I believe we are know above the 80th percentile in both of the industries that we get ranked in. I don’t have the exact percentages with me right now but I believe we are about in the 80th percentile in both and it has been close to the 90th percentile in one of them.

Pat O’Keefe: And those are very recent changes Philip told you. I don’t know if you have the most recent information on that.

Not actually —

We have reacted to that to the extent we can and the scores have gone up quite a bit as Ken says.

Pat O’Keefe: The one thing I guess that isn’t changing Stuart that seems to be a problem with ISS is that we have a two tiered structure, an AD stock, and that has been in place since the day we went public. We have addressed a number of the other issues and the other concerns that ISS had and I think we are devoted to increasing our corporate governance score because we think it is important that we be perceived and the way we act is important and the way we are perceived is important. But I think the one thing that they are hung up on is really the AD structure. They don’t like the AD structure under the ISS guidelines.

Our next question comes from the line of Rich Drossy of Morgan Joseph, please proceed.

You have covered most items but I am still not 100% clear on this 11 cent charge. You made the acquisition in 2000.

Yes.

You were capitalizing the year now.

Yes.

And you have moved to an expensing of the year now. But why did you take it all in the 4th quarter? Why don’t you go back and spread it over that historic period? Just from an accounting standpoint obviously.

Pat O’Keefe: Richard let me just explain what had happened. The way you do a typical earn out is that the earn out is capitalized at the time the payment is made. While the payment is still uncertain and it is not necessarily estimable [ph] you don’t do —

Okay, all right, that is what I thought.

Pat O’Keefe: And what we were planning on doing is capitalizing this. We paid roughly, Bill help me with these numbers, but we paid a down payment of roughly $3 million plus an earn out.

Right.

Pat O’Keefe: Okay the earn out, because the business has been so successful is turning out to be quite substantial, which if you look at the numbers I am very happy with the acquisition whether you capitalize it or you —

Right, right.

Pat O’Keefe: It doesn’t make any difference to me because if it is super acquisition the management team is highly motivated. The issues that trigged it being expense versus being capitalized is the fact that we typically, in all of our earn outs that we have incurred, we have done several of them over the years. We do not tie it to employment. This particular one is tied to employment. When you tie it to employment, the rules say that you need to expense it.

Okay.

Pat O’Keefe: You can’t capitalize it if you have tied the requirement —

Got you.

Pat O’Keefe: For ongoing employment. So when we realized the error that we had made we simply took the charge. Now the reason we didn’t go back and do any prior periods is because it is immaterial to all those periods. If you were to look at the impact on all those periods, which we did, at some place between a half a penny and a penny per quarter for each quarter over the last 12 quarters, or something like.

Okay.

Pat O’Keefe: So it is immaterial to every single quarter. So we elected to simply take the charge, and make the disclosure, and book it all in the 4th quarter.

And you will be probably booking a ten-year quarter over the next three quarters?

Pat O’Keefe: Yeah. If we hit forecast, which we are expected to hit. The business plan that we have for that business unit, it will be one penny per quarter over the next three quarters and the pay out will occur roughly September 30th of next year.

All right. Going back to mix you mentioned that you had these rollouts that impacted margins. Going forward what do we have in terms, if any, product rollout so that would be material and might have a margin impact in ’05.

Pat O’Keefe: That is a good question. We do have a number of them coming up. For example, I won’t tell you the customer but we have a product line, which is water connectors, which are these flexible connectors that connect a faucet to the supply line. And we have been successful an we have been told recently that we would be awarded that business in several major retail accounts. So they will be ongoing. They come in lumps though and for whatever reason, I am not sure why this happens but it almost always happens. The 4th quarter appears to be a period where they do a lot of rollouts and I think they do it because of traffic through there stores is higher at the holiday time. So buyers are pushing hard to get new products in the store where people can make an impulse buy. I think that is what has happened to us in the 4th quarter is the timing of these things. Although I will tell you right now in the process of several rollouts here in the first quarter and I expect we will have one or two rollouts in the second quarter.

Okay and just one final thing. Europe, very modest organic growth, obviously function of their economic situation. You have been making progress in Germany as you look out in ’05 is there a glimmer of hope that organic growth can get a bit healthier.

Pat O’Keefe: Well that is interesting enough. I have a trip planned here in the next couple of weeks to Europe.

((____)) In the next couple of weeks to Europe and that is the issue of our discussion, whether we believe we can see some hope. You have to remember, we’ve been operating for essentially 24 months now, in a bleak environment in Europe. We’ve been fortunate enough in that we put together a strategy with the OEMs, although the OEMs didn’t deliver very well in the 4th quarter of this year. But overall, if you look at last year and you look at the year before, our growth has primarily come from the growth in the OEM as a result of a strategy that specifically target OEMs, while the wholesale market was very soft. So now, what we are seeing, interestingly enough, is we are seeing some improvement in the wholesale market, but the 4th quarter showed some deterioration just because of buying patterns really from the OEMs. I think there is an inventory adjustment in those numbers in the 4th quarter.

Our next question comes from the line of Jeff Burke of Robert W. Beard. Please proceed.

Good morning. If you could just spend a quick moment on raw materials. You noticed some price increases in your comments. Could you just give us a sense of how effective those have been in offsetting the inflation you have faced, and as you look out to 05, do you expect things to get materially better, worse or stay about the same?

About 2 million, 2.2, so that is a correct statement.

Okay and with all the noise do have a sense as to what you think the normalized sort of operating margin was for the quarter.

Let’s see. Let me look at something here. I am looking at, well if you back out the Radiant charge and the restructuring it puts you at about 10%. So, you would have to back off about $1 million dollars, no excuse me about $500,000 from this. So, I think you are looking at in the mid nines to high nines. I don’t have the exact figure calculated.

Right and going forward through this year you would expect that to improve obviously. And, on the restructuring charges for you manufacturing consolidation what do expect those numbers to be in 2005 or is that generally complete at this point.

Well we haven’t disclosed that yet. We are in the process of finalizing our business plan and when we have that finalized we will disclose that but I — we are looking at some numbers but we don’t have them final yet.

You note in your release that you are not yet complete with your assessment. Can you talk about that a little bit and what the timeline is for when you think that will complete and what the implications would be for a material weakness.

Hey Bill, let me answer this and then you can add to it.

Pat O’Keefe: We are in the process and during that process we have identified a number of, what are considered to be significant deficiencies. For example, one of them is the fact that we went back and reviewed this contract on radiant heat waves and determined that we had incorrectly accounted for that as purchase price rather than as expense. So, it is something we discovered because of the enhanced environment that we had put in place. So, additional controls were put in place but it clearly represents a significant deficiency in terms of the fact that we probably should have identified that earlier than we did rather than at this point and time.

There are other significant deficiency. The process that we are going through is you need to evaluate the significant deficiency in terms of whether they individually or collectively amount to a material weakness. The reason we made the statement we did is because the numbers that we are coming out with aren’t going to be signed off by our auditors until probably March 13th. Phil is that about correct.

Yeah that is about right, yeah.

Pat O’Keefe: So we are seeing here — We know where we have a number of significant deficiencies at this point and time. There might be one or more additional identified between today and the 13th when the auditors sign off and until we get to that date we really don’t have the ability to determine whether collectively these could result in a material weakness. I think if you look at Watts in general we probably have a more complex process of trying to comply with Sarbanes-Oxley because of the fact that we are a company that was put together through a number of acquisitions and as a result, we are a number of different computer systems and a number of different accounting systems. For example, Europe is pretty much a fairly good size operating unit on its own. North America tends to be on one operating system but the results of that is from complex issues when it comes to implementing Sarbanes-Oxley.

The reason we put that statement in is because we have this gap between reporting our numbers and when the auditors are going to sign off. Do you want to add anything to that Bill?

I think that we look at what we are doing from the Sarbanes standpoint. We are doing what we feel is about 12 mini Sarbanes inside a lot because of the diverse operating systems and what not. So, it is a very complex project, more complex than most companies and that is why we put that note in the press release just to give a sense of caution. The auditors aren’t going to position to finalize until the very last minute. We have to file our K on March 15th. Then they will let us know their opinion a day or two before that.

If there were material problems, you would have it on that timeline, March 13th?

That is right.

Are the issues that you are looking at more on the operational control side or are they accounting related?

I think you have kind of a mixture there because basically we have always tried to present our numbers and calculate our numbers on a very conservative basis and value our assets conservatively and try to err on the side of too much disclosure. So, we don’t have those types of problems, issues. We have issues that are more related to allowing our accounting system just to catch up with the growth of the company. And we are not thinking that there are any areas in our numbers that haven’t been flushed out but Sarbanes sets such a hard standard that if there is even a remote possibility of an error they consider it a significant deficiency. So, it is like trying to prove a negative sometimes. It is very difficult.

So we have made a big investment in the company over the past 12 months. We have upgraded our staff. We are going to continue to upgrade the staff. So, we are committed to making sure that we are a company with the best practices as possible in this area.

Pat O’Keefe: Okay one other thing you need to understand is the adjustments that we are taking in the 4th quarter are a direct result of us putting additional control procedures in place. So, for example if we were in fact to look at the radiant contract, we want back and looked at other accrual adjustments etc. So, these are adjustments that are coming out of an enhanced control environment that we have created here.

So Sarbanes-Oxley within Watts is working in that we have embellished on our control structure and as a result we are making some minor adjustments. You know none of which — you can see that in total these aren’t substantial adjustments. They end up being .07 cents a share.

Our next question comes from the line of David Smith of Smith Barney, please proceed.

I am just wondering if we could dig a little deeper under the gross margin issue. You know stripping away the several one times issues that seem to be hitting your operating margin number but just really looking at the absorption issue and really kind of drilling down maybe into what you see in ’05 and on the gross margin side. And I know that the low cost sourcing strategy is going to play into that but if you could maybe just talk around where you see gross margins playing out in ’05 and kind of talk maybe about where channel inventories are. It sounds like you turned back on those with this production cutoff, but where we see things moving as we go into ’05 there.

Pat O’Keefe: Yeah let me make some comments in terms of; if you look at the 4th quarter you have the absorption issue but you also have something else, you have the mix. If you look at the numbers the numbers in our retail sector is substantially less profitable than our commercial sector, as an example. The fact that we had such a strong quarter from the retail point of view significantly influenced those numbers as well as the lack of absorption because of a hold back in our production schedule.

So within the quarter you have the mix and you have the absorption hitting you in the same quarter.

Got you.

Pat O’Keefe: Okay. When you look forward, we don’t make predictions but let’s just talk about something that could influence the number. One is that the 4th quarter, from my point of view was sort of a flat spot in the development of an increase in the commercial market space. I think we talked about this on the last conference call. We were concerned that the growth rate in the commercial market place seemed to have hit a little spot that flattened out in anticipation of determining who was going to be the President of the United States. That is in fact what I think we saw.

We saw the commercial place; the growth in the commercial market place had a flat spot in it. I think it is going to continue to grow and we are going to see expansion, which should have a substantial impact on our margins going forward. You take that plus our sourcing programs and we are counting on those two things to basically help us boaster our margins as we go forward and those are the two factors that I would point out.

What do see then on the mix side? I guess retail is sort of unusual this quarter isn’t it?

Pat O’Keefe: Yeah I think you are going to go back to a more normalized mix. If you take the mix for the whole year that is probably a better mix to use in some kind of modeling than it is to use the 4th quarter. The 4th quarter was an unusual mix.

I think we had three major product launches into the retail sector. I would also say that if I were to look forward I would say we go back to our estimate that we look at retail as sort of a high single digit, low double digit growth opportunity for us in the near term.

Okay.

Pat O’Keefe: So, and then we grow about 21% in this quarter. So double the average rate in this particular quarter. Good things happen. You know we introduced a number of new products, we were awarded the vendor of the year again at Home Depot. There was a lot of good things happening in the retail sector. They are all good but the margins in that business because of the commodity nature of the products we sell to those accounts is just lower.

What DIY then is percentage of the total sales in the quarter and then for the year?

I don’t have the exact percentages Dave, but the DIY would be — Well let’s see DIY was $40 million in the quarter so that is about 18% and then, let’s see year-to-date, just looking up the number here. Year-to-date would be, it is about 18% in the quarter end in the year but you know when you are doing somebody’s rollouts, okay, you have some inefficiency’s involved there and sometimes you are giving a little bit of a discount on that stuff as you roll it out. So the mix does, that high activity level when you have a 21% growth like that, does affect the margin. Okay for the quarter.

Just in the last three months. You mentioned new products a bunch of times, can you talk maybe around what percentage of total sales were new products in this quarter and where you see that in ’05.

Pat O’Keefe: Well I don’t have a new product report calculated yet but I mean the products that we have that we rolled out in the retail with the hot water recirculating pump, the pre soldered copper fitting line, and the hot water heater accessory kit, and those are going to be somewhere around $4 million.

Okay.

Pat O’Keefe: Rough, that is a rough estimate.

And they are kind of the average margin or are they slightly above.

Pat O’Keefe: Those would be, well because they are going through a rollout they are going to be slightly below the average.

Right.

They are expected to be pretty normal though when the rollout is complete.

Our next question comes from the line of Jeff Hammond from KeyBanc Capital Markets, please proceed.

I guess to go back to the absorption issue. If I look at inventory levels in the 4th quarter relative to the 3rd it doesn’t look like a whole lot of change, actually it looks like it is just down slightly. I want to get an understand of what period of time, because I know you have been working on trying to get inventories down, but you have that absorption issue kind of lingering.

Well if you are looking at the balance sheet Jeff it is tough to compare because you have foreign exchange and all that in that number. If you strip out the foreign exchange from an operating standpoint, you have a $10 million reduction in inventory. Okay so you might not be seeing that, just comparing it.

If I look at ’05 you expect inventories to kind of hold the line, go down from here, giving something of the things that you are working on.

Well I am not sure we are ready to forecast our inventory levels at this point. What we are doing right now is we are really focusing the organization on inventory management, okay. At the same time we have a lot of opportunities for additional profits and programs if you will. Some it if is related to sort things, changing the way we distribute and procure material from China etc. that will put some pressure on inventory levels. So, we have our senior logistic and manufacturing people going through that now and we are asking them to make this a major focus. So, I don’t want to give you a number because I am just not ready to do that but it is a major focus for us and well feel that we have some improvements in our inventory levels that can be achieved and we are going to do our best to get them.

Okay.

Pat O’Keefe: One other comment I want to make about inventory, you can look at inventory from a number of different points of view. One of the ways we look at them is kind of turn basis. The other way we look at them is a gross margin return on inventory. And when you look at them from a gross margin return on inventory basis in 2004 the process of doubling up on inventory that was coming in from Asia was a good move for us because we had inventories available when the market —. The market last year was an awkward market. You know one quarter you would have substantial movement in commercial activity and in the next quarter you would have a flat spot.

But I really do think from a gross margin return on inventory we did very well because we had inventory available fulfill customer requirements when our competitors did not have it. So, you can look at inventory in terms of saying, our inventory is high than we would like it to be but strategically it was a valuable resource to have in place last year.

So, that is why we are not willing to committee in terms of where we are going to end up on this number because to a certain extent we believe that we were beneficiaries of economic value drive by having higher than normal inventory last year.

I guess I am just trying to get a sense of the time frame where perhaps you under produce demand to kind of work those inventories back down.

It was all 4th quarter. Going into 3rd quarter we were still running pretty hard and then we made a severe correction. I wouldn’t consider it to be a severe correction in the 4th quarter. It is probably going to bounce back and we are not going to be operating at those same levels. You know depending on how demand kicks out here going into the spring we are probably going to see some what of a correction to that where our manufacturing variances will come back to more of a normalized basis.

Then the wholesale side, it looks like organic revenues were up 11% and I think you mentioned the back core prevention, the radiant heat, but I guess help me understand the 11% organic growth versus the commercial being flat commentary. I mean was that all residential or all market share gain.

Pat O’Keefe: A lot of that was in our backlog coming into the quarter and then when I talk about the flat spot I talk about incoming order rate. So what you saw is a little bit of that was in our backlog coming into the quarter. Coming into the — The 3rd quarter was a pretty good quarter in terms of the way I see the commercial market place. The 4th quarter showed a little bit of a breather in the commercial market space. But I mean those numbers are still good numbers. And we are believing, it is our belief at the current time that we are going to see continued growth in the commercial market space as we go forward in 2005 and 2006.

Okay and then Bill I don’t know if I missed this. Did you quantify what your Sarbanes-Oxley I guess direct or indirect was in ’04 and then perhaps talk about what the continuing portion of the expense is our any added cost to kind of bolster your internal controls going forward.

Sarbanes in the quarter was 3 million and for the full year it was 6 million and as we drove forward, I would estimate that we would have a slight reduction in sort of Sarbanes related expenses. It will be composed a little bit differently. We think and hope that our [inaudible] fee from the auditors will be done a lot more efficiently and effectively. So we will have a pickup there but we are going to have to invest in some staff to comply so that will offset some of the other savings. I think what you will see is a number that is spread a lot more evenly over the course of the year as apposed to this big choppiness we had particularly at the last half of the year. So I think it would be a slight reduction Jeff.

Okay. And then finally —

Pat O’Keefe I am stopping this Jeff just so you know, is because half of the detail requirements for Sarbanes-Oxley weren’t really released until late into the year. So, I think everybody had a problem with back ended activities.

Sure. On the, I guess the accounting charge, the 5.3 million. Am I assuming correct that all would hit the North American business?

Yes.

Our next question comes from the line of Stuart Sharp of Standard and Poors Equities, please proceed.

Most of my questions on inventory have been answered but could you give a little perspective on the areas of acquisitions that you would be looking at and free cash flow for ’05.

Pat O’Keefe: Yeah and let me cover the acquisition side and then Bill will cover the cash flow part of it. We, at the moment, have a pretty active pipeline of potential acquisitions. Some of those acquisitions are typical bolt down acquisitions to existing business units that we already have and some of them are expansions into the water filtration, water purification market place. We are also looking at, in somewhat related, but the instrumentation portion of the water treatment, water purification market as well. We recently acquired a company called HF Scientific. We look at that as sort of sticking our toe in the water on the instrumentation side of the business as well. At the moment we are not having trouble with finding activity in terms of acquisitions. So, we think our pipeline is fairly robust at the moment.

And Stuart on the cash flow, you know one big driver of that obviously is our inventory levels. So, Pat and I will be pushing all of our managers for improved performance there. With that being said I don’t have an exact promise from them, forecast from them yet but I would expect that cash flow to be equal or slightly more than they have been this year.

Up slightly from —

Yeah, I mean I am — We still had a net growth in inventory for the course of the year but we should have an improvement in our tax roles in ’05. I am not expecting inventories will grow at the rate they did this year. We are hopeful for much, much better performance. So short of having a definitive answer on inventory at this point and time I am expecting to have kind of a worse cash scenario would be cash flow equal to this year but realistically we are going to be pushing from much improved performance on inventory. So we should have you know that air free [ph] cash flow numbers. But I can’t give you a forecast yet.

According to the Institutional Shareholder Services, which ranks companies based on corporate [revenues] practices. You ranked well below average according to there industry group and the main reason is, well two of the categories that you ranked low on was auditing and take over defensives. And especially with some of the areas that you discussed the looking into for acquisitions that might be something to think about as far as GE acquiring Osmotics and an so forth. How do you feel about corporate governance?

Pat O’Keefe: When you say the issues that they are pointing out in terms of take over defense. I mean we basically, at this point and time, we have — you know first of all you have significant shareholders, right. Who have both the Gabelli Group and the Horn family who are significant shareholder, right. We don’t have traditional other kind of things that would really be an inhibitor for somebody to look at us. I mean it is really a decision on the part of the shareholder in terms of if someone where to approach us.

In terms of the other things in the corporate governance. You know I think a lot of the things we were ranked low on had been corrected. For example we had an affiliated insider on our audit committee and on our compensation committee and he has stepped off of those committees. And we have an affiliated insider as a director only not on the committees. So we made a number of changes to enhance or corporate governance scores as ISS views them. And you might want to make some comments on this.

Yes. We made several changes in the fall of 2004 and I believe we are know above the 80th percentile in both of the industries that we get ranked in. I don’t have the exact percentages with me right now but I believe we are about in the 80th percentile in both and it has been close to the 90th percentile in one of them.

Pat O’Keefe: And those are very recent changes Philip told you. I don’t know if you have the most recent information on that.

Not actually —

We have reacted to that to the extent we can and the scores have gone up quite a bit as Ken says.

Pat O’Keefe: The one thing I guess that isn’t changing Stuart that seems to be a problem with ISS is that we have a two tiered structure, an AD stock, and that has been in place since the day we went public. We have addressed a number of the other issues and the other concerns that ISS had and I think we are devoted to increasing our corporate governance score because we think it is important that we be perceived and the way we act is important and the way we are perceived is important. But I think the one thing that they are hung up on is really the AD structure. They don’t like the AD structure under the ISS guidelines.

Our next question comes from the line of Rich Drossy of Morgan Joseph, please proceed.

You have covered most items but I am still not 100% clear on this 11 cent charge. You made the acquisition in 2000.

Yes.

You were capitalizing the year now.

Yes.

And you have moved to an expensing of the year now. But why did you take it all in the 4th quarter? Why don’t you go back and spread it over that historic period? Just from an accounting standpoint obviously.

Pat O’Keefe: Richard let me just explain what had happened. The way you do a typical earn out is that the earn out is capitalized at the time the payment is made. While the payment is still uncertain and it is not necessarily estimable [ph] you don’t do —

Okay, all right, that is what I thought.

Pat O’Keefe: And what we were planning on doing is capitalizing this. We paid roughly, Bill help me with these numbers, but we paid a down payment of roughly $3 million plus an earn out.

Right.

Pat O’Keefe: Okay the earn out, because the business has been so successful is turning out to be quite substantial, which if you look at the numbers I am very happy with the acquisition whether you capitalize it or you —

Right, right.

Pat O’Keefe: It doesn’t make any difference to me because if it is super acquisition the management team is highly motivated. The issues that trigged it being expense versus being capitalized is the fact that we typically, in all of our earn outs that we have incurred, we have done several of them over the years. We do not tie it to employment. This particular one is tied to employment. When you tie it to employment, the rules say that you need to expense it.

Okay.

Pat O’Keefe: You can’t capitalize it if you have tied the requirement —

Got you.

Pat O’Keefe: For ongoing employment. So when we realized the error that we had made we simply took the charge. Now the reason we didn’t go back and do any prior periods is because it is immaterial to all those periods. If you were to look at the impact on all those periods, which we did, at some place between a half a penny and a penny per quarter for each quarter over the last 12 quarters, or something like.

Okay.

Pat O’Keefe: So it is immaterial to every single quarter. So we elected to simply take the charge, and make the disclosure, and book it all in the 4th quarter.

And you will be probably booking a ten-year quarter over the next three quarters?

Pat O’Keefe: Yeah. If we hit forecast, which we are expected to hit. The business plan that we have for that business unit, it will be one penny per quarter over the next three quarters and the pay out will occur roughly September 30th of next year.

All right. Going back to mix you mentioned that you had these rollouts that impacted margins. Going forward what do we have in terms, if any, product rollout so that would be material and might have a margin impact in ’05.

Pat O’Keefe: That is a good question. We do have a number of them coming up. For example, I won’t tell you the customer but we have a product line, which is water connectors, which are these flexible connectors that connect a faucet to the supply line. And we have been successful an we have been told recently that we would be awarded that business in several major retail accounts. So they will be ongoing. They come in lumps though and for whatever reason, I am not sure why this happens but it almost always happens. The 4th quarter appears to be a period where they do a lot of rollouts and I think they do it because of traffic through there stores is higher at the holiday time. So buyers are pushing hard to get new products in the store where people can make an impulse buy. I think that is what has happened to us in the 4th quarter is the timing of these things. Although I will tell you right now in the process of several rollouts here in the first quarter and I expect we will have one or two rollouts in the second quarter.

Okay and just one final thing. Europe, very modest organic growth, obviously function of their economic situation. You have been making progress in Germany as you look out in ’05 is there a glimmer of hope that organic growth can get a bit healthier.

Pat O’Keefe: Well that is interesting enough. I have a trip planned here in the next couple of weeks to Europe. Okay, let me just go back and first of all explain what happened throughout the year so that if anybody on the call didn’t hear this before, they hear the complete story.

Going into 2004, we saw substantial movements in raw materials, primarily copper and then we saw it in stainless steel. Later in the year we saw it in oil based products, being plastic components and things of that nature. So we reacted throughout 2004 with, I think, four different price increases throughout the year, the last one in 2004 was executed in October, which was primarily oil-based commodities pricing changes, and all of those were effective in terms of helping us maintain our margins overall.

Now, we also went out in January 05 with a price increase on a number of items, pretty much across the board. The feedback we’re getting is, for the most part, is being accepted by customers, there appears to be some competitive game playing where the competitors are deliberately not increasing the prices in an attempt to gain some short-term share. We typically don’t see a January price increase firm up, though, until you get into the volume month of March, so I’d consider the feedback we’re getting is typical feedback we hear in January and February. Demands in January and February, just because of the inclimate weather are relatively soft, and then you see wholesalers making major commitments in early March, so right now, we anticipate that we will be able to increase our prices to offset material inflation throughout 2005.

Okay, that’s great incite. One last question. You were dead-on on your assessment, there are some puzzled looks about not being able to get the revenue numbers to tie up for past periods. Are we going to get restated financial statements all at once, or will those kind of just roll in as you report quarters from here on out?

Pat O’Keefe: Bill, don’t we put that in our K?

Yes, well, when you see the K, the quarterly footnote will have that stuff taken out of it. That will be filed mid-March.

Thank you, guys.

Pat O’Keefe: The other thing you might want to look at is, I think on each one of our conference calls, we probably disclose that number on each call.

We have, and it’s in each one of our Qs, as far as the revenue goes, and you won’t see the changes on the income if that unit has essentially has broken even, so it will have a very minor impact on the profit.

[OPERATOR INSTRUCTIONS] Our next question comes from the line of Jim Funk of Gabelli and Company. Please proceed.

I’ll just keep it short. When I look at your gross margins for 2005, it seems like I shouldn’t expect any improvement till the second half, because you’re still going to go through some inventory reduction in the first half, and then I guess the mix on the retail side kind of tends to still be predominant in the first half of 05. Is that kind of a good way of looking at it?

Pat O’Keefe: We don’t make forecasts, Jimmy, you do.

Alright, that’s pretty much the thinking. The other thing is, I guess I’ll move on to your legal fees. Is there anything unusual there, (indescernible).

Pat O’Keefe: No, all the things that have happened with regard to our legal suit, the James Jones suit, have generally been positive. When the K comes out, we’ll have a detailed discussion of all of those, but really nothing new to report, Jimmy, I think we continue to grind away on that. I think all of the developments have generally been positive towards Watts, but it is ongoing litigation, it tends to be complex and uncertain. Now, the one thing you saw in this quarter is you saw the charge we took to discontinue Ops.

Right.

Pat O’Keefe: We actually believe that we have a strong case there to recover all of that money, but we’ve always taken the position all along, and we are consistent with this position, that even though we will probably recover that money, that we expense it as incurred, and then we will pick it up as an income item in a future period when the uncertainty is resolved.

Right.

Pat O’Keefe: So all of that is a continuation of a long-standing policy to expense those items as they are incurred, and then treat them as a gained contingency later on as the development of the case develops.

Okay. That’s not different from what you’ve said in the past.

Pat O’Keefe: It’s what?

It’s not any different.

Pat O’Keefe: It’s completely consistent with what we’ve done in the past, although our basis to come to a determination that we have recovered those items is improving with every court determination that is being made.

Do you think there might be some final resolution to this as you look out in the next year or so?

Pat O’Keefe: I would hope so, but I thought that three years ago, and here we are, still today. You have a plaintiff’s lawyer here who is aggressive, and who is creative, so I think we’re going to fight this thing, because we think we have a basis for our arguments, but I wouldn’t predict, Jimmy, that it would be an easy to resolve issue, nor would I predict that it would be short-term in terms of duration to resolve it.

Ladies and gentleman, this does conclude the Question and Answer portion of today’s conference call. I would like to turn the presentation back over to Mr. O’Keefe for closing remarks.

Pat O’Keefe: I just want to thank every one for joining us today. I think we did have a good quarter. I think if you look at the numbers, although there is a lot of noise in the numbers, it is generally positive, and we look forward to speaking with you in another 90 days about another good quarter as we resolve the 1st quarter here. Thank you very much for joining us.

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