Watts Water Technologies Inc (WTS) 2005 Q2 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the second quarter, 2005 Watts Water Technologies earnings conference call.

My name is Mika 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. Keith LePage, Assistant General Counsel.

Thank you.

Good afternoon.

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 Harbors 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 31, 2004.

That's filed with the Securities and Exchange Commission and other reports we may file from time to time, with the Securities and Exchange Commission.

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

While we may elect to update forward-looking statements at some point in the future, we specifically disclaim any obligation to do so.

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

Thank you, Ken.

This is Pat O'Keefe.

I just first want to tell you how we're going to run the call today.

The first thing I 'm going to do is make some opening comments.

Then i'm going to turn it over to Bill McCartney, our CFO, who will walk you through the financial details.

Then I will come back on and give you some summary comments and some comments regarding some factors that you need to consider when you are looking forward at the third and the fourth quarter.

And then we'll open up the lines for any and all questions you may have.

The first -- and these are just some general comments but if you look at the quarter, the sales increased, 10.3%, which was $21 million increase, up to a number of $228.1 million.

If you look at the six month numbers the sales increase is 13.8% which is $54.2 million increase, sales coming in at $447.2 million.

Looking at the quarter, the net income from continuing operations was flat with last year, at $14.0 million, in both 2005, and 2004.

If you look at the year-to-date numbers we're up about 5.3%, with net income from continuing operations at 26.4% this year, versus 25.1% last year.

On an earnings per share bases we came in at $0.42 for the second quarter of this year, compared to $0.43 for last year.

The most significant factor in the drop of the earnings per share was an additional 351,000 shares outstanding.

When you look at the major factors that explain the activity in the quarter and the results for the quarter, it's really four major issues.

One is that we have a difficult comparison to last year.

If you remember, last year's second quarter had a favorable impact of $900,000 pretax of sales price increase which was being matched against inventory cost that did not include higher costs, because of the use of FIFO accounting for costs of goods sold.

So there was $900,000 pretax that dropped through the P&L in the second quarter of last year, in advance of the roll in terms of the cost because of the FIFO method.

The second issue is, we really have struggled in the second quarter of 2005, to increase prices at a pace which would fully cover the continuing rise in raw material costs.

This was most acute in the retail market where customers were successful in delaying the acceptance of price increases.

We will talk a little bit later about an update on what is happening on pricing.

But this was also an issue in our OEM customer and our wholesale market as well, but to a much lesser extent.

The third issue that influences these numbers is the economic conditions in Europe.

We have relatively flat conditions, GNP in most of the western European countries are in the very low single digits. 1 or 2% in terms of economic growth during this period.

And the last is that we incurred manufacturing variances during the second quarter, due to supply chain issues with products which which we manufacture in China but are sold in North America and excess capacity in our China and North American operations.

That concludes my summary comments.

I'm going to turn it over to Bill who will walk you through the financial details and give you more color on some of the factors we talked about.

Then I will come back online and we'll answer your questions.

Bill.

Thanks, Pat.

Revenue for the quarter was up $21.2 million that's an increase of 10.3%.

The components of the growth are as follows: Organic growth was $12 million which is 5.8%; the foreign exchange rate changed, that was an increase of $2.9 million or 1.4%; and contributions from acquired companies $6.4 million, which is 3.1%.

And just as a reminder, for those of you doing the analysis here, we did divest ourselves at the very end of -- or the beginning of Q1 of this year of [Gemico LLC], and we have updated our segment information on an 8-K filed during the first quarter to help you with -- to analyze your comparisons.

So we'll look at some of the segment information now , looking at the North American revenue, North America increased $18.3 million, which is 13.2%.

So we closed out at $157.1 million.

The components of that growth, organically we grew $11.7 million which is 8.4%.

We'll talk about that in a moment, some detail there.

The foreign exchange rates inside of North America, the Canadian dollar increased -- caused an increase of $900,000, which is 7/10th of 1% and then contributions from acquired companies in North America were $5.8 million, or 4.1%.

So, again that's $18.3 million for 13.2%.

Looking at the two major markets inside of North America, first of all we have the retail.

The retail grew at 12% on the year -- excuse me on the quarter.

That's an increase of $4.5 million to $41.4 million.

The major contributors here were the continued rollout, introduction of new product into the retail space.

We are rolling out -- we are rolling out in the second quarter, which we started earlier in the year with the EZ-Sweat which is our pre-soldered copper fitting line.

We introduced our new FloodSafe water connector to True Value during the quarter.

And we have our hot water heater accessory kit as well as a new under floor electric product called warm wire.

So the increase in the retail, again -- again driven primarily by the introduction of new products, with obviously some benefit from store comps as well.

Looking at the wholesale market, wholesale closed out at $115.7 million for the quarter, that's an increase of $13.8 million, or 13.2%.

If we look at just the growth in the organic standpoint, it was 8% in the quarter.

So acquisitions contributed 5.2%.

Those acquisitions are Orion, which we acquired last year during Q2 and we only had a partial quarter so we have some portion, about half of Orion's revenue in this quarter, we consider to be acquired.

Then we have Sea Tech and HF Scientific, which we acquired at the beginning of the first quarter of this year, and then Alamo water refiners which we acquired very late in the second quarter of this year.

And those acquisitions total $5.8 million in revenue.

As Pat mentioned at the beginning of the call, it's somewhat difficult to make some comparisons this quarter, and this is where we really see the results of that difficulty.

As a reminder, at the beginning -- in the middle of the second quarter last year, we had a price increase on the wholesale market, and that resulted in approximately $900,000 of revenue achieved during the quarter last year, without the corresponding cost increases.

As a reminder, last year our wholesale growth during the second quarter was 13%, and our gross margin peaked at 36.8%.

But coming back to the second quarter of 2005, the growth -- the organic growth of 8% that we achieved was driven by fallen product lines.

We have the plumbing and the backflow up 6%.

And that's mostly a price-driven increase, because, again, we had that large unit increase last year.

So we have a very high base to compare ourselves to.

Our under floor rated heating business was very strong at 56% growth.

It closed almost $7 million in the quarter.

Again that business is driven by our PEX product line, as well as our under floor business.

Our automatic control valve line which is a small product line, but one that addresses the commercial markets, which was not part of the price increase last year -- this is a product line that we priced on a job-by-job basis, that product line increased 32% over last year's second quarter.

So, again, when we look at the -- some of the commercially driven product lines that were not in the price increase last year, they behaved quite well in the quarter and made a good contribution for us.

Our acquisitions that were in for the entire quarter, Sea Tech and HF are tracking well and as expected.

The Canadian market was up 15% in local currency.

Again, not as significantly impacted by some of these pricing issues, as I just mentioned.

The end markets in Canada are behaving well.

Again, driven by the -- the under floor rating market, as well as the PEX market.

We had a good quarter in the drain market, particularly in the Toronto area and there's some new codes regarding mixing valves, which also increased our revenue in Canada as well.

So Canada had a very good contribution for us.

Looking at Europe, total sales increased by $2.6 million, which is 4.4%.

And, again, on the press release you will see that total revenue was $63.6 million.

Looking at the components of the change, organically we were up $100,000 so that's essentially 0%, flat revenue there from an organic standpoint.

The change in the Euro versus last year contributed $1.9 million of revenue, which is 3.2%, and acquisitions were $600,000 which is 1.1%.

That's the acquisition of Electro Controls which was done very late in the second quarter.

So, when we look at Europe, as Pat mentioned, the end markets are soft, and it's more difficult for our European companies, as well as any of the companies in Europe to export due to the higher foreign exchange rate.

But we're also seeing inside of Europe, some of our larger, boiler OEM customers are experiencing the same issue where they have been pushing out orders and decreasing some orders.

So we're seeing that.

And that's the result of, again, the poor economy in Europe.

So what we're seeing, on our business is a mix away from OEM, and a little bit towards the wholesale market.

And we do have slightly low gross margins on the wholesale side.

So, again that puts a little bit of pressure on us as well.

But we feel we have gained some market share in the wholesale market in Germany.

The wholesale market in France was up slightly and that's because of our ability to be a little bit more effective, than competitors in that market with cost-reduced products coming out of Tunisia.

And we've been quite aggressive expanding into eastern Europe, into that wholesale market, with new sales offices and salespeople on the street.

And we also feel that we're gaining market share in the Nordic countries.

The acquisition we did a couple years ago of Adeb, part of Adeb is a distributor up in Sweden.

And as we kind of change out their product line and put more and more of our product in, we have been gaining market share there.

We are also in the process of expanding our Bulgarian and Tunisian factories.

The low cost strategy in Europe seems to be quite successful for us, so we're committed to that.

And at the end of the quarter we completed two acquisitions in Europe, Electro Controls, which had a small contribution to revenue and then Microflex, which we closed really the first day of the third quarter.

Looking at the China segment, revenue, trade revenue was up just a little bit from 7.2 to $7.4 million.

Looking at the components there, we saw the water works side, the water works/commercial side decline about 7%.

And we addressed that market through some of the smaller size of butterfly valves and we did see some new entrants into that market, recently with some additional competition.

So we are addressing that now.

Our more commodity-orientated sales or product lines were up 13% in the quarter.

And our intercompany activity which you don't see in these numbers was up 80%.

This is -- we were starting to see a lot of these products that we're rolling out into the retail, being manufactured in China, and being sold across, into the North American markets.

Looking at the gross margin in the quarter, the gross margin, again, was down.

As you recall, we peaked.

We hit a higher -- the highest gross margin last year at 36.5% in Q2, versus 35.6% in this year's Q2.

The main issue here really is -- as Pat mentioned, really, the $900,000 we had in revenue last year, without the corresponding cost increases, because the FIFO inventory.

We also have issues with some of the pricing and cost increases inside of North American market.

We see copper and oil at record levels here, and we experienced some manufacturing inefficiencies, as we are trying to ensure delivery to our customers, as we bring some of these products from overseas. we saw some delays there from international deliveries and we made a decision to manufacture those in the United States to ensure delivery and that caused some unfavorable manufacturing variances.

The gross margin in Europe was up slightly,about one point, again the result of our low-cost country sourcing programs and some of the product rationalization that we have done.

The Chinese gross margin was up as a result of increasing plant capacity utilization as a result of rollouts.

So our new plant in southern China is being much more heavily utilized than it has in the past.

The SG&A was up $6 million in the quarter.

The primary contributors, acquisitions were about $1.9 million, foreign exchange rate was about $600,000, and then we had some -- the earn out of $500,000, which is the -- you recall we have an earn out at Watts Radiant which we have to expense that.

We did not have that last year and we will have that earn out through the end of August.

So in the third quarter we have two months of earn out expense.

We also had some resets and buybacks that we accrued or expensed as a result of some of the rollouts we are involved with now.

So the operating earnings declined by $500,000.

Again, the result of the issues that Pat mentioned at the beginning of the call, some of the commodity cost issues, the pricing, and manufacturing inefficiencies.

The tax rate was up slightly from 36 last year, to 36.4%, and that is the result of where -- the mix of earnings, if you will, in terms of what countries we earned -- made our income in, and those countries have a slightly higher tax rate.

So it's really just as a result of the mix of earnings.

So with that, I will turn it back to Pat for some additional commentary.

The first thing I want to do is remind you we don't give specific earnings per share guidance, but I want to talk to you about some of the items you need to take into consideration as your looking forward at the third and fourth quarter.

First one is that retail pricing is slowly improving.

We have an agreement from several retailers with regard to price increases; however, those price increases are scheduled to take effect on August 15th.

So we'll have -- those price increases will only be in effect for half of the third quarter, and will be in effect for all of the fourth quarter.

We've also sent our sales and marking team on retail sites out to speak with several other customers where we are trying to negotiate price improvement as well.

In terms of the retail market, there are a number of positive rollouts that are coming here in the third quarter.

One is the rollout of the Sea Tech quick connect fitting to several major retailers.

The second is the rollout of the flood phase water connector.

We expect that in the third quarter, you will have sort of positive, in terms of rollout, in terms of revenue, but we will also see significant cost in terms of executing against that.

So when you do a rollout, you have the cost of doing the rollout, the resets of the stores, and things like that offset by the additional revenue during the period.

During the fourth quarter we expect most of that rollout and most of those rollout expenses to have been behind us.

So we're looking at improved sales in the retail sector during the fourth quarter without commiserate rollout costs.

We are optimistic about our outlook on the commercial marketplace.

If you look at some of the product lines that are sort of foretellers of what is to come in the next couple of months we're doing very well in drains, we're doing very well in control valves and things that are going into the commercial marketplace.

They typically go in before many of the other products.

So we, at this point in time, feel good about the continued improvement in the commercial marketplace.

When -- the other factor that you want to take into account is that there have been $43 million worth of acquisitions from the beginning of the year, HF Scientific, Sea Tech, Alamo, Electro Controls and Microflex, and Savard.

Totaling $43 million in total.

So that should make a positive contribution to sales and earnings during the third and the fourth quarter.

On the con side, I want to point out that we still believe the economy in Europe will remain sluggish.

The mix that we saw here in the second quarter, where it is skewed away from OEMs and toward wholesale we expect to continue.

We expect the competitive conditions to remain essentially the same as they are in this quarter, where people are scratching at each other for additional volume.

And the last issue I think that we will continue to struggle with is increase in fluctuating copper prices and oil-related products, particularly oil-based plastics.

A small issue, but not a big one, is the revaluation of the RMB, and that we believe will have a relatively minor negative effect on us during this third and fourth quarter.

That concludes my comments, operator, if you will open up the lines we will accept questions at this point.

[OPERATOR INSTRUCTIONS] Our first question comes from the line of David Smith of Smith Barney.

Please proceed.

Good afternoon, guys.

Hi, Dave.

Can you talk about some of the offshoring benefits?

You mentioned during the call, China, Tunisia, and Bulgaria.

But can you just get to the bottom of the benefits, maybe you have seen in the first half of the year.

Is it evident in the margins or is most of it being consumed by higher costs?

Well, we are seeing -- I mean, there's definitely -- let me put it this way when we go over to these low-cost countries, Dave, we typically see cost reductions of, , 20 to 30%.

Okay?

In terms of units, manufacturing cost reductions.

So we did see a large benefit last year in our numbers.

And we have seen some benefit this year, but what we're seeing this year really is some of that benefit is lost, if you will, because of this runup in commodities.

So we haven't seen as much of that benefit as we have in the past.

So -- and some of the benefits were offset -- as we mentioned, when we had some of these negative, manufacturing variances, because we had some manufacturing issues and we made the decision not to interrupt customer delivery so we manufactured them here in the U.S.

Well, can you touch on then -- I know you talked about $100 million in sourcing from low-cost countries and I think you said $175 this year. "A" is that still on track?

And "B" can you quantify for us the the net positive margin benefit last year and what you think it might be this year?

Well, as far as the volume of purchases, I think it will be still close to the 175.

I mean a lot of these rollouts we're talking about in -- coming in the next couple of quarters, all that stuff is manufacturing in Asia.

And that will be a net contributor to the bottom line, we believe, at this point.

So in terms of an actual number this year, I'm not really prepared to give you a number on that right at this call.

We can certainly look at that and try to quantify it a little bit more than we have, but --

Okay.

The program is still very viable and we feel committed to it.

We are still looking at expanding into these areas.

I mean, if you look at, for instance, the European gross margin was up a full point over last year.

And significant portion of that is due to this low cost manufacturing coming out of Tunisia.

Okay, then I guess if I look at the rise in material costs, it sounds like, especially in North America, that's overwhelming a lot of the benefits would you say?

I would say during the second quarter, that was clearly true.

If I look at these items -- and it sounds specifically like copper and oil, can you dig a little deeper into maybe how much of your cost -- like is copper a significant component?

And maybe give a sense of between those two, which had a bigger impact?

Well, if you look at our costs of goods sold approximately 60% of our cost of goods sold is material costs.

The two largest components of our material are bronze and brass which are copper-based alloys.

So, I mean, it is -- and the problem is to give a specific number is difficult because we have these various business units all across the world, so on a consolidated basis to give a number like that, it's difficult.

Right.

If I look at copper being up 20% year-over-year plus, obviously that has a major impact.

Yes, it does.

It's probably the largest class of commodity that we buy.

Yes.

And if I look at oil, it sounds like it's on the resin side and transport as well.

Yes, where we see the oil, we see it in the resin costs.

We see it in fuel surcharges.

I know that in our large business units which is Watts Regulator Company, we had fuel surcharges of about $300,000 over and above last year.

In the quarter.

So then you also have other expenses, you have to heat your factories and cool your factories and, different processes inside the factories that might consume oil as well.

Okay.

And it's also moved all of the resins which are -- a lot of the internals of our valves are effectively some form of a plastic component.

Okay.

Many of which are influenced by resin cost.

Last year we saw a runup in the commodities it's was a very broad based runup where you saw stainless steel and nickel and cast iron, as well as copper, et cetera, go up.

Right now it seems to be much more focused towards the copper and the oil.

Okay.

So on a net basis, it sounds to me like on the quarter you were down on -- as far as pricing versus cost goes.

That's correct.

As far as cost increases this quarter, are we going to see any in the wholesale?

And I know retail you just mentioned August 15, but on the wholesale channel as well?

We have already instituted some price increases.

Our pressure on both the OEM and the wholesaler is not as severe as they have been in the retail sector.

We are going back, though, at this point in time and looking at specific accounts and specific product lines where we will probably enact additional product actions.

And with Home Depot and Lowe's do they say you can't put a price increase until a certain date?

Are they very regimented?

We don't talk about specific accounts.

Well, it's just ---

In essence what happened with several of the major retail accounts is, they successfully delayed accepting pricing action.

Okay?

Not that they outrightly refused to take a pricing action when it's appropriate, but they're masters at delaying you in the process.

And depending on how artful they are at that it sometimes 30, 60 or so days.

Okay.

I got you.

Thank you very much, guys.

Thank you, Dave.

Your next question comes from the line of Jeff Hammond of Keybanc Capital Markets.

Please proceed.

Hi, good afternoon, gentlemen.

Hi, Jeff.

Hi, Jeff.

Just going back to the materials cost issue, I mean last year, you had said pretty consistently that your price increases were covering your raw material costs.

Is there any way, if you look at this quarter alone, to quantify what your inflation was relative to your price increase?

In other words, you know what's the dollar figure that you didn't cover and then along those same lines, , relative to that number, how much does it diminish, 3Q, 4Q, based on, the different moving pieces?

I mean, the estimate-- again, it's difficult to quantify it exactly, Jeff, because of all the different business units and product lines, et cetera, but I think you are talking, at least $2 million a quarter.

Versus last year's second quarter.

Okay.

And then if you were to look at 3Q, based on where your input costs are going and where your price actions are rolling in, should that get cut in half or hold the same -- I mean how should we look at that relative to the go-forward look?

Well, it's -- I don't want to quantify it exactly because we have a lot of programs in place.

We're talking to a lot of customers.

We have some things that are -- we feel pretty comfortable about, but it's -- I don't -- I don't see it getting worse, but I don't -- I don't want to predict a specific number of improvement yet.

I don't think we are there yet.

One of the reasons we don't have the ability to tell you that is because we are right as we speak in negotiations with key accounts on pricing.

And we don't really know exactly what the outcome of some of those decisions are going to be, nor the timing of those decisions.

Okay.

That's fair.

On the manufacturing variances, I guess what is your comfort level that that is a short-term issue or does that persist, you know into 3Q, 4Q?

I think that portion of it we'll see improvement on.

We've implemented a few procedures here, in terms of scheduling the product, et cetera, that we expect to see improvement there.

Now was there a way to quantify that -- , the dollar magnitude of that variance?

In the quarter it would be several hundred thousand.

Okay.

Again that's one -- to put a specific number on that, and add it or subtract it from a forecast, Jeff, I mean, it's a small number -- there are a lot of moving parts in this business, as you know.

Mm-hmm.

So I would hate to overemphasize one variance like that.

Mm-hmm -- but more importantly that is kind of a one quarter event it sounds like?

It's --

It could drag into third quarter.

It's something --as opposed to some of the material cost issue it's something that's controlled by the management in the short term, I think.

One is a mouse, and one is an elephant!

Okay that's a good analogy.

Moving over to working capital, it looks like a fairly sizable use in the quarter, mainly on the receivables side.

Bill, how should we look at working capital into the second half of the year.

Is that --

If you look at my days of working capital, Jeff, and compare it to December, we went from 117, to 122.

Okay?

Now, what we normally see at this time of year is that, particularly in Europe, they have their August shutdowns and then they come back and they start to get into eating season.

So there's a seasonal increase in working capital that occurs at the middle of the year for us because of those cyclical -- seasonality of the heating season, et cetera.

If you look at it, we're actually -- Europe is actually doing better than they were last June by a couple of million dollars.

So I'm expecting that our working capital will improve as we progress through the year.

The one area that I'm not completely sure about yet though, would be the impact from some of these rollouts.

I think working capital will improve but the inventory investment on these rollouts will be several million dollars.

So all that being said, I would say we'll see improvement between the end of June and December on working capital.

Okay.

And then finally, can you give us an update on corporate expense, you know for the year, how do you see it running in the second half, relative to last year?

We should see a decline, because I'm expecting last year -- I'm expecting a decline of about $2.5 million or so of Sarbanes-Oxley expenses.

So we saw about 500 of that this quarter.

We will see more of that as we move forward.

Remember, Jeff, last years Sarbanes-Oxley cost were back- ended in the second half of the year.

So what would -- if you did just under 18 corporate expense last year what would this year number --

Well, right now we are at 8.5, and I would expect, two quarters at about eight.

But, I mean, that's -- that's a rough guess, Jeff.

I mean, it's -- I mean, I see -- you know we have $4 million this quarter, that's probably a good run rate.

Because that has about a half a million dollars or so of reductions of Sarbanes in it.

Okay.

Thanks, guys.

Okay.

Thank you.

And your next question comes from the line of Kurt Woodward of JP Morgan.

Hi, Good afternoon, it's Kurt Woodworth.

Hi, Kurt.

Hi.

Quick question.

Would you walk through the price dynamics in the North American-- Excuse me -- North American business this year.

What the price gain was in retail and what the pricing benefit was in wholesale.

I know you isolated the plumbing and backflow prices up about 6%.

If I could just get an advocate view that would be helpful.

That 6% was in the quarter on wholesale.

Oh, it was?

Okay.

That was -- excuse me, that was relative to the plumbing and the back flow in the quarter in the wholesale market.

That's what the 6% reference was to.

When you look at the wholesale for the full year, without acquisitions, we are up almost 11%, and that -- again, because we have -- we are so decentralized it's difficult to say exactly -- but the sense that we have is that it's about half pricing and half units.

Some -- some business units are more geared towards pricing and some less, but -- on the retail side -- let me look at the number here.

The retail side we are up 17% year-to-date, and that would be almost all units.

Okay.

And just -- the point of my question is just, some of the positive data we are seeing in the commercial construction markets, the fact that -- I think you had 8% organic growth on wholesale and if you say 5 to 6% of that was in price and I know you just isolated those two product lines, if you are talking about 2 to 3% volume growth there, that doesn't seem like you are seeing much volume leverage, within that business.

I was just wondering if that is part of the issue here on the margin side, because I know you mentioned in your -- your earlier remarks that you are seeing some excess capacity.

So maybe if you could just talk to that and maybe what your utilization rates are right now versus last year.

That would be helpful.

The excess capacity is caused not by a slack in demand but more by bringing capacity on over the course of the last 12 months in China.

Okay.

So it's really additional capacity brought on board.

You have this sort of awkward period, Kurt, where you can't shut down a U.S.-based plant because you don't have your international logistics totally worked out, but you have additional capacity you brought online overseas.

So you are in that awkward zone where you can't pull the trigger in terms of completely downsizing your existing operations.

You've shrunk them down to a certain point, but you need to shrink them further.

And that's what -- that's what we -- when we refer to the excess capacity --

Okay.

The capacity we have is that that we have left in place, until such time as the logistics get worked out.

Okay.

And then a quick question on the retail pricing.

I know you talked about August 15th.

You have a price increase going through.

Given the continued rise in copper and some of the resin-based products, do you think you will have to go back to the retail customers later this year and get further price increases.

Do you think that will get you where you need to be?

And I know it's slow to see an improvement there, so maybe just talk about your expectations and how we can think about that.

At this point, we are anticipating that we will have to go back with an effective date somewhere around January 1st.

Okay.

So those accounts, because of the administrative process of changing pricing and things like that tend to resist.

So we are going to be looking at that really probably every to 30 or 60 days.

But my anticipation is you would probably have to have an effective price increase on various product lines sometime in early January.

Okay.

Thank you.

And the last question, just on the impact into Q4, you talked about a $900,000 benefit, is that on the sales line or is that at an EBIT benefit, just --

No, what you see there in sales where you have $900,000 of realized price increases, if you will, with no corresponding cost increases, we kind of beat the cost increases with our price increases.

It drops to the pretax level.

It does drop all the way straight through.

The whole 900 would be an EBIT benefit.

Sales in EBIT.

Right.

Okay.

Great.

Thank you very much.

Okay.

Thank you.

ur next question comes from the line of Richard Rossi of Morgan Joseph.

Hi there.

Hi.

A couple of things.

First, let's get back to this over lapping manufacturing for the session.

Where are you in terms of being able to eliminate that overlap domestically?

Where are you at the end of the second quarter, how much more will you have to do until you are comfortable with the capacity balance?

It's hard to question the answer, but I think you are going to be pulling capacity offline throughout the second half of this year.

So it will continue to be a lessening drag on margins?

Okay.

Also, looking at the China manufactures, how much of that manufacturing goes to the local Asian market?

About a third.

When you look at our Chinese segment, though, you know, in the -- in our GAAP numbers of $7 million, that's -- a little bit of that is exported to non-Watt companies, but most of that $7 million is going into the China market.

Okay.

Based on European exports other than Watts the rest of North American other than Watts, not significant, though.

All right.

And, again, going back to that $175 million worth of product coming from your efforts and it sounds like you are pretty much on schedule, could you give us some general sense of where you think that number might be next year?

Well, I think it will be somewhat higher, not significantly higher.

10% or so?

Yeah, I mean, it's -- it's tough to say but I wouldn't go more than that.

Okay.

The reason that I say that is that the 175 is sort of the run rate will probably be at by year end and a lot of these rollouts that we are doing now, which will be in the run rate, we'll have a full year effect on that next year.

And on those rollouts, can you give us a preview of what the rollout, the new rollouts will look like in '06 relative to '05?

Is it great?

Will they be smaller?

In a sense magnitude?

I think they have to be less, because we have been very successful in terms of the number of new products that have substantial volume.

The Sea Tech fitting, it's a little bit hard to answer this question because a year ago, we hadn't acquired Sea Tech.

So here we are doing the rollout of Sea Tech, right?

Yep.

So you have to be a little bit careful but it depends what entities we buy and whether they have the potential to be sold to the retail market.

But there this year we have the pre-soldered fittings and we have the float flood safe connectors going out here in the second half.

We have the recirk bumps.

We have the Sea Tech.

I would have to tell you, this is sort of a record year.

It is sort of a whole schedule.

It's record in terms of cost of executing resets and all this other, so the expense is high and accordingly the raw revenue will be higher as well.

So, you know -- all right but as we move through this year, those unidentified rollout expenses should start to diminish in terms of their importance?

Right, they should come down.

And one final thing, just to -- a technical thing, the tax issue on the earnouts you paid, what was -- was there any difference in tax credit percentage there versus tax rate shown on the P&L?

No.

Okay.

Very good.

Thanks very much.

Your next question comes from Ian Fleischer of Friedman Billings Ramsey.

Please proceed.

Hi, good afternoon.

Hi.

Just a quick question on acquisitions, they seem to be running at a pretty good clip this year.

What is your sense going into the second half with respect to, you know, the usual questions, the pricing, pipeline?

Well, I would say the pipeline is good.

We are trying to upsize the size of the acquisition we go after, because we are somewhat stretched in terms of integrating the smaller operations.

Buying the company and integrating it, is not proportional to its size.

Whatever you do due diligence on a business, due diligence is similar, even on a business of $20 million, versus $40 million, it's not incrementally larger due diligence.

I would say our back -- our flow of deals is good at the moment.

We don't have any problem.

The larger deals, you have a lot of financial sponsors who are bidding up prices so the multiples have moved up.

You can look at the deals we've done here year-to-date.

I think just to use a figure, I think we paid, what $45 million to acquire $43 million worth of sales.

Mm-hmm.

On an historical basis.

So that gives you a feel for what we are paying.

Right.

And with respect to Asia, do you feel like you are going to expand capacity there or are you going to stay put at this point?

If we expand capacity there, it would be specific capacity in terms of additional -- it's more like adding specific pieces of equipment then it is adding large quantities of additional capacity.

It's more working through and smoothing out what we have.

Okay, thank you.

Thank you.

[OPERATOR INSTRUCTIONS] Your next question comes from the line of Stewart Scharf of Standard & Poor's Equity.

Please proceed.

Good afternoon.

Good afternoon.

I was just wondering based on everything surrounding, in terms the price hikes if things do go according to plan and price hikes didn't materialize or were delayed, do you have a backup plan?

Are you looking to try and reduce manufacturing costs further or, anything else in order to improve margins sooner than later.

Yeah, simultaneous with what we are doing on the pricing actions, we have other contemplated actions that we are taking to make sure that we have some buffer against price increases that if we were to get pushback on price increases we'd have to close some other levers to reduce our cost and obtain efficiencies.

So there are those plans.

It's a lot easier to get paid a fair price for your product than it is to extract those others, because some of those other actions may include an implementation cost to get to the savings.

Okay.

And do you have any other use of cash, other than -- are you focusing on acquisitions or debt paydowns, anything else?

No.

We have our standard -- I think we disclosed this in the past, our capital budget, I think we gave them that a quarter ago.

Right.

And we feel at this point and time we are fine within the capital figure we gave you.

So really, the cash usage -- and you see the use of proceeds, et cetera, is primarily to fund acquisitions.

Yeah, the only other one that would be unusual, Stewart would be we are going to pay our earn out in the fourth quarter, which if you look in the commitment contingencies of -- the contractual commitments I think it is called in the 10-Q, we have that specified there, which would be 5 or $6 million.

Other than that it's just the normal ebbs and flows of CapEx.

Okay.

And inventory levels, you said you would see according to the investment and the rollouts?

Yes.

Right now are they in line with the amend.

Well, you kind of prefund -- you preload your inventory for the rollout, so we have another couple million, I think of inventory dollars to support the rollout.

Some of it's already in our numbers now.

And then you will see it decline, I think, in inventory dollars in -- in our European companies.

Between now and the end of the year.

If all things being equal, we should see maybe a slight increase in inventories between now and the end of the year.

Okay.

Thank you very much.

And your next question comes from Mark [Rueinski] of Needham & Company.

Good afternoon, guys.

Hi, Mark.

Just a clarification, the inventory that you guys were just talking about, the raw material -- the increase in the raw materials inventories is for the rollout.

Is that the sort of the way to look at it here?

Part of it is.

Okay.

Yeah.

Is -- is -- was there -- more inventory than you were expecting in some of the acquisitions that you made?

Is there any --

No.

No?

I mean the other thing, again, when you are looking at the balance sheet, if you are just looking -- if you look at the change in inventory and look at the cash flow, and that is what the operating increase is.

The balance sheet has the increase on acquisitions and foreign exchange units.

And that operating increase on inventory is, again, pre-- getting ready for the rollout and the European heating season, which we shut down in August in Europe, but we come back and the heating season is there.

So we always load up on heating products during the month of June for that season.

And that's always in the budget.

Right.

Okay.

Great.

And then just on the -- most of my other questions have been answered but on the U.S. markets, I guess people are assuming the commercial markets are doing very well and I know it is but are you seeing any -- I would say that the heavy industrial real estate mark, the heavy commercial, excuse me, is still not performing like everyone would like it.

Are you seeing that through your contributors and wholesalers?

Yeah, I think we have said this before, which is -- we've been hopeful that the commercial marketplace will pick up.

It always has sort of lagged behind our expectation.

I think it is starting to show -- if you look at the product lines that are sort of precursors of some pretty good pickup in that marketplace, they are showing some growth, however, where you're seeing that, is you are seeing it in things like hospitality industry, health care industry.

You are not necessarily seeing it like you say in some of the larger facilities.

And now could you just kind of roll that into Europe?

Is there any sign of life over there in -- in the commercial area?

The commercial area in Europe is essentially very, very slow.

We didn't see any improvement here in the first half of this year.

And we aren't forecasting significant improvement in the second half of the year.

I would say, if you are trying to find the pulse in Europe, you would be hard pressed.

I figured as much.

All right, guys, thanks.

Okay, thanks.

At this time, gentlemen, there are no further questions.

Okay.

Thank you.

I would like to thank everybody for joining us on our call, and if you have any additional questions, or anything else, we would be happy to answer them at some future point in time.

Thank you.

Once again, ladies and gentlemen, we thank you for your participation in today's conference.

That concludes today's conference.