Watts Water Technologies Inc (WTS) 2005 Q3 法說會逐字稿

Good day, ladies and gentlemen.

Welcome to the third Quarter 2005 Watts Water Technologies earnings conference call.

My name is Jackie and I will be your coordinator for today.

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

We will be facilitating a question and answer session towards the end of today's conference.

If at any time during the call you require assistance, please press star followed by zero.

I would now like to turn the presentation over to your host for today's call, Mr. Kenneth LePage, Assistant General Counsel.

You may go ahead, sir.

Thanks, Jackie.

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

Actual results may differ materially from those indicated by these forward-looking statements as a result of various important factors, including those discussed under the heading, Certain Factors Affecting Future Results, in our annual report on Form 10-K for the year ended December 31st, 2004 filed with the Securities and Exchange Commission and other reports we file from time to time with the SEC.

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.

I'll now turn the presentation over to Pat and Bill.

What we're going to do today on this call is I will take some opening comments.

I'm going to turn it over to Bill who will take you through some of the financial details.

Then we'll open the lines and allow you to ask any and all questions that you may have.

The first thing I want to talk about is for the quarter we had sales of 232,000,729 which was up 11% from the same quarter a year ago.

If you look at net income, it was essentially flat at 13,000,368, $0.40 per share.

If you add back the loss from discontinued operations, it adds back a penny, so the income from continuing operations comes in just below last year's figure at 13,439,000, or $0.41 a share.

Then, if you look at restructuring that's contained inside of the income from continuing operations this year we had restructuring charges of 655 which was an additional $0.02 a share.

Last year we had restructuring charges of 349,000 or $0.01 a share.

If you look at it after restructuring, we end up with a flat quarter when compared to a year ago numbers.

A couple of things I want to mention to you.

There's a separate press release out announcing the appointment of Bill Martino as the Chief Operating Officer and President of our North American and Asian operations.

Bill served as President of Cooper Power Systems, a division of Cooper Industries from 1994 to 2004.

He also has a significant background, having operated as Vice President of Operations for the Krouse Hines division of Cooper Industries for 1989 to 1994.

Bill comes with a depth of experience and background that I think will serve us well in the years to come.

The second issue I wanted to mention to you is that we have made some management changes.

Jeff Polofsky left the organization in late September.

We have appointed Lynn McVay to head up the operations on the retail side of the business.

And we feel that Lynn will make a major contribution in that area as well.

When I look at the overall economy, I want to mention a couple of things.

First of all, North American markets have benefited from strong residential and commercial spending, so things are pretty good here in the North American market on both the residential and commercial sides.

The economy in Europe remains relatively sluggish, particularly in France, Germany, and Italy.

That gives you a little bit of idea of where we stand economically.

North America doing fine, Europe a little bit still sluggish.

Really the same story that we talked about with you on the second quarter call.

The primary issue that we're struggling with is really our ability to fully offset the rising raw material costs with price increases.

This is particularly true in the retail channel distribution.

We'll talk about that some more later.

And that is, when you look at the shortfall and gross profit dollars, I would say the majority of it is directly related to that specific issue.

We'll have bill take you through some additional facts with regard to that marketplace and what we're doing on pricing and things of that nature.

As regards to our acquisition pipeline, remember that first of all we completed six deals so far in 2005.

The acquisition pipeline remains strong.

We're currently in some form of discussion with a number of different firms and hope to complete some transactions either late in the fourth quarter or sometime in the first quarter of 2006.

As you know, there's inherent uncertainty in closing any deals.

With those opening comments, I'm going to turn it over to Bill who'll walk you through some of the details on the numbers.

Thank you, Pat.

Looking at the consolidated revenue in the quarter, as Pat mentioned, we had top line growth of 11%.

We closed the revenue at 232.7 million.

We break that growth down from an organic standpoint on a consolidated basis, our revenue increased 11.9 million, that's 5.6%.

The foreign exchange is a very small number at 200,000 which is 1/10th of 1%.

We had some weakness in the Euro that was offset by strength in the Canadian dollar.

The revaluation of the Chinese RMB was a small number inside there as well.

Acquired companies contributed $10.5 million of revenue, and that's 5%.

So you have the sum of the three, $22.5 million of incremental revenue, and that comes to 10.7% exactly.

When we look at the segments -- and, again, awful the particulars are on the back of the press release as far as the revenue by segment -- but first we'll talk about North America.

North America grew at 14% in total on the quarter.

That's $19.6 million increase.

Breaking that down into the components, organic growth was 11.8 million or 8.4%.

And we'll talk about some of the reasons for that in a moment.

Foreign exchange was a favorable 900,000 which is 7/10ths of a percent.

That's the strength of the Canadian dollar versus the U.S. dollar.

These acquisitions contributed $6.9 million, which is 4.9%.

So the sum of those is 14% or $19.6 million.

So a strong quarter in the North American segment.

Now, looking inside of North America, the retail closed out at $41.9 million in the quarter versus last year was 37 million.

So that's almost $5 million increase or 13%.

On a year-to-date basis, we're up 16% on retail.

The strength of the quarter is due to some rollouts as well as the normal growth we would see.

We rolled out our new flood safe water connector, which is about $3.3 million.

We also rolled out some new filtration products and some new filter pack products, and we also have a product we're calling warm wire, which is product line extension of our under floor, floor warming system that's an electrical product.

So all those together contributed to the 13% growth.

On year-to-date basis, we've also rolled out some of our easy sweat fittings and our hot water heater accessory kits as well.

The retail in the top line had a strong quarter.

On the wholesale side, revenue was 118 million, up from 103 million last year's third quarter, so an increase of $14.7 million or 14%.

If we back out the acquisitions, wholesale was up 8% organically.

Looking at the 8% for a moment, both our plumbing and backflow product lines were up a little bit more than 8%.

It's a combination of pricing and units.

Our underfloor rating and heating business continues to do well.

That was up 23%.

That's a combination of our underfloor rating heating as well as our text business.

Our acquisition in the filtration space that we did last year, Flowmatic, is up 21%.

That's a result of adding some new distribution centers.

We're in the process now of consolidating the Alamo acquisition into Flowmatic.

That's a company we bought the middle of the year, another water softening, purification company.

The Canadian market is doing very well also, up almost 30%.

Some of the factors influencing that is the strong backflow market up there.

There's some new hydronic codes which we're benefiting from, and the underfloor rating heating market is also strong in Canada which is really the result of putting the Watts brand name on our underfloor rating heating product line.

A very strong market up in Canada.

The acquisitions in North America in the quarter performed to our expectations.

This includes Sea Tech, acquired in January, as well as HF, acquired in January, and then Alamo and Savard acquired in midyear.

We're very pleased with Sea Tech, they're going to be doing some rollouts into the retail space in through fourth quarter and in through 2006.

HF has been picking up some new customers with access to -- or the result of access to the Watts customer list as well as introducing some new products.

And Savard is being integrated into our existing connector business in southern California.

So, again, we're very pleased with the acquisitions in North America in the quarter.

Looking at Europe, Europe was up $3.2 million, which is 1.5%.

Looking at the segments or the factors there, organically we essentially were flat, up $500,000.

The foreign exchange is unfavorable in Europe in the quarter, so that reduced our revenue by 4/10ths of a point, 900,000.

Acquired companies in Europe contributed $3.5 million which is 1.7%, so that totaled 1.5.

Year-to-date, we're up 2%.

Similar figures on the year-to-date in the quarter.

When we look at Europe, as Pat mentioned in his opening remarks, we're continuing to see sluggish economies in the major trading areas, Germany, France, and Italy.

That represents the majority of our volume in Europe.

But what we're also seeing in Europe is that we're seeing a bit of a shift from the OEM into wholesale.

Our wholesale revenue, which represents about 46% of total revenue in Europe, grew at about 10%.

Now, that was offset by a decline on the OEM revenue which represents 50% of the revenue, and that declined 4%.

The OEM decline is primarily associated with some of the declines that the large boiler manufacturers, who represent most of our OEM customers, are seeing as a result of the softness in their end markets.

The wholesale is up, a couple things happening there.

First of all, we do see continued strength in some of our smaller markets.

The wholesale markets in Spain are up 17%.

The UK are up 7.

Austria, Switzerland is up 10%.

Eastern Europe is up more than 30%, and that's a result of some of the additional salesmen and sales offices that we've opened in Eastern Europe, including Moscow and the Ukraine.

Of course, the problem is that some of these smaller markets just represent less than a third of the business in the aggregate.

Even though they're growing nicely, they don't make up for the softness in the larger markets.

We've also been able to have some market share gains in the German wholesale market due to some promotions and more aggressive marketing programs if you will, and we're looking at focusing a lot of our activity there on northern part of Europe, Germany and the Baltic area.

On the underfloor rating and heating market, these are very promising heating markets as well as the solar market.

Again, smaller parts of the business, but they have -- they represent good pockets of strength in an overall soft market.

The market in Europe continues to be competitive due to the poor economy as well as the difficulty that the European companies have relative to exporting because of the relative strength of the Euro.

Looking at China for a moment, you look at the geographic segment, and it shows that Chinese revenue was down about $300,000, down to 7.1 million.

I think it's important, if we kind of break that open a little bit and look at what's inside that number.

If we look at the sales, the domestic Chinese market sales that go into the water works and the commercial markets, that revenue was up 30% in the quarter.

We have the fortunate stance of addressing a strong market.

We have some new sales management in there as a result of upgrading our management team in China.

We've expanded some of our product lines there, so we're offering a broader product line.

What we're doing, since we have bought out our joint venture partner last year, a lot of the revenue that was in China in prior years, which was exported to the United States, is now handled through Watts in the U.S., so that revenue was treated as intercompany, and it's eliminated so we don't see it.

That reclassification to intercompany category masks the improvement that we've made on the water works and commercial side in China.

Just looking at our intercompany revenue, which again is eliminated and you don't see it, it's up almost 100% quarter-over-quarter, so we feel that we've had a solid quarter in China, which is a bit masked again by the accounting treatment.

The gross margin.

The gross margin in total is down 110 basis points in the quarter.

That's netted out at 34.3%.

As Pat mentioned earlier, the number one issue we have here is the metal pricing.

Copper is up over $1.90.

Oil has softened a little bit, but it was up over $60 for the majority of the third quarter.

We're spending -- if you look at the copper content of our costs of goods sold across the corporation, we're spending over $100 million per year on copper and at least $25 million per year on just resin as well as a lot of other oil-based costs that we have such as transportation and heating our factories, et cetera.

So if we look at the impact that just the copper has on the quarter, it's in the neighborhood of 3.5 to $4 million increased costs that we did not recoup during the quarter.

That is the number one issue that we're working on and will be addressing over the next couple of quarters.

If you were to just look at the math there, if we had the ability to recoup that, we would have seen an increase in the gross margin which goes to show, I think, that the other programs and strategies that we're working on are working, they are sound.

But we do have this headwind on the copper.

Just looking at some detail inside the gross margin for a moment, besides the copper issues, the gross margin in Europe is flat on the quarter.

Their pricing and cost reductions are covering their increased metal costs, so we think that they're doing well.

The acquisitions are contributing to the gross margin overall.

We feel that our cost reduction program is on track.

We have a very active restructuring and sourcing program as most of you know.

We've mentioned to you in the past that we believe we will procure $175 million of product from low cost countries, and that program is on track.

We have our Bulgarian and Tunisian factories undergoing some capacity expansion right now.

We did close one of our foundries in the United States during the third quarter, So we will have some savings going forward on that.

We are able to source those products successfully from Asia.

And we've been converting a lot of -- several of our large customers over the last couple quarters to our Asian made water connectors.

We feel very positive about our restructuring and sourcing programs.

But the number one issue, as Pat and I have mentioned, is the metal pricing in the quarter.

On the SG&A, up $5 million and constant as a percentage of sales.

About half of that increase is associated with the inclusion of acquired companies and the impact of foreign exchange.

We had some small charges for some earnouts, which this is the last quarter we will have that.

And we had some -- about $400,000 of reset expenses associated with some of the rollouts, and that's behind us now for the most part as well.

Some of the costs associated with the incremental sales volume, commissions and freight and then some fuel surcharges as well.

That brings us down to the op earnings which again 110 basis point decline directly associated with the gross margin which I just mentioned.

The tax rate on the quarter is up versus last year.

As you might recall, in 2004, we had a large credit that we booked, which is associated with the California enterprise zone incentives, and that's sort of a with time favorable adjustment that we had, and now we have a more normalized tax rate if you will.

You add all that up and you exclude the restructuring charges and the earnings per share is flat on the quarter at $0.43 on revenue increase of almost 11%.

Okay.

To give you a little bit of visibility in the quarter ahead of us when you're putting your estimates together, I guess I would like to make a couple of comments.

First of all, we see the North American market continuing to be strong based on strong residential and commercial spending.

We see the European economy remaining sluggish, basically no change from what you saw in the third and third quarter.

With regard to pricing, particularly pricing into the retail market, I have confidence that Bill Martino, Lynn McVay, and their team are addressing those issues, but it will take us several quarters before we're going to see a meaningful positive impact in terms of restoring our margins back to historical levels.

As far as the acquisition pipeline, as I said earlier, it remains relatively strong.

Any acquisitions we make in the fourth quarter will have practically no effect on the quarter whatsoever.

So, with those comments, let's open the lines, operator, and we'll receive any questions.

Gentlemen, if you wish to ask a question, please press star followed by zero on your touch-tone telephone.

If your question has been answered and you wish to withdraw your question, star followed by 2.

Your first question comes from Ned Armstrong from FBR & Company.

You may go ahead, sir.

Good afternoon.

With regard to Mr. Martino's position, can you just run through the specific duties and responsibilities he'll have?

Yes.

Bill comes in as Chief Operating Officer, President of the North American and Asian Operations.

The reason there's North American and Asian operations are involved is because the coordination between our operations in Asia and those in North America is critical to us achieving our cost reduction targets.

So we're basically giving Bill responsibility -- operating responsibility -- for both all North American operations as well as Asian operations.

I will retain responsibility for the European operations and other functions in the organization.

From an operating point of view, I think my gut reaction is that Bill has a depth of operating experience.

He brings that to play.

I think we're going to see lots of benefits out of Bill as he addresses key issues in terms of cost reduction, in terms of operating issues in the North American as well as the China operations.

And then with respect to North America, you suggested that both residential and commercial markets were strong.

What was the approximate break down in revenues from each of those markets?

Ned, we don't break that down on a quarterly basis, but we don't have any reason to think that the traditional breakout of fifth 50/50 is changed significantly from what we've seen in the past.

Great.

Thank you.

Your next question comes from Mike Schneider from Robert Baird.

You may go ahead, sir.

Hi, guys.

Hi, Michael.

Maybe we can focus on retail for a minute.

First, when you back out the rollouts that went on this quarter, what's your sense of the retail momentum kind of on the same store basis if we can scrub all other rollouts.

We would have had growth sort of in the low single digits, I think, without the rollouts.

We also had some good rollouts last year's third quarter, so it's a little bit difficult to make a comparison.

We don't necessarily see those kind of same store sales numbers on a regular basis.

I think it's middle single digit type growth without rollouts.

The reason I ask is I'm just curious.

There's certainly a lot of belief or prevalent belief today that at least the TIY channel is slowing and or suffered from the hurricanes during the quarter, and I'm just wondering if you were doing mid single digit growth absent the rollouts, presumably Home Depot is rolling out at least mid digit store growth.

Does that suggest the same store sales growth were actually flat or even down?

We don't get that sense, Mike.

If you look at the hurricanes, that New Orleans market, the numbers I've seen would indicate that that representatives about 1% of the plumbing and construction markets so that, even though that's disrupted in the quarter, it's not significant enough to throw the numbers way out of whack.

So we don't get the sense that same store sales are any significant decline.

They're a significant change.

The rollouts themselves, what do you think it cost you in the quarter, and then when does -- when do the costs associated with the current rollouts really begin to ease?

Well, I would say they cost is 400 to 500,000 in the quarter in terms of what hit the SG&A line and then another, I would say, 5 or 600,000 at the margin line because you're giving some discounts and whatnot.

That eases as we get into '06.

So the rollouts continue in equal force?

No.

Less.

A little bit less.

What's coming near term either in fourth quarter or first quarter in terms of additional rollouts?

We're going to continue this flood safe rollout.

That's the largest one we have on the docket right now.

And I know our new manager down there, Lynn, will be looking at what kind of rollouts he's going to do as we get into the '06 budget.

I don't have an answer for you on that just yet.

Okay.

Talk a minute about pricing.

Obviously the DIY channel is as tough as they come in terms of pricing, but if we roll back even nine months ago, you guys seemed to be probably best in the sector at being able to recoup materials costs, and now my sense is most of the players are basically beginning to catch up on that curve, and you guys are talking, again probably contrary to the crowd.

What's changed to take you from kind of the front of the pack to back maybe even behind the curve now?

Especially vis-a-vis the retailers.

Mike, let me make sure you understand the equation here.

On the wholesale side, this is not a significant issue.

Yes.

We have been able to cover escalating raw material costs with sufficient price increases to keep our head and our margins intact.

On the retail side, you have first of all larger customers who have greater leverage on you.

Secondly, I think we had some significant cost reduction efforts, things like that, that were helping us offset that a year ago.

Some of those have been realized and are into numbers now on a year-over-year basis.

The other thing is that, as you know, these large customers have -- they tend to have agreements with you that says that, when you announce a price increase, there's a delay before it becomes effective and things of that nature.

I think what we're seeing is, a year ago, the combination of cost reduction efforts, productivity improvements, and others was helping us manage this better.

Now we're seeing those things year-over-year being even.

You're seeing the raw material costs and you're seeing the difficulty we have covering it with equal or greater price increases.

Now, that's a high priority for us, but I will tell you that it does take you probably two to three quarters before you work your way through those issues and see the P&L impact of them.

So then tell us where you are in the negotiations at this point.

Are you already complete for fiscal '06 or are you just starting those talks?

Those are ongoing depending on product lines.

In some cases we've gotten some price increases, in others we're in the middle of our negotiations depending on the specific account.

I can tell you that there's a considerable amount of effort being applied to this issue at the moment.

And also just take a step back, Pat, and talk about now pricing in the commercial sector.

As you say, wholesale has been much easier to pass along price list increases there.

What have you seen in the wake of the national water works acquisition given that that's a retailer entering in effect the commercial or wholesale distribution channel.

Have you seen pricing tougher at that account specifically as kind of an example of what may be to come?

We've not seen any impact yet at this point, Mike.

None at all.

Okay.

And then Hughes last night, another one of your big distributors, mentioned their exploring strategical alternatives, the rumor is obviously, that Home Depot is looking for another major distributor.

How does this change the landscape in your eyes, and how do you guys respond?

It's been that's your bread and butter, the commercial channel or the wholesale channel.

How do you guys address it?

What are your fears?

What are the opportunities?

Well, we're obviously trying to figure out exactly -- depending on who the buyer is, how they would change their strategy and what they would do.

You've got to remember, Mike, in the wholesale channel of distribution, our products are much more oriented toward commercial applications where there are specs, there are long-standing reputation for Watts being the quality leader, the service leader and all those other things.

So that channel of distribution to date has responded positively in the fact that, when raw material costs go up, they rationally pass those through to contractors on a proportional basis.

Now, depending on who the buyer is, if that whole policy changes, we're going to have to react to it, but I think it's a little bit too early.

We've been sitting down asking ourselves that very question, but I don't think we have any final conclusions at this point.

Okay.

That's all for now.

Thing again, guys.

Thank you.

Your next question comes from David Smith from Citigroup.

You may go ahead.

Hi, guys.

Dave.

Can you give us a sense -- not to beat this down too heavily, but on the copper side how long it takes or how much supply of inventory you guys keep on-site for copper?

Well, on a corporate-wide average, we would have between four to five months of material in our inventory in a given point in time.

Some of the retail stuff probably passes through quicker and the wholesale stuff is maybe a tad longer than that, but on average it's four to five months.

And a lot of this type of prod you feel -- product you feel -- it's fair to say you're covering all that increase?

Yes, we have.

You talked in the last call, Bill, about the price increase at Lowe's and Home Depot in August.

Did that go through?

We've gotten some increases, Dave, on the retail channel.

We'd rather not get into specifics on customer type answers like that right now.

Some of the things we were talking about on that second quarter call happened, and some did not.

We have Lynn McVay, the new retail manager, who's working on all that right now.

But we'd rather not get into specifics on customer by customer.

Okay.

I guess what I'm trying to get at is how long would it be -- I assume that we didn't see any price increases in copper.

I'm getting the impression this is definitely going to trail into the first quarter even with the price increases that you've planned.

Is it something that's -- it's not something that's going to quickly take care of itself.

Is that what you're saying?

I think the answer to that is that it depends on what happens with continuing escalation in raw material costs.

Assuming we're flat.

Assuming we're flat, I think what I was trying to tell you earlier in the call is I actually think it's going to take us two to three quarters to work our way through this issue, to be realistic.

Okay.

What about just some housekeeping things?

Any comments on operating cash flow or free cash flow in the quarter?

Yes.

We have on a year-to-date basis -- let me see if I have the numbers here.

We have basically on a year-to-date basis we're break even on a free cash basis, which is up significantly from last year.

We had negative cash flow of 25 million at the end of nine months.

And as you may know, Dave, we have a fair amount of seasonality in our cash flows where we have our best cash flow quarter in Q4, and we use a lot of cash at the beginning of the year, and I think we've done better this year on operating cash flow than we have last year and at the end of the year our numbers will be better than last year, we believe.

It doesn't mean that we're not still looking for room for improvement here, but with all the rollouts we've done and sourcing, majority of those rollouts from China, we have used -- inventory has been a consumer of cash this year.

That's the number one issue relative to the free cash flow.

How about D&A for the quarter?

I can give you the year-to-date number.

It's 20 million for D&A year-to-date and our Cap Ex year-to-date is 13.8.

Okay.

Any comment on orders or backlog?

I think you've talked, Pat, about the residential market which I expect is probably kind of peakish right now.

But what you're seeing on the order front in the commercial market?

We don't usually talk specifically about our backlog, but I can tell you that we do see the North American market remaining strong.

You're probably right about the residential market coming to a peak here, but the commercial market is still strong in North America.

Europe, on the other hand, is really a continuation of what we've seen for the last two quarters.

I'm not really seeing a significant change in the environment we've been operating in in either Europe or North America.

Right.

But I get the impression you're saying sequentially we're seeing improvement in had commercial.

We're seeing it, but it's like watching paint dry.

Right.

Coming back to your original point, I would expect that the higher margin commercial stuff would offset some of that weakness.

Are there initiatives that you think can offset some of that problem.

The mix issue sounds like it could improve.

Mix could improve.

Okay?

The other is that we are sort of doubling up on our efforts on cost reductions.

But you have a problem.

When raw materials are moving at double digit rates and a good cost reduction effort is going to get you single digit rates, you have a gap.

You have to give it really in terms of incremental price increases.

Aren't things like Asian sourcing helping you out here?

Yes.

But even in Asian sourcing, you have to understand, on the product that you've already sourced in Asia and been sourcing year-over-year in Asia, same as last year.

The raw material increase actually has a greater impact on your total cost, because you've gone from a labor content here in the United States that was greater to a smaller, so your material content as a percentage of those products actually increases.

So products that have been sourced a year ago in China and are sourced this year, the magnitude of the material increase is actually greater.

It puts more pressure on you to get those price increases through.

You know, Dave, another number, just to look at it, the margin's down 110 basis points, which is about $2.5 million.

And we know that the material that we haven't recovered is 4 million.

So we know that we're having some success on some of these other programs.

It's just that we have to get out some of our pricing aligned.

That's a good point.

We think that's why the comments I made earlier.

We think things we're working on are very sound and make a lot of sense, and we're being successful.

But as Pat says, it takes a couple quarters to get through this thing.

The last thing, can you just give us the amount of that earnout in the quarter?

About $225,000.

And that's finished now.

Right?

Yes, it is.

Completed, and we recently paid it.

Thanks a lot, guys.

Thank you.

Once again, ladies and gentlemen, it is star 1 to ask a question.

Your next question comes from Andrea Wirth from Robert Baird.

You may go ahead.

Hey, guys.

Just a couple quick questions.

First if you could address the margins in Europe, you've had some negative comparisons year-over-year the last few quarters.

If we could talk about what's causing the weakness there and kind of talk about how the mix shift is going more towards wholesale.

Does that help you or hurt you going forward?

I mean, in Europe, the gross margin is essentially flat quarter-over-quarter.

But to talk about your question there, when you have a mix towards wholesale, that hurts your gross margin, because the margins on the wholesale side are four or five points less than the OEM side.

We have an unfavorable mix developing.

But we have a lot of cost reduction programs.

We have the Tunisian and Bulgarian factories that are under expansion.

We've done a lot of product pruning in Europe and a lot of other cost reduction programs.

So the mix is unfavorable, but we have -- it's still profitable business.

When you throw in the other cost reduction programs as well as some of the acquisition contribution, it gets you to a flat gross margin.

I see.

The operating margins are down.

I'm assuming that's more just you beefing up the sales force in different areas and things like that.

Well, you have some of that, but you also have the fact now that we've beefed up the G&A staff to do their own Sarbanes-Oxley stuff, and that's why you see corporate expenses coming down.

They're spending more money doing their own local Sarbanes efforts.

When do you think margins start to -- do you actually see an improvement in '06 in operating margins in Europe given the mix shift towards wholesale or probably more flattish?

I would say we would think it would be more on the stable side.

With the economy being soft, I think it would be a bit of a reach for us to predict increasing gross margins in Europe.

And then could you give us an idea how much pricing was overall for the Company versus volumes?

Organic growth is about 6%.

How much of that was price would you guess?

It's almost impossible to answer, Andrea, because we have so many product lines and so many business units.

In the retail side, it's all units essentially.

On the wholesale side, it's a mixture.

Just one last question just in the retail channel.

You're talked about your goal as high single digit growth.

Obviously you've done better than that so far.

What are you looking at as far as '06 goes now that you've said you think residential is obviously peaking?

With interest rates where they are, can you still do high single digit growth in '06 or does that adjust down to the mid single digits just given the tough comparisons?

I think if you look at the components of that market absent any other issues, we think that high single digit growth is a reasonable achievement.

There's going to be a lot of issues there relative to -- you know -- we have some new management.

We have some new rollouts and whatnot.

But the structure of that market itself should allow us to grow in high single digits.

Great.

Thank you.

And your next question comes from Stewart Scharf from Standard &Poor's Equity Group.

You may go ahead.

Good afternoon.

Firstly, on the copper pricing, do you normally -- do you anticipate a rapid increase in that or did you expect it to stabilize?

What would prevent you from trying to push through higher prices sooner so you wouldn't have to wait several quarters before you kind of catch up?

Well, I mean, when you work on the wholesale side, we are able to get prices through much quicker.

On the retail side, I mean, you have a lot of issues you're dealing with.

You have competition, and you have the whole approval process inside of that retail channel.

There's a lot of issues you just can't go in and get a price increase as quickly as you'd like.

The Sarbanes-Oxley, what do you see this year -- it looks like about 4.5 million.

4 to 4.5, Yes.

And you see it going down for '06?

I would say, if it goes down, it will go down slightly.

I would say stable to small decrease.

Nothing significant.

I mean, we've dropped it down about 2.5 million I think this year.

And Home Depot, I've heard they tend to annually reduce their inventories.

Does that have any impact on you?

They go through a period it seems like once a year where they kind of hold off --

The big retailers generally do that in the month of January.

Their year end does not end until the end of January.

Those that have that practice tend to do it in -- after the holiday season has ended and in the month of January they tend to be very sluggish.

That doesn't have much of an effect coming up in early '06?

It's more of a timing issue.

Sometimes, if they do that, you have a slow month and you pick it up the next month.

It doesn't tend to be a large issue.

And have you thought about changing your acquisition strategy at all, looking for larger acquisitions?

Yes.

We've had a lot of conversation internally about the size of acquisitions primarily because, one, the time to do due diligence and the time to consummate a transaction is approximately the same whether it's a $10 million deal or a $60 million deal.

The other is that one of the things is we are getting larger and approaching 900 or so million on a run rate basis.

We are in need to buy human resource capital with the deal so that you tend to have more fully developed management teams with the larger deals, so it's clearly an emphasis on our part to deliberately look more closely at larger deals.

And in what area would you be looking primarily?

Well, we're looking in markets that are either -- we're looking at deals that are direct bolt-ons or tuck-ins.

We're also looking at markets that we have traditionally looked in, which is the water treatment, water purification and markets that are critically adjacent to what we do where we share some kind of critical manufacturing skill or end markets, whether it's the same channel or -- the best deals for us are where we have core technology and core knowledge in-house, and at the same time we can leverage the channel of distribution.

The ones that tend to be the most profitable for us long-term are those where we are exposing a good product line to additional channels of distribution, both retail, wholesale, and OEM.

Wholesale, retail, and OEM?

Yes.

I mean, we have reach into those three categories, and to the extent that we look at an acquisition, we look at growth initiatives where we can expose that product line to additional customer opportunities.

Are they still pricey or are you seeing them come down as far as the multiples on EBITDA?

I would say that certain deals are pricey.

In the water treatment field, for example, the high water mark was Cuno being bought by 3M.

That was probably the high mark.

I think you're probably seeing them easing off of those.

Last year was -- earlier this year I guess was probably the high point for multiples.

And you foresee more restructuring fourth quarter in '06 structuring costs?

At this point in time, we don't have a definitive plan in terms of our restructuring for 2006 yet.

I mean, Stewart, when you grow up by acquisitions here, it's sort of part of the nature of the Company where you are constantly re-examining your footprint.

So it's possible, but there's nothing been approved, and we're just starting to pull together our '06 business unit budgets.

So it's possible but nothing definitive.

How about for the fourth quarter?

I don't see anything major on the drawing board at this point in time.

Thank you very much.

Thank you.

Your next question comes from Andrew DeAngelis from KeyBanc Capital Markets.

You may go ahead, sir.

Good afternoon.

Hi there.

Just a couple things, housekeeping items.

Options.

Have you gotten the chance to look at that or '06 yet?

And what do you expect the impact to be.

Yes.

We would estimate right now that it would be $0.03 to $0.04 impact.

Is that kind of front-end loaded or is that spread evenly throughout the year?

It would be even.

I didn't catch the tax rate on a run rate basis.

What we have now is representative of our ongoing rate.

Okay.

And then separately you talked about copper being $3 to $4 million headwind.

How about resin during the quarter?

The 3 to 4 million is all materials.

Oh.

That's all materials.

Okay.

And then I guess just lastly, looking at China, you explained the impact to the top line due to the accounting treatment.

I guess what I really noticed during the quarter was the margins.

What are the sustainability of the margins in that China segment?

They look like they increased fairly substantially.

I think right now we're pretty comfortable with their margins.

If anything, the volume will continue to increase as we go forward.

With some of the new product offering and things, some of the other changes I discussed going to the commercial and water works side, we're just starting to see some of the benefit of that.

So we don't give forecast, but it's a reasonable -- I think we feel comfortable with those margins right now.

Have you seen any pricing pressure in that market?

Some on the lower end commodity oriented products.

That market is not that different from some other markets we deal in.

You have to have cost effective products.

Okay.

Thank you.

Thank you.

Your next question comes from Richard Rossi from Morgan Joseph.

You may go ahead.

Good afternoon, everyone.

Hi, Richard.

I know it's dangerous to change approaches on commodities simply because of a trend, but given some of what looks like long-term trends in terms of global growth, global demand for materials, as well as your increased exposure to the retail side of the business and the lessened ability to get price increases, have you thought about changing your approach as to how you look at your purchases of copper and resins?

More hedging?

Larger inventories, anything of that sort?

We're spending some time reviewing that very issue.

It's a very on topic question for us.

We haven't concluded that we're going to change the way we manage that part of our business.

To go into a long-term hedging program on any commodity or any currency when you're sort of at an all-time high is a little frightening.

Sure.

Understandably.

But we are looking at how we manage that, and we're not making any long-term commitments right now, and I don't think you'll see us make any long-term commitments when commodities are at an all-time high.

We think there might be some opportunities where we can leverage there.

In previous quarters, I think you did mention that you were exposed to some costs related to running domestic operations, plants while you were bringing Chinese operations up.

Has that continued to be a factor in the third quarter?

Will it be any factor in the forth quarter?

I think we have -- we don't have the exact number here, Rich, but there's definitely some cost that we're incurring right now while we bring some of these product lines up.

We have some duplicate stuff on some of our brawn products that we're putting into our wholly owned sub up in Tianjin.

That's where we're seeing most of it.

Hey, Rich, also don't forget that during the third quarter we did close a U.S. boundary.

That's right.

Took that off-line.

And that's a direct result of transitioning the regulators and some of the other Braun's products to China.

In that regard, was there a cost in the quarter related to that?

About $600,000 of restructuring costs to shut down that --

that's all in the restructuring costs.

Yes.

And then looking at on the retail side the rollouts, fewer rollouts next year, expectations therefore that the rollout costs will be lessened.

However, I'm just wondering, with less rollouts, does the growth on the retail side slow?

And on balance, does that help you in '06 in terms of profitability or does the lower growth sort of give you somewhat of a wash against the lower costs?

Well, I don't think we're signing up for lower rollouts just yet.

What I said is that we have our new manager of our retail group who's going through his plan now for the upcoming year.

I misunderstood then.

I'm sorry.

We're not signing up for rollouts on this call.

Okay?

Okay.

That's a difference between saying we're not going to have rollouts.

Right.

But I think you'll see us be very cautious on rollouts and making sure that they're as profitable as possible.

Okay.

Just one final thing.

If you looked at your filtration products at this juncture, roughly how much revenue do you have in the filtration side?

Overall about 50 million.

50 to 60 million.

All right.

That's it for me.

Thanks.

At this time, sir, you have no further questions.

Well, on that note, then, I would like to thank everybody for joining us for our call, and we look forward to speaking with you on the fourth quarter call probably to be held the first week in February.

Thank you.

Thank you.

Thank you for your participation in today's conference, ladies and gentlemen.

Have a nice day.