Watts Water Technologies Inc (WTS) 2005 Q4 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Fourth Quarter 2005 Watts Water Technologies Earnings Conference Call.

My name is Michelle, and I will be your audio coordinator for today.

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

We will be facilitating a question-and-answer session toward the end of today’s presentation.

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

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

Please proceed, sir.

Good morning.

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 31, 2004, which was filed with the Securities and Exchange Commission, and other reports we file from time to time with the Securities and Exchange Commission.

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

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 Principles.

A reconciliation of the non-GAAP financial measures to the most directly comparable GAAP measures is available in the press release dated February 7, 2006 relating to our fourth quarter 2005 financial results, a copy of which may be found in the Investor section of our website, www.WattsWater.com under the heading Press Releases.

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

Pat O’Keefe: Thank you, Ken.

The way we’d like to conduct our conference call today is that I am going to make some opening comments.

Then I’ll turn it over to Bill, who will walk you through the financial detail.

And then Bill will turn it back to me.

We’re going to talk about some things that we want you to consider when you’re building your future model with regard to the year 2006.

Then we’ll open the lines and receive any and all questions you may have.

The first thing I want to say is I’m pleased with the overall performance of the fourth quarter of 2005.

We posted improved results despite near-record raw material costs, particularly oil and the copper-based alloys.

Secondly, we were facing a headwind with regard to slow economic growth in most of the European economies.

All regions delivered solid operating growth in sales and in operating income, so it’s across-the-board kind of improvement.

Acquisitions contributed pretty much as expected and helped us boost our margins.

That was particularly true within the European environment.

We continued our programs to reduce costs by sourcing products and consolidating operations into low-cost countries in an effort to counteract the commodity pressures on margin.

We have leveraged our balance sheet in order to fund a number of acquisitions.

I think you saw that we made three major acquisitions in the fourth quarter.

We funded those acquisitions primarily with debt.

However, at the end of the year, we still have a net debt to capital employed of 33%, and we have $100 million of unused and available funding under our revolving lines of credit.

So the story really is revenues up 10.4%, net income up 83.3%, net income from continuing operations up 54%, so overall, a very good quarter.

I view this quarter as being a solid quarter, both in terms of implementing our key strategic issues and in terms of an operating performance.

So with that, I’ll turn it over to Bill, who will walk you through the details on the numbers.

Thank you, Pat.

As Pat mentioned, revenue in total was up by 10.4%.

That’s an increase of $23 million.

The components of that increase on a consolidated basis would be as follows --

Organically, we grew 6.7%, which is $14.9 million.

We experienced unfavorable foreign exchange changes, mostly the euro to the dollar, and that was unfavorable, 2.7%, or 6.1 million U.S. dollars.

And then our acquisitions contributed $14 million, or 6.4%.

That all totals $23 million, 10.4% total growth.

If we look at the earnings per share, our earnings from continuing ops, if you look at it on a pure GAAP basis, increased from $0.30 last year to $0.46.

However, if you recall last year’s fourth quarter, we had some one-time unusual charges, and if you back those charges out and you back the restructuring out and compare the earnings per share from continuing ops on kind of an ongoing basis, you would compare those numbers, and it would be $0.38 last year to $0.47 this year’s fourth quarter.

So when you take the noise out of the numbers, the bottom line behaved very nicely for us.

Now, I’d just like to talk about the revenue by the segments.

North America in total grew at 13.7%.

That’s 6% organically, 7% from acquisitions, and a very small favorable contribution from foreign exchange, which is the Canadian dollar.

Now, breaking North America into the two major components that we always talk about, retail and wholesale –

First of all, retail grew at 5% organic.

It’s about 5.5% on an organic basis.

Now, that’s much different than the year to date, which has grown at 13%.

The major difference – the major reasons for the differences, if you will, is first of all, in the fourth quarter, we did not have any significant rollouts of new products.

As you know, during the course of ’05, we’ve rolled out several new products, including the FloodSafe, the EZ-Sweat, the Hot Water Accessory Kits, and those had a major impact on our growth rate during the course of 2005.

And as we’ve discussed with all of you before, we do expect to see more choppiness on a quarterly basis in the growth rate on retail because of the timing of rollouts.

At the same time, we did see some impact from Home Depot, reducing their purchasing with us because of their inventory reduction program.

Home Depot for the full year grew at about 10% with us; in the fourth quarter, they grew at a rate of about 5%.

So the real issue here in the retail space for the quarter is really the absence of rollouts and reduced purchases from Home Depot.

On the wholesale side, revenue grew at 17% in total.

If you exclude the acquisitions, it grew at a rate of 7%.

So the wholesale revenue in the quarter was just shy of $124 million.

Looking at the reasons for the wholesale increase, we’ve had a great year for backflow, and that continued in the quarter.

Backflow sales were up 12%.

All the major markets in which we sell backflow behaved well for us.

That includes the commercial space, waterworks, as well as fire protection.

Other product lines that contributed – we continue to do well on our PEX sales.

As you know, we acquired Flexflow earlier in the year – earlier in the fourth quarter, excuse me, and they made a small contribution, and we also have a good, solid PEX business out of our Watts radiant facility.

The under-floor radiant heating business also performed well.

Our drain line performed well, specifically our Orion product line, which we acquired as part of the McCoy acquisition during 2004.

So what we saw in the quarter in the wholesale was our commercially orientated product lines did well – backflow, drains, and some of our automatic control valves as well.

The Canadian market – we did well there for the same reasons, the backflow and the PEX.

And this year at the beginning of the year, there was some expansion of the hydronic plumbing codes in Canada, and that helps create a good environment for us as well.

The acquisitions in North America contributed $10.7 million in the quarter.

That includes about $3 million from FEBCO/Mueller and about $0.5 million from Dormont.

As you recall, we closed on the Core acquisition at the beginning of December, and Dormont, we just had a couple of days of activity there.

But all in all, the acquisitions performed fine for us, and we are pleased with what we saw during the quarter from those acquired companies.

Looking to Europe, in total, we had 1.3% growth in Europe in the quarter.

Now, the three major factors there to understand that growth, first of all, organically, we grew at 6.1% in Europe, offset by some unfavorable foreign exchange of $6.8 million unfavorable.

That’s about 9.7%.

And then we had a couple of smaller acquisitions, which we had done earlier in the year, and those two companies contributed $3.4 million, which is 4.9%.

So you add all that up, and it’s 1.3%, or about $900,000.

So revenue for the European segment was $70.7 million in the quarter.

So the foreign exchange moved against us, but we’re pleased that it’s the best quarter we’ve seen from an organic standpoint during 2005.

A couple of comments on the European revenue --

First of all, the wholesale, which represents about half the revenue in Europe, grew at 1% in the OEM, which again represents the other half, grew at 8% in the quarter.

Now, that’s quite a change from the trends we’ve seen during the course of the year.

On the year, the wholesale is up about 9%, and OEM is flat on the year.

The wholesale we view overall as remaining somewhat weak in Europe due to the economy, particularly in the major trading areas of Italy, Germany, and France.

And the OEM market has been soft over the course of the year, primarily because the boiler manufacturers have reduced their purchasing because of fewer boilers being put into service.

So while -- we have reacted to that to try to offset that weakness due to the economy.

We’ve done well in Eastern Europe this year.

Our sales, about 10 million euros, so that’s up about 30% in the year.

We have been very aggressive in the German wholesale market, and we believe we’ve captured market share there.

We’ve also been focusing on products, on niche areas that give us growth opportunities, particularly the solar market -- that’s a growing area in Europe – as well as the under-floor radiant heating market, particularly up in the northern tier of Europe.

We see growth there.

We’ve also had quite a focus this year on improving the customer mix and the product mix to offset some of the unfavorable channel mix because while wholesale is up in the year and only 1% in the quarter, we do get a few extra gross margin points on the OEM versus the wholesale.

So all in all, we are pleased with the European performance with the very difficult economic conditions that we are dealing with there.

Looking at China, revenue is up almost $2 million.

It’s about 24%.

We closed at $8.4 million in the quarter.

If we look at the sales going into the commercial and waterworks space in the quarter, they’re up about 27%, 16% year to date.

Really, that’s the strength of the market in China, as well as some of the expanded product line that our Chinese managers are offering the market for both waterworks and commercial space.

Looking at the gross margin, the gross margin was 35.3% versus 34.2% last year.

And we’re also up about – we’re up 100 basis points from the gross margin in the third quarter.

Some of the reasons for the improvement in margin, we can look at it by segment.

The gross margin in China was essentially constant at 15%, and that basically is where we do see some variances because of the higher copper pricing, which are being offset by improved utilization as we continue to use more and more of our manufacturing space and source some more from China, as well as the improved sales into that domestic market.

And the margin might sound low there, but it’s heavily influenced by inter-company sales, which represent about 60% of the total volume coming out of China right now.

Looking at Europe, the gross margin increased from 29.6 last year to 31% this year.

It’s an improvement of 140 basis points.

Of the 140, 80 basis points came from acquired companies.

That’s Microflex and Electro Controls.

The rest of it came from improvements in the operation inside the European segments.

Last year, we had some expenses associated with poor efficiencies, which we have since spent some restructuring dollars on that, particularly in our gauge and instrumentation division.

We’ve seen some nice improvement performance there, which that allows us to do additional sourcing out of Bulgaria because of that work we’ve done there.

So, again, more low-cost sourcing occurring inside the European segment.

Obviously, organic growth in sales and a bit of a stronger mix toward the OEM also contribute to the improved performance in Europe.

North America –

If we combined the North America and the corporate column, which I think is appropriate to do, the gross margin would have gone from 36.6% last year to 37% this year, and that includes about 0.2 of a point unfavorable impact from the inclusion of the FEBCO/Mueller line in the quarter.

You’ll recall when we had our conference call announcing that acquisition that the gross margin for that business unit is in the low 20s, so there’s a bit of an unfavorable mix there.

But we had some good performance in our factories in the quarter with some reduced overhead spending.

You will recall that in the third quarter we closed one of our U.S. factories, so we’re receiving some of the benefit because of that.

We also generally had lower spending in the factories.

We also saw a bit of a favorable mix with the commercial products that we talked about earlier – the backflow, the control valves, the drains, etcetera.

Had some good sales performance, so the mix went in our favor during the quarter.

And for the most part on the wholesale side, we’ve been able to cover all of our commodity costs with pricing and cost reductions and spending reductions.

So the combination of those three things offset the higher commodities.

Looking at the SG&A in the quarter, $59.4 million last year, 60.2 this year.

I believe the correct way to look at this is if you were to back out those unusual charges that we discussed last – a few moments ago that occurred last year, the 2004 SG&A would have been $55.1 million.

So we’ve been able to reduce our SG&A by about 30 basis points on the year.

And the majority of the spending increase in terms of the dollar comes from the inclusion of acquired companies.

We had about $1 million reduction because of the change in foreign exchange rates.

We had about a $1.4 million reduction because of lower Sarbanes-Oxley expenses.

Some of that was offset by higher fuel surcharges.

We paid about $800,000 of fuel surcharges because of the cost of oil.

But all in all, the major things happening here really are the inclusion of the acquisitions, lower Sarbanes-Oxley expenses, somewhat offset by higher fuel costs.

But at the end of the day, we dropped the SG&A by 30 basis points in the quarter.

The operating earnings, again excluding those charges, would have gone from $20.5 million last year to $26.1 million this year, and we increased the op earnings by about 140 basis points and the dollars by about 27%, excluding the charges.

Just to give you some analysis on the operating earnings change, if you look at last year at 16.2 million, we would have lost about $700,000 at the operating line because of foreign exchange.

The acquisitions contributed a little bit over 1 million.

We had about 300,000 fewer restructuring dollars spent in this quarter than last year.

We had that unusual charge of $4.3 million last year.

And then all the items I’ve been discussing from the ongoing operations of the Company – the improved revenue, the improved gross margin, and the lower operating expenses by 30 basis points – the combination of those items contributed $5 million incremental operating earnings in the quarter.

So, again, all those items would bring you back up to the 26.1 million of op earnings in the quarter.

The tax rate in the quarter did increase quite a bit from last year.

Last year, the rate was 23.3; this year, 36.4.

I mean 36.4 is much more of a normal rate for us, but last year, we had recorded a net operating loss carry-forward as part of our China operations, and we had some tax planning that we implemented in the State of California.

And this year, we also have some – the mixed shift is a little bit different in terms of where we’re earning our income.

But the main issues really are the credits that we booked last year and the NOL in China, and 36.4 is a more normal rate for us.

Just a couple of other statistics that I think you might be interested in –

Two thousand five (2005), our total capital expenditures were $18.6 million.

Our depreciation and amortization in ’05 was 26.1.

We are budgeting $25 million of capital expenditures for 2006 with a D&A budget of 29 million.

Free cash flow last year was 12.2 million – excuse me, that’s in 2004.

The 2005 free cash is about double that at $23.4 million.

And those are the major highlights on the financials, and with that, I’d like to ask Pat to give us some commentary now.

Pat O’Keefe: Okay.

Everybody understands we don’t give guidance on a go-forward basis, but I want to point out some issues that we think are relevant as you build your forecast and build your financial model.

The way we look at 2006 is we anticipate a slowdown in the residential construction market, but we see that being more than offset with the continued recovery in the commercial marketplace.

And I think if you look at the fourth quarter numbers, the commercial marketplace was strong.

We expect it to continue to strengthen throughout 2006.

We expect to continue to struggle with near-record commodity pricing with, particularly, oil-based issues with resins and fuel costs and transportation costs.

We also see it in all the copper-based alloys.

We believe the retail sales to increase at a more modest rate, someplace in the mid-single digits, similar to what you saw in the fourth quarter.

We don’t anticipate a double-digit growth that we’ve seen in the past, so we expect to see some deceleration in the growth of the retail market.

We expect Dormont and FEBCO to contribute approximately $0.08 per share in 2006, which is what we told you previously on the conference calls for those two deals.

With the euro at current levels, we anticipate that we’ll face some unfavorable foreign exchange of maybe a penny to two pennies in probably the first and second quarter if they remain at today’s level.

We expect pricing to remain relatively difficult.

We’ve been dealing with that now for 24 months, particularly in the retail channel.

But one thing I want you to understand is that we have executed – of the price increases that we have planned in the retail channel, approximately 80% of those price increases have been implemented and accepted.

We have about 20% of those in-process discussions that are still underway without finalization of exactly what’s going to happen.

We anticipate that the pipeline will remain strong.

We had a – as I told you earlier, I think we closed on nine deals in 2005.

We see plenty of opportunity for companies that are synergistic with Watts as we go forward.

At this point in time, we don’t see any issues -- we’re not aware of any issues that were not previously discussed with you on the conference calls with regard to Dormont or FEBCO.

It’s pretty much as we depicted it earlier.

The next issue is the Board of Directors has approved a plan for us to issue some long-term debt, which Bill and I will be executing over the next couple of months.

Our intention is to take the money off the revolver and put it out on a longer-term basis at fairly attractive rates today.

And the last issue is that you should expect that we will have to expense options in 2006, and that is a number equivalent to about $0.03 per share.

With that, I would open the lines and accept any and all questions.

[OPERATOR INSTRUCTIONS]

Curt Woodworth, J.P. Morgan.

Bill, can you talk – you provided some data points on the margin this quarter with EBIT.

Based on my numbers, the incremental margin this quarter is about 26%, which seems pretty high.

And you talked about a mix benefit, as well as some one-time issues going away.

Can you just go through what some of those major items were on the margin year over year and whether you view that as sort of a sustainable level going forward?

The major items?

Well, I think the big thing – two major things happening there, Curt.

I think, first of all, when we start growing heavily skewed towards the commercial, which is again the backflow and the drain business and whatnot, I mean those incremental margins are pretty attractive.

And I mean as far as that being sustainable, that is, you know, dependent on the market, we believe that, based on what we’re seeing, that the commercial market is behaving in our favor right now.

And some of the lower gross margin products in the retail were soft.

So you have a much-improved mix there.

And when you talk about just order, you can’t just look at the revenue going up and you’re saying it’s 26% incremental because when we shut down a factory at the end of the third quarter, we pick up probably half a million dollars or so in incremental margin there.

So it’s not all happening because of margin and mix.

As I mentioned before, it is the spending.

So we had significantly reduced spending, probably $0.5 million because of that factory being shut down, and of the remaining spending, I don’t want to say it’s all sustainable, but I’d say a good portion of it is.

Okay, and what do you view the incremental margin for the company as on either on the commercial side or the wholesale side?

What’s the best way for us to kind of think about that as we look at our models for revenue growth next year and how it’s going to impact you for that channel?

On a contribution basis, on the purely commercial stuff, after freight and commissions, you’re probably talking 40%.

Forty percent?

Yes.

Okay.

Pat O’Keefe: Curt, those products are much more heavily – because of the engineering content and everything else, you’re talking probably a range of 40, even up to 50% on those engineered products.

Great.

Pat O’Keefe: Favorable – very favorable to us when the market shifts toward a commercial mix.

Right.

And then just on the retail side with -- pricing’s obviously – you know, it’s a little difficult, and copper continues to go up, what’s the strategy there for this year?

Do you think you’re going to get back to kind of a neutral position on price cost or at least the next couple quarters?

Can you talk about your expectations there?

Well, Pat referenced the pricing that we have achieved.

None of that has hit the numbers yet, so that will be incremental as we go forward.

And I don’t think we’re in a position to say that we’re going to be neutral because as copper continues to increase, we would have to go back and review all of our pricing in all of our markets.

So it’s a constant battle when you have this kind of rampant inflation on commodities.

Pat O’Keefe: Just so you understand, Curt, we implemented a number of – and made them effective in the fourth quarter -- a number of increases because of raw materials, cost changes, and we’re already in process of implementing additional ones here in the first and second quarter.

So we’ve seen metals particularly move recently, and we have to pass those on to our customers on a continuous basis.

So it’s an ongoing struggle.

You know what our performance has been to date.

Right.

Yes, I was just trying to get what you think, kind of the cost differential would be narrowing or steady state at this point in time.

I mean I know it’s hard to forecast what raw material costs are going to do, but –

If you can tell us what [cost] is going to do and when it’s going to do it, we’ll answer the question.

Fair enough.

All right, thanks.

Congratulations on a good quarter.

Thanks a lot, Curt.

Appreciate it.

Pat O’Keefe: Hey, thanks.

Ned Armstrong, FBR.

With regard to the operating margins in the quarter, is there any seasonality factor driving those at all, or is it purely the elements that you spoke of?

Yes, you have a little bit of seasonality, Ned, because you do have the heating season coming in there that is -- some of the better growth margin products come out of the heating product line.

So it’s not a huge issue, but it is there.

It’s slightly positive.

Okay, and with regard to the retail channel, you noted why the growth was down due to the lack of new product introductions.

Would you say that away from that, that the overall demand is still pretty solid there?

Or is demand actually declining even when you factor in the removal of the new products?

Well, several of those big retail accounts have had a de-inventorying emphasis, so they have an emphasis on bringing down their inventories.

We were impacted by that phenomena as well, so you have a multiple of things going on.

The one thing we would tell you that even here in the first part of the year 2006, we’ve seen erratic patterns of buying out of the retail accounts because they have their year-end – most of the retail accounts have their fiscal year-end January 31, so they were bringing down inventories in anticipation of reporting year-end numbers.

And I guess to a certain extent, it indicates to me that they’re anticipating a slowdown in the residential construction market where they have a big presence.

So I mean that’s why we look at these mid-double-digits – these mid-single-digit numbers as we go forward.

It’s a combination of slowing demand and their continuing efforts to bring down their inventories and increase their inventory turns.

Okay, and then final question regarding 2006.

Do you see much of an impact on ’06 numbers from restructuring activities regarding both what you’ve been doing as well as any that might be undertaken if they’re recent acquisitions?

I mean right now, Ned, is -- $1 million, that’s certain, and then there’s another 1.5 million to 2 that might come into play that we’re examining now.

Great.

Thank you very much.

Okay, thank you.

Andrew DeAngelis, Keybanc Capital Markets.

Just getting back to the retail situation, you mentioned the 20% of contracts not finalized.

Does that represent 20% of your retail volume?

Is that kind of how we should look at the number that you –

It really wasn’t intended that way.

Pat O’Keefe: Right.

We look at what – how do I want to say this – we look at sales volume that is under negotiation, and because of the fact that we have cost pressures, right?

And so it’s really 20% of the items that we took action on that’s still in play.

Now, interestingly enough, here in the first part of this year, we see continued effort, so there will be an ongoing process.

It’s almost a full-time job to be staying on top of pricing today.

But when we talk about the 20%, it’s 20% of the actions we’ve taken so far.

And it’s really actions we took across the fourth quarter.

In most cases, you have to give these accounts either 30, 60, or 90-day notice before you can get an effective price increase.

That’s what we’re talking about.

Okay.

You mentioned that the price that you’re going to realize on these contracts hasn’t hit the income statement yet, but at the same time, how about in terms of cost of sells, the increase in all the raw materials.

Has that impacted the income statement yet?

Well, we have about five months’ of material on hand at any given point in time, on average, and so the copper that’s hitting us in the month of January is copper that we would have bought several months ago.

And a lot of it depends, too, if you’re buying just pure raw material, like brass rod, it will hit you.

Those copper increases come into cost of goods sold faster than if you’re buying purchased valves or purchased components.

So if you look at copper today at about $2.25, that copper really won’t hit us till mid-year.

So, as Pat says, one of the reason it’s a full-time job on pricing is you’re constantly doing analysis to match up where copper is today versus what you’re buying today versus the spot market and where you think pricing needs to go, etcetera.

Absolutely.

It’s a vigil that we do.

Okay.

Just switching gears over to Europe, you kind of saw a reversal of a trend that you kind of mentioned throughout the year where wholesale was stronger and the OEM market was lighter, kind of reversed on you this fourth quarter.

Is that something that’s going to be sustainable, or should we view that trend as possibly re-reversing?

I don’t think we’re saying it’s a trend yet.

It’s just something that happened in the fourth quarter –

Okay.

-- and that’s because of the mix of product.

I mean our European managers did very well in improving the mix of the product into that OEM segment with more solar products and systems products on the under-floor radiant heating.

The manifold systems, the pump, packages, etcetera.

So we’re not saying it’s a trend yet.

Okay.

And then the bottom-line impact of currency translation into the European segment, you guys break that our separately?

It’s about $0.02 unfavorable in the quarter.

Okay.

Thank you, guys.

Pat O’Keefe: Thank you.

Congratulations.

Thank you very much.

David Smith, Citigroup.

Just quickly, can you go over – and maybe my calculation’s right or wrong.

Maybe you can reaffirm this.

But on the sales mix by the distribution channel in the quarter, it looks like, given what you’ve said, that wholesale was about 65%.

Would that be right?

I haven’t actually done that calculation, Dave, but –

I just took half of Europe and then –

Yes, I mean the retail was 41 million in the quarter in North America.

North American wholesale was 124.

So you can take half of the –

Europe?

-- half of Europe as wholesale.

Okay, so that would be – I get about 65%.

Would that be – that would be up over last year, right?

It should be up over last year, yes.

Okay.

I don’t have that comparison in front of me, but –

Okay.

What’s – when you say the 80% on the pricing contracts have been finalized, is that just pertaining to retail, or is that –

Yes.

-- for the whole Company?

No, we’re talking retail there because –

Pat O’Keefe: Yes, retail.

I mean wholesale’s kind of an ongoing thing where we did announce a price increase earlier in the fourth quarter and some during the last year, whereas we were referencing that the conversation we had with you guys.

During the third quarter conference call, we said we were going to go out and look at all this retail and focus on it.

So 80% of that effort is realized and 20% is still under negotiation.

Okay, then wholesale just is no problem to get the price increases still?

Pat O’Keefe: We continuously adjust pricing in the wholesale channel and have so far been successful.

And then as well in OEMs? [Indiscernible] the OEM side, it’s not a problem either?

Similar.

Yes, similar.

We’re passing on costs just to be able to maintain our margin.

Okay.

Do you guys have any read as far as how inventories are sitting so far in January in the wholesale and retail channel?

It sounds like retail’s down based on what your comments were today.

Yes, retail channels are clearly down because they are taking actions to reduce inventories.

The wholesale channel – typically this time of year, they also have relatively low inventories just because – but I don’t think anything unusual.

It’s just normally – the normal winter season inventory position.

In retail, is this a permanent decline, or is it something that you see building up after the year-end?

Well, we’re told by several of the major retailers that they see this as a permanent decline.

Okay.

And I infer from that that they anticipate that they don’t need the level of [safety fact][ph] they have over the last several years.

Okay.

One other thing.

You talk about an earn-out in the past couple quarters.

What was the impact in the quarter, the benefit, because I know it was in the third quarter, not in the fourth?

Right.

Well, we had booked every quarter this year -- in the first three quarters, excuse me, about 700,000, and then we had some small spillover into the fourth quarter of about 200,000 –

And it’s complete?

-- and now we’re done.

Okay.

We will never say that word again.

At least for the time being.

On the commercial construction market, you guys did seem to touch on what you’re seeing slightly – that it seems a little bit better, but any forward look on the commercial construction market for ’06?

Pat O’Keefe: Well, the only look we have is we have a number of conversations that take place with the architects and the engineering firms and contractor level –

Yes?

Pat O’Keefe: -- and they’re all telling us there’s tremendous amount of activity in the pipeline.

So we’re anticipating that – we’ve watched this now for 24 months, and it’s been coming very slow, but we think that 2006 will see some acceleration in the growth rate in that commercial marketplace.

What kind of – just assuming – just a rough inference, but how much better margins do you get as far as mix goes in that commercial market versus residential market?

It’s probably, I would say, 10 points or so.

Pat O’Keefe: Yes, I’d say a good 10 points.

Really?

Yes.

You’re talking about product that has a higher degree of engineering content and are, in many cases, specified by the engineer so that they’re specifically specifying Watts as the product they want to install.

Okay.

And that’s about half the Company, right?

Commercial is about half, that’s right.

Okay.

Pat O’Keefe: Yes, roughly.

Overall, yes.

Okay, last question.

You talked about $175 million in sourcing from low-cost [inaudible] last year for ’05?

Right.

Give us an update, maybe, where you ended the year and then what you think in ’06?

Yes, I think the slide that we were showing everyone, Dave, was – I think it said 165, and we feel that we came in extremely close to that number.

And while we don’t – I don’t have a specific number to give you right now, but we’re certainly going to be doing more international sourcing in ’06 than we did in ’05.

Okay.

Difficult to give you an exact number right now, though.

That’s great.

Thanks.

Okay, thank you.

Pat O’Keefe: Thank you.

Mark Grymski, Needham & Company.

Hey, Bill, just looking at working capital, it looks like you’re operating right around 36% of revenues, and historically, if my calculations are correct, you’re probably around 30%.

You know, with the – and I know some of inventories and things like that are hard to control due to your customers, but is there any push to maybe bring down working capital going forward?

Absolutely, absolutely.

I mean as you know, we have a new COO, Bill Martino, who’s been brought in for a number of reasons, but we are looking to improve the operations of the Company throughout, and working capital is a big focus area for us.

Pat O’Keefe: If you want to know his number-one objective, that is it.

Okay.

Is there any kind of level that you guys would feel on a – as a percentage of revenue or just getting down to more –

Well, what we’re looking – we don’t have a specific percentage there, but we believe we can grow the business this year and hold inventories constant and maybe have them decline a little bit.

Okay, okay.

And then significantly better improvement after that.

Okay, great.

And then my last question has mostly been answered, but regarding – you know, now that a lot of your competitors are flush with cash and everyone’s in a pretty good capital structure environment, what’s the – has the acquisition environment changed or multiples changing, or what are you seeing out there?

I would say in the last 90 days, there’s not been a significant change either up or down.

Right.

You know, there have been some hot properties in the water space that are out there being sold at the moment that tend to be on the higher end of the spectrum, but you know the range that we have historically have done deals, and we feel comfortable to be able to do it within those ranges.

Okay.

So there’s – you don’t see pressure placed upon you or anyone because of the environment?

Not really different from what we’ve seen over the last 24 months.

Okay.

Great, guys.

Thanks a lot, and great quarter.

Thank you.

Stuart Scharf, Standard & Poors Equity.

You’re basically focusing on productivity improvements in the low-cost regions.

Are you looking at that as more of a way of improving the margins rather than pushing through the prices?

Are the price hikes more to just offset the costs than you’re really looking to improve the operating margins from increasing your low-cost region of activity?

Well, there are two things that go on there, Stuart.

One is in today’s environment, in order to just stay competitive, you have to have productivity improvement and cost reductions despite what’s happening in raw materials, okay?

So we’ve tried to lower our cost structure and bring – manufacture products to the same standards that we manufacture them in the United States but at a lower cost.

Now, it’s gotten more complex because we’re also dealing with this headwind of raw material costs escalating on us.

But so far, we’ve been successful in maintaining our margins overall, and we remain competitive in most cases as we transition.

Now, we think long term, having the low-cost position is important to us, and if you’re going to have that low-cost position and you’re going to be effective in supplying customers, you have to have – you have to be prime, you have to be in a low-cost part of the world, and you have to have a world-class logistical system.

And that’s really what we’re trying to accomplish.

And I think so far, we’ve achieved that in terms of -- if you use the measure of maintaining your margins in a relatively difficult environment, we’ve been able to do it.

But it’s a key part of our strategy as we go forward that you’re going to see a larger percentage of our products being sourced from low-cost countries.

Okay, and regarding China, it’s a small percentage of your overall sales to you but good growth areas.

Do you have any plans to expand selling over there?

Yes, we’ve had a number of initiatives, although they’re not fully developed yet, but a number of initiatives to manufacture products to U.S. standards for installation and sale within China.

And I think you’re starting to see that our sales in China are starting to grow.

So we view China now in terms of two fronts.

One is a low-cost country for sourcing product into North America.

But we also see it as one of the better opportunities for future growth, particularly with our engineered products where there’s a real sensitivity to buying products that have reliability and quality and are highly engineered [indiscernible] commercial product.

Right.

Okay, thank you very much.

Thanks, Stuart.

Michael Schneider, Robert W. Baird.

Hey, just a list of questions.

I apologize.

Pat, first just on Home Depot and the inventory and what we should read into that.

I guess I heard, and maybe not correctly, just contradictory statements that you think the reductions may be just part of the seasonal pattern that we always see out of the retailers?

And then I think earlier you made the comment that you believe they’re preparing for a slowdown in residential.

Pat O’Keefe: No, I said – let me explain what I said, Michael –

Okay.

Pat O’Keefe: -- so you – when I was referring to the seasonal, I was referring to the wholesalers.

The wholesalers typically have their lowest inventory levels during late December and January.

And then they start stocking up.

We see a big pick-up in orders in the wholesale channel in late February throughout March and into April.

So they’re deliberately -- because of the restriction of outside activity, wholesalers typically bring their inventories down in December and January.

So we don’t see anything unusual in that pattern whatsoever.

Okay.

Pat O’Keefe: With regard to the retailers, okay, we saw a number of them literally with a design program to reduce their inventory levels, and they did that, Mike, where they were sort of playing two things against the other, which is, one, trying to maximize their year-end rebate, and, two, trying to bring their inventories down.

So you saw a good impact on us in the fourth quarter as a result of that.

We have experienced and continue to experience that into January, okay?

Now, to show you how unusual this is, we also have – first week of February, we’re getting double up.

So it’s hard for us at this point in time to tell you how it’s going to shake out, but in some – in many cases, they apparently went too far, and now they’re stocking back up because they achieved their inventory level.

Okay.

Pat O’Keefe: So it’s hard for me to tell you where it’s going to land on a quarter or the year other than the general guidance I gave you.

But your comments before stand that you think this is probably a structural reduction in their inventory and in some way a preparation for slower residential demand?

Pat O’Keefe: That’s what I’m thinking.

Okay.

And then just related to that, on the homebuilders, what – do you happen to have any numbers as to what revenue a year ago is directly to the homebuilders?

No, we don’t.

We sell through wholesale, Mike, so we don’t really have that.

You don’t, okay.

And then the collision course, I guess, between the wholesale and the retail channel.

You’ve got Home Depot acquiring wholesalers, and the latest is Hughes.

What should we think about longer term?

I imagine there’s no immediate impact, but given the retail pricing is the most difficult and the wholesale is the easiest, how do you see this playing out?

Well, I agree with you, Mike; in the short term, there’s no real impact, okay?

In the longer term, we think that they’re going to leverage their purchasing power, and interestingly enough, we’re doing some analysis at the moment to see how much overlap there is between what we sell to the retail side of their business and what we sell to the wholesale side of their business.

You have distinctly separate groups of product that you sell to each side.

Yes.

You know, for example, connectors are a big retail item.

Backflow is a big wholesale item.

So you typically see the wholesalers have moved to products that are highly engineered, more commercially oriented, or products that have strong contractor brand preference, okay?

So it’s too early to tell, but the overlap between the type of products we sell to the wholesale side of these organizations versus the retail side are relatively distinct.

And with that said, Mike, they’re going to leverage where they have the opportunity to.

Right.

And, Bill, on the refinancing that you’re planning on this year, what should we think about as the incremental borrowing cost if you stretch the maturity out?

I mean I think in the short term, you’re probably talking about 25 basis points, but if we go into the revolver, as the year goes on, we’ll gain all that – we’ll gain that amount back because the revolver pricing is declining.

So I think in the short term, it’s probably unfavorable, 20 to 25 basis points.

And when do you anticipate doing this, if you had to guess?

Hopefully, it will be in place by the beginning of the second quarter.

Okay, so we should model that in the second quarter.

Okay.

And then relative to our models, I know you don’t like to pinpoint guidance, but maybe we can just talk conceptually about the year.

If you look back at 2005, you did -- scrubbing at currency and the acquisitions, it looks like organic growth was roughly 7.5%, plus or minus.

Given that you expect residential to slow down, commercial to pick up, it seems like Europe is better.

How do you just conceptually see the organic growth rate trending in ’06 -- lower, higher, or about the same?

It was 7 – yes, your numbers are correct, 7.1 and 6.7 on the quarter.

Pat O’Keefe: We don’t really see the environment changing other than the shift like – that we talked about, Mike.

So we see the economic environment in which we’re operating being more favorable on the commercial side, less favorable on the residential side.

That results in a favorable margin shift.

Right.

Pat O’Keefe: And we see, quite honestly, the slowdown that we talked about in the retail market, but those products are lower margin, lower contribution margin.

So I would say – and the other side of it is we made two big acquisitions at the end of the year where we’re going through the process of implementing those.

We think that particularly Dormont is very – is a nice, strong business doing well.

FEBCO/Mueller/PolyJet will take us a couple quarters to get it moving.

Okay.

And then just on the first half of the year, though, we should bear in mind currency’s a negative, maybe some additional interest expense.

How should we think about first quarter, second quarter vis-à-vis what you did in the fourth quarter because if it’s a big quarter, margins are obviously very good.

You did $0.47.

But I’m looking at the First Call estimates, and the growth rate in the first quarter looks pretty healthy despite these headwinds.

I think, Mike, we’re going to be adding in Dormont and Core, and that will kind of offset, I think, the foreign exchange.

Yes.

Right?

At least in the first half.

And then those two acquisitions will be incremental in the second half because if foreign exchange rates stay where they are –

Yes.

-- and then you have a generally better mix shift because of the commercial, you have some – then you have the impact of Core and Dormont in the top line just being phased in, right, because they’re not in last year’s numbers.

On the top line?

Yes.

Would you expect them to be accretive in the first half, though, or actually dilutive as you run some [indiscernible] expenses through?

Well, I mean I think if you’re just looking at – I think Pat mentioned earlier, $0.08 for Core/Dormont, which is heavily skewed towards Dormont, right?

Yes.

Pat O’Keefe: It’s also somewhat back-ended.

Yes, and it would be back-ended a little bit, yes.

Okay.

Oh, and then just to repeat a number, Bill, you were talking about the relocation and consolidation expenses –

Right.

-- for this year.

I’m sorry, could you just repeat the numbers –

Well, we said that there’s a million that’s definite, Mike.

Okay.

And then there’s two million that we’re – some of that will definitely come into play.

We just don’t know exactly how much of it yet.

Okay.

Because we’re firming up those plans now.

Pat O’Keefe: But I mean I think at this point in time, we’re looking at an additional $2 million.

Yes.

If you modeled two, we’d be safe.

Great.

Thanks, guys.

Okay.

[OPERATOR INSTRUCTIONS]

Ian Fleischer, FBR.

My questions have been answered.

Thank you.

Thank you, Ian.

Andrew DeAngelis, Keybanc Capital Markets.

Just a quick question on the China/Asia segment.

As you kind of grow out that business, what do you view the normalized kind of sales growth margins in that business as?

The gross margins of that business?

The operating margin.

Operating margin?

Yes.

Well, I mean where we are right now, we should be able to improve those margins somewhat over time, I think, because we’re going to grow the domestic market in China more.

And we should be doing – we should be utilizing more of our capacity as time goes on.

So those margins should improve somewhat over time.

And then is [Chenshaw][ph] still scheduled to close sometime in first quarter here?

Pat O’Keefe: We currently have some issues that we are having difficulty resolving, so it’s taken longer than we anticipated, and we’ll have to see how that goes.

Okay.

Thanks, guys.

Pat O’Keefe: Okay.

Ladies and gentlemen, this does conclude the question-and-answer portion of today’s conference call.

I’d like to turn the presentation back over to Mr. O’Keefe for closing remarks.

Pat O’Keefe: Well, thank you.

Hey, I wanted just to let you guys know we appreciate your continued interest in Watts.

We are happy to report a very strong quarter, and we look forward to talking with you on the quarterly call at the end of the first quarter.

So thank you again.

Ladies and gentlemen, thank you for your participation in today’s conference call.

This does conclude your presentation, and you may now disconnect.

Have a great day.