Watts Water Technologies Inc (WTS) 2008 Q2 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the second quarter 2008 Watts Water Technology earnings conference call.

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

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

We will be facilitating a question-and-answer session towards the end of this conference.

(OPERATOR INSTRUCTIONS).

I would now like to turn the presentation over to your host for today's conference, Mr.

Kenneth R.

Lepaige, Assistant General Counsel.

Please proceed.

Thank you.

Before Pat and Bill begin, I want to let you know that various remarks they may make about the Company's future expectations, plans and prospects constitute forward-looking statements under the Safe Harbor provisions of 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 factors, including those discussed under the heading "Risk Factors" in our annual report on Form 10-K for the year ended December 31, 2007, and other reports we file from time to time with the Securities and Exchange Commission.

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

While we may elect to update forward-looking statements at some point in the future, we disclaim any obligation to do so and, therefore, you should not rely on these statements as representing our views as of any date subsequent to today.

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

Thank you, Ken, and good afternoon, everyone.

Welcome to the second quarter conference call and thank you for your continued interest in Watts Water Technologies.

Following my remarks, Bill McCartney, our CFO, will provide you with financial highlights for the Company in total and Bill will also cover individual sector results.

Then we will answer any questions you may have.

Before we get into the quarterly results, I'd like to briefly update you on a few important items.

First, regarding the progress on our restructuring program, in Q2, we took an additional pretax charge of approximately $1 million related to severance and relocation costs.

In the quarter, we finalized the move of our Chinese joint venture operation whose physical plant was taken over by eminent domain.

This move will ultimately reduce headcount and improve our manufacturing efficiency.

We will speak to China separately in a few minutes when we discuss our outlook.

In general, we are on target regarding the timing and implementation of various restructuring programs in the U.S.

and China.

Our European management team is reconsidering the details of its restructuring program, which will cause a delay in both the timing and cost incurred and the expected savings to be realized.

We now expect savings in 2008 from the restructuring exercise will approximate $500,000 pretax, amount which is -- this amount is $400,000 lower than discussed previously, again with most of the savings being realized in the second half of 2008.

With regard to the Chinese joint venture purchase, in June we paid approximately $3.3 million for our partners' interest.

There was a conditional $2.2 million that may be owed to our former joint venture partners, but only upon one partner meeting certain terms and conditions of the purchase agreement.

As we had mentioned before, having this operation fully under the Watts umbrella will allow us to control this Company in the same fashion as we control other wholly-owned business units.

Now, let's provide you with an update on our stock repurchase program.

As of yesterday, Monday, June 28th (sic), we had repurchased 2.45 million shares on the open market and we've invested 68.1 million to repurchase those shares.

The accretions on earnings per share for the repurchase of the shares in Q2 '08 was $0.03.

We expect an effect on earnings per share from the repurchase program in 2008, we approximate at $0.12.

As mentioned last quarter, we still expect to have capital flexibility in the form of existing cash and available credit lines to be opportunistic in the acquisition marketplace.

Next, let me address the acquisition program.

As you already know, on May 30th, we announced the closing of the acquisition of Blucher Metals at a cost of approximately $169 million, plus the assumption of approximately 15 million in debt.

The Blucher acquisition is the largest that Watts has ever made and as you know, Blucher is a leading provider of stainless steel drain systems in Europe and a worldwide leader in providing stainless steel drainage products to the marine industry.

Blucher offers Watts a new platform within the European marketplace.

The transition of blucher into the European operations has gone very smoothly during the first two months.

Blucher, as expected, was dilutive to our earnings in Q2 by $0.01.

We expect Blucher will be dilutive by approximately $0.04 in Q3 and anticipate that Blucher will be accretive to earnings by approximately $0.05 in Q4.

As mentioned during the first quarter conference call, we continue to explore other potential acquisition candidates in Europe and we continue to see deal volume in the U.S., but at lower levels.

We would hope that the pipeline will pick up as we move forward during the remainder of this year and into 2009.

In China, however, our focus in the near-term continues to be on operational improvement.

Our 2008 initiative to maximize cash flow and promote operational efficiency and productivity are proceeding well.

Regarding cash flow, I am again pleased to inform you that we continue to generate positive cash flow through the various working capital initiatives.

For year-to-date June 2008, we expect to generate positive cash from operating activities of approximately 40 million which compares favorably to the $200,000 net use of cash from operating activities in the first half of 2007.

Net cash outflows from working capital has decreased from approximately 57.7 million in the first half of 2007 to approximately 7 million in the first half of 2008, so great progress made there.

Regarding operational improvement, lean and Six Sigma continue to be a strong area of development at Watts.

To date, 1,200 Watts employees have attended training programs.

The executive leadership team has received formal lean awareness training and process innovation training during the second quarter.

We have recently placed a senior person to head up our lean and operational excellent effort.

Each major manufacturing location is working to build lean, Six Sigma black belts and green belts, and in addition, they are establishing steering teams to charter, prioritize and execute events.

Performance score cards have been implemented that track the key metrics such as on-time delivery, inventory turns, cost reduction and quality improvement.

We have conducted several high-impact ties-in events and have generated cost and inventory reduction.

We will expand lean techniques to our small manufacturing locations as the year progresses.

We are still in the early stages, but are very committed to this endeavor and are very pleased with our early successes.

I'd like to take a moment now to discuss the most important resource -- our people.

As a Company, we are committed to finding talented people who can lead the organization into the next decade.

As I just mentioned, we hired a senior-level employee to drive our lean initiative.

In the second quarter, we also hired a new president of North America and China, David [Coughlin], who will make significant contributions to our business.

We also hired a new VP to add more depth and expertise to our sourcing capabilities and we expect that a new general manager for our French operation will be on board in the near future.

We anticipate that these leaders will help us drive new business opportunities and will help make our operations more efficient in the future.

As mentioned in the last conference call, in a changing economic environment, we believe that new product development and product expansion into new markets will be an important driver of growth.

As an example, we believe our results for Q2 were enhanced by packages we sell into the European solar and energy conservation marketplace.

These packages were first introduced in 2006 and our sales have expanded as a reaction to higher oil and gas costs.

Finally, I'd like to make the following observation regarding the just-ended quarter and our outlook for the balance of 2008.

Bill will provide you with financial details in a moment.

Overall, our financial results for Q2 were stronger than we anticipated, given the macro-economic environment in which we are dealing.

We had organic growth in sales for the first time since Q3 '07.

Europe contributed to a solid quarter as we were able to leverage additional volume with some rationalization efforts we have made over the past several years in Italy.

Some of the big customers in Europe are large boiler OEMs.

We have -- they have increased their inventories in anticipation of new orders for alternative energy and energy conservation devices.

We believe they are anticipating that the higher oil and gas prices are going to increase demand for such products and turn products -- and turn the packages and products we sell to these OEMs for solar and other applications were very strong in Q2.

Although we have minimum insight into the future demand for these large European customers, given recent order intake, we expect the trend will continue into the third quarter and we still believe that our broad product offering that we can deliver on a pan-European basis will allow us to continue to gain market share versus smaller competitors.

Turning our attention to the European macro environment, we see signs of an economic downturn with increased inflation and higher unemployment.

Higher energy costs are causing wildcat strikes in some countries such as Spain, UK and France.

A recent article in the "Wall Street Journal," July 25th, indicated that the risk of recession in the 15-year-old zone countries is higher than -- given some of the more recent negative trends.

All in all, this information provides a concerning outlook for Europe, so whereas near term we are somewhat bullish, given the reaction to the higher oil and gas prices and the slug of alternative energy products we're selling, we are not sure of the impact the economy will have on our results as we move forward into 2009.

In North America, our growth in Q2 was positive due to higher U.S.

retail sales and a Canadian economy that is still performing relatively well.

In general, we experienced, and are continuing to see a lot of variability in customer demand.

For the first month and a half of Q2, our run rates were on par with those that we experienced in Q1.

Orders in much -- orders came in much stronger later in the quarter.

It appears that the retailers and wholesalers were restocking in Q2 after having run their inventories down in Q1 and the first part of Q2.

We also saw sales increases in the big membership stores such as Costco, likely an indication that consumers are trying to save money in a tight economy.

Our Canadian business continues to perform well in most areas of the country.

Alberta is an especially active area, given the growing oil sand production due to the higher oil prices.

There are also new code regulations for backflow devices in Canada, which is helping our backflow sales there.

Wholesale sales in North America were down 1% in Q2 which is primarily due to the softness in the residential market.

The U.S.

commercial markets are tough to gauge.

We see larger markets are fairly strong, but some of the smaller commercial markets are struggling.

Macro data from -- for commercial area is not very positive and as mentioned in the past, we look at both the Dodge Reports and the Architectural Billing Index as data points in evaluating macro-economic trends.

The Dodge Report of expectations for commercial square footage as of March showed a reduction of 12.8 for 2008 compared to 2007.

This reduction has increased from 7.4 as predicated in the December time frame.

The June ABI index showed as 46.1, which was up from May, but still below 50 for the fifth consecutive month, meaning business levels at the architectural firms have deteriorated and continue to deteriorate.

Both these trends are obviously concerning.

At this point, I hold to my previous statement that the commercial space will have minimum growth for the remainder of 2008.

Taking a look at the domestic residential channels, we see -- we sell into, the headline news is not very -- is fairly gloomy.

Single home inventory levels stand at 11.1 months in June.

Single family construction starts were down sequentially 5% from May of '08, which is the lowest pace since January of 1991.

Home prices keep on falling and potential buyers are squeezed by banks through tighter lending standards.

In short, I still don't believe that we will see any upside in the residential marketplace until approximately mid-2009.

Regarding the pricing in the U.S., we are expecting selected price increases to take effect in September.

These are mostly to cover cost increases in products made of cast iron, where we've seen escalating costs, but the effect will be minimum on Q3, but have a positive effect on the margins in Q4.

As the U.S.

-- as far as the U.S.

replacement market is concerned, from where we -- from what I can gather, the market remains fairly steady and will remain that way for the remainder of 2008.

In summary, our view on North America is -- we can expect Canada to continue a solid performance.

We see near-term opportunity in the U.S.

running at rates that are somewhat between what we saw in the first and second quarter of 2008, and we are not sure we will receive any restocking effects like we saw from retailers and wholesalers at the end of quarter two.

Margins may be slightly constrained in Q3 until we see the benefits from selected price increases which will help margins in Q4.

Now, let's talk a little bit about China for a moment.

The Q2 results for China were disappointing, exasperated by the move of our plant in Tianjin, TWT and a labor dispute at a South China plant, WPT, which we discussed during our Q1 conference call.

Both of these issues continue to negatively effect our results in Q2.

As mentioned during the Q1 conference call, much of the Chinese operation serves as a feeder plant for products sold into the North American, and to a lesser extent, into Europe.

As North America has trimmed inventory levels as part of the Company's overall working capital initiative, production levels at our Chinese locations have dropped significantly, which has caused overhead under-absorption issues.

Commodity prices, value-added tax and a currency swing have also effected our China results.

The main Chinese domestic sales company, [Cheng-Chou], which makes large diameter hydraulic butterfly valves, is experiencing shipping delays due to the earthquake in Central China a few months ago.

Although order rates remain strong, we expect shipping delays to persist into 2009.

Our senior operational management is keenly focused on addressing the production and potential operating opportunity that exists in our Chinese manufacturing.

We expect further plans will be initiated over the next several quarters.

In short, we expect China will continue to under-perform with capacity issues and shipment delays through the remainder of 2008.

Now, I'd like to turn the call over to Bill McCartney, who will take you through the financial highlights.

Then we will take any questions.

Bill?

Okay.

Thank you, Pat.

First of all, just a note that the figures that we released today in our press release are consistent with the prerelease that we had a week ago Friday, and as I go through the results here, I'd like to comment both on a comparison basis to Q2 2007, as well as to Q1 of 2008, just to give you a feel for where we experienced some of the improvements.

So here we go.

We'll say revenue, $389 million was up 11% versus Q2 last year and we picked up $45 million of revenue versus Q1, and as we go through the segments, I'll point out in each area the reasons for the improved revenue.

When we look at the overall revenue though, organically, we grew $5.7 million or 1.6% from foreign exchange, primarily the Euro.

We picked up $20 million or just about 6% and from acquisitions, we picked up $12 million, 3.5% and those are the acquisitions of TGI and Blucher.

So that totals $39 million.

What I'd like to do now is just to take a look at our overall -- we call it reconciliation to our earnings per share, both to last year and to Q1.

When you look at last year's second quarter, we had a $0.46 EPS which excludes our restructuring charges.

As we roll forward into Q2 this year, we pick up $0.03 because of our buyback.

We picked up $0.05 because of the foreign exchange rates, the Euro strengthening relative to the dollar.

In Q2 of this year, we had some favorable results in our tax line due to a change in some of the Italian tax law and a favorable result on a state tax audit here in the United States, so that's $0.03 there.

Then we lost $0.01 from Blucher.

We thought we would have about $0.02 of dilution; we actually had $0.01 of dilution.

Blucher's margins came in a little bit better than we were expecting due to a good mix and some good savings on some material projects, but we still had dilution of $0.01.

Then if you look at below the line, we lost $0.04 versus last year and that's primarily due to lower interest earnings because of having less cash on board as a result of our stock buyback and acquiring Blucher and lower interest rates versus last year.

When you look at all those adjustments and that tells you we would have had a $0.52 quarter, so from an operating standpoint, we believe that in the second quarter of this year, we had a $0.04 improvement in our operations.

And I'll go into detail on that as we go through the segments, but that's primarily driven by improved pricing in North America, a little bit of a favorable mix.

In Europe, we have volume and leverage occurring and then offset -- some offsets from China as a result of the issues that Pat mentioned a moment ago, some of the increasing costs we're seeing associated with foreign exchange, VAT, and lower volume in the plants.

Now, the same analysis, if you take a look at that, comparing ourselves to Q1 of 2008, you recall we had $0.39 earnings per share from operations, excluding restructuring.

We would have picked up about $0.01 from Q1 on foreign exchange rates.

We would have picked up about $0.03 because of the tax rate issue.

We lost $0.01 on -- because of dilution of Blucher and we lost $0.01 below the line, not because of the change in interest, but because of the minority interest changing because we bought out the 40% of our Chinese joint venture, so we lose that minority interest.

So that tells you that we would have had a $0.41 quarter on a comparable basis.

We had a $0.56 quarter, so we had $0.15 improvement in operations from Q1 into Q2.

When we look at that, it's really driven by improved volume and gross margins in North America, improved volumes in operating leverage in Europe, and again, offset by some of the operating issues in China around plant moves and increased costs.

What I'd like to do now is just go into the typical analysis that we provide you regarding our segments.

When we look at North America in total, $235 million of revenue, that's an increase of 4.5% versus last year and that's 2% organic growth; about 1% from foreign exchange, that's the Canadian dollar, and acquisitions of 2%, which those come to 4.5% or $10 million.

Now, looking at the wholesale side in North America, if you exclude the acquisitions, we were at $181 million and that compares to $163 million in Q1 and we're down about 1% versus last year.

When we look at Q2 over Q1 in North American wholesale, really what we're seeing is that we had a pretty good irrigation season and the commercial construction came in pretty good.

As Pat mentioned, some of the -- some markets are weak and some markets are strong, but overall, the commercial came in good versus Q1.

Compared to Q2, last year obviously, we're continuing to see the softness in the residential side, but the commercial side is up somewhat.

We believe that we would have had an overall volume increase on the commercial side of very low single-digits and the residential side, a decrease in unit volume of about 10% and then those items are offset by some favorable pricing.

Looking at the retail side, $48 million in Q2 compared to $43 million last year and $43 million in Q1 of '08.

What we're seeing here versus last year, we're seeing some rollouts at some of the large chains on some new products that we're doing, and we're seeing some pricing.

And we believe that we have a decrease in unit volume of about 5% because of the slowness on the residential side.

Now, we compare that to Q1 and we saw about 11% reduction because of the slowness in residential which we also believe was due to some destocking.

So we had a pickup of about 5 points because of the change in destocking in Q1 to some improved stocking levels in Q2.

In Europe, $139 million in the quarter, that's a growth rate of 29% versus last year and compared to Q1, Europe was $122 million.

Looking at the components there, we had organic growth of $4.8 million, which is 4.4%.

The FX was 18 million versus last year, about 17% and then the acquisitions, 8 million or 7.6% which totals $31 million or 29%.

Again, we compare that activity to Q1, organically we had negative growth in Q1 in Europe of 7 points, so we saw quite a difference in our order entry rate, really due to the factors that Pat mentioned where sort of late in the quarter, we saw a surge in orders around energy-efficient products once oil hit about $140 a barrel.

And we expect those trends to continue into the next couple of quarters, as Pat mentioned.

In China, $15 million of revenue, that's a decrease of 14% versus last year and it's a pickup of about $5 million versus Q1.

So when we look at China -- but first of all, you recall in last year's second quarter, we had four months of activity for a couple of our smaller business units, and this year, we're only having three months of activity because if you recall, last year, as we explained to you that we were bringing all of our accounting and reporting up to a current basis, so we had a four-month quarter.

So that actually had an impact of about a $2.5 million pickup on the revenue.

So without -- if you had a three-month quarter to a three-month quarter, the total revenue in China would be flat year-over-year and it still is up 5 million versus the first quarter.

I think Pat mentioned a lot of the issues that we're having there.

The order entry rate for our infrastructure business remains good, even though we're having some issues around delayed shipments because of the earthquake and we had fewer sales because of some of the disruption in the other plants.

On the gross margin side, 34% on a consolidated basis.

That's up 1.5 points versus last year and versus 33.2% in Q1.

We'll talk about the margin in each of the segments.

North America's gross margin was 35.4%.

That's up 4.1% versus last year and up about a point versus Q1.

Looking at the margin in North America, we have much more favorable pricing versus last year in North America.

We also had a much more favorable product mix on some of our products on the commercial side.

And then versus Q1, it's really associated primarily with the sales volume that I mentioned earlier to you.

In Europe, the gross margin is 33%.

That's one of the best margins we've seen in Europe for many years and that's an increase of 1 point versus last year and 1.5 points versus the first quarter.

What we're seeing in Europe relative to the margin is a function of the increased volume, but as you recall, about a year and a half ago, we did some restructuring in Europe where we consolidated a couple of plants in Italy into one plant.

So we're starting to see the impact of that plant consolidation with this increased volume.

We're also in the process of the current year restructuring in Europe, where we were bringing additional work into those plants and then a combination of the restructuring, bringing the work in-house from another plant that we're downsizing and the increased volume from the energy orders, that really created some nice operating leverage in our Italian factories.

And that's what gave us, in combination with the volume, gave us a nice improvement in the gross margin in Europe.

Again, looking at China, the margin is 7%.

That's down from 15% last year and it's down a point from Q1.

Again, it's the same issues that we've been mentioning, lower production levels and some of the higher costs that we're dealing with around the foreign exchange rates, the change in taxes, some local inflation and the inefficiencies that we're dealing with surrounding plant relocations and some of the labor issues that we have in southern China.

The SG&A at $96 million is up 12 million versus last year.

We break that out into the factors.

From an organic standpoint, we were up 4.7 million.

The foreign exchange was 4.2 million and then the inclusion of the SG&A from acquired companies is $3.5 million and that brings you to the 12.4 million in total.

So operating earnings, $35 million at 9%, that's up from last year at 8.6 and up from first quarter, which was 7.6 and that really is a result of the improved gross margins and the operating leverage from the volumes that we discussed.

When we look at the overall operating earnings, we're up about $5 million versus last year and that is primarily due to two factors.

One is the volume and improved margins and then contribution from foreign exchange.

Below the line, we had a decrease of about -- excuse me, an increase in expense below the line of about 4 million.

That is entirely due to changes in interest income as a result of the lower cash we have on hand because again, the purchase price of purchasing Blucher, the stock buyback and some of the lower interest rates.

The tax rate, 31.2%, this quarter down about a point versus last year and down about 2.5 points versus Q1 and that's the result of the tax law change in Italy and the state tax audit that we had in the U.S.

Overall, net income from continuing operations at $20 million is up from last year at $17.7 million.

So I think with that, we can now open it up for any questions that you might have.

(OPERATOR INSTRUCTIONS).

And your first question comes from the line of Mike Schneider of Robert Baird.

Please proceed.

Good afternoon, guys.

Hey, Michael, how you doing?

Good.

Pat, maybe first just on your opening comments about some of the European restructuring being rethought, I think, to use your word, could you explain what's changed there and again, run through the math as to the savings delay, I guess, or push-out?

Yes, they're rethinking some of the restructuring in terms of -- mostly in terms of the timing of it and it's mostly delayed because of the fact that I mentioned later in my comments that we were hiring a new manager for one of our operations, the French operation.

And they want to make sure that he's completely -- he or she, whoever comes on board, is completely behind their program and is brought into it.

So that's really what it is, more of a delay, Mike, than a change in the program.

And you had been modeling -- or 400,000 of the savings gets pushed from '08 to '09?

That's right.

That's correct.

Okay.

And then just in the domestic wholesale channel, it looks like volumes -- if I recall last quarter, the volumes in U.S.

wholesale were down about 10% in Q1 and in Q2, it looks like they were probably down mid-single-digits.

Any change in distributor tone or restocking, destocking or just in product mix or strength that occurred during Q2 to explain, I guess, the less negative results?

Yes, it's quite clear, Mike, what was going on.

In Q1 and for the first half of Q2, we still had destocking going on and they were selling off inventory and bringing their inventory levels down.

Apparently, they went too far because we saw both on the retail side and on the wholesale side, the last 45 days of the quarter, a very strong input that continued right to the end of the quarter.

Now, I think that's a reflection of the fact that activity wasn't as low as they anticipated it going into the summer months.

So the question that we're struggling with now is will we see that continue into the third quarter and we don't really know at this point.

We also don't know what they're going to do as they get toward the end of their quarter, whether there's a restocking in anticipation of a strong fall.

It depends, I think, a little bit on what the basic activity is at the contractor level.

The one thing I'd say, Mike, this is a really unusual year.

Our demand patterns defy history and they're much more erratic.

Sure.

What --

And that's what you saw.

I think we probably got our forecast -- the internal forecasts for the first half of the year were accurate, but they were inaccurate depending on if you measured them by quarter or if measured them by month.

Sure.

And then just in Europe, the strength in the solar and geothermal type products led to growth.

Are you able to discern what Europe did, I guess, or what the trend was in Europe through the quarter if you back out those type of products?

Well, we were on a path, Mike.

If you look at Q1, okay, before we had the surge in oil, we were down 7% and sort of going into the first half of Q2, we were thinking we were sort of flat on that kind of a trend.

So then we wound up being positive about 5 points in the whole quarter and that surge of orders really starting occurring in the second half of the year -- second half of the quarter, rather.

Okay.

So --

And that's continuing into the third quarter as well, Mike.

And can you describe these type of products?

What are the typical applications?

What type of systems, who are the customers and specifically, is this a channel fill going on or an inventory build by some of these OEMs?

And just really, I guess, what the sustainability of this trend is if we assume crude stays where it is.

Yes, these are sub-component systems that go into basically solar application and condensing boilers.

Condensing boilers are more efficient boilers, Mike, and the solar is an alternative energy package.

We also make a number of units that measure the heat usage, the thermal heat usage, by an individual apartment, apartment by apartment.

So you might have a centralized heating system for a large multi-story apartment building, but you want to effectively put a cash register on every individual apartment to measure the energy use in that apartment.

So those are the type of products that these are.

And in terms of like a channel fill or inventory stocking by the OEMs, can you detect where they are in this process?

Well, I think, Mike, they are anticipating a strong fall selling season because I think they expect that people will upgrade their existing heating system to put in a more energy efficient or an alternative energy system.

So I think you're going to see -- this is anticipated demand that will be sold primarily in the third and fourth quarter.

And does this cannibalize other products you've got?

Not really, no.

Okay.

Thank you.

And your next question comes from the line of Kevin Maczka of [Mack] Capital Markets.

Hi, Pat, Bill.

Hi, there.

Hi, how you doing?

Just a question on the raw material side.

I think we said last quarter that you were expecting a little bit bigger hit in Q3 than what you thought you'd see in Q2.

Is that still your expectation?

And you always get the question about the whole price-cost relationship.

Could you just give a little bit more color on where you stand there?

Yes, that statement, we still hold by that.

What we're seeing is increases in plastic resins because of the oil and we're seeing increases in cast iron, a little bit on the copper side as well, but mostly driven by cast iron and plastics.

And we are going out with a price increase which will be effective for our major business units toward the end of -- the middle of September, so we will see a little bit of unfavorable hit on the margin in Q3 because of material.

And then if we're successful with the price increase, we expect to offset that for Q4.

Okay.

And then Pat, just going back to your comments on the outlook in Europe, I was a little bit confused.

I think you were talking about the surge in oil potentially benefiting some of these energy conservation products that you're rolling out, but yet, of course, the slowing economy in general is a negative.

So how do we reconcile that again?

I'm pretty bullish on the second half of the year in Europe.

I'm concerned as we go into 2009, okay?

I think the demand that we're seeing here in the second quarter is going to continue into the -- at least way through the third quarter and probably into the fourth quarter.

What I'm concerned is is what happens as we go into 2009 because there are a lot of issues in Europe similar to what we're seeing in North America in terms of the economic slowdown.

Okay.

And just finally, one more quick one if I could.

The energy products, can you talk about what percent of your mix in Europe those represent today?

About half our business in Europe, Kevin, is heating, okay, in terms of -- Pat will say half of it is OEM, okay, and these are selling heating products into the large pressure vessel, boiler and water heater manufacturers.

And they've been going through a transition over the last couple of years, transitioning from gas-fired appliances to solar and what-not, alternate energy technologies.

And their base businesses on the gas-fired side has been declining anywhere from 25 to 30% per year for the last two years or so, but what we saw in this quarter was when oil really hit an all-time high -- I think like $140 a barrel is sort of what we call the point of pain where people really got up and took notice.

Like $4 a gallon for gas is very painful for the people in the U.S.

where they start changing their behavior.

Well, it feels like $140 a barrel is the point of pain in Europe for these heating products, so it is a major part of our business and it's been going through quite a transition over the last couple of years.

Okay, great.

Thank you.

And your next question comes from the line of Ned Armstrong of FBR Capital Markets.

Thank you.

Good afternoon.

Hey, Ned, how are you?

Good, good.

To the degree that you can, can you talk about the commercial markets in the U.S.

by type of structure, be it office, hotel, retail?

Are you able to differentiate any patterns there as to whether one is any worse than the other or not?

Well, let me just make some general comments and then you can look at the Dodge Reports and this will help you, but Watts is generally beneficial when there's a high occupancy rate in a facility and particularly high occupancy with high sanitary -- concentration of sanitary processes.

So if you were to look at the Dodge Report, Watts is best in something like a doctor's office or a nursing home or a hospital with a lot of beds and a lot of sanitary function in them.

You think of hotels being the same way.

We sort of hate warehouse space and those kind of things.

So if you look at the Dodge Reports -- I don't have them available at the moment, but you want to look at those areas where -- healthcare is a good one; the hospitality industry is a good one; office space is a good one for us; prisons are good ones for us.

And when you get to manufacturing and industrial space, it's pretty much discounted.

Okay.

Bill, on the tax benefits that you alluded to, do you know what the impact of each one separately is?

Is that possible to break out?

I can tell you if you'd like.

Let's see.

The one in Italy was EUR 330,000 and in the Massachusetts -- well, in the United States, it was $430,000.

Okay.

And then what was the share count at the end of the quarter?

Hold on, I'll give it to you in one second.

It should have been on the press release, Ned, but let me just see.

I think I have it here -- 36.8 million.

That was the end of the quarter?

Yes.

Okay, good.

Thank you.

Okay.

Your next question comes from the line of Christopher Glenn of Oppenheimer.

Hi, thank you.

Hi, Chris.

Hi.

So around the solar geothermal in Europe, you kind of gave a breakdown of the segment in terms of the half heating, half OEM.

My impression is that the solar geothermal energy related things kind of cross-cut over both of those pieces.

Can you kind of resize that to your current mix?

I think what we were saying is that half -- approximately half our business in Europe is OEM; the other half would be -- you'd have about 45% wholesale and about 5% do-it-yourself.

And these large -- this OEM business is the large boiler manufacturers that are incorporating all these products into their units in their systems, okay?

The wholesale side still -- so the OEM is primarily a heating-oriented business, how you heat water.

The wholesale side is both plumbing and the replacement business for heating as well, but we don't see the geothermal solar on the wholesale side because it's still relatively new and the replacement business really hasn't built up in there yet.

Okay.

And the OEM side, it's the majority now?

It's a significant portion of the OEM business.

I don't want to say it's the majority.

Okay.

And then in North America, really the [bifurcation] between the first half of the quarter and the second half of the quarter, in terms of sell-through, do you think that kind of averages out to what the appropriate sell-through is going from destocking to overcompensating?

I'd say that's a fair representation of what we saw overall.

Okay.

So although it's difficult, the kind of unit volumes you saw in the quarter would be the best shot at kind of earmarking a run rate.

Yes, the best way to look at it, I think, is if you look at the first six months of the year, you had destocking probably for -- let me think -- four out of the six months, and then you had restocking for two out of the six months.

And if you take a -- the best estimate at this point in time is if we look at the economic environment, probably that average is good.

Okay.

And then on the restocking, do you think pre-buy ahead of the price increases had any benefit in the quarter and who'd be more likely, the OEM side or the wholesale side, to engage in pre-buy activity?

We didn't see any pre-buying [information on the] pricing.

We saw that earlier in the economic cycle, but now at this late stage in the economic -- there's been so much inflation in raw materials that wholesalers aren't reacting that way at this point.

Okay.

And then lastly, could we just get an overall picture on what the consolidated unit volumes were year-over-year in the Europe and North American segments?

Well, I think I gave the unit volumes earlier.

I'll repeat it on North America, which is -- the estimates we have here internally are the residential would be down somewhere around 10% for unit volumes.

Commercial would be up around 4% and then pricing offsets that.

And then when it comes to unit volumes in Europe, we don't really track that here because there are so many business units and markets and what-not that it's not something that we really do, but if you look at our overall organic growth in Europe, we were up $4.8 million which is 4.4%.

And that would have some pricing in it, as well as unit volume and that's a significant change from Q1 where we had negative organic growth of 7% in Q1.

Okay, great.

Thanks a lot.

Okay.

Your next question comes from the line of Ryan Connors of Boenning & Scattergood.

Good evening.

Hello there.

I wanted to spend a couple of minutes if we could actually on the balance sheet.

I think we've gone through a pretty good depth on the end markets and so forth, but one of the things I thought was kind of interesting that for a period of time during the second quarter, the stock actually did trade meaningfully below book value for an extended period.

Obviously, we could interpret that a number of ways, but one of them would be that the market was saying it thought that the value of the goodwill and/or the inventory on the balance sheet would have to be written down.

So I wondered if you could just take a few minutes to address how you assess those assets for impairment and what sorts of triggering events might lead you to take a look at that, especially on the intangible asset side, and what the likelihood would be, in your view, that you'd have to take that kind of action?

And if so, whether or not you'd have to raise capital and that kind of a scenario.

Well, first of all, I don't envision any type of impairment on inventory at all.

I mean, we have a very conservatively valued inventory.

A lot of it is material cost that's in there.

So that's really not an issue at all.

When it comes to the goodwill and the intangibles, I mean, under the rules, we're required to do a full impairment analysis every year, which we do on October 29th at the closing of our October -- and if you look at what we did last year, we had a pretty wide gap between the carrying value and the economic value of our intangibles.

The only place that even, I think, has a potential or a concern around any impairment rate, maybe you'd have some goodwill in China, which we don't -- we only carry a few million dollars of goodwill in China.

So as we have some of those business units that are struggling, you're always subject to that, but it's -- that is not -- well, let's say that is a very small percentage of our intangible assets.

Okay.

Okay.

That's helpful.

Thanks, Bill.

And then also just -- I don't know if you mentioned -- I don't think you did.

Obviously, there's been a lot of noise on the tax line.

Can you just update us what your full year kind of guesstimate is for a run rate?

Without any favorable or [unfavorable] adjustments, the tax rate would be about 34%.

Okay, great.

Well, other than that, it's been very comprehensive here, so that's it for me.

Thanks, guys.

Thank you.

Your next question comes from the line of Todd Vencil of Davenport.

Hi, thanks, guys.

Good evening.

Good evening, Todd.

Hi, Todd.

Most of my questions have been gone over, but you mentioned that some -- most of the larger markets and commercial construction are hanging in there; some of the smaller markets maybe had softened.

Can you maybe highlight some of those that have softened?

You're talking like southern California and Florida are the softer markets for us right now.

Okay.

And Blucher ended up having some, I guess, some dilution in the quarter.

Do you have any update on what the accretion throw-down is going to look like?

Are you looking for the same amount?

Well, we had $0.01 of dilution in the quarter.

I think, when we first talked about Blucher to Wall Street, we were thinking that it would have $0.02, but their operating results were a little bit better.

We're expecting $0.04 of dilution in Q3.

Right.

And then once we get into Q4, we will then have the inventory and the customer backlog and all those issues amortized.

And we should have a pickup of accretion of $0.05 in Q4.

I think you'd said it was going to be about $0.05 a quarter next year.

Is that still good?

Yes.

Okay.

That's all I got, guys.

Thanks a lot.

Okay.

Thank you.

And your next question comes from the line of Jeff Hammond of KeyBanc Capital Markets.

Hi, good afternoon, guys.

Good afternoon.

Good afternoon.

Hey, just in terms of some of the issues in China, can you give us a sense of -- is that still a drag on profitability into the second half of the year?

Are you losing money there or is there a point where we kind of get back to favorable profitability?

I'd say it's a drag on us for the remainder of this year.

Okay.

And then just shifting gears, you mentioned how you thought the alternative energy systems project or orders you thought were sustainable into the third quarter.

Are you getting some direct feedback from these OEMs that's suggesting that there's more behind it or what gives you the confidence that those aren't one time in nature?

I think the OEMs are pretty bullish on these products at the moment, so we're basing that -- we're making that statement based on our incoming order rates.

Okay.

So there's been some follow-on orders that would suggest that that persists into the third quarter?

Yes, you had a strong order rate and a strong reorder rate continues.

Okay.

And then as you look at the other -- kind of the flow or distributor business that's maybe more consumer oriented in Europe, how would you characterize trends there?

I think if you look at big markets like the UK, it's slow; if you look at big markets like Italy and the southern part of Europe, it's slow.

And it's fairly -- it's pretty decent in France and it's pretty decent in Germany and northern Europe.

Okay.

And then finally, I guess, it seems like the big aberration, or one of the major aberrations between 1Q, which seemed depressed, and 2Q, which was pretty good, is this destocking versus restocking.

Is there a way to quantify the magnitude of the contribution there on a not-profit or earnings basis in the second quarter that maybe is not sustainable?

I mean, if you look at the -- for instance, Jeff, in Q1, the wholesale revenue was 163 million; in Q2, it was, excluding acquisitions on an apples-to-apples basis, would have been about 181 million.

So we had about $18, $19 million pickup in wholesale revenue quarter-over-quarter.

So it's a very meaning -- I don't have the exact EPS on that, but it's a very meaningful part of the improvement.

Okay.

And you feel the same way about the sequential improvement in retail?

Yes, if I -- on retail, we had a $5 million pickup versus Q1 and what we -- when we did the analysis, we identified specifically the new product rollouts and some of the pricing, and when you net that out of the changes that we saw in the quarter, it tells you that we had a decrease in revenue of about 5% versus last year.

Now, if you do that same analysis and you look at -- compare yourself to Q1 or the same analysis done in Q1, for Q1, you'd say we had a decrease in revenue of about 11% because of destocking and the economy.

So we had -- basically, the run rate was cut in half versus last year from Q1 into Q2.

But it sounds like underlying fundamentals would suggest that the 1Q trend was maybe a little more normal than the 2Q trend.

On retail, I think if you look at the last numbers I've seen out of Depot and Lowe's, I think their same-store sales are down around 7, 8%, if I recall.

And that's sort of in the middle of those two numbers between 5 and 11, and as Pat discussed a moment ago, we're sort of thinking that a normal trend for all this North American business is somewhere between Q2 and Q1.

Okay.

That's helpful.

Just a final question on Blucher.

Can you remind us how big the marine component of that business is?

It is 20% of their total business.

Okay.

And then can you just remind me some of the other big buckets in terms of end markets?

We have -- residential is about 25; commercial is 25.

We have food processing of about 30 and then marine is 20.

Okay.

Thanks, guys.

Okay.

Your next question comes from the line of Jim [Fung] of [Gabelli] and Company.

Please proceed.

Hi, gentlemen.

Actually, most of my questions were answered, but I just had one thing.

Could you just kind of list a little more what your product lines are in Europe for this geothermal market that you're selling to the OEMs?

What the product lines are into the OEMs?

Yes.

Well, we sell things like electronic controls, manifold systems, pump groups, control valves, safety release valves.

And as Pat mentioned, we sell a unit that measures energy usage by measuring the flow and heat of water into an individual apartment, an energy-monitoring product line.

Okay.

And these are the products that you saw very strong sales in the quarter then --

Yes.

-- and going into the third quarter, okay.

All right.

Thanks very much.

Thanks, Jimmy.

Okay.

(OPERATOR INSTRUCTIONS).

And your next question comes from the line of Christopher Glen of Oppenheimer.

Yes, just a quick one on any impact in '09 on the tax rate mix, the base of sales, with Blucher and also maybe with the European growth given the energy efficiency kind of outside.

Are we seeing a little downward pressure on the tax rate?

I don't think it's -- I think what will happen, Chris, is that any downward pressure from those sources, which those sources do have a little bit lower tax rate, might be offset by some non-deductible losses out of China, so I wouldn't change the tax rate.

Okay, thanks again.

Okay.

There are no further questions.

I would now like to turn the call back over to Mr.

Pat O'Keefe.

Well, I want to thank everyone for joining us today and your interest in Watts.

We look forward to talking to you on the third quarter conference call, which will be probably the end of October, the beginning of November.

So thank you very much.

Ladies and gentlemen, that concludes the presentation.

Thank you for your participation.

You may now disconnect.

Have an excellent week.