Watts Water Technologies Inc (WTS) 2012 Q1 法說會逐字稿

Watts Water Technologies.

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Good day ladies and gentlemen.

And welcome to Q1 2012 Watts Water Technologies earnings conference call.

My name is Laura, and I will be your operator for today.

(Operator Instructions).

I would now like to turn the call over to your host for today,Kenneth Lepage, General Counsel.

Please proceed.

Thank you.

Good morning.

On the call we me today as always is David Coghlan our CEO and Bill McCartney our CFO.

Please be aware that remarks we may take during today's call about the Company's future expectations, plans, and prospects constitute forward-looking statements under the Private Securities Litigation Reform Act of 1995.

Actual results may differ materially from those indicated by theseforward-looking statements as 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, 2011, and other reports we file from time to time with the Securities and Exchange Commission.

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

While we may elect to update these forward-looking statements we disclaim any obligation to do so.

During this call we may refer to non-GAAP financial measures.

These measure are not prepared in accordance with general accepted account principals.

The reconciliation of the non-GAAP financial measures to the most directly comparable GAAP measures is available in the press release dated May 1, 2012, relating to our first quarter 2012 financial results.

A copy of which may be found on the Investor Relations section of our website at www.wattswater.com under the heading Press Releases.

I will now turn the presentation over to David, and Bill.

Good morning everyone.

Thank you for joining our first quarter earnings call as always we appreciate your interest in our Company.

I would like to start by providing you a brief overview of the quarter, then I will give you the latest view on the market conditions in our key regions and a sense for where we see those markets trending as we move further into 2012.

After that , I will hand the call over to Bill to review our financial performance in more detail, and after Bill's discussion I will summarize , and we will open up the call to your question.

Let me start by recapping the quarter.

First let me say that the Watts management team is disappointed with our first quarter.

While our end markets are creeping along the bottom and while that isn't helping volumes , we had expected to deliver better operating performance with many of the key issues in the quarter being internal ones.

These issues were largely concentrated in North America and can be grouped into three categories.

First, we experienced greater than expected cost increases in non copper bearing raw materials which we did not offset with productivity savings.

You will recall we moved quickly and successful to increase prices last year to get ahead of copper driven inflation.

We are now seeing inflation coming through in our non copper bearing spend.

Second, as we prepare our products and plants over to new brass and bronze alloys which meet the requirements of the reduction of lead in Drinking Water Act, we allocated a higher than expected amount of our production capacity to preproduction runs; therefore, we did not absorb our fixed overhead in a normal manner, we also had to outsource a portion of machining production to meet customer demand there by increasing our costs.

This transition is a very significant initiative for the plumbing industry as a whole.

We are pushing very hard to be well in advance of the January 1, 2012, implementation date to ensure we sustain our position as a leader in the industry and minimize transition risk.

As result of this push to be early, we expect to incur more transitional cost over the next few quarters.

Third, after a period of declines our North America business experience higher product liability costs in the quarter due to an increase in claims volume, which caused us to increase our product liability reserve.

In general , pricing was less of an issue during the quarter as our pricing initiatives of last year in the North America wholesale market were sustained.

Indeed we were able to pick up some pricing in select markets especially in Europe and the North American DIY market.

On the copper bearing material front, we saw cost stabilize and we believe near term copper cost will not be significant factor affecting margins.

So what are we doing to address these issues?

First we are working hard to limit further cost increases in North America , and to mitigate those we have taken.

Second, we are accelerating other initiatives including some SG&A cost reductions programs, rate cost coverage programs, and some additional manufacturing footprint consolidation programs.

Third, we are reenergize some recent product lines to potentially accelerate revenue growth, and we are implementing some selective price increases in areas where we had minimal increases last year.

We anticipate the combined effect of these actions will lead to improved earnings over the next several quarters.

On a positive note our European business delivered organic operating earnings that were on par with the first quarter of 2011 .

We accomplished this despite the general (Inaudible) in much of Europe and incremental IT spending as we near the go live date in Germany of common ERP platform.

We believe we are taken some market share in certain product lines in Europe, and Q1 was the best quarter we have seen for some time in terms of proceed realization and productivity gains in Europe.

Within Europe, Germany continued to perform well during the quarter especially for product into the under floor heating market place.

Our BLUCHER drain product line also performed well in the quarter both in terms of building backlog and in terms of shipments.

Socla delivered another solid quarter.

Finally, our Asia business delivered 13% organic sales growth, albeit off a small base, as we start to see the benefit of our refocused efforts on the China market.

Now let's move to talk about the market conditions we are dealing with in 2012.

First let's look at Europe.

We haven't seen Q1 Euro zone GDP statistics yet, but our expectations are that Europe may have experience minimal to slightly negative growth in Q1, on top of negative growth in the fourth quarter 2011.

From our view Germany , France , the Nordic region and Russia are expanding with many other markets weak or contracting.

The UK recently announced they are in a technical recession as did Spain some weeks ago.

And we see politics an playing an important role on how the Eurozone responds to the ongoing issues as the elections in France and the fall of the Dutch government plays out.

Any further austerity measures that may be undertaken by these and other governments could cause further contraction in the near term.

However, overall our view of Europe and how it affect Watts in 2012, really hasn't changed much than what we talked about in late February.

We remain cautious about the uncertain macro economic environment in Europe.

We remain concerned about southern Europe particularly Italy where we have substantial operations.

But we believe the repair, replace , up grade business should continue, and we are pleased with the Q1 results of our efforts to focus on growth opportunities in under floor heating and drains, and in market such as Germany, eastern Europe , and The Middle East.

A major challenge in Europe will continue to be price cost issues for our copper bearing products in an environment where we face fragmented competition.

We have responded to some of the recent increases in copper prices by announcing further price increases in a number of key markets in Europe.

And as I mentioned earlier , we made solid headwind in Q1 on the price realization front in Europe.

Let's move on to North America.

We still believe North America may grow modestly in 2012.

The U.S.

economy is likely to continue its steady but slow growth, although U.S.

GDP in Q1 was a little disappointing at 2.2% compared to 3% in the fourth quarter of 2011.

However recent statistic on housing starts and housing permits have been positive driven heavy by multi-family construction.

We still see foreclosure overhang, distress sales , and high unemployment levels as a barrier for significant growth in residential construction in 2012.

We believe existing home sales should be steady which is encouraging for ourrepair, replace, up grade business.

Commercial construction expectations remain somewhat muted.

The an ABI has provided positive signs with 5 consecutive months of growth through March, but that has yet to show any significant change in projects breaking ground.

So in summary, things are moving in the right direction in North America, but given our place in the construction cycle we don't see any significant volume gains occurring in the market in 2012.

Finally, let's look at Asia.

In Asia our operations are still small at present, so significant growth there won't necessarily move the needle in the short term, but we do anticipate that our longer term growth prospects there are bright.

We believe there is a significant opportunity for us to grow in the China marketplace, and we are making some nice progress in laying the foundation for sustained growth there both in the plumbing market and the HVAC market.

China's economy is expected to grow by roughly 8% in 2012 , and a significant portion of domestic portion of domestic GDP is accounted for by real estate including construction.

China is developing its code and regulatory infrastructure, and Chinese consumers are increasingly investing in their homes.

We are also starting to work outside of China to create a presence in other markets in southeast Asia where growth opportunities exist.

So we remain excited about the long-term potential for growth in Asia even though its impact in the short term may not be substantial.

Let me turn it over to Bill now

Okay.

Thank you David.

We look at the revenue line we close at $364 million.

That is a 10.4% increase.

Looking at the components of that increase from an organic standpoint we had $3 million growth just about 1%.

The change in the foreign exchange rate decreased our revenue by $5 million, so that is a negative 1.5%.

And then the inclusion of the acquisition Socla and tekmar increased our revenue by $36 million which is 11%.

At the very bottom line adjusted net income from continued operations $16.1 million that is an increase of 2.5%.

However, if we look at the adjusted EPS from continued operations, $0.43 per share which is equal to last year.

In our GAAP numbers we have some restructuring cost .

I know everyone is always interested in that by region.

If we look at North America $400,000 pre tax, $200,000 after tax.

Europe $1.3 million pretax,$800,000 after tax.

That is $1.7 million in total preand $1 million after tax.

That had an impact of $0.03 per share in the quarter.

Looking at the segment performance now.

North America we closed our revenue at $210 million that is an increase of $8 million or just about 4% growth.

The factors there, organically we grew $3.7 million, 1.8%.

The change in the Canada exchange rates declined just a little bit , so that had an adverse impact of $300,000 or one-tenth of a percent.

And then in North America the acquisition accounted $4.5 million,2.2%.

And that is a piece of the Socla business and the tekmar business which we acquired during Q1.

Looking at the wholesale and retail break out.

Wholesale is $165 million in the quarter which is an increase of 46 million or 4%.

In the retail at $45 million an increase of $2 million or 5%.

When we look at the North American market overall basically flat from a volume standpoint with an increase coming predominantly from pricing.

Looking at the European segment, $149 million of revenue an increase of $25 million or 20%.

Again, the factors there we had a negative situation on organic growth a decline of $1.1 million just a little under 1%.

Europe on the organic standpoint that is about negative 2.5% or so on volume with the offset being price.

Foreign exchange, change in the euro versus last year we lost $5 million there or negative 4%.

The inclusion of Socla $31 million or 25% growth , so that is a total of $25 million.

The total for Europe is 20% growth.

Again, as David said earlier, in Europe we are seeing some solid growth from BLUCHER.

We see the hit rate improving on their project.

We see more exports from BLUCHER outside of Europe.

Germany continues to be strong in the under floor heating market, and Socla sales overall are good particularly in eastern Europe with the offset being southern Europe particularly in Italy where we have a weak domestic markets in exports into north Africa out of the Italy are also weak.

China revenue was $5 million an increase of 31% even though small base.

I should say about $500,000 of that is organic 13%, and the rest is primarily the Socla business in China.

Again, as David said earlier, we are doing well in China small base, picking up additional distribution and seeing some nice growth in some of our heating products.

The issue for the quarter for Watts is the gross margin on a consolidated basis we had a margin of 35.6%, and that is a decline of 110 basis points versus last year first quarter.

We see in looking at the segments Europe did perform well on the margin line at 34.9% that is an increase of 70 basis points.

That is driven by the improved pricing the achievement of the some of the productivity initiatives.

And, again we had good mix in Europe because of the performance of BLUCHER.

Some of this was offset by some of the increase commodity cost, but overall good margin performance in Europe.

The issue we have again in the quarter is the North American gross margin.

The margin in North America for Q1 35%.

That is a decline of 230 basis points versus last year's first quarter.

When we kind of break that out , the decline is about half.

Half of it is associated with the increase material cost , and the other half is associated with some of the inefficiency in lead free cost that we saw in our manufacturing plant.

The materially cost driven --these are non commodity costs, so the copper was relatively stable when we compare Q1 to Q1 and Q4 to Q1 as well.

What we are seeing is some of the cost driven primarily by energy, if you will.

We saw increase resin cost, increase freight cost, and these are things we have experience very recently.

On the overhead side again half of miss on the margin is the overhead.

We can break that out in two components, so half of that half is associated with cost we incurred because of the lead free transition.

We are dedicating more of our production capacity to the preproduction runs of these lead free products.

We are also having to outsource some of our production.

Again, we are incurring additional cost, and we are not getting the traditional level of fixed overhead absorption.

It is the combination of the two items.

And then the other half of the overhead issue, if you will , is really associated with some of the productivity issues.

We didn't hit our productivity objectives in the quarter, and we believe a lot of that is really due to the fact that we have manufacturing and engineering and transition teams focused on the lead free transition.

So we have identified very specific programs to address these issues.

We have some issues around material costs, obtaining some relief from some of our vendors.

We are looking at our freight management programs ,and freight allowances with our customer and so on, as well as implementing some expectative price increases.

We do anticipate the lead free cost that will continue for the next 2 quarters to 3 quarters.

We are pushing our productivity teams very hard, so we are expecting to see improvement there.

We do expect to see improvement in the North American margins over the next couple of quarters, but it will be a couple of quarter to see the materially cost move back in, to implement the price increases, and to get the lead free transition behind us.

On the SG&A front.

SG&A was $101 million versus $97 million last year an increase of $4 million.

To walk through that increase.

We got an increase from an organic standpoint of $1.4 million that was entirely associated with the increase in product liability.

We booked about a $2 million number there.

The change in the foreign exchange rates caused a decline in our SG&A of $1.2 million.

The inclusion of Socla and tekmar increased our SG&A $10 million.

And then we had a reduction of $6 million dollars versus last year's Q1.

You will recall we did book some CEO separation costs last year, so we are identifying that separately for you.

The combination of those items takes us to the $101 million.

The operating earnings at $28.7 million is a decline of $1.6 million.

Again, that is associated with the low gross margin in North America, which is partially offset by the improved margins in Europe and the contribution from our acquired companies.

The tax rate at 28%, that is down from our normal run rate of about 33%.

We did have a favorable tax audit in Holland at our Dutch corporate office in Holland, and that was a favorable adjustment which impacted our tax rate and that was a contribution of $0.02 in the quarter.

So net income at $16.1 million on an adjusted basis a slight increase from last year of $400,000.

And $0.43 on an adjusted basis comparable with last year.

With that, I would like

Thanks very much, Bill.

Look we didn't deliver the type of performance we wanted in Q1, and we are unhappy with that.

Some of the issues were outside of our control, but in others we stubbed our toe.

So our focus for the coming quarters will be to reinforce our commitment to our three strategic priorities, and they are growth, operational excellence, and (Inaudible).

We are going to focus on growth initiative, such as reenergize our new product introductions, increasing our focus on selling more of existing products to existing customers, and pushing harder on our geographic initiative.

We are going to focus more on operational excellence by driving an increased number of our productivity projects through fruition, by doing a better job of mitigating the cost increases we have seen recently, and keeping costs in line with expected sales volumes, and by accelerating some additional footprint consolidation.

And we are going to move our (Inaudible) Watts concept forward by taking advantage of some SG&A leverage opportunities which we have been working on, and will accelerate the implementation.

By continuing to standardize our processes through our ERP deployment program, we will go live in Germany this week , and by deploying shared services across more of our organization.

So despite the slow start to 2012 , we believe that our focus on these efforts will improve our operating performance as the year progresses.

At this time, we would like to open up the line and address any questions that you might have.

Laura, would you mind opening up the line for

Yes.

(Operator Instructions).

Your first question comes from the line of Nick Prendergast from BB&T Capital Markets .

Please

Hi, good morning.

Good morning, Nick.

You gave us a lot of info on Europe.

Perhaps maybe you could just remind us what is your European exposure?

Maybe if you could go from increasing exposure what nations do you have the most exposure to, and then go in decreasing order?

Our number one market is France, second would be Germany number three is Italy, and then once you get past that we would be looking at the Nordic region as four, the UK would be five.

We have a presence in every country in Europe from Portugal to Kazakstan and Indonesia to Norway.

We are in every country , but you can kind of look at the larger populations.

But because of the Socla acquisition , France is our number one

Got it.

That brings me to my next question.

We are seeing organic growth slipping sequentially here, it is actually turning negative in Europe.

What is your M&A pipeline looking like?

We continue to work an activity pipeline.

We continue to hold our acquisition standards so that we do the right deals.

All right.

Thank you very much.

Thank you.

Your next question comes from the line of Garik Shmois with Longbow Research .

Please

Hi, thank you.

First question is , Bill, you outline the year-over-year margin decline in North America certainly attributable to the cost inflation and inefficiency that you saw in the quarter.

I am wondering is the inference if you strip out these several issues you had in the quarter, that gross margins and North America would have been stable?

Just wondering if you could provide some color if possible on a like for like basis what gross margins are like

Your statement is correct.

If we didn't have these issues particularly on the overhead side , we would have stable to up slightly up margins.

That is the trend we had been on for quite a while with the focus we have on continuous improvements and using the tools and educating the folks and taking that to the next step around footprint consolidation.

We have a long history of the past several years of improving gross margins.

We ran into this lead free situation, where we have a tremendous portion of our work force in the manufacturing plants focused on this, and because of that we had to outsource some products.

We had to increase our spending on lead free and dedicate a fair amount of the our production capacity to these preproduction runs, which are by definition of the accounting rules have to be expensed.

I think we would had at worse stable margins if we hadn't had this

Okay.

Looking at the top line growth in North America.

Did any of these plant disruptions that occurred in the quarter did it cause you any sales loss?

No , we don't believe so.

We have had one or two minor hiccups here and there which were not due to lead free in terms of delivery rates.

They were potentially the knock off effect of some consolidations moves we made.

But as we look at our overall delivery rates, overall they have been pretty good they are 95% and above.

We don't believe any of these resulted in any customer loss.

We made sure of that by moving to outsource some production where we had some bottlenecks because of the preproduction runs.

While that cost us it allowed us to retain the customer

Okay.

Thanks for that.

My last question is on the1% growth in North American wholesale.

I am just wondering looking at some of the macro data points around new construction and even repair and remodel in the first quarter and the outlook for the full year.

I am just wondering it came in a little bit below our expectations, what were you seeing in the first quarter specifically?

Was it maybe destocking at wholesale , or was it weather that limited the upside in the quarter, and maybe if you could talk a little bit more about your outlook for flattish demand for 2012?

I am just trying to understand the disconnect from what you are seeing and some of the macro indicators on the building

That is a great question.

I think it is fair to say that our channel teams are tired of seeing the numbers coming from us in terms of what is going on with home starts and the other macro data that we are seeing.

Aligned with question what are we seeing.

What we are hearing from our channel contacts and what we are also hearing from fellow travelers in our space is that our part of the industry is still not showing a whole lot of growth.

Did we see channel inventory contract in the quarter, no, nothing meaningful we know about.

So we are looking at it and saying we are later in the construction cycle, so we are keeping our eyes open to see how this moves through.

Okay.

Thanks for the color.

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

Please

Morning, Jeff.

Good morning.

Just to understand the moving pieces on these costs again.

If we use 1Q as the baseline, and you quantified those pretty well, does the lead free number persist through the rest of the year or does that number start to fade as you ramp?

How should we think about price offsetting some of this material inflation and I guess does the product liability number a one timer?

If we put this in round numbers, what Bill talked about was the $6 million issue in the quarter in North America, $4 million of which is on the gross margin split between the low lead and the material cost issue and the final $2 million in the product liability issue.

If we look at lead free , what we have been doing is trying to accelerate our efforts in lead free.

The last thing we want to be left with is a bunch of the leaded inventory as we approach the transition point.

And so we are starting to see Canada talk about implementing lead free, which means that there is no place left for leaded inventory.

So we decided toaccelerate our efforts , get through this transition as quickly as possible well ahead of the implementation date, so , A, we could transition safely, and ,B, we could transition early enough so we could avoid any inventory issues.

So we have several hundred preproduction runs to do.

And we have done a good chunk of them in the first quarter and we could start to see them finish up as we move through

Okay.

Net-net the way we originally thought about this was we would run our preproduction runs through a 5 or 6 quarter period.

So we are trying to condense them into 3 quarter, so we get this done early and avoid any inventory issues through the transition.

Okay.

And the materially cost issue you are putting through price to cover that and that is just a transition?

We are doing a couple of different things.

We moved very quickly last year to put pricing increases ahead of material inflation and we got the benefit of that for a couple of quarters.

We saw a lot of material inflation hit us, non copper bearing material inflation hit us in the first quarter.

So we are taking two actions.

The first one is we are starting to put our fingers in the dike to stop the flow end of additional material increases, and we will follow that by trying to push some of the water back through the dike in terms of getting some benefits back from our vendors.

The second action we are taking there are a number of products, they are non copper bearing products, and we did not implement significant price increases last year , so speculatively we are going through those and looking to implement price increases.

They may not be a one for one coverage between the price increase actions and some of the mitigation actions we are hoping to squeeze that gap down over the next couple of

Okay.

That is helpful.

Just back on the North America markets you said you are later in the construction cycle.

As you try to look and get visibility , talk to your customers about quoting activity , et cetera.

Does it feel like as we move through the year you start to benefit from some of those more favorable news flow on the construction side or is visibility is still

Visibility is still clouded.

As we talk to our channel contacts they are certainly seeing and enjoying a benefit in terms of sales of products in the industrial arena, but they are hopefully for a lift sales in the residential and commercial arena.

But we are not seeing a whole lot of them point to our types of products and say they are seeing significant lifts now.

So it is pretty cloudy and we are trying to keep a close eye on it.

Okay.

I'm sorry.

Just on the product liability, is that a one time hit, or are you running at elevated product liability costs going forward?

The product liability issue the best way of explaining it is, it is an actuarially calculation based on incoming claim rates on product liability claims.

These could be products we sold a year ago , 3 years ago, 5 years ago, 7 years ago, even 9 years ago.

And as our actuary looks at the incoming claim rate, he makes a judgement on what we should do with our reserves.

Just to try and put a frame work around this because it is not driven by current product quality issues.

The largest area that we have claims in is water connectors.

And we sell in excess of 20 million water connectors a year.

And our incoming claims rate on an annualized basis is bouncing around between 1300 and 1800 claims.

So it is the actuarial projection of those claim rates that drives the adjustment in the reserves.

So if you do the math on the claims versus the units sold, you certainly don't see a significant quality issue, so it is the actuarial

Right.

I guess what I am asking is, is it a onetime adjustments to true it up, or is it a new higher run rate based on --

It is an actuarially true up based on some changes in the rates over the last couple of quarters.

Okay.

Perfect , thanks

Thank you, Jeff.

Your next question comes from the line of [T.R.

Demetri] from [Cododen & Company].

Please proceed.

.

Hi, good morning guys .

I apologize if I missed anything as I was bouncing around calls.

Just wanted to ask you how we can think about what is driving organic revenue in terms of new construction versus repair, replace

Well, over the last several years it has really bee repair, replace which is driving our business.

And even though we are looking at the leading indicators of construction permits and housing starts we are not seeing any meaningful change in the business we are seeing from new construction yet.

So it is still the repair, replace, up grade element of our business that is driving organic growth.

Great.

Just on the pricing environment is it fair to say that you still expect to cover a North American wholesale and DIY and Europe continue to be challenging, is that?

We indicated a little early we have sustained the price increases that we put through last year in North America wholesale, and we have improved our price realization in North America retail, and we had a nice forward momentum in terms of price realization in Europe.

Looking forward because of some non copper bearing material increases that have come in, we are looking for selective price increases on product we did not put up in any significant degree last year.

So we will be implementing those over the next couple of months, and it will take a little bit of time for those to read through.

Great.

Just on the incremental cost related to the conversion of lead free production .

Can you give me an idea of what that means?

Is that like retooling machines to the new standards, and going forward what can we think

Yes, we mentioned that a little bit earlier.

What we have been doing is pulling forward and accelerating a serious of preproduction runs for each of our product families.

Up till now lead free has been a relatively small part of the market driven by a couple of states.

So our strategy has been to satisfy lead free requirements by outsources those products.

As we prepared for a January 1, 2014, transition date and as we see other countries like Canada begin to move towards lead free, we decide to we needed to accelerate the transition of those lead free products into our plants.

By January 1, 2014, it will be in excess of 90% of our brass and bronze volumes.

As we bring those products into our plants in order to ensure we can produce them properly and we have our costing right, our processes are set up correctly we do a preproduction run for each product family.

And we have about 400 of those to do.

We have been accelerating those, and as we push them through the plants, those preproduction runs are taking up material , labor, and overhead which are not absorbed into sellable product.

So we will work through that over the next 3 quarters then it will

That is great.

That does it for me.

Thanks, David.

Thank ,

Okay.

Your next questions comes from the line of David Rose from Wedbush Securities .

Please

Good morning gentlemen.

A couple of quick questions.

How are you managing the California and Vermont lead free product lines for the same plants that you have stepped up production on these preproduction runs?

Well, maybe we ought to just step back and try to educate folks a little bit on lead free.

The lead free movement started in 2 states, California and Vermont.

And then it moved to Maryland and Louisiana and then the federal government decided to implement a law, which is slightly different than the existing laws, but it makes it a nation wide requirement by January 1, 2014.

So as we look at the states that had already gone , of the products that needed to be converted approximately 10% of their volume were lead free and 90% were leaded.

That 10% we decided to manufacture at third party locations.

As it move from 10% to the 90% it will be after January 1, 2014, we need to pull it into our plants.

David, they are the same products.

The scope of the products covered may be slightly different from state legislation and federal.

But the product we make for California that is lead free will be the same product we will make to meet the federal

Okay.

I guess that is the part I missed.

That was already being outsourced that 10%?

Correct.

I guess there are two follow up questions on the lead side.

One is intuitively the 10% is relatively small so that should help your margins overtime.

But as you look at this product that is in part being outsourced and in part you are carrying before the federal mandate.

You can't get pricing, full pricing , on lead if it is not required.

Are you pricing the product line the same as your product with lead for right

The challenge the industry has -- first of all, the 10% that we are suppling today is outsourced.

Right.

And the federal regulations come in at 90% of the volume associated with those products will be lead free and we are pulling that into our plants.

The challenge for the industry is the cost of lead free alloys is higher than leaded alloys.

Right.

So the industry has two options.

It can avoid phasing lead free into the market place until January 1, 2014.

In which case a lot of our customers will have a lot of leaded product they can't sale and they will want return it.

And this is an industry issue.

Or we can transition early which means the higher priced product will have to come into market in advance of the transition date.

So the industry is collectively looking at this , and obviously each company will make their decision.

My guess is everybody will move early to avoid the consequences of the inventory

There is a risk for you as well that you carry this lead free inventory and you can't push it through at higher prices, right?

The reason we are transitioning early is that we avoid the leaded inventory issue and we are working closely with our customers because it is an issue for them as well.

So we want to go early, and we believe that is the way the industry is going to go to avoid the issue of leaded inventory.

Got it.

Okay.

But there is still a risk that the lead free could potentially be an inventory issue for you if the end markets don't move through quickly enough.

Is that fair?

Right.

But our customer would be took stuck with leaded inventory, we could be stuck with leaded inventory, so we believe it is in everybody's best interest to transition early

Okay.

I understand.

Thank you.

And then on the productivity issue.

You folks have been lean for quite some time.

It sounds like you are maybe a little bit thin on the bench to have this sort of problem where you can't transition one to a new product line at the same time execute on your lean initiatives.

Were there any changes in personnel?

Did you lose people?

If not, do you have add to your bench and does this imply a pick up to SG&A?

David, here is the way I try and (Inaudible).

By moving earlier and faster on lead free we are transition in excess of 30,000 skews.

We are dedicating our -- it is not so much that we are thin on the bench.

It is that as try to accelerate this program through our facilities in order to transition in excess of 30,000 skews you have to have all hands on deck.

David, this is much more involved than just introducing a new product line.

I can imagine .

Okay.

That is helpful actually.

Lastly, can you describe any impact if at all that you have seen from some of the aggressive pricing in the market place such as

Well, on the plumbing side when you stake the lead in driving through price increases you do run the risk that you may loss a little bit share of margin from holding to your price increases, and we have seen some of that.

But some of the areas are job related.

So as you push out your price increases you can look job by job, and make individual decisions to try to protect your market share.

So we have push out aggressively on price and we are now looking at the jobs coming through the system and we are trying to make sure we maintain our share situation.

So it is a couple of moving pieces that you are managing at the same time.

Okay.

You haven't seen any on a distributor basis or wholesale basis any impact from United Pipe at all?

I have to say, David, I am unfamiliar with --

Okay.

Nobody else in the channel is particularly weak, right?

There is a couple of customer that have been weak .

We are keeping our eye on it.

The bad debt situation from our perspective right through the recession has been extremely well managed, our DSOs are under control and percent current we are well over

Okay.

That is helpful.

Thank you very much.

Okay.

Your next question comes from the line of Jamie Sullivan with RBC Capital Markets .

Please

Good morning, Jamie.

Good morning.

This is Sid standing in for Jamie.

Hi, good morning.

Can you hear me?

Yes.

The first question I had was with regards to the increase professional service fees in Europe relating to the pending Germany ERP implementation.

Was this anticipated , and how do you project this going

Good question.

What often happens when you deploy a new ERP system, you run into more complication than you originally envisioned.

We did deploy more consulting in the first quarter to try to get us through that so we could get to launch.

We do see those ease once we get past first deployment.

First deployment is this week in Germany and then we move on the U.K.

next .

So we should see those consulting fees

Okay.

So just to get an idea of those ERP implementation.

Is this like the start of the ERP implementation and is there a plan to do it another parts of the business, other territories like North America.

So there could be potentially similar costs related to the U.K.

implementation later or other parts also?

We use a system in ERP system in North America called a QAD it is a mid market ERP system.

We are deploying QAD in Europe for the first time with Germany being our beta.

We will deploy that over the next several years across our other sites in Europe.

Since it is an updated and upgraded enterprise system, we will take that updated and upgraded system back in to North America.

So this is a multi year process.

Okay.

Coming back to the lead free question.

One of the questions I had was that -- first I wanted to see if I understood this correctly.

What happened was that this lead free thing (Inaudible) in your 10-Ks going back to 2009 or 2010 time frame.

This was sort of a thing you already knew you would have to do.

So I suppose what happened this quarter was that you accelerated the preproduction runs because of Canada and you wanted to be ahead of the curve, am I correct there?

Yes, the lead free legislation that you refer to back in 2009 related to some individual states California and Vermont who went this route; therefore, it was a very small portion of our output and we could meet it from third party suppliers.

Last year the federal government, the EPA , decided to introduce legislation requiring this nation wide by January 1, 2014.

And we are now seeing other countries such as Canada jump on board.

As we look at this, our original view was that we would run our preproduction runs over 4 to 6 quarter basis and still be ready in plenty of time for January 2014.

However, to mitigate the risk of unneeded leaded inventory we decided to accelerate.

We are doing more of the preproduction runs in the first quarter than we had anticipated, and therefore it affected our absorption

Okay.

Continuing on the same issue.

I guess for going to the lead free situation you will transitioning your plants in terms of manufacturing capabilities and you will be transitioning to a substitute for lead.

So on both of these items have your plants all transition (Inaudible) have all your plans transition, and what is the substitute for lead?What material is used and how is the pricing mix around that material, the supply situation around that material?

First of all, just to make sure people understand.

The old legislation allowed us to use copper based alloys which had up to 8% lead.

The new legislation allows us to use copper based alloys with less than 0.5% of lead.

So the substitutes that the industry is looking at are various, and they include using silicon in place of lead or using a material called bismuth in place of lead.

So different products and different companies are adopting different alloys.

So that has significant implications for the way you cast, machine, et cetera.

Okay.

I guess you have your supply situation for silicon and bismuth and that is something that has already been planned?

Yes.

Okay.

The issue really is as we introduce product families into our plants and do preproduction runs there is a cost to that, because you are testing it, you are trialing, you are making sure you can do it properly , and you have to expense those costs .

Not all of our plants are tooling.

We are doing approximately 400 preproduction runs, and we will do them in stages , and when they are complete our plans will

Okay.

Coming to Socla what sort of accretion did Socla contribute in the quarter?

Socla contributed $0.05.

Okay.

And for China I think we saw some strong growth for China.

If I remember in the past, a lot of Chinese products used to be exported to Europe, so is that dynamic changing?

What is driving that growth in China?

The growth you are seeing in China is coming in 2 buckets .

One there is a 13% organic growth rate which predominately sales in the China market, and then you have the addition of the Socla sales in the China.

So the organic growth we are experiencing are coming from our growth initiative in the Chinese

Okay.

So it is not related to exports to Europe or anyplace else it is organic within.

No.

In terms of incremental margin like what sort of incremental margins and when do we expect to return to the 35% plus incremental margin range?

That is still our objective.

And we believe that as we get through this transition of lead free and getting some of the material costs reduced and some of the pricing adjusted that David mentioned that we will definitely be returning back to that 35% incremental margin on incremental revenue.

I would expect we would be there by the end of year.

Okay .

And you mentioned about the non copper material cost.

Which specific material are you referring to that is driving this

We are seeing a long tail .

We have a seen an increase in our resin costs, which are obviously driven by oil.

We are seeing an increase in some of our cast iron.

We are seeing an increase in packaging, freight rates, et cetera ,

Okay.

And just one final question on the wholesale North American growth in drains.

Is that related to BLUCHER?

We are seeing nice progress in our entire drains business in North America .

We are seeing particularly nice progress with our BLUCHER product line in North

Thank you , that is all I had

Thank you.

Your next question comes from the line of [Suid Sarp] from [Asenti Sampo].

Please proceed.

Good morning.

Good morning.

I was just wondering just digging a little deeper regarding the lead free, and material costs, and so forth.

How does that change the mix , and how you plan for volatility in the markets especially for copper.

Where generally in the past it has taken 5 to 6 months to pass the cost through based and based on FICO counting.

Is there any change that you are looking at as far the

Well, we said in the past, you are correct in that those dynamic really don't change.

Because we are moving to this newer material.

What you are referring to there typically is what you see is the change in the copper rate will hit our P&L anywhere 5 to 6 months later and that is based on the inventory that we carry plus the commitments we have with our vendors.

That really will not change with this material.

I think in terms of the pricing power of the Company and so on relative to copper based products I don't see that really changes with this new material.

The new material will cost a bit more, and we will have to adjusted our prices at some point when we start putting it out into the field and we will address that when the time comes.

In terms of the dynamics that you are talking about , the historically dynamics, I don't see those

Are customers generally accepting the prices that you are putting through now?

Well, the industry has had an opportunity to get used to this, because of the fact that 4 states have already had lead free laws.

So customers in those states and the suppliers that supply those customer have had an opportunity to sort of work through this issue and establish the pricing levels and from our prospective, yes, the industry is getting higher prices for the higher cost alloys.

Okay.

Regarding your capital allocation, how are you breaking that down?

Plus you continue to look for acquisitions, any share buybacks or anything?

At the end of the quarter we had about $250 million or so of cash on hand.

We are still expecting to have a solid cash flow year like we have had the last 4 years in a row.

We have a very conservative balance sheet.

So our number one focus relative to capital allocation remains the M&A market.

We do believe that creates the most value for our shareholders and improves the firm overall.

We remain committed to that.

Historically half of our growth has come from acquired companies, because acquisitions are opportunistic by nature.

Even though we have a very well defined strategy in terms of what we are looking for, but you never know when properties will become available.

But we do remain committed to that strategy that we shared with everyone over the years.

M&A is first.

We remain committed to our dividend.

We have dividend every quarter since we went public in 1986.

We historically issue between 15% and 20% of our earnings in dividend.

We remain committed to that.

We are not committed to a buyback at the moment.

We did a buyback last year.

We bought 1 million shares.

We have a philosophy of buying back the creep, and we remain committed to that.

But I don't see any major buybacks in the near term.

Okay.

And just on the stock depreciation isthat still looking at about $0.18 for the year , and when are your ROI targets for the mid teens done, what is the target date for

As everyone will recall when we acquired Socla last April we said that it would be accelerative in the range $0.14 to $0.18.

We just did $0.05 in Q1, so we feel very comfortable that will remain at the top of the range,maybe a little better.

We feel comfortable with that.

Our plan for Socla was to hit 12% ROIC in year 3 , and we don't see any reason why we won't hit

Okay.

Thank you very much.

Okay.

Thank you.

(Operator Instructions).

Your next question comes from the line of Ryan Connors from Janney Montgomery Scott .

Please

Morning, Ryan.

Good morning.

I wanted to ask a question on the lead free issue a little more conceptual in nature.

Over the years you have talked about generally speaking the code approval nature of your business as a positive that it is moat around your business and helps sustain returns over times especially for companies like Watts that get out ahead of these types of things.

So it is an ironic element that it is actually negative this time around.

So I wondered if you can kind of frame that.

How you look at that whole issue of code approval now in light of what has happened in lead free.

And is this kind of one off, or is that element of the business still there and you still believe it is a competitive differentiator?

And then relatively, are there any other big changes to code either state or national that are on the horizon that would cause a similar issue that we are seeing with this issue today?

Let me deal with the second question first , Ryan, if I may.

We don't see any other significant issues out there that are either major positive or major negatives in the North American market place.

Then let me move on to the lead free situation.

The way I look at this is we are dealing with a very complex initiative which we have got to work through our processes and get behind us.

However, if we stand back and look at this in terms of the long-term I believe this is positive for Watts.

I say that for a couple of different reasons.

First of all most companies in our industry will be supply a mix of leaded and lead free products.

For example, the legislation refers to products that are potable in nature.

So companies will still be supply products into for example irrigation markets where it is not potable water.

So there will continue to be a mix of leaded and lead free products.

The law also provides that he who introduces the product in to commerce is responsible for ensuring compliance with the law.

So as we talk to customers and our channel partners the point we are making is you have got to trust your suppliers a lot through this whole process to ensure there is no cross contamination , and you are not being provide a leaded product for a lead free application.

And so as responsible companies such as Watts work on bullet proofing their supply chains, we believe we will have an advantage in being our customer partner, in being the trusted partner.

The second area where we believe we have an advantage is there a wide variety of alloys that manufactures can choice to use in a lead free environment.

And we believe we have the technical and engineering heft to make sure we make the right choices for the right application such that for example you don't end up with a product that cracks 3 or 4 years after it has been installed.

We see ourself going through a difficult transition process faster than we originally thought.

Once we get through it , we believe your position as a trusted partner with our customers and engineering and technology heft give us and other reputable companies in the

Okay.

That is a very through and informative response.

Thanks to both of you for your time today.

Thank you.

Your next question comes from the line of Jamie Sullivan from RBC Capital Markets.

Please proceed.

Hi , I had a couple of follow-up questions.

(Inaudible)Besides that mergers and acquisition still remains your number one priority for cash deployment.

I was wondering in terms of Europe now that you have Socla somewhat behind you and because of the economic situation there.

Are you seeing some greater opportunities in terms of the prices that business might available

We are certainly see some cases where companies are perhaps struggling a little bit in Europe.

But I have to confess we have not seen many cases where the EBITDA multiples have changed substantially.

Okay.

The second question is in Europe what is dynamics around this lead free situation is that something that might be expected sometime in the future?

We do not see any signs of it coming in the near term.

Okay, that is all.

Thank you.

Thank you.

There are no further questions at this time.

I would like to turn the call back over to David Coghlan, CEO.

Thank you, that was a good call with a lot of great question.

We appreciate your interest , and we appreciate your anxiousness to try to understand what went on in the quarter and what we are doing about it.

Our focus is going to continue to drive for growth, operational excellence, (Inaudible) in Watts get quarter one behind us and deliver an improved operating performance as the year progress.

Thanks for your time .

Thanks for your interest , and look forward to chatting at the end of

Ladies and gentlemen that concludes today's conference.

You may now disconnect, and have a great day.