Watts Water Technologies Inc (WTS) 2012 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Q3 2012 Watts Water Technologies Earnings Conference Call.

My name is Alex and I'll be your operator today.

At this time, all lines will remain on listen-only.

We'll conduct a question-and-answer session towards the end of your conference.

(Operator Instructions).

Please be aware that the remarks made during today's call about the Company's future expectations, plans, and prospects constitute forward-looking statements under the Privacy Security 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 the Company's annual report on Form 10-K for the year ending December 31, 2011, and other reports that the Company files from time to time with the Securities and Exchange Commission.

In addition, forward-looking statements represents the Company's views only as from today and should not be relied on as representations of its views in future dates.

While the Company may elect to update these forward-looking statements, it disclaims any obligations to do so.

During this call, the speakers may refer to non-GAAP financial measures.

These measures are not prepared in accordance with general accepted accounting principles.

A reconciliation of non-GAAP financial measures to the most direct comparable GAAP measures is available in the press release dated Tuesday, the 30th of October 2012, related to the Company's third quarter 2012 financial results, a copy of which may be found in the Investor Relations section of the Company's website, at www.wattswater.com,under the heading press release.

I would now like to turn the call over to Mr. David Coghlan, Chief Executive Officer.

Go ahead, sir.

Thank you.

Good morning, everyone, thank you for joining our third quarter earnings.

We appreciate your continued interest in Watts Water.

For those on the call who live or work in New York, New Jersey or other mid Mid-Atlantic states, our thoughts are with you and your families as you recover from Sandy.

I'd like to begin by providing you a brief overview of the third quarter, then talk about market conditions in our key regions and give you a sense for where we see these markets going in the last quarter of 2012 and into next year.

I'll then hand over to Bill McCartney, who will take you through our third quarter performance in more detail.

And after Bill's discussion, I'll give you an update on our lead-free initiatives, then summarize and open the call to your questions.

Let me start with an overview of the quarter.

We were pleased with the performance of the Company in the third quarter.

We were able to improve our operating results sequentially on top of a fairly solid second quarter result.

And we saw organic sales growth in both Europe and Asia.

As a result, we delivered adjusted earnings per share of $0.63 in Q3 compared to an adjusted earnings per share of $0.53 in Q2.

Adjusted operating margins were up one percentage point sequentially from Q2 and 2.5 percentage points over Q1 of this year.

This is consistent with the path forward we outlined earlier in the year.

European sales in the quarter increased organically by about 3%, despite a challenging macro economic environment.

If you recall, organic growth in Europe in both Q1 and Q2 were soft, so we were quite pleased with the results in Q3.

Much of the increase was related to stronger [Lucor] drain sales, stronger sales of heating products from our German operation, and continued growth in the Middle East and Eastern Europe.

Southern European markets, such as Italy, continue to be soft.

And for the first time in 2012, we saw some softness in France, where bookings for the quarter were spotty.

In North America, sales were essentially flat on an organic basis, as sales gains in the DIY improvement sector were offset by slightly lower sales into the wholesale market.

Let me make a couple of comments concerning our wholesale sales performance vis-a-vis all the positive new home construction news.

We're encouraged by the pick up in residential construction and we believe this bodes well for our future, assuming this growth trend continues -- but a couple of points to bear in mind.

First of all, the 20% increase in US home construction is off historic lows, so a modest movement upward isn't necessarily going to equate to an immediate windfall for Watts.

Secondly, new residential construction today represents much less of our portfolio sales than it has, historically,as we believe that the repair of place market is now driving a significant majority of our US sales.

If you do some fat math, we think the uplift in new residential construction should drive incremental sales of around 1% to 2%, but in Q3, we believe any upward swing from new construction was offset by a slower than expected start to the heating season.

So net-net, we were down slightly against last year in the wholesale channel.

In summary, we're encouraged by the long-term potential that a sustained recovery in new home construction in the US brings, but like a number of our peers, we haven't seen the needle move significantly enough yet to meaningfully affect our results.

In North America, we also continued to make progress on a number of the issues that affected our first quarter performance, including cost associated with the conversion to lead-free.

We have essentially completed the pre-production runs associated with the manufacturing conversion to lead-free at the end of Q3, with only a handful of [PEPAPs] left to go, and as expected, our North American adjusted margin increased one percentage point over Q2 to 13.2%.

This result was also helped by our cost containment efforts and our productivity initiatives.

Finally, our Asia team delivered another solid performance, both sequentially and compared to last year.

Sales were up organically versus Q3 of last year by 22% and year-to-date, are up 13% versus 2011.

This result was driven by our focus on attractive segments within the plumbing and HVAC markets and from investing in a stronger sales and distribution team.

In general, pricing was not a major issue during the quarter, although we are still facing pricing challenges in certain markets.

But we were encouraging that our European team was able to selectively improve price realization in the marketplace.

We believe the breadth of our product offering in Europe and our ability to respond quickly to customer demand is allowing us to selectively take some market share, as well as improve pricing.

In North America, the DIY market continues to be challenging, as the number of line reviews with DIY customers increases.

On the wholesale side, there have been some geographic pockets where market pricing has been more challenging, forcing us to react there on a job by job basis.

Regarding commodity costs, copper bearing product costs have been fairly stable so far this year and actually trended down in Q3, providing some tailwind to us in gross margins.

However, this tailwind was muted somewhat by the seasonal fall-off in volumes that we typically experience during the second half of each year, which can impact plant absorption.

Further, product mix has been impacting gross margins, as our DIY sales continue to expand faster in North America than wholesale sales, as has happened on a year-to-date basis.

Let's discuss the current market conditions and where we see things trending into the final quarter of 2012 and into 2013, as well.

Let me first talk about Europe.

During the course of 2012, we've been executing on a plan; to mitigate the macro economic effects of our end marketsby one, targeting selective share gain opportunities in our core markets, by leveraging our broad product range and our quick turn order fulfillment capabilities;and two, growing our business in the Middle East and Eastern Europe.

While Southern Europe has been a drag on our business throughout the year, we've been able to mitigate its effects and deliver some reasonable results in Europe this year.

Our order intake in Q3 remained fairly stable with Q2, so we believe we'll end the year in Europe in relatively good shape, taking into consideration normal seasonality.

However, as we think about our business prospects in Europe for 2013, we're approaching the new year with an air of caution.

From a macro economic prospective, there were many data points suggesting that Europe may experience further economic turmoil before things get better.

Aside from the continuing concerns about Southern Europe, there's increasing concerns about an economic slowdown in Germany and France.

And as I mentioned earlier, in Q3 we saw our French business soften, for the first time, in 2012.

Now, we don't know if this single data point will become a trend.

But it concerns us, as France is our largest European market.

As we look forward into 2013, we recognize that the macro economic landscape, despite our best efforts, could become more of a hindrance to our European results.

Let's now look at North America.

In Q4, we believe that the retail sector will continue to grow as compared to prior year, and that the wholesale business will show some growth, assuming the heating season finally kicks in.

From a sequential prospective, we believe that business will be inline with historic trends.

Looking at 2013, we've all ready discussed the new residential construction market, and again we're hopeful that the positive trends experienced in 2012 will continue into 2013.

Existing home sales, we believe, should be steady in the $4.5 million to $5 million range, which when combined with commercial existing building investments, is encouraging for our repair and replacement business.

However, commercial construction expectations remain mixed.

The ABI has been in positive territory the last two months, which is encouraging.

But if you review trends in the index since January 2011, on three occasions the index was above 50, only to regress for two or more months thereafter.

Our feeling is that commercial construction could have little positive effect on our end markets in 2013.

Finally, let's discuss Asia.

As I mentioned last quarter, we anticipate that our longer term growth prospects in Asia are bright.

We believe there is significant opportunity for to us grow in the domestic China marketplace and we're making some nice progress in laying the foundations for sustained growth there.

China's economy is growing by roughly 7.5% despite recent declines.

And a significant proportion of domestic GDP is still accounted for by real estate, including construction.

We are focusing on bringing our worldwide capabilities into the Chinese market where high end construction contractors want to emulate established European and US plumbing codes when specking their jobs, and where consumers are increasingly focused on comfort and safety in their homes.

As a result, not only are we seeing demand in China for our localized products, but also for our more highly engineered German, Italian and French manufactured products.

Let me turn it over to Bill now who will provide you with more insight into our operating performance in Q3.

Okay, thank you, David.

We'll look at revenue for the quarter on a consolidated basis.

We closed the quarter at $361 million, that represents a decline of almost $10 million or about 2.5% in the quarter.

Looking at the components of that change; from an organic standpoint, we grew the business almost $6 million, slightly less than 2%, so that's a slight improvement over the trends we saw earlier in the year.

However, the change in the foreign exchange rates, primarily the Euro, had an adverse impact on our revenues.

So because of the FX rates, our revenue declined $18 million, almost 5%.

And the inclusion of the revenue of Tekmar, which we acquired earlier this year, increased our revenue by almost $3 million, so that all adds up to $9.6 million or a decline of 2.6%.

Again, driven by the FX rates, primarily.

The bottom line, from a GAAP standpoint, our EPS was $0.53.

However, when we look at our as adjusted numbers, we're reporting $0.63 for the quarter, and that compares to $0.69 last year -- so we're down $0.06.

However, just as a reminder, when we look at last year's third quarter, that was the strongest quarter that we've seen in the Company's history, so it's a difficult comparison.

The way we discussed our performance that we would be monitoring ourselves on a sequential basis this year, and we have seen continued sequential improvement from Q1 and Q2, and again, into Q3.

The acquisition of Tekmar contributed $0.01 to our earnings in the quarter.

Just looking at some of the special and restructuring items that we used to include or calculate our as adjusted numbers.

I know some of the folks out there are interested in those numbers on a segment basis.

North America, we had charges of $1.6 million pre-tax $1 million after tax.

Europe was $400,000 pre-tax and $300,000 after tax.

China was $1.6 million pre and post tax.

And at the corporate level, $800,000 pre-tax and $500,000 after tax, so that totals $4.4 million pre-tax and $3.4 million post tax, which equals $0.10 per share.

Now, looking at the segments.

North America, we closed the revenue at slightly over $207 million in the quarter, so that's up about $2 million or 1%.

Again, the components there -- a very small decline from an organic standpoint of about $500,000.

The foreign exchange rate, which is the Canadian rate, we saw a slight decline there of about $300,000.

The Canadian rate declined about 2% versus last year's Q3.

We're now at parity with the Canadian dollar.

This again, this is where we see the inclusion of the revenue of Tekmar in North America for about $2.5 million.

So that the total change, $1.8 million,nine-tenths of 1%.

As David mentioned earlier, the wholesale revenue was down slightly, 1%, offset by some gain on the retail side of 4%.

In Europe, the revenue for the quarter, $146.5 million,which is decline of $13 million or 8%.

Again, that decline is entirely driven by the foreign exchange rates.

The average rate we used last year for the translation was almost $1.41, Euros to the dollar.

This quarter, it was about $1.26, so the Euro has declined about 11%.

So that decline equals $18 million or 11% on the European numbers.

From an organic standpoint, we were pleased to see an increase of about $5 million or 3%, and we attribute that to the improvements of the growth we've seen at Blucher in Germany, which is offsetting some of the softness that we are experiencing down in Southern Europe.

European segment represented almost 47% of our revenue in the quarter.

China, small base but very solid performance, $7.3 million in (inaudible) dollars revenue in the quarter, an increase from Q2 and from Q3 last year.

Revenue in the quarter up 24%.

That is almost completely attributable to the organic growth, with a small pick up on the FX rates due to the Chinese currency.

On the gross margin, on a consolidated basis, we closed the quarter at 36.1%, that is a decline of 50 basis points versus Q3 of last year.

But again, remember we're comparing to an extremely strong quarter last year.

When we look at the margin on a sequential basis, we were up 60 basis points from Q2 of this year.

What we see inside the gross margins -- we see a nice improvement in North America on a sequential basis.

We were up 130 basis points.

Again, attributable to a much more efficient processing our no-lead transition, as well as some nice progress on some of the material costs that we discussed with you in Q1 -- the non-commodity inflation, if you will.

Europe, the margin is up 90 basis points from last year and is consistent with what we've seen earlier in this year.

The improvement in Europe is attributableto some of the factors that David mentioned.

We've seen pricing, we've experienced some solid productivity, and of course the sales volume helps, as well.

SG&A at $93.5 million, its an increase of $900,000 versus last year at this time.

As we walk through the SG&A, last year at $92.6 million, from an organic standpoint, we saw an increase of $3.9 million.

The FX rates, primarily the Euro, caused a decline in SG&A of $4.1 million, then inclusion of Tekmar increased SG&A by $1.3 million.

So that brings us up to the $93.5 million of SG&A.

So on the SG&A itself, we did see a decline in the run-rate from earlier this year,again, associated with some of the cost containment programs that we've outlined for you in the prior quarters.

Versus the increase versus last year's primarily associated with some investments we're making, primarily in Europe, around our new ERP system -- as we're in the thick of a deployment there.

Operating earnings, on as adjusted basis, at $37.5 million equals 10.4%.

Again, as we compare to last year, somewhat of a decline of $7 million.

When we look at the decline, break it into its components -- from an organic standpoint, we declined $6 million, again primarily because of the increase in the margin versus last year.

We had $1.9 million decline in operating earnings because of the foreign exchange rates, andthen $500,000 improvement because of the acquisition of Tekmar.

When we look at that foreign exchange, it did have an adverse impact on our earnings per share of $0.04.

However, our share buyback program, which we completed earlier that year, offset that unfavorable foreign exchange and that contributed $0.04.

So the combination of FX and a buyback really offset each other.

So when you look at the earnings per share, really is the result of operations.

Below the line -- other income and expense declined by $600,000, that's primarily due to decreased interest expense.

The tax rate at 32.5%, that's down 50 basis points from last year.

And that is associated -- or due to the mix of income, whereas Europe had a strong quarter this year and the tax rates in Europe are a little bit lower than we see in North America.

So net income on an as adjusted basis, $22 million with $0.63 of EPS.

The shares outstanding at 35.2 million.

And one other note is to mention free cash flow for the year-to-date, nine months ended September, we're at $56 million, which is an improvement of 38% versus last year and represents 106% of our net income.

And as those of you that follow us closely know that we are cyclical in our cash flows, and that as we progress through the year, each quarter on a sequential basis we have an improvement in our cash flow.

Based on history, we are set up for a good cash year.

With that, I'll turn it back to David to have a little bit of discussion on our lead-free program.

Bill, thanks very much.

We thought it worthwhile to spend a few minutes giving you our thoughts and expectations regarding a major shift in the plumbing industry, which is our biggest business, that being the required conversion to lead-free alloys, for all pipes, fittings and valves used in potable or drinking water applications.

This shift is in response to the Reduction of Lead in Drinking Water Act, which would become effective in January of 2014.

And that law requires that the wetted surfaces of all potable water products installed after January 1, 2014, have no more than 0.25% weighed average lead content.

And that's down from the current 8% limit.

The January 2014 date is a hard stop, meaning the law does not allow for the sale or installation of leaded products for potable applications after that date by manufacturers, by retailers or wholesalers, and by contractors.

This change applies nationwide, although as many of you know, similar changes have all ready occurred in a small number of states, including California, Vermont, and Louisiana.

Our overall strategy regarding the transition to lead-free is two-fold.

First, we believe we can use this change as a way to differentiate ourselves from other competitors who may not have the financial wherewithal or the technical and/or operational resources to successfully manage the change.

We believe we have the capabilities and the resources to re-vamp our products, our supply chain, and our manufacturing processes, and to also assist our customers transition their businesses in a timely and effective manner.

We are also working proactively with the EPA and with local authorities to ensure that the new standards are clear, than they're properly enforced to ensure that all industry participants have to meet the more stringent requirements, and thereby minimize the risk to our customers.

Our second strategic goal is to maintain our gross margin percentage on the approximately $300 million of sales which will be affected.

We expect the costs of lead-free products will be 10% to 20% more than current costs for leaded products, and we hope to adjust pricing accordingly, so as to maintain our gross margin percentage as much as we possibly can.

As a market leader, we believe we're in the forefront in responding to the many issues the migration the lead-free will entail.

The transition will involve, amongst other issues, product and operational changes, customer education, and inventory and channel management.

From a product prospective, our work is essentially complete.

And operationally, we have begun construction of a new lead-free foundry and initiated the conversion of our production activities to allow us to segregate key manufacturing processes for leaded and lead-free products.

As you know, this work created some choppiness in our North American results during the first half of this year, but we felt an accelerated changeover process was essential to meet expected quality standards and the customer demand associated with the nationwide roll-out.

We're spending over $16 million on the new foundry, with an expected second quarter 2013 commission date.

We also expect to spend another $4 million on our machining and assembly processes.

So our expectation is that total capital spend for the Company in 2013 will be elevated because of the lead-free conversion, to as high as $41 million.

Beyond 2013, we expect that our capital spend will moderate to more historic levels.

On the customer front, we're finding varying degrees of awareness amongst our customers of the new law.

We believe this provides us as a market leader with an opportunity to help our customers plan for and manage the transition to lead-free products with education and the provision of management tools.

Internally, we've trained all of our sales personnel, who in turn have commenced informal discussions with our customers about the new requirements.

In addition, we along with some other industry players, have formed a consortium that has begun formal trading at industry trade shows and other events for plumbing and HVAC contractors.

And we're also working to train architects, engineers and distributors.

These programs are designed to educate them about the new law and how it will have a very tangible effect on their businesses in 2013, and also to help them plan for and manage the transition.

In addition, we're distributing a range of useful literature and maintaining an active website, weareleadfree.net, that is all about lead-free and the transition.

From an inventory and channel prospective, we have developed transitional timing for the introduction of lead-free products and we're communicating these to our customers.

We will cease production of slower moving, sea-level leaded products effective January 1,B items by March 1, and our fast-moving A items by April 1, with the objective of having leaded items work through ours and our customers inventory well before the end of 2013.

We expect some of our larger customers will likely transition quicker, as they have the logistical expertise to move large quantities of product in and out of their DCs and storage and branches.

Finally, to give you a general sense of how this major initiative will affect our business next year, we estimate that on an annual basis, approximately $300 million of sales will be impacted, but this will occur on a gradual basis, as 2013 is a transition year.

We expect some choppiness in cash flows and inventory levels over a couple of quarters during 2013, as we build up our lead-free inventories in advance of our operational transition.

But we expect inventory levels to be at more normal levels by year-end.

We may also generate some negative manufacturing variances for a quarter or two, both before and after we commission the new foundry.

But keep in mind, manufacturing changes will be focused at three of our 25 worldwide plants.

So, in summary, this is a significant change for our plumbing business and for the entire industry in the US.

But we are working very hard to make the transition as seamless as possible for our customers and our business, and to use this transition as an opportunity to differentiate ourselves as one of the leaders in the industry in the process.

So let me summarize.

In closing, we believed we delivered a solid quarter for our shareholders.

Our European and Asia teams both delivered very solid results and our North American team continued to deliver sequentially improved performance, while executing on a challenging lead-free conversion process.

We believe we've laid out a plan for lead-free that if executed well, should provide us with upside potential for the long-term after the transition is completed.

Before I open the line for questions, I'd like to do two things.

First, this is Bill McCartney's last earnings call as our CFO . Bill has been a tremendous contributor to Watts over a long and distinguished career and has played an important role in the Company's development.

I also know he's worked closely with many of you on the call to help you understand our company ands it prospects.

So, on behalf of us and you, I'd like to wish him the very best as he retires.

Thank you, David, appreciate that.

It's been a pleasure.

Secondly, I'd like to introduce you to Dean Freeman, who will take over as CFO on November 12th, once the Q is filed.

Dean has a great background and will help us a lot to move forward on our journey.

We recently issued a press release giving more of Dean's background and I urge you to look at that to see the pedigree that we're bringing on board.

Dean, welcome to the team.

Thank you.

Thrilled to be here.

With that, why don't we open the line up to your questions.

Alex, can you open the line, please?

Certainly.

(Operator Instructions).

The first question comes from the line of Garik Shmois and he's calling from Longbow Research.

Go ahead, please.

Thank you.

Congratulations, Bill, on your retirement.

Thank you.

My first question was on the corporate expense line, about $2.9 million lower in the quarter.

Wondering if you could provide more color on that and how we should expect that to be modeled going forward?

Some of the things that we talked about on some of the earlier calls, some of the cost containment programs that we were initiating earlier in the year have come through.

So we made some changes on some of our freight programs, we've continued some of our consolidation programs.

In other words, we have more shared service centers, particularly around some of our advertising and marketing areas.

Some of those savings were slightly offset by some of the investments we're making Europe around IT.

We're in the beginning of an ERP deployment in Europe.

So we're make some investments in there.

And the other issue you have to remember, Garik, is that earlier in the year, we did take an unusually large charge, a true-up, if you will, from actuarial standpoint on our product liability accrual.

So we believe that was a one-time charge or an unusual charge.

There's some moving pieces there, but we are focused on keeping that SG&A growth in check, as we go forward.

Okay, thanks.

In the past two quarters, you were able to quantify how much extra costs were associated with the conversion of your plants to lead-free.

Could you provide how much of a cost headwind it was in the third quarter?

And maybe how much is left in the 2012 program?

It sounds like you're mostly done with the process, but any numbers around that would be helpful.

In the quarter, we're probably looking at rounding it at probably $1 million.

And looking forward, our [PEPAPs] are essentially done, we only have a handful left.

So it will be insignificant in the fourth quarter.

Okay, thanks.

Then, just on lead-free --could you provide maybe a little bit more color on your mix of sales in the quarter in North America?

If you're seeing any meaningful shift being lead-free here initially in the market?

Or are you anticipating obviously a much more sizeable jump in 2013?

The question is, how many of your sales in the third quarter was the new lead-free product offering?

The way to think about it is that our customers are going to be cautious about shifting too far in advance because of the extra costs involved in lead-free products.

So we would say that approximately 10% of our plumbing products are currently lead-free.

And that's driven by the individual states who proceeded the national law, states like California, Vermont, Maryland, Louisiana.

We don't anticipate that the vast bulk of our customers will start the shift before the middle part of next year.

Okay.

You're out in front with the lead-free conversion this year.

Have you seen your competitors start to convert themselves?

Or are they still lagging behind with the expectations of a 2013 event for them?

Firstly, I think the issue is much more visible for us because the plumbing part of our business is much more significant than it is for some of the other publicly quoted companies in our space.

And secondly, all of our competitors are actively working on this issue, at least the reputable, quality competitors.

And we think they're going to be ready, as well.

The ones we're more concerned about is the moms and pops, and some of the imported products from developing companies, where they may not be as sophisticated or as familiar with what the changes imply.

And that's why we're focused so much on the EPA, in terms of ensuring there's a level playing level through appropriate certification and testing.

Okay, thanks.

My last question -- you're measuring this year on sequential improvement.

I'm wondering if you could provide your view on margins in the fourth quarter relative to the third quarter?

Obviously, you've made some nice progression here sequentially on margin.

Should we anticipate that the fourth quarter margin, despite it -- historically being somewhat of a weaker quarter, could you see margin expansion sequentially in Q4?

Obviously, we're going to remain focused an all of these items, both on the lead-free conversion, improving our non-commodity inflation on some of our material costs and so on, but there is -- we would expect to see continued improvement there.

But I want to caution you that we do have normal seasonality in our business and fourth quarter tends to be the quietest quarter, relative to revenue and so on.

Because once -- both for Europe and the US, once you get in -- you're sort of tailing off heating season as you get into early December, then you have the holidays, so it's a quieter quarter.

I will caution you.

We are going to focus on these continued improvements, but we do have some seasonality.

Okay.

Thanks again and best of luck, Bill.

Thank you very much.

The next question comes from the line of Kevin Maczka, calling from BB&T Capital Markets.

Go ahead, please.

Good morning, Kevin.

Thanks, good morning.

I'd first echo the congratulations to both Bill and Dean.

Thank you.

Thanks, Kevin.

First on Europe, an interesting reversal there with better organic growth this time in Europe than in North America.

Sounds like maybe with France for the first time is starting to slow a little bit, that European piece may not be entirely sustainable.

How much of the Middle East is driving that?

And can you size the Middle East portion?

Because it would seem that maybe that is a more sustainable growth market right now.

If you were to rank order where our growth in the third quarter came from, the first source of growth is improvement in the win-loss rate at our Blucher business.

We would look at that business as taking share within the space it occupies.

And that team is doing a great job on managing their quoting book.

Secondly, we've done very well in our heating business, which is largely based in Germany.

And that business focuses on the larger heating OEMs and the boiler sets and underfloor heating systems that they make.

There, I think the industry that we serve, the customers we serve are taking share from other customers that perhaps we don't serve.

So it's the large German OEMs who are taking share.

And we've done a very good job of working with their engineering groups to, if you like, build us in to their new systems and next generation systems.

And so we've looked at that and said it's a share gain.

Outside of that, the next areas would be Eastern Europe and lastly, the Middle East.

At this point, Eastern Europe and the Middle East are a relatively small part of the business, but we are seeing some nice double digit growth in those regions.

To put it into context, the Middle East is not the primary driver.

Although you're right,looking forward, it does offer some stability, as does a large part of Eastern Europe.

Got it, thanks.

Shifting over to the lead-free -- a question there.

Is it fair to characterize this, that this has been such a big disruption for your business, in terms of preparing for this, that maybe some of your teams that would have otherwise been focused on other cost or continuous improvement type of initiatives, have had to be dedicated solely towards this lead-free initiative?

And now that that's winding down and we're getting closer next year to the launch, that maybe those folks can go back and kind of reemphasize some of the other cost initiatives?

Is that a fair way to characterize that?

I think it is a fair way to characterize it, Kevin.

When we talked about our Q1 underperformance, not only did we talk about the costs of doing the [PEPAPs], which is running lead-free products through our manufacturing plans to check that we can manufacture them appropriately, but we also talked about the opportunity cost which was involved by our continuous improvement teams focusing on the issue.

Just to give you a simple example.

For all of our suppliers, we're going in and doing detailed supplier audits to make sure that their manufacturing processes enable us to be confident to meet the requirements of lead-free.

So that's time that our sourcing folks are spending doing supplier audits that they're not spending on driving sourcing productivity.

So, yes, as we get through that and as we tidy up and enable our supply chain and our plants, then we'll be able to swing back and focus on continuous improvement.

Got it.

Finally for me, to follow-up to that, going back to Bill's comment about the difficult comp and the 12% margin from a year ago, I think everyone is interested in when we may be able to see us trend back towards that level.

Can you just revisit your long-term margin goals and plans with us, in terms of when we get beyond lead-free, maybe there's some lift there, if you maintain those gross margins, and then you continue to do the other continuous improvement initiatives that you're doing; is it reasonable to think we'll see that again in 2013 or 2014?

We've articulated a margin goal of 12%, which we believe is achievable if we can continue to drive the sort of continuous improvement that we've been driving, if we continue on the path towards footprint consolidation, and if we get some volume growth from a sustained recovery in new construction.

And again, people who have modeled that out have sort of said, is that a very long pot and is there opportunity beyond that?

What we've traditionally said is, look, let us get to the 12% first, then we'll think about the next pot.

Kevin, you have to remember that as we grow and what we have seen is that organic growth comes through at like 35% or so to the bottom line.

As we see some of the markets return and we focus on some of these other initiatives, the prospects, I think, are very bright as we see that operating leverage that we've created come through.

Got it.

Okay, thank you.

Thanks, Kevin.

Thank you.

Our next question comes from Brett Linzey from KeyBanc Capital Markets.

Good morning, Brett.

Good morning, guys.

As you think about some of the structural challenges within the European marketplace, and expectations for 2013 to be tepid activity; how do you feel about the current cost structure there, the ability to navigate some of the markets and really your assessment of cost levers in a more muted growth scenario heading into next year?

Well, first of all, just to talk about the market environment.

The analogy we try to use with people is to remind them before new construction in Europe slowed down in 2007 and 2008, we might have been standing on the fifth or sixth step of a step ladder.

Since then, we've been standing on the first or second step.

Our repair, replace, upgrade business has carried us through.

So we are concerned about muted economic expectations going into 2013, particularly with respect to France and Germany.

But new construction across Europe has been soft for the last number of years anyway.

As we look at our cost structure in Europe, we've continued to work that cost structure over the last several years, and so it is better than it was before this decline.

We've talked about the fact that we've closed 14 to 15 rooftops over the last four years, a number of those have happened in Europe.

And we're continuing to work on fine tuning our footprint in Europe to make sure it's properly positioned going forward.

Secondly, we've been driving productivity initiatives, both Lean and SixSigma, throughout all of our facilities.

And we've also been ramping up our capabilities in the strategic sourcing arena.

And last but not least, the SG&A management in Europe has been very good, they've managed that very tightly, and will continue do so.

So, as Europe tightens, our focus will be on maintaining our margins and adjusting appropriately.

Okay, great.

And then just in terms of expectations for 2013 on the top line.

You guys gave some pretty good color just in terms of underlying growth.

Could you talk about your ability to outgrow, whether its share gains, new products, et cetera?

I know you gave a couple of examples within the German business.

How should we think about that trending into next year as well?

We think that in 2013, despite a lot of choppiness in some markets with Southern Europe, particularly Italy, hurting us earlier in the year, we think if we step back and look back at the market positioning; that, A, we've taken selective share and, B, we've been able to get price realization to try to recover some of the commodity costs that hit us earlier.

We'll continue to focus on our strategy.

We see areas where there's further opportunity for selective share gain.

And we also see opportunity for further growth in developing markets, including Eastern Europe and the Middle East.

That's on the plus side.

The question is, what's the degree of the negative -- what's the degree of contraction in Germany and France, and how might that affect us?

When you put the two together, it's tough to look through that fog and see how it will net out.

Okay, great.

Thanks, guys.

Thank you.

The next question comes from Jim Foung from Gabelli & Co.

Go ahead, please.

Good morning, Jimmy.

Good morning.

First, congratulations, Bill, on your retirement.

Good luck.

Thank you.

Great to work with you.

Congratulations, Dean, for coming on board.

Look forward to your transition from Flowserve.

Great.

Look forward to working with you.

David, a few questions here.

Earlier you talked about new residential construction being a smaller part of your business than in the past.

I was just wondering if you could give us a break out between what your exposure is to residential versus commercial constructions for both new and repair and renovation?

What we've always said -- first of all, at this stage, roughly 50% of our business is US and 50% is non-US.

Then if you look within the US, how we've classically described our business over the course of a cycle is 50% residential, 50% commercial.

And then the other side of that two by two matrix, 50% new construction, 50% repair, replace, upgrade.

If you look at the decline in the new construction markets over the last four to five years, it's tough to identify a backflow that's going into new construction versus repair, replace, upgrade.

So this is rough math; but our sense is that probably between 70% and 80% -- 75% to 85% or our residential business is repair, replace, upgrade today.

That's a big number.

Sounds like solid support going forward.

A, I think what it does, it sort of underlines the strength of our repair, replace business.

But B, it does also point to the fact that if we can get a couple of years of strong residential new construction under our belts, there's growth potential there.

Right.

Terrific.

And then just regarding the lead-free products.

Have you been able to quantify, kind of your market share gains from that line of plumbing products in 2014 and beyond, as you convert earlier than your competitors or from mom and pops?

It's very difficult to project how the share gain will play out.

What we're trying to do, I think now, is by working with the EPA and with some other reputable manufacturers in the industry, we're trying to set the table, if you like, for ensuring a level playing field.

And we think that by doing that, it will weed out some marginal players who will struggle to make the transition.

How that might play out in market share between the less sophisticated and sophisticated players in the industry, and then amongst the sophisticated players in the industry -- tough to figure that out.

And then how big is your plumbing products today?

Because that's the way --

We have -- what we're trying to signal to folks who are working the models for next year is that there's $300 million of our US revenues which are affected by this change.

Okay, terrific, great.

Thank you.

Thank you.

The next question comes from Jamie Sullivan from RBC Capital Markets.

Good morning, Jamie.

Good morning.

Congrats, Bill, congrats, Dean.

Thanks, James.

Thanks, Jamie.

Just a few on the lead-free and the outlook there.

Do you have a sense of how much the market is the higher quality players like Watts and how much is the smaller mom and pops?

You get into the whole issue about market versus served market, et cetera.

If we look at it from our prospective, we would say that in the served market in the plumbing industry, the market segments that we're playing in and that other reputable companies are playing in, we'd say that somewhere in the region of 80% or so of those market segments might be served by the top 10 or 15 players who you could put into reputable.

Sure.

That's helpful.

And then of those, I'm assuming those are many of the players in the consortium you talking about in educating the customer base.

Does it seem like their plans are similar to yours, in terms of timing and pricing of the cut over at this point?

Well, very difficult to understand what others are going to do on areas like pricing.

But in terms of changeover times, I think all good companies are going to get out and listen to their customers.

Our sense is that the DIY customers will try to shift a little earlier.

And that can the wholesale market will shift in the second quarter.

And it seems to me a lot of sophisticated players are seeing that and are targeting similar timeframes.

Okay, great.

Then in terms of how the smaller players or less reputable players adjusted to the changes in California, Louisiana, Vermont, those areas; what did you observe when that change was made?

Well, one of the things that we've been talking about our customers about is that the California version of the EPA, about six months after the change, went out and did some random sampling of product from the shelf.

There was one basket of products from reputable companies, the more sophisticated players in the industry, and from that basket of good, there was one product that didn't meet lead-free specifications.

So the vast majority of those products met the criteria.

From the other basket; less sophisticated manufacturers, imported products, private label products, there was a 50% failure rate.

So our point is, that if you impose a law, you need to enforce the law.

And so if there's a solid certification and testing process, we believe that it will separate, if you like, the men from the boys.

And the argument we're making with our customer is, who do you want to partner with?

The sophisticated manufacturers of which there are many, a number, or the ones who are going to create risks for you?

Great, thank you very much.

(Operator Instructions).

our next question comes from the line of Stewart Scharf and he's calling from S&P Capital IQ.

Go ahead, please.

Good morning.

And all the best to you, Bill, in your future endeavors.

And welcome, Dean.

Thank you.

Can you talk a little about the M&A market, and specifically Socla, how that deal is working out, especially in light of softness in France?

And you had projected about $0.18 of accretion for this year and ROI of 12% by the [third year] after the deal, and can you just expand on that a little bit?

Yes.

You're absolutely right, we talked about a range for the first year out with Socla of $0.13 to $0.18 accretion, and we over-delivered on the high end there in the first 12 months.

As we look out beyond the first year, we very happy with that acquisition.

We think it's a great addition to the portfolio, and we think the integration is going well.

And the synergies are coming along very nicely, both at the front end of the business as well as the operational side.

In terms of the outlook with respect to France, obviously we're watching the market situation in France very carefully, and we are looking at our cost structures in case we have to make any changes there.

But we still think that this is a good acquisition and that we'll be able to deliver on the sort of targets that we outlined.

In terms of the M&A pipeline in general, I think a lot of people will tell you that given the economic outlook in Europe, as well as fiscal cliff, changes in taxation, et cetera, that's coming down in the pike in North America, that it's a little more uncertain in terms of buyers and sellers out there at the moment.

And we're certainly seeing that.

There's a pipeline of opportunities that we've been working and looking at.

But we remain conservative in terms of what we're prepared to pay.

And we want to make sure that we do the right deal for the future.

And so that tends to take the hit rate down a little bit.

Okay.

Would you say the deals are still in the nine times EBITDA range?

Or are they going up?

I think what we're looking at is perhaps a larger spread between ask and bid than you might have seen some time ago, given the sort of uncertainties that are out there at the moment.

Okay.

Regarding lead-free again.

You said that the cost would be about 20% higher.

Are you planning or do you think you'll be able to pass all of that along to customers?

Depending on the product, we put a range out of between 10% and 20%, depending upon the amount of metal content in the product.

Our objective is to maintain our gross margin percentage.

We'll be working very hard do that.

Okay, thank you very much.

Thank you.

Thank you.

We have no further questions in the queue.

I would now like to hand the call back to David for closing remarks.

Okay, well, first of all, thanks to everybody who joined us.

We know, particularly for those in the Mid-Atlantic states, there's an awful lot of things going on at the moment.

Technology is not back up to where it needs to be,there's a lot of delayed calls.

So we appreciate you taking the time to join us.

And as always, we appreciate your interest in our company.

We'd like to wish all of you and your families the best for the forthcoming holiday season.

And we look forward to speaking with you on our fourth quarter earnings call in February.

So thanks very much, everybody.

Bye-bye.

Thank you for joining today's conference.

This concludes your presentation.

You may now disconnect and have a great day.