Watts Water Technologies Inc (WTS) 2013 Q2 法說會逐字稿

Good day, ladies and gentlemen, and welcome to Q2, 2013, Watts Water Technologies earnings conference call.

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

All participants are in a listen-only mode.

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

(Operator Instructions)

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

Actual results may differ materially from those indicated by these forward-looking statements as a result of various factors including those discussed under the heading Risk Factors in the Company's annual report on form 10K for the year ended December 31, 2012, and other reports the Company has filed from time to time with the Securities and Exchange Commission.

In addition, forward-look statements represent the Company's views only as of today, and should not be relied upon as representing its views as of any future date.

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

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

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

A conciliation of the non-GAAP financial measures with the most directly comparable GAAP measures is available in the press release dated Tuesday, July 30, 2013 relating to the Company's second-quarter 2013 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 Releases.

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

Please proceed, sir.

Delu, thank you.

Good morning, everyone, and thanks for joining our second-quarter earnings call.

I'll start with a brief overview of the financial and business highlights for the quarter.

Then I'll give you our latest view on the market dynamics in each of our geographies, and a sense for where we see those markets trending as we move further into 2013.

I'll also update you on our expected segment performance from a top-line perspective for 2013.

Finally, I'll go through a high-level review of our realignment efforts before handing the call over to Dean Freeman to review our financial performance in more detail.

After Dean's discussion, I'll try and summarize and then we'll open the call to your questions.

So let me start with the financial highlights for the second quarter, which you'll see on slide 2 of our conference call presentation.

Consolidated sales in the second quarter were up 1.1% against the previous year.

Organic sales were up 50 basis points, with increases in North America of 3% and Asia of 26.2%, being substantially offset by a 4.5% organic sales decline in EMEA.

We delivered an adjusted operating margin in the second quarter of 10.1%, or 70 basis points higher than our second-quarter 2012 performance, and our adjusted earnings per share of $0.57 was approximately 10% ahead of the second quarter last year.

The net effect of our share buyback programs was $0.01 accretive to this quarter's adjusted EPS.

Dean will provide more color on the results in a moment.

With added sales volume, better product mix, and continuing productivity and cost-control initiatives, North America was able to deliver an adjusted operating margin of 14.1% during the quarter, a 190 basis point improvement, versus Q2, 2012.

North America wholesale sales were up 4% in total during the quarter.

On the retail front, our sales were down almost 1% in the quarter as we continued to encounter pricing pressures resulting from customer line reviews.

The second-quarter impact to North American operations of our lead-free transition program was approximately $1.4 million, driven principally by labor inefficiencies as our factories continued the lead-free transition.

That means our year-to-date incremental costs totaled $2 million.

You'll recall that during our Q1 conference call, we said that we expected additional lead-free related cost in Q2 and Q3 to total $2 million to $3 million, with the majority of that cost in Q2.

We now expect to incur $1 million of these costs in Q3.

EMEA's adjusted margins declined 60 basis points to 8.4%, as compared to the second quarter last year, driven by volume declines in some major markets.

In France and Germany, quarterly sales were both 10% below the previous year.

The French wholesale plumbing market and German HVAC market continued to be soft.

Our Blucher Drains business, along with export sales into the Middle East remain strong, and we saw eastern European sales bounce back sequentially from the first quarter, after a tough winter.

In Asia, we continued to build out our pluming and HVAC capabilities and to broaden our market coverage.

The overall China economic environment remains positive.

Our Inter-company business was also stronger during the business -- during the quarter, which helped with trends absorption.

We did see a shift in sales to more buy-sell products during the quarter, which negatively affected adjusted margins, but overall, our Asia team delivered another strong quarter.

Finally, from a cash perspective, we retired $75 million of unsecured senior notes in May, using cash on hand, and we purchased $10 million of our common stock on the open market during the second quarter as part of our most recently-announced share repurchase program.

Our net debt-to-cap ratio remains conservative at 11.7% and we had approximately $182 million of cash on hand at June 30.

If you turn to slide 3, let's review the business highlights in the quarter.

Let me start with EMEA.

I've already mentioned that certain core markets like France and Germany continue to be soft.

Italy was slow as well.

We did see some signs of stabilization in France as the quarter progressed and June orders picked up in Germany after a very slow start to the quarter.

The Drains business continued its strong performance as they maintained their momentum on project wins.

The US lead-free initiative continued on track during the second quarter.

As the quarter progressed, we noticed more of our wholesale customers starting their transition to lead-free products.

We expect this transition to accelerate as we move through the third quarter.

Operationally, the new foundry was formally commissioned in June and will wrap up output during the third quarter with the intention to be at normal capacity by the end of the third quarter.

North American unit volume was up 4.6% overall during the quarter.

However, sales were hindered by retail pricing pressures.

Sales of some key new residential construction product lines were up 7.5% on average during the quarter, and we've also started to see some minor movement upward on the non-residential front.

We also saw a sequential pickup in orders from the first quarter, but certain core product lines that we sell into non-residential applications, like specialty drains, remain flat or down to prior-year.

Further, we've had some new product introductions that have promise, but have yet to gain traction in the market.

And from a customer perspective, we've noted sales at smaller wholesalers are basically flat with last year, while we're seeing a solid growth at larger customers.

This signifies to us that smaller customers are being very cautious in taking on new inventories as they begin to transition to lead-free inventory.

Finally, our efforts in emerging markets including Asia, the Middle East, and eastern Europe continue to deliver results during the quarter.

If we turn to slide 4, let's discuss current market dynamics.

Let me start with EMEA.

Macro head winds in Europe continued, and have affected some of our core businesses more deeply than in the first quarter.

We still estimate French wholesale markets remain down 10% to 15% due to a softening economy.

Our German business declined again during the second quarter as compared to last year, and we've now seen no growth in our German business for three quarters, as the wholesale and OEM markets in Germany have softened due to the economy.

As mentioned, we did see some signs of stabilization in France and Germany as the quarter progressed.

But a portion of the German uptick resulted from business we picked up due to the major flooding that occurred during the quarter.

Southern Europe, and especially Italy, continues to be depressed, with political uncertainty in many southern countries, adding to the consumer's anxiety.

On the drains front, we believe that business will remain solid, as will our emerging markets in Europe.

Overall, I see our European end markets with a little more risk than opportunity as 2013 progresses.

Let's now look at North America.

We see the same trends in North America as we discussed in May.

Residential new construction is strong, and continues to trend upwards with the latest full-year housing starts estimate by Wells Fargo to grow by 27% to 990,000 starts for 2013.

We expect existing home sales will be steady and the residential repair and replacement business, as tracked by the LIRA index, to remain positive.

We have seen a small pickup in some commercial vertical markets, but others are still down.

The ABI index has continued its mostly-positive trend during the quarter, so we expect that a more positive commercial construction uptick may occur as the second half of 2013 progresses.

Finally, let's discuss Asia.

Chinese GDP was up 7.5% year-over-year in the second quarter, so the overall economy continues to grow steadily.

We've discussed before our focus on high-end construction markets in China, where our European and US technologies are in demand and where consumers are increasingly focused on ensuring comfort and safety in their homes, and we're expanding our sales footprint into Tier 2 and Tier 3 cities within the country.

One consequence of the Chinese government's latest efforts to slow down the real estate market in major cities is that shadow banking has diminished.

Shadow banks are second-tier lenders that have helped to finance in many projects in the larger cities.

The increase in interest rates has hurt their business and may cause a slowdown in construction in the Tier 1 cities.

But we expect to maintain our overall momentum in Asia as the year progresses.

Now, if we move to slide 5, I'll provide you with our updated view of how we see 2013 shaping up.

For EMEA, I think we've laid out the challenges there already, and we will certainly endeavoured to mitigate the downward market pressures wherever possible.

However, our current outlook suggests that we'll experience a 3% to 5% decline in sales for the full-year of 2013 at constant FX rates.

Our previous downside range was 2% to 5%, so we see marginally more risk as we look at EMEA for the balance of the year.

We see business volumes picking up in North America, with growth from residential new construction and remodeling.

We still do not anticipate that commercial construction will provide much tailwind for the balance of the year.

So we continue to expect core business growth in North America for all of 2013 in the 2% to 5% range.

In addition, we estimate that the effect of expected lead-free sales may provide an incremental 1% to 2% to our North American sales this year.

As regard to Asia, our expectation is that the team will continue to execute it sales plans, and we're maintaining our sales growth expectations of 20% to 25% for the full year.

As mentioned earlier, we still anticipate incremental costs of $1 million in Q3 for the lead-free transition.

And we expect further acceleration by our customers as they transition during lead-three -- during Q3 to lead-free product skews.

We expect to spend approximately $37 million in CapEx for the full year of 2013, meaning a second-half spend of approximately $19 million.

If we move on to slide 6, I'd like to summarize for you our anticipated realignment efforts.

The board has approved management's plan to accelerate certain operating footprint consolidation programs, and SG&A improvements, that we had been contemplating.

Our initial efforts will focus on Europe, and we've outline in general the expected costs and benefits of the European programs.

Total costs will approximate $16 million, of which $2 million would be for capital spending.

The remaining costs will include severance, relocation costs, and professional fees.

We expect that approximately 70% of the total spend will occur by the end of 2014.

Expected annualized savings approximate $7 million, which we expect to fully realize by 2016.

Presently, we anticipate that we'll capture 50% of the savings in 2014 and 90% by the year-end 2015.

The timing of the costs and the related savings is somewhat fluid, as we will need to engage various workers' counsels and various local government entities to gain plan approvals.

The end result is we expect to reduce our manufacturing square footage in Europe by approximately 10%.

The board also approved the disposal of Austroflex, an Austrian-based manufacturer of pre-insulated piping products.

This business has not met performance expectations since its purchase approximately three years ago.

If you recall, we took a sizable asset write down in 2011 for the Austroflex business.

We expect a loss on disposal of approximately $2 million in Q3.

The sale Austroflex will reduce our European square footage by an additional 6%.

Let me turn it over to Dean now, who will provide you with more insight into our operating performance in the second quarter.

Thanks, David, and good morning, everybody.

As usual, I'll try to keep my comments very brief.

I think David hit most of the major topic points, and I'll apologize in advance if I repeat anything David said.

But we'll try to add some color, more detail as we go through the pack.

I'm on slide 9 and again, as David pointed on a consolidated basis for the quarter, the organic revenue was up 50 basis points, North America 3% of that, offset by EMEA, down 4.5%, with solid growth in Asia, 26.2%.

A little more color on North America -- as David talked about, the wholesale channel up roughly 4% organically on a unit basis, 4.6%.

The OEM channel was also up around 3.2% and again, as was mentioned, retail was down 1%.

We continue to see pricing pressure in the retail big-box end markets and they've really accelerated some highly-competitive line reviews and in certain cases we've taken selective price reductions to hold share.

I think also as was mentioned, the other dynamic we saw in the quarter is that large wholesalers are fully engaged in the lead-free inventory transition.

The volume is tracking to plan.

It's solid in terms of the growth.

However, we have seen a bit of an air pocket in the lead-free transition with the small wholesalers as they look to de-stock as much as possible with leaded products before they have to restock with lead-free product.

We obviously think this is transitory, but we're watching it closely.

Looking at EMEA for the quarter, we did see, as was mentioned, 4.5% organic decline in the region driven by Germany and France.

We did see improvement in the month of June.

We believe that was, in fact, driven by OEM orders as a function of the central European flooding.

We think that situational to the event and not necessarily a going-forward trend.

However, we do continue to be cautious in our outlook.

That said, we continue to invest in the markets that continue to grow.

The Drains business was up over 4%, emerging markets was up over 20%, and our electronics business was up close to 30% in the quarter.

Small numbers, but solid growth in those markets that are -- that continue to grow.

As David talked about, we are planning actions to deal with the expected revenue declines in the year, and I'll talk a little bit about that later in my comments.

On a consolidated basis for the quarter, we did see 50 basis point improvement in gross margins, driven largely by performance in North America, which improved margins by 110 basis points year-over-year on higher sales volume, supply chain productivity, and lower commodity costs.

This does include about $1.4 million of the expected production inefficiencies related to the lead-free transition in the second quarter.

We talked a lot about that.

And year-to-date we're about $2 million in negative impact related to the lead-free transition, and I think as David talked about, another million in the third quarter.

The adjusted operating profit for the quarter was $37.6 million.

Again, as was mentioned, a 70 basis point improvement to 10.1%, and largely driven by the 20% improvement in the adjusted operating income coming out of North America.

They were at 14.1% of sales, offsetting the declines in EMEA.

So a solid performance out of North America.

The adjusted tax rate for the quarter was 34.2%, that's a 110 basis points over last year, and that's largely driven by the earnings mix in North America versus EMEA versus the prior year.

As David mentioned, $0.57 of EPS, a $0.05 improvement over prior-year -- 9.6%.

That does include a penny of benefit from the share repurchase program for the quarter, I think as was mentioned.

Year-to-date revenue was basically flat organically -- North America up 3%, EMEA down 5%, Asia up 30%.

Gross margins up 40 basis points on a year-to-date basis -- again, largely driven by North America, and largely driven by productivity, volume, and SG&A controls.

Adjusted operating profit year-to-date is $68.1million, improved 70 basis points year-over-year to 9.3% of sales.

Again, as was mentioned, expanding margins and lower G&A being the key drivers.

Tax rate isn't changed over prior-year at 31.6%.

Year-to-date adjusted earnings at $1.06, about 12% growth versus prior-year, $0.03 of benefit from share repurchases.

You can read the slides on the regional performance so I'll just turn to slide 17, primary working capital, as we've talked about several times, almost exclusively effected by the inventory build to support the lead-free conversion, about $27 million of inventory.

On the next slide, free cash -- again, exclusively effected by the higher capital spend on the lead-free foundry.

And I think as David mentioned, $10 million of share repurchases for the quarter under our 2013 plan.

We plan $13 million in the second half of the year.

We used $75 million to cash to pay down debt and we ended the quarter with $102 million in cash -- again, to repeat what -- all of David's comments.

Lastly, let me make a couple of comments regarding the board-approved realignment initiative in Europe.

First, it's important to point out, and I think as David clearly pointed out in the slides that he spoke to, this still requires further review by European employee representative bodies and other outside agencies, so we're not across that hurdle quite yet.

We're still very much in the early stages of the rollout plan, and we'll be limited in how much detail we can talk about with regard to scope and timing, so we'll be careful about that.

However, I think as David pointed out, and as we've said in the past, our approach is to be both tactical in dealing with the short-term realities of the economic situation of the region, but also to be strategic in achieving the long-term sustained improvement in growth and profitability that we're targeting over the next several years.

So with that, I'll just turn it back over to David.

Dean, thank you.

In summary, during the quarter, we gained momentum in the North America wholesale market, the lead-free project continued on track, and Asia and our other emerging market businesses performed above expectations.

North America and EMEA controlled their operating costs well, and consolidated adjusting operating margins expanded as North American sales increased and product mix was favorable.

We expect the market and EMEA to remain soft, and we expect to implement our realignment initiatives in Europe as the second half 2014 progresses.

So with that, why don't we open up to the line to your questions?

Delu, can you open up the lines, please?

Yes, sir.

Thank you, ladies and gentlemen.

(Operator Instructions)

Please stand by for your first question.

Your first question comes from Kevin Maczka of BB&T Capital Markets.

Please proceed, sir.

Good morning, Kevin.

Good morning.

First, if I could start on North American margins -- nice lift there, year over year and sequentially, and it sounds like you have got some pockets like retail where there's some increased price pressure; you've got a new foundry that's not at full capacity yet.

I know you've been working on the cost side and lean, and maybe mix was favorable; but I'm just wondering if you could parse through that a bit?

I'm trying to get a sense for sustainability of the strong margin that we just saw, there.

Well, there's a couple of different drivers, so let me go through them in order as best I can.

First of all, we have talked for some time about the fact that when we get additional volume, the drop-through rate is quite positive.

So we saw some benefits from that.

Second, within our cost structure, we did see some benefits coming into the P&L from the reduction of copper prices.

We also had a benefit in our cost structure because of advantageous mix overall, both channel and product.

Third, we've continued to drive our productivity efforts and we continue to see profit.

And fourth, we've been managing SG&A tightly on a global basis, and we saw the benefits of that flow through in North America as well.

They're really the drivers.

Kevin, let me just add a little bit more color.

The impact of the commodity prices was anywhere from 30 to 50 basis points on a gross basis, of the benefit that we saw.

The overall general productivity that we saw on a gross basis was roughly 150 basis points, and that's all sourced from the comments that David said -- that's general productivity in our supply chain, it's some manufacturing productivity, and cost savings coming from ongoing initiatives in our supply chain.

Okay, so of those four things -- copper continues to work in your favor, and productivity, SG&A control are going to be ongoing initiatives; volume, presumably, would get better as the cycle improves.

Right.

None of that sounds one-time in nature in any way.

Correct.

Okay.

Yes, sir.

Can I just shift over and ask one more on price?

You mentioned from selective pressures like the line reviews that are ongoing.

Are you seeing price pressure of note -- or opportunity anywhere else?

And as it relates specifically to lead, now that we're another quarter into it, what's your early experience there with being able to maintain price and margin?

Well, obviously there's some choppiness during the transition, because at certain points in time, certain wholesalers and certain manufacturers may have differing amounts of leaded versus lead-free material, and therefore, you may see -- let's say, non-normal comparatives between these two buckets.

But if we look at general trends, we've said right through this transition that our objective is to maintain our gross margin percentage as we do the transition from leaded to lead-free.

We remain confident that is still obtainable.

Outside of that, are we seeing any major challenges or opportunities on the pricing front?

We remain concerned about what is going on in retail.

We're working it as hard as we can, but outside of that, we don't have any major concerns.

Okay, thank you.

Okay.

Thank you.

The next question is from the line of Jeff Hammond of KeyBanc Capital Markets.

Good morning, Jeff.

Please go ahead, sir.

Hey, good morning, guys.

Hey, Jeff.

Just to be clear on the lead-free -- your spend is still in line, it's just some spending shifted from 2Q to 3Q?

Yes.

Okay, great.

And then, second half -- it sounds like you get some growth acceleration in North America and some of that is the pricing coming in.

I guess you hold the gross margin percentage, but you get maybe a little bit lower incremental on that revenue growth?

Yes, that's the logic, exactly.

Okay, good.

You mentioned some pockets of optimism in commercial and some hope for second-half recovery.

Can you just expound on that?

What are you seeing that gives you some comfort -- whether it be in the order book or anecdotally?

And how does that shape your view in the second half and into '14?

Well, I won't go through an exhaustive list, but as we get smarter about the key vertical markets, on the commercial front in which we operate we're seeing some trends, positive and negative.

So an example of a positive trend is spending in the hospitality vertical market.

We're certainly seeing some growth there.

And that's coming from new construction, and it's also coming from existing buildings, as hotel operators refresh and upgrade their buildings after a four to five year lack of investment.

On the negative side, we're seeing a slowdown in governmental buildings.

So obviously, you slow down in construction, very few projects on the books, and also slow down in investments and existing buildings.

So they would be bookends.

As we move across the vertical market spectrum, we're seeing some other vertical markets which have had some positive trends and others which are flat or negative.

So we're pleased to see some positive trends after a tough four or five years, and we do expect that over time those positive trends will start to outweigh the negative.

But we're not calling for any substantial commercial market rebound until later in the year or next year.

Okay, thanks, guys.

Okay, Jeff.

Thank you.

Next question is from Garik Shmois from Longbow Research.

Thank you.

Just a clarification question on slide 6 on the realignment summary.

Just wanted to be clear -- are you spending $16 million to realize $7 million in annualized cost savings?

Is that how we should be thinking about it?

Yes.

Okay, great.

Is it possible to provide the breakout on the cost savings -- how much you anticipate will be variable versus fixed cost savings?

We're not prepared to do that at this point.

We want to remain high level on this because there's a lot of discussions that have to take place with local government entities, with workers' councils, et cetera.

We can flesh that out later as we move further through that process.

Okay, that's fair.

Just shifting to North American DIY, just a follow-up question on the sales trends there -- you talked about pricing pressure because of the line-item reviews, but just wondering what you're seeing on the volume end; if you're starting to see some of the DIY spend starting to come back?

I think if you look at the plumbing aisle in the major DIY chains, they are starting to see a little bit of lift.

And so there's two dynamics going on -- well, there's three dynamics going on.

The first dynamic is, they're managing the transition to lead-free in the plumbing aisle.

The second dynamic is, they're certainly seeing some consumer demand lift in certain categories.

And then the third one is that, by and large, there's a lot of line review activity, which means that volume is shifting in and shifting out as incumbents lose business or as players gain new business.

So it's a pretty complicated set of dynamics.

But overall, from our perspective, what we're saying is that volumes are remaining relatively steady as a result of the lead-free transition and the line reviews, but we have decided to take a little bit of a cut on price in certain areas to maintain share.

Okay, thank you for that.

Lastly, one more clarification question on the lead-free.

With the pick up in sales to large wholesalers -- or at least they're being early adopters with the lead-free products -- can you talk a little bit more about the margins there?

How stable have you been able to keep the margin percentage with the large customers who have taken on the lead-free earlier on in the process?

Our objective was all along to maintain our gross margin percentage, and we're meeting that objective.

Okay.

Thank you so much.

You're welcome.

Thank you.

The next question is from John Moore of CL King.

Please go ahead.

Good morning, guys.

Good morning; welcome.

Thank you.

I had a couple of questions related to the lead-free transition.

First of all, I know you were expecting a lot of the contractors to stop booking any large projects with any leaded products some time here in the third quarter.

And that the transition to marketplace would really occur much sooner than the January deadline.

I'm just curious if that's playing out as you anticipated.

It is.

I think there's still a lot of dynamics, though, that go on within that.

If I'm working on a small project with a completion date in the next couple of months, at which time the inspectors will sign off on the job, I have no great incentive yet to want to use lead-free.

But if I'm engaged in a significant project that's going to drag on for several months or a year, the inspection will take place at the end.

So I'm going to be very cautious about using leaded product on that job because the inspection will take place most likely after the end of the year.

So, depending on the mix of quick-turn projects versus long-term projects, that will have an impact.

Also, where my supplier -- my wholesaler of choice -- is at in their conversion is going to have an impact.

There's a lot of variables, but it's moving forward as we expected.

Okay.

I guess, do you have a sense of how many -- what the breakdown between quick-turn and long-term projects are?

And do you think the industry will be fully lead-free or 90% lead-free by the fourth quarter?

I think, John, that the key driver over the next couple of months is not going to be so much the mix of projects.

That will certainly play a role, but I think the biggest driver over the next couple of months is wholesalers' plans.

If you just go back to the comments we mentioned a little bit earlier in the call, large wholesalers, who tend to operate their own distribution centers, and whose internal supply lines to the counter is therefore longer -- they're already off and running in the conversion and most of them are going to be done pretty soon.

So therefore, if I do come in, looking -- if I'm a contractor and I look for a leaded product, they're probably not going to be carrying it.

As we said, we are seeing smaller wholesalers manage their inventories very tightly so that they can get rid of as much leaded as possible before they stock up on lead-free.

So our view is that the wholesalers are going to be the main driver of this.

And so by the end of the third quarter, we would be surprised if there's many wholesalers out there who have not converted.

Perfect, all right, thank you.

And then, I was just wondering if you had any better sense -- I know the market -- there's a significant piece in the market that's served by some lower-cost providers and I know we haven't been sure whether they're going to make the switch or not.

Have you got any better sense at this point where that market share could go, or if it could become available?

I'm not so sure there's going to be any existing player in the marketplace who will decide not to make the switch.

Because, remember -- over the last four to five years, they've had to make the switch if they wanted to stay in markets like California anyway.

I think the issue really becomes, as this becomes a nation-wide rollout, the quality that those guys are able to bring to the market -- their choice of alloys, the effectiveness of their manufacturing quality control processes -- is something that their customers will be watching carefully and they'll be seeing good results versus bad results.

So I think that's really where the rubber will meet the road.

Got it.

Okay, thanks.

And one last one, just on the realignment strategy.

I apologize if I missed this -- the new realignment strategy, does that primarily include head count and facilities, or is the ERP system consolidation that I think you've been planning included in that as well?

Yes, I wouldn't say there's anything related to ERP consolidation.

We're going to be careful about breaking out savings or costs with regard to the different categories, as we talked about earlier.

We do have to pass certain regulatory review in the region and we're still very much in the early stages of the rollout plans.

So we're going to be careful about how we break it down.

But, you know, John, too, to take it a little step further, the sort of things that we've talked about in the past remain the sort of things that we continue to be focused on.

Yes.

So we are looking at our footprint.

We are looking at operational efficiencies through the creation of shared services and realigning back-office activities.

And we're also looking at how do we do things in a more efficient and effective way throughout the SG&A line.

So it's sort of an all-of-the-above type of approach.

Got it.

All right, well, nice quarter, guys.

Thanks for the time.

Thanks, John.

Thank you.

The next question is from the line of James Sullivan of RBC Capital Markets.

Good morning, Jamie.

Good morning.

A couple of questions on margins.

First, on the European side -- wondering how we should think about long-term potential for that segment?

I know if we look back historically, the segment's been as high as 13%.

Is that a relevant number for the potential margin?

And we put that against prior peak revenues and $7 million savings?

Just wondering if you could maybe directionally help us with how to think about the margin potential in Europe.

Well, obviously the margin, Jamie, has been significantly impacted by the volumes.

But I can tell you -- and, as David pointed out, our efforts, our planned efforts regard to realignment, the ongoing efforts that we have with regard to productivity and supply chain -- none of that has stopped.

And this is all about accelerating that, creating more efficient and effective platform.

So certainly getting back to historic margins, but obviously also looking forward to continuing to expand and grow.

So, Jamie, to add just a little bit of color to that, we've talked repeatedly about the fact that our midterm objective is to get to a global 12% operating margin.

And in order to get there, Europe will have to get back to its peak margins and go beyond that.

Yes.

Volume and continuing declines in the market, obviously, are headwinds as we move that way.

But that's what we're focused on.

That's what we're working towards, and that is what we're committed to achieving.

That's helpful.

And then switching to North America, did you mention -- I think you mentioned mix a little bit.

Can you add a little color there on where you saw the mix benefit in the product side?

Well, I mentioned two different sources of mix.

So first of all, channel.

Obviously, we saw growth in our wholesale business and a negative 1%, driven by price, in retail.

Wholesale is a higher-margin channel than retail, and so that gives us favorable mix.

Second, if we look within some of our products, we saw some nice growth in particular product segments.

An example would be back flow, which are higher margins than our average.

So there were a number of positive-mix developments on the products size, and they switched to more wholesale on the channel side.

The OEM channel was also up, which is positive to the mix.

Thanks.

And then one more, if I could, just on cash flow metrics.

Can you just help us think about long-term, what you see as normalized working capital metrics and CapEx?

Well, it depends on how you define long-term, but certainly we've targeted over 100% of free cash as a percentage of net income.

In terms of CapEx, we have certainly not cut back.

We certainly focus on projects that are accretive to our overall return on invested capital, and we'll continue to invest as is necessary in order to support the growth in the performance of the business.

Obviously lead-free was an important component of that.

Obviously with our proposed plans in Europe, that will be a part of it.

And in terms of working capital, as we've said, I think we've done a pretty good job on receivables and payables.

There's a great opportunity to continue to take down working capital from an inventory perspective.

The Company has done a great job, I think, certainly historically, in bringing working capital down.

But the inventory build to support the lead-free is obviously the investment that is needed to grow the business and support that transition, but certainly offers future opportunity for reduction.

Thank you.

Thanks, Jamie.

Thank you.

(Operator Instructions)

We move to our next question from the line of Jim Giannakouros of Oppenheimer.

Please go ahead.

Good morning.

Jim, please go ahead.

Your line is live.

Oh, sorry about that.

Good morning.

Austroflex's sales on a trailing 12-month basis and even contribution -- can you give us those?

Yes.

So the revenue last year was EUR14 million.

Yes, that's about it.

EBIT was below $1 million.

Got it.

I should say -- sorry EURO1million.

Euro.

Okay.

Below EUR1 million.

Thank you.

And just to revisit margins again -- just tacking on; asking it a little differently than the way Jamie just did -- when we look back at your last five, six years, I think we estimate restructuring activity has taken out about $15 million or $16 million in costs, but we know that lead initiatives in ERP consolidation have contributed to your profitability as well in North America.

Can you quantify in any way their contributions over the past several years?

And on the related topic, on Europe, any targets that -- a high-level target you might have on just those two components, how they can contribute to getting to a 2016 margin along the lines of how you estimated annualized savings on the restructuring side being $7 million?

Gee, Jim, that's a tough one.

You know, the challenge in answering that question, I think, goes back to the fact that while we were restructuring, we were not looking at a stable volume environment.

Exactly, yes.

So the relationship to the amount of volume drop versus the amount of capacity you take out is going to have a huge impact on the way you think about that, right?

So going forward, that whole relationship should change as markets stabilize and grow.

I think maybe the best way that we can put it to you is that, we've talked publicly in the past about incremental volume leveraging down at about 35% or so.

So that comes from a leaner, meaner set of processes, and it also comes from a slimmed-down footprint.

And maybe that is the best way we operators can think about it.

Okay.

All right?

Yes.

No further comment.

Got it.

Just a finer point -- I know you don't want to give guidance -- but just trying to do math around Europe.

It's running in the low 8%s as far as the operating margin -- mid-8%s so far this year.

It is a 10% margin achievable next year, given the announced moves and assuming no organic growth in the region, so your restructuring activity cost-saves, and also taking out Austroflex?

Jim, we would be reluctant to give that sort of specificity about next year.

Yes.

Obviously, volume in Europe -- and anybody who's got a better view of that can chime in -- but certainly volume will play a significant role in ultimately how margins perform.

But I think David said it best --12% global operating income is the target, and we certainly need Europe to get back to historic levels in order to achieve that.

The difficulty about answering your question about next year is, we're finding it terribly difficult to make a call on where the markets go.

And so those trends are going to have a huge impact on what sort of a number we might expect to see next year.

We're in the early stages of engaging with works councils and local authorities on the restructuring efforts, and that's going to have a huge impact on timing.

So you put those uncertainties together, and if we threw out a number, the accuracy of that number is going to be low.

But look, Europe is still a very important market to us.

It will come back one day, and this is really all about positioning it for the future.

That's why we would say, look, it's tough to say what's exactly going happen next year, but our long-term goal is to get to global 12%.

And in order to do that, Europe needs to get back to its historic profitability rates and go a bit beyond it.

Thank you.

The next question is from the line of [Stuart Shaw] of S&P Capital IQ.

Please go ahead, sir.

Good morning, thank you.

Good morning.

Could you talk a little about the do-it-yourself home improvement business?

I was just wondering why that's been weak.

Although the wholesale is strong, the residential -- it is more the commercial side than the residential?

Or it is split eventually?

I think, Stuart, we tried to answer the question on retail a little earlier, so maybe let me try it again to see if I can do better.

First of all, we are seeing, within the plumbing aisle of our retail customers, some increase in customer sales.

We are also seeing an increase in line reviews.

And when a line review is concluded, the manufacture either wins the business or loses the business, and that means that chunks of business move in and move out of the sales line based on the win-loss ratio.

And the second impact of those line reviews is that there's a price associated with that business.

What we're seeing is effectively three moving pieces -- an increase in consumer demand in DIY, a movement of volume in and out as a result of line reviews.

The combined effect of those two in our business is approximately 0% -- in other words, they net out.

And the result of the line review is a negative 1% sales decline, largely due to price.

If we compare retail to wholesale, you're looking at two very different animals, because you're looking at DIY demand largely in retail, and you're looking at professional demand in wholesale.

So you're not going to have a whole lot of DIYers going into a retail customer to buy product to build a new home.

And you're certainly not going to find DIYers go into retail to buy a lot of product for the commercial market.

And so there's a big difference between the channels.

So hopefully, that answered part of the question.

The last piece I just try and talk about is what is going on in wholesale.

We're seeing three different trends.

First, we're seeing -- well, four, really -- we're seeing improvement in residential new construction.

We're seeing a steady repair [of place].

We're seeing a mixed picture in commercial, which means it's net-net flat.

Then we're seeing a movement in demand from leaded to lead-free, with a solid transition on the part of large wholesalers, and some air pockets as smaller wholesalers run down inventory before they make the transition.

So hopefully that's not too complicated, but that's the best way I can try and explain it.

No, thank you for the color.

That's very helpful.

Also on the M&A, where do you stand with that strategy?

Has it changed at all, based on your focus on the realignments in Europe?

And with growth being strong in Asia, and it being such a small percentage of your overall sales, are you looking to expand that percentage?

I guess the best way of responding to that is to say our M&A strategy remains intact.

We remain a careful buyer and so that means that we walk away from properties that might be attractive but which are not at a multiple that we deem appropriate.

We did do our last two largest-ever acquisitions in Europe; and so that, combined with the downturn there, would make us a little bit more careful about acquisitions in Europe.

But outside of that, we've got a pipeline.

We're working it, but we remain a prudent buyer.

Okay, thank you very much.

Thank you.

Gentlemen, you have no further question in the queue.

I will hand the call back to Mr. David Coghlan for closing remarks.

Thanks very much, Dalu.

In closing, I would like to thank all of you for taking the time to join us today for our second-quarter call.

We very much appreciate your continued interest in Watts Water, and we look forward to talking to you again during our third-quarter earnings call in late October.

Have a great day.

All the best.

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

You may now disconnect.

Have a great day.

Thank you.