Watts Water Technologies Inc (WTS) 2015 Q2 法說會逐字稿

Ladies and gentlemen, thank you for standing by and welcome to the Watts Water technologies second quarter 2015 earnings conference call. At this time all participants are in a listen-only mode. Later we will conduct a question and answer session and instructions will be given at that time. (Operator Instructions). I would now like to introduce your first speaker for today, treasurer and VP of Investor Relations, Mr. Tim MacPhee. You may begin, sir

Thank you, Andrew. Good morning, everyone, and thank you for joining our second quarter earnings call. Joining me today are Bob Pagano, President and CEO, and Todd Trapp, our CFO. Bob will begin by providing a summary of the quarter. He will offer some color on current market conditions and will update you on Phase 1 of the Americas Asia-Pacific transformation initiative. Todd will discuss the financial results for the second quarter in more details and update our outlook. Bob will summarize and then we will open the call to your questions. The earnings press release and earnings call presentation we issued last evening includes some non-GAAP financial measures and we have included in those documents the necessary reconciliations to GAAP measures.

You can find a direct link to the web cast of today's conference call on our website at www.wattswater.com. We will archive the web cast on the site for replay. I would like to remind everyone that in the course of this call, to give you a better understanding of our operations, we will be making certain forward-looking statements. These statements are subject to numerous risks and uncertainties that could cause actual results to differ materially from such statements.

For information concerning these risk and uncertainties, see Watts Water's publicly available filings with the SEC. The Company disclaims any intention or obligation to revise or update any forward-looking statements whether as a result of new information, future events or otherwise. Now I will turn the call over to Bob Pagano.

Thanks, Tim, and good morning, everyone. Please turn to slide 3 in the earnings call presentation and I'll briefly provide an overview of our second quarter. Overall I'm pleased with the progress we made in the quarter. Our transformation efforts are moving ahead nicely. We were able to drive operational margin expansion despite lower revenues and we generated strong cash flow.

Heading into the second quarter we knew our top line would be challenged as we signaled during the April call. Organic sales in EMEA were down due to a top macro environment especially in some of our larger countries such as France and Germany. In the past quarter, however, we did see the overall EMEA sales decrease moderate from Q1 as we expected. America's organic sales were affected by the product rationalization effort and to a lesser extent rainy weather in the south central US. Overall, America's core product line sales were flat with last year if you exclude the effect of the rationalization. Asia-Pacific performed very well during the second quarter with solid double-digit growth.

AERCO had another strong quarter. Year-to-date AERCO sales growth is over 10% compared to the prior year as we continue to perform very well in the commercial high condensing boiler marketplace. Also in the second quarter, the movements from the strength of the US dollar primarily against the Euro and Canadian dollar negatively impacted our top line. However, despite the revenue head-winds, we were able to expand our adjusted operating profit and margin percentage and maintain a constant adjusted EPS quarter over quarter.

We also delivered strong cash flow in the quarter driven mainly by better working capital management. Todd will provide more details in a few moments. In Q2 we continue to execute on our various restructuring and transformation initiatives in EMEA and in the Americas. A key milestone is our announcement last evening that we have reached an agreement to sell certain non-core product lines in the US to Sushi, a strategic buyer.

I'll provide more information on the transaction in just a few minutes. We're still working through the details of Phase 2 of the US transformation program as we execute on Phase 1 and expect to provide more details for you during our third quarter call. Finally, the EMEA actions are progressing as planned with savings initiatives on track for 2015 and beyond.

Two other points of note. First, from a shareholder perspective, the board has approved a new $100 million share repurchase program.

This program is in line with our balanced capital allocation strategy. Second, in early June we received of a favorable determination letter from the IRS concerning our proposed pension plan settlement. We expect to formally settle all obligations related to the pension plan during the third quarter. Costs both cash and non-cash are still in line with the estimates we provided during our Q1 call. Moving to the markets, let's turn to slide 4. Let's begin with the Americas.

In general, the US economy continues to grow but at a slower rate than was forecasted when we entered went to 2015. Certainly the harsh winter and rainy spring affected many businesses tied to construction. Key residential indicators we watched such as the Wells Fargo data on housing starts and builder sentiment and the (inaudible) remodeling index continue to look encouraging and suggest steady growth. On the commercial side the dodge momentum index in the ABI index have been trending positive.

Overall we expect to see continued macro growth in the US although at a more moderate pace. Now let's review the EMEA markets. Overall the EURO area appears to be stabilizing as GDP expectations are holding firm. Quantitative easy may help stimulate incremental activity however it's difficult to correlate to the our orders but certainly lower rates should trigger a more active construction market. Geographically our markets are mixed. Construction data from France suggests both residential and commercial markets are down in the 8% to 12% range.

The boiler marketplace in Germany where a majority of our OEM customer reside is down mid-single digits this year. Eastern Europe remains fragile with geopolitical issues and sanctions affecting the Russia economy and the uncertainty in Greece is also driving tension in the region. I think the mood in EMEA is getting better but the region has a long way to go before we see sustainable growth. Finally, let's discuss Asia-Pacific. Economic growth in Asia-Pacific is moderate particularly in China where we see continued head-winds in the housing market.

We think that the recent stock market volatility in China may be impacting customer or consumer sentiment. The Chinese government is taking steps to avert a market crash but I think people still feel somewhat uneasy about their personal finances and wealth. GDP expectations in other parts of the region are holding firm.

So overall, our markets are a mixed bag with pockets of growth being offset by lagging economies and slow end markets. Now I want to update you on the Americas Phase 1 transformation exercise so please turn to slide 5. You may recall as part of Phase 1 that we commenced a portfolio rationalization effort focused on removing products that are non-core. We identified four sizable product lines, in particular fittings, tubing, brass and tubular and water connector products. And we also identified other smaller product lines that will be discontinued.

I'm happy to report that yesterday we have entered into a definitive agreement to sell the first three product lines I mentioned to Sushi. The sales price is $35.5 million. This is an asset deal and includes two US manufacturing locations. Total product line sales for these four products were $105 million in 2014, mostly sold in the DIY market. We expect to close the transaction by the end of the Q3.

We are winding down other product lines, the most significant being water connectors which are manufactured at a dedicated facility in China. Manufacturing at this facility will be discontinued in the fourth quarter and we are currently pursuing a sale of these assets. Water connectors represented approximately $75 million in sales in 2014. And there are a few miscellaneous product lines that totalled approximately $10 million of sales in 2014 which will be discontinued by year end.

From a financial perspective, we anticipate that our second half 2015 sales reduction related to all product lines will be in the $65 million to $75 million dollar range with a loss in sales weighted a little more towards Q4. Given we have lost approximately $15 million in year-to-date sales, we expect total loss sales for 2015 will be between $80 million and $90 million. And in 2016, the total lost sales will approximate $190 million.

Costs related to Phase 1 are trending to the mid point of the range we previously provided. We'll provide a full accounting of all the costs once the product line sales are completed.

Finally, the global sourcing program as part of Phase 1 is on track providing savings at the $4 million annual run rate we discussed previously.

Now I'll turn this over to Todd to talk about our second quarter operating results in more detail and update you on our revenue outlook for the remainder of 2015. Todd?

Thanks, bob and good morning, everyone. Let's turn to slide 6 and let me walk you through the financial results. In the second quarter, we reported sales of $387 million, down 2.3% on a reported basis and down 3.4% on an organic basis. During the April call, we signaled that the second quarter's top line would be challenged due to the foreign exchange head-winds, a continued softness in Europe, the effects of the Americas product line rationalization and overall tougher comps in both Americas and EMEA. Foreign exchange mainly related to the weaker EURO negatively impacted sales quarter over quarter by 7.1% or roughly $28 million.

This substantially offset the upside from the AERCO acquisition which contributed approximately 8% growth. In the Americas, we also experienced some top line head wind from the flooding that occurred in the south central US region. As I mentioned, the product line rationalization also had an impact on our top line and if you adjusted this initiative, our consolidated organic sales would have been down roughly 1%. Regionally, organic sales were down 3.8% in the Americas and down 4.1% this EMEA which more than offset a 14.6% increase in APAC.

Adjusting for the product line rationalization, Americas would have reported flat growth in the quarter. I'll provide more color on the regional performance in a few minutes. Adjusting operating profit increased 2.9% to $42 million. Which translated into an adjusted operating margin of 10.9%. Up 60 basis points on a year-over-year basis. Favorable product mix including AERCO, strong productivity and other cost savings initiatives more than offset the impact from the lower volume absorption in the higher anticipated SG&A spent.

As we communicated back in February and again in April, our SG&A costs are higher due to the addition of AERCO and an increase in stock compensation, pension, compliance and other costs. Further, we are making investments in sales and marketing and product lines with strong margin profiles like our global drains business. Adjusted net income of $24.3 million and adjusted EPS of $0.69 were both flat with Q2 of last year. Adjusted EPS included a negative impact of $0.07 in the quarter for foreign exchange and a $0.03 head wind associated with the product line rationalization.

AERCO contributed $0.09 in EPS in the quarter. The effective tax rate was 33.8% which is 100 basis points higher than in Q2 of last year primarily due to the mix of earnings in the quarter being more heavily weighted to the US. Free cash flow in the second quarter improved by almost 9% year-over-year driven by working capital primarily inventory. Our inventory is significantly lower on a year-over-year basis due to the efforts to right-size safety stock levels in our distribution centers and by improving prophesies between sales, planning, operations and logistics.

So now let's turn to slide 7 and let's review the America results for the second quarter. Sales were $263 million, a reported increase of 8.7% but down 3.8% on our organic basis. Again, adjusting for the product line rationalization, Americas would have reported flat growth. There were several discreet items that impacted organic growth in the Americas during the quarter.

First, the timing of price increases from both last year and this year affected Q2 comparability. As you may recall, we introduced a price increase in June of last year which accelerated approximately $3 million of sales into Q2 of 2014. Similarly, in 2015, we announced a price increase effective April 1 which accelerated approximately $4 million of sales out of Q2 and into Q1 of 2015. Second, as mentioned earlier in the call, we were also impacted by the flooding in the south central US region which saw sales declines in the 9% range for the quarter.

Adjusting for both the price and weather head winds, core organic growth would have been approximately 4% in the Americas during the second quarter. AERCO continues to perform very well led by strong boiler and after market sales. As Bob mentioned, year-to-date growth exceeded 10%. In line with our full year growth expectations. Also it is worth noting that the integration savings are on track to what we communicated back in February. From a channel perspective, wholesale organic sales were down 1.9%. Our retail sales were down 15.2%, partially offset by a 7% growth in the OEM channel.

As a reminder, the retail channel is it where most of the rationalized products are sold. Adjusted operating profit for the quarter was $38.6 million, a 31% increase. This translated into operating margin expansion of 250 basis points to 14.7% despite the volume reduction. The margin expansion was due to favorable product mix including AERCO, pricing and strong productivity which included improved performance out of Franklin New Hampshire site where more than offset lower absorption.

Overall, we were pleased with the Americas ability to deliver operating margin expansion despite lower revenue during the quarter. And as I will discuss momentarily, we believe we should see improved top line growth in the second half of this year. Turning to slide 8, let's review EMEA's quarterly results. Sales of $112 million were down $31.7 million on a reported basis or approximately 22%, and down 4% organically. Foreign exchange driven by the EURO's decline against the US dollar accounted for $25.8 million or 18% of that sales decline.

The organic decrease was concentrated in our larger countries mainly France and Germany. As Bob mentioned earlier in the call, the markets we serve in France are down in the high mid-single digits, and in Germany the major OEM boiler manufacturers also continued to experience year over years sales declines. We are also seeing declines in eastern Europe primarily driven by the continued weakness in the Russian market which is down double digits in the quarter.

With that said, we did see some pockets of growth within EMEA during the quarter. Middle East sales were especially strong, up 51%, given the timing of drains projects shipped during the quarter. Overall, our European drains platform was up 5%. We also saw continued good performance in the UK as our sales were up 15% compared with last year. So we're seeing some growth in some of the other regions but unfortunately not enough to offset the difficult conditions in France, Germany and Russia. Regarding channel sales, wholesales was down 1.5% driven by lower plumbing sales primarily in France. And in OEM sales, decreased 5.7%, mostly related to HVAC products sold into Germany.

Adjusted operating profit for the quarter was $10.7 million, a decrease of $6.2 million, or 37%, which translated into an adjusted operating margin rate of 9.5%. Approximately $2.3 million, or 37% of the operating profit decrease, was due to foreign exchange. Lower volume and absorption and stainless steel cost increases more than offset the benefit from our transformation and restructuring efforts.

As Bob mentioned, we're executing on a restructuring plan in Europe and are seeing the expected benefits. So as forecasted in the first half, EMEA was a challenge. We started to see some improvement in order rates as we exited June and expect to see sequential improvement in the second half as we lapse on easy comps. Now on slide 9, let me provide a summary of APAC results in the second quarter.

APAC sales were approximately $12 million, a 14.6% organic increase over the prior year driven by higher valves and under floor heating volume. Sales have remained strong despite indications of slowing construction in China.

We have expanded our distribution presence into tier 2 and tier 3 cities and have increase our focus on some key verticals such as hospitals, data centers, and urban complexes which are resulting in some incremental growth opportunities. Adjusted operating profit decreased 24% to $1.6 million in the quarter and APACs adjusted operating margin decreased 700 basis points to 13.4%.

The key driver of the decline was lower absorption due to a 20% reduction in inter-company sales in the quarter. This reduction was triggered by lower demand due to the exit of non-core products. So in summary, another strong quarter for the APAC team. Margins were and will continue to be affected by the inter-company volume drop related to the exit of non-core products. So on slide 10, let me highlight a couple items related to year-to-date free cash flow. Year-to-date free cash was $29.5 million, up over 250 basis points as compared to the first half of last year. Compared to June of 2014, we improved inventory turns in all regions and DSO improved in both EMEA and Asia-Pacific.

So we are making strides on working capital management and we see further opportunities ahead. Also year-to-date are capital assessment increased 18% mostly related to the addition of AERCO. In addition, our existing stock buy-back program is on track as we've purchased approximately 350,000 shares of our class A common stock in the first half at a cost of the roughly $20 million.

So a strong cash performance in the first half for Watts.

Finally, turning to slide 11, I'll provide a brief update on our revenue outlook for the second half of the year. Please note the growth rates on slide 11 equate to core organic sales which excludes the impact of AERCO and non-core products. In the Americas, we reported 1% core organic growth during the first half of this year. But as I mentioned, there were some discreet items such as weather, in a timing of pricing actions which affected core growth.

Excluding these discreet items, we believe our core organic sales growth grew in the 3% range in the first half. So as we look at the second half, we think our top line will grow in the 3% to 5% core organic range. We believe the economic outlook in the US remains positive. We will continue to realize some incremental pricing benefits and we do have some easy comparisons which all equate to a second half improvement. In EMEA, organic sales declined approximately 5% in the first half of the year.

We had some tougher comparisons, especially in the second quarter. However, the sales decline did decrease from Q1 to Q2 as we had forecasted. The economy is stabilizing and the overall sentiment appears to be improving slightly. With how we exited June, and what we're seeing so far in July, we think EMEA sales will be flat to down 2% during the second half of this year. Which is an improvement over the first half. In APAC, we had an exceptional first half, mainly due to the ramp-up of our valve and heating businesses.

That ramp-up began in the second half of 2014 so comparisons will be a little more challenging in the second half. We are estimated sales growth between 10% and 15% in the second half for APAC. Again, very strong performance, especially when compared to the current challenges in China. So lots a puts and takes but in summary versus our last update we are seeing stronger performance in APAC and AERCO, EMEA basically in line and slightly lower growth projections in the Americas.

Now let me turn the call over to Bob for a wrap-up before moving to Q and A. Bob?

Thanks, Todd. If you would, please turn to slide 12 and let me give you an update on our top strategic priorities. I would like to review with you our progress over the last 14 months since I came to Watts Water. There are certain priorities I felt were key to transforming the Company. First, I evaluated my management team to ensure we possessed the skill sets needed to grow this business profitably.

I have filled some key positions on my leadership team including President of the Americas, CFO and VP of Continuous Improvement. And we continue to look for opportunities to accelerate management and employee development and add key skill sets at all levels of the organization.

The EMEA transformation and restructuring initiatives are on track and the team is executing commendably against those plans. They have made steady progress in driving savings throughout Europe but their efforts have been more than offset by the overall market downturns in EMEA. We'll continue to assess our cost positions in this region given the overall market environment.

We also made some hard decisions as part of the America one transformation effort regarding people and product lines. But the end result is we'll focus our key resources on more profitable customer and product portfolios that drives innovation and is more solution oriented.

We are also delivering on our global sourcing saving commitment. Phase 1 transformation should deliver sustainable marked expansion in 2016 and beyond. At this point we've also moved to settle some long-term obligations for the Company with the expected US pension settlement being the largest to date. And we'll continue to look at other opportunities to settle other long-term obligations.

The Americas phase 2 transformation continues to be refined as this process was impacted by the Phase 1 sale.

As previously discussed, the focus will be on consolidating and optimizing our manufacturing and distribution footprint to better support the needs of our customers and improve our cost structure. Again I'll provide more details in our Q3 call. I do expect to invest a portion of our future savings into re-invigorating customer training, R&D, and our new product development pipeline. I noted this during our first quarter call, the commercial excellence, our ability to delight our customers were new and innovative products is a key for us to continue to be able to differentiate ourselves in the marketplace.

Finally we will continue to looking for every opportunity to continuously improve performance in our Company. We are increasingly working together as one organization between businesses, countries and regions to provide our customers with value-added products and solutions. We have our strategic priorities as an organization and we are on track to complete what we said we would do. So with that, Andrew, please open the lines for questions.

(Operator Instructions). And I'm showing our first question or comment comes from the line of Jeff Hammond from KeyBanc. Your line is now open.

On the Americas kind of the more moderate growth, I mean if you talk about the indicators, they all seem pretty positive so I'm just trying to understand what do you think is driving the lower growth rate thus far this year and into the second half?And, you know, if you could just talk about also the sustainability of the margin performance you had in the Americas in Q2?

Okay, Jeff, this is Bob. First of all, you know, the growth certainly was disappointing from our perspective. You know, as Todd said earlier, we had some tough compares with timing of our price increases that we had signaled but certainly the south central really was a disappointment in that, you know, we saw, you know, the timing, the rainy weather, and just the commercial impacts of construction related to the oil and gas business just in that area. So anyways, so that, you know, was moderated. I think we all saw GDP this morning come out and it was lower than expectations.

So I think just in general, it was softer than we have seen. In addition, you know, we're focusing not only on rationalizing our product portfolio in our let's call it the undifferentiated products, we're also looking at our differentiated products to make sure, you know, we are a capitalizing on the lower tail of that. So we're doing market and channel rationalization as well as product rationalization especially before we move the products in Phase 2.

So there's probably a little growth in there. It's difficult to watch it in all aspects but, you know, we're feeling better about the second half because the second half doesn't have all the noise of the price increases and hopefully this weather will subside so we thought that in the first quarter with the harsh winter but now moving on, you know, hopefully in the third and fourth quarter we'll have better weather. So, you know, I think it's just more, you know, tepid growth and I think we're not the only ones seeing that.

And related to the second part of your question.

Jeff, I'll jump in on the second question in terms of the sustainability of the Americas margins. I would say that, you know, in Q2 we saw, you know, 14.7% margins and from my perspective, you know, a lot of that's being driven by lower (inaudible) from a productivity standpoint. Material savings and commodities and planned productivity and from my perspective I see that continuing in the second half of the year. So I would say the margin rates that we saw in Q2 for the Americas, you know, we should be somewhere in that range as we headed into the second half of the year.

Okay. And then just quickly on the sale. You know, and maybe just talk to us about how you're thinking about dilution overall from this rationalization, you know, kind of given that you've now sold a piece. And then, you know, as we look out and we get the cost out, how do you kind of make up, you know, for those lost sales and lost EBITDA and make this an accretive shift?

Yes, so I'll take that. What you saw with this rationalization, I'll go back to the original concept. You know, in the long run we knew that product for us with a decreased focus and it was decreasing both from a sales and margin point-of-view over the long run so we knew it was dilutive to our overall margins. So in a perfect world without the EURO, you know, AERCO acquisition would have been more from a bottom line point-of-view would have offset the dilution that would cause in 2016 or not.

So we'll continue to look for both organic growth as well as a acquisitive higher EBITDA growth with our acquisitions as we go forward. In addition when you look at the second part of this year, you know, as I said before, the absorption impact is going to be heavier as we exit the year and wind down some of the operations. So I think you'll see more of that in China.

Will be tougher margins in the second half even from the second quarter in China because they're bearing the largest impact of the negative absorption in the China results because they produced, you know, the products that were shipped to North America. So overall, though, I think selling this, it was faster than we expected. It allows my team to be more focused on our differentiated products and grow from that point-of-view. So we are excited about this, you know, transition and, you know, we're looking to moving forward and allocating our resources on our more profitable products.

Okay. Thanks a lot.

Thanks.

And our next question or comment comes from the line of Jim Giannakouros from Oppenheimer. Your line is now open.

Just to clarify as far as your absorption issues that you're citing in North America, is that isolated to the retail wind-down or there some still that you're experiencing in the foundry?And if it is in the foundry, how long before that's no longer the case?

I was hoping we would not talk about the foundry. Anyways, no, the foundry's doing really well. It's really related to the retail reduction as well as we've been reducing inventory, there's been some absorption impacts with that. So really it's the wind-down of the product as we said before. As we wind this down, we have stranded fixed costs that we won't be able to completely exit until the end of this year. So that's really driving it.

Got it. Okay. And then moving to Europe, I fully understand that, you know, you have, you know, lower volumes that are depressing margins but when I look at a time like 2010 where you were at similar revenues but at a much higher profitability, I'm just trying to, I can't get from your margin experience then, fast forward four to five years where you've done a serious amount of restructuring in the region and now you're at a similar revenue level but at lower margins. Are there mixed head of winds at play? Any color there would be helpful.

Well, it's primarily volume driven and I guess there's some mix in it. But also realize we've added some costs toward the end of last year and fully this year for our overall new organization which is really a pan European organization. However, the benefit of that is really in our tax line. So you're not actually seeing it in the margins but our effective tax rate in Europe has gone down, you know, quite a bit. So you've got to put both of those in perspective.

But really it's volume and absorption driven. We have a heavy fixed costs with our footprint in Europe and as you know, that footprint is very difficult and costly to get out of but we'll continue to look at that and monitor that and make sure, you know, we're optimizing that footprint for the future.

Okay. Thanks. And one more if I may, quick one. On just your priority list as far as uses of cash, you announced another $100 million in share repurchases. I see that you do have 6% or so debt coming due early next year. How should we be thinking about your priority list because I know that you probably have some M&A pipeline that's building as well so if you could kind of just categorize your priority list as far as uses of cash, that would be great.

Yes. So, Jim, the other thing too just to mention is we do have a pension settlement that's going to occur in Q3 which is going to use some of our cash. But, you know, in terms of our track record of returning capital to shareholders in the foreign dividends and share repurchases and I think we have a good track record there and we're going to continue to do so in the future. And so as it relates to the share repurchase, we typically don't talk about the timing of it but I can tell you that we're going to be absolutely offsetting dilution from a share issuance associated with our employee plans at a minimum and the share repurchase will continue to be an important part of our play book going forward.

Great. Thank you.

And our next question, or comment comes from the line of Kevin Maczka with BB&T Capital Market. Your line is now open.

Question on AERCO. I'm just wondering if that's exceeding your internal plans? They did $0.09 this quarter. I know it's seasonably heavy in Q2 and Q3. That's almost half the accretion you were expecting for the full year.

Yes, we're real pleased, Kevin with, you know, AERCO's performance. They had a real solid Q2 and solid first half and we're excited where they're going. We want the team to keep it up and a little tougher comparison in the second half of the year for them but we're excited about AERCO and the prospects with the Company.

Okay. Shifting over to the (inaudible) you're very clear on the second half and full year top line impact of the sales that are coming out. But to bring that down to the bottom line when you say the costs are trending to the mid point, I think before you were talking about decremental margins this year on that in the 15% to 20% range. Is that what you mean by trending towards the mid point?

Well, we actually meant in the overall cost to implement the restructure. But, you know, going back to your really the 15% to 20% is what we talked about before, we think that's still valid in the second half of the year as we start dropping those veils really at the gross profit level versus what I call the operating income level which you'll really see the benefit once we get rid of all of these fixed costs in the second half of the year, you'll see the benefit fit coming into 2016.

So still looks like 15% to 20% decrementals on that $80 million to $90 million reduction this year is good and that will be much less than that because of the fixed costs take-out on the additional $100 million next year?

Correct.

Okay. And then just to be clear, all of this is coming out of the Americas, correct, even though we're manufacturing water connectors in China, that's not coming off the Asia PAC line?

Yes, there's a piece of the Asia-Pacific sales because they also sold the products so we'll see a reduction in the Asia-Pacific sales. Certainly much less than the North America sales. But there's an absorption impact and a margin hit in their margins we expect to be south of what we reported in the second quarter and the second half of the year because of that significant, I mean it was a large facility and we're still in the wind-down of that.

So of the $75 million that's winding down, that's manufactured in China, just curious how much of that is, would have been reported on that Asia PAC line versus the Americas?

About $15 million in the second half.

$15 million, okay. Okay. Thank you.

thank you.

And our next question or comment comes from the line of Ryan Castle with Global Hunter. Your line is now open.

All right, thanks, guys. I wanted to ask about the transformation to phase 2. I know there will be more details coming out but what hasn't been done? You know, what could be the target and focus without getting into the quantitative numbers?

Well, I think our team continues to work on Phase 2. You know, a lot of analysis is going on as well as a lot of what I call preparation for Phase 2 is going on. So, you know, we're still making progress behind the scenes. What we're very careful of is the timing of the announcements because it impacts our employees and we want to make sure given the scope of Phase 1 what we sold and what we're driving inside of Phase 1 was a lot of resources.

Phase 1, you know, with the sales we're also providing transitional services. So that's taking some of our resources that's slightly delaying phase 2 but in the long run we're real pleased with the out come and what we think is the incremental cash flow associated with the sale as well as it was a great thing for our existing employees versus winding down the businesses, they'll have opportunities at Sushi to continue with their careers.

Okay. Fair enough. Good luck with the transformation.

Thank you.

Our next question or comment comes from the line of Joe Giordano with Cowen. Your line is open.

Thanks for taking our questions here. I just wanted to clarify in slide 5 the financial impact on 2016 from the Americas transformation, it's an incremental 100 off of 2015, right? It says 190. That's off 2014, right?

Yes, that's correct.

Okay. And then just looking at AERCO, so it looks like 2Q margins were 19% versus 9% in 1Q. I know you can see the revenue how it falls out that it's second quarter, third quarter weighted. Is that a pretty normal margin kind of shift that you would expect and would you think, like, 3Q is similar to 2Q and 4Q is similar to 1Q is roughly how we should look at that?

I think, Joe, your you're spot on. The big driver of the performance from Q1 to Q2 is driven by volume and favorable mix. We saw some nice performance out of their after market business but I would think that Q3 margin profile would be somewhat consistent and then Q4 would be closer to Q1.

Okay, fair enough. And on EMEA, I guess margins there may be a little bit below what we're looking for and I was wondering if you could quantify what you've seen so far in the first half cost savings from the efforts that you've put in last year, like, what have you realized to date there and what are you kind of building into the second half and where do you kind of see margins shaking throughout?

In the first half we saw about $4 million of cost savings associated with the restructuring and transformation efforts in EMEA and we assume that similar time of performance in the second half of the year. So again, the big driver is really just a volume and the absorption associated with that. And so if you look at their margin profile in EMEA, they were 7.5% in Q1. We said it was going to get a little bit better in Q2 and it did at 9.5 and we think it's going to continue to get better and during the second half of the year as that some of that volume stabilizes.

Okay, fair enough. And then lastly for me, the impact of the lost sales from the transformation in 2015, it seems to be a bit more back weighted than probably a lot of people had modeled, certainly more towards 4Q. So is there any sort of margin implications that you would kind of guide us to in the second half related to that? Like, the weighting of those sales and when that decline is going to hit?

I still think it's in the 15% to 20% range. It's difficult on the timing of Q3 and Q4. Certainly Q4 given that we're selling the Americas piece, that will be done by Q3 so we'll so a large impact out of the Americas in Q4. So as I said earlier in my comments, I think it's going to be a heavily weighted more towards Q4 as we wrap up and that business both in the Americas and in Asia.

I would add one comment is that in Q3 we think it's somewhere between $25 million and $35 million decline from a year-over-year perspective as it relates to the sale of the undifferentiated products.

Good. Thanks, guys

Thank you.

And our next question or comment comes from the line of Kevin Bennett with Sterne Agee Capital. Your line is now open.

Bob, if I go back to Asia-Pac real quick, I know you've talked about margins are going to get worse in the third quarter than they were in the second quarter. If I look out once all this is done, I mean where do you think those set allow? Are we looking an at new run rate in the low teens or can we get back up to the high teens?

I think it's going to be, you know, more on that lower end because there was a lot of volume and absorption that they had as they transferred a lot of business to the U.S. So a lot of their company margin. So the team there is focused on really developing and growing. You saw the large growth in the first quarter and second quarter and that's really most of that growth is focused on what we call differentiated products. So, you know, you're going to see a shift and it could be more in the high single digits as we start off. So as we're reallocating resources, adjusting our fixed costs, etc, it's going to get substantially reduced from where it's been running without that inter-company volume.

Got it. Okay. That's helpful. And then if I think about price costs, I know of you guys raised prices but given what we've seen in just the commodity complex, can you talk about the benefit you may be seeing from lower material costs and how you view that going forward?

Yes. So certainly we're seeing benefits in the material costs side. Certainly our customers are pushing for portions of that back. Pricing, you know, we're seeing the 1-ish range in the Americas but we're really seeing difficult price pressure inside of the EMEA. You know, with the volume decreases, a lot of our customers are pushing real hard for price decreases.

So we're actually seeing negative pricing inside of EMEA. So, you know, we're trying to hold our own on that but certainly we're seeing the benefit of commodities. Europe isn't seeing the benefit of commodities because most of the commodities are bought in US dollars so with the depreciation of the EURO they're not seeing that benefit of commodities. So overall, though, both of those I believe are positive for the whole Company and we believe we will continue to see that in is second half the year.\

Got it. So net-net we're looking at a positive impact?

Absolutely.

And then last question for me, I was wondering if you could talk about your order rates and maybe as the quarter progressed and then what you're seeing into July?

Yes. So let's start with Americas. I think as we looked in Q2, we got off to a pretty slow start in the month of April and we saw orders progress I would say nicely in May and June. And what we're seeing so far in July is probably a little bit softer than we expected but still there are on forecast and again feeling pretty good about what we have in there for Q3. As it relates to Europe, we actually saw some really nice progression as we went through Q2 and early polling in July is that the order rates are actually stabilizing which for from an Europe perspective is pretty positive. So I would say Americas slightly lower than expectations in July and EMEA is probably in line with what we expected.

Got it. Thanks for that, Todd. Thank you, guys

Thank you.

And I'm showing no further questions at this time so with that I would like to turn the conference back over to President and CEO, Mr. Bob Pagano.

Thanks, Andrew. In closing I would like to thank you for taking the time to join us today for our Q2 earnings call and we appreciate your continued interest in Watts Water. We look forward to speaking with you again during our Q3 earnings call in late October. Thank you.

Ladies and gentlemen, thank you for participating in today's conference. This concludes the program. You may now disconnect.