Watts Water Technologies Inc (WTS) 2016 Q2 法說會逐字稿

Good morning. My name is Chris and I'll be your conference operator today. At this time, I would like to welcome everyone to the Watts Water Technologies Inc. second quarter 2016 earnings conference call. (Operator Instructions) Tim MacPhee, Treasurer, Vice President Investor Relations, you may begin your conference.

Thank you and good morning everyone and welcome to our second quarter 2016 earnings conference call. Joining me today are Bob Pagano, President and CEO, and Todd Trapp, our CFO. Bob and Todd will provide their perspective and analysis on our second quarter results, provide key initiatives update and discuss our latest outlook for the second half of this year. Following our prepared remarks, we will address questions related to the information covered during the call.

Today's webcast is accompanied but a presentation which can be found in the Investor Relations section of our website. We will reference these slides throughout our prepared remarks. Any reference to non-GAAP financial information is reconciled in the appendix of the presentation.

Before we begin, I'd 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 risks and uncertainties see Watts Water's publicly available filings with the SEC.

The company disclaims any intentions or obligations to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. I will now turn the call over to Bob Pagano.

Thanks, Tim. And good morning, everyone. I'm on slide three in the presentation, where I'll provide some commentary on the second quarter. Overall, I'm very pleased that in the second quarter we continue the momentum in operating performance that we delivered in the first quarter. Organically we grew revenue in all regions and the pace of growth improved sequentially from the first quarter.

We delivered a record quarter for operating margin and EPS as a result of the transformative actions we've taken as an organization. From a first half perspective, our results were generally in line with our full-year outlook for the company. Todd will review the quarter's results and our outlook for the second half in more detail.

From a worldwide market perspective we continue to see a mixed performance. In the Americas, much of the construction data remains lumpy but overall we expect both the non-resi and resi markets to grow in the low to mid-single digits this year. EMEA continued to stabilize through the quarter.

In terms of the potential Brexit impact, the UK represents only a very small portion of our business, approximately 2% of worldwide revenues. And the recent terror attacks and failed coup in Turkey have become the latest issues from Europe. The impact from all of these events is something we are watching closely but it is still too early to make a call at this time.

Finally, we are seeing growth in markets outside of China that is countering some softness in the domestic China commercial marketplace which is consistent with what we saw in the first quarter. Now, if you recall back in February, I spoke about building on the foundation of our previously announced transformation efforts. We identified four areas of focus in 2016, including, one, executing on announced operational programs, two, realigning our regional organizations and building out the team, three, reinvesting in growth, and, four, dragging top line growth and operating the margin expansion. I'd like to provide an update on our progress so please turn to slide four.

Our transformation initiatives are on plan and continue to drive results. As a reminder, phase one focused on establishing a global sourcing initiative and enhancing our product portfolio. To date, we have recognized the expected global sourcing benefit and the positive margin impact from eliminating lower margin product sales.

In the second quarter, we finalized the sale of China's subsidiary involved in the production of undifferentiated products. Most of the cash proceeds will be received in the third quarter, but this effectively completes phase one of the Americas Asia-Pacific transformation. Phase two of the transformation is well underway. We have mostly completed the rationalization of North America's distribution facilities and the manufacturing and right sizing is on target to be completed by mid-2017. Effective savings for 2016 are being realized with incremental savings in 2017 and beyond. Finally, the EMEA restructuring announced in February is moving ahead and we expect to begin implementing the plan in the fourth quarter.

Next are the organizational realignment and team development activities which are moving along well. Within Europe, we recently announced the combination of two platforms into one, now called European Fluid Solutions. And we announced the new sales organization resulting from European platform consolidation. The focus of this realignment is to become more customer centric in Europe.

By realigning our sales team to regional leaders selling a full complement of product, we believe that we can drive improved customer focus, organizational accountable and better leverage our wide product portfolio. Internally we have also promoted global leaders for our drains, water quality and electronics platforms to help drive those businesses on a worldwide basis.

We continue to build out our leadership team. My immediate team has been established as has the tier of leaders below my direct reports. We have identified qualified internal candidates for key roles. And where we didn't have the internal candidate, we've hired people, mostly from larger more mature organizations, that bring with them the skill sets we need to help us accelerate growth and become a leaner, more efficient company.

I've spoken many times about reinvesting for growth and our goal to reinvigorate the front end of our business. One example that we've mentioned previously is our new training center. We expect to train almost 3,000 people, either on-site or online in 2016. The on-site training typically occurs over a two to four-day period which we have found invaluable in providing critical face time with and feedback on our products. So this key initiative is moving ahead as planned and we continue to focus on enhancing the customer's experience with Watts.

Also in July, we completed our second innovation summit. Consistent with last year's meetings, the summit brought Watts' sales and engineering teams from around the world together to understand our broad capability, share ideas and help drive customer-focused solutions into product development and into our processes.

Lastly, our final 2016 focus area involves driving top-line growth and margin expansion for the year. Year-to-date, we have grown organically by approximately 3%, excluding the extra shipping days in the first quarter. And year-to-date, operating margins of 11.1%, again, excluding extra shipping days, are 150 basis points higher than the same period last year.

In the second half, we expect to accelerate some of the investment spending. And as a reminder, we will feel the effects of fewer shipping days in the fourth quarter. So we expect the magnitude of margin expansion will moderate from the first half levels but still expect a strong year for the company.

Now, I'll turn the call over to Todd to talk about our second quarter operating performance and latest outlook in more detail. Todd?

Thanks, Bob. And good morning, everyone. I'm on slide five which shows the second quarter results. We reported sales $371 million, we're down about 4% quarter over quarter. This decline was driven by the exit of undifferentiated products in 2015, which impacted sales by $34 million or 9%. On our organic basis we grew 4% driven by strength in Americas, EMEA and Asia-Pacific. And I will talk more about the regional performance in a few minutes.

Adjusted operating profit of $44 million increased $2 million or 5%. This translated into adjusted operating margins of 11.9%, up 100 basis points versus last year and a record second quarter for the quarter. We attained this margin while continuing to invest in our growth initiatives as previously communicated. Higher volume, favorable sales mix, including the exit of undifferentiated products, and productivity were the main drivers of this Q2 strong margin performance.

Adjusted EPS of $0.75 was approximately 9% better than last year. The $0.75 also represented a new record quarter for the company. The growth in EPS was driven primarily by strong operational performance, which more than offset a $0.06 headwind associated with the exit of undifferentiated products.

For the quarter, the effective tax rate was 34.6%, about 80 basis points higher than prior year, some of which was driven by the mix of worldwide earnings. So overall we are very pleased with our performance as we set new highs in adjusted operating margin and EPS in the second quarter.

Now, turning to the regions on slide six, let's review America's results for the quarter. Sales were $239 million, down 9% on a reported basis, all driven by the exit of undifferentiated products in 2015, which was a $32 million headwind for the region in the quarter. More importantly, organic sales were up 4% versus Q2 of 2015. We have strong performance out of AERCO, which was up double digits in the quarter. We also saw a higher volume in our [core] backflow regulator and mixing valve product lines which more than offset continued softness in our products that serve the industrial end markets.

Adjusted operating profit was $39.5 million, a 2% increase year over year. Operating margin expanded 180 basis points to 16.5%, a new high for the Americas region. The margin improvement was driven by higher volume, favorable sales mix, including the positive impact in the exit of undifferentiated products, and productivity, which includes the benefit from the lower raw material costs. So, again, another strong quarter for Americas and a continuation from what we saw in the first quarter.

Let's turn to EMEA's results on slide seven. Sales of $117 million were up 5% on a reported basis and up 3% organically. Foreign change was positive during the quarter by about 2%. All of our European businesses grew organically in the quarter. HVAC led the way primarily due to our electronics business which benefited from new product introductions into the OEM channel. And we also saw a modest growth in water and plumbing and drainage business during the second quarter as well.

Providing some additional color by region, we saw a solid double digit growth in Italy, Scandinavia and the Middle East and minimal growth in France, basically in line with the French construction markets. In Germany, we continue to experience pressures in the OEM channel, although the rate of decline subsided from Q1. And in Eastern Europe was flat for the quarter with growth in Czech Republic being offset by continued headwinds in Russia.

Adjusted operating profits for EMEA for the quarter was $13 million, up 23%, which translated into operating margins of 11.1%. An increase of 160 basis points as compared to Q2 last year. The strong margin expansion was driven by volume and productivity, including lower material costs and benefits from ongoing restructuring initiatives. For Europe, this is the third consecutive quarter where we've seen some stabilization. But as Bob mentioned, we will be keeping a close eye on any potential impact of Brexit and other geopolitical issues affecting this region.

Moving to slide eight, let's review Asia-Pacific's results. In the quarter, sales were approximately $14 million, up 19% on a reported basis and up 5% organically over the same period last year. It's a similar story to what we've encountered in the first quarter. We continue to see softness in our traditional China-based valve business due to slower than expected commercial markets, which is partially offset by strong demand for our underscore heating product used in residential applications.

Our valve business outside of China continues to grow strongly through expanded distribution with incremental growth in Australia, Indonesia and Singapore. And the Apex acquisition performed well and contributed about $3 million in sales during the quarter. Sales outside of China now represent about 50% of total Asia-Pacific sales versus 15% last year, driven by the addition of Apex and the growth in other countries I just mentioned.

Adjusted operating profit for Asia-Pacific decreased 19% to $1.3 million in the quarter, which translated into adjusted operating margins of 9.2%. The key driver of the decline was a 50% reduction in affiliate sales due to the exit of undifferentiated products. As Bob mentioned earlier, we finalized the sale of our China subsidiary that was involved in supplying undifferentiated products to the Americas.

In the second quarter, for GAAP reporting, we booked an after tax gain of about $8 million related to the sale which we treated as a special item so the gain is not included in our adjusted results. Most of the gain is related to accumulative currency translation adjustment as part of the disposition. Cash proceeds will be about $8 million, which we expect to receive by the end of the third quarter. Once this happens, phase one of the Americas Asia-Pacific transformation initiative will be successfully completed. So in summary, Asia-Pacific performed as expected during the second quarter with increased organic growth driven by sales outside of China.

On slide nine, a few items I'd like to point out related to free cash flow. Year-to-date, free cash outflow was $11 million as compared to an inflow of $29 million last year. The incremental outflow was primarily driven by a planned working capital increase to support the Americas transformation initiative, including establishing buffer inventory to facilitate the opening of our new distribution center in Columbus, Ohio.

We also had cash outlays which negatively impacted free cash flow in the first half, including product liability settlements and higher tax payments. From a deployment perspective, we funded about $7 million more in capital expenditures in the first half versus prior year, consistent with our plan to invest in growth and productivity projects.

We also purchased approximately 91,000 shares of our class A common stock at a cost of $5.2 million during the quarter. Year-to-date we have purchased 359,000 shares for approximately $17.6 million. And we also announced a dividend increase of 6% during the second quarter. This is the fourth consecutive year we've increased our dividend. Consistent with past few years, we do expect our cash generation will improve as the second half progresses and we are focused on achieving 100% cash conversion for the year.

Finally, turning to slide ten and the outlook to the second half of the year. Overall, on a consolidated basis, we expect organic sales growth excluding shipping days in the second half will remain fairly consistent with our first half performance at approximately 3%. Just a reminder that the three-day benefit we saw on the first quarter associated with the extra shipping days will be a headwind for us in the fourth quarter.

By region, the Americas should see consistent growth from relatively stable end markets. We are approaching EMEA with a little more caution given recent events and some tougher comps in the fourth quarter, so we are forecasting flattest growth in the second half. And Asia-Pacific sales pace should pick up in the back half of the year as our China valve business recovers and we continue to see growth in countries outside of China.

As Bob mentioned earlier, excluding additional shipping days, our adjusted operating margins grew by about 150 basis points during the first half of 2016. We expect margin expansion to moderate more in the second half as we compare against tougher comps and ramp up investment spending to fund some of our growth initiatives. We expect to attain 100 plus basis points for the full year operating margin expansion with a potential for some upside.

Finally, we are forecasting that the second half should generate strong cash flows consistent with our performance over the past several years. And with that, I will turn the call back over to Bob before we begin Q&A. Bob?

Thanks, Todd. To quickly summarize, we had a very good second quarter, which saw growth in organic sales with record margins in earnings per share. We continued to drive our various transformation programs and are focused on other key areas which we believe should drive continued performance going forward. And we are anticipating a steady operating performance during the second half of 2016. Delivering full year operating margin expansion of at least 100 basis points with a potential for modest upside and our goal is to drive 100% free cash flow conversion for the full year. With that, operator, please open the line for questions.

Thank you. (Operator instructions) The first question is from Ryan Connors with Boenning and Scattergood. Your line is open.

Great. Thanks for taking my question. I wanted to talk a little bit about the pricing impact of some of the commercial excellence initiatives you're putting through, things like the new training center. You know, historically, I think Watts is already known in the contractor channel as a premium brand at a premium price and presumably that's even more so today given the exit of some undifferentiated lines.

So my question is, do you believe that there's still room for you to pick up pricing structurally in the marketplace as you get more disciplined on how you go to market? Or do you think you're more or less priced appropriately in the marketplace and that the bigger opportunity there is actually market share?

So, Ryan, I think there's both. I think we did see some -- a little pricing pressure in Q2 as we adjusted some of our products. I think we've talked about in the past that for our OEMs we do tie pricing to [LME]. So with some of the commodity prices coming down we had to give a little of that back.

But in general, we feel good about our ability to pass along pricing. I think the reliability and quality of our product stands by itself. And I think that we'll continue to push price where we can. We continue to look at -- we test price elasticity. Sometimes we back off on that and sometimes we push it. So, again, as we continue to look at our portfolio, we'll adjust our commercial excellence initiatives and our pricing accordingly, but overall we feel good about it.

Okay. And then on the market share side, I mean, obviously it breaks into a product by product discussion pretty quickly. But when you're doing things like the training center and other commercial excellence-type programs, I mean, how do you look at the market share you have today in the product lines you're retaining and whether there's an opportunity to pick up share? Is there any way to quantify that side of the opportunity?

Unidentified Company Representative^ So I look at -- the new training center has just started, right? So it opened up in April. So I think it's difficult to do that. But in the long run, we believe training as well as new product introductions will allow us to gain market share.

So I think certainly that was the reason why we're doing it. We believe in -- to continue to train the industry and look for opportunities to grow because in the end that's what it's all about. So, I think it's a combination of training, new product development and making sure our pricing is appropriately in the right markets.

Got it. And then one more. Just on the operating margin, we're almost 12% in the quarter, over 11% I guess year-to-date which obviously is impressive and great progress against your initial target, which I think was, if I remember, something like 12%, 13%. So can you update us on your latest thinking about margin target base on the what you know this much deep into the realignment process?

Well, certainly our goal is to get up into the 15% long-term. And certainly, some of the heavy liftings going on with our portfolio readjustments and some of the overall restructuring initiatives. So longer term, I feel good about that.

You know, the team is executing, we're working together and we're starting to gain our stride. So I think as we continue to go, we'll see the continued restructuring and supply chain savings that we've talked about, and we feel good about longer term on those margins.

That's great color. Thanks for your time this morning, gentlemen.

Thank you.

The next question is from Jeff Hammond with KeyBanc Capital Markets. Your line is open.

Hey. Good morning, guys.

Good morning, Jeff.

Hey, I just wanted to go at the margin question a little bit differently. You know, Bob, you mentioned the 15% target year there in North America and certainly above prior peak and Europe has been a lager. So if you just kind of contrast the two, other than macro, are there structural issues for Europe getting to that same level? Is it just a matter of time? Maybe just compare and contrast kind of where you think you are and Europe's margin trajectory versus where you've come on North America.

Yeah, I think there is a little structural difference because a large portion of our business in Europe is through the OEM channel, which tends to be lower margin. But I do believe there's opportunities for improvement. We do have structural cost issues. We have a lot of plants and I would call it high-cost areas and as you know we've talked about it's difficult to shutter those costs on a cost effective basis, right? Long paybacks, et cetera.

So I think structurally we are a little bit challenged, but do I believe there's still opportunities and we're making progress on our restructuring initiatives. We'll be implementing that in the fourth quarter. So we'll see the benefits inside of next year.

So, really, the team has been making great strides. It's unfortunate the Brexit thing happened, so I think that creates a little uncertainty in the region at this point in time, but overall our team is making progress in Europe.

So on that point, I mean, I think you've been a little nervous about Europe coming end of the year and you've been able to put up some organic growth and really nice margin improvement. So what's kind of inflected there -- were you've been able to put those results up?

Well, I think it all centers around our teams are now becoming more focused on the customer and understanding what parts of our business to push, strategic accounts, all of that, and being selective on various pricing initiatives. So, again, I think the team -- we reorganized it. We've eliminated what I call some redundant overhead and structural costs out of there. And really the whole focus is getting close to our customers.

So we saw a little bounce in Italy, which was nice. You know, France was up just a little bit, a tick, basically flat up a little bit. But I think once Germany stabilizes, I think when -- we sell to a lot of OEMs in Germany that ship outside of Germany, in particular to Russia and other countries and I think they're having some difficulty. So once that stabilizes, I'll feel better about that.

So again, I have been cautious about Europe and I believe rightly so. First two quarters or actually even in the fourth quarter we saw some growth. So we had three good quarters and unfortunately this Brexit thing I think we saw some softness in July a little bit. But we're starting to see that rebound a little bit.

So, again, I think it's natural for all the uncertainty to have happened given the end of the quarter. But the teams are feeling pretty good about as we go, but we're being a little cautious. We continue to be cautious and watch our cost structure and driving our growths.

Great. Thanks a lot, Bob.

Thanks, Jeff.

The next question is from Jim Giannakouros with Oppenheimer. Your line is open.

Hey, guys. Good morning.

Hey.

Good morning, Jim.

I'll make it three for three, I guess, on Europe. I'll start with the margins. Again, just asking near term, can you give us where you guys see you're running at baseline on an annual basis if revenues stay flat once you've [lacked] the benefits of all the actions that you're taking there? But then I guess overlaying incremental investments such as building out your sales.

Hey, Jim, this is Todd. You know, I think if you look at the margin rates in the second quarter as you know, a little bit north of 11%. And I would say if volume kind of holds at these levels, I would say that's probably a pretty good range to keep it at, at this point in time. And they're going to continue to benefit from some of the lower restructuring, some of the restructuring action taking place in the quarter in the last couple quarters. So I think somewhere in that 10% to 11% range would be how I'd categorize, Europe's probably second half margin performance based on what we've seen so far in the first half.

That's helpful. Thanks. And just a little granular on Europe, the demand. You said -- you mentioned Germany [OE] channel softness, was that destocking or you're seeing a demand reset specifically in Germany? Thanks.

I think it's a combination of both, actually. I think the German boiler manufacturers have been having a difficult time, especially on the residential side. So, again, I think it's continued adjustment. I think they continue to right size. They have decided to insource some of their products.

So, again, I think it's just a reset because you know the difficult -- the cost to reduce labor, et cetera. But our feedback is by the end of the year we feel that that should subside and then the comps get more in line with what we've been seeing on a run rate basis.

Got it. Thank you. Switching over to the Americas. Specifically you guys called out the [res on res] tailwinds and your leverage well understood. The continued softness in industrial end markets understood, but where exactly -- I mean, can you get a little more granular there on what you're seeing in industrial end markets and how much of that is oil and gas? Thanks.

Yes. I mean, our industrial business is about 3% of overall business. It's a small portion of it, but, yes, it is tied mainly to the oil and gas side of the business, where we have some product lines in that. So that continued to be soft, down double digits on us. But, again, it's a small portion of our portfolio and hopefully that starts stabilizing at some point here.

But probably in Q4 we'll lap comps again on that. So, again, we had some backlog coming into last year that didn't ship out to the end of the fourth quarter. So by the end of this year I think we'll get back down into that steady state where we're lapping decent comps on that.

That's all I had. Thanks, guys.

Thanks, Jim.

Thanks, Jim.

The next question is from Joseph Giordano with Cohen. Your line is open.

Hey, guys. Good morning. Thanks for taking my questions. I was curious in Europe, if Brexit winds up being worse than -- I don't know no one has any real idea what it's going to be but if it turns out to be worse are there additional programs that you guys kind of have in the back of your mind that you could just put through real quick to kind of right size that business even further than what you're doing currently?

Yes. I mean, when we look at it, less than 2% of our business. We're not real strong in the UK. It's really the question of what is the macro indicators all around Europe and the overall impact. I think we're constantly looking at our cost structure. We know -- you know we have some European restructuring initiatives going on.

So we'll continue to look and monitor that, but right now our teams, they felt the noise, they felt the shock, but honestly they believe we'll move on and things will go forward with it. So right now we're watching it closely and we'll look for opportunities, further opportunities if we need to. But right now the team believes we've got the right actions in place.

Okay. I wanted to talk about the one last question, like global drains. When you go through that process, is that mostly internal training or how much is customer education? What are the initial results like? It didn't work -- are you just trying to push volumes and have your customers understand the full range of breadth of product that you guys have? Is that the ultimate goal there?

Yes. I think a lot of it is just we have a broad product range and certainly literature needs to be changed but a lot of our products are global in nature, where we can package them and put them together. And in the past we've been very siloed and the whole goal is to open up the portfolio for the entire organization. It requires marketing materials, trainings from our customers, training for our internal piece.

So it's a combination of all of the above. And the goal is really to take a global look and a global product portfolio and provide a customer solution. And some of our customers, large customers are global in nature. So we want to follow, develop strategic relationships with them and bring our products global with them. So it's a combination of all of the above and we're in the early innings of that initiative.

Are you starting to see some product sales of, like things in Europe that you are selling in the US but not historically there? Are you starting to see some tangible evidence there so far?

Actually, the biggest benefit we're seeing is products we make in Europe and selling them into North America in our stainless steel drains business. So we're gaining some traction there. We've added resources in specializing on that. So that's where we are getting our early winds but we believe there's just as much opportunity the other way around, bringing products into Europe right now.

But right now, the other opportunity is bringing our products both made in North America and in Europe into the Middle East and in Asia. So all of those are initiatives that are going on right now.

Great. And then just last for me on the Americas, how did sales trend throughout the quarter?

When I look at trends, it was interesting for the quarter. April was soft and we saw it ramp up in May and June. And it's funny, July started off a little soft, but, again, our sales team is confident in it coming back. So it's trendy, but the teams feel good and confident.

All the indicators that we look at, construction in both non-res and res are looking positive. And as you know, 65% of our North America business is repair and replace, which tends to go with GDP. So, again, on balance our team feels good about that and we're somewhat -- we watch the ups and downs. Some of it is lumpy depending on the commercial-type business. So, again, cautiously optimistic.

Thanks, guys.

Thank you.

The next question is from Ryan Connors with Boenning and Scattergood. Your line is open.

Thanks. Just a quick follow-up question. Bob, you mentioned in your prepared remarks this idea of having to go outside the organization to sell certain [peeps] where you don't feel like you've got the appropriate internal candidate. And I know there's some examples of that in Franklin, for example. But can you talk about how you go about that? Is it a compensation part of the pitch you're making to some of these people from larger, more mature organizations? Or what are the elements that you're using to try to bring people on board?

Well, Ryan, it has usually nothing to do with compensation. We really talk to teams about what we're trying to do, what we're trying to build, the momentum we're starting to get. And they meet our leadership team, and really see the opportunities inside of the organization. So certainly compensation has to be a part of the discussion, but, honestly, that's the very last thing we talk about.

So really everybody is excited to be part of this company. We have a strong 140 year history, a great brand and we're now going to capitalize on that brand to grow in the future. So people are excited to join us, and, you know, all the people that have joined us are excited to be here. So they want to be part of a winning team.

That's great. Thanks again.

Thank you.

Thank you.

Showing no further questions at this time and this will conclude today's conference call. You may now disconnect. Thank you.