Watts Water Technologies Inc (WTS) 2016 Q4 法說會逐字稿

Good morning. My name is Lindsey and I will be your conference operator today. At this time I would like to welcome everyone to the Watts Water Technologies Incorporated fourth-quarter 2016 earnings conference call.

(Operator Instructions)

Thank you, Mr. Tim MacPhee, you may begin your conference.

Thank you. Good morning, everyone. Welcome to our fourth-quarter and full-year 2016 earnings conference call Joining me today is Bob Pagano, CEO and President, and Todd Trapp, our CFO. Bob will discuss our key accomplishments for 2016, provide an overview of our fourth-quarter results, discuss our 2017 goals and address the macro markets. Todd will offer his detailed analysis on our fourth quarter and full-year results and provide our initial outlook for 2017. Bob will then summarize our discussion and following our prepared remarks, we will address questions related to the information covered during the call.

Today's webcast is accompanied by a presentation, which can be found in the Investor Relations section of our website. We will reference these slides throughout our prepared remarks. For purposes of today's call, all references to key performance metrics will be on an adjusted basis unless otherwise indicated and non-GAAP financial information and metrics have been reconciled and included in the Appendix section of the presentation.

Before we begin, I would like to remind everyone that during 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 intention or obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

Now, let me turn the call over to Bob Pagano.

Thank you, Tim. Good morning, everyone. We are on slide 3 in the earnings call presentation, where I will provide an overview of this past year and initial thoughts on 2017. 2016 was a transformational year for Watts. We made excellent progress on many initiatives that we identified as important to our future success. Financially, our efforts delivered a record performance in adjusted operating margin and adjusted EPS for the full year.

Now let me briefly comment on our quarterly results. Our fourth quarter performance was in line with the outlook we provided in November. We expected and achieved marginal sequential improvement in organic growth. Adjusted for shipping days, our consolidated sales were flat, as compared to down 1% in Q3.

In the fourth quarter, growth in the Asia-Pacific was offset by some softness in EMEA while the Americas were flat. Notably, we achieved strong adjusted margin expansion again this quarter, up 100 basis points, driven by our focus on portfolio enhancements and continued cost savings initiatives. Cash flow also continued to be a very good story for the Company. Todd will provide additional color on the financial results in a few moments.

Now, let's discuss our accomplishments for the year. First is putting the right people in place to drive our strategy forward. As you will recall, we initiated several key senior level management changes to drive a one Watts mindset. Munish Nanda took over responsibilities for Europe, including Eastern Europe, while Elie Melhem assumed responsibilities for the Middle East and Africa.

We made these changes to simplify our organization and employ a more global business approach. Munish realigned platforms and leadership in both Europe and the Americas and created some global product platforms like drains, water quality and electronics. This enabled us to focus on the voice of our customer, implement global new product development and promote more cross-selling opportunities within EMEA and around the world.

In addition, with the acquisition of PVI in November, we established a new Heating and Hot Water Solutions platform, led by Jim Dagley, a recent addition from Johnson Controls. We expect this alignment to foster customer-centric solutions and commercial boiler room applications.

We also took meaningful steps to foster a one Watts culture. This past November, we held the first ever Connect Conference, bringing together our top 140 leaders from around the world. The focus of this senior leadership meeting was on growth and accountability and feedback from the attendees has been extremely positive.

Second, we continue to drive customer and commercial excellence. In April, we reestablished our position as a leader in training the industry when we opened our Watts Works Learning Center in north Andover. The Learning Center provides customer, distributors, sales representatives and our associates a hands on experience with the Company's products and technologies and provides us invaluable feedback on customer needs. In the US, we trained approximately 4,300 people, including 3,700 online courses during 2016. We also established a Learning Center in Dubai as part of our Middle East expansion, and we invested in our existing Learning Centers in Italy and California as well.

Third, a principal focus for the team has been executing on our transformational and restructuring efforts and we delivered on that goal. Phase two of the Americas transformation, launched in the second half of 2015, addresses our infrastructure requirements to streamline the product portfolio and is expected to be completed in mid-2017. We anticipate that these two efforts should improve our planning process, realize savings from redundancy, reduce working capital and improve our customer's overall experience. We will continue to drive new and existing programs in 2017 and beyond to generate further efficiencies as part of our normal operations.

Fourth is disciplined and effective capital allocation. The PVI acquisition, which closed last November enhances our portfolio, enabling us to address more customer solutions in the growing commercial heating and hot water space. At a reminder, our capital deployment strategy is balanced as we seek to invest organically through CapEx and internal projects and inorganically through M&A. We also continue to return cash to shareholders.

Finally, we remain acutely focused on controlling what we can and our operational efforts yielded strong financial result in spite of tepid top line growth. Those efforts drove record adjusted operating margin and adjusted EPS in 2016. If you recall, we anticipated 2016 consolidated adjusted operating margins would increase by 100 basis points. We are proud to have exceeded our goal, delivering a 130 basis points increase over last year. This margin increase included incremental investments in sales and marketing, R&D, training efforts as well as systems to help seed future growth. Further, free cash flow conversion exceeded 120% of net income this year. So a great performance turned in by the entire team.

In summary, 2016 was an eventful and exciting year for Watts. As we move into 2017, our top priority will be profitable growth. 2016 was about building and strengthening our foundation, including implementing various transformational actions and seed planting for future growth.

To improve our organic growth trajectory in 2017, we expect to introduce new products, expand geographically, drive solution selling and concentrate on key account management. We will also continue to rationalize lower margin products from our portfolio. We expect adjusted operating margins will continue to expand as we realize incremental savings from our transformation and restructuring actions. Consistent with last year, we expect to continue to reinvest a portion of the anticipated savings in selling and marketing, R&D, and systems.

All investments are focused on the long-term viability of the Company. We expect a complete Phase two of the Americas transformation by mid-year and should reap more of the benefits we previously discussed.

Now, let's talk about the market, so please turn to slide 4. Let me share some macro data and some regional observations for 2017. In the US, we expect to see continued growth with GDP forecast to expand to 2.3% above the 1.6% 2016 estimate. Based on information we derived from IHS, total residential spending in 2017 is forecasted to increase low single digits, but below 2016 numbers, as student debt, higher mortgage rates and lower refinancing activity weighs on new home buyers.

Non-residential spending in 2017 is forecasted to increase in the low single digits, with growth in office and institutional, offset partially by an expected decline in the commercial submarket. Keep in mind that we typically do well in the institutional submarket where there tends to be more complex plumbing and HVAC content.

Obviously, a big unknown that could affect the US markets in 2017 is the new administration's ability to achieve its policy agenda. The proposals are far reaching and timing and final regulations have yet to be determined. We are monitoring the landscape closely and will continue to keep you apprised of how any developments affect our Company.

Turning to Canada, which is about 8% of the America's business, we expect conditions in the construction markets to remain under pressure. Both residential and non-residential spending is forecasted to decline slightly in 2017.

In the Eurozone, the overall outlook is generally stable, with GDP growing at about 1.6%, nominally lower than 2016. We are forecasting flat to low single digit growth for both residential and commercial construction spending in our larger markets like France, Germany and Italy. Other factors that may affect Europe are FX volatility and continued geopolitical events such as Brexit and upcoming elections in Germany, the Netherlands and France. The overall outlook for Europe is somewhat muted given the degree of uncertainty.

Emerging markets GDP expectations are moderating, as Russia is forecasted to be moderately positive for the first time in three years and the Middle East is expected to remain lumpy. As we've noted before, geopolitical issues are likely to continue to have an impact. In China, GDP is expected to remain robust at 6.5%, while GDP in the greater Asia-Pacific region is expected to remain stable at 2016 levels. Residential and non-residential spending in China is expected to grow, but at a slightly lower levels than 2016. As a reminder, our Asia exposure is only 5%.

Overall, the macro data suggests our markets will remain mixed and somewhat uncertain. I will now turn the call over to Todd, who will review our results for the quarter and full year and offer our initial outlook for 2017. Todd?

Thank you, Bob. Good morning, everyone. I am on slide 5 which shows the fourth quarter results. We delivered sales of $342 million, down 5% quarter over quarter, both on a reported and on an organic basis, which was in line with our expectations. The organic sales decline was primarily driven by a reduction in shipping days in the quarter.

As you recall, we mentioned back in early 2016 that because of the way our fiscal calendar fell, we gained approximately four shipping days in Q1 and lost a similar number of days in Q4 when compared to 2015. Excluding the effect of fewer shipping days in Q4, organic sales were flat.

We also had several puts and takes which offset one another. The 2015 exit of undifferentiated products and the negative impact of currency was a headwind of $13 million, or 4% in the quarter. Fully offsetting these reductions were the acquired sales of PVI and Apex.

Adjusted operating profit of $37 million increased 5% despite the lower sales. This translated into an adjusted operating margin of 10.9%, up 100 basis points versus Q4 of last year. Favorable sales mix, including the exit of undifferentiated products and continued benefits from productivity and restructuring actions more than offset incremental investments in sales and marketing, R&D, and IT.

Adjusted EPS of $0.64 was 8% higher than last year and a Q4 record for the Company, driven by strong operating performance. The effective tax rate in the quarter was 32.9%, consistent with last year. So, overall, a similar result to Q3, as we delivered strong operating margin and EPS performances despite a sluggish top line. As Bob mentioned, we focused on those aspects of the business that we would control and executed accordingly.

Moving to the regions, let's turn to slide 6 and discuss the America's results. Sales were $223 million, down 4% on a reported basis and flat on a days adjusted basis. The reported sales reduction was driven by the exit of undifferentiated products of $8 million and $3 million from the retail sales erosion that we communicated on the Q3 call. The recently acquired PVI contributed about $9 million in sales during the quarter. Growth in backflow, mixing valves and drains were offset by softness in some of the specialty products in the aforementioned retail sales erosion.

We are also seeing pressure in Canada as well as from products that serve the industrial markets. AERCO was relatively flat, rebounding from the softness that we saw in Q3. AERCO is still experiencing some project delays and push-outs given the uncertainty in the marketplace.

Adjusted operating profit for the quarter was $34 million, a 3% increase year over year. Operating margin expanded 100 basis points to 15.3% due to favorable mix, including the impact from the exit of undifferentiated products and continued strong productivity, including benefits from sourcing and lower commodity costs. So another record operating margin in the performance by the Americas.

Turning to slide 7, let's review EMEA's results. Sales were $104 million, down $9 million, or 8% on a reported basis. Foreign exchange, mostly related to the euro, accounted for $3 million of the sales decline. Excluding the shipping days' impact, organic sales were down 1% in the quarter.

So let me provide some more color by platform. On a shipping days adjusted basis, Fluid Solutions sales were flat organically. Sales of electronics products continued to make solid gains, but were offset by lower demand of our water and plumbing products, mostly in the French marketplace. Sales on the drains platform were down approximately 3% compared to Q4 last year, as we saw some destocking activity in the Nordic region at some of our wholesalers, as well as continued product delays in the UK.

By geography, our performance was mixed. We saw growth in Italy where our energy efficient products remained strong. On the other hand, sales declined in France due to a softer refurbishment market and in Germany, due to slower HVAC sales into boiler manufacturers.

Adjusted operating profit in EMEA for the quarter was roughly $9 million, a decrease of $1.4 million from last year. Operating margin of 8.5% contracted 50 basis points, primarily due to lower sales which more than offset the benefits from our transformation and restructuring efforts. For EMEA, a somewhat softer quarter due to volume declines in some of larger markets and continued sluggish spending given the current political environment.

Now moving to slide 8, let's take a look at Asia-Pacific results for the fourth quarter. Asia-Pacific reported sales were roughly $15 million, an increase of 26% over the prior year. The reported increase was driven by acquired sales of $3.7 million. Adjusted for shipping days, organic sales increased by 18% compared to the fourth quarter of 2015.

Residential sales of our under-floor heating applications within China remained very strong, which was being offset by a decline in China valve volume due to lumpiness in the commercial end markets. We continue to see growth outside of China of double-digits in the quarter, driven by demand for our water and plumbing products in areas such as Australia and Southeast Asia.

Adjusted operating profit of $2.1 million increased by $1.4 million as compared with the same period last year. Operating margin of 14.4% was significantly higher than last year due to volume, acquisition benefits and sourcing savings. In summary, Asia-Pacific delivered another good quarter, led by performance outside of China.

I am now on slide 9. Let me speak briefly about the full-year results. Sales for the full year were $1.4 billion, down $69 million, or 5% on a reported basis and up 1% organically. The decline was primarily a result of the strategic exit of undifferentiated products, which was roughly $96 million or about 7%.

Organically, Americas and Asia-Pacific sales were up 1% and 12%, respectively, while EMEA's sales were essentially flat year over year. Operating margin was a record 11.4% for the year, or 130 basis points higher than 2015.

We are proud to have exceeded our margin expansion goal by 30 basis points. Sales mix, transformation and restructuring benefits and continuing productivity, including sourcing initiatives were the driving factors. Also, important to note, the margin expansion included incremental investments during the year, consistent with our guidance.

Adjusted full-year EPS of $2.67 was up $0.26, or 11% versus the prior year. Again, another record result for Watts, primarily driven by improved operational performance.

Let's move to slide 10 where I would like to make a couple comments on cash. Free cash flow continues to be a very good story for Watts. We delivered $102 million of free cash flow in 2016, which was up 25% versus the prior year. This translated into a conversion rate of 121%.

Working capital performance was fairly neutral to cash flow this year, mainly impacted by our 2015 transformation activities. If you recall, we had strong cash collections in 2015 from divested product lines and in 2016, we temporarily increased inventories to minimize customer disruptions as part of rationalizing our distribution and manufacturing footprints.

CapEx increased 30% in 2016, driven by incremental investment in our facilities to support our growth and productivity initiatives. Our reinvestment ratio was 118%, up significantly from 2015 reflecting our commitment to reinvest back into the business. During 2016, we expanded our credit facility by $300 million to $800 million, using a portion of the proceeds to retire private placement debt and to help fund the PVI acquisition in the fourth quarter.

This facility provides us with ample liquidity and flexibility as we prioritize capital allocation in the future. In 2016, we also returned $51 million to shareholders in the form of dividends and share repurchases. Our stock repurchase program remained active as we purchased 500,000 shares for almost $27 million during the year at an average price of $53.

Now, turning to slide 11, let's discuss the general framework we considered in preparing our 2017 outlook. First, let's look at expected headwinds. Consistent with our ongoing strategy, we are going to reinvest in the business. Commodity cost, especially copper, increased during the second half of 2016. And the forecast from IHS is that it will remain at higher levels in 2017.

We anticipate that the euro will be under pressure this year. In our plan, we have pegged the euro at $1.05, about $0.06 lower than the 2016 full year average. As a reminder, we estimate that for every point move in the euro/US rate, there is an impact to full-year sales and EPS of $4 million and $0.01, respectively.

The US DIY erosion that began in the third quarter of 2016 will continue into the first half of 2017. As also part of our ongoing initiative to strengthen our portfolio, we are planning to rationalize a small portion of low margin products in both Europe and Asia-Pacific.

In the middle column, you can see some of the items that are more uncertain. No surprise that it is centered more around the political environment, both in the US and in Europe. The quicker we have clarity and resolution on some of the unknowns, obviously, the better it is for everyone. At this point in time, we think our markets may be cautious, at least through the first several months of 2017 as the events unfold.

Finally on the tailwind side, we expect to reap incremental benefits from our transformation and restructuring efforts, especially in the Americas and Europe. Acquisitions, primarily PVI, will be incremental to our results. Growth in Asia-Pacific should continue given our small base and recent investments. And lastly, we expect pricing to be positive in 2017 to help mitigate most of the commodity inflation.

With that framework in mind, please turn to slide 12 and I will provide details on our 2017 outlook. Starting with our sales, we estimate that Americas should grow low single digits. Growth in our traditional plumbing products may be tempered during the first half of the year due to the continued market sluggishness as we exited 2016 as well as tougher comps. As you recall, we had a fairly strong first half last year.

We expect AERCO should return to solid growth through new product and geographic expansion and PVI should add roughly $45 million in sales year over year, which will more than offset the $6 million of DIY erosion that we will see in the first half of 2017.

For EMEA, we have forecasted sales to be flat. While we believe our business has stabilized over the course of 2016, we remain cautious given the broader macro and the political uncertainty. The flat sales forecast also includes approximately $5 million of lower margin sales we anticipate rationalizing during the year.

In an Asia-Pacific, we expect organic sales to increase high single digits in 2017. We also expect to be rationalizing approximately $9 million of certain OEM-directed undifferentiated product sales this year. Again, this is part of our continuing effort to enhance our portfolio.

So for overall Watts, organic sales are estimated to grow low single digits for 2017. Growth is expected to pick up more in the back half of the year.

Turning to margins, we are targeting a full-year operating margin in the 12% range, roughly a 60 basis point margin expansion versus 2016. Included in that assumption are savings from transformation and restructuring efforts, as well as some incremental investment. We also expect PVI's margins to be in the high single digits during the integration phase.

A couple of comments on Q1. We expect the year will start off slowly, in line with the general business environment we experienced in Q3 and Q4 of 2016. Our top line will also be challenged by some tougher comps given the strong start we had last year and further portfolio rationalization, which we expect to be more weighted towards the first half. So, flattish to slightly down on the top line.

From an operating margin perspective, Q1 2017 margins may also be fairly flat given last year's tougher comps. Also, PVI's margins should negatively impact consolidated margins by 20 basis points each quarter, until integration programs take hold, which will likely be in late 2017 and into next year.

And finally, a few housekeeping items. We estimate capital spend for the full year of $36 million to $40 million as we continue to reinvest in our manufacturing facilities and systems, which will support future growth and productivity. Depreciation and amortization should approximate $50 million to $52 million while the effective tax rate should be in the 34% range.

Regarding capital deployment, we expect to repurchase shares at a rate that will at least offset option dilution, and we will continue to pay a competitive dividend. Now let me turn the call over to Bob before moving to Q&A. Bob?

Thanks Todd. Please turn to slide 13 and let me summarize our discussion. We continue to execute on our transformational strategy that we outlined in 2015. Our team has worked diligently to focus on the customer, drive a one Watts culture, and align our businesses. Operationally and financially, we delivered on our 2016 commitments.

We are approaching 2017 with some caution, given what we saw in the second half of 2016 and uncertainty associated with the new administration's ability to translate campaign promises into policy and new legislation, the pace and timing of which is unknown at this point. We are currently seeing a pause in the marketplace as customers are delaying projects, until there is more clarity on proposed legislation.

Therefore, we think our growth in the first half of 2017 will be marginal and will accelerate in the second half of this year. As Todd mentioned, we plan to deliver continued margin expansion in 2017 while continuing to invest for future growth. And finally, we will continue to be disciplined in capital deployment, expecting to spend wisely on CapEx, strategic M&A and returning excess cash to shareholders.

Over the last two years, we have made substantial progress in our journey to become a leaner, customer-centric organization. These years were about stabilizing our foundation, driving transformation and seed planning for the future. This year, we will be keenly focused on growth through solution-selling, geographical expansion, new product instructions and key account management. I am confident our team will continue to deliver on its commitments for 2017 and beyond.

With that, operator, please open the lines for questions.

Our first question comes from the line of Ryan Connors of Boenning & Scattergood.

Thanks for taking my questions. And thanks for the detailed outlook for 2017. Very helpful. I had a bit of a bigger picture question on the policy side, Bob. I know there is not too much you can say in detail about the direction this will go.

But can you at least kind of give us some quantification of the Company's presence in Mexico as it relates to assembly and/or manufacturing? And how material that is and how that's shifted in the last few years with the realignment and how you look at the different scenarios about what is being talked about there in terms of a border tax, adjustment tax, and how that could or could not impact Watts.

Yes. When we exited undifferentiated products, a lot of that was produced in Mexico. So our exposure in Mexico is very limited. Our bigger exposure is imports from China. We are a net importer; I would say it is not as material as maybe some of our competitors would have. As you know, we have a foundry in the local area here in the US as well as our boilers are mainly produced in the US. So, again, we have some exposure, but I would say it's not as much as maybe others would have.

Okay. And in that exposure, is it manufacturing, or are you exporting components, say, from the US for assembly in Mexico? Is that --

It is primarily -- we're importing products to be assembled in the US. We do export some products out, but it is primarily import and we are reviewing alternatives. We do have the ability to bring more stuff to our local foundry, as well as we will look at other capabilities inside the US. So e are reviewing all alternatives at this point in time until we -- there is more clarity on this.

Got it. Okay. And then just a housekeeping update from last quarter. You talked about some distinct dealer disruption related to some of the product realignment then and that was pretty discreet and isolated in nature. But can you just update us on that topic as well?

Yes. We are seeing similar, just like we thought. That is carrying over -- carried over to Q4 and it's going to carry into the first half of next year. And we put that in our guidance assumptions. The second thing we're doing is continuing to look at our product portfolio, which is in EMEA.

We are getting rid of about $5 million worth of DIY and also related to our exit of undifferentiated products. We have the same issue inside of China at this point in time. Again, we are continuing to watch our portfolio. As you know, we have many, many SKUs and we continue to look at the tail end of those SKUs.

Got it. That is helpful. Thanks for your time this morning.

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

I wanted to dig in a little bit here on slide 11, particularly some of the headwinds. First, can we talk about commodity inflation, maybe just remind us your inputs. How big is copper and copper-based products? How big do you think that growth headwind on the commodities and what you are doing on pricing actions to kind of mitigate that?

Sure. As Todd mentioned, copper is going up. We are seeing that. But we don't give out the details of our copper exposure for competitive reasons, but I will tell you, we are planning a price increase to mitigate that. We believe it will stick and we are implementing that in February as we speak. So, we are on top of that. We believe our pricing actions will mitigate the copper increase.

Okay. Then is there a way to quantify what the incremental year-on-year benefits are for both the transformation, and then the offset on the investment side as you look at 2017?

Yes. So, Jeff, this is Todd. I think in 2017, it's going to be very similar to what we saw in 2016. Most of the restructuring transformation benefits are going to be in that $10 million range. And from an investment perspective, I would say we're going to make similar types of investments in those, I'll call it, $6 million to $7 million range in 2017, as well. So pretty similar to what we saw in 2016.

And then just finally, Europe is kind of been a tough market to grow. It seems like more broadly a lot of my other companies have been seeing at least a modest growth. Just help me understand what you think really needs to happen there to kickstart the growth? Thanks.

I think it's really centered around the political uncertainty. With all the elections going on, we're strong in France and that is where most of the political uncertainty is at this point in time. We have seen some positives in Italy. So we're optimistic in that regard. But Germany is, for us, we primarily sell to the German boiler OEMs and they had difficult times.

When you look at it, we are being somewhat conservative in our outlook until more -- things are known based on these elections. France is the one I'm probably most concerned about. The UK, we do a little bit business there. There were some timing issues in the fourth quarter with our drains business there. Again, it is nice to see a little growth from Italy. From a Russia point of view, that has been down. We think it's going to be relatively stable at this point in time and maybe even a tick up.

Thanks, guys.

Our next question comes from the line of Mike Halloran of Robert W. Baird.

Just a quick clarification on the Q1 comment. You said flat to slightly down revenue comment. Was that organic or and all-in revenue number?

It was an all-in number.

Great. Great. And then, second question, on the Heating and the Hot Water Solutions side. It is good to see some progression from Q3 levels. Maybe talk about what the competitive environment looks like? How you think that business is performing relative to the environment? As you get through this year, what do you think it will take to get back towards that normalized long-term growth rate that you guys have talked about?

Mike, we believe 2017, we are going to get back to that normal run rate which is in the high single digits. We did see competitive pressure. In particular, where there is lumpiness in projects, it gets very competitive out there. We've seen some new entrants trying to come in.

But we are excited at the recent [ACWA] Show to unveil our brand new product that we believe is a differentiator in the marketplace. So we believe we have the ability to put that new product out there and which differentiates us from our competition but we are planning a return to high single digits in the Heating and the Hot Water Solutions group.

Could you then -- last one. Just on the capital deployment side, maybe just some thoughts on how the pipeline looks for today, how valuation levels look like in the market and how active things are from your perspective?

So, I can't comment on any specific transaction, as you know, but clearly, our pipeline remains full. We keep on looking at them. Evaluations are similar to what I think we are seeing in the current marketplace. No real change. But we keep on looking and developing our relationships at this point in time. So, other than that, I am not sure of any more details I can comment on that at this point.

Appreciate it. Have a good one.

Your next question comes from the line of Jim Giannakouros of Oppenheimer & Co.

On the statement of -- that you are pivoting towards growth, I take that as an investment statement. Is that more of a North America statement or does that apply in EMEA as well?

It is primarily North America and Asia-Pacific, but we are investing in Europe, and particularly in our electronics platform and other differentiated products like drains, where we believe we have a competitive advantage. So, it is growth in all areas and as you know in our business, as we said earlier, we are planting a lot of seeds.

Those seeds may take multiple years to go forward. But again, we believe it is important that we continue to plant those seeds. We are spending more in R&D, sales and marketing and looking at continued geographical expansion.

Got it. And, thank you. If we can get a little more granular as far as your expense base in 2017. Appreciating that you are still doing a little bit more of a growth investment. You talk about expanding sales and marketing, IT. You're stepping up R&D. How are those buckets comparing versus 2016? Are we at a run rate or any of those step-ups temporary or nonrecurring in nature?

Well, Todd can get more specific, but I know in R&D in particular, we plan on spending more in that area than we have in the past. Probably 2.1% of sales at this point in time. As well as investing in sales and marketing, and plus the run rates. Our training facility, as an example, wasn't started until April.

So we will continue to have those run rates into next year. But we are continuing our focus in those areas as well as with the new acquisition, certainly our operating expenses, in particular, sales and SG&A will continue to go up.

Got it. Okay. And just to be clear on the 1Q commentary and the tough comps. Is that -- should we be thinking about that as weather-related? We obviously had barely a winter last year, very mild. Is that what we should be thinking about, is really just weather or was there something going on specifically in North America that we should be factoring. Thanks?

So, if you think about Q1 last year, from a top line perspective, we had a strong start, I think, across all regions. When you turn to the margin, from a margin perspective, I think every region in Q1 last year expanded margins in excess of 200 basis points. I think it's more of just an overall comp issue than anything to do with weather at this point in time.

I think the other thing, just to -- important to keep in mind is some of the DIY and product rationalization will impact Q1 somewhere in that $7 million to $8 million range. The Americas will also benefit from approximately $13 million of acquired sales of PVI during the quarter and the other thing that is a headwind a little bit is FX. So FX last year was $1.10, $1.11. Today, the Euro rate is at $1.06. So that could be a little bit of a headwind from a top line perspective as well. But I think it is more of a comp issue than, I think, anything about weather.

Appreciate it. Thank you.

(Operator Instructions)

Our next question comes from the line of Ryan Cassil of Seaport Global.

Could you flush out what you're thinking on the boilers business? I think that's kind of seen the biggest change in growth dynamics over the last couple quarters. Are you thinking this is more of a short-term issue, or perhaps is it a bit of a turning point in the commercial/non-res cycle?

No. We don't believe that it is a turning point at all. We believe there are opportunities. I think just with the uncertainty and the stimulus and what was happening, projects just got pushed out and delayed. We were -- we remain disciplined in our pricing because we didn't want to give up margins, so I think it is a pause. Our projects that we see in backlog, they haven't been released but it's just been more lumpy.

But as I said earlier, I believe that business is going to grow high single digits again this year. So that is what we're planning. We introduced a whole slew of new products in that segment so we are pretty excited about it.

Okay. So the front log of that business, any color you could give there? Are you seeing lots of -- a healthy pipeline of new work for that business? Thinking of the project backlog?

Sure. The project pipeline looks strong. What we did is, if you recall, the first half of last year, that business was strong. We saw a big dip in the Q3. It was flattish in the fourth quarter, so we got some tough competitors in the first half of this year and I think it will be more smoother in the second half of next year.

But overall, projects, visibility, and remember, a large portion of our business -- of that business is retrofit, where we believe we have high paybacks to convert to more efficient condensing boilers. So there is also a payback to people for switching their boilers to do that. So, overall, we feel confident we will get back on track with that business.

Okay. Great. Then you mentioned new products and introducing products in new geographies. I know boilers, you talked about that in the past. Just from a timing standpoint, do you think that is a benefit to 2017, or you introduced the products in 2017 and really, a bigger sales uptick is an 2018 story?

I think it is a bigger impact in 2018. I think 2017, is, again we are seeding that. We did get some approvals just recently on some of our boilers. But some of the markets, in particular, China as an example, the condensing market is new. So it's going to be slow to adopt.

But they are clearly looking for more higher efficiency products so that is an opportunity for us. But again, we've got to work with policy and drive some of that. So it's not going to be instantaneous but we believe over the long run, it's the right seed to plant.

Okay, and then last one for me. Just going back on the price increase for February, is this -- are you expecting to get any net pricing outside of labor and raw material inflation? Then, could there be -- just given the rise in raw materials as quickly as we have seen for products like copper, is there a period in the short term where you get squeezed, then you put through that price increase and it kind of all works itself out? Any color or cadence there would be helpful.

We don't believe it's going to be a net negative squeeze at all, because we had purchased product in advance of some of these increases so we are a little in front of it, not through hedging but just pre-buying. So we believe net-net, it should be even. We are certainly going to drive towards positive price this year, but, again, it all depends on the environment and how competitive it is out there.

Great. Thank you.

Our next question comes from the line of Joe Giordano, Cowen.

On M&A, when you look across your geographies and I guess some of the market uncertainties, it is tough to tell if some markets break up or down from here. How does that guide your outlook in terms of what you are willing to pay when it's -- when you are uncertain which direction some of these businesses are going? How do you move forward from there and how does that impact your discussion?

Joe, the first thing we look at is what is the strategic potential and how does that fit in our overall strategy? We sometimes -- I don't want to get caught up in some of the noise. We are clearly looking at the long term. We put valuation differences based on some of those uncertainties. But the first criteria is what is the strategic implication to our business?

And do we believe that will make a stronger portfolio for us. So, that is our first criteria. And then some of the uncertainty, that all turns into valuation at this point in time related to that. So, again, we are focused on the strategy and then valuation and clearly, we're going to be disciplined in this environment.

Okay. Great. Then, a little bit more on the AERCO delay that you've been seeing. Is there any specific submarket that you'd call out there?

Not really. I mean, we have seen it across the board. That is why it's been widespread from that perspective. Again, it is competitive out there. But again, we believe we have a superior product and a value differentiator from our competitors. So, again, timing, lumpy, and just driven by uncertainty.

Okay. And then, one clarification, Todd. On the realized savings and the investments, you mentioned that $10 million in savings and $6 million to $7 million in investment. I assume that the $10 million of savings is an incremental one versus last year. Is the $6 million to $7 million in investment spending like the same level as from last year or is that $6 million to $7 million incremental? So you are really looking at a net-net period?

Yes, so I would say from the restructuring side, that $10 million is incremental year over year from 2016 to 2017. On the investment side, that $6 million to $7 million we talked about is incremental investments.

Okay. Fair enough. And then my last question. Are the organic outlooks that you guys presented for across the segments, are those inclusive of the rationalization in the low single digit or whatever -- in that segment?

Yes. It is. I mean, all the growth rates we talked about have the product rationalization included in there.

All right. Thanks, guys.

There are no further questions in queue at this time. I will turn the call over to Mr. Bob Pagano for closing comments.

So, in closing, I would like to thank you for taking the time to join us today for our fourth quarter earnings call. We appreciate your continued interest in Watts Water Technologies. We look forward to speaking with you during our Q1 earnings call in May. Thank you.

This concludes today's conference call. You may now disconnect.