Watts Water Technologies, Inc. Q2 2009 Earnings Call Transcript

Jul.28.09 | About: Watts Water (WTS)

Watts Water Technologies, Inc. (NYSE:WTS)

Q2 2009 Earnings Call Transcript

July 28, 2009 5:00 pm ET

Executives

Kenneth Lepage – General Counsel and Secretary

Pat O’Keefe – President and CEO

Bill McCartney – CFO and Treasurer

Analysts

Christopher Glynn – Oppenheimer

Jeff Hammond – KeyBanc Capital Markets

Mike Schneider – Robert W. Baird

Keith Hughes – SunTrust

Michael Gaugler – Brean Murray and Carret

Scott Graham – Ladenburg Thalmann

Michael Coleman – Sterne Agee

Jim Foung – Gabelli & Company

Michael Roomberg – Boenning & Scattergood

Jamie Sullivan – RBC Capital Markets

Operator

Good day, ladies and gentlemen, and welcome to the Q2 2009 Watts Water Technologies Earnings Conference Call. My name is Anita, and I will be your operator for today. At this time, all participants are in a listen-only mode. We will be facilitating a question-and-answer session towards the end of this conference. (Operator instructions).

I would now like to turn the call over to Kenneth Lepage, General Counsel. Please proceed.

Kenneth Lepage

Thank you. Good afternoon and welcome to the Watts Water Technologies second quarter 2009 earnings conference call. On the call with me today are Pat O’Keefe, our President and Chief Executive Officer; and Bill McCartney, our Chief Financial Officer.

Please be aware that any remarks we may make during today’s call about the company's future expectations, plans and prospects constitute forward-looking statements under the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995.

Actual results may differ materially from those indicated by these forward-looking statements as a result of various factors, including those discussed under the heading Risk Factors in our Annual Report on Form 10-K for the year-ended December 31st, 2008 and other reports we file from time to time with the SEC.

In addition, forward-looking statements represent our views only as of today and should not be relied upon as representing our views as of any future date. While we may elect to update these forward-looking statements, we disclaim any obligation to do so and you should not rely on these statements as representing our views as of any date subsequent to today.

During this call, we may refer to non-GAAP financial measures. These measures are not prepared in accordance with generally accepted accounting principles. A reconciliation of the non-GAAP financial measures to the most directly comparable GAAP measures is available in the press release dated today’s date relating to our second quarter 2009 financial results, a copy of which may be found in the Investor Relations section of our website www.wattswater.com under the heading Press Release.

I will now turn the presentation over to Pat and Bill.

Pat O’Keefe

Thank you, Ken, and good afternoon everyone. Welcome to our second quarter conference call and thank you for joining us today. After my opening remarks, Bill McCartney, our CFO will provide you with the financial highlights for the quarter. Bill will also discuss individual sector results. Then we will address your questions.

As I have reported to you during the last several quarters, we continued to focus on maximizing cash flow through out the organization. In the first half of 2009, we generated positive cash from operating activities of approximately $74.5 million, almost double the $41.8 million of cash generated from operating activities in the first half of 2008. We achieved this despite a 43% reduction in the first half income from continuing operations due to our favorable focus on working capital management and our cost savings initiative.

Our free cash flow for the first half of the year approximated $66 million or 140% increase over the 2008’s free cash flow of $27.5 million, again as a result of working capital management and also closely managing our capital spend. Cash flow remains a key driver for our company as we navigate through the global recession.

We have achieved savings in the first half of 2009 through various programs and initiatives. Since October 2008, when we first announced our reduction in force program, our worldwide headcount has decreased by 14%. We have also implemented salary reduction, worker furloughs and other cost reduction during the first half of 2009 to help us control our spend.

We continue to expand our liquidity during the second quarter. At June 28th, 2009 our net debt to capital ratio was 18.3% which compares favorably to 22.8% at December 31st, 2008. We had approximately $179 million worth of cash on hand versus $166 million at December 31st.

Our cash position has increased even though we made a decision to pay down our line of credits by approximately $43 million during the first six months of 2009. As a reminder, our next large debt payment of $50 million is not due until May of 2010. Needless to say, I believe that liquidity is a major strength for our company.

I would now like to speak to you about the results for Q2. Let me first address the large charge of $18.7 million taken into discontinued operations in the quarter. This charge was primarily for the disposal of TEAM Precision Pipe Works in the UK, which we previously announced in May.

TEAM was a 2004 acquisition, whose core operation were in pipe and tube assembly, primarily used in the HVAC market and the automotive application. The automotive end of the market has been quite depressed for the better part of two years and the outlook for synergies with TEAMs in metal bending capabilities diminished due to certain market development. We explored various options to either improve or divest the company. Finally, we determined that placing team in hands of an administrator which is the UK’s equivalent of bankruptcy was our most viable option.

As a result, we relinquished control of team to the administrator in May and wrote off the net assets to discontinued operations in the second quarter. Our operating results prior to restructuring charges exceeded our own internal expectation. I would like to highlight that we had two product liability cases resolved during the quarter which resulted in a one-time gain of $0.03.

From an operating perspective, we have seen pricing pressure causing reductions in certain markets. But overall, price erosion was not a major issue during the quarter. We continued to experience plants under absorption which was offset to some extent by our cost reduction and main initiative.

Gross margins were 110 basis points higher than Q2 of 2008 and sequentially were 220 basis points greater than Q1. The year-to-year margin expansion was due primarily to one acquisition accounting charges in 2008 for Blucher; two, incorporating Blucher in our results for the full quarter of 2009; and three, eliminating the results of PWT, a former Chinese – China subsidiary from this year’s operating results.

The sequential gross margin expansion was due to one, more plant absorption than we realized in Q1 and some lower raw material cost working their way through our inventories. Operating margins for Q2 were consistent with the same period of 2008 at 9.1%. Currency swings from year-to-year negative to the impact at operating earnings by $0.03, but this really was less than we anticipated, as the Euro has steadily gained ground against – this year against the US dollar.

Looking at our major end markets, the US commercial sector is still very depressed. Sales into the US wholesale channel in Q2 declined 18% organically against Q2 of 2008. This percentage decrease was the same as we experienced in Q1. We still see wholesalers continue to destock what we believe that the pace of destocking has substantially lessened.

As you know, we review the AIA Index as a predictor of commercial construction market. Unfortunately, the June index declined to 37.7 from 43.7 in March when we last spoke. The AIA Chief Economist was quoted as saying the architectural firms are concerned that the construction market conditions will not improve even as soon as next year. So given what we are seeing in our business and the general macro information we are reviewing, our outlook for the commercial sector has not changed. We expect to see continued deterioration in commercial marketplace for at least the reminder of this year and likely into the first half of 2010.

Our US retail sales in Q2 were 7% below Q2 of 2008, but sequentially were flat with Q1 of 2009. Last year’s Q2 included some product rollouts to large retail chains. These rollouts did not reoccur this year to the same extent making our comparisons relatively difficult. Our belief is that the retail stocking has ended and our retail business will remain stable for the reminder of this year.

In Europe, we have seen organic sales decline from 13% in Q1 to 17% in Q2 as compared to the same period last year. Destocking was still an issue as European OEMs – with European OEMs as more customers were seeing smaller orders with faster turnaround. As mentioned last quarter, we also think that the OEMs have overstocked in Q4 and we are still working off their inventories throughout the first half of this year.

Our organic OEM sales were up 24% from Q2 of last year. Our perception currently is wholesale inventories are at low levels, so we believe the destocking activity with the wholesaler has subsided. Sales to the wholesalers was down 9% organically in the quarter. Sales into Eastern Europe has remained depressed due to poor economic conditions. Credit – customer credit risk remain a major issue in Eastern Europe.

In our major markets we are seeing general slowness in all the areas. Germany OEM sales were light. We continued to see declines in Italy, driven by lower wholesale and export activity. Approximately half of our Italian operation serves as a feeder plant to sister companies throughout Europe, so under absorption in those areas was initially as demand in those plants weakened. Lower sales in France and Germany related to wholesale and DIY channel softness.

In turning our general outlook for the reminder of 2009, we hold our view that consolidated revenues will be lower compared to prior – comparable prior year’s quarter by 15% to 20%. We believe the US retail business has stabilized, but there is no real upside in the near term. Our US wholesale sales will continue to be challenged by the declining commercial sector and our major European markets are also in the effects of the recession.

We see the overall gross margins pending as anticipated during our last conference call. Under absorption will continue to be overwriting factor for the reminder of this year. We do see some potential margin expansion in Q3 as lower copper – cost copper run through our P&L, but we will lose some of that benefit through Q4 as higher copper prices that was recently purchased starts to bleed into our – through our inventory.

Please recall the benefits of our footprint reductions will not be realized until 2010. So we will continue to be challenged throughout 2009 by plant under absorption and potential plant moving in efficiencies later in the year.

Let me update you now on recent restructuring initiatives. As you may recall, the Board approved the program in Q1 to consolidate our manufacturing footprint in North America and China. In mid July, we announced to our employees one of the initiatives involved in this program.

We planned to relocate our Flex production from Langley, British Columbia and from Springfield, Missouri into one central campus in Kansas City. Our under the floor heating operations will still remain in Springfield, Missouri. This initiative will allow us to rationalize our Flex manufacturing, drive process efficiencies and provide central location for distribution throughout the United States and Canada.

The total cost estimate will be approximately $2.7 million including severance cost, shutdown cost, moving and startup cost. In addition, we expect to spend approximately $1.9 million in capital to outfit our new production site. We anticipate the move will be completely by Q2 of 2010 and provide they will provide us with annual savings of approximately $1.5 million. Other initiatives included in our overall footprint program are generally on track, but full announcements have not been made to our employees, so I am not able to discuss the details with you at this point.

Lastly, let me address our acquisition program. Although, we continue to make inquiries and are looking at several targets, our acquisition program has been somewhat muted given the state of the economy and our current philosophy on cash conservation. We believe we are in an advantageous position given our cash availability to get a deal complete and we have spoken with some interesting company, but nothing is eminent.

Now, I would like to turn the call over to Bill McCartney, who will take you through the financial highlights. Then, we will answer any of your questions. Bill?

Bill McCartney

Okay, thank you, Pat. We will run down some of the details here. Looking at revenue in the quarter, we closed at $312 million, that’s a decline of $72 million or almost 19% versus last year, even though we were up $17 million from Q1.

When you look at the $72 million or 19%, 16.5% was a decline from an organic standpoint, the foreign exchange rates, the weakening of the dollar caused us to have a negative growth of 4%. The inclusion of Blucher for a full quarter, as you may recall, we bought Blucher last year on June 1st, so now we have two extra months in Q2 this year that compares to almost 3%. And then as you also recall, in December of 2008, we disposed one of our business units in China, so that was worth $3 million or about 1% decline, because of that issue.

Just looking at the earnings from a US GAAP standpoint, we reported a loss of $0.10 per share that includes the loss from TEAM which is included in discontinued operations. If you look at continuing ops, we are in $0.41 a share and then when you again look at continuing ops without the restructuring charges, we are in $0.42 a share. If you compare that to last year, $0.56 a share, so only 19% decline in revenue, our EPS declined 25%. Off that $0.42, if you compare that to the first quarter which we earned $0.23. So we’ve got a nice improvement from Q1 relative to the results from operation.

North America, the revenue here $194 million, which has declined of about 17%. North America is where we saw the bulk of the increased revenue from Q1 and Q1 in North America we achieved a $178 million of revenue. But the decline in North America of 17% is a combination of 16t% from an organic standpoint and 1% from weakened foreign exchange rates, primarily the Canadian dollar, the average rate we use for the Canadian dollar in 2009 was $0.85 compared to $0.99 in Q2 ’08.

On the wholesale side which is where we achieved that $16 million increase. We had 154 – excuse me, $152 million of revenue which is a decline of 19% compare that to Q1 of $135 million. Again just to reiterate some of Pat’s comments and what we saw in Q2 was some destocking. We believe that we are close to that being essentially complete. We did some heavier destocking in Q1, so as we go into Q2, we get some seasonality.

We believe the inventory is approaching a much more of an equilibrium standpoint, but we are hearing that the wholesalers are going to be very vary of restocking, but nonetheless, we think that most of that is behind us. So any change in the end markets we should see a relatively quickly in our order entry rates.

Looking at the retail side, $43 million in the quarter that’s flat with Q1 and down about $3.5 million from last year’s Q2. When we look at that it’s really – we are feeling the pinch there primarily in the tile distributors which are dependent on new housing stops where we sell a lot of our under floor electrical equipment.

And last year, we also in Q2, we’re at the tail end of some heavy rollouts on some of our recirculation pumping equipment, so we are feeling there as well. But we also know that same-store sales for some of our larger customers (inaudible) and what not down between 8% to 10%. So it’s really – the decline is primarily due to the same-store sales decline in the US.

In Europe, the Q2 revenue was $109 million, just about flat with the Q1 this year and down 19% versus Q2 last year. That 19% we can classify it, 16.7% from an organic standpoint. The FX rates in Europe, the dollar weakened so that had contributed to additional decline of about 10%. The average rate we used in Q2 was almost $1.36 compared to $1.56 last year. And again we have the inclusion of Blucher for the full quarter, so that contributed 8%, so all that comes together 19%.

And again where we see saw the biggest impact in Europe was in our OEM business across all of our major markets in Europe. We know that a lot of customers because of the declining economy in Europe. They had closed their factories for a good period during the quarter. They’re really focusing on inventory reduction. They’re also due to some strikes [ph] as well with some of our customer base. So the combination of the weak economy, inventory reduction hurt our OEM business in Europe during Q2.

Looking at China, revenue of $9 million down from $15 million Q2 ’08, that’s a decline of $6 million or 41%. It’s really from an organic standpoint that explains about half the decline, we were down $3 million organically and that really is associated with declining sales for export sales out of China, primarily into Europe because of the poor economic conditions in that end market. When we look at our infrastructure sales in China, they were flat on the quarter versus last year.

The gross margin in Q2, 35.4%, that’s up comparatively 110 basis points and up sequentially by 220 basis points. As Pat mentioned, the major drivers of the improved margin in Q2, one is the inclusion of Blucher for a full quarter, as well as last year, we had one month of purchase accounting issues associated with Blucher that were required to amortize some of the purchase price under the US GAAP rules, so that’s behind us.

We also have the sale of our business unit in China, which was a money loser, so that’s behind us. We also have several operating – several of our units have operating improvements particularly in China. We also have our cost reductions that we have been implementing during the course of this full year.

If we look at the gross margin compared to Q1 of 220 basis points, a lot of it is due to the improved sales volume versus Q1, the operating improvements in China and at the tail end of the quarter, we started to expense some of the lower cost material as well. So good contribution in the quarter from the gross margin.

On the SG&A expenses, $81 million that’s flat with Q1 and down from Q2 ’08 by $15 million. As we walked across the reasons here, last year, we had $96 million in organic standpoint, we have decreased our expenses by $13 million, foreign exchange rates had a decrease of $4 million in SG&A, the inclusion of a full quarter of Blucher increases our SG&A by $4 million, and then a disposal of our business unit in China decreases our SG&A by $2 million. So that takes you from the $96 million down to the $81 million.

Operating earnings without the restructuring $29.2 million that’s a decline of about $7 million versus last year and an increase of about $13 million from Q1. When we look at the comparison to Q1 again that’s associated with the improved gross margin and the improved revenue. And when we compare ourselves to last year, the $7 million really is couple of factors here, one is from an organic standpoint, we lost about $8 million because of the decreased sales volume, we lost about $2 million because of the change in foreign exchange rates, the inclusion of Blucher for the quarter added about $1 million, the disposal of our Chinese business unit which was losing money increased our operating earnings by about $2 million.

Below the line, pretty steady quarter there comparing to last year, we were at $6.8 million, this year Q2, we are $5.4 million. Basically, it’s a change in interest rates that caused that. Interest income is down a $1 million, which is a function of lower interest rate and less cash on hand, because we used our cash towards the end of the quarter to acquire Blucher. And then interest expense is down about a $1 million and that’s a function of lower effective interest rates.

The tax rate is up 3 points to 34.2%. The major issue here is last year, the rate was a little bit low because of a change in some of the tax rules in Europe, which caused us to have a one-time credit and we also had a favorable tax audit that settled last year as well. So the 34.2% is a little bit more representative of a normal tax rate for us. It’s just that last year was a bit on the low side.

So we take that down to earnings per share again, $0.42 ex-restructuring and we really look at the quarter as a $0.39 quarter from an operating standpoint, because as Pat mentioned in this remarks, we had $0.03 of favorable legal settlements which is really one-time results for us. So from an operating standpoint, $0.39 compared to $0.56 last year and $0.23 in Q1.

And just a couple of statistics on the cash flow side, depreciation and amortization year-to-date $22.8 million, capital expenditures are $8.5 million.

So I think with that, I would like to open it up for any questions that you might have.

Question-and-Answer Session

Operator

(Operator instructions) Our first question comes from the line of Christopher Glynn of Oppenheimer. Please proceed.

Christopher Glynn – Oppenheimer

Good afternoon. So the gross margin burst in a few years and sounds like you are guiding up sequentially, did I hear that correct?

Bill McCartney

We don’t provide guidance. We are explaining that the margin was up and why it was up. I mean if you look at the reasons we talked about the inclusion of Blucher and Blucher will be here for the foreseeable future and we will not buyback our Chinese business unit. Operating improvements at WPT are (inaudible) guys are doing a nice job and the cost reductions are holding. I mean it’s – and I don’t want to say we are giving guidance on that, but we do – we are pleased with our margin performance.

Christopher Glynn – Oppenheimer

Okay. And just more talking about the directional trends, hopefully this can be taken outside the – straight I’d have asked for guidance. But directionally from the second quarter, you are seeing seasonality, it sounds like sequentially softening in the US non-res. But overall, what would you characterize the impact of the economy on seasonality you are seeing through the months?

Pat O’Keefe

Well you have the impact of the non-res, which is big negative impact. We have the retail probably being a push from quarter to quarter in terms of the environment there in terms of retail. In Europe, you probably have sequential, some softness going forward due to the fact that Europe in general has trended one quarter behind the US. And I would say you also have ongoing issues with regard to absorption, because we are managing for cash and that as a result, we are only building inventory when it's required. But you are going to have continued overhead absorption issues going into the next couple of quarters.

Christopher Glynn – Oppenheimer

The inventory is down nicely. Do you have a target inventory level or assuming sort of static business levels?

Pat O’Keefe

Yes, we have inventory turns established for each and every one of our businesses. In terms of how they rollup, I don’t have that number in front of me. But we are expecting that continue to manage inventories very constructively throughout the year.

Christopher Glynn – Oppenheimer

Okay. And last one, just the placement of the legal gains; you pick it as a reduction to SG&A?

Bill McCartney

Yes it is. Yes.

Christopher Glynn – Oppenheimer

Okay. Thank you.

Bill McCartney

Thanks Chris.

Operator

Our next question comes from the line of Jeff Hammond of KeyBanc Capital Markets. Please proceed.

Jeff Hammond – KeyBanc Capital Markets

Hi, good afternoon, guys.

Bill McCartney

Hi, Jeff.

Pat O’Keefe

How you’re doing, Jeff?

Jeff Hammond – KeyBanc Capital Markets

Pat, just back to your progression on the different markets, how should we think about this destocking impact or the abatement of destocking, is that – is that outweighed by underlying deterioration in non-res or is that positive delta 2Q to 3Q as it goes away?

Pat O’Keefe

I see the non-res deterioration being a pretty strong factor as we go forward. I also see the OEM market in Europe being downward pressure on the OEM market in Europe, particularly when you look at it and trying to comparative basis quarter-to-quarter to last year.

Jeff Hammond – KeyBanc Capital Markets

And is that the progression you saw through 2Q, whereas the quarter progressed, the declines accelerated?

Pat O’Keefe

Pretty much so. Yes, in both the European OEM and the US non-res.

Jeff Hammond – KeyBanc Capital Markets

Okay. And then –

Pat O’Keefe

In North American non-res.

Jeff Hammond – KeyBanc Capital Markets

Okay. And then just on back to the gross margin discussion, you talked about kind of the two structural changes with Blucher and China, but I’d imagine certainly, maybe you get some additional absorption issues, but commodity sound like there are an incremental (inaudible). Can you just talk about price cost gap in 2Q and quantify maybe how much that – how much more of tail wind into 3Q, 4Q?

Pat O’Keefe

Yes, I see the pricing being a little bit more favorable in Q3. And then at Q4, you’re going to start seeing it rollover on it again and you are going to see late in the quarter the material starting to rise. So we tend to be probably five months or so in arrears in terms of when copper and when our other raw materials run through our P&L. I would tell you in Europe, probably we are going to see similar that you will see some margin expansion during the third quarter and end in the fourth quarter, but softening as you get closer to the end of the year.

Jeff Hammond – KeyBanc Capital Markets

Okay. And then just shifting gears, the China business is kind of been bouncing around, profitable, not profitable. I think with this divestiture, you show a small profit. Is that something you think is sustainable and how do you think of the long-term run rate of margins for that business?

Pat O’Keefe

Yes, I don’t think we are done fixing China by any means. But I think we now have at a point where it’s more stable than it’s been in the past. So I think you probably see some stability there in terms of going forward.

Jeff Hammond – KeyBanc Capital Markets

Okay. Thanks guys.

Pat O’Keefe

Okay.

Operator

Our next question comes from the line of Mike Schneider with Robert W. Baird. Please proceed.

Mike Schneider – Robert W. Baird

Good afternoon, guys. Maybe first just on the under absorption question, I think last quarter you quantified and ended about $8.5 million. You have a number billed this quarter as what you think under absorption cost is?

Bill McCartney

Yes, it’s going to be somewhere in the neighborhood of 7, 7.5, I guess less than Q1, but still a meaningful number for us.

Mike Schneider – Robert W. Baird

And going into Q3, I presume as you have remedied the inventory situation more so that number will decline again.

Pat O’Keefe

I mean as more of these end markets ended destocking continued with our inventories, things just reach a new equilibrium and that becomes less of an issue. But when you have sales declines of 16%, 17%, the issue does not go away.

Mike Schneider – Robert W. Baird

Sure.

Pat O’Keefe

And so, I think it’s a gradual – it’s a part where we would expect some gradual improvement there.

Mike Schneider – Robert W. Baird

Okay. And then in Europe, the August and there were August holiday shutdowns, can you give us a sense of do you actually expect Europe to deteriorate further based on the holiday shutdowns, just what are you hearing from your OEMs in terms of their production schedules?

Pat O’Keefe

You got to remember, Mike, the holiday shutdowns are an annual thing. So they did last year, they will do it this year and they will do it from now till time that I am still in the business. But typically what you see is, there is a lot pre-buying before they go on holiday and there is a lot of buying in anticipation where they place POs for delivery just after they have returned. So we are not – we are thinking that that’s probably a year-over-year factor will be negligible.

Mike Schneider – Robert W. Baird

But I guess what I am referring to is like the US over Easter and Christmas, one would suspect that your OEM customers in Europe are going take 60 days off and not 30 days off this fall, what are you hearing from them?

Bill McCartney

Well most of the customers they are on in Q2 are on reduced work schedules already. But I don’t – we don’t see that that is going change during Q3.

Pat O’Keefe

Yes. All the customers I’ve had contacts with my (inaudible) have been on furlough for most of May and most of June. And holiday season as you know begins here in July and August, so I think they’re probably going to use a different methodology to get hours out of the plan, but I don’t think it’s going to have a substantially different impact.

Mike Schneider – Robert W. Baird

Okay. Then, switching to US retail, the revenue being flat sequentially seems to me to suggest there was no seasonality you have seen in the renovation market this spring, yet others are talking about I guess at least some seasonality in household products. Is there something unusual about rollouts or maybe products shelf space actually coming out that would explain why the sales were actually flat sequentially?

Pat O’Keefe

I think number one – one thing about our retail is that we have talked about occasionally the (inaudible) Mike is that we have a little bit more choppy results, because we tend to do a lot of rollouts and what not. So there is no significant shelf space or anything like that that we are losing. But last year we had some significant rollouts in Q1 and Q1 with a hot water recirc pump. And this year, we are feeling the pinch more than normalizing because of the lower housing starts on that’s particularly on the tile distributors, not necessarily the big box guys, but on the tile guys that we sell some under floor heating equipments through that channel.

Mike Schneider – Robert W. Baird

Okay. And because their – because the sales were flat sequentially, ordinarily retail sales I believe for you would be down sequentially in Q3. I guess what have you seen in July and what’s your understanding or modeling for Q3 retail.

Bill McCartney

I think Pat mentioned earlier that we think we are sort of at a static run rate I think the wording you used, right, for retail.

Mike Schneider – Robert W. Baird

Even accounting for the seasonality in 3Q.

Bill McCartney

Yes.

Mike Schneider – Robert W. Baird

Okay. And then those were the final question on materials. Gross margins as you said were up 220 basis points sequentially. What amounted materials contribute to that 220?

Bill McCartney

It would have been a small piece of it, Mike, because we didn’t really start getting the cheaper materials. Some of the divisions had cheaper materials running into the numbers starting in June. It wasn’t one of the major contributors.

Mike Schneider – Robert W. Baird

Okay, thank you.

Bill McCartney

Okay.

Operator

Our next question comes from the line of Keith Hughes of SunTrust. Please proceed.

Keith Hughes – SunTrust

Thank you. I was a little confused with some of your previous comments. If you look at your European residential focus products, did business get sequentially worse from the first to the second quarter?

Bill McCartney

Well, I mean Europe from Q1 into Q2 was flat. The – we did see more of a deterioration on the OEM business, Keith, which is really we are selling in some of that alternative energy space and it’s really we think a result of both the economy and these – this particular end markets doing an awful lot of destocking, because they just got ahead of themselves. The wholesale side was only down about 9%, which is going to be residential and commercial.

Keith Hughes – SunTrust

Okay. All right, and final question, the corporate expense is not pretty significant year-over-year, besides just the cost cutting you have been working on, was there any other items in there?

Bill McCartney

That will you see the benefit of some of the favorable legal settlements that we’ve discussed.

Keith Hughes – SunTrust

Okay. So it will be on that line. All right. Thank you.

Bill McCartney

Okay.

Operator

Our next question comes from the line of Michael Gaugler of Brean Murray and Carret.

Michael Gaugler – Brean Murray and Carret

Good evening, every one.

Pat O’Keefe

Hi Mike.

Bill McCartney

Hi Mike.

Michael Gaugler – Brean Murray and Carret

Nice job on the quarter by the way.

Pat O’Keefe

Thank you.

Michael Gaugler – Brean Murray and Carret

Pat had mentioned in his opening remarks the pricing environment remains challenging and I have noticed that one of your key raw material cost copper business is steadily moving higher. I am wondering if you had any thoughts or perhaps any different strategies regarding copper particular going forward as your end markets recover hopefully sometime in 2010, perhaps maybe doing a little pre-buying or some type of hedging, because I would anticipate there is a raw material cost rise faster than your – or come before your ability to reprice?

Pat O’Keefe

Yes, you are pretty much correct. The environment right now to get price increases is not very robust. So we – although in a quarter if you read in my comments, we had downward pricing pressure. But overall, when you look at Watts on a consolidated basis, I don’t think pricing pressure was a significant factor in this quarter. Now it’s going to become a problem as we go forward, because – and particularly copper has been rising for sometime and it is probably going to continue to rise.

So we do have approximately a four-month hedge in terms of our natural buying patterns. But you are going to see – you are going to see some pressure later in the year on our margins as that higher cost raw material starts through our inventories in indoor cost of goods sold. As far as 2010 is concerned, I would have taken a look at that, but we don’t have – we not – haven’t developed a strategy with regard to that.

Bill McCartney

Mike, historically, our habit has been that we do not do financial derivatives in the future contracts and swaps and what not on commodities. But we do allow our divisions to make some commitments on the actual deals with vendors that makes sense and we will allow it to go out an extra couple of months when it makes sense. And we are always examining that strategy because it plays an important part of our profitability. But I would imagine that strategy will probably be the same in 2010. But as Pat says, we haven’t finalized anything yet. But we’re always looking for good advice and re-examining our strategy.

Pat O’Keefe

I think you are right by the way that you will see pricing pressure before you see the cost pressure with what you see pricing opportunity.

Michael Gaugler – Brean Murray and Carret

Okay. Most of my questions have been answered. Again, thanks guys and nice quarter.

Pat O’Keefe

Thank you.

Bill McCartney

Thank you.

Operator

Our next question comes from the line of Scott Graham of Ladenburg Thalmann. Please proceed.

Scott Graham – Ladenburg Thalmann

Hi, good afternoon.

Pat O’Keefe

Good afternoon. Hi, Scott.

Scott Graham – Ladenburg Thalmann

A couple of questions on the gross margin which – that was a really good number and I am just wondering when you read off the benefits to gross margin in the quarter, Blucher, sale of China, operations improvements in China and cost reductions, should we look at that is sort of a tiering of kind of how the most important to least important or will you just put them out there?

Pat O’Keefe

No, we will display them out there. They’re all important enough factors to mention, so we just thought we – we are not suggesting that one is more important and what has more of have an effective than other one.

Scott Graham – Ladenburg Thalmann

Okay. But I am guessing though that cost reductions, because most of your strategies are due towards next year that might be a little less than the others or is that not right?

Pat O’Keefe

Well, I would say that the operating improvement in China the guys that are working on are very important contributor and the cost reductions would be a little bit less, I would agree with that. And then the sale of that business unit is China was also important.

Scott Graham – Ladenburg Thalmann

Okay.

Pat O’Keefe

Adjustments probably are the lower before that we mentioned.

Scott Graham – Ladenburg Thalmann

Right. Fair enough. And so if I look at your SG&A number, which on a year-over-year basis was obviously down a lot, how much would you say in SG&A was sort of structural cost versus the volume?

Pat O’Keefe

$1.5 million net benefit because of those legal settlements, that’s in SG&A. And then be a couple of million dollars would be reduced selling expenses commissions and freight and the reminder would be a lot of the cost reduction, the reduction for – the wage reductions and so on that we have been doing.

Scott Graham – Ladenburg Thalmann

I think you said that number was like $6 million on a year-over-year basis in the first quarter, so that would have accelerated a little bit in the second quarter.

Pat O’Keefe

It’s at least equal for that.

Scott Graham – Ladenburg Thalmann

Yes, okay. I was also wondering about some of the things that you’re doing in China. I mean, obviously stats [ph] is doing a great day in improving the operations. Could you give us an idea, if we look at last year, which was a loss of call it, around at $3 million, what piece was sale of the operation versus what piece was the operating improvements, but it won’t come up to the million?

Pat O’Keefe

The disposal of that business unit contributed $2 million to operating earnings this year versus Q2 last year. And our operating earnings in China, in total improved by $3.6 million. So two of the three sixes are disposal of the unit, the rest of it is operating improvement.

Scott Graham – Ladenburg Thalmann

Got you. So I had. Thanks a lot.

Pat O’Keefe

Okay.

Operator

Our next question comes from the line of Michael Coleman of Sterne Agee. Please proceed.

Michael Coleman – Sterne Agee

Hi, good afternoon, guys.

Pat O’Keefe

Hi, Michael.

Michael Coleman – Sterne Agee

Kind of you just answered this, but do you have an estimate for what that TWT business lost in the third quarter or the fourth quarter of last year?

Bill McCartney

I don’t have with me, but I would – the estimate would be approximately the sustained run rate as probably and maybe a little bit less than we saw in Q2.

Michael Coleman – Sterne Agee

For both third and fourth quarter.

Bill McCartney

Right.

Michael Coleman – Sterne Agee

Okay, great. And the tax rate either for the year or the back half of the year, what do you think?

Bill McCartney

I would use 33.5%.

Michael Coleman – Sterne Agee

Okay, thanks.

Operator

Our next question comes from the line of Jim Foung of Gabelli & Company. Please proceed.

Pat O’Keefe

Hi Jimmy.

Jim Foung – Gabelli & Company

Hi, good quarter, guys. I guess it was just a couple of items. In terms of cost reductions, how much did you realize in the second quarter and how much would you anticipate in the second half of this year that will be incremental to the second quarter?

Bill McCartney

Well, I think we just spoke when we were speaking with Scott; we were in that neighborhood of about $6 million.

Jim Foung – Gabelli & Company

Okay. In Q2, right?

Bill McCartney

In Q2. And we are not really forecasting an increase there for Q3 and Q4, but we are working on it and we are continuing to reduce our headcounts selectively. We have our factory managers focused on productivity and purchasing guys on cost reductions, material and so on. That’s not really guiding anyone from more than we’ve already done now.

Jim Foung – Gabelli & Company

Okay. But you have more restructuring actions in place which you implement?

Pat O’Keefe

We were working on a water restructuring project. A lot of them have been announced and others that we’re working on that are smaller and into the normal and ongoing in nature. So I mean that’s one of the things we do for living Jim is cut costs.

Jim Foung – Gabelli & Company

We can’t do that too here. In terms of Blucher, did you get all the margin improvement in Q2, in Blucher or is there more incremental improvement coming in the second half of this year?

Pat O’Keefe

Well we think that the issue of Blucher is that we do have margin improvement there versus last year. The issue with Blucher is that they are suffering from some decreased revenue just like the rest of our businesses. But in terms of the margin percentage where that Blucher is generating, we are pleased with that.

Jim Foung – Gabelli & Company

Could you give us that percent?

Pat O’Keefe

Well, their operating earnings are going to be somewhere around 15%.

Jim Foung – Gabelli & Company

15% okay. And you kind of reached that target in Q2?

Pat O’Keefe

We are doing, yes.

Jim Foung – Gabelli & Company

You’re doing that, okay. And then also lastly, the material costs, I guess and it’s giving us like your average cost of copper, because you work on kind of – you buy sporadically or irregularly. What was your average costs in Q2 for copper and where do you think it will be in Q3?

Pat O’Keefe

About – hope $3 a ton.

Jim Foung – Gabelli & Company

$3 a ton in Q2.

Pat O’Keefe

Yes. And then as we get into Q2, it will be in the low $2 range.

Jim Foung – Gabelli & Company

You mean Q3, right?

Pat O’Keefe

Increasing in Q4.

Jim Foung – Gabelli & Company

Okay. Low $2 in Q3. And then how much is in Q4?

Pat O’Keefe

It will be probably close to 250 because this – the copper spot right now is 250.

Jim Foung – Gabelli & Company

Okay, all right. And then – okay. And when do you think you will get back to the $3 range again?

Pat O’Keefe

Well, you tell me when copper is going to be $3; the answer is four months later.

Jim Foung – Gabelli & Company

All right, good. Okay, thanks very much.

Pat O’Keefe

Okay, Jim.

Operator

Our next question comes from the line of Michael Roomberg of Boenning & Scattergood. Please proceed.

Michael Roomberg – Boenning & Scattergood

Hi guys, good afternoon.

Pat O’Keefe

Hello.

Michael Roomberg – Boenning & Scattergood

Congrats on a little first three nice quarters given the environment. On the pricing side, I want to focus less on the cost of goods sold, want to zero in on the different channels that you guys sell through. Have you seen any specific pricing pressure during the quarter? Could you kind of walk us through the different channels that you sell through and give us some outlook on what you expect to see now that the price of copper has come down, whether or not that looks to be more – you love to see more – you expect to see more pushback from your customers?

Pat O’Keefe

I don’t necessarily believe that cost of copper has come down. It’s starting to move back up. One of the reasons that I said that we didn’t have a significant issue with pricing in a quarter is because copper was in essence moving upward and customers are recognizing that asking for price increase is going to be responding whether no we can’t afford it given the cost of copper that’s coming at us. So we really to a certain extent we are getting pressure from competitors who are doing things to try to get some volume in the door. But in general, the response from the customers in general is that they recognize that copper is moving against all of us at this point in time.

Michael Roomberg – Boenning & Scattergood

Right. Okay. Thank you.

Operator

(Operator instructions) Our next question comes from the line of Jamie Sullivan of RBC Capital Markets. Please proceed.

Jamie Sullivan – RBC Capital Markets

Hi, good evening.

Pat O’Keefe

Hello Jamie.

Jamie Sullivan – RBC Capital Markets

Wondered if you could just remind us as with all of the restructuring that you have done what you expect the incremental savings and as you go into next year, where you expect that to be.

Pat O’Keefe

The – what we have discussed in the past is that the restructuring programs that we have announced and that we are working on will generate $5 million after-tax savings and those will start to come into the number during early 2010.

Jamie Sullivan – RBC Capital Markets

Okay. Great. And then you started a little bit about seeing some expedited orders from customers. Can you talk about any trends there? Has that stayed the same as they’re looking or vary of building inventory, if you can comment on that?

Pat O’Keefe

I think in general, we are seeing that in both the North America and we’re seeing in Europe as well that the size of the orders are being reduced and then the number of times they are asking for shorter lead times, can we meet at shorter lead time is – I have mentioned in my opening comments specifically in Europe, but I think it’s also been true, we saw extensively in the second quarter in North America as well. It’s just an indicator – it’s a good indication to us when we are nearing the bottom in terms of the destocking process.

Bill McCartney

That’s why it’s so critical Jamie for us to have good fill rates and delivery rates with our customers, because when times are tough like this they depend on us for quick deliveries and we tend to get that business right way.

Pat O’Keefe

I think that showed up in the second quarter with the – we did better than we expected partially because of the fact that we were from an operating point of view, delivering on a timely basis.

Jamie Sullivan – RBC Capital Markets

Okay. Thanks. And if you could just comment I guess on the various stimulus packages around the world, if you are seeing any benefit in your businesses?

Pat O’Keefe

The one in the US is hard to quantify, because there is so many limitations with regard to it, particularly they make America as the requirements of that part particular bill. But we are seeing and have continued to see stimulus bills in Europe, particularly with those that are tied to energy conservation that have been we have taken advantage of and we think that it’s not stopping us from having declines in revenue, but it’s probably a cushion underneath us so that we are – we would have saw deeper declines had we have not seen some of those programs in place, particularly in the OEM sector in Europe, where we make a lot of products for oil and manufacturers that are energy conservation related.

Jamie Sullivan – RBC Capital Markets

Okay. And how about in China, are you seeing anything there?

Pat O’Keefe

Not really. Nothing that’s actually benefiting us directly.

Jamie Sullivan – RBC Capital Markets

Okay. All right, thanks. That’s all I had.

Pat O’Keefe

Thank you.

Operator

With no further questions in queue, I would like to turn the call over to Pat O’Keefe for closing remarks. Please proceed, sir.

Pat O’Keefe

Yes. I just want to take the opportunity to thank everybody for joining us today. Needless to say, this was a pretty positive quarter, one that exceeded our expectation and I look forward to seeing you on the call for the third quarter results in late October. Thank you.

Bill McCartney

Thank you.

Operator

Thank you for your participation in today’s conference. This concludes the presentation. You may now disconnect and have a great day.

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