Watts Water Technology, Inc. Q3 2009 Earnings Call Transcript

Oct.28.09 | About: Watts Water (WTS)

Watts Water Technology, Inc. (NYSE:WTS)

Q3 2009 Earnings Call

October 27, 2009 5:00 pm ET

Executives

Kenneth LePage – General Counsel

Patrick S. O’Keefe – President, Chief Executive Officer & Director

William C. McCartney – Chief Financial Officer & Treasurer

Analysts

Kevin Maczka – BB&T Capital Markets

Richard Paget – Morgan Joseph & Co., Inc.

Michael Schneider – Robert W. Baird & Co., Inc.

Christopher Glynn – Oppenheimer

Jeffery Hammond – Keybanc Capital Markets

Scott Graham – Ladenburg Thalmann & Co.

Todd Vencil – Davenport & Company, LLC

Ryan Connors – Boenning & Scattergood, Inc.

Jamie Sullivan – RBC Capital Markets

[Michael Coleman – Watts Water Technology]

Operator

Welcome to the Q2 2009 Watts Water Technology earnings conference call. At this time all participants are in a listen only mode. We will conduct a question and answer session towards the end of this conference. (Operator Instructions) I would now like to turn the call over to Mr. Kenneth LePage, General Counsel.

Kenneth LePage

Welcome to the Watts Water Technologies third quarter 2009 earnings conference call. On the call with me today are Pat O’Keefe, President, 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 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 those forward-looking statements as a result of various factors including those discussed under the heading risk factors in our annual report on Form 10K for the year ended December 31, 2008 and other reports we file from time-to-time with Securities & Exchange Commission.

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 other date. While we may elect these forward-looking statements, we disclaim any obligation to do so. 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 third quarter financial results a copy of which may be found in the investor relations section of our website at www.WattsWater.com under the heading press releases. I will now turn the presentation over to Pat and Bill.

Patrick S. O’Keefe

Welcome to our third 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 the individual sector results and then we will address your questions. First, I must mention the outstanding job our employees have achieved in maximizing cash flow not only year-to-date but especially during the third quarter. In the first six months of 2009 we generated $74.5 million in cash from operating activity. In the third quarter alone we almost matched that generating $73.3 million in cash from operating activities.

Our cumulative year-to-date total cash generation by operations is $147.8 million which is 63% more than the $90.4 million of cash generated from operating activity in the first nine months of 2008. We achieved this despite a 37% reduction in year-to-date income from continuing operations due to our continued focus on working capital management, our cost savings initiatives and lower commodity costs. Our free cash flow for the first nine months of this year approximated $132.5 million an 89% increase over 2008 comparable free cash of $70.2 million. Again, as a result of working capital management and also closing managing our capital spend. Cash flow generation as we talked about before remains a key driver to our company. \

As a result of our efforts to maximize cash we expanded our liquidity through the third quarter. As of September 27, 2009 our net debt to capital ratio was 12.2% which compares favorably to the 22.8% at December 31, 2008. We had approximately $233 million of cash on hand versus $166 million at December 31st. Our cash position has increased even though we paid down debt of approximately $61 million during 2009 including completely paying down our line of credit and we maintained our dividend consistent with the prior year paying $12.2 million in dividends through September. We believe the added liquidity provides us with the flexibility that we need to ride out this recession.

Now, I’d like to talk briefly about our results for the Q3. Let me address a couple of large onetime charges that affected our P&L during the quarter. First, included in our restructuring and other charges is a $5.5 million non-cash pre-tax write down of land and building at one of our facilities. This facility is included in the manufacturing footprint consolidation program we announced earlier this year. We are moving part of the operation of this facility to an existing manufacturing location and the remaining manufacturing operations will be either moved or outsourced.

We are currently negotiating to sell the facility to a potential suitor. As part of that negotiation we have determined that the net book value assigned to the land and building are no longer supported by their expected future cash flow which is primarily the proceeds from the sale. Therefore, we recognize the impairment of those assets in this quarter.

The other large adjustments relates to the charge of $8.2 million of which $5.9 million is non-cash taken to discontinue operations in the quarter. This charge is primarily for the operating loss and estimated loss on the disposal of Watts Valve Changsha or CWV. CWV is the Chinese manufacturer of large diameter butterfly valves used primarily in China’s various infrastructure and water markets including hydropower, thermal and nuclear power. We discovered during the past quarter that CWV sales methods may be in violation of the foreign corrupt practices act FCPA. You may recall we disclosed this issue in the second quarter 10K. An investigation by our outside council of CWV’s sales practices is ongoing. We are currently marketing the company through an investment banker and hope to finalize a sale within the next six to nine months.

Our operating results prior to restructuring charges exceeded our own internal expectations. Sales were in line with our expectations and we delivered solid gross margin performance in Q3 slightly better than we had anticipated. Gross margins were 310 basis points higher than Q3 of 2008 and sequentially were 60 basis points greater than Q2 of 2009. Although pricing pressure remains a constant issue in our market price erosion was not a major factor during this quarter.

Operationally, gross margins were higher versus Q3 of last year due to lower raw material costs, lower reset costs and efficiencies in our operations both in China and in Europe. Further, our gross margin increased due to the sale of TWT which was in our results through mid October of 2008 an in addition acquisition charges related to Blucher negatively impacted last year’s margins. These margin enhancements were partially offset by overheads that were not fully absorbed due to reduce sales volume especially in the commercial sector. The sequential margin increase from Q2 was mainly due to lower raw material costs.

Operating margins for Q3 of 2009 were fairly consistent with the same period in 2008, declining by 10 basis points to 8%. Restructuring costs reduced margins by 210 basis points and 20 basis points in 2009 and 2008 respectively. Currency swings from year-to-year negatively impacted operating earnings by $0.01 but this swing was less than we had anticipated as the Euro has been steadily gaining ground against the US dollar. At current fx rates we expect the Euro will have a positive effect on earnings in the fourth quarter of this year in relation to the fourth quarter of 2008.

Looking at our major end markets, the US commercial market remains depressed. Sales in to the US wholesale channel in Q3 declined 21% organically against Q3 of 2008. We had experienced 18% declines in wholesale sales versus comparable prior year periods in both Q1 and Q2 though the market is far from recovering at this point. While we believe the majority of the destocking with wholesalers has subsided, they still remain cautious in terms of rebuilding their inventory.

The American Billing Index, ABI was 43.1 in September although activity has picked up since earlier this year when the index stood at 33.3. This predictor indicates that the commercial construction will remain depressed throughout at least the next nine months. As mentioned by the American Institute of Architects in their September press release, factors such as tight bank credit, requirements for bigger developer equity stakes and conservative appraisals had made project financing very difficult. So, our near term outlook for the commercial sector has not changed. We expect to see continued deterioration throughout the commercial market place at least through the first half of 2010.

Our organic US retail sales in Q3 were 6.6% higher than Q3 of 2008 and sequentially flat with Q2 and Q1 of this year. Part of the increase was due to the timing of product resets performed in Q2 of last year and the remainder is due to the increase in volume of new product introductions and market share gains. Consistent with our discussions last quarter, we think that our retail business will remain stable and that substantially retail destocking has ended.

In Europe our organic sales declined by 17% in Q3 which was in line with Q2. As mentioned last quarter, more customers are seeking smaller orders with faster turnaround. Organically, OEM sales were off 26% from Q3 of last year which compares to a 24% reduction in the second quarter. Our perception currently is that wholesale and OEM inventories are at very low levels though we believe that their destocking activities have subsided. However, we think OEMs will continue to manage inventories very closely in order to conserve cash as the year end approaches.

Sales to wholesalers are down approximately 10.6% organically in the quarter versus 9% in Q2. Sales in to Eastern Europe have remained depressed due to poor economic conditions. Some currencies in Eastern Europe are beginning to show recovery against the euro but customer credit remains an issue. In our major geographical markets of Germany, Italy and France we believe the economies have touched bottom and have stabilized. We are currently flexing our work force as needed to expected production levels.

Now, I’d like to discuss our outlook both for the remainder of 2009 and how in general we see 2010 shaping up. For Q4 we expect the rate of sales decline will be between 10% and 15% versus Q4 of 2008 which is lower than the 15% to 20% we have experienced year-to-date. This reduction in sales is not necessarily signaling an uptick in business so much as Q4 in 2008 was the first quarter we started to experience a decline in US sales so comparables are more in line with the previous quarters.

We now believe Q3’s gross margin levels will be maintained through Q4. We had previously expected to lose the benefit of lower copper as Q4 has progressed by higher priced metals are not affecting our P&L as anticipated and the increases in Q4 due to higher price commodities will likely be offset by better absorption and other production efficiencies. We estimate that $1.2 million of FCPA costs will be charged to operating results in Q4 which is about $700,000 more than we recorded in Q3.

Now, looking in to 2010 in general we expect the first half of the year to be very challenging as the US commercial market tries to find a bottom and the US retail and the European markets slowly begins to crawl out of a recession. Overall, we see year-on-year reductions in commercial sales of 10% to 15% with more of that reduction weighted in the first half of the year. We see US retail as stable with growth anywhere from flat to up 3%. We see overall European markets up 3% for the year with most of the growth in the European markets registered in the latter half of 2010.

With regard to gross margins, please realized 36% of sales as we did in the Q3 is an historical very high level for us. In 2010 we expect gross margins will be affected by higher commodity costs especially copper based products. We are making plans to increase prices in certain product lines to offset commodity increases. We hope that we can be effective in passing along commodity costs as we have done in the past but at the same time I want you to realize the sustainability of any price increase will be market driven.

We also believe our margins will be impacted by exposure to the commercial market downturn. In the commercial end markets which are expected to be off 10% to 15% we are currently predicting that we will have a mix and volume issue which will negatively affect our 2010 gross margin. On the plus side, we expect to receive some benefit starting in late Q2 from our footprint consolidation initiatives which I will discuss with you in a moment. Just one note regarding liquidity, next year $50 million of our private placement is coming due in May of 2010. We presently expect to fund this payment through operations.

Now, let’s talk for a moment about our restructuring initiatives. The pex production relocation project which was mentioned last quarter is moving along as anticipated. This initiative will allow us to rationalize our pex manufacturing, drive process efficiencies and provide a central location for distribution throughout the US and Canada. We are still estimating total cost of $2.7 million including severance costs, shutdown cost, moving costs and setup costs.

In addition, we expect to spend approximately $1.9 million in capital to outfit the new production site. We anticipate the move will be completed in the latter part of the second quarter of 2010 with annualized savings of approximately $1.5 million. As mentioned earlier, we took a non-cash charge of $5.5 million for our manufacturing facility that is part of our footprint consolidation exercise. We expect to announce our intentions to close this facility to all the affected employees during the fourth quarter.

To date we have taken a pre-tax restructuring charge of $1.3 million related to this project for both severance and moving costs. Once the project is finalized which we estimate to be during the second quarter of next year, we anticipated annual savings of approximately $1.5 million. Last, let me address the acquisition program. As you know, it’s been a quiet year on the acquisition front. We presently are reviewing a number of acquisition candidates on various stages of review and due diligence. As always, we continue to look at potential deals and as previously discussed we believe we are in an advantageous position given our cash availability to get a deal completed.

With that, I’ll close of my comments and turn it over to Bill McCartney who will take you through the financial highlights.

William C. McCartney

As Pat mentioned, revenue closed at just under $304 million which is a decline of $68 million or 18%. Factors there on the 18% first of all organically were down $61 million which is 16%, the foreign exchange adversely impacted us to the tune of $5 million or 1% and then the disposal of TWT last year was a reduction of $2 million of revenue there for half a point.

We look at the earnings per share of $0.09 on a GAAP basis. I think the way we look at it is we would add back in our discontinue operations charge of $8 million which is $0.22 and then we would add back in our restructuring charge of $5.8 million after tax which is $0.16. When you adjust for those items we believe we have an operating quarter of $0.47 per share. That would compare to last year at $0.46 per share when we had again $68 million of incremental revenue. The restructuring charge of $5.8 million was recorded in SG&A and is primarily the result of marking to market the assets which are in China which are going to be sold.

Now, just looking at some of the segments, North America at $182 million, almost $183 million was down 16%. The biggest chunk of that was wholesale which closed at $140 million which is down 21% versus last year and that’s without the foreign exchange. With the fx, we closed at $139 million. That’s down about $14 million versus Q2 which about half of that is a normal seasonal change and half of that is the result of some of the commercial markets starting to slide. Again, as pat mentioned, we continue to see softness in the residential and the commercial is starting to slide. Really no restocking is seen yet and no meaningful uptick on residential at this point in time.

On the retail, $43 million which is an increase of 6% or about $2.5 million primarily the result of some new product introductions as well as picking up some additional shelf space in the retail space. In Europe we closed at $116 million which is a decline of 19% or $28 million. The factors there are decline organically of $24 million which is about 17% and then the change in the foreign exchange rates resulted in Europe’s revenue declining by $4 million or 2.8%.

This year our average translation rate for the euro in the third quarter was $1.43 versus last year at $1.48. I think you have to remember when we’re looking at Europe on a comparable basis, last year we had very strong energy quarters and we had some channel fill as well. This year as a result of the impact of the bad economy, we saw a decline particularly on the OEM side and that was reflected across most of our European countries. Germany was down about 20%, Italy 25%, France 15% and you see softness in Eastern Europe and Northern Europe as well.

China, closed at $4.8 million a decline of $4.1 million. Of that $4.1 million, $2.1 is a decline from an organic standpoint. That’s primarily the result of lower exports from China to the European market. We also have a decline of $2 million because of the sale of TWT last year and just as a reminder, now that we are treating Changsha as a discontinued operation their numbers are no longer included in our China segment.

The gross margin at 36%, that’s an increase of 310 basis points versus last year and an increase of 60 basis points versus Q2 of this year. The increase from Q2 is really the result of lower metal running through cost of goods sold and as Pat mentioned earlier, the improvement versus last year is the result of several things. One is the sale of TWT and [inaudible] so those lower gross margin companies are no longer in our numbers. We are no longer amortizing the purchase prices of Blucher which we were in the third quarter of last year. We have seen some significant improvements in operating efficiencies in one or our Chinese companies versus last year and we continue to see the impact of some of our lean projects resulting in labor efficiency.

Now, we obviously have lower cost metal running through the P&L this year versus last year however, that benefit is primarily offset through the overhead absorption variances that we see as a result of the lower volume. Again, as Pat mentioned, as we expect to see some of the higher price copper running through the P&L early in 2010 we are looking at price increases to offset that.

The SG&A at $78.8 million is a decline of $12.6 million or almost 14% and that’s down a couple of million versus Q2 when we recorded $81 million of SG&A so our cost reduction program is continuing to be effective here. When you look at the decline from last year $91 to $79 million this year, organically we are down $10 million which is the result of cost reductions and lower variable selling expenses. Foreign exchange declined SG&A by about $1 million and then the disposal of TWT results in a decline of $1 million as well.

Bringing us down to operating earnings, again if we exclude the restructuring charges that we recorded we would show operating earnings of $30.6 million. That’s compared to last year at $31 million so we’re approximately the same operating earnings ex restructuring which is reflects 180 basis point improvement versus last year. Again, if you compare us to Q2 on a sequential basis we’re up about $1.5 million in operating earnings ex restructuring and that’s reflective of about $10 million less in sales which includes operating earnings as a result.

Below the line we went from $6.6 to $4.7 million versus Q3 last year primarily the result of lower debt and lower interest rates on the effective debt. The tax rate almost 41% in the quarter compared to 31% last year. The increase is really due to the fact that when we took the restructuring charge of almost $4.5 million of that was an item that we could not tax benefit. So, if you remove that item from the calculation our tax rate would have been closer to 33%. The impact of 41% is really from that item that we did not tax benefit.

Again, the net income ex restructuring $17.4 million about a $500,000 increase versus last year and again, we believe we had a $0.47 earnings per share from an operating standpoint ex restructuring. Just one note before we open up for questions, our depreciation and amortization on a year-to-date basis of $34.4 million and our cap ex at $15.3 million. With that, we’d like to open it up to any questions you might have.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Kevin Maczka – BB&T Capital Markets.

Kevin Maczka – BB&T Capital Markets

I guess my first question is on pricing, you made some comments there that price erosion has not been an issue so far. It sounds like with raw materials ticking back up, you’re looking to go back to the market for more price. I guess, can you just comment with the top line outlook you gave for 2010, what kind of assumptions are you making there and what is the market look like? Does it look to be receptive to price increases right now?

Patrick S. O’Keefe

I’d say it’s too early to tell with reset activity. We all are affected by the same raw material escalation that we anticipated. We’re seeing it already in terms of purchase orders that we’re placing in to the market. With regard to what happened in the third quarter we really saw pricing being relatively stable and even throughout the quarter consistent with what we saw in the second quarter. We anticipate to be honest with you, in the fourth quarter of 2009 for it to be consistent as well.

William C. McCartney

The other point I’d like to make there Kevin, just reading the transcript of some of the companies that have released, quite a few of them have mentioned price increase coming early in 2010 as well so we’re not alone in this regard.

Kevin Maczka – BB&T Capital Markets

Bill, what’s your view on the channel inventory now. We went through such destocking for so many quarters and maybe we’re reading to see some restocking now. What’s the channel look like?

William C. McCartney

Well, our belief is that the channel looks pretty skinny at the moment.

Patrick S. O’Keefe

We don’t believe that there’s going to be any restocking here in the fourth quarter because people are going to play their cards pretty close to their chest with regards to balance sheet at December 31st. We see no restocking whatsoever in the fourth quarter.

Kevin Maczka – BB&T Capital Markets

Then just quickly on the market share gains you referenced at retail, can you put any numbers to that or more color? Maybe who you’re taking share from?

William C. McCartney

We have the normal competitors out there Kevin that we always talk about. This is some of the larger chains where we’ve picked up some additional shelf space.

Operator

Your next question comes from Richard Paget – Morgan Joseph & Co., Inc.

Richard Paget – Morgan Joseph & Co., Inc.

I just wondered, you already commented on your market share gains but in terms of new products, can you give us a little bit more information on what you’re rolling out now and what’s selling on the retail side?

Patrick S. O’Keefe

Well, one of the ones we had the most success with was the new dishwasher hose assembly that was sold in to retail this quarter and it was well received. That was one of the bigger impacts that we had in the quarter.

Richard Paget – Morgan Joseph & Co., Inc.

Are you starting to see any of the energy efficient type products start to pick up given some of the initiatives to greenify buildings and save water and/or energy?

Patrick S. O’Keefe

Not really. We think it’s a little bit too early for that. You have to remember what drives that is a couple of things, one is higher energy costs which we really haven’t hit those levels yet and secondly would be a much more vibrant construction market and we certainly don’t have that at the moment. We do think long term in the US that is a very good growth market for us but in the current environment we don’t really see it.

Richard Paget – Morgan Joseph & Co., Inc.

So even with some of the tax incentives and some of the government mandates on the commercial side with some of the institutional buildings that still hasn’t really come in to effect?

Patrick S. O’Keefe

We see it here and there with some of the federal and army basis where they are rehabbing that and bringing things up to more current standards, we do see it but it’s not enough to really move the needle in a meaningful way.

Richard Paget – Morgan Joseph & Co., Inc.

Then on the charges, any way you can break that down between the operating segments?

William C. McCartney

On a pre-tax basis we booked $6.3 million of restructuring of which $5.2 was China, $400,000 was in Europe, $700,000 was in North America and then we took a $500,000 tax benefit at the corporate level. Then the discontinued operations charge was all in China.

Operator

Your next question comes from Michael Schneider – Robert W. Baird & Co., Inc.

Michael Schneider – Robert W. Baird & Co., Inc.

Maybe we can just talk about volume trends, within the quarter I’m just curious, we’ve heard a number of residential product companies state that their comparison even in very difficult areas like pools have turned positive in the month of August and September. Did you see a sequential strengthening or any change in trends by market?

William C. McCartney

Not really Mike, we normally have a stronger September than we do July and August because you see the start of [inaudible] and also Europe is very, very quiet in August for us. Our September was stronger than our July and August but we just view that as normal trends. I don’t think we’re at a point where we’re really starting to see any meaningful pick up in residential.

Michael Schneider – Robert W. Baird & Co., Inc.

In Europe, I’m just curious if there was a distinction between the OEM performance and the wholesale performance in that market?

William C. McCartney

Yes, I can give you that figure. The wholesale was down about 11%, the OEM was down about 26%.

Michael Schneider – Robert W. Baird & Co., Inc.

Then is OEM down that much simply against a tougher comparisons to last year when some of the energy efficient products were selling hot?

William C. McCartney

That’s right, you have to remember in Q2, Q3 and to a certain extent Q4, we have big energy quarters in Europe. I think we also as we learned in Q1 of this year there was a little bit of channel filling going on as well because there was so much excitement that some of the OEMs got a little bit ahead of themselves.

Michael Schneider – Robert W. Baird & Co., Inc.

Are there any initiatives now proposed or pending that would drive similar type sales for solar products or furnace or heat pump products, whatever they are?

William C. McCartney

One of the things that we’re seeing which is a proposal which we don’t know if it’s going to pass but we’re optimistic about it is in Germany they’re looking at standards to be set around heat loss in a structure that would specifically address standards for pipes, windows, etc. If that were to pass we would be the beneficiary of that and if it were to pass we think that would probably spread to other European countries as well. That’s one of the more interesting things that are being considered at the moment but it’s not passed yet.

Michael Schneider – Robert W. Baird & Co., Inc.

Then gross margins, seeming to me to be probably the single biggest swing factor to what you earn in 2010. Can you give us a sense, if you look at copper at $3 right now and some of the steel and components where they are today, it strikes me though that you’re still flat right now year-over-year probably on an average basis if you look at 2009 versus 2008. So, is it a case where you don’t really see an average cost of raw materials rising in the P&L as we enter 2010?

William C. McCartney

If you were to look at the average for the year that’s probably – I haven’t done that analysis for the whole year, we kind of focus on things more on a quarter-by-quarter trending but it’s not an unreasonable assumption.

Michael Schneider – Robert W. Baird & Co., Inc.

The reason I ask is then if indeed we don’t see an absolute increase in raw material costs in 2010 for you, gross margins while they’ll be an adverse hit because of the lower commercial mix, you get the benefit of additional cost savings actions and lean initiatives, it strikes me that the 36 is sustainable in 2010 barring a significant change in volumes?

Patrick S. O’Keefe

I think you should have a bias downward Mike.

Michael Schneider – Robert W. Baird & Co., Inc.

Really?

Patrick S. O’Keefe

Yes. I think raw material costs are a bigger factor that you’re awaiting.

Michael Schneider – Robert W. Baird & Co., Inc.

Then, I guess I’ll ask the pricing question maybe a different way which is if you look at your position today versus even two years ago when you were going out with price increases, is there something different competitively in any of your key markets or positions with the retailers or mix that would inhibit or constrain your ability to go out with pricing right now other than just weak markets?

Patrick S. O’Keefe

I’d say weak markets is the biggest concern. It’s more difficult to get a price increase to stick in a difficult market like we’re in.

Michael Schneider – Robert W. Baird & Co., Inc.

Final question on just the cash, you pay off the $50 million private placement, what’s the rate on that? And then, I guess do you start to consider buying back stock here just given that it doesn’t strike me acquisition multiples have come down all that much, in fact, may have risen. I’m just curious if you’ve kind of updated your priority list there for the use of cash?

William C. McCartney

The rate on that private placement is about 5% give or take ¼ of a point. We are back looking and talking to companies. We do have very similar screening process as we’ve always had and the same disciplines. Just because we’re talking to people doesn’t mean we’re going to rush in and do a deal. I don’t know if I’m answering your question or not but we feel more comfortable that we won’t have a big double dip in the economy and that we’ll be able to continue to generate reasonable cash flows and that we still think we can have the signs to do a deal.

Patrick S. O’Keefe

I would say Mike acquisitions are in our DNA.

Operator

Your next question comes from Christopher Glynn – Oppenheimer.

Christopher Glynn – Oppenheimer

Getting back to some of the margin drives, Pat did you say that the under absorbed overhead would become less of an issue in the fourth quarter?

Patrick S. O’Keefe

To a certain extent. What I said is I see margins being consistent in the fourth quarter with what we achieved in the third quarter mostly because of the fact that we had previously been talking and thinking that we’d see higher raw materials hitting our P&L and hitting us during the fourth quarter and we’ve now revised our forecast to when they’ll hit us. They’re going to hit us more in the first quarter than they would in the fourth so that’s the driver.

Christopher Glynn – Oppenheimer

Where do you see your inventory position right now? Are you comfortable with that, do you have a target?

Patrick S. O’Keefe

We’re on an effort to reduce inventories and improve customer service delivery as measured by on time deliver and fill rates. We still think we have opportunities to squeeze additional unnecessary working capital off of our balance sheet.

Christopher Glynn – Oppenheimer

Is there a longer term turns target that you could articulate?

William C. McCartney

Right now our turns are about 2.7 which we consider that to be quite low. There’s no reason we can’t significantly improve that over a couple of year period. That’s part of the whole thinking behind lean and all the other things we’re doing, sales and operational planning and moving our IT systems and so on, the reduction of our manufacturing footprint is another big contributor to inventory reduction. So, we’re far from satisfied with our inventory position but it’s a multiyear task to get it up to significantly higher turnover. But, we’re thinking that inventories should be source of cash for the foreseeable future.

Christopher Glynn – Oppenheimer

Just lastly on the kind of SG&A run rates, that you’ve had this year have been pretty consistent. If we think about next year it sounds like maybe some variable factors, different mix in markets but how much of that is really the kind of unstainable belt tightening, furloughs, etc.? What are we thinking trend line for the SG&A dollar levels?

William C. McCartney

If you look at our number in the quarter, barring any fx changes, just looking at organic changes we’re about $79 million and to me that feels pretty reasonable. I mean, I think we’re in a very good range, we’re going to try to keep it in a very tight range around that number.

Operator

Your next question comes from Jeffery Hammond – Keybanc Capital Markets.

Jeffery Hammond – Keybanc Capital Markets

You talked about some of the individual restructuring programs. I just wondered if you could kind of boil it down to what did you get this year for temporary cost savings, what are you getting this year from restructuring savings and just based on what you’ve done what’s the incremental cost saves in to 2010?

William C. McCartney

Remember now this year we did our [inaudible] and we already told everyone that was just $10 million alone in the US.

Jeffery Hammond – Keybanc Capital Markets

That’s savings this year?

William C. McCartney

Yes. We have several millions additional in Europe from headcount reductions. We have a couple of million dollars in the US based on salary reductions. We have things we’ve announced and we also have an ongoing program with our lean programs if you will, where we’re pushing all of our plant managers for productivity. We’re looking for a couple of points net productivity as we move forward to come out of our cost of goods sold. Now, that’s not necessarily a promise but that’s the objective that we’ve set and we have programs in place and people in place, etc. to focus on that.

We also have as Pat mentioned in his opening remarks, there are a couple of factory closures that we’re going to see the benefit from next year which is several million there that will start to come through the P&L as well. We have some other programs, footprint issues that we’re looking at that we haven’t announced but we won’t really see a benefit of those in 2010 but probably we will be working in 2010 to get a benefit in 2011.

Jeffery Hammond – Keybanc Capital Markets

If you take the facility closure and just this lean productivity what do you think your all in incremental cost savings in ’10 would be?

William C. McCartney

Well, I haven’t put pen to paper yet, we’re working on that right now with our 2010 plan but just the plant closures is $3 million alone and a couple of percentage points from cost of goods sold is our objective.

Jeffery Hammond – Keybanc Capital Markets

Then just looking at how your raw material costs would be coming through your P&L, when do you need to start capturing these prices increases you were talking about?

Patrick S. O’Keefe

Probably within the first quarter.

Jeffery Hammond – Keybanc Capital Markets

Finally, do you have an estimate for corporate expense for the fourth quarter? How should we think about that line item in to ’10?

William C. McCartney

Corporate expense in the fourth quarter, I don’t see why it would be that much different than it is now. We’ll have a little bit maybe $500,000, or I think we said $700,000 [inaudible] expenses, other than that it should be flat. Then, as you go in to ’10 the FCPA expenses go away.

Jeffery Hammond – Keybanc Capital Markets

So like a normal run rate would be kind of $7.5 to $7.7 million a quarter?

William C. McCartney

$7.5 million.

Operator

Your next question comes from Scott Graham – Ladenburg Thalmann & Co.

Scott Graham – Ladenburg Thalmann & Co.

I really don’t have too many questions just really some logistical stuff. I was just wondering, do you think you can keep your capital expenditure level on a quarterly basis kind of where you’re at right now, number one. Number two is I know you guys typically carry a lot of cash on the books in preparation for acquisitions and what not but are you closer to the finish line on a couple of things than you were in the second quarter? Are you closing in on anything would you say?

Patrick S. O’Keefe

We typically don’t discuss where we are because as soon as we discuss it, it spooks the story and we get a delay. But, we have an active pipeline although in this environment is a bit more difficult to work through due diligence and there is always more contingency issues to negotiate through the negotiation process. I would say that we sort of at this point in time have several active deals whether they will come to fruition or not is yet to be seen.

Scott Graham – Ladenburg Thalmann & Co.

Are these normal Watts sized deals, historical norm, are they below the norm or do you think that maybe there are a couple of opportunities above the norm?

Patrick S. O’Keefe

They are pretty much down the strike zone, what you’ve seen us do in the past.

Scott Graham – Ladenburg Thalmann & Co.

And the cap ex number, I know it’s been pretty flat it’s just you’re driving tremendous free cash flow off of a very low cap ex number, can you guys keep that the same? I assume you can with the lower facility count, right?

Patrick S. O’Keefe

You can probably figure 75% of depreciation and amortization.

Operator

Your next question comes from Todd Vencil – Davenport & Company, LLC.

Todd Vencil – Davenport & Company, LLC

Bill, what were the sales associated with the discontinued operations in the quarter?

William C. McCartney

It would be about $3 million Todd. I don’t have an exact figure but that’s a rough estimate.

Todd Vencil – Davenport & Company, LLC

Alluding to a question that was asked earlier, are you guys seeing with regard to M&A and multiples and seller expectations, have you guys actually seen a move up or a move in any direction that you would be able to sort of get the signal from the noise on?

Patrick S. O’Keefe

We haven’t closed any deals and finalized them. We’ve made offers that are lower in the range that we would have made a year or two years ago but we’re also seeing resistance from sellers in terms of accepting those offers.

Todd Vencil – Davenport & Company, LLC

On any level, I guess final question and a pretty broad question, are there any sort of regional differences in the US in terms of demand trends that you’re seeing either on the resi side or the commercial side or anything at all?

Patrick S. O’Keefe

You can imagine that the big states like Florida and California where the economy has hit them the hardest is showing substantially more deterioration than some of the areas like New England. But, it’s the kind of stuff you read every day in the newspaper as to the markets that have been the most hit by housing starts and housing pricing.

Todd Vencil – Davenport & Company, LLC

What’s your outlook on how those states come back? Do you think California and Florida lag the recovery?

Patrick S. O’Keefe

I would anticipate they will, yes.

Operator

Your next question comes from Ryan Connors – Boenning & Scattergood, Inc.

Ryan Connors – Boenning & Scattergood, Inc.

Most of my detailed question have kind of been answered so I guess kind of a bigger picture issue. Pat and Bill there’s a lot of talk about the cost cutting in to next year and the impact of that on the income statement but from a longer term perspective I wonder if you can just talk about where you are strategically in terms of restructuring and entering the next upturn on the top line, whenever that comes, obviously not necessarily next year. But, do you view yourselves now as a leaner, more profitable entity in to the next upturn? If so, in what magnitude and really I guess the core of the question is how much of the cost cuts are really permanent per say and how much of those costs will come back as the top line recovers, when ever that is.

Patrick S. O’Keefe

If you look at our numbers, our operating earnings on a historical basis, you can pretty much figure we’re in this 10% range and when we come out of this our objective is to come in more like a 12.5% or 13% from an operating earnings basis. We think that there are some of the costs reductions that are temporary and it will be given back as the economy starts improving but there is an awful lot of footprint and driving unnecessary costs out of the business and things of that nature that will be permanent.

Operator

Your next question comes from Jamie Sullivan – RBC Capital Markets.

Jamie Sullivan – RBC Capital Markets

Most of my question have been answered, I guess just a quick one on the tax rate, what we should be expecting going forward?

William C. McCartney

A normalized tax rate for us would be more in the 33% to 33.5% range.

Operator

Your next question comes from [Michael Coleman – Watts Water Technology].

[Michael Coleman – Watts Water Technology]

You mentioned previously on the previous question 12.5% to 13.5% operating margin, what are you assuming in terms of granite growth backdrop to hit that kind of margin?

William C. McCartney

We don’t have to get all the way back to where we were prior to the downturn but we need to see positive growth, 5% to 6%, organic growth to start hitting those kinds of numbers and we need to finish up some of the restructuring programs that we’re in the middle of right now. Those are two major assumptions in that number. But, that is as Pat said, that is our focus. If you look at all the things we’ve been doing over the past year or so where we’ve been trimming the portfolio, disposing of companies that aren’t as profitable who don’t fit the core, trying to reduce the footprint so that we have a company that has a better mix in the portfolio, a better margin mix and a company that has a lot more operating leverage. That’s what we’re really focusing on so when we come out of this thing we’re leaner meaner.

[Michael Coleman – Watts Water Technology]

Kind of looking at 2010 you gave a kind of outlook for commercial to be down 10% to 15% with greater weight towards the first half of the year. Just so we’re clear on this is that your expectation – that’s not your expectation for Watts overall is it?

Patrick S. O’Keefe

No, because we gave you the other pieces as well.

[Michael Coleman – Watts Water Technology]

In terms of an fx impact or what are you thinking just the components on an organic or fx in terms of 2010?

William C. McCartney

On a foreign exchange basis?

[Michael Coleman – Watts Water Technology]

Yes.

William C. McCartney

It’s difficult to forecast Mike, I mean if you look at the Euro, the average rate for the year for us so far has been $1.36. I know the Euro I think yesterday was about $1.50 or $1.49, somewhere in that range. If the Euro stays where it is it is very favorable to us in 2010. But, we’re not in the game of forecasting that right now. I can just tell you what it is today. It’s favorable right now.

Patrick S. O’Keefe

It will be favorable in the fourth quarter.

Operator

There are no further questions.

Patrick S. O’Keefe

I want to just thank everyone for joining us today. I think this has been a good quarter for us and we’re proud to have these kinds of results and we look forward to talking to you at the fourth quarter conference call which will be held probably in early February.

Operator

Thank you for your participation in today’s conference. This concludes the presentation. You may now disconnect.

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