Watts Water Technologies' (WTS) CEO Bob Pagano On Q2 2016 Results - Earnings Call Transcript

| About: Watts Water (WTS)

Watts Water Technologies (NYSE:WTS)

Q2 2016 Results Conference Call

August 05, 2016 09:00 AM ET

Executives

Timothy MacPhee - VP, IR

Bob Pagano - President and CEO

Todd Trapp - CFO

Analysts

Ryan Connors - Boenning & Scattergood

Jeff Hammond - KeyBanc Capital Markets

Jim Giannakouros - Oppenheimer

Operator

Good morning my name is Chris and I will be your conference operator today. At this time, I'd like to welcome everyone to the Watts Water Technologies Inc. Second Quarter 2016 Earnings Conference Call. All lines have been placed on mute to prevent any backgrounds noise. After the speaker's remarks there will be a question-and-answer session. [Operator Instructions]

Tim MacPhee, Treasurer, Vice President, Investor Relations. You may begin your conference.

Timothy MacPhee

Thank you, and good morning, everyone, and welcome to our second quarter 2016 earnings conference call. Joining me today are Bob Pagano, President and CEO; and Todd Trapp, our CFO.

Bob and Todd will provide their perspective and analysis on our second quarter results, provide a key initiatives update and discuss our latest outlook for the second half of this year. Following our prepared remarks, we will address questions related to the information covered during the call. Today's webcast that is accompanied by a presentation which can be found in the Investor Relations section of our website. We will reference these slides to [indiscernible] our prepared remarks. Any reference to non-GAAP financial information is reconciled in the appendix of the presentation.

Before we begin I'd like to remind everyone that in the course of this call, to give you a better understanding of our operations, we will be making certain forward-looking statements. These statements are subject to numerous risks and uncertainties that could cause actual results to differ materially from such statements. For information concerning these risks and uncertainties, see Watts Water's publicly available filings with the SEC. The company disclaims any intentions or obligations to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

I will now turn the call over to Bob Pagano.

Bob Pagano

Thanks, Tim, and good morning, everyone. I am on Slide three in the presentation, where I'll provide some commentary on the second quarter. Overall I'm very pleased that in the second quarter we continued the momentum in operating performance that we delivered in the first quarter. Organically we grew revenue in all regions and the pace of growth improved sequentially from the first quarter. We delivered a record quarter for operating margin and EPS as a result of the transformative actions we have taken as an organization. From a first half perspective our results were generally in line with our full year outlook for the company. Todd will review the quarter's results and our outlook for the second half in more detail.

From a worldwide market perspective, we continue to see a mix performance, in the Americas much of the construction data remains lumpy but overall we expect both the non-resi and resi markets to grow in the low to mid single digits this year. EMEA continued to stabilize through the quarter. In terms of the potential Brexit impact the UK represents only a very small portion of our business, approximately 2% of worldwide revenue. And the recent terror attacks and failed coup in Turkey have become the latest issues for Europe. The impact from all of these events is something we are watching closely but it's still too early to make a call at this time. Finally, we are seeing growth in market outside of China that is countering some softness in the domestic China commercial marketplace which is consistent with what we saw in the first quarter.

Now if you recall back in February, I spoke about building on the foundation of our previously announced transformation efforts. We identified four areas of focus in 2016 including; one, executing on announced operational programs; two, realigning our regional organizations and building out the team; three, reinvesting in growth and four, driving topline growth and operating the margin expansion.

I'd like to provide an update on our progress, so please turn to Slide four. Our transformation initiatives are on plan and continue to drive results. As a reminder phase one focused on establishing a global sourcing initiatives and enhancing our product portfolio. Today we have recognized the expected global sourcing benefit and the positive margin impact from eliminating lower margin product sales.

In the second quarter we finalized the sales of China subsidiary involved in the production of undifferentiated products. Most of the cash proceeds will be received in the third quarter, but this effectively completes phase one of the Americas Asia Pacific transformation.

Phase two of the transformation is well underway, we have mostly completed the rationalization of North America's distribution facility and the manufacturing right sizing is on target to be completed by mid-2017. Expected savings for 2016 are being realized with incremental savings in 2017 and beyond. Finally, the EMEA restructuring announced in February is moving ahead and we expect to begin implementing the plan in the fourth quarter.

Next, are the organizational realignment and team development activities which are moving along well. Within Europe, we recently announced the combination of two platforms into one now called European Fluid Solution, and we announced the new sales organization resulting from European platform consolidation. The focus of this realignment is to become more customer centric in Europe. By realigning our sales team to regional leaders selling the full complement of products, we believe that we can drive improved customer focus, organizational accountability and better leverage our wide product portfolio. Internally we have also promoted global leaders for our drains, water quality and electronics platforms that help drive those businesses on a worldwide basis.

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

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

Also in July we completed our second innovations summit, consistent with last year's meetings the summit for our [watch] sales and engineering teams from around the world together to understand our broad capability, share ideas and help drive customer focus solutions into product development and in core processes.

Lastly our final 2016 focus areas involves driving topline growth and margin expansion for the year. Year-to-date we have grown organically by approximately 3% excluding the extra shipping days in the first quarter. And year-to-date operating margins of 11.1% again excluding extra shipping days are 150 basis points higher in the same period last year. In the second half we expect to accelerate some of the investments spending and as a reminder we will feel the effects of fewer shipping days in the fourth quarter. So we expect the magnitude of margin expansion will moderate from the first half levels, but still expect a strong year for the company.

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

Todd Trapp

Thanks Bob and good morning everyone. I am on Slide 5, which shows the second quarter results. Reported sales of 371 million were down about 4% quarter-over-quarter, this decline was driven by the exit of undifferentiated products in 2015, which impacted sales by $34 million or 9%. On an organic basis, we grew 4% driven by strengths in Americas, EMEA and Asia Pacific, and I will talk more about the region performance in a few minutes.

Adjusted operating profit of 44 million increased 2 million or 5%. This translated into adjusted operating margins of 11.9% up 100 basis points versus last year and a record second quarter for the company. We attained this margin while continuing to invest in our growth initiatives as previously communicated. Higher volume, favorable sales mix including the exit of undifferentiated products and productivity were the main drivers of this Q2 strong margin performance. Adjusted EPS of $0.75 were approximately 9% better than last year, the $0.75 also represented a new record quarter for the company. The growth in EPS was driven primarily by strong operational performance which more than offset a $0.06 headwind associated with the exit of undifferentiated products.

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

Now turning to the regions on Slide 6 let`s review Americas result for the quarter. Sales were 239 million down 9% on a reported basis all driven by the exit of undifferentiated products in 2015, which was a $32 million headwind to the region in the quarter. More importantly organic sales were up 4% versus Q2 of '15.

We had strong performance out of AERCO which was up double digits in the quarter. We also saw higher volume in our core backflow, regulator and mixing valve product lines, which more than offset continued softness in our product that serve the industrial end markets.

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

Let's turn to EMEA's results on Slide 7, sales of 117 million were up 5% on a reported basis and up 3% organically. Foreign exchange was positive during the quarter by about 2%. All of our European businesses grew organically in the quarter. Apex led the way primarily due to our electronics business, which benefitted from new product introductions into the OEM channel. And we also saw modest growth in [indiscernible] plumbing in drains business during the second quarter as well.

Providing some additional color by region, we saw solid double digit growth in Italy, Scandinavia and the Middle East, and minimal growth in France, basically in line with the French construction markets. In Germany, we continue to experience pressures in the OEM channel, although the rate of declines [subsided] in Q1. And in Eastern Europe was flat for the quarter with growth in Czech Republic being offset by continued headwinds in Russia. Adjusted operating profits for EMEA for the quarter was $13 million up 23% which translated into operating margins of 11.1%, an increase of 160 basis points as compared to Q2 last year.

The strong margin expansion was driven by volume and productivity including lower material cost and benefits from ongoing restructuring initiatives. For Europe this is the third consecutive quarter where we are seeing some stabilizations, but as Bob mentioned we will be keep a close eye on any potential impact of Brexit and other geopolitical issues affecting this region.

Moving to Slide eight let's review Asia Pacific results. In the quarter sales were approximately $14 million up 19% on a reported basis and up 5% organically over the same period last year. It’s a similar story to what we have encountered in the first quarter. We continue to see softness in our traditional China based valve business due to slower than expected commercial markets, which is partially offset by strong demand for our under-floor heating product used in residential applications. Our valve business outside of China continues to grow strongly through expanded distribution with incremental growth in Australia, Indonesia and Singapore. And the Apex's acquisition performed well and contributed about $3 million in sales during the quarter.

Sales outside of China now represent about 50% of total Asia Pacific sales versus 15% last year, driven by the addition of Apex and the growth in other countries I just mentioned.

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

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

On Slide nine, a few items I'd like to point out related to free cash flow. Year-to-date free cash outflow was $11 million as compared to an inflow of $29 million last year. The incremental outflow is primarily driven by a planned working capital increase to support the Americas transformation initiative including establishing buffer inventory to facility the opening of our new distribution center in Columbus Ohio. We also had cash outlays which negatively impacted free cash flow in the first half including product liability settlements and higher tax payments. From a deployment perspective we funded about $7 million more in capital expenditures in the first half versus prior year, consistent with our plan to invest in growth and productivity projects.

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

Finally, turning to Slide 10 and the outlook to the second half of the year, overall on a consolidated basis we expect organic sales growth excluding shipping days in the second half will remain very consistent with our first half performance at approximately 3%. Just a remainder that the three day benefit we saw in the first quarter associated with the extra shipping days will be a headwind for us in the fourth quarter.

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

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

Finally, we are forecasting that the second half should generate strong cash flows consistent with our performance over the past several years.

And with that I will turn the call back over to Bob, before we begin Q&A. Bob?

Bob Pagano

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

So with that operator, please open the line for questions.

Question-and-Answer Session

Operator

Thank you. [Operator Instruction] The first question is from Ryan Connors with Boenning & Scattergood. Your line is open.

Ryan Connors

I wanted to talk a little bit about the pricing impact of some of the commercial excellence initiatives you are putting through, things like the new training center. Historically I think Watts has already known that the contracted channel is a premium brand and a premium price and presumably that's even more so today given the exit of some of the undifferentiated lines. So my question is, do you believe that there is still room for you to pick up pricing structurally in the market place as you get more disciplined on how you go to market? Or do you think you are more or less priced appropriately in the market place and the bigger opportunities there is actually market share?

Bob Pagano

So Ryan, I think there is both. I think we did see some little pricing pressure in Q2 as we adjusted some of our products -- I think we talked about in the past that for our OEMs, we do tie pricing to LME, so with some of the commodity prices coming down we had to give a little of that back. But in general we feel good about our ability to pass along pricing. I think the reliability and quality of our product stands by itself and I think that we'll continue to push price where we can -- we continue to look at -- we test price elasticity, sometimes we back off on that and sometimes we push it. So again as we continue to look at our portfolio we'll adjust our commercial excellence initiatives and are pricing accordingly but overall we feel good about it.

Unidentified Analyst

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

Bob Pagano

So I look at -- the new training centers just started right so it opened up in April, so I think it's difficult to do that but in the long run we believe training as well as new product introductions will allow us to gain market share so I think certainly that was the reason why we are doing it we believe in to continue to train the industry and look for opportunities to grow because in the end that’s what it's all about. So I think it’s a combination of training, new product development and making sure our pricing is appropriately in the right markets.

Unidentified Analyst

Got it and then one more, just on the operating margin I think we are almost 12% in the quarter over 11% I guess year-to-date which obviously is impressive and great progress against initial target which have increased if I remember something like 12%, 13% so can you update us on your latest thinking about margin target based on what you know this is much deeper into the realignment process?

Bob Pagano

Well certainly our goal is to get up into the 15% long term and certainly some of the heavy lifting going on with our portfolio, readjustments and some of the overall restructuring initiatives so longer term I feel good about that. The team is executing, we are working together and we are starting to gain our stride. So I think as we continue to go we will see the continued restructuring and supply chain savings that we have talked about and we feel good about the longer term those margins.

Operator

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

Jeff Hammond

I just want to go at the margin question a little bit differently, Bob you mentioned the 15% target you had there in North America and certainly above prior peak and Europe's been a laggard, so if you just kind of contrast the two other than macro -- are there structural issues for Europe getting to that same level, is it just a matter of time, maybe just compare and contrast kind of where you think you are Europe's margin trajectory versus where you have come on North America?

Bob Pagano

Yes, I think there is a little structural difference because a large portion of our business in Europe is through the OEM channel which tends to be lower margin but I do believe there is opportunities for improvement. We do have structural cost issues, we have a lot of plans and I would call it high cost areas and as you know we have talked about its difficult to shutter those cost on a cost effective basis right long paybacks et cetera. So I think structurally we are a little bit challenged but I do believe there is still opportunities and we are making progress on our restructuring initiatives, we'll be implementing that in the fourth quarter, so we will see the benefits inside of next year. So really the team's been making great strides, it's unfortunate the Brexit thing happened, so I think that creates a little uncertainty in the region at this point in time, but overall our team is making great progress in Europe.

Jeff Hammond

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

Bob Pagano

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

So we saw a little bounce in Italy which was nice, France was up just a little uptick basically flat to up a little bit. I think once Germany stabilizes, I think when -- we sell to a lot of OEMs in Germany that ship outside of Germany in particular to Russia and other countries and I think they are having some difficulty. So once that stabilizes, I’ll feel better about that. So again I have been cautious about Europe and I believe rightly so, we saw first two quarters or actually even in the fourth quarter we saw some growth. So we had three good quarters, and unfortunately this Brexit thing, I think we saw some softness in July a little bit, but we are starting to see that rebound a little bit. So again I think it's natural for all the uncertainty to have happened, given the end of the quarter. But the teams are feeling pretty good about as we go. But we are being a little cautious -- we continue to be cautious and watch our cost structure and driving our growth.

Operator

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

Jim Giannakouros

I’ll make it three for three, I guess on Europe. I’ll start with the margins, again just asking near term, can you give us where you guys seeing you are running at base line on an annual basis if revenue stay flat once you lap the benefits of all the actions that you are taking there. But then I guess overlaying incremental [investment] such as building out your sales?

Todd Trapp

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

Jim Giannakouros

That’s helpful thanks. And just a little granular on demand, you mentioned Germany OEM channel softness, was that destocking or you are seeing a demand reset specifically in Germany? Thanks.

Bob Pagano

I think it's a combination of both actually. I think the German boiler manufactures have been having a difficult time especially on the residential side. And so again I think its continued adjustment, I think they continue to right size, they have decided to insource some of their products. So again I think it's just a reset because you know the difficult the cost to reduce labor et cetera but our feedback is by the end of the year we feel that that should subside then the comps get more in line with what we have been seeing on a run rate basis.

Jim Giannakouros

Switching over to the Americas, specifically you guys called out the resi non-resi tailwinds and your leverage there well understood the continued softness in industrial end markets understood but where exactly can you get a little more granular there on what you are seeing in industrial end markets and how much of that is oil and gas? Thanks.

Bob Pagano

Yes, I mean our industrial business is about 3% of our overall business, it’s a small portion of it but yes, it is tied mainly to the oil and gas side of the business, where we have some product lines in that. So that continued to be soft down double digits on us but again it’s a small portion of our portfolio and hopefully that starts stabilizing at some point here. But probably in Q4 will lack comps again on that. So again we had some backlog coming in into last year that didn’t ship out till the end of the fourth quarter so by the end of this year I think we will get back down into that steady state, we are lapping descent comps on that.

Operator

The next question is from [Gerald Giordano] with Cowen. Your line is open.

Unidentified Analyst

I was curious in Europe, if Brexit wounds up being worse than -- and I don’t know [if anyone has realized here what this can turn out to be] but if it turned out to be a little bit worse, are there additional programs that you guys have in the back of your mind that you can just put through real quick to kind of right size that business even further than what you are doing currently?

Bob Pagano

Yes, I mean when we look at it less than 2% of our business we are not real strong in the UK, it's really the question of what is the macro indicators all around Europe and the overall impact. I think we are constantly looking at our cost structure we know -- you know we have some European restructuring initiatives going on so we will continue to look and monitor that but right now our teams -- they felt the noise they felt the shock, but honestly they believe we will move on and things will go forward with it. So right now we are watching it closely and we will look for opportunities, further opportunities if we need to, but right now the team believes we have got the right actions in place.

Unidentified Analyst

I wanted to talk about the one last question like global training -- when you go to that process, is that mostly internal training or how much is customer education and what are initial results like, is it more just -- are you just trying to push volumes and have your customers understand the full range of breadth of product that you guys have, is that the ultimate goal there?

Bob Pagano

Yes, I think a lot of it is just we have a broad product range and certainly literature needs to be changed, but a lot of our products are global in nature where we can package them and put them together and in the past we have been siloed and the whole goal is to open up the portfolio for the entire organization so it requires marketing materials, trainings from our customer, training for our internal peace. So it’s a combination of all of the above and the goal is really to take a global look and a global product portfolio and provide a customer solution and some of our customers, large customers are global in nature so we want to follow develop strategic relationships with them and bring our products globally with them. So it's a combination of all of the above and we are in the earlier innings of that initiative.

Unidentified Analyst

Are you starting to see some product sales out like things in Europe that you are selling in the U.S. but not historically there, have you started to see some intangible evidence there so far?

Bob Pagano

Actually the biggest benefit we are seeing in is products we make in Europe and selling them into North America and our stainless steel drains business. So we are gaining some traction there, we have added resources and specializing on that, so that’s where we are getting our early wins but we believe there is just as much opportunity, the other way around bringing products into Europe right now. But right now the other opportunity is bringing our products both made in North America and in Europe into the Middle East and in Asia, so all of those are initiatives that are going on right now.

Unidentified Analyst

Great, and then just last from me on the Americas, how does sales trend throughout the quarter?

Bob Pagano

When I look at trends, it was interesting for the quarter, April was soft and we saw it ramp up in May and June, and it's funny, July started off a little soft, but again our sales team is confident and they are coming back. So it's trendy -- but the teams feel good and confident, all the indicators that we look at construction in both non-res and res are looking positive. And as you know 65% of our North America business is repair and replace which tends to go with GDP. So again on balance our team feels good about that and we are somewhat -- we watch the ups and downs, some of its lumpy dependent on the commercial type business. So again cautiously optimistic.

Operator

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

Ryan Connors

Yes, thanks. Just a quick follow up question, Bob you mentioned in your prepared remarks this idea of having to go outside the organization to feel certain e-trade, don't feel like you have got the appropriate internal candidate and I know there are some examples of that [in Franklin] for example, but can you talk about how you go about that, is it a compensation, a part of the pitch you are making to some of these people from larger, more mature organizations or what are the elements that you are using to try to bring people on board?

Bob Pagano

Ryan, it has usually nothing to do with compensation. We are really talking to teams about what we are trying to do, what we are trying to build. The momentum we are starting to get and they need our leadership team, and really see the opportunities in side of the organization, so certainly compensation has to be a part of the discussion. But honestly that is the very last thing we talk about. So really everybody is excited to be part of this company, we have a strong 140-year history, a great brand and we are now going to capitalize on that brand to grow in the future. So people are excited to join us and all the people who have joined us are excited to be here. So they want to be part of a winning team.

Operator

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

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