Watts Water Technologies, Inc. Q1 2008 Earnings Call Transcript

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 |  About: Watts Water Technologies, Inc. (WTS)
by: SA Transcripts

Operator

Welcome to the first quarter 2008 Watts Water Technologies earnings conference call. (Operator Instructions) I would now like to turn the presentation over to your host for today’s call, Kenneth Lepage, Assistant General Counsel.

Kenneth R. Lepage

Before Pat and Bill begin their presentation, I want to inform you that various remarks they may make 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 31, 2007 filed with the SEC and other reports we file from time to time with the SEC.

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

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

Patrick S. O’Keefe

Welcome to our Q1 conference call and thank you for your continued interest in Watts. Following my remarks, Bill McCartney, our CFO, will provide you with the financial highlights for the company in total and Bill will also discuss individual sector results. Then we will address your questions.

Before we get into the quarterly results, I would like to briefly update you on a few important items. First regarding the progress on our restructuring program, in Q1 we took an additional pre-tax charge of approximately $1.3 million related to severance, relocation costs and asset write-downs.

In the quarter, we announced to employees the rightsizing of our manufacturing facility in Italy. We continued with the move of our Chinese joint venture operations whose physical plant was taken over by eminent domain by simultaneously rightsizing that operation. This move will reduce headcount and improve our manufacturing efficiencies.

As I will discuss in more detail in a minute this move and other events in China negatively affected our results for the quarter by about $0.07. In general, we are on target regarding the timing and implementation of the various restructuring programs. We expect savings in 2008 from the restructuring exercise will still approximate the $900,000 pre-tax amount discussed last quarter, with most of the savings being realized during the second half of the 2008.

We mentioned at the February conference call that we had entered into a contract to purchase the remaining 40% of the Chinese joint venture. We had hoped for a Q1 closing but the timing of government approvals and licenses has delayed the closing until early May. We will pay approximately $5.2 million for our partners’ interest. Having this operation fully under the Watts umbrella will allow us to control this company in the same manner as we control other wholly owned business units.

Now a quick update on our stock-repurchasing program, as of Friday, April 25 we have repurchased approximately 2.2 million shares on the open market and we had invested approximately $63.2 million to repurchase those shares. The effect on earnings per share from repurchasing these shares in Q1 ‘08 was $0.03. We expect the effect on earnings per share from the repurchasing program in 2008 to be approximately $0.12 for the entire year. As mentioned last quarter, we still expect to have the capital flexibility in the form of existing cash and/or available credit lines to be opportunistic in the acquisition marketplace.

Next, let me address the acquisition program for a moment. When we last spoke, I mentioned our focus was on the European candidates, where we had been following several potentially interesting companies. As you may already know, on April 9, we announced the pending acquisition of Blucher Metal, which is located in Denmark. Blucher is the leading provider of stainless steel drainage systems in Europe and a worldwide leader in providing stainless steel drainage products to the marine industry.

Broadly speaking, Blucher sells about 80% of its products into land-based applications and 20% into marine applications. In terms of product lines, about one-half of Blucher’s product sales are in push-fit pipes with approximately 60% of these pipes’ sales sold to land-based applications and the remaining 40% sold into the marine market. The remainder of sales is in drains and channels. The drain portfolio includes light duty drains for both residential and commercial buildings, heavy-duty drains for industrial applications and marine drains used in various types of ships.

Both residential and commercial products are sold primarily through wholesalers and contractors. The residential marketplace is driven by price and design. The commercial and industrial marketplaces are more focused on quality and meeting specifications. Where hygiene is a priority in the industrial space, Blucher’s stainless-steel products are the preferred choice.

Marine products are sold directly to shipyards where function, quality and product safety are key. Blucher has a number of certificates and approval within the shipbuilding industry for fire resistant, shock and vibration, which we think provide barriers to other competition. Blucher sells push-fit pipes and marine drains used in galleys, cabins, kitchens and on deck.

We expect the marine business will continue to grow nicely. Based on industry reports gross tonnage to be supplied to shipyards in 2007 through 2009 is expected to grow at an average CAGR of 22%. Geographically, approximately 50% of Blucher’s sales are concentrated in the Nordic countries, with 25% located in the U.K., France and Germany, and the remaining 25% located in other countries. The company sees geographical expansion as a major growth driver in the future. We think that Watts’ existing sales channels will facilitate and accelerate Blucher’s expansion into these other areas.

At $183 million in purchase price, the Blucher acquisition is the largest acquisition Watts has made. Blucher will offer us a new platform within our European markets. We hope to close this acquisition in either May or June timeframe, but this will depend on the timing of government approvals. If we finalize the Blucher acquisition in May, we expect the operating results will be dilutive to earnings by approximately $0.03 in the second quarter.

We are also exploring other potential acquisition candidates in Europe as well. As far as the domestic U.S. marketplace is concerned, we continue to see low levels of activity and deal volume, but we hope to see this pipeline pick up as we move forward in 2008. In China, our focus in the near-term is on operational improvements.

As we discussed in our February Q4 conference call, two important goals of the company in 2008 are to maximize cash flow and promote operational efficiencies and productivity. With regard to cash flow, I’m pleased to inform you that the first quarter of 2008, we expect to generate positive cash from operating activities of approximately $14.8 million, which compares favorably to a $13.8 million use of cash from operating activities in Q1 of 2007.

The first quarter is typically a period in which we are a net user of cash. This year, with the focus on working capital management, net cash outflows from working capital have decreased from approximately $43.5 million in Q1 of 2007 to approximately $3.5 million in the first quarter of 2008.

Regarding operational improvements, in Q1, the organization was very active in promoting operational excellence. Various levels of management were involved in training concerning Lean and Six Sigma manufacturing techniques. To date, 160 people have attended training programs in both North America and China.

A Lean Champion and Coordinator have been established for each of our major manufacturing locations. Performance scorecards have been developed as well that will track our key metrics such as on time delivery, cycle time reduction, inventory reduction and quality improvements.

We are still in the early stages but are very committed to this endeavor. We are planning further training for Six Sigma Black Belts and Green Belts and we will expand Lean techniques to our smaller manufacturing locations as the year progresses. We are also performing a search for a senior level person to head up our Lean manufacturing initiative.

During a recent strategic review, management team developed strategic and tactical initiatives which we expect will be rolled out over the next two years. These initiatives will either enable the company to perform in a more efficient manner or will ultimately drive greater cost efficiencies throughout the company.

In a challenging economic environment, we believe new product development and product expansion into new markets will be important growth drivers for growth. We think we have a solid pipeline of products in both North America and Europe that will be introduced through the remainder of 2008 and into early 2009.

Finally with Q1 behind us, I’d like to make the following observations regarding our outlook for the balance of 2008. As we have discussed in February, we expected 2008 to be a challenging year. However, given the macro developments and reflecting on our own results from Q1, where our organic growth has declined for the second consecutive quarter, the challenge may be more daunting and the recovery may be longer than we had expected.

In the U.S., our business is working within a macroeconomic environment that includes jobless claims rising, producer prices increasing, consumer confidence sliding, inflation creeping up, foreclosure at record levels, commodity prices including oil at near-record highs and tight credit markets. I think people in the trenches are past thinking about a potential recession and our discussions now are about how long it will last. Globally, it appears that the U.S. malaise is causing other parts of the world to sneeze.

Looking at the domestic residential channels we sell into, the headline news remained downbeat. Single-family constructions starts in March of approximately 947,000 units, almost 12% below February of ‘08 and approximately 37% below March of 2007 and this represents the lowest level in 17 years. Application for home building permits, which are generally considered to be a sign of future economic activity, continued to trend down.

With March adjusted units at 297,000 this is 5.8% below February of ‘08 and almost 41% below March of 2007. These statistics are indicative to me that the residential housing market has not yet bottomed out. I was more hopeful in early February that the residential construction would turn around in late 2008. At this time, I don’t think we truly see the upside in this marketplace until early in 2009.

We now are seeing the commercial market showing signs of slowing down. As we discussed in early February, we follow the Architectural Billings Index, ABI. Through December of 2007, the index core had been at 50 or above for 34 straight months, which was a positive indicator. However, starting with January, the index began to decline and as of March month-end, it stands at 39.7, which is the lowest level since the survey was begun in 1995.

We also review data from Dodge for expectations on square footage growth in commercial space. The latest data suggest that commercial arena will actually see a decline in square footage construction of approximately 7.4% in 2008, with declines across almost the entire spectrum of commercial marketplace.

So from a commercial marketplace point of view, I believe I need to recalibrate my earlier outlook from growth at a slower rate in 2007 to minimum growth in 2008. As for the U.S. replacement market, from what I can see, this will remain relatively stable throughout the remainder of 2008.

In Europe, we expect to see growth in the general economy slow due to the impact of reduced exports to the U.S. and with some impact from the credit crunch. In particular, we expect that German marketplace will continue to have difficulties and we are seeing that slowness in Germany creep into our business in Eastern Europe as well.

Unfortunately, these trends have persisted. We see the traditional boiler business throughout Europe declining and being replaced by solar and under-the-floor heating applications. We do feel even in this challenging environment that we are making progress in taking market share by providing boiler product offerings to our customers across Europe.

Before I discuss our outlook in China, let’s spend a moment to address various issues we encountered in Q1 that negatively affected our Chinese operations. At our TWT joint venture, the plant move has taken longer than we had hoped, which did cause shipment delays. This move has led to plant inefficiencies, personnel turnover, and unexpected costs to be realized in Q1. We expect to be completely moved and into our new operations by mid-June, which should begin to alleviate the moving pains we have experienced. We expect continued improvement at this plant for the remainder of 2008.

Our WPP plant operations were impacted by missed shipments and under-absorbed overhead caused by a lingering labor dispute at the plant. Workers were protesting over compensation issues and also were concerned about their future with WPP given management’s recent initiative to outsource some of the operations of this plant to domestic Chinese suppliers. We reached a settlement with these workers in during April, which will allow WPP the flexibility to downsize its workforce while providing the workers with an agreed amount for overtime and severance.

Finally, our Changsha facility, which makes large diameter hydraulic butterfly valves, the severe weather experienced in China during February halted production and shipments for better part of the month. The plant itself was without power for 19 days. Going forward, we expect Changsha’s shipments will pick up and help move their backlog. So we would expect that Q2 would be a decent quarter for Changsha. We think that TWT and WPT domestic business will take another quarter to sort out.

Further, please remember that a significant portion of our China production is bound for both the U.S. and Europe. With these two end markets slowing, we expect the China plants will be running at less than full capacity. We intend to control inventory levels in reaction to the slowness in the residential space. We remain bullish on the Chinese domestic market and we are confident that our new China general manager is the right person to accelerate sales growth as we move forward.

Now at this time, I’d like to turn the proceedings over to Bill McCartney, who will take you through the financial highlights. Then we will answer any and all questions you might have.

William C. McCartney

Looking at the quarter, first a couple of comments on the consolidated results and I’ll go into comments on the segments. As you see from the press release, revenue was down about $2 million at $344 million in the quarter. When you break that apart, organically we saw a decrease in revenue of $24 million, that’s 6.9%.

The foreign exchange helped to offset that, which is a positive $17.8 million or 5.1% and that is primarily the Euro but we saw some favorable activity there from Canada and China as well. And then we had $4.1 million from the acquisition of TGI, which we acquired in November ‘07.

We look at our earnings after taxes from continuing ops at $14.7, which is excluding restructuring charges and that’s a decrease of 27%. And that represents $0.39 a share compared to $0.52 a share last year, again excluding the restructuring charges. And as Pat mentioned, the buyback of our stock added $0.03 because of the fewer shares outstanding.

In North America, the revenue closed out at $211 million. That’s a decrease of about 3% and again on a consolidated North American basis, organically we were down 6%. That is $13 million. The FX offset a little bit of that with a positive $2 million or 1% and again, the acquisition of TGI at $4 million or 2% and that brings us to a decline of $6.9 million or 3.2%.

Now, we just take a look at the wholesale and the retail, which are inside of our North American operations. Wholesale closed out at $168 million, which is a decline of 2% but if you back out the acquisitions in the foreign exchange, organically wholesale was down about 5% overall or just about $9 million. And what we’re seeing inside of wholesale in North America is about a 10% decline in units offset by about 5% pricing overall.

When we look at the residential side inside of that number, the residential would be down higher than that and then offset with some positive from a commercial side but not a lot. We’re seeing the commercial side very spotty in the quarter with some of those leading indicators softening as Pat mentioned. The waterworks is down, which is tied to the residential side of the business and commercial is flat to up slightly for those products that are geared towards strictly commercial applications.

When we look at the retail side of the business, we closed out at $43 million, which is decline of 8.7% and again, we look at the changes inside of there. Basically from an organic standpoint, we saw a decline of about 10% in units, which we again attribute that to the softness in the economy and what’s happening in the residential space.

And we saw some offset in pricing and rollouts. Again, that positive news had slight offset in that we have a slight residue from some of the product lines that we exited last year because of some low margins that we are experiencing there. But basically the important message there we think is a decline of 10% in units because of the economy in the U.S. and the softness in the residential space, because our retail market is driven primarily by activity in residential.

Looking at Europe in total, the revenues are $122.7 million. That’s an increase of $7 million or 6%, but if we look at the components there from an organic standpoint, we saw a decline of $7.7 million or 6.7%, offset by the favorable foreign exchange in which the Euro strengthened relative to the dollar. That’s a $14.8 million contribution or 12.8%. Again what we see in Europe, if you exclude the discussion on foreign exchange and looking at the organic activity, is an overall market that is fairly soft and we think our management team in Europe is doing a pretty good job there. We are introducing new products to offset the softness in the markets.

We are repackaging our products in different ways in terms of bundling them with more value-add, combining them into packages, introducing new products around thermal controls, energy controls, and solar applications as well as having selective price increases where we can do that in Europe. Even though it’s a soft market and we do believe we are gaining market share in this weak market because of the new product introduction and the packaging that we have been undertaking there.

In China, total revenue closed at just shy of $10 million, which is a decline of about 19%. When you break that into the components from an organic standpoint, we were down about $3 million, which is 25% with a slight offset from the strengthening of the RMB of 6.6%, which again brings you back to that 19% level.

And what’s happening here is really consistent with what Pat mentioned earlier, the relocation of our joint venture from one side of Tianjin to the other, offset our ability to ship product during the quarter, the labor dispute that we had done in Southern China and then the loss of power at our Changsha Valve Works plant in Changsha in Hunan Province and we lost power for the almost the entire month because of the snowstorm, and obviously we were unable to have material delivered to the plants, etc.

So that snowstorm rather really caused our issues and we are thinking that issue for Changsha is behind us at this point in time. We have not changed our review relative to the end markets in China, that remains strong, but we do have another quarter or so to sort out some of these operational issues at TWT and WPT.

When we look at the gross margin, on a consolidated basis in the quarter at 33.2%, essentially flat with last year’s first quarter. If we look at the margins by segment, though, the gross margin in North America at 34.5% is up from last year’s first quarter, 1.6%, which is really the result of improved unit pricing versus last year.

Of course, the issue that we are mostly concerned about in addressing right now is the fact that we saw a margin decline in North America from the fourth quarter, because in the fourth quarter of ‘07 the gross margin was 38.1%.

So what we’re seeing here really is not a deterioration in pricing so much as what we are seeing is an increase in some of our cost structure and most of that is emanating from China where we’re seeing increased foreign exchange rates, the VAT rebate has decreased and that was effective during the summer and now we’re starting to see that come through our cost of goods in a meaningful way.

And of course, we’ve experienced quite a bit of labor inflation in China as well because of the higher demand for professional people as well as some of new labor laws that have recently passed in China. And as Pat mentioned, we’re working on streamlining those plants through some downsizing and some Lean initiatives as well.

In Europe, the margin at 31.5% is essentially flat with last year’s first quarter and is up slightly from the fourth quarter of ‘07 where we were 29.8%. Most of our business units were very steady from any of the comparisons that we have. So there are no major issues relative to the gross margin in Europe.

And of course in China, the gross margin of the quarter at 8%, that’s a decline of ten points from last year’s first quarter or a decline of four points from the fourth quarter. And that’s all related to the issues that we’ve just discussed with you around the labor disruption and the plants relocation and the manufacturing variances and lower trade revenue that resulted from those issues.

The SG&A, $87 million or 25% of revenue, that’s an increase of $3 million versus last year. When we look at the components of that $3 million, from an organic standpoint we saw the SG&A declined by $1.7 million. The impact from the foreign exchange rates increased SG&A $3.7, the inclusion of the SG&A from TGI acquired in November ‘07 added $1 million to our SG&A and that totaled the $3 million. There were no major issues from the business standpoint inside of our SG&A expenses during the quarter.

That brings us to our operating earnings. If we look at it excluding the restructuring, $27.6 million, 8% of revenue, which is a decline of about 10% versus last year’s first quarter. And the issue really is if you break it down into its components from an organic or internal standpoint, we saw a decline in our operating earnings of about $4.9 million, which again some of that is offset by foreign exchange rates. And the issue really here is the volume decline in conjunction with the operating issues that we have seen in China during the quarter.

Below the line, other income and expense increased $2.2 million, two major issues here. One is a decrease in our interest income which is associated with lower levels of cash because of the stock buyback and the acquisition of the TGI, so we have less cash earning interest and we also had some foreign exchange losses below the line as well.

Our effective tax rate in the quarter, 33.9% versus last year at 26.4%. Where we really see the impact is in last year’s first quarter, we had a favorable tax settlement in Italy in which we had accrued some expense thinking that we are going to have some tax payment on some withholding issues there and we had a favorable settlement on that.

And we reversed that to the accrual that we had for that, we reversed it to income in the quarter. So we had a one-time artificially low tax rate in last year’s first quarter. The 33.9% is much more representative of what we are expecting as we go forward for the year as we have discussed in the past.

So the net income in the quarter excluding the restructuring on an after-tax basis, $14.7 million, which is a decline of $5.5 million or 27%. So our depreciation and amortization in the quarter totaled $10 million.

And I think with that, we can open it for any questions that you might have.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Curtis Woodworth – JP Morgan.

Curtis Woodworth – JP Morgan

Bill, when you look at the gross margins this quarter, excluding some of the one-time issues in China, they were essentially up year-on-year and I know it was maybe a little bit of an easier comp. But given some of the negative operating leverage that you saw, is it really just price gains that were able to offset that? Was there anything else in there?

William C. McCartney

Well, the issue really on the quarter, Curt, relative to the margin, is two main things happening there. One is the increased level of costs that we saw coming through because of our Chinese operations, the VAT and the foreign exchange rates and whatnot and then just the operating issues themselves in China that we just took as an expense in the quarter. Those are the two issues impacting us relative to the gross margin percentage. And we obviously had negative organic growth. So you don’t have any revenue growth to offset those issues.

Curtis Woodworth – JP Morgan

Yes, that’s my idea, is that if you strip out some of those other cost items that your North American and European businesses would have been up year-on-year despite negative operating leverage for North America,

William C. McCartney

If you at look at year-over-year, you’re right. But we’re really focused on comparing ourselves to fourth quarter because if you look at that, we have a decline in the margin in North America, which is our major concern.

And remember last year, we had the first quarter, the margin was less than it had been in the prior quarters and we told everyone that we were going to have sequential improvement throughout the year, which we did and that’s through cost reduction and managing our pricing. And so we’re not so much concerned relative to the comparison to last year as we are concerned about the comparison to fourth quarter.

The fourth quarter was an all-time high gross margin during the year. It was probably little bit too high. It’s maybe not sustainable but we do have to and we are working on improving the margin going forward relative to the fourth quarter with all these Lean initiatives and whatnot.

Curtis Woodworth – JP Morgan

So given some of the one-time cost issues this quarter, is it fair to say you think that this would be more of the trough margin rate for the year for the company?

William C. McCartney

Well, I think as Pat mentioned in his remarks that, that those issues in China, it’s going to take us another quarter to settle them down or to see them start to improve. So we don’t want to give the impression that you are going to see big improvement in Q2 because these issues in China just go away. It’s going to take us at least a quarter to sort them out. These are probably trough margins but not necessarily one quarter.

Curtis Woodworth – JP Morgan

In terms of the copper and resin exposure, some of the incremental costs you’re seeing for that. What is your thinking around getting price increases to offset that? Can you remind us what that total spend is for you?

Patrick S. O’Keefe

Yes, Curt, it’s quite clear that you have a number of raw materials that are escalating. We all know where oil is, we know that copper is on the rise, we know that stainless steel is on the rise, we know that cast and malleable iron are on the rise. So we clearly have to take initiative for further price increases throughout the year to make sure that we cover those escalating raw material costs.

Curtis Woodworth – JP Morgan

But do you feel that you’ll be behind the curve near term? Or do you feel that given you cycle through your inventory, I think it’s five to six months, that you will have enough time then to get price. So basically, are there any near-term margin implications that we should be concerned about?

William C. McCartney

I think that those items are going hit us more in the third quarter; we’ll see a little bit of impact probably in the second but mostly in the third quarter by the time those higher metal prices start actually going into cost of goods sold for us. So we will have time to address pricing issues before those hit us.

Patrick S. O’Keefe

Assuming the market participants cooperate.

William C. McCartney

Yes, that’s right.

Operator

Your next question comes from Jeff Hammond - KeyBanc Capital Markets.

Jeff Hammond - KeyBanc Capital Markets

To focus on these China issues, it looks like you had about a $3 to $4 million hit this quarter from these temporary issues. Can you parse that out between the weather issues that go away and what lingers and then also give us your confidence level that the other two issues are indeed resolved by the end of the second quarter?

William C. McCartney

In terms of the impact, the weather issue was the smallest. The weather issue had more of an impact on the top line than the bottom line because it’s a very well run plant and they were able to control their expenses and react to the decline in the revenue relatively quickly.

So the more severe impact on the bottom line was from the other two issues, the plant relocation and the labor dispute. The plant relocation would add the most impact, followed by the labor issue in southern China. So we think unless there’s another major weather catastrophe that issue probably goes away and that helps the top line and the bottom line a little bit. And the other two issues will take as Pat mentioned again, it will take the second quarter to sort through those.

Jeff Hammond - KeyBanc Capital Markets

So you are pretty confident that it’s a two-quarter impact with the other two issues? And maybe that if it was $3.5 million this quarter, it is just nominally lower in the second quarter?

William C. McCartney

That’s your forecast. We don’t give guidance but we’re trying to explain to you.

Jeff Hammond - KeyBanc Capital Markets

You mentioned the big drop in the gross margin sequentially and you’ve talked about some different issues, inflation in China, value-add tax. Can you help me understand how much of some of the one-time issues exacerbated that or is that a completely separate issue?

William C. McCartney

I view that as a separate issue, because those are ongoing costs that we need to address versus the temporary issues which you see in the China segment.

Jeff Hammond - KeyBanc Capital Markets

And why do you think that that was such a huge swing in such a short period of time?

William C. McCartney

Well, it’s how our costs, it takes five to six months to come through. And lots of those issues were changing during the third quarter of last year and you also have an impact of mix where a lot of those products are wholesale products. Some of our smaller bronze devices that go into wholesale and we had a stronger mix towards wholesale in the first quarter.

Jeff Hammond - KeyBanc Capital Markets

So, have you have been taking actions to resize or the cost footprint as you have seen these coming for two quarters or is that something you need to go on a go forward basis?

William C. McCartney

We’ve been doing an awful lot, I think, on the cost side but it’s going to take a while for it to come through. We’ve been upgrading a lot of our manufacturing folks. We’ve been very, very active on the sourcing side both in China and in the U.S., looking at the footprint issue as well. But that is something you don’t turn around in a quarter.

Jeff Hammond - KeyBanc Capital Markets

So, at what point do you start to maybe rethink how much you have coming from China versus what you are you just sourcing in the U.S.? Obviously the supply chain gets stretched with the China strategy.

Patrick S. O’Keefe

Some of your make by analysis are already indicating that certain products that were marginal can be manufactured in North America as cost effectively as they can in China. So you are starting to see a reversal of some of the economics here.

Jeff Hammond - KeyBanc Capital Markets

Have you announced or are you contemplating any further price increases?

Patrick S. O’Keefe

We have to have further price increases. We have announced some price increases that were announced in January of this year. We have others that are planned but the timing of them is different. They are all driven by really escalating raw material costs. So I think quite honestly, there is a need for additional price increases just to cover the cost increases we’re seeing in the market and we think those cost increases are sustainable.

Jeff Hammond - KeyBanc Capital Markets

What do you think the order of magnitude of those increases is?

Patrick S. O’Keefe

You’re talking anywhere, believe it or not, in cast iron and malleable iron; you are talking 30-some percent down to teens in terms of some of the other raw materials.

Jeff Hammond - KeyBanc Capital Markets

And you think in the environment you’re seeing, you think that you can pass those through?

Patrick S. O’Keefe

I think they are going to impact us as well as all of our competition in a similar fashion. So I think it may take a while to push them through, but I think they inevitably have to go through because they impact all of us to the same extent.

Operator

Your next question comes from Brian Jones – RBC Capital Markets.

Brian Jones – RBC Capital Markets

Could you walk us through how Blucher is tracking today relative to where it was when management last had the conference call and how it might be responding to a slower European economic environment?

Patrick S. O’Keefe

Well, first of all we haven’t closed on Blucher, so we can’t disclose financial results of an acquisition that hasn’t closed.

Brian Jones – RBC Capital Markets

But you have to be tracking like the LTM results or be getting updates from the company as you finish diligence?

Patrick S. O’Keefe

Yes, we are getting updates from the company, but I don’t think at this point in time we’d choose to disclose them.

Brian Jones – RBC Capital Markets

Is there any material change to maybe the growth outlook for that environment or that company as Europe slows down?

Patrick S. O’Keefe

We’re going to have to pass on answering that question. It’s a similar question to what you just asked.

Brian Jones – RBC Capital Markets

CapEx for the quarter, maybe I missed this?

William C. McCartney

$8.3.

Brian Jones – RBC Capital Markets

On your balance sheet, the $15 million in long-term investment securities, is that your auction rate exposure?

William C. McCartney

Yes, it is. We have $15 million of auction rate securities, which we have classified as a long-term investment this quarter.

Operator

Your next question comes from Mike Schneider - Robert W. Baird.

Mike Schneider - Robert W. Baird

On the pricing issue again, so you’re going out with another round. I am wondering if you could look back to the January price increases. What was your net realization on those and was it lower or higher than you had been running in 2007?

William C. McCartney

Well, I think the January ones, Mike, were very selective, and to be honest, I didn’t hear that they were not effective at this point in time.

Mike Schneider - Robert W. Baird

So you’ve not noticed any particular degradation on your ability or in your ability to realize price at this point and I ask because the magnitude of what presumably is needed now around mid-year has got to have risen significantly. And couple that with a market that by your comments is weakening both in Europe and the United States, I think we’re trying to understand what is the efficacy of that next round of pricing going to be?

Patrick S. O’Keefe

We don’t really know until we go out with it, Mike. So it’d be hard to give you a forecast. You understand the issue, which is you’re going out with cost driven price increases that are absolutely necessary in order to maintain any reasonable integrity in your margins. But you have soft environment that you’re going out in and it all depends on how the customers react to those price increases and even more importantly, how your competitors are impacted by the same cost increases.

Mike Schneider - Robert W. Baird

So any prediction about your net realization, Pat? You sound more cautious, but in the past you have been extremely successful in getting price. Is there something new or different that you would point to suggest that you may not be as successful this time or is it just the backdrop of a weaker market?

Patrick S. O’Keefe

It’s basically the backdrop of a weaker market.

Mike Schneider - Robert W. Baird

When you go to some of your larger DIY customers and wholesalers, have there been any additional lines or product lines that you’ve targeted for pruning if you will, or where there is serious discussions and disagreements over pricing going forward?

Patrick S. O’Keefe

Nothing material, Mike.

Mike Schneider - Robert W. Baird

Europe specifically, margins flat year-over-year at 31.5% is pretty impressive and actually up sequentially, even on a 7% organic decline. Bill, maybe you can give us just some color on how you did it and what’s different about Europe versus the U.S.?

William C. McCartney

Yes, in the quarter, we had a little bit of a favorable mix towards wholesale and away from OEM. But I think what is really happening there, Mike, is that the people in Europe, I give them very high marks in terms of packaging the product. We are not just selling widgets, we’re going upscale, we are selling lot more control packages, and there is a lot more engineering content to our products. We are bundling products together into a little bit more of a systems approach. We are focused on energy savings and conservation, etc. So they’ve done a very nice job in repositioning the company and their product portfolio, if you will.

Mike Schneider - Robert W. Baird

And the weakness that you cited in boilers specifically in Europe, that was a source of significant growth over the last couple of years. Is it a case where you’ve just taken the share, all the share there is to take or most of it? Or is it indeed this energy conservation trend towards solar and other alternatives?

Patrick S. O’Keefe

I think it’s a longer-term trend, Mike.

Mike Schneider - Robert W. Baird

And do boilers alone explain most of the 7% decline in Europe or was it fairly widespread?

William C. McCartney

It would be boilers, but I think you’re also seeing some weakness in some of the end markets, particularly like in Eastern Europe, as they start to feel the impact from the soft German economy in particular. Market weakness and a technology change, if you will.

Mike Schneider - Robert W. Baird

And then in the North American wholesale market, it was down 5% organically, I believe. The trend line through the quarter, I’m just curious if this was a March inventory de-stocking or adjustment by your distributors or did you see fundamental trends deteriorate through the quarter?

Patrick S. O’Keefe

It was a pretty steady drumbeat throughout the quarter, Mike.

Operator

Your next question comes from Kevin Maczka - BB&T Capital Markets.

Kevin Maczka - BB&T Capital Markets

I was thinking that the first quarter might be your low water mark in terms of total revenues. But given your macro commentary, it sounds like getting worse both domestically and in Europe. I know you don’t give guidance on the top line, but can you comment might that first quarter be more of a high water mark instead of a low water mark if these macro economies are getting so much worse?

William C. McCartney

If you’re looking in a normal year, the second and third quarter tend to be a little bit higher than the first and fourth just because of seasonality around irrigation and construction in the spring and then the heating season in the fall. Whether that’s going to be different this year remains to be seen but we are concerned around some of the trends that we are started to see in the first quarter.

Kevin Maczka - BB&T Capital Markets

I’m wondering what a more normal growth rate is in China once you ex out the weather and all the disruptions you had there, it seems like everything and nearly every industry grows double-digits in China. But you mentioned that a lot of your business is exported back to the U.S., back to Europe. What is a more normal-type growth rate for your China business?

William C. McCartney

I think if you look at the infrastructure business that we have there, you’re talking growth rates that are sustainable of 20% to 25%. But we did mention that a lot of the activity comes back to the States, but that does not show up as trade revenue in China. That’s inter-company revenue, which we don’t show on the segments.

But it does impact the profitability if we decrease the production levels in China because of lower demand from the States. You wind up having absorption variances and what not. But the infrastructure market in China is still very strong. We are very committed to it. And we see that as a long-term growth opportunity. It just happens to be a small part of the business.

Patrick S. O’Keefe

Ranging in the 20%-plus opportunity.

Kevin Maczka - BB&T Capital Markets

Bill, as you look at your portfolio of products, is that where you want it now or is there still some culling of underperforming products or businesses to take place yet?

William C. McCartney

We don’t have any plans for any major change-outs right now.

Patrick S. O’Keefe

We periodically look at our product lines though and I think in an environment like we are operating in today, we probably need to go back and take a look at some of those.

Operator

Your next question comes from Francesca McCann - Stanford Group.

Francesca McCann - Stanford Group

In terms of the pricing pass-throughs, how successful have those been and where do you anticipate those for Europe specifically?

Patrick S. O’Keefe

If you look at the history, which has taken place over really the last four or so years, I’m not saying any of them are easy, but we’ve been effective in passing through some pretty aggressive price-based adjustments based on cost as the driver. And I think our customer base is pretty aware of what’s going on with copper, they are very aware of what’s going on with oil, very aware of what’s going on with stainless steel.

So I would anticipate with the exception of the fact that your end markets are slowing down, that we would have a pretty good shot at pushing those through because everyone is aware of what the cause of them is. We’re not trying to improve our margins or anything else. We’re just trying to pass through cost increases that are materially based. And secondly, they do impact you and your competitors at about the same rate. Even if they’ve got a small advantage, it’s temporary.

Francesca McCann - Stanford Group

Also looking at some of the new products that you are introducing in Europe, can you discuss a little bit what legislation or what tax incentives support those product lines?

William C. McCartney

Francesca, it’s all over the board there. Every country is different. Some countries are actually outlawing gas-fired boilers. Some countries are providing incentives around tax rebates when you file your tax returns. It’s all over the place. But generally speaking, it’s a much more supportive environment in Europe than you see in the States around either legislation and/or incentives.

Francesca McCann - Stanford Group

So would you say then, that all or most of your new products there are directly driven by legislation or some type of tax benefits?

Patrick S. O’Keefe

They are more driven by energy conservation.

William C. McCartney

We are saying that we’ve been successful because we’ve been transitioning the product line towards these conservation and more engineering content in our product line and we’ve been, we think, beating their overall trends in Europe. It doesn’t mean that all of our products are like this. We still sell some potable water products and traditional plumbing products that have nothing to do with this. But because we’ve been transitioning the product line we’re doing better than the general trend in Europe.

Patrick S. O’Keefe

Francesca, there are two trends that have helped us in terms of our new product development in Europe. One is to package components into a system, where you make the installation of a system much easier and you can do it with a plumber’s apprentice versus a full-scaled plumber.

So one is, I would consider the theme to be ease of installation. The other one is energy conservation, which is driven by a movement away from floor-based traditional gas and oil-fired burners to alternative under-the-floor heating systems, solar heating systems and things like that. So I think really the trend is ease of installation and energy conservation are the two drivers.

Francesca McCann - Stanford Group

And then still on the European market, what signs do you see that show that the Northern European countries and your new market with the acquisition is somehow more resilient to the slowdown that we have seen spreading and spreading into Eastern Europe?

Patrick S. O’Keefe

Only thing we could talk about is we have seen softness in Germany, we have seen some softness in Italy, we have seen some softness in Southern Europe, but we haven’t seen the same softness in the other economies.

Francesca McCann - Stanford Group

And then share repurchase plans moving forward?

Patrick S. O’Keefe

Yes, you see that in the quarter we didn’t buy very many shares back. We basically reserved our cash for the acquisition of Blucher. So we are sitting down now to evaluate where we’re going. But our feeling is, is that we would reserve our stock repurchase for repurchases at more attractive prices than we have seen. So really I think we still have, we have a program out there but we have chosen not to buy at high levels. Remember, our first priority is acquisitions for our use of cash.

Operator

Your next question comes from Christopher Glynn - Oppenheimer.

Christopher Glynn - Oppenheimer

Just in terms of the China-North America interplay and the reported trade revenues wouldn’t be impacted in China by the North America weakness, but the margins would because the absorption in some of the products in the same factory as the domestic sales is that right?

William C. McCartney

Yes, in some cases that is true. We have about five factories or so in China. Some are captive that just produce product back to the United States and if they produce it at a normalized level of capacity, then there is no manufacturing variances.

But if we take them below their normalized capacity levels according to the accounting rules, we have to expense the absorption variances. So that would impact the margin in China when we do that. Some of the factories are mixed where we are selling into the domestic Chinese markets and bringing it back to the States. So you have both situations.

Christopher Glynn - Oppenheimer

So the captive markets, those absorption variances are reflected in the North American margins, I take it?

William C. McCartney

Now, they’d be reflected in the China segment when they occur.

Christopher Glynn - Oppenheimer

So they are not really matched with the revenues then?

William C. McCartney

Well, they’re matched in the segment in which they occur. So they are not matching the North American revenues, though, you are right.

Christopher Glynn - Oppenheimer

Maybe another angle on the pricing versus the end market, it looks like maybe price was a little stronger in the fourth quarter than it was in the first, is that fair?

William C. McCartney

Well, I think our unit pricing basically held up from fourth to first for the most part. If you’re looking at changes in the margin here, it’s because of these operating issues and the decline in volume. There’s a little bit of mix going on there, but.

Christopher Glynn - Oppenheimer

Do you have a more specific figure on what the price was in Europe?

William C. McCartney

It’s difficult for us to get around that because there is so many business units in Europe, in different countries and the price increases are very selective over there. So, it’s difficult to come up with a meaningful disclosure there.

Operator

Your next question comes from Ned Armstrong - FBR Capital Markets.

Ned Armstrong - FBR Capital Markets

In your introductory remarks, you had mentioned a number of different operating initiatives you were pursuing. Can you just talk a little bit about the benefits that you hope to get from those initiatives in terms of points and margin inventory turns and the type of timeframe that you anticipate they will be realized over? And I understand you can’t be precise, but if you could just give us some good directional information, I think that would be helpful.

Patrick S. O’Keefe

Yes. The programs you’re referring to are, one, we’re focused on maximizing our cash flow and the second one is we’re clearly focused on operational efficiencies and productivity improvement, trying to inoculate the organization with Lean fixing techniques.

Our gut reaction is that these programs will probably pay for themselves in 2008 and will have ongoing benefits in 2009. I don’t have real hard numbers for you, but I think it’s quite clear that we have a nice opportunity to work on these programs and improve the organization’s operating efficiencies long-term as well as near-term.

Ned Armstrong - FBR Capital Markets

Now, are you thinking as far as in terms of maybe 100 to 200 basis points over the next couple of years or something significantly more or maybe less?

William C. McCartney

Ned, if you are in a world-class manufacturing company, you should be able to get a couple of hundred basis points out of your cost of goods on an annual basis. The question is how long will take us to get to that level? We don’t know yet but we’re putting an awful lot of emphasis on this and upgrading our management.

That is sponsoring and requiring all of our manufacturing people and even the administrative people and whatnot, everyone is going to these Lean training and Six Sigma training sessions and we’re putting a lot of resource into it as well as upgrading a lot of our strategic sourcing personal to help us on that side as well.

So we’re trying to attack it from all levels, looking at sourcing, manufacturing. We’re also looking at our distribution expenses, how we can take cost out of that, that’s a big operation for us at this point in time. So we are upgrading all of these with new management, with additional resources, training, etc.

Ned Armstrong - FBR Capital Markets

From the acquisition perspective, clearly it would seem that the universal companies that you’re looking at as acquisition candidates are feeling the same type of pressures that you are in the European and American markets. Have you seen that translate to multiples yet and has that weakness resulted in sellers maybe pulling in their horns a little bit and waiting for a recovery, whenever that may come.

Patrick S. O’Keefe

Yes, in my opening comments, I talked about that a little bit. We have seen some nice properties come to market in Europe and I think at fairly okay multiples in terms of numbers that can make sense from the economic models that we run. We run the same economic model on every deal we do. I think in the U.S., we see the market, if anyone was exposed to the residential market; it’s probably deferring taking their property to market any time soon. We’re hoping to see some pickup in the second half of the year. But right at the moment, there is very few properties up for sale.

Ned Armstrong - FBR Capital Markets

With respect to Europe, any countries stand out as being especially resilient or particularly weak in the current environment?

Patrick S. O’Keefe

Yes. I think we’ve said this, but we’ve seen softness particularly in Germany and dropping down into Italy. I’m a little bit concerned too because you also have another issue which we are dealing with it at the moment which is the pound sterling is dropping versus the Euro, so that you need to the extent that you manufacture products in Euro-based plants, you have price increases that need to take place to recover the changes in the currency in the U.K. So my gut reaction is you will probably see a little bit of sluggishness in the U.K. going forward.

Ned Armstrong - FBR Capital Markets

And you haven’t really seen any country that’s been particular resilient to the forces at work over there?

Patrick S. O’Keefe

Not really, to be honest with you. I think there is nobody standing out as being totally resistant. I think you see just a general slowing down.

Operator

Your last question comes from Ryan Connors - Boenning & Scattergood.

Ryan Connors - Boenning & Scattergood

Obviously we are in a very difficult environment right now in terms of the point that we’re at in the cycle. And given that both of you have been through down cycles in this industry before, I thought it would be valuable to get your perspective on how this cycle compares with past down cycles and economic cycles and construction downturns that you’ve been through. And in particular, are we in an environment here that’s a whole lot worse than what you’ve seen in the past or is this par for the course for what you would expect to be seeing at this point in the cycle?

Patrick S. O’Keefe

Well, let’s just talk about when you had down cycles that were significant. You had a cycle in the early ‘80s, which was quite severe. You had another down cycle that took place in I’d call it 1990, ‘91, ‘92 timeframe and probably closer to ‘92. And both of those were pretty severe. You remember in the early ‘80s, you had high interest rates driving housing markets down to very low levels.

And so I think this is little bit different in that this is caused by liquidity issues in terms of credit availability. And our objective is quite honestly when you think about the initiative that we’ve already discussed in my opening comments and on the answers to some of these questions, we’re focused on maximizing our position in terms of driving unnecessary costs out of the business, maximizing cash flow with the intention of coming out of this down turn a stronger company than we went into it.

So when you look at all the initiatives, that are really what they’re trying to do, you are trying to build yourself into a world-class organization, despite the fact that your end markets are tough. So a lot of our initiatives are focused on cost reduction and focused on cash generation.

Operator

There are no further questions.

Patrick S. O’Keefe

Thank you everybody for joining us today. We look forward to talking with you at the end of our second quarter, which will probably be the end of July. We will have that scheduled here shortly. So thank you for joining us and thank you for your continued support of Watts.

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