Watts Water Technologies Inc. Q2 2008 Earnings Call Transcript

| About: Watts Water (WTS)

Watts Water Technologies Inc. (NYSE:WTS)

Q2 2008 Earnings Call

July 29, 2008 5:00 pm ET

Executives

Kenneth Lepage - Assistant General Counsel

Pat O'Keefe - CEO and President

Bill McCartney - CFO and Treasurer

Analysts

Mike Schneider - Robert Baird

Kevin Maczka - BB&T Capital Markets

Ned Armstrong - FBR Capital Markets

Christopher Glynn - Oppenheimer

Ryan Connors - Boenning & Scattergood

Todd Vencil - Davenport & Company

Jeff Hammond - KeyBanc Capital Markets

Jim Fung - Gabelli & Company

Operator

Good day, ladies and gentlemen, and welcome to the second quarter 2008 Watts Water Technologies Earnings Call. My name is Schinel, and I will be your coordinator for today. (Operator Instructions)

I would now like to turn the presentation over to your host for today's conference, Mr. Kenneth R. Lepage, Assistant General Counsel. Please proceed.

Kenneth Lepage

Thank you. Before Pat and Bill begin, I want to let you know that various remarks they may make about the company's future expectation, 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 most recent annual report on Form 10-K for the year ended December 31st, 2007, and other reports we file from time to time with the Securities and Exchange Commission.

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. 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.

Pat O'Keefe

Thank you, Ken, and good afternoon, everyone. Welcome to the second quarter conference call and thank you for your continued interest in Watts Water Technologies.

Following my remarks, Bill McCartney, our CFO, will provide you with financial highlights for the company in total, and Bill will also cover individual sector results. Then, we will answer any questions you may have.

Before we get into the quarterly results, I would like to briefly update you on a few important items; first, regarding the progress in our restructuring program. In Q2, we took an additional pre-tax charge of approximately $1 million related to severance and relocation cost.

In the quarter, we finalized the move of our Chinese joint venture operations whose physical plant was taken over by eminent domain. This move will ultimately reduce headcount and improve our manufacturing efficiency. We will speak to China separately in a few minutes when we discuss our outlook.

In general, we are on target regarding the timing and implementation of various restructuring programs in the U.S. and China. Our European management team is reconsidering the details of this restructuring program which will cause a delay in both the timing and cost incurred and the expected savings to be realized. We now expect savings in 2008 from the restructuring exercise will approximately $500,000 pre-tax. This amount is $400,000 lower than discussed previously, again with most of the savings being realized in the second half of 2008.

With regard to the Chinese joint venture purchase, in June, we paid approximately $3.3 million for our partner's interest. There is a conditional $2.2 million that may be owed to our former joint venture partners, but only upon one partner meeting certain terms and conditions of the purchase agreement. As we have mentioned before, having this operation fully under the Watts umbrella will allow us to control this company in the same fashion as we control other wholly-owned business units.

Now let's provide you with an update on our stock repurchase program. As of yesterday, Monday, June 28th, we had repurchased 2.45 million shares on the open market and we have invested $68.1 million to repurchase those shares. The accretions on earnings per share from the repurchase of the shares in Q2 '08 were $0.03. The expected effect on our earnings per share from the repurchase program in 2008 will approximate at $0.12.

As mentioned last quarter, we still expect to have capital flexibility in the form of existing cash and available credit lines for the opportunistic and acquisition market price.

Next, let me address the acquisition program. As you already know, on May 30th, we announced the closing of the acquisition of the Blücher Metal at a cost of approximately $169 million, plus the assumption of approximately $15 million in debt. The Blücher acquisition is the largest that Watts has ever made. As you know, Blücher 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. Blücher offers Watts a new platform within the European marketplace.

The transition of Blücher into the European operations has gone very smoothly during the first two months. Blücher, as expected, was dilutive to our earnings in Q2 by $0.01. We expect Blücher will be dilutive to by approximately $0.04 in Q3 and anticipate that Blücher will be accretive to earnings by approximately $0.05 in Q4.

As mentioned during the first quarter conference call, we continue to explore other potential acquisition candidates in Europe, and we continue to see deal volume in the U.S., but at lower level. We would hope that the pipeline will pick up as we move forward during the remainder of this year and into 2009. In China, however, our focus in the near-term continues to be on operational improvement.

Our 2008 initiative to maximize cash flow and promote operational efficiency and productivity are proceeding well. Regarding cash flow, I am again pleased to inform you that we continue to generate positive cash flow through the various working capital initiatives.

For year-to-date June 2008, we expect to generate positive cash from operating activities of approximately $40 million, which compares favorably to the $200,000 net use of cash from operating activities in the first half of 2007. Net cash outflows from working capital have decreased from approximately $57.7 million in the first half of 2007 to approximately $7 million in the first half of 2008, so great progress made there.

Regarding operational improvement, Lean and Six Sigma continue to be a strong area of the government at Watts. To date, 1200 Watts employees have attended training programs. The executive leadership team has received formal Lean awareness training and process innovation training during the second quarter. We have recently placed a senior person to head up our Lean and operational excellence effort. Each major manufacturing location is working to build Lean/Six Sigma black belts and green belts. In addition, they are establishing steering teams to charter, prioritize and execute events.

Performance scorecards have been implemented that track the key metrics such as on-time delivery, inventory turns, cost reduction and quality improvements. We have conducted several high-impact Kaizen events and have generated cost and inventory reduction. We will expand Lean techniques to our small manufacturing locations as the year progresses. We are still in the early stages, but are very committed to this and therefore are very pleased with our early successes.

I would like to take a moment now to discuss the most important resource, our people. As a company, we are committed to finding talented people who can lead the organization into the next decade. As I just mentioned, we hired a senior level employee to drive our Lean initiative.

In the second quarter, we also hired a new President of North America and China, David Coghlan who will make significant contributions to our business. We also hired a new VP to add more depth and expertise to our sourcing capabilities, and we expect that a new general manager for our French operation will be on Board in the near future.

We anticipate that these leaders will help us drive new business opportunities, will help make our operations more efficient in the future.

As mentioned in our last conference call, in a changing economic environment, we believe that new product development and product expansion into new markets will be important driver of growth. As an example, we believe our results for Q2 were enhanced by packages we sell into the European solar and energy conservation marketplace. These packages were first introduced in 2006, and our sales have expanded as a reaction to higher oil and gas costs.

Finally, I would like to make the following observation regarding the just ended quarter and our outlook for the balance of 2008. Bill will provide you with financial details in a moment. Overall, our financial results for Q2 were stronger than we anticipated, given the macroeconomic environment in which we are dealing. We had organic growth in sales for the first time since Q3 '07.

Europe contributed to a solid quarter as we were able to leverage additional volume with some rationalization efforts we had made over the past several years in Italy. Some of the big customers in Europe are larger boiler OEMs. They have increased their inventories in anticipation of new orders for alternative energy and energy conservation devices.

We believe they are anticipating that the higher oil and gas prices are going to increase demand for such products, and in turn, the packages and products we sell to these OEMs for solar and other applications were very strong in Q2. Although, we have minimum insight into the future demand for these large European customers, given the recent order intake, we expect that trend will continue into the third quarter, and we still believe that our broad product offering that we can deliver on a Pan-European basis will allow us to continue to gain market share versus smaller competitors.

Turning our attention to the European macro environment, we see signs of an economic downturn with increased inflation and higher unemployment. Higher energy costs are causing wildcats strikes in some countries such as Spain, U.K. and France. A recent article on a Wall Street Journal on July 25th indicated that the risk of recession in 15-year-old zone country is higher than given some of the more recent negative trend. All in all, this information provides a concerning outlook for Europe.

So, near term, we are somewhat bullish, given the reaction to the higher oil and gas prices and the slug of alternative energy products we are selling. We are not sure of the impact the economy will have on our result as we move forward into 2009.

In North America, our growth in Q2 was positive due to higher U.S. retail sales and a Canadian economy that is still performing very relatively well. In general, we experienced and are continuing to see a lot of variability in customer demand.

For the first month-and-a-half of the Q2, our run rates were in par with those that we experienced in Q1. Orders came in much stronger later in the quarter. It appears that the retailers and wholesalers were restocking in Q2 after having run their inventories down in Q1 and the first part of Q2. We also saw sales increases in the big membership stores such as Costco, likely an indication that consumers are trying to save money in a tight economy.

Our Canadian business continues to perform well in most areas of the country. Our burden is an especially active area, given the growing oil-sand production due to the higher oil prices, but also new cold regulations for backflow devices in Canada, which is helping our backflow sales there.

Wholesale sales in North America were down 1% in Q2 which is primarily due to the softness in the residential market. The U.S. commercial markets are tough to gauge. We see larger markets are fairly strong, but some of the smaller commercial markets are struggling. (inaudible) for commercial area is not very positive and mentioned in the past.

We look at both the Dodge reports and the architectural billing index as data point in evaluating macroeconomic trends. The Dodge report of expectations for commercial square footage as of March showed a reduction of 12.8 for 2008 compared to 2007. This reduction has increased from 7.4 as predicated in the December timeframe.

The June ABI index stood at 46.1, which is up from May, but still below 50 for the fifth consecutive month, meaning business levels at the architectural firms have deteriorated and continue to deteriorate. Both these trends are obviously concerning. At this point, I would hold to my previous statement that the commercial space will have minimum growth for the remainder of 2008.

Taking a look at the domestic residential channels, the headline news is fairly gloomed. Single-home inventory levels stand at 11.1 months in June. Single-family construction starts were down sequentially 5% from May of '08, which is the lowest space since January of 1991. Home prices keep on falling and potential buyers are squeezed by banks through tighter lending standard.

In short, I still do not believe that we will see any upside in the residential market place until approximately mid-2009. Regarding the pricing in U.S., we are expecting selected price increases to take effect in September. These are mostly to cover cost increases in products made of cast iron where we are seeing escalating costs. However, the effect will be minimal on Q3, but has a positive effect on the margins in Q4.

As far as the U.S. replacement market is concerned, from what I can gather, the market remains fairly steady and will remain that way for the remainder of 2008.

In summary our view on North America is that we can expect Canada to continue its solid performance. We see near-term opportunities in the U.S. running at rates that are somewhat between what we saw in the first and second quarter of 2008. We are not sure we will receive any restocking just like we saw from retailers and wholesalers at the end of quarter two.

Margins maybe slightly constrained in Q3 until we see the benefits from selective price increases which will help margins in the Q4.

Now, let's talk a little bit about China for a moment. The Q2 results for China were disappointing and exasperated by the move of our plant in Tianjin TWT and our labor dispute at a South China plant WPT, which we discussed during our Q1 conference call. Both of these issues continue to negatively affect our results in Q2.

As mentioned during the Q1 conference call, much of the Chinese operations served as a (inaudible) plant for products sold into the North American and to a lesser extent into Europe. As North America has trimmed the inventory levels as part of the company's overall working capital initiatives, production levels at our Chinese locations have dropped significantly, which has caused overhead under-absorption issues. Commodity prices, value-added tax and a currency swing have also affected our Chinese results.

The main Chinese domestic sales company, Changsha, which makes large diameter hydraulic butterfly valves, is experiencing shipping delays due to the earthquake in Central China a few months ago. Although order rates remain strong, we expect shipping delays to persist into 2009.

Our senior operational management is keenly focused on addressing the production and potential operating opportunities that exist in our Chinese manufacturing. We expect further plans will be initiated over the next several quarters. In short, we expect China will continue to under-perform with capacity issues and shipment delays through the reminder of 2008.

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

Bill McCartney

Okay. Thank you, Pat. First of all, just to note that the figures that we released today on our press release are consistent with the pre-release that we had a week ago, Friday. As I go through the results here, I would like to comment both on a comparison basis to Q2 2007 as well as to Q1 of 2008 just to give you a feel for where we experienced some of the improvements.

So, here we go. Revenue, $389 million, was up 11% versus Q2 last year, and we picked up $45 million of revenue versus Q1. As we go through the segments, I will point out in each area the reasons for the improved revenue.

When you look at the overall revenue, though, organically, we grew $5.7 million or 1.6% from foreign exchange, primarily the euro. We picked up $20 million or just about 6%. From acquisitions, we picked up $12 million, 3.5%. Those are the acquisitions of TGI and Blücher. So, that totals $39 million.

What I would like to do now is just to take a look at our overall, we call, reconciliation to our earnings per share, both to last year and to Q1. When we look at last year's second quarter, we had $0.46 EPS, which excludes our restructuring charges. As we row forward into Q2 this year, we pick up $0.03 because of our buyback. We picked up $0.05 because of the foreign exchange rates, the euro strengthening relative to the dollar.

In Q2 of this year, we had some favorable result in our tax line due to a change in some of the Italian tax law and a favorable result on a state tax audit here in the United States. So, that is $0.03 there. Then we lost $0.01 from Blücher. We thought we would have about $0.02 of dilution. We actually had $0.01 of dilution, Blücher's margins came in a little bit better than we are expecting due to a good mix and some good savings on some material projects. However, we still had dilution of $0.01.

If you look it below the line, we lost $0.04 versus last year, and that is primarily due to lower interest earnings because of having less cash on board as a result of our stock buyback and acquiring Blücher and lower interest rates versus the last year.

We look at all those adjustments and that tells you we would have had a $0.52 quarter. So, from an operating standpoint, we believe that in the second quarter of this year, we had $0.04 improvement in our operations. I will go into detail now as we go through the segments, but that is primarily driven by improved pricing in North America, a little bit of a favorable mix in Europe. We have volume and leverage occurring and then some offsets from China as a result of the issues that Pat mentioned a moment ago, some of the increase in cost was seeing associated with foreign exchange, VAT and lower volumes in the plants.

Now, the same analysis, if you take a look at that, comparing ourselves to Q1 of 2008, you will recall we had $0.39 earnings per share from operations, excluding restructuring. So, we would have picked up about $0.01 from Q1 on foreign exchange rates. We would have picked about $0.03 because of the tax rate issue. We would have lost $0.01 on because of dilution of Blücher. We would have lost $0.01 below the line, not because of the change in interest, but because of the minority interest changing, because we brought out the 40% of our Chinese joint venture. So, we loose that minority interest.

So that tells you that we would have $0.41 quarter on a comparable basis. We had $0.56 quarter. So, we had $0.15 improvement in operations from Q1 into Q2. We look at that, it is really driven by improved volumes and gross margins in North America, improved volumes in operating leverage in Europe and again offset by some of the operating issues in China around plant moves and increased costs.

What we would like to do now is just go into the typical analysis that we provide you regarding our segments. Look at North America in total, $235 million of revenue. That is an increase of 4.5% versus last year and that is 2% organic growth, about 1% from foreign exchange that is the Canadian dollar, and acquisitions of 2% which both come to 4.5% or $10 million.

Now, looking at the wholesale side, in North America, if you exclude the acquisitions, we were at $181 million, and that compares to $163 million in Q1, and was down about 1% versus last year. When we look at Q2 over Q1 in North American wholesale, really what we are seeing is that we had a pretty good irrigation season and the commercial construction came in pretty good. As Pat mentioned, some markets are weak and some markets are strong, but overall, the commercial came in good versus Q1.

Compared to Q2 last year, obviously we are continuing to see the softness in the residential side, but the commercial side is up somewhat. We believe that we would have had an overall volume increase on the commercial side, very low single digits, and on the residential side, a decrease in unit volume of about 10%. Then those items are offset by some favorable pricing.

Looking at the retail side, $48 million in Q2 compared to $43 million last year and $43 million in Q1 of '08. Versus last year, we are seeing some rollouts and some of the large changes on some new products that we are doing, and we are seeing some pricing. We believe that we have a decrease in unit volume of about 5% because of the slowness on the residential side.

Now, we compare that to Q1, and we saw about 11% reduction because of the slowness in residential which we also believe was due to some destocking. So, we had a pick-up of about 5 points because of the change in destocking in Q1 to some improved stocking levels in Q2.

In Europe, $139 million in the quarter, that is a growth rate of 29% versus last year. Compared to Q1, Europe was $122 million. Looking at the components there, we had organic growth of $4.8 million, which is 4.4%. The FX was $18 million versus last year, about 17%, and in the acquisitions, $8 million or 7.6%, which totals $31 million or 29%.

Again, we compare that activity to Q1, organically we had negative growth in Q1 in Europe of 7 points. So, we saw quite a difference in our order entry rate really due to the fact, as that Pat mentioned, where late in the quarter, we saw a surge in orders around energy efficient products, once we will hit about $140 a barrel. We expect those trends to continue into the next couple of quarters, as Pat mentioned.

In China, $15 million of revenue, that is a decrease of 14% versus last year, and it is a pick up of about $5 million versus Q1. So, when you look at China, first of all, you recall in last year's second quarter, we had four months of activity for couple of our smaller business units, and this year, we are only having three months of activity, because if you recall, last year, as we explained to you that we were bringing all of our accounting and reporting up to a current basis. So, we had a four-month quarter. So, that actually had an impact of about $2.5 million pick-up on the revenue.

So, if you had a three-month quarter to a three-month quarter, the total revenue in China would be flat year-over-year, and it still is up $5 million versus the first quarter. However, I think Pat mentioned a lot of the issues that we are having there. The order entry rate for our infrastructure business remains good, even though we are having some issues around the late shipments because of the earthquake, and we had fewer sales because some of the disruptions in the other plants.

On the gross margin side, 34% on a consolidated basis, that is up 1.5 points versus last year and versus 33.2% in Q1. Now, we will talk about the margin in each of the segments. North America's gross margin was 35.4%. That is up 4.1% versus last year and up about 1 point versus Q1.

Looking at the margin in North America, we have much more favorable pricing versus last year in North America. We also had a much more favorable product mix and some of our products on the commercial side. Then versus Q1, it is really associated primarily with the sales volume that I mentioned earlier to you.

In Europe, gross margin is 33%. That is one of the best margins we have seen in Europe for many years, and that is an increase of 1point versus last year and 1.5 points versus the first quarter. So, we are seeing in Europe relative to the margin, it is a function of the increased volume, but as you recall, about a year-and-a-half ago, we did some restructuring in Europe where we consolidated a couple of plants in Italy into one plant that were starting to see the impact of that plant consolidation with this increased volume.

We are also in the process of the coming year restructuring in Europe where we are bringing additional work into those plants. Then a combination of the restructuring, bringing the work in house from another plant that we are downsizing and increased volume from the energy orders, that really created some nice operating leverage in our giant factories. That is what, in combination with the volume, gave us a nice improvement in the gross margin in Europe.

Again, looking at China, the margin is 7%. That is down from 15% last year, and it is down 1 point from Q1. Again, it is the same issues that we have been mentioning, lower production levels and some of the higher costs that we are dealing with around foreign exchange rates, change in taxes, some local inflation and the inefficiencies that we are dealing with surrounding plant relocations and some of the labor issues that we have in Southern China.

The SG&A at $96 million is up $12 million versus last year. We break that out into the factors. From an organic standpoint, we were up $4.7 million. The foreign exchange was $4.2 million. Then the inclusion of the SG&A from acquired companies is $3.5 million, and that brings you to the $12.4 million in total.

So, operating earnings, $35 million at 9%, that is up from last year at 8.6% and up from first quarter which was 7.6%. That really is a result of the improved gross margins and the operating leverage from the volumes that we discussed. When you look at the overall operating earnings, we are up about $5 million versus last year. That is primarily due to two factors. One is the volume and improved margins and then contribution from foreign exchange.

Below the line, we had an increase in expense for the line of about $4 million. That is entirely due to changes in interest income as a result of the lower cash we have on hand, because again purchasing Blücher, the stock buyback and some of the lower interest rates.

The tax rate 31.2% this quarter, down about 1 point versus last year and down about 2.5 points versus Q1, and that is the result of the tax law change in Italy and the state tax audit that we had in the U.S. Overall net income from continuing operations at $20 million is up from last year's $17.7 million.

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

Question-and-Answer Session

Operator

(Operator Instructions)

Your first question comes from line of Mike Schneider of Robert Baird. Please proceed.

Mike Schneider - Robert Baird

Good afternoon.

Pat O'Keefe

Hi, Michael, how are you doing?

Mike Schneider - Robert Baird

Good. Pat, maybe first just on your opening comments about some of the European restructuring being rethought. I think you use your word. Could you explain what is changed there and again run through the math as to the savings delay, or push-out?

Pat O'Keefe

We are rethinking some of the restructuring mostly in terms of the timing of it. It is mostly delayed because of the fact that I mentioned later in my comment that we were hiring a new manager for one of our operations, the French operation. They want to make sure that he or she whoever comes on Board is completely behind that program and is brought into it. So, that is really what it is, more of a delay, Mike, than a change in the program.

Mike Schneider - Robert Baird

You had done modeling, 4,000 of the savings gets pushed from '08 to '09?

Bill McCartney

That is right.

Pat O'Keefe

That is correct.

Mike Schneider - Robert Baird

Okay. Then just in the domestic wholesale channel, if I recall last quarter, the volumes in U.S. wholesale were down about 10% in Q1. In Q2, it looks they were probably down mid single digits. Any change in distributor tone or restocking, destocking or just in product mix or strength that occurred during Q2 to explain the less negative results?

Pat O'Keefe

Yes, it is quite clear, Mike, what was going on. In Q1 and for the first half of Q2, we still had destocking going on. They were selling off their inventory and bringing their inventory levels down. Apparently, they went too far, because we saw both on the retail side and on the wholesale side, the last 45 days of the quarter are very strong import that continued right through the end of the quarter.

Now, I think that is a reflection of the fact that activity was not as low as they anticipated it, going into the summer months. So, the question that we are struggling with now is where we see that continue into the third quarter. We do not really know at this point. We also do not know what they are going to do as they get toward the end of that quarter.

Whether there is a restocking in anticipation of a strong fall, it depends I think a little bit on what the basic activity is at the contractor level. The one thing I would say, Mike, this is a really unusual year. The main patterns defy history and now they are much more erratic.

Mike Schneider - Robert Baird

Sure.

Pat O'Keefe

That is what you saw. I think our internal forecasts for the first half of the year were accurate, but they were inaccurate depending upon if you measure them by quarter or measure them by month.

Mike Schneider - Robert Baird

Sure. Then just in Europe, the strength in the solar and geothermal type products led to growth. Are you able to discern what Europe did, or what the trend was in Europe through the quarter if you back out those types of products?

Bill McCartney

Well, we were on a path, Mike. If you look at Q1, okay, before we had the surge in oil, we were down 7%. Going into the first half of Q2, we were thinking we were flat on that a trend. We wound up being positive by 5 points in the whole quarter and that surge of orders really started occurring in the second half of the quarter.

Mike Schneider - Robert Baird

Okay. So…

Pat O'Keefe

They are continuing into the third quarter as well, Mike.

Mike Schneider - Robert Baird

Can you describe these type of products, what are the typical applications, what type of systems, who are the customers, and specifically, is this a channel fill going on or an inventory build by some of these OEMs and just really what the sustainability of this trend is if we assume crude stays where it is?

Pat O'Keefe

Yes, these are sub-component systems that go into basically solar application and condensing boilers. Condensing boiler is a more efficient boiler, Mike, and a solar is an alternative energy package. We also make a number of units that measure the thermal heat usage by individual apartment, apartment by apartment. So, you might have centralized heating system for a large multi-storey apartment building, but you want a factor reported cash register on every individual apartment to measure the energy use in that apartment. So, those are the type of products that these are.

Mike Schneider - Robert Baird

In terms of like a channel fill or inventory stocking by the OEMs, can you detect where they are in this process?

Pat O'Keefe

Well, I think, Mike, they are anticipating a strong fall selling season, because I think they expect their people to upgrade their existing heating system to put in a more energy efficient or alternative energy system. This is anticipated demand that will be sold primarily in the third and fourth quarter.

Mike Schneider - Robert Baird

This has cannibalized other products you have got?

Pat O'Keefe

Not really, no.

Mike Schneider - Robert Baird

Okay. Thank you.

Operator

Your next question comes from the line of Kevin Maczka of [BB&T] Capital Markets.

Kevin Maczka - BB&T Capital Markets

Hi, Pat and Bill.

Pat O'Keefe

Hi, there.

Bill McCartney

Hi. How you are doing?

Kevin Maczka - BB&T Capital Markets

Just a question on the raw material side. I think we said last quarter that you were expecting a little bit bigger hit in Q3 then what you thought you would see in Q2. Is that still your expectation? You always get the question about the whole price cost relationship. Can you just give a little bit more color on where you stand there?

Pat O'Keefe

Yes, that statement we still hold by that. What we are seeing is increases in plastic resins because of the oil, and we are seeing increases in cast iron, a little bit on the copper side as well, but mostly driven by cast iron and plastics. We are going out with a price increase which will be effective for our major business units towards the middle of September. So, we will see a little bit of unfavorable hit on the margin in Q3 because of material. Then, if we are successful with the price increase, we expect to offset that for Q4.

Kevin Maczka - BB&T Capital Markets

Okay. Pat, just going back to your comments on the outlook in Europe, I was a little bit confused. I think you were talking about the surge in oil potentially benefiting some of these energy conservation products that you are rolling out, but you had, of course, the slowing economy in general as a negative. So, how do we reconcile that again?

Pat O'Keefe

I am pretty bullish on the second half of the year in Europe. I am concerned as we go into 2009, okay? I think the demand that we are seeing here in the second quarter is going to continue at least through the third quarter and probably into the fourth quarter. Where I am concerned is, is what happens as we go into 2009, because there are a lot of issues in Europe similar to what we are seeing in North America in terms of the economic slowdown.

Kevin Maczka - BB&T Capital Markets

Okay. Finally, one more quick one if I could. The energy products, can you talk about what percent of your mix in Europe those represent today?

Bill McCartney

About half our business in Europe, Kevin, is heating. Okay? I will say half of it is OEM, okay? These are selling heating products into the large pressure vessels, boiler and water heater manufacturers. They have been going through a transition over the last couple of years, transitioning from gas side appliances to solar and what not, these alternative energy technologies.

Their base businesses on gas side has been declining anywhere from 25% to 30% per year for the last two years or so. However, what we saw in this quarter was when oil really hitting an all time high, I think like $140 a barrel, what we call the point of pain, where people really got up and took notice. Like $4 a gallon in gas is very painful for the people in the U.S. so they started changing their behavior. What feels like $140 a barrel is the point of pain in Europe for these heating products? So, it is a major part of our business and it is being going through quite a transition over the last couple of years.

Kevin Maczka - BB&T Capital Markets

Okay, great. Thank you.

Operator

Your next question comes from the line of Ned Armstrong of FBR Capital Markets.

Ned Armstrong - FBR Capital Markets

Thank you. Good afternoon.

Pat O'Keefe

Hi, Ned, how are you?

Ned Armstrong - FBR Capital Markets

Good, good. To the degree that you can, can you talk about the commercial markets in the U.S. by type of structure, be it office, hotel, retail? Are you able to differentiate any patterns there as to whether one is any worse and the other are not?

Pat O'Keefe

Let me just make some general comments, and then you can look at the Dodge reports, and this will help you. However, Watts is generally beneficial when there is a high occupancy rate in a facility and particularly high occupancy with high sanitary concentration of sanitary processes. So, if you were to look at the Dodge reports, Watts' best is something like a doctor's office or a nursing home or a hospital with a lot of beds and a lot of sanitary function in them.

You think of hotels being the same way. We hate warehouse space and those things. So, if you look at the Dodge report, I do not have them available at the moment, but you want to look at those areas where healthcare is a good one, hospitality industry is a good one, office space is a good one for us, prisons are good ones for us. When you get to manufacturing and industrial space, very much discounted.

Ned Armstrong - FBR Capital Markets

Okay. Bill, on the tax benefits that you alluded to, do you know what the impact of each one separately? Is that possible to break out?

Bill McCartney

I can tell you if you like. The one in Italy was 330,000 euros. In the United States, it was $430,000.

Ned Armstrong - FBR Capital Markets

Okay. Then, what was share count at the end of the quarter?

Bill McCartney

Hold on. I will give it to you. One second. It should have been on the press release, Ned. Let me just see it. I think I have it here. 36.8 million.

Ned Armstrong - FBR Capital Markets

That was at the end of the quarter?

Bill McCartney

Yes.

Ned Armstrong - FBR Capital Markets

Okay, good. Thank you.

Bill McCartney

Okay.

Operator

Your next question comes from the line of Christopher Glynn of Oppenheimer.

Christopher Glynn - Oppenheimer

Hi. Thank you.

Pat O'Keefe

Hi, Chris.

Christopher Glynn - Oppenheimer

Hi. So, Around the solar geothermal in Europe, you gave a breakdown of the segment in terms of the half heating, half OEM. My impression is that the solar geothermal energy related things crust over both of those pieces. Can you resize that to your current mix?

Bill McCartney

Well, I think what we were saying is that approximately half our business in Europe is OEM. It has a about 45% wholesale and about 5% do-it-yourself. This OEM business is the large boiler manufacturers that are incorporating all these products into their units in their systems. Okay? So, the OEM is primarily a heating-oriented business, i.e., heat water.

The wholesale side is both plumbing and the replacement business for heating as well. We do not see that geothermal solar on the wholesale side, because it is still relatively new in the replacement business, really has not built up in there yet.

Christopher Glynn - Oppenheimer

Okay. On the OEM side, it is the majority now?

Bill McCartney

It is a significant portion of the OEM business. I do not want to say it is the majority.

Christopher Glynn - Oppenheimer

Okay. In North America, it really bifurcates through the first half of the quarter and the second half of the quarter. In terms of sell-through, do you think that averages out to what the appropriate sell-through is, just going from destocking to over-compensating?

Pat O'Keefe

I would say that is a fair representation of what we saw overall.

Christopher Glynn - Oppenheimer

Okay. So, although it is difficult, unit volumes just saw in the quarter would be the best shot at earmarking a run rate?

Pat O'Keefe

The best way to look at it and I think is that if you look at the first six months of the year, we had destocking probably for, let me think, four out of the six months. Then we had restocking for two out of the six months. The best estimate at this point in time is, if we look at the economic environment, probably that average is good.

Christopher Glynn - Oppenheimer

Okay. Then on the restocking, do you think a pre-buy ahead of the price increases had any benefit in the quarter and who would be more likely, the OEM side or the wholesale side, to engage in pre-buy activity?

Pat O'Keefe

We did not see any pre-buy, and it is based on the pricing. I think we saw that earlier in the economic cycle, but now at this late stage in the economic, there has been so much inflation in raw material that wholesalers are not reacting that way at this point.

Christopher Glynn - Oppenheimer

Okay. Then lastly, could we just get an overall picture on what the consolidated unit volumes were year-over-year in the Europe and North American segments?

Bill McCartney

Well, I think I gave the unit volumes earlier on repeated North America, which is the estimates we have here internally. The residential would be down somewhere around 10% per unit volumes. Commercial would be up around 4%, and then pricing offsets there. Then when it comes to unit volumes in Europe, we do not really track that here, because there is so many business units and markets and what not that it is something that we really do.

If you look at our overall organic growth in Europe, we were up $4.8 million, which is 4.4%. That would have some pricing in it as well as unit volume. That is a significant change from Q1 where we had negative organic growth of 7% in Q1.

Christopher Glynn - Oppenheimer

Okay, great. Thanks a lot.

Bill McCartney

Okay.

Pat O'Keefe

Thank you.

Operator

Your next question comes from the line of Ryan Connors of Boenning & Scattergood.

Ryan Connors - Boenning & Scattergood

Good evening.

Pat O'Keefe

Yes.

Ryan Connors - Boenning & Scattergood

I want to spend a couple of minutes, if you could, on actually on the balance sheet. I think we have gone through pretty good depth on the end markets and so forth. One of the things that were interesting, for a period of time during the second quarter, the stock actually did trade meaningfully below book value for an extended period. Obviously, we can interpret that in number of ways. One of them would be that the market was saying it thought that the value of goodwill and/or the inventory and the balance sheet would have to be written down.

So, I wondered if you would take a few a minutes to address how you assess those assets for impairment and what sorts of triggering events might need you to take a look at that, especially on the intangible asset side and what the likelihood would be in your view that you would have to take that action? If so, whether or not you would have to raise capital in that a scenario?

Bill McCartney

Right. Well, first of all, I do not envision any type of impairment on inventory at all. I mean we have a very conservatively valued inventory. A lot of it is material cost that is in there. So, that is really not an issue at all.

When it comes to the goodwill and the intangibles, I mean under the rules, we are required to do a full impairment analysis every year, which we do on October 29 at the closing of our October. If you look at what we did last year, we had a pretty wide gap between the carrying value and the economic value of our intangibles.

The only place that even I think has a potential concerning around the impairment where it maybe have a goodwill in China, which we do not carry a few million dollars of goodwill in China. So, as we have some of those business units that are struggling, you are always subject to that, I would have said that is a very small percentage of our intangible assets.

Ryan Connors - Boenning & Scattergood

Okay, that is helpful. Thanks, Bill. I do not know if you mentioned. I do not think you did. Obviously, there has been a lot of noise on the tax line. Can you just update us what you full-year guesstimate is for the run rate.

Bill McCartney

Without any favorable or unfavorable adjustments, the tax rate would be about 34%.

Ryan Connors - Boenning & Scattergood

Okay, great. Well, then that is been very comprehensive here. So, that is it for me. Thanks.

Pat O'Keefe

Thank you.

Operator

Your next question comes from the line of Todd Vencil of Davenport & Company.

Todd Vencil - Davenport & Company

Thanks. Good evening.

Pat O'Keefe

Good evening, Todd.

Todd Vencil - Davenport & Company

Most of my questions have been gone over, but you mentioned that most of larger market in commercial construction are hanging in their, some of the smaller markets may be hits off and can you may be highlight some of those that have softened?

Pat O'Keefe

You are talking like Southern California and Florida are the softer markets for us right now.

Todd Vencil - Davenport & Company

Okay. Concerning Blücher into the (inaudible) some dilution in the quarter. Do you have any update on what the accretion would ultimately look like? Are you looking for the same amount?

Bill McCartney

We had a $0.01 dilution in the quarter, I think when we first talked about Blücher to the Wall Street we were thinking that it would have $0.02, but their operating results were little bit better. We are expecting $0.04 of dilution in Q3.

Todd Vencil - Davenport & Company

Right.

Bill McCartney

Then once we get into Q4 we will then have the inventory and the customer backlog and all those issues amortized. We should have a pickup or accretion of $0.05 in Q4.

Todd Vencil - Davenport & Company

I think you said it was going to be about $0.05 a quarter next year is that still good?

Bill McCartney

Yes.

Todd Vencil - Davenport & Company

Okay. That is all I have got. Thanks a lot.

Bill McCartney

Thank you.

Operator

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

Jeff Hammond - KeyBanc Capital Markets

Hi. Good afternoon.

Pat O'Keefe

Hi, Jeff.

Jeff Hammond - KeyBanc Capital Markets

Just in terms of some of the issues in China can you give us a sense of, is that still a drag on profitability into the second half of the year, are you loosing money there or is there a point were we get back to favorable profitability?

Pat O'Keefe

No I would say it is a drag on us for the remainder of this year.

Jeff Hammond - KeyBanc Capital Markets

Okay. Then just shifting gears, you mentioned how you thought the alternative energy systems projects or orders you thought were sustainable into the third quarter. I mean are you getting some direct feedback from these OEMs suggesting that and there is more behind it or what gives you the confidence that those are not one time in nature?

Pat O'Keefe

I think the OEMs are pretty bullish on these products at the moment, so we are basing that, we are making that statement based on our in coming order rates.

Jeff Hammond - KeyBanc Capital Markets

Okay. So there has been some follow-on orders that would suggest that that persists in the third quarter?

Pat O'Keefe

You had a strong order rate and that strong order rate continues.

Jeff Hammond - KeyBanc Capital Markets

Okay. Then as you look at the other floor distributor business that is may be more consumer oriented in Europe, how would you characterize trends there?

Pat O'Keefe

I think, if you look at big markets like the UK its slow, you look at big markets like Italy and Southern part of Europe it is slow, and it is pretty decent in France and it is pretty decent in Germany and Northern Europe.

Jeff Hammond - KeyBanc Capital Markets

Okay. Finally, it seems like the big aberration or one of the major aberrations between 1Q, which seem to present 2Q which was pretty good as this destocking versus restocking, is there a way to quantify the magnitude of the contribution there on a op profit or earnings basis in the second quarter that might may be is not sustainable?

Bill McCartney

If you look at the differences, Jeff, in Q1, the wholesale revenue was $163 million. In Q2, it was excluding acquisitions on apples-to-apples basis, would have been about a $181 million. So we had about $18 million, $19 million pick up in wholesale revenue quarter-over-quarter. Those are very meaningful, I do not have the exact EPS on that, but I mean it is a very meaningful part of the improvement.

Jeff Hammond - KeyBanc Capital Markets

Okay. You feel the same about the sequential improvement in retail?

Bill McCartney

Yes, I mean, on retail we had $5 million pick up versus Q1. When we did the analysis, we identified specifically the new product rollouts in some of the pricing and when you net that out of the changes that we saw in the quarter, it tells you that we had a decrease in revenue of about 5% versus last year.

Now, if we do that same analysis and you look at Q, compare yourself to Q1, our same analysis has been done for Q1. It says we had a decrease in revenue of about 11% because of destocking in the economy. We had a basically the run rate was cut in half versus last year from Q1 to Q2.

Jeff Hammond - KeyBanc Capital Markets

It sounds like underlying fundamentals would suggest that the 1Q trend was maybe a little more normal than the 2Q trend?

Bill McCartney

On retail, I think if you look at the last numbers I have seen out of (inaudible) low that the same-store sales is down around 7%, 8%, if I recall. That is in the middle of those two numbers between 5 and 11. As Pat discussed a moment ago, we are thinking that a normal trend for all this North American business is somewhere Q2 and Q1.

Jeff Hammond - KeyBanc Capital Markets

Okay. That is helpful. Just final question on Blücher. Can you remind us how big the marine component of that business is?

Bill McCartney

It is 20% of their total business.

Jeff Hammond - KeyBanc Capital Markets

Okay. Then can you just remind me that some of the other big buckets in terms of end markets?

Bill McCartney

Yes, residential is about 25, commercial is 25. We have food processing of about 30 and then Marine is 20.

Jeff Hammond - KeyBanc Capital Markets

Okay. Thanks.

Bill McCartney

Okay.

Operator

Your next question comes from the line of Jim Fung of Gabelli & Company. Please proceed.

Jim Fung - Gabelli & Company

Hi, gentleman. Actually most of my questions have been answered, but I just have one thing could you just list a little more, what your product lines are in Europe for this geothermal market that you are selling to the OEM's?

Bill McCartney

What the product lines are into the OEM?

Jim Fung - Gabelli & Company

Yes

Bill McCartney

Well, we sell things like electronic controls, manifolds systems, pump groups, control valves, safety relief valves, and as Pat mentioned we sell a unit that measures energy usage by measuring the flow and heat of water into an individual apartments in energy monitoring product line.

Jim Fung - Gabelli & Company

Okay. These are the products that you saw very strong sales in the quarter there…

Bill McCartney

Yes.

Jim Fung - Gabelli & Company

…and going into the third quarter. Okay, alright. Thanks very much.

Pat O'Keefe

Thanks Jimmy.

Bill McCartney

Okay.

Operator

(Operator Instructions)

Your next question comes from the line of Christopher Glynn of Oppenheimer.

Christopher Glynn - Oppenheimer

Yes, just a quick one on any impact in '09 on the tax rate mix, the base of sales with Blücher and also maybe with the European growth given the energy efficiency turn outside and are we seeing a little downward pressure on the tax rate?

Bill McCartney

I think what would happen versus that any downward pressure from those sources do have a little a bit lower tax rate might be a offset by some non-deductible loses out of China. So I would not change a tax rate.

Christopher Glynn - Oppenheimer

Okay. Thanks again.

Bill McCartney

Thank you.

Operator

There no further questions. I would now like to turn the call back over to Mr. Pat O'Keefe.

Pat O'Keefe

Well, I want to thank everyone for joining us today and your interest in Watts. We look forward to talking to you in the third quarter conference call, which will be probably at the end of October, the beginning of November. So thank you very much.

Operator

Ladies and gentlemen, that concludes the presentation. Thank you for your participation. You may now disconnect. Have an excellent week.

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