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Watts Water Technologies Inc (NYSE:WTS)
Q3 2019 Earnings Call
Oct 31, 2019, 9:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Ladies and gentlemen, thank you for standing by and welcome to the Watts Water Technologies Third Quarter 2019 Conference Call. [Operator Instructions]

I would now like to hand the conference over to your speaker today, Tim MacPhee, Vice President, Investor Relations. Please go ahead.

Timothy M. MacPhee -- Treasurer, Vice President Investor Relations

Thank you, and good morning, everyone. Welcome to our third quarter 2019 earnings conference call. Joining me are Bob Pagano, President and CEO; and Shashank Patel, our CFO. Bob will provide a business overview of the quarter and Shashank will address the financial results and offer our latest outlook for the fourth quarter. Following the prepared remarks, we will address questions related to the information covered during the call.

Today's webcast is accompanied by a slide presentation which can be found in the Investors section of our website. We will reference these slides throughout our prepared remarks. Any reference to non-GAAP financial information is reconciled in the appendix of the presentation.

Let me remind everyone that during the course of this call to give you a better understanding of our operations, we may be making certain forward-looking statements. These statements are subject to numerous risks and uncertainties that could cause actual results to differ materially from such statements. For information concerning these risks and uncertainties via publicly available filings with the SEC. The company disclaims any intention or obligation to update or revise any forward-looking statements whether as a result of new information, future events or otherwise.

Let me now turn the call over to Bob Pagano.

Robert J. Pagano -- Chief Executive Officer and President

Thanks, Tim, and good morning, everyone. Please turn to Slide 3 in the presentation where I'll provide an overview of the quarter. We delivered a solid performance in the third quarter. As anticipated, top line organic growth moderated due to tougher comps and slowing market expansion. However, we were able to drive record quarterly sales, operating margin and EPS. Regionally, the Americas continued broad growth was partially impacted by softer heating and hot water platform sales due to project timing. Europe continued on a steady pace and the APMEA returned to nominal growth while continuing to be challenged by Middle East project delays. Shashank will review the financial details in a few minutes.

Now let me make a few comments about the markets. We expect to see mixed growth in the fourth quarter in the Americas non-residential end market. More recent indices that we follow, including the PMI and API have recently touched multi-year lows and the Dodge Momentum Index has been trending downwards year-over-year. The institutional end market is also mixed, with growth in healthcare spending being offset by lower educational spend. On the residential side, year-over-year changes in new housing starts and existing home sales have stabilized recently and have shown a slight uptick in Q3. Lower interest rates may help the residential side to some extent but that could take time. So we see market moderation continuing in the Americas for the remainder of this year and as we head into 2020.

Global policy uncertainty, rising protectionism and other geopolitical factors have become prominent backdrops in Europe. In the UK, economic activity is expected to remain muted in the coming quarters. The ECB recently revised its GDP expectations for the Euro Area to 1.1% for 2019 and 1.2% for 2020. So in general, we remain cautious regarding Europe. And in APMEA, we see a continued mixed bag with the market spotty depending on the region. Macro issues like China trade, oil refinery bombings in Saudi Arabia and the Turkey-Syria conflict only create additional uncertainties in those regions.

Now let me provide some more background on our latest acquisition. In late August, we purchased the assets of Backflow Direct, a California-based company that designs and manufactures large diameter stainless steel backflows primarily used in commercial fire protection applications. Backflow Direct was established about seven years ago and the founder is well known in the backflow prevention industries and to Watts as well. Strategically, Backflow Direct provide some innovative products and fire protection applications that broaden our offerings to meet customers' requirements. We are also excited that the former owner, a well-respected professional in backflow prevention is joining our team to aid in future backflow development opportunities. We're excited to add Backflow Direct to our portfolio.

Finally, our outlook for the second half of 2019 has not changed from the guidance we provided in August. We still expect growth in the second half to be 2% to 3% on a consolidated basis, with Americas growing 3% to 4%, Europe 1% to 2% and APMEA in the 5% to 7% range.

Now, I'll turn the call over to Shashank to talk about our third quarter operating performance and provide more color on our fourth quarter outlook. Shashank?

Shashank Patel -- Shashank Patel

Thanks, Bob, and good morning, everyone. Please turn to Slide 4 and we will discuss the third quarter consolidated results. Reported sales of $395 million were up 1% as organic growth of 2% was partially offset by a foreign exchange headwind of approximately $6 million or 1% during the quarter. Consolidated organic growth was in line with our expectations, and I will address our regional performance in a few minutes.

Adjusted operating profit was $52 million, an increase of 4%. This translated into an adjusted operating margin of 13.3%, up 40 basis points versus last year and an all-time quarterly record for the company. Price productivity including restructuring savings and higher volume partially offset by investments and inflation were the main drivers of the record margin performance. We continue to invest in growth and productivity initiatives. In fact, in the third quarter, we spent approximately $4 million on investments, about $1 million more than we had anticipated. More than half of the total investment spend was focused on our smart and connected initiatives.

Adjusted earnings per share of $1.04 was a 5% increase over last year and a new third quarter record for the company. Adjusted earnings per share increase was driven by operations, negative foreign exchange and positive share dilution were each $0.01 and were net neutral. The adjusted effective tax rate in the quarter was 28.5% consistent with the prior year.

Turning to cash. On a year-to-date basis, free cash flow was $76 million, a 77% increase as compared to the same period last year. The increase was mainly due to higher income, reduced inventory levels, lower tax payments and reduced capital spending. Historically, the fourth quarter is a strong cash flow quarter for the company and we expect that trend to continue this year as well. Our goal is to attain 100% free cash flow conversion for the year.

During the third quarter, we repatriated approximately $7 million in cash. Year-to-date, we have repatriated about $37 million using a majority of that to paydown debt. In the third quarter, we purchased approximately 48,000 shares of our common stock at a cost of $4.5 million. Year-to-date, we've returned a total of $38 million to shareholders in dividends and share repurchases as part of our balance capital deployment strategy.

We also incurred some costs at corporate this quarter which have been classified as special items. First, we incurred $2.3 million of professional fees including legal and tax costs to optimize and simplify our European legal structure from a pan-European perspective and align with previous restructuring initiatives. We also incurred other professional fees in order to obtain a much deeper understanding of our product, country and customer profitability which should help guide our future new product development and other investments. We expect to complete this review in the fourth quarter.

The second special item of $0.9 million related to acquisition costs incurred for the Backflow Direct acquisition and cost of other acquisition efforts that did not come to fruition. So to reiterate Bob's comments, a solid third quarter performance setting new quarterly highs in sales, adjusted operating margin and adjusted earnings per share, while continuing to invest for the future.

Now to the regions on Slide 5. Let's review Americas' results for the quarter. Sales of $270 million were up approximately 3% both on a reported and organic basis. The organic growth was driven by price realization and volume increases in plumbing valves, drains and water quality products. Growth was partially offset by softness in heating and hot water products from project timing delays and continued competitive pricing. As expected, price was a smaller contributor to growth as compared to the first half. Also the prebuy during the second quarter ahead of the previously announced July 1 price increases, negatively impacted the Americas sales growth by about 2% in the third quarter.

Adjusted operating profit in the Americas was $48.9 million, a 9% increase year-over-year. Adjusted operating margin increased 100 basis points to 18.1%, driven primarily by price and productivity which more than offset incremental growth investments and inflation. To summarize, a good quarter for the Americas.

Moving to Europe, please turn to Slide 6. Sales of $108 million were down 3% on a reported basis and up 1% organically. Foreign exchange, mainly the euro was a headwind of about $5 million or 4% in the quarter. The organic sales increase was driven by solid growth within our drains platform and to a lesser extent growth within core plumbing and HVAC products in the fluid solutions platform. Drain sales into marine applications continued to be strong. By geography, we saw strength in France, Italy and the Nordic regions. We saw softness in Germany and the UK. France was driven by increases in core plumbing and drains products. Italy and Scandinavia were both stronger due to growth within our plumbing product lines. Sales in Germany were down as both plumbing and drains products were soft. Finally, the UK was down amid Brexit uncertainties in the market.

Adjusted operating profit for Europe in the quarter was approximately $12 million, a 5% decrease as compared to last year. Operating margin of 11.2% decreased 30 basis points versus the third quarter of last year. The benefits of incremental price and productivity including restructuring savings were more than offset by incremental investments and the timing of certain costs. So for Europe steady top line growth with a slightly lower operating margin performance. We expect adjusted operating margins should expand in the fourth quarter.

On Slide 7, let's review APMEA's results. In the quarter, sales of $16.5 million were down 1% on a reported basis and up 1% organically. The third quarter was a continuation of APMEA's first half performance with strong growth in China offsetting weakness in other regions, especially the Middle East where projects continued to be delayed. Sales in China were up double-digits organically, mainly driven by commercial valves. Sales outside China decreased by double digits due to the Middle East and Korea.

Adjusted operating profit and adjusted operating margin was significantly affected by a decrease in intercompany sales volume, unfavorable country sales mix and additional investments which are only partially offset by additional productivity savings. Recall that last year, the Americas purchase additional product from our Chinese sister companies in anticipation of the higher tariffs. In summary, APMEA returned to growth during the quarter with solid growth continuing in China but the profits were negatively affected primarily by unfavorable intercompany volume and Middle East project timing.

Finally, turning to Slide 8. I'd like to make a few comments on the fourth quarter. On a consolidated basis, we expect year-over-year fourth quarter organic sales growth of approximately 3%. Growth rate should increase sequentially from the third quarter in the Americas and APMEA, while Europe's growth should be fairly consistent as compared to the third quarter. Adjusted operating margin in the fourth quarter should expand versus the prior year, supported by price, volume growth, continued execution of our productivity and restructuring initiatives, partially offset by inflation. We expect incremental growth investments of $2 million to $3 million in the fourth quarter versus last year.

Excluding special items, we anticipate total corporate costs in the quarter to be $10 million to $11 million and expected restructuring savings are $1 million in Europe. We expect full year adjusted operating margin expansion should be at the high end of the 50 to 70 basis point range that we provided during our February outlook. Our adjusted effective tax rate should approximate 28.5% in the fourth quarter. The FX impact should be negative as compared to the fourth quarter last year. Our average euro exchange rate last year was 1.14. Our current expectation is 1.10 for the fourth quarter of this year. We are expecting strong cash flow generation in the fourth quarter consistent with our performance over the past several years. We estimate capital spending will approximate $30 million for the year.

Finally, we anticipate incremental costs of $1 million to $2 million in the fourth quarter including additional costs to finalize the European project, I discussed earlier. We will highlight these costs as special items.

With that, I'll turn the call back over to Bob before we begin Q&A. Bob?

Robert J. Pagano -- Chief Executive Officer and President

Thanks, Shashank. To summarize, the quarter played out as we had expected with solid earnings and margin expansion along with tempered top line growth. We acquired the assets of Backflow Direct to extend our product range and meet our customers' needs. And we expect our second half sales and margin expectations to be in line with our previous outlook.

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

Questions and Answers:

Operator

Certainly. [Operator Instructions] And our first question comes from the line of Nathan Jones, Stifel. Your line is open.

Adam Farley

Yeah. Hi, good morning. This is Adam Farley on for Nathan.

Robert J. Pagano -- Chief Executive Officer and President

Good morning, Adam.

Shashank Patel -- Shashank Patel

Good morning.

Adam Farley

I guess you've been very consistent with your strategy of organic investment and driving growth and margin expansion. So I want to focus first on growth, your comments on the macro were helpful. I was wondering though if you could talk about some of your strategies that penetrate in some of your international markets like the Middle East. What does that look going forward? Are you seeing traction there? And then also if you could talk about some of your Connected Solutions and maybe an update there?

Robert J. Pagano -- Chief Executive Officer and President

Yeah. Thanks, Adam. Certainly, we believe there is opportunity and growth inside the Middle East region. Right now, our quoting activity is very high. We are continuing to invest there. But we're being very cautious from a, let's call it, a collection point of view. There is a lot of jobs out there. We're really tight with our terms because it's really important we remain disciplined and get our cash. So lot of activity and we're seeing some projects being delayed with some of the uncertainty that I talked about previously. So again, we believe in the long run though. We have low market share there and it's a huge opportunity for us to grow. So we'll continue to invest there.

On the connected products, they still remain very strong. We're driving -- those are continuing to grow double the rate that our existing portfolio is growing and we plan on being in the double digits as a percentage of our overall sales by the end of this year. So again, great opportunities, our continued investment is in that area and we believe that will be opportunities for growth in the future.

Adam Farley

All right, great. And then just switching over to the margin side, maybe talk about moving into 2020 there's a lot of uncertainty. How are you guys going to balance growth investments and then also margin expansion? So where are you guys in the lean transformation journey? And then just -- any color over there would be great.

Robert J. Pagano -- Chief Executive Officer and President

Yeah. So when we look at margins next year obviously dependent on how far the top line grows, that will determine how far we expand. But we -- as you know, we have many opportunities for lean in our organization, both in our factories and in our front-end. And that's really our focus because we believe we need to continue to drive productivity to allow us to invest in the future. So margin increases, that's our continued goal as we've always stated, we believe we have the opportunity to do that. But in the face of that, we've also been looking at our overall corporate investments on where -- in our global investments on where we believe we can drive overall shareholder value by investing in growth opportunities. So we haven't done a lot of M&A and we believe investing in ourselves is the best value for our -- long-term for our shareholders. So again we'll be reviewing that as we get closer to 2020, but I still believe we have ample opportunity to grow our margins.

Adam Farley

Great. Thank you.

Robert J. Pagano -- Chief Executive Officer and President

Thanks.

Operator

And our next question comes from the line of Jeff Hammond, KeyBanc. Your line is open.

Jeff Hammond -- KeyBanc -- Analyst

Hi. Good morning, guys.

Shashank Patel -- Shashank Patel

Good morning.

Robert J. Pagano -- Chief Executive Officer and President

Good morning, Jeff.

Jeff Hammond -- KeyBanc -- Analyst

Just on the Americas commentary outlook, can you just kind of bifurcate what you're seeing in the business specifically in terms of areas that might be weakening versus kind of the high level macro data which might be pointed to more caution but maybe you're not seeing yet in the business?

Robert J. Pagano -- Chief Executive Officer and President

Yeah. So our first issue is the comparison against last year. If you recall in the Americas, in last year, we grew about 10%. So some of that was related to the tariffs and -- but overall we see very good activity but we look at the leading indicators as those are something we look at on a forward basis is predicting our future. So activity sales is strong. We did see in our heating and hot water some of our business got pushed into the fourth quarter, some delayed funding happened, lot of quotation activities are still out there. So again, we see growth but just probably slower growth because a lot of growth has been driven by price increases, those as a result of tariffs that'll slow down as we go into next year. And then again our leading indicators are saying that in particular in the commercial area that they should be slowing in the future. But our teams are optimistic we'll get our fair share in more of the market that's out there.

Jeff Hammond -- KeyBanc -- Analyst

And then this time -- I guess delays and timing issues, does that reverse in 4Q or is that something that's pushing into 2020?

Robert J. Pagano -- Chief Executive Officer and President

I would say both, we are seeing -- we have a strong backlog on the heating and hot water solutions group into the fourth quarter. So our orders were up double digits in Q3, it's just the shipping was in Q4. Some educational institutions just delayed the timing of the funding of those projects. Normally they seasonally are in Q3 and it moved out into Q4. So again, we should have a solid Q4 in that business.

Shashank Patel -- Shashank Patel

And just a note on the heating hot water side, our lead times are longer, so those projects came and that's why Bob talked about orders were good, but they'll be shipping in Q4. On the other side of the business, it is book and ship business primarily.

Jeff Hammond -- KeyBanc -- Analyst

Okay, great. And then can you give us any more on Backflow Direct what's their annual revenue. Is there a revenue contribution to think about for 4Q and anything around kind of the multiple you paid for the business?

Robert J. Pagano -- Chief Executive Officer and President

Yeah. So Jeff, they've been running about $2 million to $2.5 million per quarter. And again we've -- the owner has asked us to not talk about the details of the transaction, but you obviously could read our cash flow statement. But anyways we believe it's a great opportunity for us in the long run from an R&D point of view. It saves us about three years of development. They have a unique product that is smaller and lighter than our existing product, so it fills the need that we have in our portfolio, and I think it's -- in the long run will aid in our new product development. So we're really excited about this acquisition.

Jeff Hammond -- KeyBanc -- Analyst

And then maybe one last one I -- Shashank you talked about some professional fees and looking at your European business strategically and from a tax. Any kind of early observations from that on how you maybe you're thinking about the tax structure differently or strategically or any opportunities that are coming out of that? Thanks.

Shashank Patel -- Shashank Patel

Yeah. So, as you know, we did restructuring in our Amsterdam office last year. And as a result of that as well as the tax law changes within the Eurozone, we decided to do an assessment of our legal entity structure and we incurred some legal and tax fees. As we gain further insights from that effort -- from that analysis we also hired consultants to actually do a deeper dive of our product and customer profitability by country to help guide us in future investments. So I think we're still in the middle of that. We're going to complete that in the fourth quarter, but it'll certainly help us drive better investment decisions as we go forward. So more to come on that in the next call.

Robert J. Pagano -- Chief Executive Officer and President

And Jeff to add, we set up a principle company inside of Amsterdam and again a lot of billing and centralized activity was going through that. So we wanted to break that back up because we're really more focused on the countries at this point in time, and we believe it's a better opportunity to do that. So that's why we needed to break that up and allocate the right cost to the right places.

Jeff Hammond -- KeyBanc -- Analyst

Okay. Thanks, guys.

Robert J. Pagano -- Chief Executive Officer and President

Thank you.

Shashank Patel -- Shashank Patel

Thank you.

Operator

Our next question comes from the line of Brian Lee, Goldman Sachs. Your line is open.

Unidentified Participant

Hey, how is it going? This is Alex [Phonetic] on for Brian.

Shashank Patel -- Shashank Patel

Good morning, Alex.

Robert J. Pagano -- Chief Executive Officer and President

Good morning, Alex.

Unidentified Participant

Hey, just a quick one from me. I appreciate the macro color at the -- in the prepared remarks. So in light of those trends that you mentioned, have you -- are there any changes to the business model or the markets that you're targeting going into next year or is it just a bit of cyclicality that you're seeing?

Robert J. Pagano -- Chief Executive Officer and President

I think it's a bit of cyclicality I mean we're going to continue on our investments, our new product development, our connected strategy. All of that we believe will allow us to have above-market growth opportunities. So that's really important, and I always remind everybody that 60% to 65% of our business is repair and replace, that tends to follow GDP and as we all see GDP is continuing to be positive although slightly moderating. But overall, the business model is sound, we'll continue to invest in emerging markets also because we have low market shares there. But right now, there's a little political turmoil in some of those countries that we've been investing in, but again, we're in it for the long run and we believe there's opportunities in the long run.

Unidentified Participant

Great. Appreciate that. And just to follow-up there. Would you say those trends that you were referring to are occurring in Europe as well?

Robert J. Pagano -- Chief Executive Officer and President

Yes, certainly in Europe, I mean, I think with the Brexit the uncertainty in that whole region in the, let's call it, the trade impacts that are going on as a result of that. So there is a report out yesterday that France is coming back. We had a strong growth in France So that's an opportunity for us. So again, as you followed me, I've always been very conservative in Europe just to make sure our cost structure are in alignment. But our two other businesses that are growing in their both our drains and electronics, those are global growth businesses and we believe there is opportunities to continue to grow in those markets. The other areas, I think there'll be more slower growth and we'll make sure our cost structure is aligned to that.

Unidentified Participant

Excellent. Thanks a lot.

Robert J. Pagano -- Chief Executive Officer and President

Thank you.

Operator

And our next question comes from the line of Joseph Giordano of Cowen. Your line is open.

Francisco Javier Amador -- Cowen and Company -- Analyst

Hi guys, good morning. This is Francisco in for Joe.

Shashank Patel -- Shashank Patel

Good morning, Francisco.

Robert J. Pagano -- Chief Executive Officer and President

Good morning.

Francisco Javier Amador -- Cowen and Company -- Analyst

Good morning. So you guys called out some of the momentum in U.S. institutional building that seems to be weakening within the things like the Dodge Momentum Index slowing down. Are you guys seeing anything notable that you could be calling out in that part of the business specifically?

Robert J. Pagano -- Chief Executive Officer and President

Not really, I mean, again quoting's up. We've seen some project delays and that's normal, right. In our business, when there is uncertainty projects just get pushed out and stuff, but we've not seen any cancellations and hopefully some of this uncertainty will go by, but we still see good spending, but some of those indicators are longer leading indicators. And I think that's what we're very cautious on. So again, we're going to be watching that carefully. We're talking to our sales team, they still feel bullish. But we're also very cautious in washing around the corner to make sure we're prepared if there is any significant downturn. But right now, steady as it goes. And again, but remember our compares and tariffs and all that are also impacting our growth into the future.

Francisco Javier Amador -- Cowen and Company -- Analyst

Okay, great. And then in terms of German OEMs. Have you guys seen any positive signs on that side?

Robert J. Pagano -- Chief Executive Officer and President

Not really. I think it's -- again and we all read about the German economy and potentially they've have been in recession and I think there's just muted spending right now. I mean -- so that's something we're going to watch cautiously. It's not been horrible, but we've not seen growth there and that's an area we just will remain cautious on.

Francisco Javier Amador -- Cowen and Company -- Analyst

Okay, great. Thank you.

Robert J. Pagano -- Chief Executive Officer and President

Thank you.

Operator

And there are no further questions at this time. I will turn it back over to Bob Pagano for closing remarks.

Robert J. Pagano -- Chief Executive Officer and President

Thank you everybody for taking the time to join us today for our third quarter earnings call and we appreciate your continued interest in Watts. We look forward to speaking with you again in our fourth quarter call in February. Thanks, again.

Operator

[Operator Closing Remarks]

Duration: 29 minutes

Call participants:

Timothy M. MacPhee -- Treasurer, Vice President Investor Relations

Robert J. Pagano -- Chief Executive Officer and President

Shashank Patel -- Shashank Patel

Adam Farley

Jeff Hammond -- KeyBanc -- Analyst

Unidentified Participant

Francisco Javier Amador -- Cowen and Company -- Analyst

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