Watts Water Technologies, inc (WTS) Q3 2021 Earnings Call Transcript

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Watts Water Technologies, inc (WTS -1.72%)
Q3 2021 Earnings Call
Nov 4, 2021, 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 2021 Earnings Conference Call. [Operator Instructions] I would now like to turn the call over to Tim MacPhee, Treasurer and Vice President, Investor Relations of Watts Water Technologies, Inc. Please go ahead, sir.

Timothy M. MacPhee -- Vice President of Investor Relations & Treasurer

Thank you, and good morning, everyone. Welcome to our third quarter earnings conference call. Joining me today are Bob Pagano, CEO and President; and Shashank Patel, our CFO. During today's call, Bob will provide an overview of the third quarter results and discuss the current state of our operations and markets. Shashank will discuss the details of our third quarter performance, provide our initial outlook for the fourth quarter and offer a revised outlook for the full year 2021. Following our remarks, we will address questions related to the information covered during the call.

Today's webcast is accompanied by a presentation, which can be found in the Investor Relations section of our website. We will reference this presentation throughout our prepared remarks. Any reference to non-GAAP financial information is reconciled in the appendix to the presentation. Before we begin, I'd like to remind everyone that during the call, we'll be making certain comments that constitute forward-looking statements. These statements are subject to numerous risks and uncertainties that could cause the actual results to differ materially. For information concerning these risks, see Watts' publicly available filings with the SEC. The company disclaims any intention or obligation to update or revise any forward-looking statements, whether because of new information, future events or otherwise.

I request that questions be limited to one, plus a follow-up, to ensure everyone has an opportunity to participate. If you have additional questions, please rejoin the queue. Let me now turn the call over to Bob.

Robert J. Pagano -- Chief Executive Officer, President & Executive Director

Thanks, Tim, and good morning, everyone. First, I must recognize the efforts of all our employees for their sustained commitment while dealing with continued supply chain and logistics challenges and the delta variant. Our team has maintained a customer focus and have worked diligently to deliver on our promises to them. My sincere thanks to the entire team for their hard work. Now please turn to slide three in the presentation, and I'll provide an overview of the quarter. The team produced another strong quarter despite supply chain and logistics challenges. We delivered record third quarter sales, adjusted operating margin and adjusted earnings per share. All regions' sales grew organically by double digits.

Our results benefited from the continued economic recovery as well as price and volume tailwinds. Cash generation remains a focal point. Year-to-date, we have increased our free cash flow by 26% as compared to last year. Shashank will review the financial results in more detail momentarily. In late September, we purchased Sentinel Hydrosolutions in an all-cash transaction. Sentinel, a $6 million sales business, provides leak detection solutions mostly to the high-end residential market. Sentinel's systems are designed to detect leaks in water pipes, plumbing fixtures and appliances, and will automatically shut off water when a leak is detected.

This acquisition further expands our developing focus in leak detection technology. I'd like to welcome our Sentinel colleagues to Watts. Like many companies, we're dealing with supply chain and logistics challenges. We previously mentioned concerns involving components used in our electronics products. Since then, supply chain and logistics issues have gotten more dynamic. We are seeing disruptions across the board in all regions, impacting many of our core raw materials and components. Lead times, on average, have more than doubled, and suppliers are dealing with labor constraints.

We're addressing these and other problems daily to maximize customer order fulfillment. Our expectation is that supply chain and logistics disruptions will continue into 2022. We are monitoring this issue closely. Now let me talk about the markets. In general, markets have continued to be positive. GDP expectations in most regions portend a solid finish to 2021 for repair and replacement in both commercial and residential end markets. In the Americas, single-family residential new construction remains strong, and we've seen some pickup in multifamily starts as well. Repair and replacement business in both nonresidential and residential end markets remains strong. We still see pent-up demand in older projects, while new project starts are still lagging.

Contractors are also dealing with materials and skilled labor shortages at job sites in addition to substantial inflation on project costs. In Europe, German and Italian OEMs continue to benefit from government energy efficiency subsidies. Repair and replacement was again strong in France. We are beginning to hear customer feedback that there is more uncertainty heading into Q4 as projects are being delayed due to material and labor shortages, as well as an across-the-board inflationary impact on project costs. The team is watching this trend closely.

In APMEA, underlying market demand has improved but is being impacted by the pandemic. New Zealand and Australia have both had recent lockdowns affect their economies. China market demand has been steady, but is being impacted by a potential correction in the housing market in COVID outbreaks that caused lockdowns, which impacts both suppliers and customers. China is also experiencing power outages, which is further exasperating the supply chain. Finally, given our performance in the third quarter and our expectations for Q4, we are raising our full year sales outlook.

Let me turn the call over to Shashank, who will discuss the third quarter operating performance and provide more detail on our fourth quarter expectations and revised full year outlook. Shashank?

Shashank Patel -- Chief Financial Officer

Thanks, Bob. Please turn to slide four, and let's review the third quarter consolidated results. Sales of $455 million were up 18% on a reported basis and up 17% organically, driven primarily by the global economic recovery. Foreign exchange and acquisitions combined had a favorable year-over-year impact of $5 million. Adjusted operating profit of $66 million increased 24% and adjusted operating margin of 14.4% increased 60 basis points as volume, price and productivity more than offset the impact of supply chain challenges, logistics inflation, incremental investments, incentives and business normalization costs.

Adjusted earnings per share increased by 32% for the reasons just cited in addition to lower interest expense and reduced foreign currency transaction losses. The adjusted effective tax rate of 26.9% is 40 basis points lower year-over-year. For GAAP purposes, we recorded a charge of $0.9 million related to the previously announced restructuring of our Mery facility in France. We expect approximately $1 million more will be incurred in the fourth quarter. We anticipate another $5 million to $6 million in restructuring costs in 2022 with respect to this plant closure upon completion. As Bob noted, year-to-date free cash flow is up 26% to $120 million as compared to the same period last year. This was driven by higher net income and lower capital spend.

We expect to maintain free cash flow conversion at 100% or more of net income for the full year. Our balance sheet remains strong and provides ample flexibility. The gross and net leverage ratios at the end of September were 0.6 times and negative 0.3 times, respectively. Our net debt to capitalization ratio at quarter end was negative 8%. During the quarter, we purchased approximately 25,000 shares of our common stock at an investment of $4 million primarily to offset dilution. Turning to slide five, and our regional results. Organic sales in all regions increased by double digits during the quarter, primarily from the continued strong economic recovery.

Reported regional sales also benefited from favorable foreign exchange movements. In addition, the Americas had approximately $1 million in acquired sales. Americas' organic sales increased 17% during the quarter, with broad growth across all of our major product categories driven by strong repair and replacement and single-family residential markets and price. We had minimal benefit in the quarter from the U.S. South Central freeze. Americas' adjusted operating margin declined by 30 basis points during the quarter as gross margin expansion from price, volume and productivity was more than offset by inflation, incremental investments, incentives and business normalization costs.

Europe sales increased over 14% organically, delivering another solid quarter with expansion in both the Fluid Solutions and Drains platforms. Sales were up in all key regions, driven by the wholesale activity in France and Italy, continued strong OEM demand in Germany and Italy, driven by local government energy subsidies, and an uptick in Scandinavian sales due to a gradual recovery of the commercial and marine market. Europe's adjusted operating margin expanded by 420 basis points, benefiting from volume, price and productivity, which more than offset inflation, incremental investments and business normalization costs. APMEA continued its strong performance with sales up 33% organically.

The region saw double-digit growth in most locations, except for New Zealand, where sales were down due to COVID-related shutdowns. Adjusted operating margin expanded by 400 basis points in APMEA in the quarter as trade and intercompany volume and productivity more than offset inflation and business normalization costs. Moving to slide six, and general assumptions about our fourth quarter and full year 2021 outlook. Our expectation for the fourth quarter is sales should expand by 10% to 14% over the fourth quarter of 2020.

We anticipate that fourth quarter adjusted operating margin should range from 13.4% to 13.8%. Margins may be challenged due to the impact of inflation, especially from supply chain and logistics costs, as well as continued growth in business normalization costs and incremental investments. Corporate costs should approximate $11 million to $12 million for the fourth quarter. We expect interest expense sequentially will be flat to the third quarter. The adjusted effective tax rate should approximate 26%. Foreign exchange would be a headwind to last year should current rates persist throughout the fourth quarter. As a reference, the average euro-dollar foreign exchange rate for the fourth quarter of 2020 was 1.19. Please recall that for every $0.01 movement up or down in the euro-dollar exchange rate, our European annual sales are impacted by approximately $4 million, and our annual EPS is impacted by $0.01.

We expect seasonally strong cash flow to end the year. For the full year 2021, we anticipate organic growth to be 14% to 17% or about 350 basis points higher at the midpoint than our previous outlook in August. Full year adjusted operating margin, adjusted margin expansion and free cash flow expectations are anticipated to be in line with our previous outlook in August. Other full year inputs are noted on the right with some minor changes since August. So with that, let me turn the call over to Bob before we begin Q&A. Bob?

Robert J. Pagano -- Chief Executive Officer, President & Executive Director

Thanks, Shashank. To summarize, I'd like to leave you with a few key points. Third quarter results were better than we anticipated and was aided by continued global demand and a strong repair and replacement market. We continue to drive price and proactively manage the many supply chain issues to support our customers. We continue to invest for the long term, including smart and connected solutions. We have raised our full year 2021 revenue outlook.

Adjusted margin expansion remains in line with previous expectations. Finally, given our strong results today and our already healthy balance sheet, we are well positioned to drive our strategy, including expanding our smart and connected offerings and executing on strategic M&A opportunities as they arise. With that, operator, please open the lines for questions.

Questions and Answers:

Operator

[Operator Instructions] Your first question comes from Ryan Connors of Boenning and Scattergood.

Ryan Michael Connors -- Boenning and Scattergood, Inc. -- Analyst

I just had a couple of big picture questions actually, just to start off. Bob, I'm curious how you're posting some really great numbers. Obviously, it's a good demand backdrop. I'm curious, just philosophically how you're looking at this environment in terms of committing capital to things like capacity expansion. We had some peer companies out today saying they are going to commit capital expanding capacity.

But in your case, is the idea that this is going to be sustained long enough that you get behind it and invest and increase capacity and do the other things you need to do? Or do you think this is going to be normalized at some point, you don't want to strand those types of investments?

Robert J. Pagano -- Chief Executive Officer, President & Executive Director

Ryan, good morning. Yes, when we look at capacity, I think we have plenty of capacity. We've been spending a lot of time and effort in automating our factories, and we have ample capacity in our complete network here. So I'm not going to add additional capacity, but I'll invest in automation inside of our factories.

Ryan Michael Connors -- Boenning and Scattergood, Inc. -- Analyst

Okay. Okay. When I say capacity, I guess I mean the capacity along the supply chain, things like altering your supply chain to make it less complex, you're reading a lot about sort of the reverse of globalization to bring things back home. So I guess I'm talking about all of the above in terms of capital investment versus buybacks and -- so just, is this going to last long enough where you're going to reconfigure everything you do? Or do you just think this is kind of -- the Fed is going to normalize monetary policy, things will settle down and you just kind of go back to the old Watts. I mean what's your philosophy there?

Robert J. Pagano -- Chief Executive Officer, President & Executive Director

Well, in general, our philosophy, as you know, Ryan, is we usually produce where we ship. We're more vertically integrated than most people, and we do outsource stuff, and we've looked at alternative capabilities and, like everyone else, during the supply chain crunch. But look, I think it will come back to normal at some point in time here. You got some shock in demand based on -- we started with the freeze. You've had some hurricanes, you've got abnormal demand, you've got increasing pricing. So that will settle down. And eventually, I think it will come back to normal. But we've always believed in the philosophy of manufacture where you ship your product. So it's right in line with -- been our strategy all along.

Ryan Michael Connors -- Boenning and Scattergood, Inc. -- Analyst

Okay. I'll have that, thanks very much.

Operator

Your next question comes from Joe Giordano of Cowen and Company.

Robert G. Jamieson -- Cowen and Company -- Analyst

Hi, good morning. This is Robert on for Joe. Just a quick one. Were any sales pushed out during the quarter due to these logistics or supply chain issues? It doesn't seem like there would have been a ton. And then, I guess, just also another question on pricing specifically. And what does that look like in the backlog?

Robert J. Pagano -- Chief Executive Officer, President & Executive Director

Yes. I mean, look, certainly, we probably could have shipped a little bit more, but it's not a huge number. I think our teams executed and we have a great flexible workforces that flex where the volume is. And if there were supply chain issues, we moved to another area to allow us to do that. But yes, a little bit more, but it's not a big, huge number. Shashank, do you want to take the price?

Shashank Patel -- Chief Financial Officer

Yes. On the pricing, the price realization in the third quarter was approximately 5%. And then you asked about Q4. And obviously, we announced our third stellar price increases between September one and October 1. Our expectation on price realization in Q4 is in the 7% to 10% range.

Robert G. Jamieson -- Cowen and Company -- Analyst

Okay. That is great. Thanks very much.

Operator

Your next question comes from Walt Liptak of Seaport Research.

Walter Scott Liptak -- Seaport Research Partners -- Analyst

Thanks. I wanted to ask about your operating leverage. The profitability in Europe segment looks pretty good at above 40% even with the inflationary environment and tough logistics. I wonder if you could talk a little bit about just how the Europe business is operating, I guess, from a production and shipment point of view and how pricing is going. Are they on the same cadence of price increases that you just mentioned?

Robert J. Pagano -- Chief Executive Officer, President & Executive Director

So Walt, as you know, we have a fixed cost base in Europe. And as the volume goes up significantly like in the third quarter, we get significant leverage of those fixed costs. Secondly, we did get price in Europe as well, right? As we all know, Europe is a little harder to get in price, but we did get good price in Europe. And then lastly, over the last several years, the teams have been doing a good job on the commercial side of it, on the commercial management side of it as far as margin expansion with, for example, the OEM channel. So we continue to work that. So it's a combination of all of those fees that we got that nice operating leverage.

Walter Scott Liptak -- Seaport Research Partners -- Analyst

Thank you.

Operator

Your next question comes from Jake Jarnigo of Baird.

Jake Allen Jarnigo -- Robert W. Baird & Co. Inc. -- Analyst

Good morning guys. I'm in for Mike Halloran. Just a follow-up on the price cost comments. I appreciate the detail on what was achieved in the quarter and implied for 4Q. So I guess what does that imply for kind of price carryover into next year? Are we talking low single digits type number as a buffer and then is there potentially plans to do another one at some point as you go into next year? And what are you looking at to determine that?

Shashank Patel -- Chief Financial Officer

Yes. So Jake, well that will depend on, as we said, we have some price increases announced between September one and October 1, depending on the region. And it will depend on the realization of those. But clearly, as we've had three sets of price increases there's carryover into next year. Our goal is always to be positive on the price cost piece. So we'll continue to watch that. And over the next three months, we'll decide what the January price increases look like. Right now, we are slated in for January price increases.

Jake Allen Jarnigo -- Robert W. Baird & Co. Inc. -- Analyst

Great. That's helpful. And then high level here. You talked about the demand environment being mostly pent-up related outside of new housing starts on the residential side. Leading indicators on the non resi side still look pretty good. How are you kind of reconciling that at a high level, how do you see this playing out? And this isn't necessarily a 2022-specific question, but I would love to get your thoughts on the potential for the type of construction cycle that could be ahead and what are the variables that could be tailwinds or what are the impediments to that? We want to look at your thoughts there. Thanks.

Robert J. Pagano -- Chief Executive Officer, President & Executive Director

Jake, when you look at it, I mean, residential, both, new construction and repair and replace, has been really strong. What we've also seen is repair and replacement on the commercial side has been very strong. In addition, when you look at the new construction on the commercial side, we've seen a lot of -- let's call it, the projects that started before the pandemic, they were all delayed, and now they're coming online. They're taking longer than expected, but there was a stronger backlog, probably, quite honestly, higher than we thought from that point of view.

So when we look at construction, certainly in the difficult markets of office buildings, stores, malls, lodging, etc., they're still significantly below 2019 levels from a new construction point of view. So again, when you look at some of these leading indicators, overall commercial new construction still is down. But some of the air pocket that we thought has just been absorbed by this strong repair and replacement and some of the new construction related to those previously started construction projects. So as we look into next year, certainly, the background looks strong GDP coming into next year.

However, we've got some headwinds in there with the freeze. We were not expecting a freeze to happen. And we've also got to look at a lot of people are building stock and supply chain capabilities, beating price increases, etc. So there will be some channel destocking, I believe, as we head into next year. So we're reconciling all that right now. And we'll provide more input to you guys when we do our next earnings call.

Jake Allen Jarnigo -- Robert W. Baird & Co. Inc. -- Analyst

Okay. Thank you.

Operator

Your next question comes from Jeff Hammond of KeyBanc.

David Edmund Tarantino -- KeyBanc Capital Markets Inc. -- Analyst

This is David Tarantino on for Jeff. So you kind of touched on it just then, but could you just give like a little bit more of an overview on the channel dynamics, just given all the supply chain and logistics constraints and kind of how much destocking has happened, if so?

Robert J. Pagano -- Chief Executive Officer, President & Executive Director

I'm not sure we're seeing destocking. I think a lot of what we're seeing in the channels is the channels are stocking right now for two different reasons. Number one, they're trying to beat price increases from an inflationary point of view; and number two, they're trying to grab inventory before future jobs happen. So we're actually seeing a dynamic where we're even seeing contractors starting to have warehouses to put inventory in just to wait for upcoming projects. So what's happening here is there's an inventory but not the right necessarily mix of inventory.

So you may have 3/4 of everything you need for a job, but you're missing that other quarter. So they're stocking up what they can and waiting for the additional components as they come. As we talked earlier in my prepared remarks, lead times in general have doubled out there right now because of this demand in some of this. So again, we're watching that very closely, and we'll take advantage of the opportunity with our supply chain.

David Edmund Tarantino -- KeyBanc Capital Markets Inc. -- Analyst

Great. And then just on M&A, just following the acquisition of Sentinel, what are your thoughts on any more incremental M&A going forward?

Robert J. Pagano -- Chief Executive Officer, President & Executive Director

Well, look, you never can time M&A. We continue to be very disciplined in our M&A. It has to make strategic and financial sense. And certainly, we've got some high multiples out there right now, but we're going to be disciplined. We're going to look at opportunities as they arise, and we'll continue to watch it. The pipeline continues to be full but it takes two to tango, and we've got to make sure it makes financial sense. So with our healthy balance sheet, we'll leverage that as appropriate.

David Edmund Tarantino -- KeyBanc Capital Markets Inc. -- Analyst

Great. Thank you.

Operator

[Operator Instructions] Your next question comes from Ryan Connors of Boenning and Scattergood.

Ryan Michael Connors -- Boenning and Scattergood, Inc. -- Analyst

Great, thanks for taking the follow-up. I wanted to ask a couple more. One was on -- as these lead times extend, we're starting to hear more about sort of double ordering and bullwhip effects and things like that, not necessarily specific to your product lines, but just in the economy as a whole. Have you seen any evidence of that, that any part of your backlog could be a double order by a customer that could be subject to cancellation, or any thoughts there?

Robert J. Pagano -- Chief Executive Officer, President & Executive Director

Yes, Ryan, we're seeing some of that. It's not material. But we're seeing some of that with people placing orders. And then if it's not delivered, they'll potentially cancel it. But I think we've been hitting more than we've been losing from that regard. So again, our vertically integrated supply chain strategy is actually helping out in this environment.

Ryan Michael Connors -- Boenning and Scattergood, Inc. -- Analyst

Okay. Okay. And then my last one was just on the connected strategy. You go back a couple of years ago, pre-COVID, you sort of rolled that out. It was a very significant initiative for you. I know you're mentioning how you're still investing in that. But presumably, given the technology content there, those would be some of the product lines where you're having more issues in terms of components and things like that. So how has all this kind of impacted the rollout and the penetration of that connected strategy? Or has it kind of pushed that out to the right? And if so, how do you go about reaccelerating that if and when things normalize?

Robert J. Pagano -- Chief Executive Officer, President & Executive Director

Yes, Ryan, a good point here. Listen, we've had to take some of our key engineers and allocate them back on existing products because of the chip shortages, and when you change chips, you also have to change the circuit boards, right? So we've had to reengineer some existing products and taking some people off of some of our new product developments. But I'm not letting the team off the hook, right? We have a goal to get 25% connected by 2023. And we're still focused on that.

We'll watch how this chip shortage impacts that. But right now, 2023 is a couple of years away. So I'm not giving up yet on that target. But certainly, it is having an impact, one that we never planned on when we certainly put that target out, but I'm still proud of the team that we're in the mid-teens still on our smart and connected products as a percentage of sales. So we've come a long way over the last several years.

Ryan Michael Connors -- Boenning and Scattergood, Inc. -- Analyst

That's great. Thanks again for your free time.

Operator

At this time, we have no further questions, I will now turn the floor back over to Bob Pagano for any additional or closing remarks.

Robert J. Pagano -- Chief Executive Officer, President & Executive Director

Thank you for taking the time to join us today for our third quarter earnings call. We appreciate your continued interest in Watts, and we look forward to speaking with you again in February to discuss our fourth quarter and full year 2021 results. Enjoy the upcoming holidays, and please stay safe. Take care.

Operator

[Operator Closing Remarks]

Duration: 29 minutes

Call participants:

Timothy M. MacPhee -- Vice President of Investor Relations & Treasurer

Robert J. Pagano -- Chief Executive Officer, President & Executive Director

Shashank Patel -- Chief Financial Officer

Ryan Michael Connors -- Boenning and Scattergood, Inc. -- Analyst

Robert G. Jamieson -- Cowen and Company -- Analyst

Walter Scott Liptak -- Seaport Research Partners -- Analyst

Jake Allen Jarnigo -- Robert W. Baird & Co. Inc. -- Analyst

David Edmund Tarantino -- KeyBanc Capital Markets Inc. -- Analyst

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