Watts Water Technologies, Inc. — FY 2018 Form 10-K
Reporting period: Fiscal year ended December 31, 2018. The filing also reports fourth-quarter results. Amounts are in U.S. dollars; financial amounts are in millions unless otherwise noted.
Business context
Watts designs and manufactures products for water flow control, heating and HVAC, drainage and water reuse, and water quality. It operates in the Americas, Europe, and Asia-Pacific, Middle East and Africa (APMEA), selling primarily through wholesale distributors, OEMs, specialty channels, and DIY retailers. The Americas generated 66% of 2018 sales. Management’s strategy emphasizes differentiated solutions, operational efficiency, acquisitions, and smart and connected products.
Financial performance and liquidity
| Metric | FY 2018 | FY 2017 | Change / context |
|---|---|---|---|
| Net sales | $1,564.9 | $1,456.7 | Up 7.4%; organic growth was 6.1%, with foreign exchange contributing 1.3% |
| Gross profit / margin | $656.5 / 42.0% | $602.4 / 41.4% | Margin expanded 0.6 percentage points |
| Operating income / margin | $188.4 / 12.0% | $162.3 / 11.1% | Operating income up 16.1% |
| Net income | $128.0 | $73.1 | Reported results include different Tax Act impacts in each year |
| Diluted EPS | $3.73 | $2.12 | Adjusted diluted EPS, a non-GAAP measure, was $3.74 versus $3.02 |
| Operating cash flow | $169.4 | $155.9 | Up $13.5 |
| Free cash flow | $135.7 | $126.9 | Non-GAAP; after capital expenditures and asset-sale proceeds |
| Cash and cash equivalents | $204.1 | $280.2 | Declined as cash was used in part to repay debt |
| Total debt, including current portion | $355.0 | $499.5 | Net debt was $149.3, versus $216.9 |
| Working capital / current ratio | $372.6 / 2.1x | $456.2 / 2.4x | Decrease primarily reflected lower cash |
Operating income benefited from pricing, volume, productivity, and restructuring savings, partly offset by higher material and transportation costs, inflation, and growth investments. SG&A was 29.7% of sales in both years. The effective tax rate fell to 26.7% from 48.9%; 2018 included a $3.7 million benefit from finalizing Tax Act accounting, while 2017 included a $25.1 million Tax Act charge. The final Toll Tax liability was $33.5 million, payable over eight years; $14.6 million had been paid by year-end.
Fourth-quarter 2018 sales were $387.6 million and net income was $32.3 million, or $0.94 per diluted share, compared with sales of $366.3 million and a net loss of $2.3 million, or $0.07 per share, in fourth-quarter 2017.
Changes versus prior year
- Sales growth was strongest in the Americas: reported sales rose 8.4% there, compared with 6.1% in Europe and 2.0% in APMEA. Organic growth was 8.4%, 1.8%, and 1.6%, respectively.
- Gross margin increased from 41.4% to 42.0%; operating margin rose from 11.1% to 12.0%.
- Net income increased substantially, but the comparison is affected by the 2017 Tax Act charge and the 2018 Tax Act benefit. Adjusted net income was $128.3 million versus $103.9 million.
- Operating cash flow rose, while capital expenditures increased to $35.9 million from $29.4 million. Financing cash outflow was $202.9 million, including $194.5 million of debt payments, $28.3 million of dividends, and $26.0 million of share repurchases, partly offset by $50.0 million of borrowings.
- Net debt to capitalization declined to 14.3% from 20.7%. The company remained compliant with debt covenants; reported leverage was 0.80x against a maximum of 3.25x.
Outlook, risks, contingencies, and unusual items
- Outlook: The filing provides no formal earnings or sales guidance. Management expects the January 2019 backlog of $103.2 million to convert to sales during 2019, but cautions that backlog is not indicative of future operating results. Planned 2019 capital expenditures are $35–$40 million. The company’s target is to derive 25% of revenue from smart and connected products by 2023.
- Controls issue: Management concluded that internal control over financial reporting and disclosure controls were not effective at December 31, 2018 due to a material weakness in risk assessment and controls for accounting for Tax Act liabilities, specifically the effect of foreign tax credits. A tax liability and provision misstatement was corrected before the financial statements were issued. The auditor gave an adverse opinion on internal control, while issuing an unqualified opinion on the financial statements. Management aimed to remediate the weakness by year-end 2019.
- Key operating risks: Economic and construction cycles, competition and pricing pressure, copper and stainless-steel costs and tariffs, foreign exchange, international sourcing, product defects and recalls, cyber and business interruption risks, regulatory changes, and execution of restructuring, ERP upgrades, acquisitions, and smart-product initiatives.
- Legal and environmental: The company estimated aggregate reasonably possible legal losses above accrued amounts at approximately $5.3 million pretax. It was defending approximately 300 asbestos-related lawsuits; the complaints generally did not identify company products as the exposure source, and no judgments had been entered. The company could not estimate a loss range for the Chemetco contaminated-site matter because remediation costs and responsible-party shares remained undetermined.
- Capital returns: Dividends paid in 2018 were $28.3 million. In February 2019, the board declared a $0.21 quarterly dividend per share and authorized a new stock repurchase program of up to $150 million.
- Other items: The company adopted ASC 606 in 2018 with no material impact. It expected adoption of lease accounting to add approximately $25–$40 million each to assets and liabilities in 2019, without a material effect on earnings or cash flow.
Most important facts for investors to verify
- Progress and evidence of remediation of the material weakness in tax-related financial reporting controls.
- How much 2018 earnings growth reflects sustainable operating improvement versus the differing Tax Act effects; review GAAP and adjusted results together.
- Whether pricing and productivity can continue to offset commodity, freight, tariff, and inflation pressures.
- Cash conversion, working-capital needs, planned capital spending, and debt repayment relative to dividends and repurchases.
- Developments in the Chemetco matter, asbestos and product-liability claims, and the estimated $5.3 million of reasonably possible legal losses above accruals.
- Execution of the 2019 restructuring and the smart-and-connected revenue target, as well as the assumptions underlying the expected backlog conversion.