Watts Water Technologies, Inc. — Q3 2013 Form 10-Q
Reporting period: Third quarter and first nine months ended September 29, 2013; comparisons are to the periods ended September 30, 2012. Dollar amounts are in millions except per-share data. Watts supplies water quality, safety, flow-control and conservation products, primarily in North America and EMEA, with a growing presence in Asia.
Financial performance
| Metric | Q3 2013 | Q3 2012 | Nine months 2013 | Nine months 2012 |
|---|---|---|---|---|
| Net sales | $371.8 | $352.8 | $1,097.5 | $1,072.9 |
| Gross profit | $133.9 | $127.7 | $395.6 | $384.9 |
| Gross margin | 36.0% | 36.2% | 36.0% | 35.9% |
| Operating income | $30.2 | $32.5 | $94.4 | $92.6 |
| Income from continuing operations | $17.5 | $18.3 | $52.7 | $52.2 |
| Net income | $15.4 | $18.7 | $50.4 | $52.9 |
| Diluted EPS | $0.43 | $0.53 | $1.41 | $1.46 |
- Q3 sales increased 5.4%, comprising $12.7 of organic growth and $6.3 of favorable foreign exchange. Organic growth was strongest in North America (+8.6%); EMEA declined 4.2% and Asia grew 15.1%.
- Q3 operating income fell 7.1%, as higher SG&A more than offset higher gross profit. SG&A rose 9.8% to $100.7, including increased product-liability, sales-related freight and commission, personnel and legal costs. Operating margin was approximately 8.1%, versus 9.2% a year earlier.
- For the first nine months, sales rose 2.3% and operating income 1.9%. North America and Asia grew; EMEA sales declined 2.1%, primarily reflecting weaker market conditions and lower OEM/project sales. Continuing-operations diluted EPS increased to $1.48 from $1.44.
- Discontinued operations included the August 2013 sale of Austroflex for net proceeds of $7.9 and an approximately $2.2 after-tax disposal loss. Total net income also reflects discontinued-operations losses of $2.1 in Q3 and $2.3 year to date.
Cash flow, balance sheet and liquidity
- Nine-month cash from continuing operating activities was $67.7, down from $71.5. Free cash flow, as defined by the company, was $46.5 versus $53.8; the cash conversion rate was 88.2% versus 103.1%. Working-capital investment—particularly receivables and inventory—plus higher capital spending contributed to the decline.
- Capital expenditures were $22.6 year to date. Management expected approximately $34 for full-year 2013 and approximately $11 in the final quarter, including spending on lead-free manufacturing capabilities.
- Cash and cash equivalents were $227.2 at September 29, down from $271.3 at year-end 2012; approximately $196.6 was held by foreign subsidiaries. Current assets were $812.9 and current liabilities $310.3; working capital was $502.6 and the current ratio 2.6x.
- Total debt, including current maturities, was $308.3; net debt was $81.1, and net debt to capitalization was 7.6%, compared with 10.8% at year-end. The company repaid $75.0 of senior notes that matured in May. It had no revolver borrowings, $270.4 of available credit and $29.6 of standby letters of credit; it reported compliance with debt covenants.
- Financing uses included $75.0 of debt repayment, $20.0 of share repurchases and $13.1 of dividends. The quarterly dividend was $0.13 per share; the company repurchased approximately 402,000 shares for $20.0 year to date under a new authorization of up to $90.
Outlook, commentary and risks
- No earnings or revenue guidance was provided. Management identified construction and remodeling demand, water-related regulation and codes, organic growth, and selective acquisitions as important business drivers.
- The July 2013 European restructuring is intended to reduce the European manufacturing footprint by approximately 10% and better align costs with expected revenue. Expected pretax charges total approximately $14.0, with $3.1 incurred through Q3 and $10.9 remaining; completion is expected by the end of Q4 2015. Some actions remain subject to local review and worker-council consultation.
- EMEA goodwill was $218.2. Following weaker performance, management’s updated valuation showed fair value approximately 15% above carrying value; further deterioration in Europe or a significant rise in interest rates could put goodwill at risk of impairment.
- Other key exposures include lead-free conversion execution and related inventory/production inefficiencies, raw-material costs and pricing pressure, foreign exchange, construction-market cyclicality, product-liability claims, litigation, and restructuring execution. Management reported a recent increase in product-liability claims, mostly related to legacy products.
- Legal matters included a putative class action alleging toilet-connector failures; the case was stayed while the parties explored settlement, and the company could not estimate a reasonably possible loss for that matter. Across disclosed legal contingencies, estimated reasonably possible losses above accrued amounts totaled approximately $6.5 pretax. Management said outcomes could affect results or cash flows in a particular period, but did not expect the matters collectively to materially adversely affect financial condition.
- Disclosure controls were reported effective, with no material change in internal control over financial reporting during the quarter.
Important facts for investors to verify
- Whether North American growth and lead-free conversion gains can offset ongoing EMEA weakness, retail pricing pressure and conversion inefficiencies.
- How product-liability claims, settlements and actuarial estimates develop, including exposure from legacy products and the toilet-connector litigation.
- Progress, total costs, savings and timing of the European restructuring, and whether EMEA’s goodwill valuation cushion is maintained.
- Cash conversion, inventory levels and capital spending as the lead-free transition proceeds; consider the substantial concentration of cash in foreign subsidiaries and potential repatriation taxes.
- Debt maturities, covenant compliance, available revolver capacity, and the pace of share repurchases and dividends relative to cash generation.