Watts Water Technologies, Inc. — Q2 2013 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2013; unaudited. Comparisons are with the quarter and six months ended July 1, 2012, except balance-sheet comparisons, which are with December 31, 2012. Amounts are in millions unless stated otherwise.
Business context and results
Watts supplies water quality, safety, flow-control and conservation products, principally in North America and EMEA, with a smaller and growing presence in Asia. It reports three geographic segments and four product categories. Demand is affected by construction and remodeling activity, foreign exchange, commodity costs and regulation.
| Metric | Q2 2013 | Q2 2012 | Six months 2013 | Six months 2012 |
|---|---|---|---|---|
| Net sales | $371.3 | $367.4 | $733.4 | $728.6 |
| Gross profit / margin | $133.7 / 36.0% | $130.4 / 35.5% | $263.2 / 35.9% | $258.9 / 35.5% |
| Operating income | $35.6 | $33.2 | $63.9 | $59.8 |
| Continuing-operations net income | $18.9 | $18.2 | $35.0 | $33.7 |
| Net income | $18.9 | $18.5 | $35.0 | $34.2 |
| Diluted EPS | $0.53 | $0.51 | $0.98 | $0.93 |
Cash flow, debt and liquidity
- Six-month operating cash flow was $21.3, versus $22.9 a year earlier. Capital spending was $18.0, versus $9.6; reported free cash flow was $4.7, versus $14.3. Free cash flow is a company-defined non-GAAP measure.
- Cash fell to $181.9 from $271.8. The company attributed the decline mainly to repayment of maturing debt, share repurchases, higher inventory and capital spending.
- Total debt, including current maturities, was $308.4, down from $384.6. The company repaid $75.0 of senior notes that matured in May and reported no borrowings on its revolving credit facility at June 30.
- Working capital was $469.5; the current ratio was 2.6 to 1. The $300.0 revolving facility had $270.4 of unused and available credit, with $29.6 of standby letters of credit outstanding. The company reported covenant compliance.
- About $144.6 of cash was held by foreign subsidiaries. Repatriation could trigger taxes; management said it intended to permanently reinvest these earnings and had no current plan to repatriate them.
Material changes versus the prior period
- Q2 sales rose 1.1% reported; organic sales increased 0.5%. North America organic sales increased $6.5 (3.0%) and Asia increased $1.7 (26.2%), while EMEA declined $6.4 (4.5%). Euro appreciation added $2.1 to reported Q2 sales.
- Q2 operating income increased 7.2%, reflecting higher gross margin and essentially flat SG&A. North America operating income improved, while EMEA operating income declined amid weaker volume and higher restructuring costs.
- For the six months, sales rose 0.7% reported, with organic sales nearly flat. North America and Asia grew; EMEA contracted. Operating income increased 6.9%.
- Six-month net income benefited from lower share count: share repurchases contributed an estimated $0.03 per share. The company repurchased approximately 213,000 shares for $10.0 in Q2.
- Foreign-currency translation reduced six-month comprehensive income; accumulated other comprehensive loss was $22.9 at June 30.
Outlook, commentary and risks
- Management expected approximately $37 of 2013 capital-equipment spending, including lead-free production conversion; it expected approximately $19 of capital spending in the second half. A six-month lead-free inventory build added about $27 of inventory investment.
- On July 30, the board approved a European restructuring to reduce the manufacturing footprint by about 10%. Estimated charges are $14 pretax (about $10 after tax), with approximately $9.8 expected through fiscal 2014 and the remainder in fiscal 2015; completion is expected by the end of Q4 2015. Approximately $2 of additional capital expenditure is expected.
- On August 1, the company completed the sale of Austroflex for approximately $9 and estimated an after-tax disposal loss of about $2. Its results are to be reported as discontinued operations beginning in Q3 2013.
- European weakness was an impairment indicator: updated analysis found EMEA reporting-unit fair value about 15% above carrying value. EMEA goodwill was $214.8; further deterioration or significantly higher interest rates could put it at risk. No impairment was recorded in the period.
- Management identified risks from construction-market conditions, lead-free conversion execution, raw-material availability and pricing, competition and pricing pressure, currency movements, product liability, environmental costs and restructuring execution.
- The company disclosed approximately $8.2 of reasonably possible legal loss in excess of amounts accrued, pre-tax. It said outcomes could vary materially; management did not expect the disclosed matters to materially affect overall financial position. A toilet-connector putative class action remained in early stages, and the filing did not provide a reasonably estimable loss range for that matter.
- The company declared a $0.13-per-share quarterly dividend payable August 30, 2013. It reported effective disclosure controls and no material change in internal control over financial reporting during the quarter.
Key facts for investors to verify
- Whether EMEA sales and operating performance stabilize, and whether the reported 15% goodwill valuation cushion is maintained.
- Whether the European restructuring achieves expected savings and proceeds within the disclosed cost, timing and capital-spending estimates.
- Lead-free conversion progress, inventory levels and cash conversion; Q2 and six-month free cash flow were substantially below prior-year levels.
- Cash availability and potential tax costs if foreign-held cash is needed domestically, alongside debt repayment and credit-facility capacity.
- Developments in legal matters, especially the toilet-connector litigation, and changes in the estimated $8.2 of reasonably possible losses.
- Completion and accounting treatment of the Austroflex disposal, including the estimated loss and discontinued-operations presentation.