Watts Water Technologies, Inc. — Q1 2011 Form 10-Q
Reporting period: First quarter ended April 3, 2011, compared with the quarter ended April 4, 2010. Amounts are in U.S. dollars; financial figures are in millions except per-share data. Watts supplies water quality, safety, flow-control and conservation products, reporting North America, Europe and China segments.
Financial results and liquidity
- Revenue: Net sales were $329.9, up 3.3% from $319.3. Organic sales grew 1.7%; acquisitions added $4.6 and foreign exchange added $0.5. North America sales were $202.1, Europe $124.0 and China $3.8.
- Margins and operating income: Gross profit rose to $121.0 from $117.6, while gross margin edged down to 36.7% from 36.8%. Operating income fell 11.9% to $22.9 from $26.0. SG&A increased to $97.0 from $88.3, including a $6.3 CEO separation charge.
- Earnings: Continuing-operations net income was $11.1, or diluted EPS of $0.29, versus $12.2 and $0.33. Total net income was $11.1 versus $8.1, as the prior-year quarter included a $4.1 after-tax discontinued-operations loss. The effective tax rate on continuing operations declined to 35.6% from 42.4%.
- Cash flow: Cash from continuing operating activities was $0.9, down from $4.7. Capital spending was $6.6, resulting in free cash flow of negative $5.7 versus negative $1.9. Management attributed weaker cash generation partly to higher inventory valuations and restructuring-related inventory.
- Balance sheet and debt: Cash and equivalents were $418.5 at April 3, up from $329.2 at year-end. Total debt, including current portion, was $470.9 versus $378.7; net debt was $52.4 versus $49.5, and net debt to capitalization was 5.2% at both dates. Working capital was $701.6; the current ratio was 3.5:1.
- Credit availability: Revolver borrowings were $92.1, with $34.9 of letters of credit outstanding and $173.0 of unused available credit. The company reported compliance with its credit-facility and note-agreement covenants.
Material changes and management commentary
- Sales gains reflected stronger North American and European wholesale demand, including gas connectors and backflow products in North America and drain and under-floor radiant products in Europe. North American DIY sales declined 4.8%; China sales declined.
- Raw-material inflation pressured margins: copper spot prices were approximately 18.9% higher year over year. Management said announced price increases and productivity and facility-consolidation efforts were intended to mitigate cost pressure; the filing notes cost increases had not yet been fully recovered in some markets.
- Operating income declined in North America and Europe, while China improved to $0.8 from a $1.1 loss. Corporate expense rose to $14.3 from $11.1. Management cited CEO separation costs, commodity costs and continuing French restructuring inefficiencies among the factors affecting results.
- Interest expense rose to $5.9 from $5.2, primarily due to incremental private-placement debt and higher credit-line fees.
Outlook, transactions, risks and unusual items
- Outlook: No full-year revenue or earnings guidance is provided. Management anticipated cash-flow improvement during 2011 and expected approximately $32.5 of capital expenditures for the year. It expected additional 2011 capital spending of approximately $25.9 after Q1.
- Socla acquisition: On April 29, 2011, after quarter-end, Watts completed its acquisition of Danfoss Socla and related water-controls businesses for EUR 120.0, approximately $175.7 at the cited exchange rate, subject to adjustments. The consideration included EUR 58.0 cash and EUR 62.0 debt, funded with cash and euro borrowings. Socla reported approximately $130.0 of 2010 revenue; purchase-price allocation was not complete. Pro forma Q1 2011 sales and continuing-operations net income were $363.3 and $12.7, respectively.
- Restructuring and divestiture: A new European facility-consolidation program was expected to cost $2.0 pre-tax, with $0.2 incurred by quarter-end. The 2010 Europe and North America programs had $1.3 and $2.8 of expected costs remaining, respectively. The planned TWVC sale was expected to close before the end of Q3 2011, subject to approvals; management estimated $5.9 net proceeds and described potential tax and currency-translation gains upon completion.
- CEO separation: Former CEO Patrick O’Keefe resigned January 26, 2011. The company recorded a $6.3 charge, including $3.3 expected cash severance and $3.0 non-cash award-modification expense.
- Contingencies and risks: The filing reported no material developments in existing litigation, environmental remediation or the CWV Foreign Corrupt Practices Act investigation during the quarter. Key risks include housing and construction demand, commodity costs and pricing, competition, foreign exchange, product liability, regulatory compliance, restructuring execution and acquisition integration. Orion goodwill of $24.6 was identified as potentially at risk if commercial-market conditions deteriorate; its fair value exceeded carrying value by 17% at the October 2010 impairment analysis.
- Controls: Management concluded disclosure controls were effective and reported no material change in internal control over financial reporting during the quarter.
Important facts for investors to verify
- Socla’s final purchase-price allocation, financing costs, integration progress and contribution to results.
- Whether pricing actions offset copper and other input-cost inflation without materially affecting volumes or margins.
- Operating cash-flow recovery, inventory levels and the funding needs of acquisition and capital-spending plans.
- Progress and total costs of European and North American restructuring, and completion of the TWVC sale and related anticipated gains.
- Developments in the CWV FCPA investigation and other legal or environmental contingencies.
- Debt levels, covenant headroom and the effect of additional borrowings following the Socla transaction.