Watts Water Technologies, Inc. — Q3 2010 Form 10-Q
Business context and period: Watts designs and manufactures water quality, safety, flow-control and conservation products, principally for residential and commercial markets. This unaudited filing covers the 13 weeks ended October 3, 2010, and the first 39 weeks of 2010; comparisons are to the corresponding 2009 periods. The nine-month 2010 period included four additional working days.
Financial performance
Amounts are in millions of dollars except per-share data and percentages.
| Metric | Q3 2010 | Q3 2009 | Nine months 2010 | Nine months 2009 |
|---|---|---|---|---|
| Net sales | $314.6 | $303.8 | $957.9 | $902.7 |
| Gross profit / margin | $113.8 / 36.2% | $109.4 / 36.0% | $352.0 / 36.7% | $315.6 / 35.0% |
| Operating income | $31.5 | $24.3 | $90.8 | $68.3 |
| Continuing-operations net income | $17.3 | $11.6 | $51.7 | $30.9 |
| Net income, including discontinued operations | $17.3 | $3.4 | $47.5 | $3.2 |
| Diluted EPS | $0.46 | $0.09 | $1.27 | $0.09 |
| Cash from continuing operating activities | Not separately presented | Not separately presented | $75.3 | $146.2 |
| Free cash inflow | Not separately presented | Not separately presented | $58.1 | $131.2 |
- Q3 sales rose 3.6%; reported nine-month sales increased 6.1%. Organic sales growth was 4.9% and 6.0%, respectively. Q3 organic growth was reported across all three segments: North America 4.1%, Europe 5.9% and China 4.2%.
- Q3 operating income increased 29.6%; nine-month operating income rose 32.9%. Nine-month gross margin improved 1.7 percentage points. Management attributed improvements chiefly to higher volumes, factory absorption, product mix and productivity initiatives.
- Nine-month diluted EPS from continuing operations was $1.38, compared with $0.83; total diluted EPS was $1.27 versus $0.09. The 2009 comparison included substantially larger losses from discontinued operations.
- Nine-month operating cash flow and free cash inflow fell from 2009, mainly due to higher working-capital requirements, including increased receivables and inventory. Capital expenditures were $18.4, versus $15.4.
Balance sheet, debt and liquidity
- At October 3, 2010, cash and cash equivalents were $292.3; current assets were $866.1 and current liabilities $291.4. Working capital was $574.7, up from $489.8 at December 31, 2009; the current ratio was 3.0 versus 2.6.
- Total debt, including current maturities, was $378.9, compared with $354.9 at year-end 2009. The company issued $75.0 of 5.05% senior notes due 2020 and repaid $50.0 of notes at maturity. It reported no revolver borrowings and $265.3 of unused available capacity under its $300 million revolving facility; $34.7 of standby letters of credit were outstanding. The company reported compliance with debt covenants.
- Cash increased $34.1 during the nine months. Investing activities used $50.8, including $36.1 for acquisitions; financing activities provided $10.4, including debt proceeds and dividend payments. Dividends were $0.11 per share in Q3 and $0.33 per share for the nine months.
Material changes and management commentary
- North American and European sales increased, but management noted a softening in North America, including DIY customer destocking following expiration of the first-time homebuyer tax credit. The U.S. commercial market remained weak; management did not expect improvement for the balance of 2010 or well into 2011.
- Foreign exchange, mainly euro weakness, reduced Q3 and nine-month diluted earnings by approximately $0.03 per share versus the comparable periods. Copper spot prices were about 10.5% above year-end 2009 and 24.4% above July 7, 2010; the company cited raw-material cost and pass-through exposure.
- Management expected $4.0–$7.0 of capital spending for the remainder of 2010. It reported no full-year earnings or revenue guidance in the supplied filing text.
- Two acquisitions were completed: BRAE, a rainwater-harvesting solutions provider, and Austroflex, a European pre-insulated pipe systems manufacturer. Their results were included from acquisition dates and were not material to consolidated results.
- A new U.S. restructuring plan will close two North Carolina manufacturing facilities and consolidate operations elsewhere. Expected pre-tax charges are approximately $4.9, plus approximately $2.0 of training and pre-production costs; planned consolidation capital spending is approximately $1.2. Management estimated annual after-tax cash savings of $1.6, expected to be fully realized in the second half of 2012, with completion expected by Q3 2011.
Risks, contingencies and unusual items
- The company recorded $5.6 of costs and expenses in discontinued operations during the first nine months, primarily related to the Foreign Corrupt Practices Act investigation concerning its former China Valve (Changsha) business. The filing describes an estimated reserve and related legal costs; final exposure is uncertain.
- The divestiture of China Valve was completed in January 2010. The company also reported a planned sale of Tianjin Watts Valve, expected to close before year-end subject to government approvals, with anticipated net proceeds of approximately $5.9.
- Other cited exposures include product-liability and environmental matters, competition, economic and construction-market weakness, foreign exchange, commodity costs and restructuring execution. Management said there were no material developments in other litigation or environmental matters during the quarter.
- A $2.8 tax benefit during 2010 primarily reflected release of a European valuation allowance. The filing also identifies possible future goodwill impairment exposure at the Orion reporting unit if commercial-market deterioration materially exceeds expectations.
- The company reported effective disclosure controls and procedures and no material change in internal control over financial reporting during the quarter.
Important facts for investors to verify
- Whether cash conversion recovers from the nine-month decline and working-capital investment, particularly receivables and inventory.
- Progress on North American facility consolidation, total restructuring and implementation costs, and whether projected savings are achieved on schedule.
- Developments, reserves and potential consequences of the FCPA investigation, as well as the status and proceeds of the Tianjin asset sale.
- Whether weak U.S. commercial demand, retail destocking, euro movements and rising commodity costs affect sales, margins or guidance.
- Acquisition integration and performance, and the sensitivity of goodwill and other asset valuations to future operating results.