Watts Water Technologies, Inc. — Q2 2016 Form 10-Q
Reporting period: Second quarter and six months ended July 3, 2016; comparative periods ended June 28, 2015. Amounts are in millions of U.S. dollars except per-share data. Watts supplies products and solutions for water flow, heating, drainage, and water quality, reporting in the Americas, EMEA, and Asia-Pacific.
Financial performance and position
| Metric | Q2 2016 | Q2 2015 | Six months 2016 | Six months 2015 |
|---|---|---|---|---|
| Net sales | $371.1 | $386.9 | $715.3 | $743.1 |
| Gross profit / margin | $150.7 / 40.6% | $145.8 / 37.7% | $285.9 / 40.0% | $276.3 / 37.2% |
| Operating income | $45.7 | $34.8 | $76.9 | $57.6 |
| Net income | $28.6 | $19.3 | $44.8 | $30.9 |
| Diluted EPS | $0.83 | $0.55 | $1.30 | $0.88 |
| Operating cash flow | Not separately provided | Not separately provided | $7.8 | $41.9 |
- Sales declined 4.1% in Q2 and 3.7% in the first half. Organic sales grew 3.8% in Q2 and 4.9% in the first half, but were more than offset by discontinued or divested non-core product sales and, in the first half, unfavorable currency effects.
- Gross margin improved year over year, which management attributed primarily to favorable product mix after exiting low-margin products, manufacturing productivity, sourcing and material-cost savings, and restructuring savings. SG&A was $110.5 in Q2 and $213.1 for the first half.
- Operating income included an $8.7 pre-tax gain on the sale of a China subsidiary in Q2. Q2 net income included an $8.3 after-tax disposition gain, or $0.24 per share; therefore reported earnings growth includes a material unusual benefit.
- First-half operating cash flow was $7.8; capital expenditures were $19.2, producing free cash outflow of $11.4, versus free cash flow of $29.5 in the first half of 2015. Management cited working-capital effects of transformation initiatives and higher income-tax and product-liability payments.
- At July 3, cash was $286.7; total debt outstanding was $606.6, with $601.5 of long-term debt net of current portion and issuance costs. Net debt was $316.3 and net debt to capitalization was 30.1%, compared with 28.4% at year-end 2015.
- Working capital was $578.0 and the current ratio was 3.1:1. Cash included $262.8 held by foreign subsidiaries; repatriation to the U.S. could trigger taxes. The company stated that U.S. operations typically generate sufficient cash for domestic obligations.
Changes, outlook, and notable matters
- Regional results: Q2 Americas sales fell to $239.5 from $262.8, primarily reflecting the non-core product exits; EMEA sales rose to $117.4 from $112.2; Asia-Pacific sales rose to $14.2 from $11.9. Segment operating income improved in EMEA and Asia-Pacific; Americas operating income was $35.4 versus $36.1.
- Transformation and restructuring: The program is expected to cost $63–$68 pre-tax in total, including $20.4 of restructuring, $13.4 of goodwill and intangible impairments, and $29–$34 of other transformation and deployment costs. Costs are expected through 2017. The company expects the Americas footprint to shrink approximately 30%; the program is intended to improve utilization, reduce working capital, and improve customer delivery. Management said it eliminated approximately $165 of combined Americas and Asia-Pacific sales through low-margin product exits.
- Spending outlook: Management expected 2016 capital-equipment spending of $35–$40; after $19.2 in the first half, it expected a further $16–$21 during the remainder of the year. The filing provides no specific full-year revenue or earnings guidance.
- Debt and interest rates: A new five-year credit agreement entered February 12, 2016 includes a $300 term loan and a $500 revolving facility, both maturing in 2021. At quarter-end, $300 was drawn on the term loan, $230 on the revolver, and $245.1 of credit was unused and available; letters of credit were $24.9. The company reported compliance with debt covenants. It entered into interest-rate swaps on $225 notional to hedge LIBOR exposure.
- Capital returns and acquisitions: First-half share repurchases totaled $17.6, and dividends totaled $12.0. Approximately $65.1 remained under the $100 repurchase authorization. A quarterly dividend of $0.18 per share was declared August 4, payable September 16. Watts acquired an additional 50% of AERCO Korea for approximately $4, bringing ownership to 90%, with a commitment to acquire the remaining 10% by December 31, 2017. AERCO Korea results were not material.
- Legal and other exposures: The proposed $14 settlement of the Ponzo and Klug connector class actions was awaiting court approval; Watts expected to pay approximately $4.1 after insurance proceeds of up to $9.9. The filing estimates approximately $4.2 of reasonably possible legal losses above amounts accrued, subject to significant uncertainty. Watts was defending approximately 313 asbestos-related lawsuits; it reported no judgments against it in those cases.
- Key risks: Management highlighted construction-market conditions, raw-material availability and pricing, competition, variable borrowing rates, currency movements, execution and savings from restructuring, acquisitions, product safety and liability, environmental costs, and litigation. The company reported effective disclosure controls and no material change in internal control over financial reporting during the quarter.
Important facts for investors to verify
- How much of reported earnings growth is sustainable after excluding the China-sale gain and other restructuring, transformation, acquisition, and tax items?
- Whether organic sales growth and gross-margin improvement continue after the non-core product exits, particularly in the Americas.
- Whether working capital normalizes and operating cash flow improves after the first-half decline and negative free cash flow.
- Progress, remaining costs, savings, and execution risks for the transformation program, including the planned footprint reduction and 2016 capital spending.
- Approval and final terms of the connector-class-action settlements, insurance recovery, and any changes in other legal exposures.
- Debt repayment, interest-rate exposure, foreign-cash tax implications, and continued compliance with credit-agreement covenants.