Watts Water Technologies, Inc. — Q2 2014 Form 10-Q
Business context and period. The company supplies water quality, safety, flow-control and conservation products, as well as HVAC-related products, through the Americas, EMEA and Asia-Pacific segments. This unaudited report covers the 13 weeks and six months ended June 29, 2014; comparisons are with the periods ended June 30, 2013.
Key financial results
| Metric | Q2 2014 | Q2 2013 | First six months 2014 | First six months 2013 |
|---|---|---|---|---|
| Net sales | $396.0 million | $366.8 million | $761.2 million | $725.7 million |
| Gross profit | $139.0 million | $132.8 million | $272.3 million | $261.7 million |
| Gross margin | 35.1% | 36.2% | 35.8% | 36.1% |
| Operating income | $36.6 million | $35.6 million | $62.4 million | $64.2 million |
| Net income | $21.3 million | $18.9 million | $35.4 million | $35.0 million |
| Diluted EPS | $0.60 | $0.53 | $1.00 | $0.98 |
- For the first six months, cash from continuing operations was $18.4 million, versus $21.8 million. Free cash flow, a non-GAAP measure, was $8.0 million versus $5.2 million.
- At June 29, 2014, cash was $244.3 million; total debt, including current maturities, was $306.6 million; net debt was $62.3 million. Net debt to capitalization was 5.8%, up from 3.8% at year-end 2013.
- Working capital was $547.4 million and the current ratio was 2.7 to 1. The company had $476.4 million of unused credit under its $500 million revolving facility and was in compliance with its covenants.
Material changes and management commentary
- Q2 sales rose 8.0%; organic sales increased 6.5%, with foreign exchange contributing $5.5 million. Americas organic sales grew 8.3%, EMEA 2.3%, and Asia-Pacific 22.9%. First-half sales rose 4.9%, with organic growth of 3.7%.
- Q2 gross margin fell 1.1 percentage points, mainly from higher Americas production costs, lower absorption and increased customer rebates; EMEA efficiencies and favorable material prices partly offset the decline. First-half gross margin was down 0.3 percentage points.
- Q2 operating income increased 2.8%, supported by EMEA performance, but first-half operating income declined 2.8%. Higher SG&A and restructuring charges weighed on the half-year result. SG&A included $5.1 million of EMEA transformation deployment costs for the first six months.
- First-half operating cash flow declined as higher receivables and inventory, including inventory to support the lead-free conversion, used cash. Cash also declined from year-end, primarily due to share repurchases.
Outlook, risks and unusual items
- Management expected 2014 capital expenditures of $25–$28 million, including approximately $15–$18 million for the remainder of the year, and approximately $20 million of additional share repurchases for the remainder of 2014.
- The EMEA transformation is expected to continue through 2016. The European footprint restructuring is expected to cost approximately $14.7 million pretax and be completed by the end of fiscal 2015; $8.1 million of expected costs remained at June 29, 2014.
- The pension plan was terminated effective July 31, 2014, subject to regulatory requirements; the SERP was terminated effective May 15, 2014. Management estimated related cash outflows of approximately $30–$40 million, subject to change with asset values, interest rates and participant elections.
- The Trabakoolas toilet-connector class settlement totals $23.0 million, with the company responsible for $14.0 million after anticipated insurance proceeds. Final court approval was issued after quarter-end; the order could be appealed. The company reported a $21.3 million remaining liability at June 29, 2014.
- Management estimated reasonably possible legal losses above accrued amounts at approximately $10.3 million pretax. It stated that ultimate outcomes are not expected to materially affect financial condition, but could materially affect results or cash flows in a particular period. Environmental liabilities were described as not material; the company was defending 47 asbestos lawsuits.
- Key risks include construction and remodeling demand, competition and pricing, raw-material costs, lead-free foundry production efficiency, foreign exchange, restructuring execution, product liability, litigation and acquisitions. Approximately $217.0 million of cash was held by foreign subsidiaries; repatriation could incur taxes, and the company said it had no current plans to repatriate those earnings.
Important facts for investors to verify
- Whether sales growth and margins persist, especially in the Americas, and whether lead-free production costs and customer rebates moderate.
- Actual restructuring and EMEA transformation costs, savings and completion timing.
- The timing and final funding needs for pension-plan and SERP settlements.
- Final status of the Trabakoolas settlement, including any appeal, insurance recovery and payments; changes in other legal contingencies.
- Cash generation, working-capital needs, planned capital spending and repurchases, and the practical availability and tax cost of foreign-held cash.