Watts Water Technologies, Inc. — Q2 2017 Form 10-Q
Reporting period: Second quarter and six months ended July 2, 2017; comparative periods ended July 3, 2016. Dollar amounts are in millions except per-share data.
Business context
Watts supplies water-flow, heating, drainage and water-quality products for residential and commercial markets. It reports three geographic segments: Americas, Europe and APMEA. Results include PVI, acquired in late 2016. The company shifted its Middle East business into APMEA beginning in 2017 and retrospectively revised 2016 segment comparisons.
Financial performance
| Metric | Q2 2017 | Q2 2016 | Six months 2017 | Six months 2016 |
|---|---|---|---|---|
| Net sales | $378.5 | $371.1 | $725.7 | $715.3 |
| Gross profit / margin | $156.7 / 41.4% | $150.7 / 40.6% | $300.5 / 41.4% | $285.9 / 40.0% |
| Operating income / margin | $44.8 / 11.8% | $45.7 / 12.3% | $80.5 / 11.1% | $76.9 / 10.8% |
| Net income / margin | $27.2 / 7.2% | $28.6 / 7.7% | $48.9 / 6.7% | $44.8 / 6.3% |
| Diluted EPS | $0.79 | $0.83 | $1.42 | $1.30 |
| Operating cash flow | — | — | $9.0 | $7.8 |
- Q2 sales rose 2.0%; PVI contributed $13.5, offset by $4.6 of foreign-exchange headwind and a $1.5 decline in organic sales. Americas sales increased 3.0%, Europe declined 1.0%, and APMEA was flat.
- Q2 gross margin improved on manufacturing productivity, restructuring savings, price realization and favorable European mix. Operating income was down 1.9%, largely because Q2 2016 included an $8.7 gain on a China subsidiary sale.
- For the first half, sales increased 1.5%, including $28.8 from acquisitions; organic sales declined $6.2, foreign exchange reduced sales by $8.7, and divestitures reduced sales by $3.5. Higher gross profit and lower interest expense supported higher net income.
- First-half operating cash flow less capital expenditures was a $1.9 free-cash-flow outflow, improved from an $11.4 outflow a year earlier. Working-capital movements included cash uses from receivables ($41.5), inventory ($13.1), and payables/accruals ($23.4).
Debt, liquidity and capital allocation
- At July 2, cash and equivalents were $217.5, down from $338.4 at year-end; approximately $205.0 was held by foreign subsidiaries. The company said repatriation could incur tax and that it intended to permanently reinvest foreign earnings.
- Management reported net debt of $330.8 and net debt to capitalization of 29.3%, versus 29.8% at December 31, 2016. The balance sheet lists $37.9 of current debt and $510.4 of long-term debt; the debt note separately reports a $551.2 carrying amount including current debt, so the figures do not fully reconcile in the filing text.
- The $500 revolving facility had $177.0 drawn, $297.3 of unused available credit and $25.7 of letters of credit outstanding. The $300 term loan had $288.8 outstanding; both facilities mature in February 2021. The remaining €9.0 million Facility Agreement balance was repaid July 20, 2017. The company reported covenant compliance.
- First-half financing cash outflow was $131.9, including $126.3 of debt payments, $12.8 of dividends and $9.0 of share repurchases, partly offset by $20.0 of borrowings. Capital expenditures were $11.0; management expected approximately $20–$24 of capital spending for the rest of 2017.
Outlook, commentary and risks
- No formal revenue or earnings guidance is provided in the supplied filing text. Management expected the Americas/APMEA transformation program to be substantially completed by year-end 2017, with remaining restructuring costs estimated at $2.2; the broader program’s estimated pretax cost was approximately $65.
- Management cited product innovation, selective acquisitions, regulatory and code requirements, water conservation and economic conditions as growth factors. It also highlighted product rationalization, which reduced first-half organic sales by an estimated $9.4.
- Key exposures include housing and construction cycles, raw-material availability and prices, competition, variable interest rates, foreign exchange, product quality and liability, litigation, environmental compliance, and execution and savings from restructuring. Floating-rate exposure is partly hedged with interest-rate swaps; the company also uses foreign-exchange forwards.
- Legal matters: reasonably possible legal losses above recorded accruals were estimated at $4.6 pretax. Connector class-action settlements became final in May 2017; the company received $9.9 of insurance proceeds and reported $5.3 of remaining settlement liability to be paid over three years.
- Revenue recognition guidance was scheduled for adoption January 1, 2018; the company was assessing its impact and expected to use the modified retrospective method. Disclosure controls were deemed effective, with no material change in internal control over financial reporting reported for the quarter.
Most important facts for investors to verify
- Reconcile the $551.2 debt carrying amount in the debt note with the balance-sheet debt entries and management’s $330.8 net-debt calculation.
- Track organic demand by region and channel, especially Americas specialty products, European plumbing and water products, and APMEA project timing, separately from acquisition and currency effects.
- Assess whether margin gains and transformation savings can continue as restructuring winds down, and whether product rationalization continues to constrain sales.
- Monitor cash conversion and working-capital requirements, as first-half free cash flow remained negative despite improved operating cash flow.
- Review actual restructuring costs and savings, remaining legal exposure, foreign-cash accessibility and taxes, and the eventual effect of the 2018 revenue standard adoption.