Watts Water Technologies, Inc. — Q2 2020 Form 10-Q
Reporting period: Second quarter and six months ended June 28, 2020. The company supplies flow-control, HVAC and gas, drainage, and water-quality products across the Americas, Europe, and Asia-Pacific, Middle East and Africa (APMEA). Amounts below are in U.S. dollars; financial statements are unaudited.
Financial performance and liquidity
| Metric | Q2 2020 | Q2 2019 | Six months 2020 | Six months 2019 |
|---|---|---|---|---|
| Net sales | $338.7m | $416.8m | $721.3m | $805.5m |
| Gross profit / margin | $134.9m / 39.8% | $174.6m / 41.9% | $297.7m / 41.3% | $338.8m / 42.1% |
| Operating income | $31.0m | $54.3m | $78.8m | $101.0m |
| Net income | $20.2m | $36.4m | $52.2m | $67.4m |
| Diluted EPS | $0.59 | $1.06 | $1.53 | $1.97 |
- Q2 sales fell 18.7% reported and 18.6% organically. Six-month sales fell 10.5% reported and 10.2% organically. COVID-19-related volume declines drove the contraction across all three regions; DIY sales partly offset the decline in the Americas.
- Q2 operating income declined 42.9%; six-month operating income declined 22.0%. Lower volume pressured gross profit and margin, partly offset by pricing, productivity, cost reductions, and some European and APMEA government subsidies.
- Operating cash flow was $47.3m for the first half, versus $19.7m a year earlier. Free cash flow, a company-defined non-GAAP measure, was $25.0m versus $5.4m. Management attributed the improvement primarily to lower receivables, which more than offset lower earnings and higher inventory.
- Cash was $148.7m at quarter-end, down from $219.7m at year-end 2019. Total debt was $262.5m, compared with $309.2m at year-end; net debt was $113.8m versus $89.5m. Net debt to capitalization increased to 10.4% from 8.4%.
- The company had $667.5m of current assets and $278.9m of current liabilities. It reported $518.7m of unused revolving-credit availability after $265.0m drawn and $16.3m of letters of credit. Cash included $103.7m held by foreign subsidiaries.
Material changes and notable items
- On April 24, 2020, the company replaced its prior credit agreement with an $800m senior unsecured revolving facility, extending maturity to February 2022. The term loan was repaid with revolver proceeds. The reported revolver rate was 2.5% at June 28; the company was in covenant compliance.
- Restructuring charges were $5.3m in Q2 and the first half, primarily workforce and other actions in response to COVID-19. Expected total costs for the 2020 actions were approximately $9.5m, with $5.6m incurred by June 28. Q2 also included a $1.0m long-lived asset impairment charge in the Americas.
- Q2 diluted EPS included after-tax charges of $0.12 per share for restructuring, $0.02 for impairment, and $0.01 for footprint optimization, according to management.
- Capital expenditures were $23.8m in the first half. Management expected a further $15m–$20m of capital-equipment investment in the second half of 2020.
- After quarter-end, the company completed an all-cash acquisition of Australian Valve Group on July 3, deemed not material, and declared a $0.23-per-share dividend on July 27, payable September 15.
Outlook, risks, and contingencies
- Management estimated Q3 2020 sales could decline 8%–12% versus the prior year. It reported sequential monthly improvement in orders and sales during Q2 as restrictions eased, but expected operations to remain negatively affected in Q3. It gave no clear full-year sales or earnings forecast; results remained highly uncertain.
- COVID-19 risks include renewed restrictions, reduced customer demand and capital spending, manufacturing interruptions, employee absences, supply-chain and distribution disruption, delayed customer payments, and customer or supplier financial distress. Management said it did not anticipate difficulty paying debt as due, while noting future liquidity and results could be adversely affected.
- The company temporarily suspended share repurchases to conserve cash and reinstated the program effective June 29. It maintained its dividend rate and took other cost and cash-preservation steps.
- Interest-rate swaps ceased qualifying for hedge accounting after the new credit agreement changed the LIBOR floor. Subsequent mark-to-market changes are recognized in earnings; $1.2m of previously recorded loss in other comprehensive income was expected to be reclassified into interest expense through February 2021.
- Management estimated reasonably possible legal losses above amounts accrued at approximately $4.8m pre-tax. It could not estimate a loss range for the Chemetco Superfund matter because remediation costs and responsible parties remain undetermined.
- No goodwill impairment trigger was identified at June 28, 2020. Management highlighted the Heating and Hot Water Solutions reporting unit, with $218.9m of goodwill, as potentially vulnerable if a prolonged pandemic materially changes valuation assumptions.
Most important facts for investors to verify
- Whether the stated Q3 sales decline range and sequential recovery assumptions materialized, given continuing pandemic and end-market uncertainty.
- Cash conversion and working-capital trends, particularly receivables collectability and inventory, alongside the reduction in cash and increase in net debt.
- Revolver utilization, covenant compliance, borrowing costs, and the effect of variable rates and swap mark-to-market changes.
- Execution and total cost of the restructuring plan, and any further impairment indicators, especially for the Heating and Hot Water Solutions reporting unit.
- Developments in legal and environmental contingencies, including the currently unquantifiable Chemetco remediation exposure.