Watts Water Technologies, Inc. — Q1 2019 Form 10-Q
Reporting period: The 13 weeks ended March 31, 2019; comparisons are with the first quarter ended April 1, 2018. Amounts are in U.S. dollars. Watts supplies flow-control, heating, drainage and water-quality products across the Americas, Europe and APMEA.
Financial performance
| Metric | Q1 2019 | Q1 2018 | Change |
|---|---|---|---|
| Net sales | $388.7 million | $378.5 million | Up 2.7%; organic sales up 5.6%, partly offset by $11.0 million of unfavorable foreign exchange |
| Gross profit / margin | $164.2 million / 42.2% | $156.7 million / 41.4% | Margin up 0.8 percentage points |
| Operating income / margin | $46.7 million / 12.0% | $43.9 million / 11.6% | Up 6.4% |
| Net income | $31.0 million | $28.2 million | Up 9.9% |
| Diluted EPS | $0.91 | $0.82 | Up 11.0% |
| Operating cash flow | $(24.2) million | $(26.1) million | Cash used decreased |
| Free cash outflow | $(31.1) million | $(33.4) million | Non-GAAP measure |
Management attributed improved gross margin and operating income primarily to pricing, higher volume and productivity savings, partly offset by inflation, tariffs, strategic investments and restructuring costs. Q1 2019 net income included a $1.0 million after-tax restructuring charge ($0.03 per share). The effective tax rate was 27.4%, versus 28.2%.
Segments and material period-over-period changes
- Americas: Sales were $258.9 million, up 7.4% reported and 7.7% organically. Operating income rose to $43.1 million from $36.4 million, supported by price and volume gains.
- Europe: Sales were $116.3 million, down 5.4% reported, although organic sales increased 2.5%; currency translation reduced sales by $9.7 million. Operating income fell to $13.2 million from $14.9 million, reflecting foreign exchange and $1.4 million of restructuring charges.
- APMEA: Sales were $13.5 million, down 6.4% reported and 3.1% organically. Management cited softness in Korea and China; operating income was $1.3 million versus $1.4 million.
Consolidated sales growth was led by Americas and European drainage activity. The euro’s depreciation was the principal foreign-exchange headwind. SG&A rose 3.0% to $116.1 million, including increased strategic growth, R&D, commercial and technology investments.
Liquidity, debt and capital allocation
- Cash and cash equivalents were $170.2 million at March 31, down $33.9 million from year-end. Current assets were $729.9 million and current liabilities $321.8 million; the current ratio was approximately 2.3.
- Cash used in operations was $24.2 million, mainly reflecting increases in receivables and payments in accounts payable and accrued liabilities. Capital expenditures were $6.9 million.
- Long-term debt including its current portion was $371.1 million based on the balance-sheet and MD&A amounts; net debt was $200.9 million. The company reported a net debt-to-capitalization ratio of 18.2%, compared with 14.3% at December 31, 2018. The narrative also cites 14.4% for year-end.
- The company had drawn $50.0 million on its $500 million revolving facility, with $424.2 million of unused and available capacity after letters of credit. It reported compliance with credit and note-agreement covenants.
- Cash dividends paid were $7.3 million; Watts repurchased 74,409 shares for $5.6 million. A new $150 million repurchase authorization was approved in February; no purchases under that authorization had occurred by quarter-end.
- Watts held $142.6 million of cash at foreign subsidiaries and said it had no current plan to repatriate foreign earnings. It expected $30–$35 million of capital expenditures for the remainder of 2019.
Outlook, risks and unusual items
- The filing provides no full-year revenue or earnings guidance. Management described growth drivers including product innovation, acquisitions, water-quality and conservation requirements, code enforcement and economic conditions, and said it would continue Smart and Connected initiatives.
- European restructuring actions, initiated in 2018, were expected to cost approximately $6.0 million pre-tax in total; approximately $5.4 million had been incurred by March 31, 2019, with costs expected to be completed during 2019. The quarter included $1.4 million of additional charges.
- Disclosure controls and procedures were deemed ineffective at quarter-end because of a material weakness in internal control over financial reporting previously reported in the 2018 Form 10-K. Management expected remediation before year-end 2019, subject to successful implementation and testing.
- Legal matters include product-liability, environmental and commercial claims. The company estimated reasonably possible legal losses in excess of accruals at approximately $5.2 million pre-tax. It could not estimate a loss range for the Chemetco Superfund matter because remediation scope, cost and allocation among potentially responsible parties remained undetermined.
- Key exposures include foreign-exchange movements, interest rates on floating-rate debt, tariffs and general inflation, and commodity costs that may not be passed through to customers. The company uses derivatives for hedging, not trading.
- Adoption of the new lease standard added $33.6 million of operating right-of-use assets and $33.9 million of operating lease liabilities on January 1, 2019. The company said adoption did not materially affect the income statement or cash flows.
Important facts for investors to verify
- Track whether Americas growth and European organic growth persist, and whether European sales and operating income recover from currency and restructuring headwinds.
- Assess working-capital conversion: operating cash flow remained negative despite higher earnings, with receivables and other operating liabilities using cash.
- Confirm progress and testing of the material-weakness remediation plan, given the ineffective controls conclusion at quarter-end.
- Review debt and leverage disclosures: the filing gives $371.1 million from balance-sheet/MD&A debt components but $372.5 million as carrying amount in the fair-value note; the reported year-end leverage ratio also varies between 14.3% and 14.4%.
- Monitor restructuring costs, capital spending, repurchases and potential outcomes of legal and environmental contingencies.