Watts Water Technologies, Inc. — Q1 2020 Form 10-Q
Reporting period: First quarter ended March 29, 2020 (generally 13 weeks); comparative period ended March 31, 2019. Amounts are in U.S. dollars unless noted.
Business context
Watts supplies flow-control, HVAC and gas, drainage and water-reuse, and water-quality products for residential and commercial markets. It reports three geographic segments: Americas, Europe, and Asia-Pacific, Middle East and Africa (APMEA). Many products were classified as essential during the COVID-19 emergency.
Key financial results
| Metric | Q1 2020 | Q1 2019 |
|---|---|---|
| Net sales | $382.6 million | $388.7 million |
| Gross profit / margin | $162.8 million / 42.6% | $164.2 million / 42.2% |
| Operating income | $47.8 million | $46.7 million |
| Net income | $32.0 million | $31.0 million |
| Diluted EPS | $0.94 | $0.91 |
| Net cash used in operating activities | $0.9 million | $24.2 million |
| Free cash flow (non-GAAP) | $(8.4) million | $(31.1) million |
Cash and cash equivalents were $245.4 million at March 29, 2020, versus $219.7 million at year-end 2019. Total debt was $379.4 million on the balance sheet, while the debt note reports $380.0 million including the current portion; net debt was $134.0 million, and net debt to capitalization was 12.2% (8.4% at year-end). The company had $404.2 million of unused available capacity under its prior revolving facility, after $80.0 million drawn and $15.8 million of letters of credit. It reported compliance with debt covenants.
Changes versus prior year and quarter-end
- Reported sales fell 1.6% ($6.1 million); organic sales fell 1.2% ($4.6 million). Foreign exchange reduced sales by $4.1 million, and acquired sales added $2.6 million. Management estimated COVID-19 reduced Q1 sales by approximately $10–$15 million.
- Americas sales rose 0.9% to $262.4 million; Europe fell 5.2% to $110.2 million; APMEA fell 25.5% to $10.0 million. Lower European and APMEA sales reflected pandemic-related volume declines and currency effects.
- Gross profit declined $1.4 million, but gross margin improved 0.4 percentage point. Operating income increased 2.4%, supported by productivity, lower restructuring costs, and early pandemic cost actions; lower volume, inflation/tariffs, and strategic investment partly offset gains.
- Interest expense declined $0.6 million to $3.0 million, primarily due to lower interest rates. Effective tax rate rose to 28.3% from 27.4%.
- Operating cash use improved from $24.2 million to $0.9 million, primarily due to working-capital timing; free cash flow remained negative. Financing cash flow included $70.0 million of additional borrowing, $14.7 million of share repurchases, and $8.0 million of dividends.
Outlook, risks and unusual items
- The company withdrew its full-year outlook and expected Q2 2020 sales to decline 25%–30% year over year. It warned that pandemic effects could continue for several quarters and remain difficult to predict.
- Management cited risks from weaker demand, project and repair activity, supply-chain disruption, reduced production capacity or temporary facility closures, employee absenteeism, customer payment delays, and customer or supplier financial distress. It stated it did not anticipate difficulty paying debt as due.
- Cost and cash measures included merit deferrals, salary and incentive reductions, furloughs, discretionary and factory-cost reductions, an April reduction in force, reduced planned capital spending, a temporary stock-repurchase suspension, a flat dividend, and deferred employer payroll taxes. The company estimated $4–$5 million of payroll taxes would be deferred under the CARES Act.
- Management expected $25–$30 million of capital expenditures for the remainder of 2020 before noting pandemic-related plans to reduce planned spending; the filing does not give a revised capital-expenditure target.
- On April 24, 2020, after quarter-end, the company replaced its credit agreement with an $800 million revolving facility maturing February 2022 and used it to repay the prior term loan. The change made existing interest-rate swaps ineffective as cash-flow hedges; subsequent fair-value changes are to be recorded in earnings through February 2021.
- No goodwill impairment trigger was identified at quarter-end, but management noted that a prolonged pandemic could affect the Heating and Hot Water Solutions reporting unit’s valuation and potentially prompt an impairment test.
- Reasonably possible legal losses above amounts accrued were estimated at approximately $4.9 million pre-tax. The company could not estimate a loss range for its Chemetco Superfund matter.
- A $0.23 per-share quarterly dividend was declared May 4, 2020, payable June 15, 2020. Q1 diluted EPS included a $0.01-per-share after-tax footprint-optimization charge; Q1 2019 included a $0.03-per-share restructuring charge.
Important facts for investors to verify
- How actual Q2 and full-year sales, margins, cash flow, and working capital compare with the disclosed pandemic estimates and withdrawn outlook.
- Use of the new $800 million facility, resulting debt and interest costs, covenant headroom, and the effect of the now-ineffective swaps.
- Whether planned cost actions, the reduction in force, reduced capital spending, and suspension of repurchases deliver the expected cash savings.
- Developments in customer collections, supply continuity, facility operations, and the potential goodwill impairment risk at the Heating and Hot Water Solutions unit.
- Updates to legal and environmental contingencies, including the Chemetco matter.