Watts Water Technologies, Inc. — Q1 2017 Form 10-Q
Business context and period. Watts supplies water-flow, heating, drainage and water-quality products for residential and commercial markets. This unaudited report covers the 13 weeks ended April 2, 2017, compared with the first quarter ended April 3, 2016. Amounts below are in U.S. dollars; financial statement amounts are in millions unless noted.
Key financial results
| Metric | Q1 2017 | Q1 2016 | Change |
|---|---|---|---|
| Net sales | $347.2 | $344.2 | +0.9% |
| Gross profit / gross margin | $143.8 / 41.4% | $135.2 / 39.3% | Margin +2.1 percentage points |
| Operating income / operating margin | $35.7 / 10.3% | $31.2 / 9.1% | +14.4% |
| Net income | $21.7 | $16.2 | +34.0% |
| Diluted EPS | $0.63 | $0.47 | +$0.16 |
| Cash from operating activities | $(9.1) | $(21.9) | Cash outflow narrowed |
| Capital expenditures | $5.8 | $9.2 | Down $3.4 |
| Free cash flow, company-defined | $(14.9) | $(31.0) | Cash outflow narrowed |
Balance sheet and liquidity at April 2, 2017: Cash and equivalents were $287.0, down from $338.4 at year-end; current assets were $798.4 and current liabilities $387.5. Balance-sheet current and long-term debt totaled $623.6; the debt fair-value note separately reports carrying debt of $626.7, a difference the filing text does not clearly reconcile. Net debt, using the company’s reconciliation, was $336.6 versus $312.0 at year-end; net debt to capitalization was 30.8% versus 29.8%. The company reported $302.4 of unused and available credit under its credit agreement and said it was in compliance with debt covenants.
Material changes and operating trends
- Sales increased only $3.0: acquisitions added $15.3, offset by organic sales decline of $4.7, foreign-exchange impact of $(4.1), and discontinued non-core product sales of $(3.5). Organic sales declined 1.4% overall.
- Americas sales rose 2.9% to $228.7, while Europe sales fell 3.1% to $104.9; APMEA sales were flat at $13.6. Organic sales fell approximately 2% in Americas and 10% in APMEA, while Europe grew approximately 1%.
- Gross-margin improvement reflected Americas transformation and sourcing savings and European productivity and restructuring savings. SG&A rose $5.0, or 4.9%, partly due to acquisitions, higher freight and distribution costs, and growth-related outside services.
- Operating income increased $4.5. Management cited improved gross margin, productivity savings, lower transformation and restructuring costs; APMEA operating income declined $0.7.
- Interest expense fell $1.9, primarily because a higher-interest private placement note was retired in 2016 and replaced with lower-cost borrowing. The prior-year comparison included a $1.7 non-cash acquisition gain; Q1 2017 included $0.8 of losses on foreign-exchange forwards.
- The effective tax rate declined to 29.5% from 39.8%, including a $1.2 tax benefit from jurisdictional rate reductions; the prior-year rate included a tax-audit reserve.
Outlook, risks and unusual items
- No full-year revenue or earnings guidance is provided. Management expected $30–$34 million of capital spending for the remainder of 2017.
- The Americas and APMEA transformation program was substantially complete, with completion expected in 2017. Total estimated pre-tax program costs were approximately $65 million, including restructuring, impairment and other deployment costs. Europe’s restructuring actions were also expected to finish in 2017.
- Cash generation remains a consideration: operating cash flow and company-defined free cash flow were negative in the quarter, though both outflows improved year over year. The company said much of its cash—$267.8 million—was held by foreign subsidiaries and that repatriation could trigger taxes; it had no current plan to repatriate those earnings.
- Debt includes a €110 million facility due December 19, 2017; €79.0 million remained outstanding at quarter-end, with scheduled repayments beginning June 30, 2017. The $500 million revolving facility and $300 million term loan mature in February 2021. Floating-rate exposure is partly hedged through interest-rate swaps.
- Risks identified include construction and housing-market conditions, raw-material pricing and availability, competition, variable interest rates, foreign-exchange movements, acquisition and product-development execution, regulatory and product-safety compliance, environmental costs, and litigation.
- Connector class-action settlements had final court approval on April 13, 2017, after the quarter-end, and were expected to become final May 15 absent appeal. The company reported a remaining settlement liability of $13.2 million and insurance receivable of $9.9 million. It estimated reasonably possible legal losses above accrued amounts at approximately $4.0 million pre-tax.
- Q1 2017 net income included after-tax transformation deployment costs of $1.3 million and restructuring costs of $0.4 million, partly offset by $1.2 million of tax benefits. The company declared a subsequent quarterly dividend of $0.19 per share, payable June 16, 2017.
Important facts for investors to verify
- How sustainable are margin gains and cost savings given declining organic sales in the Americas and APMEA and project delays in key markets?
- What explains the difference between balance-sheet debt of $623.6 million and the $626.7 million carrying amount cited in the fair-value note?
- Can the company meet the euro-facility repayment schedule and sustain dividends, capital spending and share repurchases while generating positive operating cash flow?
- Are the connector settlements final, and are the recorded liability and insurance recovery adequate as claims are resolved?
- What will be the effect of adopting the new revenue-recognition standard, which the company planned to implement January 1, 2018?