Watts Water Technologies, Inc. — Q1 2016 Form 10-Q
Business context and reporting period
Watts supplies water-flow, heating, drainage and water-quality products to residential and commercial markets. The quarter ended April 3, 2016, and generally covered 13 weeks. Results are compared with the first quarter ended March 29, 2015. Amounts are in U.S. dollars.
Financial results and liquidity
| Metric | Q1 2016 | Q1 2015 |
|---|---|---|
| Net sales | $344.2 million | $356.2 million |
| Gross profit / margin | $135.2 million / 39.3% | $130.5 million / 36.6% |
| Operating income / margin | $31.2 million / 9.1% | $22.8 million / 6.4% |
| Net income | $16.2 million | $11.6 million |
| Diluted EPS | $0.47 | $0.33 |
| Cash from operating activities | $(21.9) million | $0.8 million |
- Gross margin expanded 2.7 percentage points. Management attributed the improvement principally to product mix, productivity, restructuring savings and lower material costs.
- Cash and cash equivalents were $259.4 million at April 3; restricted cash was $18.2 million. Working capital was $562.8 million and the current ratio was 2.9:1.
- Debt carrying value, including current maturities, was $598.2 million; reported gross debt outstanding was $600.9 million before unamortized issuance costs. Net debt was $338.8 million, and net debt to capitalization was 31.7%, up from 28.4% at year-end 2015.
- Free cash outflow, a company-defined non-GAAP measure, was $31.0 million versus $4.8 million. The company cited planned inventory accumulation for its Americas transformation and distribution-center transition.
- The company reported $475.1 million of unused and available credit under its new facility as of April 3, before subsequent borrowing. On April 28 it borrowed $230 million to repay $225 million of 5.85% senior notes due April 30; about $245 million of revolving credit remained potentially available afterward.
Material changes versus the prior period
- Sales declined $12.0 million, or 3.4%. Organic sales rose $19.3 million, but were more than offset by $28.8 million of divested sales and $5.1 million of unfavorable foreign exchange; acquisitions added $2.6 million. Organic growth was about 5.5%, or 2% excluding two to three additional shipping days.
- Americas sales fell $15.1 million, while EMEA sales rose $2.0 million and Asia-Pacific sales rose $1.1 million. Operating income increased $8.4 million, or 36.8%, led by Americas and EMEA.
- The effective tax rate rose to 39.8% from 33.1%, mainly due to the mix of worldwide earnings and a reserve increase for an ongoing tax audit. Interest expense increased $0.8 million, principally reflecting the new credit agreement.
- Other income included a $1.7 million pretax gain from remeasuring the company’s previously held interest in AERCO Korea after it acquired an additional 50%, bringing ownership to 90%.
Outlook, management commentary and risks
- No specific full-year revenue or earnings guidance is provided. Management expects 2016 capital expenditures of approximately $35–$40 million; after $9.2 million in Q1, it expected $26–$31 million for the remainder of the year.
- The Americas and Asia-Pacific transformation is expected to cost $63–$68 million pretax, including $20.4 million of restructuring, $13.4 million of goodwill and intangible impairment, and approximately $29–$34 million of other transformation costs. Costs are expected through 2017; the plan includes reducing the Americas operating footprint by about 30%.
- The company expected to complete the sale of a China operating entity in Q2 2016 for approximately $9 million, with an estimated pretax gain of $8–$9 million. The $18.2 million escrow deposit was classified as restricted cash and was expected to be returned when the sale closed.
- Management cited exposure to construction-market conditions, foreign exchange, variable interest rates, commodity and raw-material costs, competition, product liability, environmental compliance and execution of restructuring and acquisitions. Approximately 40% of Q1 sales were denominated in currencies other than the U.S. dollar.
- A proposed settlement of the Ponzo and Klug connector class actions totals $14 million; the company expected to pay approximately $4.1 million after insurance. Court approval remained outstanding. The company estimated reasonably possible legal losses above recorded accruals at approximately $3.9 million pretax. It was defending approximately 312 asbestos lawsuits; no judgments had been entered against it.
- The company declared a quarterly dividend of $0.18 per share on May 10, up from $0.17 declared per share in Q1. Management reported compliance with debt covenants at April 3 and effective disclosure controls.
Most important facts for investors to verify
- Whether organic growth persists after adjusting for additional shipping days, and whether sales declines from product exits and foreign exchange continue.
- Whether margin gains and planned transformation savings offset the program’s remaining costs, and whether restructuring is completed on schedule.
- Working-capital and inventory trends, operating cash generation, and liquidity after the April refinancing and future capital spending.
- Final closing and proceeds of the China sale, including the expected gain and release of restricted cash.
- Final court approval and insurance recovery for the connector settlement, plus developments in other legal and environmental matters.