Watts Water Technologies, Inc. — Q3 2014 Form 10-Q
Business context and period: Watts designs and manufactures products for water quality, safety, flow control and conservation, as well as related HVAC and drainage markets. The filing covers the 13 weeks ended September 28, 2014, and the first nine months of fiscal 2014; comparisons are with the corresponding 2013 periods. Amounts are in U.S. dollars.
Financial performance and position
- Revenue: Q3 sales were $376.0 million, up 1.1% from $371.8 million; organic sales increased 1.2%. Nine-month sales were $1,137.2 million, up 3.6% from $1,097.5 million.
- Regional trends: Q3 organic sales increased 4.1% in the Americas and 27.9% in Asia-Pacific, but fell 5.0% in EMEA. Nine-month organic sales increased 5.4% in the Americas and 18.6% in Asia-Pacific, and declined 2.2% in EMEA.
- Profit and margins: Q3 gross profit was $138.1 million, with a 36.7% gross margin versus 36.0% a year earlier. Operating income rose to $42.7 million from $30.2 million; net income was $22.6 million versus $15.4 million. Diluted EPS was $0.64 versus $0.43. For the first nine months, operating income was $105.1 million versus $94.4 million, net income was $58.0 million versus $50.4 million, and diluted EPS was $1.64 versus $1.41. Nine-month gross margin was 36.1% versus 36.0%.
- Cash flow: Operating cash flow was $73.5 million for the first nine months, compared with $67.7 million. Capital expenditures were $16.1 million versus $22.6 million. The company reported free cash flow of $57.8 million versus $46.5 million and a free-cash-flow-to-continuing-net-income conversion rate of 99.7% versus 88.2%.
- Liquidity and debt: At September 28, cash and equivalents were $272.4 million; current assets were $848.6 million and current liabilities $299.8 million. Working capital was $548.8 million and the current ratio was 2.8. Total debt, including current maturities, was $305.7 million; net debt was $33.3 million, and net debt to capitalization was 3.3%. The company had no borrowings under its new $500 million revolving facility, with $476.4 million available after letters of credit. It reported compliance with debt covenants.
- Capital returns: Nine-month dividends were $15.2 million, and the company repurchased approximately 496,000 shares for $29.1 million. The quarterly dividend was $0.15 per share.
Material changes and management commentary
- Q3 operating income improved primarily through higher gross profit, lower SG&A and restructuring charges. Management cited reduced lead-free foundry inefficiencies and lower product-liability costs in the Americas, as well as cost controls and efficiencies in EMEA.
- Q3 SG&A fell 5.7%, including lower product-liability and insurance costs, legal costs and personnel costs. Nine-month SG&A rose 1.4%, partly reflecting EMEA transformation costs, import duties and higher sales-related commission and freight costs.
- The continuing-operations effective tax rate rose to 37.9% in Q3 from 29.7%, and to 34.8% for nine months from 31.1%. Management attributed the increase in part to EMEA uncertain-tax-position reserves, earnings mix and the prior-year Danish tax-rate reduction.
- Foreign currency translation and pension remeasurement contributed to a $63.0 million nine-month other comprehensive loss; accumulated other comprehensive income/loss moved from $12.0 million income at year-end 2013 to a $51.0 million loss at September 28, 2014.
Outlook, risks and unusual items
- EMEA transformation: The program is expected to continue through 2018. Management forecast annual savings of approximately $4.0 million in 2014, $12.0 million in 2015 and $21.0 million by 2018. Expected non-recurring deployment costs were $2.7 million for Q4 2014 and $6.7 million in 2015. These are forecasts, not guarantees.
- Spending plans: Management expected $7–9 million of capital spending and approximately $11 million of share repurchases for the remainder of 2014. The filing also estimated total 2014 European restructuring costs of $10.4 million, with $3.4 million remaining at quarter-end.
- Pension plans: The company terminated its U.S. Pension Plan and SERP. It remeasured the plans in Q3, increasing the pension liability by $17.1 million and recording a $10.5 million after-tax pension loss in other comprehensive income. Estimated cash outflow to settle the plans was approximately $35–45 million, subject to change; Pension Plan asset distribution was expected after regulatory approval, anticipated in late 2015.
- Legal matters: The Trabakoolas toilet-connector class action settlement became final, with $8.8 million remaining to be paid over four years after insurance proceeds were received. Separately, management estimated reasonably possible legal losses above accrued amounts of approximately $5.8 million, pre-tax. The company was defending 59 asbestos lawsuits; it reported prior dismissals before trial in each case. Environmental liabilities were not considered material.
- Other events: CFO Dean Freeman was terminated without cause on October 14, 2014; CEO Robert Pagano was appointed interim CFO while the company searched for a successor. Approximately $240.3 million of cash was held by foreign subsidiaries, and repatriation could trigger taxes; the company said it intended to reinvest undistributed foreign earnings abroad.
- Principal risks: The filing highlights economic and construction-market cyclicality, competition and pricing pressure, raw-material costs, foreign exchange, manufacturing inefficiencies, product liability, environmental compliance, restructuring execution, acquisitions and product-development risks. Management reported effective disclosure controls and no material change in internal control over financial reporting during the quarter.
Important facts for investors to verify
- Whether EMEA sales trends stabilize and the transformation delivers the forecast savings, while controlling deployment costs.
- Actual pension-plan settlement timing and cash requirements compared with the estimated $35–45 million outflow.
- Future legal and product-liability developments, including the estimated $5.8 million of reasonably possible losses above accruals.
- Cash availability and potential tax costs if foreign-held cash must be repatriated, alongside planned repurchases, dividends and capital spending.
- The impact of currency movements, raw-material prices and higher tax rates on subsequent results.
- Post-quarter CFO transition and the company’s progress in appointing a permanent CFO.