Watts Water Technologies, Inc. — Q2 2012 Form 10-Q
Business context and period: Watts designs and sells water quality, safety, flow-control and conservation products, as well as HVAC-related products. It reports North America, Europe, Middle East and Africa (EMEA), and Asia segments. The quarter ended July 1, 2012; the six-month period covers 26 weeks. Figures below are in U.S. dollars unless noted.
Key financial metrics
| Metric | Q2 2012 | Q2 2011 | Six months 2012 | Six months 2011 |
|---|---|---|---|---|
| Net sales | $371.1 million | $375.7 million | $735.3 million | $705.6 million |
| Gross profit / margin | $131.8 million / 35.5% | $130.3 million / 34.7% | $261.4 million / 35.6% | $251.3 million / 35.6% |
| Operating income | $33.7 million | $26.6 million | $60.6 million | $49.5 million |
| Net income from continuing operations | $18.5 million | $12.9 million | $34.2 million | $24.0 million |
| Continuing-operations diluted EPS | $0.51 | $0.34 | $0.93 | $0.64 |
| Operating cash flow | — | $23.9 million | $20.7 million | |
| Free cash flow (company-defined) | — | $15.3 million | $9.3 million |
- Revenue trends: Q2 sales declined 1.2%; organic sales fell 0.4%, as North American and Asian growth was offset by weaker EMEA sales. Currency translation reduced Q2 sales by $16.2 million, while acquisitions added $13.1 million. First-half sales rose 4.2%, including $49.4 million from acquisitions and a $21.3 million currency headwind.
- Profitability: Q2 operating income increased 26.7%, aided by lower restructuring and acquisition-related costs and acquisition contributions. Q2 gross margin expanded 0.8 percentage points; first-half gross margin was unchanged. Lead-free production conversion costs pressured North American margins.
- Cash, liquidity and debt: Cash was $167.8 million at July 1, versus $250.6 million at year-end 2011. Working capital was $400.5 million and the current ratio 2.1, down from $521.9 million and 2.8. Long-term debt, including current maturities, totaled $385.1 million; $77.0 million was current, including $75 million of senior notes due May 2013. Net debt was $217.3 million and net debt to capitalization 20.0%, versus 13.9% at year-end. The company had no revolver borrowings, $265.4 million of available capacity, and was covenant-compliant.
- Cash uses and capital returns: First-half investing cash outflow was $26.1 million, including $17.5 million for tekmar and $9.6 million of capital expenditures. Financing cash outflow was $79.8 million, primarily reflecting $63.2 million of repurchases, debt repayment and dividends. The two-million-share repurchase program was completed in July for a total $65.8 million. A quarterly dividend of $0.11 per share was declared July 31.
Changes, outlook and notable items
- Q2 EMEA sales declined 9.5% overall, reflecting a $15.5 million currency impact and $9.3 million lower organic sales; North America sales rose 4.6% and Asia sales rose 10.2%. For the first half, North America operating income fell $6.1 million, while EMEA operating income rose $8.2 million.
- Management expected cash flow to improve during the remainder of 2012 and planned approximately $26 million of additional capital-equipment investment; full-year capital spending was expected to be approximately $36 million. No earnings or revenue guidance was provided in the filing.
- Management said the European downturn and weaker-than-expected EMEA results prompted an updated goodwill assessment. EMEA fair value remained above carrying value, but the $202.7 million EMEA goodwill balance could be at risk if results deteriorate further or interest rates rise significantly.
- The company expects to fund or refinance the $75 million notes maturing in May 2013. It noted that repatriating foreign-held cash could incur tax; approximately $75.8 million of cash was held by foreign subsidiaries, which the company intends to keep reinvested abroad.
- Lead-free product conversion, construction-market conditions, foreign exchange, commodity costs, competition, product liability and restructuring execution were identified as risks. Management reported $2.1 million of incremental product-liability costs in the first half.
- A putative nationwide class action filed in March 2012 alleges toilet-connector failures and seeks unspecified damages and other relief. The company could not estimate a loss range, but did not believe, based on information then available, that the matter would materially affect its financial position or results.
- CFO William C. McCartney announced plans to retire; he was to remain through December 14, 2012 to support succession and transition. The company expected approximately $1.5 million of pre-tax retention-related charges over that period; the Q2 charge was immaterial.
- Q2 2011 net income included $1.7 million from discontinued operations; Q2 2012 had none. First-half 2011 net income included the same discontinued-operations item, so continuing-operations comparisons are more informative.
Important facts for investors to verify
- Whether EMEA performance stabilizes and whether the goodwill valuation cushion remains adequate.
- Progress and remaining costs of lead-free conversion and North American and European restructuring.
- Funding or refinancing plans for the May 2013 $75 million note maturity and the company’s cash needs after repurchases and planned capital spending.
- Developments, potential exposure and any provision related to the toilet-connector litigation and other product-liability claims.
- Whether organic sales, cash generation and margins improve as management anticipated; interim results were not necessarily indicative of full-year performance.