Watts Water Technologies, Inc. — Q3 2012 Form 10-Q
Reporting period: Third quarter and nine months ended September 30, 2012; comparisons are to the third quarter and nine months ended October 2, 2011. Amounts are in U.S. dollars unless noted.
Business context
Watts designs and manufactures products for water quality, safety, flow control and conservation, as well as HVAC and related applications. It reports North America, EMEA and Asia segments. The January 2012 acquisition of tekmar added hydronic HVAC controls to North America.
Key financial metrics
| Metric | Q3 2012 | Q3 2011 | Nine months 2012 | Nine months 2011 |
|---|---|---|---|---|
| Net sales | $361.2 million | $370.8 million | $1,096.5 million | $1,076.4 million |
| Gross profit / margin | $130.2 million / 36.1% | $135.7 million / 36.6% | $391.6 million / 35.7% | $387.0 million / 36.0% |
| Operating income | $33.1 million | $41.2 million | $93.7 million | $90.7 million |
| Net income | $18.7 million | $23.7 million | $52.9 million | $49.4 million |
| Diluted EPS | $0.53 | $0.63 | $1.46 | $1.31 |
- Cash flow: Nine-month operating cash flow was $73.7 million, versus $56.5 million. Capital expenditures were $18.8 million; free cash flow, a non-GAAP measure, was $56.0 million versus $40.7 million.
- Liquidity: Cash and cash equivalents were $209.5 million at September 30, 2012, down from $250.6 million at year-end 2011. Working capital was $428.5 million, compared with $521.9 million; the current ratio was 2.1x versus 2.8x.
- Debt: Total debt, including current maturities, was $384.8 million; $77.0 million was current, including $75.0 million of senior notes due May 2013. Net debt was $175.3 million and net debt to capitalization was 16.1%, versus 13.9% at year-end. No revolving-credit borrowings were outstanding; $265.4 million of capacity was available, and the company reported covenant compliance.
- Dividends and repurchases: Nine-month dividends were $12.1 million. The company completed a two-million-share repurchase program for $65.8 million. A quarterly dividend of $0.11 per share was declared for payment in November 2012.
Material changes versus comparable periods
- Q3 sales declined 2.6%; organic sales grew 1.6%, but foreign exchange reduced reported sales by $18.0 million, primarily from euro depreciation. Acquired sales added $2.6 million. Nine-month sales increased 1.9%, including $52.0 million of acquired sales, partly offset by a $39.3 million foreign-exchange headwind.
- Q3 operating income fell 19.7%, and net income fell to $18.7 million from $23.7 million. Drivers included lower gross margin, higher SG&A and impairment charges. The reported Q3 after-tax restructuring and impairment charges were $2.9 million, or $0.08 per share; currency movements reduced comparative EPS by $0.04, while share repurchases increased it by $0.04.
- Nine-month operating income rose 3.3% and net income rose to $52.9 million from $49.4 million. Lower prior-year CEO separation costs and reduced restructuring charges helped, while North America operating income declined $11.6 million. Nine-month continuing-operations EPS improved to $1.46 from $1.26.
- North America Q3 organic sales dipped 0.2%; EMEA organic sales grew 3.1%, while reported EMEA sales declined 8.0% amid currency effects. Nine-month organic sales increased 1.7% in North America and declined 1.2% in EMEA.
Outlook, commentary, risks and unusual items
- Management expected 2012 capital spending of $27–$30 million, with $8–$11 million planned for the remainder of 2012. It anticipated higher capital expenditures in 2013 as lead-free production conversion is completed.
- The company is converting U.S. manufacturing to meet the federal requirement for no more than 0.25% weighted-average lead content in wetted surfaces by January 2014. Management cited pre-production, outsourcing and other costs as pressuring margins; commodity costs had trended down during Q3.
- Management cited construction and remodeling activity, foreign exchange, raw-material availability and prices, competition, product liability, and successful execution of acquisitions and restructuring as factors affecting results. Approximately 47% of nine-month sales were denominated in currencies other than the U.S. dollar.
- EMEA goodwill was $210.7 million. The updated impairment assessment found fair value above carrying value, but management warned that further European deterioration or higher interest rates could put goodwill at risk. The company recorded a $1.0 million BRAE goodwill impairment and $1.4 million of impairment charges related to assets held for sale.
- 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 reasonably possible loss range, citing the early stage and unresolved issues, but said it did not currently expect a material effect. Product-liability costs increased by $2.1 million during the first nine months.
- The filing identifies conflict-minerals compliance and customer certification demands as potential sources of supply-chain, cost and competitive risk. It also notes foreign-cash repatriation could incur taxes; about $102.1 million of cash was held by foreign subsidiaries, which the company intended to permanently reinvest.
- Other notable items: a $1.6 million Q3 charge adjusted the gain on the 2011 TWVC disposal; the BRAE contingent earnout liability was reduced by $1.0 million. A new CFO was appointed effective November 12, 2012.
Important facts for investors to verify
- Whether North America margins recover as lead-free conversion proceeds, and the timing and scale of remaining conversion costs and 2013 capital spending.
- Whether EMEA performance and valuation support the $210.7 million goodwill balance under weaker economic conditions or higher discount rates.
- The maturity plan for the $75.0 million of notes due in May 2013 and the availability of cash held outside the United States.
- Developments in the toilet-connector litigation, product-liability claims and related accruals, including any material change to management’s loss assessment.
- Whether reported earnings and cash generation continue to support dividends, investment and capital returns after the completed $65.8 million repurchase.