Business context and reporting period
Watts Water Technologies, Inc. designs and manufactures products for water quality, safety, flow control and conservation, serving residential and commercial markets through North America, Europe and China. This unaudited Form 10-Q covers the second quarter and six months ended July 3, 2011; comparisons are to the periods ended July 4, 2010. Amounts are in U.S. dollars.
Financial performance and position
| Metric | Q2 2011 | Q2 2010 | Six months 2011 | Six months 2010 |
|---|---|---|---|---|
| Net sales | $375.7 million | $324.0 million | $705.6 million | $643.3 million |
| Gross profit / margin | $130.3 million / 34.7% | $120.6 million / 37.2% | $251.3 million / 35.6% | $238.2 million / 37.0% |
| Operating income | $26.6 million | $33.3 million | $49.5 million | $59.3 million |
| Continuing-operations net income | $12.9 million | $22.2 million | $24.0 million | $34.4 million |
| Diluted EPS, continuing operations | $0.34 | $0.59 | $0.64 | $0.92 |
| Net income / diluted EPS | $14.6 million / $0.39 | $22.1 million / $0.59 | $25.7 million / $0.68 | $30.2 million / $0.81 |
Q2 sales rose 16.0%, but organic growth was 0.6%; six-month sales rose 9.7%, with 1.1% organic growth. Acquisitions and favorable foreign exchange contributed substantially to reported growth. Operating margins were approximately 7.1% in Q2 and 7.0% for the six months, down from 10.3% and 9.2%, respectively.
For the first six months, continuing operating cash flow was $20.7 million, down from $33.2 million. Capital expenditures were $12.0 million; free cash flow, as defined by the company, was $9.3 million versus $21.7 million. Cash and equivalents were $266.7 million at July 3, versus $329.2 million at year-end 2010. Working capital was $593.6 million and the current ratio was 2.9.
Total debt, including current maturities, was $475.9 million; net debt was $209.2 million, and net debt to capitalization was 17.6%, compared with 5.2% at year-end. The revolving facility had $178.4 million of unused available credit, with $87.0 million of euro borrowings and $34.6 million of letters of credit outstanding. The company reported compliance with debt covenants. Stockholders’ equity was $978.5 million.
Material changes versus comparable periods
- Profitability declined despite higher sales. Gross margin fell 2.5 percentage points in Q2 and 1.4 points over six months, principally from higher commodity costs not fully recovered through pricing, Socla acquisition accounting charges, and product mix.
- Operating income fell 20.1% in Q2 and 16.5% for the six months. North America and Europe both reported lower operating income; China improved from a small six-month operating loss to income.
- Interest expense increased 24.1% in Q2 and 18.9% for the six months, mainly due to borrowings and fees associated with the Socla acquisition and additional private-placement debt.
- Cash from operations and free cash flow declined amid lower earnings, higher inventory investment and tax payments. The Socla acquisition drove increased investing outflows and debt; cash used for acquisitions was $162.9 million in the first half.
Outlook, commentary, risks and unusual items
- Management said it expected cash flow to improve during the balance of 2011. It planned approximately $20.5 million of additional capital expenditures in the second half, for about $32.5 million in full-year 2011 capital spending. No specific full-year sales or earnings guidance is provided.
- Management cited high copper and other raw-material costs, and said pricing actions might not fully recover increases. Copper’s July 1, 2011 spot price was reported 47.8% above the year-earlier level. Housing and remodeling demand, competition, foreign exchange, and the execution and costs of restructuring and acquisitions are key risks.
- Socla was acquired on April 29 for approximately $172.8 million, financed with cash and euro borrowings. Since acquisition, it contributed $27.7 million of revenue and a reported $3.6 million operating loss, including $3.6 million of acquisition-accounting charges and $2.7 million of restructuring charges. Management anticipated approximately $2.2 million of remaining acquisition-accounting charges in Q3.
- First-half results included a $6.3 million pre-tax charge for the former CEO’s separation agreement. Restructuring and other charges were $6.6 million for the first six months; programs include Socla-related actions and a European facility closure, with costs expected through 2012.
- The company reduced its estimated probable pre-tax FCPA-related liability to approximately $3.8 million and recorded $1.7 million of income from discontinued operations from a reserve adjustment. No definitive SEC/DOJ resolution had been reached; the final loss could exceed the estimate. Environmental remediation matters had no material developments in the first half.
- The proposed sale of TWVC was expected to close in Q3 2011, subject to government approvals. Management estimated net proceeds of $5.9 million and expected an after-tax $7.9 million currency-translation gain and a $3.9 million tax-provision reversal upon completion.
- After quarter-end, the board authorized repurchases of up to 1.0 million Class A shares and declared a $0.11 per-share dividend. Management stated disclosure controls were effective and there was no material change in internal control over financial reporting.
Important facts for investors to verify
- Whether subsequent pricing actions offset commodity inflation without materially weakening volumes or market share, particularly in Europe and North American DIY.
- Socla’s underlying operating performance after acquisition-accounting and restructuring costs, and the final purchase-price allocation and working-capital adjustments.
- The final amount and timing of any FCPA settlement, including whether it exceeds the current $3.8 million pre-tax estimate.
- Progress on restructuring, expected remaining charges and savings, and whether cash flow improves as management anticipated.
- Completion and financial effects of the TWVC sale, and the company’s debt, liquidity and repurchase plans following the acquisition.