Watts Water Technologies, Inc. — Q3 2016 Form 10-Q
Reporting period: Third quarter and nine months ended October 2, 2016; comparisons are to the corresponding 2015 periods. Amounts are in millions of dollars except per-share data.
Business context and financial performance
Watts supplies flow-control, heating, drainage and water-quality products, primarily to residential and commercial markets. It reports three geographic segments: Americas, EMEA and Asia-Pacific.
| Metric | Q3 2016 | Q3 2015 | Nine months 2016 | Nine months 2015 |
|---|---|---|---|---|
| Net sales | $341.1 | $366.3 | $1,056.4 | $1,109.4 |
| Gross profit | $142.0 | $142.2 | $427.9 | $418.5 |
| Gross margin | 41.6% | 38.8% | 40.5% | 37.7% |
| Operating income (loss) | $36.5 | $(30.2) | $113.4 | $27.4 |
| Net income (loss) | $21.9 | $(25.7) | $66.7 | $5.2 |
| Diluted EPS | $0.63 | $(0.73) | $1.93 | $0.15 |
- Q3 sales declined 6.9%; management attributed $24.3 of the decrease to divested or discontinued non-core products. Organic sales fell 1.4%, with Americas down 2.8%, EMEA down 0.5%, and Asia-Pacific up 25.8%.
- Nine-month sales declined 4.8%, largely reflecting $87.0 of divested sales; organic sales increased 2.6%. Americas sales fell 6.1%, while EMEA rose 1.8% and Asia-Pacific rose 26.5%.
- Gross margin improved in both periods, which management attributed mainly to product mix, manufacturing productivity, sourcing and material-cost savings. The Q3 operating-income comparison is substantially affected by a $64.7 long-term-obligation settlement charge recorded in Q3 2015.
- Interest expense was $4.9 in Q3 and $17.1 for nine months, down from $6.2 and $18.0, respectively, in 2015. The company reported effective tax rates of 32.4% for Q3 and 33.8% for nine months.
Cash flow, debt and liquidity
- Nine-month operating cash flow was $69.6, versus $41.9 in 2015. Capital expenditures were $26.3, producing reported free cash flow of $43.3, compared with $22.8 in 2015. The prior-year operating cash flow included a $49.2 outflow for long-term-obligation settlements.
- Cash and cash equivalents were $338.6 at October 2, 2016, up from $296.2 at year-end 2015. Approximately $284.9 was held by foreign subsidiaries; repatriating foreign cash could trigger taxes, and the company said it intended to keep undistributed foreign earnings invested abroad.
- Working capital was $599.8, and the current ratio was 3.2 to 1, compared with $514.0 and 2.7 to 1 at December 31, 2015.
- Reported debt, including current portion, was $602.9 net of issuance costs; net debt was $264.3. Net debt to capitalization was 25.9%, versus 28.4% at year-end 2015.
- The five-year credit agreement, maturing February 2021, comprises a $300 term loan and a $500 revolving facility. At quarter-end, $230 was drawn on the revolver, $244.4 of credit was unused and available, and $25.6 of standby letters of credit was outstanding. The company reported covenant compliance. Term-loan and revolver interest rates were 2.32% and 1.99%, respectively.
Material changes, outlook and notable items
- The Americas and Asia-Pacific transformation program includes exiting low-margin products and reducing the Americas operating footprint by approximately 30%. Estimated total pretax program costs are $63–$68, including $20.4 of restructuring costs and $29–$34 of other transformation and deployment costs; costs are expected through 2017.
- Management expected 2016 capital equipment spending of approximately $34–$36; it also anticipated $7–$10 of capital equipment investment in Q4.
- In Q2 2016, Watts completed the sale of a China subsidiary, recognized an $8.7 pretax gain (including a non-cash currency-translation adjustment), and expected total proceeds of approximately $9.0. It had received $3.8 through Q3 and expected the balance in Q4.
- After quarter-end, Watts acquired PVI Industries’ parent company for approximately $78, subject to a working-capital adjustment. PVI makes commercial stainless-steel water-heating equipment. The company also declared a $0.18-per-share quarterly dividend payable in December.
- Two proposed connector class-action settlements total $14; the company expected to pay approximately $4.1 after insurance proceeds of up to $9.9. Court approval was still pending. The filing estimates aggregate reasonably possible legal losses above accrued amounts at approximately $4.1 pretax. Watts also reported defending approximately 325 asbestos lawsuits; it said discovery had not shown substantial exposure to its products and no judgments had been entered against it.
- Key disclosed risks include construction-market conditions, raw-material availability and pricing, competition, variable interest rates, foreign exchange, product and environmental liability, litigation, and execution and cost outcomes of restructuring and transformation initiatives. Management reported effective disclosure controls and no material change in internal control over financial reporting during the quarter.
Important facts for investors to verify
- How much of sales and profit trends reflects ongoing organic performance versus discontinued products, acquisitions, currency movements and shipping-day differences.
- Whether margin gains and transformation savings are sustainable, and whether total program costs remain within the $63–$68 estimate and expected timeline.
- Current borrowing levels, variable-rate exposure, covenant headroom and the location and potential tax cost of foreign-held cash.
- Status and ultimate cost of the connector settlements, including court approval and insurance recoveries, and any changes in other legal contingencies.
- Final PVI purchase accounting and working-capital adjustment, and the acquisition’s subsequent contribution to results and cash flow.