Watts Water Technologies, Inc. — Q3 2011 Form 10-Q
Reporting period: Third quarter ended October 2, 2011; nine months ended October 2, 2011. Comparisons are with the periods ended October 3, 2010. Amounts are in millions except per-share data.
Business context
Watts designs and manufactures water quality, safety, flow-control and conservation products, as well as related HVAC products. It reports North America, Europe and China segments and sells primarily through wholesale, DIY and OEM channels. Results include Socla from its April 29, 2011 acquisition.
Financial performance
| Metric | Q3 2011 | Q3 2010 | Nine months 2011 | Nine months 2010 |
|---|---|---|---|---|
| Net sales | $370.8 | $314.6 | $1,076.4 | $957.9 |
| Gross profit | $135.7 | $113.8 | $387.0 | $352.0 |
| Gross margin | 36.6% | 36.2% | 36.0% | 36.7% |
| Operating income | $41.2 | $31.5 | $90.7 | $90.8 |
| Income from continuing operations | $23.6 | $17.3 | $47.6 | $51.7 |
| Net income | $23.7 | $17.3 | $49.4 | $47.5 |
| Diluted EPS | $0.63 | $0.46 | $1.31 | $1.27 |
- Quarterly sales rose 17.9%; management attributed $35.6 of the $56.2 increase to acquisitions, $11.8 to foreign exchange and $8.8 to organic growth. Organic sales increased 2.8% overall, led by North America; Europe and China were slightly lower organically.
- Nine-month sales rose 12.4%, driven mainly by acquisitions ($73.5) and foreign exchange ($28.9), with $16.1 of organic growth. Segment sales for the nine months were North America $619.7, Europe $441.1 and China $15.6.
- Quarterly operating income increased 30.8%, with operating margin approximately 11.1% versus 10.0%. Nine-month operating income was essentially flat, with margin approximately 8.4% versus 9.5%. Europe’s nine-month operating income fell $6.0 to $31.2, while North America rose $2.2 to $84.4.
- Quarterly gross margin improved 0.4 percentage points, helped by North American price increases, productivity and mix; nine-month gross margin fell 0.7 points, principally due to European raw-material cost recovery shortfalls and Socla acquisition-accounting charges.
- Nine-month operating cash flow from continuing operations was $56.5, down from $75.3. Capital expenditures were $16.4; reported free cash flow was $40.7 versus $58.1, and cash conversion was 85.5% versus 112.4%. Management said the cash-flow decline primarily reflected higher tax payments.
Balance sheet, debt and liquidity
- At October 2, 2011, cash and equivalents were $246.3, down from $329.2 at year-end 2010. Current assets were $864.9 and current liabilities $301.8; working capital was $563.1 and the current ratio 2.9, compared with 3.1 at year-end.
- Total debt, including current maturities, was $454.2 versus $378.7 at year-end. Net debt was $207.9 versus $49.5; net debt to capitalization increased to 18.2% from 5.2%, mainly due to Socla acquisition funding.
- The $300.0 million revolving credit facility had $198.8 of unused available capacity and $34.6 of letters of credit outstanding. The company reported compliance with its credit and note-agreement covenants.
- Investing cash outflow was $179.0, including $162.9 for acquisitions. Financing cash inflow was $30.5; it included $184.0 of long-term debt proceeds and $116.0 of repayments. The company repurchased 1.0 million shares for $27.2 and paid $12.3 in dividends.
Material changes, outlook and management commentary
- Socla, acquired for net consideration of approximately $172.8, contributed $63.2 of reported revenue and a $1.0 operating loss since acquisition; the loss included $5.4 of non-recurring acquisition-accounting charges and $2.8 of restructuring costs. Purchase-price allocation remained preliminary.
- Management cited slow expected growth in residential and commercial markets, continued commodity-cost volatility and uneven ability to recover cost increases. North American wholesale pricing helped offset raw-material costs; Europe and North American DIY recovery remained incomplete.
- A North American reduction in non-direct payroll of approximately 10% incurred $1.1 of quarterly severance. Management expects annual operating-cost reductions above $5.0. It expected approximately $22.0 of 2011 capital expenditures, including about $6.0 for the remainder of the year, and anticipated cash-flow improvement in the balance of 2011.
- Restructuring and other charges were $1.9 in Q3 and $8.5 for the nine months. Remaining estimated costs included $3.6 for Socla integration and $1.1 for the 2011 European restructuring. The company also recorded a $6.3 first-quarter charge related to the former CEO’s separation.
- On October 13, 2011, Watts settled SEC allegations concerning potential FCPA violations at former subsidiary CWV, without admitting or denying the allegations. It agreed to pay $3.6 in disgorgement and prejudgment interest and $0.2 in penalties; the company expected the settlement to resolve government investigations. The reserve was reduced by $1.7 in Q2 2011.
- Management expected the sale of TWVC to be finalized in Q4 2011, subject to final agreements, with approximately $5.5 of net proceeds and an anticipated after-tax gain of about $7.5, plus a $3.3 gain from reversing a tax provision.
- Subsequent to quarter-end, the board declared a $0.11 quarterly dividend and froze pension accruals effective December 31, 2011. Watts expected a $1.4 Q4 curtailment charge and approximately $2.0 in annual savings from the pension and 401(k) changes beginning in 2012.
Risks, contingencies and controls
Key disclosed risks include economic weakness affecting construction and remodeling, raw-material availability and pricing, competition and pricing pressure, variable-rate borrowing costs, foreign-exchange movements, acquisition and product-development execution, product liability, environmental compliance, and restructuring and litigation outcomes. Commodity costs declined modestly during Q3 but management anticipated continued volatility. The company uses derivatives for hedging, not speculation. Environmental remediation and other litigation remained outstanding, with no material developments reported for the first nine months. Management concluded disclosure controls were effective and reported no material change in internal control over financial reporting during the quarter.
Most important facts for investors to verify
- Whether organic growth and pricing gains can persist, particularly in North American wholesale, and whether Europe can recover input-cost increases.
- Socla’s post-acquisition contribution, integration costs and final purchase-price allocation, including goodwill and intangible-asset values.
- Cash generation after acquisition spending, working-capital investment and higher debt; verify management’s expected year-end cash-flow improvement.
- Progress and realized savings from restructuring, the payroll reduction and the pension-plan freeze.
- Completion and accounting impact of the TWVC sale, and final cash and obligations associated with the FCPA settlement and other contingencies.