Watts Water Technologies, Inc. — FY2011 Form 10-K
Reporting period: Fiscal year ended December 31, 2011; filing dated February 28, 2012. Watts designs and sells water safety, flow-control, conservation, HVAC and water-quality products. It reports North America, Europe and Asia segments.
Financial performance
| Metric | FY2011 | FY2010 | Change |
|---|---|---|---|
| Net sales | $1,436.6 million | $1,274.6 million | +12.7% |
| Gross profit / margin | $515.5 million / 35.9% | $464.9 million / 36.5% | Margin down 0.6 percentage points |
| Operating income | $117.1 million | $114.2 million | +2.5% |
| Continuing-operations net income | $64.7 million | $63.1 million | +2.5% |
| Net income attributable to Watts | $66.4 million | $58.8 million | +12.9% |
| Diluted EPS | $1.78 | $1.57 | Up $0.21 |
| Operating cash flow / free cash flow* | $128.2 million / $106.3 million | $113.4 million / $91.0 million | Both increased |
Fourth quarter: Sales were $360.2 million versus $316.7 million in Q4 2010. Continuing-operations income was $17.1 million versus $18.4 million; net income was $17.0 million versus $11.3 million. Diluted continuing-operations EPS was $0.46 versus $0.30.
Sales growth included $105.0 million from acquisitions, $28.0 million from foreign exchange and $29.0 million of organic growth (2.3%). North America sales rose 4.3% and Europe sales 27.2%, with Europe’s increase substantially acquisition- and currency-related; Asia sales were nearly flat. Europe operating income fell to $28.7 million from $43.7 million, while North America rose to $112.0 million from $106.4 million and Asia improved to $12.2 million from a loss.
Gross margin pressure reflected incomplete recovery of commodity costs in Europe and North American DIY, Socla acquisition accounting charges, French restructuring inefficiencies and higher freight. Management said price recovery improved in the second half, particularly in North America.
Liquidity, debt and capital
- Cash and cash equivalents were $250.6 million, down from $329.2 million. Working capital was $531.0 million versus $578.4 million; the current ratio was 2.9 versus 3.1.
- Total debt, including current maturities, was $399.4 million; net debt was $148.8 million versus $49.5 million in 2010. Net debt to capitalization increased to 13.9% from 5.2%.
- Operating cash flow was $128.2 million. Investing activities used $188.3 million, chiefly for Socla and capital equipment; financing activities used $23.9 million. Capital expenditures were $22.7 million.
- The $300 million revolving facility matures in 2015. At year-end Watts had $252.4 million of unused available credit, $13.0 million drawn and $34.6 million of letters of credit outstanding. The company reported compliance with debt covenants; its leverage ratio was 1.06 against a maximum of 3.25, and interest coverage was 7.13 against a minimum of 3.50.
- Watts paid $16.3 million in dividends and repurchased 1.0 million Class A shares for $27.2 million. The quarterly dividend remained $0.11 per share.
*Free cash flow is a company-defined non-GAAP measure: continuing operating cash flow less capital expenditures plus asset-sale proceeds.
Material changes, outlook and notable items
- Acquisition and divestiture: Watts acquired French water-controls business Socla in April 2011 for approximately $172.4 million, financed with cash and euro borrowings. Socla contributed $94.8 million in sales and $1.6 million in operating income after acquisition-related charges. The sale of Tianjin Watts Valve in China was completed in Q4 2011, generating a $7.7 million pretax gain and an approximately $11.4 million after-tax gain, including a tax benefit.
- Reported earnings included significant unusual items: $17.4 million of impairment charges, $8.8 million of net restructuring charges, $6.3 million in former-CEO separation costs, a $1.5 million pension curtailment charge and $5.8 million of Socla acquisition costs. Offsets included the Tianjin sale gain, a $1.2 million earn-out adjustment and legal-settlement gains. The filing’s selected-data note estimates a $17.0 million after-tax net cost for identified items.
- Outlook: No quantified revenue or earnings guidance is provided. Management anticipated approximately $36 million of 2012 capital expenditures and expected the $81.4 million backlog reported at February 10, 2012 to convert to sales during 2012. Selected price increases were announced for 2012, but management cautioned that their success was uncertain and that European pricing remained difficult.
- Post-year-end: Watts acquired tekmar Control Systems on January 31, 2012 for an initial CAD $18.0 million, with total consideration capped at CAD $26.2 million subject to an earn-out. A $0.11 quarterly dividend was declared February 7, 2012.
- Key risks: Weak construction and remodeling markets, European sovereign-debt uncertainty and potential Euro Zone disruption; copper and other input-cost volatility and limits on passing through increases; foreign-exchange exposure; lead-free product conversion requirements nationwide from January 2014, including supply, manufacturing-cost and obsolete-inventory risks; acquisition integration and restructuring execution; product liability, environmental matters, customer credit risk and potential asset impairments. Management identified European goodwill as more exposed if conditions deteriorate; its reported fair-value cushion was 9% for Europe and 18% for Blücher at the October 2011 test.
- Contingencies and controls: The SEC’s FCPA settlement concerning former China subsidiary CWV required $3.8 million in disgorgement, interest and penalties; amounts had been accrued by 2010. Watts disclosed approximately 47 asbestos lawsuits, with dismissals obtained in all cases before trial to date, and estimated reasonably possible legal losses above accruals of approximately $3.3 million pretax. Management and the auditor reported effective internal control over financial reporting; Socla’s controls were excluded from management’s 2011 assessment.
Investor verification points
- Separate organic growth from the material contributions of Socla, other acquisitions and foreign exchange; assess the underlying trajectory of European operations.
- Review whether commodity-cost recovery and restructuring benefits restore gross margins, and whether the announced 2012 price increases hold.
- Assess Socla integration, final purchase-price allocation, acquisition returns and tekmar’s earn-out terms and contribution.
- Monitor net debt, cash deployment, covenant headroom and the maturity/refinancing profile, particularly the $225 million due in 2016.
- Track impairment assumptions and European goodwill exposure, lead-free conversion costs and capacity, and the resolution of legal and environmental contingencies.
- Confirm future dividend sustainability and the effects of foreign-subsidiary cash restrictions and potential repatriation taxes.