Watts Water Technologies, Inc. — Q3 2018 Form 10-Q
Business context and period. Watts supplies water-flow, heating, drainage and water-quality products to residential and commercial markets. This unaudited filing covers the quarter ended September 30, 2018 and the first nine months of fiscal 2018; comparisons are with the periods ended October 1, 2017. Amounts are in millions of dollars, except per-share data.
Financial performance
- Third quarter: Sales were $390.9, up 7.2% reported and 8.0% organically. Gross profit was $164.5, with a 42.1% gross margin versus 41.9%. Operating income rose 5.8% to $46.9; net income was $31.5 versus $26.5, and diluted EPS was $0.92 versus $0.77.
- First nine months: Sales were $1,177.3, up 8.0% reported and 5.8% organically. Gross profit was $490.6, with a 41.7% gross margin versus 41.6%. Operating income increased 14.6% to $143.0; net income was $95.7 versus $75.4, and diluted EPS was $2.78 versus $2.19.
- Segments: Q3 Americas sales increased 9.8% on a segment basis, Europe 2.4%, and APMEA 0.4%. Americas operating income rose to $45.0; Europe declined to $9.4 from $13.4, while APMEA increased to $2.5 from $0.5. Nine-month sales growth was strongest in Americas, up 8.0% on a segment basis; Europe was up 8.4%, partly reflecting favorable currency translation.
- Cash flow: Nine-month operating cash flow was $66.6 versus $73.4. Capital expenditures were $24.1, resulting in reported free cash flow of $42.6 versus $56.7. Free-cash-flow conversion to net income was 44.5%, down from 75.2%.
- Liquidity and debt: Cash was $156.8 at September 30, 2018, down from $280.2 at year-end 2017; $133.4 was held by foreign subsidiaries. The company reported net debt of $222.0 and a net-debt-to-capitalization ratio of 20.1%, versus 20.7% at year-end. It had $260.6 outstanding on its term loan, $45.0 drawn on its $500 million revolving facility, and $429.2 of unused and available revolving credit. The company reported compliance with debt covenants.
- Margins and costs: Q3 gross margin improved 0.2 percentage points, while nine-month margin improved 0.1 points. Pricing, volume and productivity helped offset higher copper and stainless-steel costs, inbound transportation and inflation. SG&A was 29.2% of sales in both Q3 and the first nine months of 2018? The filing reports 29.2% for each; nine-month 2017 was 29.8%.
Material changes and management commentary
- Management attributed growth primarily to higher volume and pricing, especially in the Americas. Q3 organic sales were partly offset by unfavorable currency translation; nine-month reported sales also benefited from favorable foreign exchange, particularly the euro.
- Interest expense declined as debt was repaid, partly offset by higher interest rates. The company said it repatriated approximately $121 million of foreign earnings through the first nine months and used most of that cash to reduce debt.
- Nine-month operating cash flow and free cash flow fell year over year, which management attributed to working-capital movements, timing of tax payments and withholding related to repatriated cash, and higher capital spending.
- The company expected to invest approximately $7–$10 million in capital equipment during the remainder of 2018. It did not provide specific earnings or sales guidance in the supplied filing text.
- Management declared a quarterly dividend of $0.21 per share on November 1, 2018, payable December 14, 2018. Nine-month dividends declared were $0.61 per share versus $0.56.
Risks, contingencies and unusual items
- Q3 restructuring charges were $3.4, primarily related to European headquarters and manufacturing cost-saving actions; the reported after-tax impact was $2.5, or $0.07 per share. The newer European program was estimated to incur total charges of approximately $5.0, with costs expected within 12 months.
- The company estimated reasonably possible legal losses above accrued amounts of approximately $5.6 pre-tax. For the Chemetco Superfund matter, it could not estimate a reasonably possible loss because the remediation plan, total responsible parties and cost allocation remained undetermined.
- The 2017 Tax Act accounting remained provisional for certain items, including the toll tax and deferred taxes. The company estimated its toll-tax obligation at $23.3, payable over eight years, and included an estimate of current GILTI tax in its 2018 provision.
- Management identified exposure to foreign-exchange movements, interest rates and commodity prices, including copper and stainless steel. Derivatives are used for hedging rather than trading. The company also noted that ASC 842 lease adoption in 2019 is expected to add right-of-use assets and lease liabilities; the impact could not yet be quantified.
- ASC 606 revenue recognition adoption had no material impact. Management stated disclosure controls were effective and reported no material change in internal control over financial reporting other than updates to revenue-recognition processes and controls.
Important facts for investors to verify
- Whether pricing and volume growth can continue to offset higher material, transportation and other inflationary costs, particularly in Europe.
- Cash conversion and working-capital performance, given the year-over-year decline in operating cash flow and free cash flow.
- Debt repayment, cash location and availability of the revolving facility, including the effect of repatriation and tax payments.
- Actual restructuring costs and savings, and developments in the Chemetco matter and other legal contingencies.
- Final tax effects of the 2017 Tax Act and the balance-sheet impact of adopting the lease standard in 2019.