Watts Water Technologies, Inc. — Q1 2012 Form 10-Q
Reporting period: First quarter ended April 1, 2012, generally a 13-week period; compared with the first quarter ended April 3, 2011. Unaudited consolidated results. Amounts below are in U.S. dollars unless noted.
Business context
Watts designs and manufactures products for water quality, safety, flow control and conservation, principally for residential and commercial markets. It reports North America, EMEA and Asia segments. Its January 2012 acquisition of tekmar expanded its HVAC and hydronic controls offerings; the 2011 Socla acquisition continued to contribute to results.
Financial performance and liquidity
| Metric | Q1 2012 | Q1 2011 |
|---|---|---|
| Net sales | $364.2 million | $329.9 million |
| Gross profit / margin | $129.6 million / 35.6% | $121.0 million / 36.7% |
| Operating income | $26.9 million | $22.9 million |
| Net income | $15.7 million | $11.1 million |
| Diluted EPS | $0.42 | $0.29 |
| Operating cash flow | $3.2 million | $0.9 million |
| Capital expenditures | $4.9 million | $6.6 million |
| Free cash flow (non-GAAP) | $(1.4) million | $(5.7) million |
Sales rose 10.4%; reported growth included $36.3 million from acquisitions, while organic sales increased 0.9%. Gross margin fell 1.1 percentage points. Operating margin was approximately 7.4%, versus 6.9%. Net income benefited from higher operating income and a lower effective tax rate of 28.1%, compared with 35.6%.
By segment, sales were $210.0 million in North America, $149.2 million in EMEA and $5.0 million in Asia. Operating income was $20.2 million, $12.8 million and $1.4 million, respectively; North America declined from $26.7 million, while EMEA and Asia improved. Corporate expense declined to $7.5 million from $14.3 million, chiefly reflecting the absence of the prior-year $6.3 million former-CEO separation charge.
At April 1, 2012, cash and cash equivalents were $230.8 million, down from $250.6 million at December 31, 2011. Working capital was $530.5 million and the current ratio was 2.8:1. Total debt, including current maturities, was $395.6 million; net debt was $164.8 million, and net debt to capitalization was 14.7%, versus 13.9% at year-end. The company had $256.1 million of available revolving credit and $9.3 million of euro-denominated revolver borrowings; it reported compliance with debt covenants. Approximately $75.5 million of cash was held by foreign subsidiaries, and repatriation could trigger taxes.
Material changes and management commentary
- Organic sales increased in North America and Asia but declined in EMEA. Selected price increases supported sales; lower volumes partly offset them.
- North American gross margin was pressured by higher non-commodity purchase costs and manufacturing inefficiencies, including pre-production and transition costs for low-lead products. The federal lead-content limit requires a reduction to 0.25% by January 2014.
- EMEA sales growth included acquisition effects; organic results were affected by weaker activity in Italy and lower OEM sales. Currency movements, particularly euro depreciation, reduced reported sales.
- Tekmar’s initial purchase price was CAD $18.0 million, with possible earn-out and adjustments; total consideration is capped at CAD $26.2 million. The quarter included $34.8 million of Socla revenue and $2.5 million of Socla operating income, including restructuring charges.
Outlook, risks and unusual items
- Management expects operating cash flow to improve through 2012, noting first-quarter seasonality. It expects approximately $36.0 million of capital spending for 2012, including about $31.1 million for the remainder of the year. No specific full-year sales or earnings guidance is provided.
- Restructuring and other charges were $1.7 million in the quarter. Programs include Socla integration, European restructuring and North American production relocations and site closures; North American actions are expected to continue through mid-2013.
- A March 2012 putative nationwide class action alleges toilet-connector failures and seeks unspecified damages and other relief. The company said it could not estimate a reasonably possible loss range at this early stage, but did not expect a material effect based on information then available.
- EMEA goodwill was $216.1 million. At the October 2011 impairment test, estimated fair value exceeded carrying value by 9%; a 1 percentage-point increase in the discount rate would have resulted in impairment. Further deterioration in European markets or higher discount rates could put goodwill at risk.
- Other principal risks include construction-market weakness, raw-material costs and supply, competition and pricing pressure, foreign exchange, product liability, regulation and code compliance, acquisitions, restructuring execution and litigation. Product-liability costs increased by $2.1 million in Q1.
- The board declared a quarterly dividend of $0.11 per share on May 1, payable June 1, 2012. Disclosure controls were reported effective; no material change in internal control over financial reporting was reported for the quarter.
Important facts for investors to verify
- Whether organic sales and margins improve, particularly in North America and EMEA, and whether low-lead conversion costs subside.
- Tekmar’s earn-out and final purchase accounting, and the ongoing sales and profitability contribution from Socla.
- Cash-flow conversion, planned capital expenditures, debt reduction and the availability of cash held abroad after potential repatriation taxes.
- Progress and remaining costs of restructuring programs, and any material developments in the toilet-connector litigation or product-liability claims.
- Whether EMEA performance and valuation assumptions change enough to require goodwill impairment.