Watts Water Technologies Inc Q3 FY2020 Earnings Call

Ladies and gentlemen, thank you for standing by and welcome to the Watts Water Technologies Third Quarter 2020 Earnings Conference Call. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Timothy M. MacPhee, Treasurer and Vice President, Investor Relations of Watts Water Technologies Inc. Thank you. Please go ahead.

Thank you, and good morning, everyone. Welcome to our third quarter 2020 earnings conference call. Joining me today are Bob Pagano, President and CEO; and Shashank Patel, our CFO. Bob will provide a business overview for the quarter and offer his preliminary views of the 2021 markets. Shashank will address the third quarter financial results and discuss our outlook for the fourth quarter. Following the prepared remarks, we will address questions related to the information covered during the call. Today's webcast is accompanied by a slide presentation which can be found in the Investors section of our website. We will refer to these slides throughout our prepared remarks. Any reference to non-GAAP financial information is reconciled to the relevant GAAP measure in the appendix to the presentation. Before we begin, I'd like to remind everyone that during the course of this call, we may be making certain comments that constitute forward-looking statements. These statements are subject to numerous risks and uncertainties that could cause actual results to differ materially. For information concerning these risks, see Watts' publicly available filings with the SEC. The company disclaims any intention or obligation to update or revise any forward-looking statements whether as a result of new information, future events or otherwise. Let me now turn the call over to Bob.

Thanks, Tim, and good morning, everyone. Please turn to Slide 3 in the presentation, and I'll provide an overview of the quarter. First, I must again applaud the efforts of all our employees for adjusting to the challenges of the pandemic. Our employees have remained deeply engaged with our customers whether working on site or remotely, delivering our products on time and with the quality they have come to expect in the Watts' solutions. The teams have worked diligently while adhering to safety protocols to ensure we maintain close customer contact through order fulfillment, training and responding to inquiries. And while travel is restricted, we've expanded virtual plant tours which allow local leaders a chance to update senior management on their most recent customer and operating initiatives. These virtual tours are also promoting greater employee engagement and helping to drive productivity during these difficult times. Our third quarter operating performance was solid as we again delivered results that exceeded our internal expectations. Our seasoned management team has played a critical role in taking proactive actions that have optimized the performance of the business despite challenging underlying market conditions. The sales decline in the quarter was less pronounced than we had anticipated, both in the Americas and Europe. Despite the tough macro environment, we maintained our focus on driving our smart and connected strategy. We also increased adjusted operating profit and expanded adjusted operating margin versus Q3 last year despite the lower sales volume. This was driven primarily by the aggressive cost actions we've undertaken in response to the pandemic. Cash also remains a focal point and year-to-date, we've increased free cash flow by 25% as compared to the same period last year. Operationally, we've now instituted all cost-out programs we discussed earlier this year. During the third quarter, we estimate total run rate savings approximated $20 million. Year-to-date savings have totaled $42 million. We continue to review additional cost actions to support operational efficiency. Shashank will review the financial results in more detail momentarily. Now I'd like to provide our current views of the market. In the Americas, the construction industry is adjusting to the new normal, while job sites that were already under construction are back online and being driven to completion. Residential repair and replacement demand was encouraging through the third quarter as we saw continued strength in our DIY channel, and September's record existing home sales support continued growth there. Our products that go into hydronic and electric heating applications and residential irrigation should continue to perform well. The new single-family home construction market is performing well amid low interest rates, and demand is strengthening as people migrate to the suburbs. Year-over-year housing starts have been positive since June, and permits are also up. We'll continue to focus and capitalize on residential opportunities especially in the higher-end, single-family homes. In Europe, we saw many companies working through the traditional August vacation holiday to catch up on project backlogs and support customer restocking efforts. German OEMs benefited from ongoing government energy efficiency subsidies, and China continued to lead in rebounding from the pandemic. Conversely, there are a number of developments that are concerning. Many of the current COVID-19 trends we are seeing around the world are worrisome and impact all our markets. I realize we are nine months into this pandemic and the markets have stabilized to some degree, but COVID-19 is still driving a lot of end-market uncertainty. So with that as a backdrop, our worldwide markets are currently mixed. Traditional macro data like ABI and the construction industry competency index and other information we've recently assessed are indicating a slowdown in our commercial markets into 2021. As a result, we expect that new construction in the commercial building sub-verticals of hospitality, office, retail, multifamily and commercial marine will continue to be challenged. However, we do expect that there will be continued growth in the health care, data centers and food and beverage markets. Our teams are leveraging our expansive product breadth and channel reach to focus in on these growth sub-verticals. In nonresidential repair and replacement whose growth traditionally followed GDP, we see repair and replacement being impacted by the deferring of discretionary replacement and renovation given the magnitude of the pandemic. Break and fix activity should grow especially given our large installed base. Renovation and retrofit activity may be softer, especially in the challenged hospitality and commercial submarket. Regardless of how the markets unfold next year, we are confident that our diversified product portfolio and unmatched distribution capabilities should provide us the flexibility to shift our focus to meet the demand in those products, markets and regions that offer us the best growth prospects during this difficult time. And we'll continue driving our smart and connected solutions that we believe will be critical as we transition into the new normal. So overall, we are currently cautious about our initial market outlook for next year. We see pockets of growth opportunities, but uncertainty driven by the continuation of the COVID-19 pandemic is causing the markets to pause. As I've said before, commercial construction activity slows during periods of uncertainty and we're clearly at that point in the North American, European and Middle Eastern markets. Our view on 2021 is evolving as the markets remain in flux and as our team continues to formulate their operating plans for next year. We'll provide further growth expectations during our February 2021 earnings call. As for our fourth quarter outlook, we expect sales will be soft compared to last year and we anticipate operating margins to improve relative to last year but at levels below the third quarter as temporary cost reductions are partially phased back into the business.

Thanks, Bob. Please turn to Slide 4 to review the third quarter consolidated results. Sales of $384 million were down 3% on a reported basis and down 5% organically driven primarily by the continued impact of COVID-19. Foreign exchange had a favorable year-over-year impact of $5 million and acquisitions, net of divestitures, accounted for $4 million of incremental sales year-over-year. Adjusted operating profit and adjusted earnings per share both increased by 1% as compared to last year despite lower sales. Adjusted operating margin of 13.8% increased 50 basis points as cost actions and productivity more than offset the impact of volume loss and incremental investments. Incremental cost action savings of $20 million in the quarter were the main driver of the adjusted operating profit and adjusted margin improvements. The adjusted effective tax rate of 27.3% is 120 basis points lower year-over-year. The reduction is due to final regulations being issued in the U.S., allowing for higher tax exceptions on foreign-sourced income. For GAAP purposes, we recorded a charge of $3.4 million, primarily related to the previously announced and expanded restructuring initiatives, most of that being severance. Savings from these expanded programs should approximate $3 million annually. We expect to book $1 to $2 million of additional cost for asset relocation and asset write-offs in the fourth quarter that also relate to these programs. These costs will be classified as special items when incurred. As Bob noted, year-to-date free cash flow is up 25% to $95 million as compared to the same period last year. We have been laser-focused on working capital optimization including improvement in accounts receivable, and the teams' efforts have resulted in strong results as our DSO declined by 9% year-over-year. Year-to-date, we've invested an incremental $15 million or 77% in capital expenditures versus last year. That CapEx spend includes manufacturing expansion and upgrades in key product categories and incremental spending on productivity enhancements. We expect to maintain free cash flow conversion at 100% or more of net income for the full year. Our balance sheet remains strong and provides ample flexibility in these uncertain times. The gross and net leverage ratios at the end of September were 1.1x and 0.3x, respectively. Our net debt to capitalization ratio at quarter-end was 5.5%. During the quarter, we purchased approximately 41,000 shares of common stock at a cost of $3.7 million. We resumed repurchases at the beginning of the third quarter and, aligned with our long-standing approach, are primarily focused on offsetting share dilution.

Turning to Slide 5 and our regional results. Organic sales declined in all regions but less than we had anticipated in the Americas and Europe. Americas organic sales declined by 4% during the quarter, slightly better than our expected reduction of 6% to 10%. We saw better performance in traditional plumbing, electronics and water quality products, which more than offset an expected softness in heating and hot water products. We also fulfilled restocking orders as customers were buying to replenish depleted second quarter inventory levels. Europe sales were down 6% organically, much better than the 14% to 18% decline we had anticipated driven by resiliency in fluid solution product sales, especially within electronics. As expected, sales remained soft within Europe's drains platform, with commercial marine sales impacted by cruise shipbuilders temporarily closing plants to level load production. Sales in many of our key regions in Europe were down versus the third quarter last year with the exception of France, which grew in the low single digits. France sales were driven by an unexpectedly busy summer as companies worked through the traditional holiday period on fears of a second COVID wave. APMEA sales were down 22% organically, with China down only by low single digits, an improvement over the second quarter as China's economy continues to recover. However, the Middle East, East and Southeast Asia, including Australia, were down double digits due to the continued impact of COVID. New Zealand sales were positive in the quarter from domestic plumbing demand, while the AVG acquisition in Australia contributed $3.5 million in sales during the third quarter performing moderately above expectations. Adjusted operating margin of 18.4% in the Americas was 30 basis points higher than last year. Cost actions and productivity more than offset the volume loss and incremental investments. Americas decrements of 8% on lower sales volume were better than expected due to aggressive cost actions. Europe's adjusted operating margin of 11.3% was 10 basis points higher than last year for similar reasons as the Americas. Europe's adjusted operating profit was flat on reduced sales volume and better than anticipated due to aggressive cost actions. APMEA's adjusted operating margin increased 640 basis points to 15.1% driven by cost actions, productivity and a 7% increase in affiliate volume, which more than offset a reduction in third-party volume.

Moving to Slide 6 and general assumptions about our fourth quarter operating outlook. As Bob mentioned, our expectation is operating margin should expand on reduced sales volume as compared to the fourth quarter of last year. We are estimating organic sales for the fourth quarter to be at 4% to 8% below the fourth quarter of 2019. This range includes some caution regarding uncertainty around COVID-19. We anticipate that fourth quarter adjusted operating margin should range from 12.5% to 13%. Corporate costs should approximate $9 to $10 million for the fourth quarter. We expect interest expense sequentially will be flat to the third quarter. The adjusted effective tax rate should approximate 27.5%. Foreign exchange would be positive to last year should current rates persist throughout the fourth quarter. As a reference, the average euro-dollar foreign exchange rate for the fourth quarter of 2019 was 1.11. We expect seasonally strong cash flow to end the year. Total capital spend is estimated at $45 million for the full year.

So with that, let me turn the call over to Bob before we begin Q&A. Bob? To summarize, I'd like to leave you with a few key themes. Employee safety, engagement and customer service remain top priorities. We continue to expand our protocols to maximize employee safety while simultaneously meeting our customer needs. Third quarter results were better than expected as activity improved when compared to the second quarter. Cost actions provided significant benefits in our third quarter and year-to-date results. We continue to review our cost base for further opportunities. Our balance sheet remains solid and provides flexibility to execute our balanced capital allocation strategy. Our ability to generate cash during these turbulent times has been critical. We continue to invest for the long term in both smart and connected solutions and in productivity-enhancing capital spending. We expect year-over-year margin improvement in the fourth quarter on reduced volume. Our outlook is mixed and cautionary, especially in certain commercial markets, given leading indicators and continued market uncertainty due to COVID-19. We will continue to keep a close pulse on our markets. And finally, we are prepared to react quickly to market changes with mitigating actions and remain focused on positioning Watts to capture opportunity as our markets recover with our diversified portfolio and by executing our smart and connected strategy. With that operator, please open the lines for questions.

Your first question comes from Nathan Jones of Stifel.

This is Adam Farley on for Nathan. Just on the restocking event that took place in the Americas, could you provide a little more color on that? And then going into the fourth quarter, do you expect to see any further restocking? And could that possibly go into 2021 as well?

Yes. In July, we experienced a restocking in North America primarily due to a resumption of construction that began in late May, which helped to deplete some of their inventory. July saw a significant restocking, but we have observed a gradual decline since then. From May through October, sales have remained steady in that channel compared to the significant stock-up in July. As we approach 2021, looking at the fourth quarter, I think wholesalers will be assessing their inventory levels. Therefore, it is too early to determine if restocking will occur at this time. Additionally, the ongoing impact of COVID-19 introduces continued uncertainty in the market, as we have discussed previously.

Okay. And then turning to water quality, I know it's a smaller piece of the portfolio, but you did highlight it in the presentation. Were you seeing any favorable trend there? We've heard from other companies water quality improvement, home improvement as a favorable trend.

Yes, we're seeing very positive as related to our residential piece in that marketplace as well as some of our commercial piece of that. But water quality has been favorable so has our most of our residential market. We actually saw our residential market up double digits in the quarter. So we believe that will continue with the focus on renovation and the single-family homes growing. As I've said, we're more cautious about the commercial markets at this point in time. That's the one we're watching very closely.

Your next question comes from Jeff Hammond of KeyBanc.

The decrementals for the third quarter and the second half look really impressive. I'm trying to understand how much of the cost savings for the year are temporary, and how much is related to mix and structural changes versus temporary costs. As we look ahead to 2021, how should we view the incrementals compared to the normal, especially since some of the temporary costs may come back in?

Yes. So Jeff, it's Shashank. So as we had talked three months ago and we're pretty much on the same basis, we had about $55 million of cost-out in 2020. Year-to-date through the third quarter, we're at $42 million, as Bob noted, and $20 million of that was in the third quarter. We get another $12 million, $13 million in the fourth quarter. Out of that $55 million, roughly $8 million, $9 million was permanent in nature, which was restructuring activities. And that was $8 to $9 million. And as we look into next year, with the additional actions we took, that's going to be approximately $10 million of permanent cost-out. And when you look at the rest of the rest of the $55 million beyond restructuring, things like travel and mark-on and things like that, right now we're in the planning stages of 2021. Clearly, with the fact that the vaccine might not be available for a period of time, some of those costs will not be coming back, especially in the first six months, but we're in the early planning phases. So by February, we'll know exactly what that cost savings number is for 2021.

Would you think incrementals look a little bit lower than normal just as temp costs come back in or not necessarily?

I think overall, obviously, we still got the long-range target once we get beyond COVID of expanding the operating margins, right? So when you look at the incremental drops, we're still looking at 25% to 30% on volume. Our decrementals, with the cost actions, we've done a nice job of managing the decrementals.

Okay. Great. As we look toward 2021, it's clear that your business has shown considerable resilience outside of the second quarter. You've mentioned the replacement aspect, particularly in the residential sector. I'm trying to understand how we balance the potential recovery from easier comparisons against the ongoing commercial uncertainties and how much recovery you anticipate for some of these sectors in 2021.

Yes, Jeff, that is something we've been analyzing a lot. And we just completed our strategic planning process where we engaged external support, did a lot of voice of customer analysis. And what we're seeing here is, this March, we're actually seeing an air pocket, right? Like, we look at our Drains business which has steadily gone down as an early indicator. So what's been happening is people have been completing existing construction in commercial buildings. However, they were not doing any new buildings. And we're seeing that continue to push out. Including October, we saw Drains down double-digit. So that's the area we're getting most concerned. And as we're looking into next year, because of the COVID continuing to extend longer than I think everybody thought and going into next year, overall, North America, honestly, we believe, will be overall flat at best for next year. We believe Europe is going to be down, and APMEA is going to be up. So we're not seeing that rebound in commercial construction. Residential is doing fine. That's offsetting multifamily which is also projected to be down and focused on that. So from a residential, those kind of net. But the basic commercial building is soft and it's going to continue to be soft into next year.

And those are market comments for each of the markets compared to your business. If you consider that alongside the replacement side of the business and possibly outgrowing it, how much better can you perform than those kinds of market projections?

Yes, I believe it reflects both our market and our outlook. Additionally, in terms of repair and replacement, this traditionally aligns with GDP trends. However, our recent analysis indicates that around 40% of our repair and replacement work involves immediate fixes, while the remaining 60% pertains to preventative maintenance and renovations. Due to the significant impact of COVID-19 on certain vulnerable markets, there has been a tendency to delay these renovations. Eventually, this backlog will need addressing. We maintain the view that our repair and replacement activities should ultimately align with GDP growth. At present, however, the effects of COVID and the absence of stimulus measures are exacerbating this situation. We are witnessing a divergence in trends as we move through the rest of this year and into next year, which makes direct comparisons challenging.

Your next question comes from Ryan Connors with Boenning and Scattergood.

I wanted to actually drill down, a little bigger picture topic, on just the channel situation. And I realize you had a destocking, which is encouraging. But just from a bigger picture perspective, can you talk about how the channels to market are evolving to the sort of new normal? Is there any evidence of wholesalers, or at least the marginal ones, being disintermediated, more of a virtual selling model, direct to customer? I mean how is all this impacting your channel to market, if at all?

We are not observing any of our smaller wholesalers going out of business. Instead, they have been merging with larger wholesalers, and this trend seems likely to continue. The larger wholesalers possess more online resources and are taking advantage of them. So far, we have not encountered any bankruptcies among our smaller wholesalers. However, I believe this situation presents a long-term opportunity for the larger wholesalers to absorb the smaller ones.

Okay. And I guess the restocking kind of supports that, right, because if there were balance sheet issues and so forth, there would be a limited capability to sort of take in inventory and they'd be on more of an adjusting model? Is that a good way to read that?

Yes. I agree.

Okay. As a follow-up to that, I know it was a smaller deal, but Backflow Direct clearly had a more direct online and virtual distribution model, which seems quite timely. Can you provide an update on how that has progressed, how the product line has been integrated, and whether the distribution aspect has been incorporated into your regular distribution or if you are still maintaining that online selling model?

The answer to your question is all of the above. So first of all, Backflow Direct is performing very well, fully integrated into our business, and we are offering that product line to our traditional build business as well as we're offering it through online capabilities given the various channels. So the answer is we are capitalizing that. We continue to add products to that website in capabilities, and we'll continue to leverage that for the parts of the market that want to go direct like that. But overall, we're very pleased with that acquisition.

Your next question comes from Bryan Blair of Oppenheimer.

I was hoping you can provide a little more color on October order rates. I'm trying to gauge how much caution you're baking into the Q4 outlook of 48% organically.

Yes. October order rates were essentially flat, which is typical as people tend to restock at the start of the quarters, followed by a decline. Given the COVID-19 spike, we are particularly concerned about Europe, and typically, the Americas see a similar trend three to four weeks later. With the approaching holiday season, there is apprehension in the market. Currently, the situation is in line with our expectations. We anticipate that November and December will see a slight decline as we move past this period.

Okay. That all makes sense. And if you're willing to drill down a little bit more on regional planning assumptions, how are you thinking about top line trends across Americas, Europe and APMEA for the fourth quarter? And then any color on margin expectations and the sources of the year-on-year expansion you're guiding, that would also be helpful.

Yes, so for the fourth quarter, what breaks up the top line, as we're looking at it, we're expecting overall to be down 4% to 8%. Americas will be down 3% to 6%, Europe 6% to 10% and APMEA down 5% to 10%. So that's our internal planning assumptions. And again, it all depends on what's going on with COVID and the continued market uncertainty.

Okay, very helpful detail. And then Shashank, APMEA margins were quite a bit better than we expected in the third quarter. I was wondering if you could parse out the impact of AVG contribution and how much of a lift, if any, you've seen so far from the transition through a distribution model versus direct sale in Korea.

Korea sales a year ago were not significant, but moving forward, they will positively impact margins. The margin improvement in the APMEA region is partly due to intercompany volume, which enhances both absorption and productivity. We experienced favorable outcomes from the intercompany volume processed through our factory in Ningbo. Additionally, we achieved margin expansion on third-party sales, particularly in China, where we focus on data centers that generally have higher margins. Our business in the Middle East-Africa region declined year-over-year, but it still contributed positively to margins. Overall, these factors helped improve our margins. The AVG business, which has higher margins, also made a contribution, with about $3.5 million in inorganic sales during the third quarter, resulting in higher margins as well.

Your next question comes from Walt Liptak with Seaport Global.

I wanted to ask a follow-on question with that geographic look. That was helpful. It sounded in your prepared remarks, like, some of the government subsidies were helping you guys a little bit. And I think Europe has been a little bit, because of maybe the political situation, able to come up with government programs to support businesses. So I wonder if you could talk a little bit about that. And the outlook for the Americas for the fourth quarter looks a little bit more stable than Europe, I wonder why that is. And do you think there may be more government support in the U.S.?

In Germany, there are energy efficiency subsidies in place that have been beneficial for OEMs and residential boiler manufacturers, which is a significant part of our business there. These subsidies have supported German manufacturers, contributing to better performance than we anticipated. They worked through the summer months, which we hadn't expected. However, as this activity subsides, we have some concerns about recent shutdowns, although they have not impacted manufacturing yet, mainly affecting restaurants and bars. There is increased uncertainty in the marketplace, and we expect this will slow things down. Government stimulus has played a role in this area, but due to the COVID outbreak, we are cautious about the fourth quarter. In the Americas, the residential sector has been performing well, and some subsidies in the hospitality market may have aided repairs and replacements. However, since those subsidies have diminished, we are observing a slowdown in normal repairs and renovations, and we are monitoring this situation closely. As mentioned earlier, uncertainty leads to decreased building activity. Our leading indicator, Drains, was down significantly in October, indicating that new building projects are not being initiated at this time, just completing existing ones. We face a gap in activity, and we believe this may persist into the second half of next year.

Understood. With the smart technology, it seems you're continuing to invest in that area. What feedback are you receiving from customers regarding smart technology? Is there a trend where your clients are seeking digital solutions to reduce workforce needs or improve oversight of their water systems?

Yes, I think there is a clear trend in the industry. As we've said before, there's a shortage of plumbers, there's a shortage of maintenance people and anything we can do to monitor and identify issues before they become big issues is going to help building owners in this environment. So we're getting more and more focused on that. So I think that strategy is right on and more important than ever in this current environment.

There are no further questions at this time. I will now turn the call back to Bob Pagano for closing remarks.

Okay. Thank you, everyone, and for taking the time to join us today for our third quarter earnings call. We appreciate your continued interest in Watts, and we look forward to speaking with you again in February to discuss our fourth quarter and full year 2020 results. So enjoy the upcoming holidays, and please stay safe. Thank you.

Ladies and gentlemen, this concludes today's conference call. Thank you for calling. You may now disconnect.