Watts Water Technologies Inc Q3 FY2021 Earnings Call

Ladies and gentlemen, thank you for standing by, and welcome to the Watts Water Technologies Third Quarter 2021 Earnings Conference Call. All lines are in a listen-only mode to prevent any background noise. After the speaker's remarks, there will be a question-and-answer session. Thank you. I would now like to turn the call over to Tim MacPhee, Treasurer and Vice President, Investor Relations of Watts Water Technologies Incorporated. Please go ahead, sir.

Thank you, and good morning, everyone. Welcome to our third quarter earnings conference call. Joining me today are Bob Pagano, CEO and President; and Shashank Patel, our CFO. During today's call, Bob will provide an overview of the third quarter results and discuss the current state of our operations and markets. Shashank will discuss the details of our third quarter performance, provide our initial outlook for the fourth quarter and offer a revised outlook for the full year 2021. Following our remarks, we will address questions related to the information covered during the call. Today's webcast is accompanied by a presentation, which can be found in the Investor Relations section of our website. We will reference this presentation throughout our prepared remarks. Any reference to non-GAAP financial information is reconciled in the appendix to the presentation. Before we begin, I'd like to remind everyone that during the call, we'll be making certain comments that constitute forward-looking statements. These statements are subject to numerous risks and uncertainties that could cause the 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 because of new information, future events or otherwise. I request that questions be limited to one, plus a follow-up to ensure everyone has an opportunity to participate. If you have additional questions, please rejoin the queue. Let me now turn the call over to Bob.

Thanks, Tim, and good morning everyone. First, I must recognize the efforts of all our employees for their sustained commitment while dealing with continued supply chain and logistics challenges and the delta variant. Our team has maintained a customer focus and has worked diligently to deliver on our promises to them. My sincere thanks to the entire team for their hard work. Now, please turn to slide three in the presentation and I'll provide an overview of the quarter. The team produced another strong quarter despite supply chain and logistics challenges. We delivered record third quarter sales, adjusted operating margin and adjusted earnings per share. All regions' sales grew organically by double digits. Our results benefited from the continued economic recovery, as well as price and volume tailwinds. Cash generation remains a focal point. Year-to-date, we have increased our free cash flow by 26% as compared to last year. Shashank will review the financial results in more detail momentarily. In late September, we purchased Sentinel Hydrosolutions in an all-cash transaction. Sentinel, a $6 million sales business, provides leak detection solutions, mostly to the high-end residential market. Sentinel's systems are designed to detect leaks in water pipes, plumbing fixtures and appliances and will automatically shut off water when a leak is detected. This acquisition further expands our developing focus in leak detection technology. I'd like to welcome our Sentinel colleagues to Watts. Like many companies, we're dealing with supply chain and logistics challenges. We previously mentioned concerns involving components used in our electronics products. Since then, supply chain and logistics issues have gotten more dynamic. We are seeing disruptions across the board in all regions impacting many of our core raw materials and components. Lead times on average have more than doubled and suppliers are dealing with labor constraints. We're addressing these and other problems daily to maximize customer order fulfillment. Our expectation is that supply chain and logistics disruptions will continue into 2022. We are monitoring this issue closely. Now, let me talk about the markets. In general, markets have continued to be positive. GDP expectations in most regions portend a solid finish to 2021 for repair and replacement in both commercial and residential end markets. In the Americas, single-family residential new construction remains strong and we've seen some pickup in multifamily starts as well. Repair and replacement business in both nonresidential and residential end markets remains strong. We still see pent-up demand in older projects, while new project starts are still lagging. Contractors are also dealing with materials and skilled labor shortages at job sites in addition to substantial inflation on project costs. In Europe, German and Italian OEMs continue to benefit from government energy efficiency subsidies. Repair and replacement was again strong in France. We are beginning to hear customer feedback that there is more uncertainty heading into Q4 as projects are being delayed due to material and labor shortages, as well as an across-the-board inflationary impact on project costs. The team is watching this trend closely. In APMEA, underlying market demand has improved, but is being impacted by the pandemic. New Zealand and Australia have both had recent lockdowns affecting their economies. China market demand has been steady, but is being impacted by a potential correction in the housing market and COVID outbreaks that caused lockdowns which impact both suppliers and customers. China is also experiencing power outages which is further exacerbating the supply chain. Finally, given our performance in the third quarter and our expectations for Q4, we are raising our full year sales outlook. Let me turn the call over to Shashank who will discuss the third quarter operating performance and provide more detail on our fourth quarter expectations and revised full year outlook. Shashank?

Thanks, Bob. Please turn to Slide 4 and let's review the third quarter consolidated results. Sales of $455 million were up 18% on a reported basis and up 17% organically driven primarily by the global economic recovery. Foreign exchange and acquisitions combined had a favorable year-over-year impact of $5 million. Adjusted operating profit of $66 million increased 24% and adjusted operating margin of 14.4% increased 60 basis points as volume, price and productivity more than offset the impact of supply chain challenges, logistics inflation, incremental investments, incentives and business normalization costs. Adjusted earnings per share increased by 32% for the reasons just cited in addition to lower interest expense and reduced foreign currency transaction losses. The adjusted effective tax rate of 26.9% is 40 basis points lower year-over-year. For GAAP purposes, we recorded a charge of $0.9 million related to the previously announced restructuring of our Méry facility in France. We expect approximately $1 million more will be incurred in the fourth quarter. We anticipate another $5 million to $6 million in restructuring costs in 2022 with respect to this plant closure upon completion. As Bob noted, year-to-date free cash flow is up 26% to $120 million as compared to the same period last year. This was driven by higher net income and lower capital spend. 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. The gross and net leverage ratios at the end of September were 0.6x and negative 0.3x respectively. Our net debt to capitalization ratio at quarter end was negative 8%. During the quarter we purchased approximately 25,000 shares of our common stock at an investment of $4 million primarily to offset dilution. Turning to Slide 5 and our regional results. Organic sales in all regions increased by double digits during the quarter primarily from the continued strong economic recovery. Reported regional sales also benefited from favorable foreign exchange movements. In addition, the Americas had approximately $1 million in acquired sales. Americas' organic sales increased 17% during the quarter with broad growth across all of our major product categories driven by strong repair and replacement and single-family residential markets and price. We had minimal benefit in the quarter from the US South Central freeze. Americas' adjusted operating margin declined by 30 basis points during the quarter as gross margin expansion from price, volume and productivity was more than offset by inflation, incremental investments, incentives and business normalization costs. Europe sales increased over 14% organically delivering another solid quarter with expansion in both the Fluid Solutions and Drains platforms. Sales were up in all key regions, driven by the wholesale activity in France and Italy and continued strong OEM demand in Germany and Italy, driven by local government energy subsidies and an uptick in Scandinavian sales due to a gradual recovery of the commercial and marine market. Europe's adjusted operating margin expanded by 420 basis points benefiting from volume, price and productivity which more than offset inflation, incremental investments and business normalization costs. APMEA continued its strong performance with sales up 33% organically. The region saw double-digit growth in most locations except for New Zealand where sales were down due to COVID-related shutdowns. Adjusted operating margin expanded by 400 basis points in APMEA in the quarter as trade and intercompany volume and productivity more than offset inflation and business normalization costs. Moving to Slide 6 and general assumptions about our fourth quarter and full year 2021 outlook. Our expectation for the fourth quarter is sales should expand by 10% to 14% over the fourth quarter of 2020. We anticipate that fourth quarter adjusted operating margin should range from 13.4% to 13.8%. Margins may be challenged due to the impact of inflation, especially from supply chain and logistics costs as well as continued growth in business normalization costs and incremental investments. Corporate costs should approximate $11 million to $12 million for the fourth quarter. We expect interest expense sequentially will be flat to the third quarter. The adjusted effective tax rate should approximate 26%. Foreign exchange would be a headwind 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 2020 was 1.19. Please recall that for every $0.01 movement up or down in the euro-dollar exchange rate, our European annual sales are impacted by approximately $4 million and our annual EPS is impacted by $0.01. We expect seasonally strong cash flow to end the year. For the full year 2021, we anticipate organic growth to be 14% to 17% or about 350 basis points higher at the midpoint than our previous outlook in August. Full year adjusted operating margin, adjusted margin expansion and free cash flow expectations are anticipated to be in line with our previous outlook in August. Other full year inputs are noted on the right with some minor changes since August. So with that let me turn the call over to Bob before we begin Q&A. Bob?

Thanks, Shashank. To summarize, I'd like to leave you with a few key points. Third quarter results were better than we anticipated and were aided by continued global demand and a strong repair and replacement market. We continue to drive price and proactively manage the many supply chain issues to support our customers. We continue to invest for the long term including smart and connected solutions. We have raised our full year 2021 revenue outlook. Adjusted margin expansion remains in line with previous expectations. Finally, given our strong results today and our already healthy balance sheet, we are well positioned to drive our strategy including expanding our smart and connected offerings and executing on strategic M&A opportunities as they arise. With that operator, please open the lines for questions.

Thank you. The floor is now open for your questions. Your first question comes from Ryan Connors of Boenning and Scattergood.

I just had a couple of big picture questions to start off. Bob, I'm curious how you're postureing during this environment in terms of committing capital to things like capacity expansion. We had some peer companies out today saying they are going to commit capital expanding capacity. In your case, is the idea that this is going to be sustained long enough that you get behind it and invest and increase capacity and do the other things you need to do, or do you think this is going to normalize at some point and you don't want to strand those types of investments? Philosophically, are you going to reconfigure your supply chain to make it less complex and shorten it, or do you think things will settle down and you'll return to the prior Watts strategy? What's your philosophy there?

Ryan, good morning. When we look at capacity, we believe we have plenty of capacity. We've been spending a lot of time and effort in automating our factories and we have ample capacity in our complete network. So I'm not going to add additional capacity, but I will invest in automation inside of our factories. Our philosophy is we usually produce where we ship. We're more vertically integrated than most, and we do outsource some things and have looked at alternative capabilities like everyone else during the supply chain crunch. I think this will come back to normal at some point. There were shocks to demand based on the freeze and some hurricanes, plus abnormal demand and increasing pricing. That will settle down. We've always believed in the philosophy of manufacturing where you ship your product, so this is in line with our strategy.

Okay. I'll hop back in queue. Thanks so much.

Your next question comes from Joe Giordano of Cowen and Company.

Hey. Good morning. This is Robert on for Joe.

Hey, Robert.

Hey, good morning. Just a quick one. Were any sales pushed out during the quarter due to these logistics or supply chain issues? It doesn't seem like there would have been a ton. And then I guess another question on pricing specifically. What does that look like in the backlog?

Certainly, we probably could have shipped a little bit more, but it's not a huge number. Our teams executed and we have a flexible workforce that flexes where the volume is. If there were supply chain issues, we moved to another area to allow us to do that. But it was not a big number. Shashank, do you want to take the pricing?

On pricing, price realization in the third quarter was approximately 5%. Regarding Q4, we announced price increases between September 1 and October 1. Our expectation on price realization in Q4 is in the 7% to 10% range.

Okay. That’s great. Thank you very much. I’ll jump back in queue.

Thanks.

Your next question comes from Walt Liptak of Seaport Research.

Hi, thanks. I wanted to ask about the operating leverage. The profitability in the Europe segment looks pretty good even with the inflationary environment and tough logistics. Can you talk about how the Europe business is operating from a production and shipment point of view and how pricing is going? Are they on the same cadence of price increases that you mentioned?

Walt, good morning. We have a fixed cost base in Europe, and when volume goes up significantly, like in the third quarter, we get significant leverage on those fixed costs. We also achieved price in Europe. Europe is generally a bit harder to get price in, but we did get good price there. Over the last several years, the teams have done a good job on the commercial side, managing margins with the OEM channel and other channels. So it's a combination of volume leverage, pricing and commercial management that produced the operating leverage.

Okay, great. Thank you.

Thank you.

Thanks Walt.

Your next question comes from Jake Jarnigo of Baird.

Yes, good morning. I'm in for Mike Halloran. Just a follow-up on the price-cost comments. I appreciate the detail on what was achieved in the quarter and implied for Q4. What does that imply for price carryover into next year? Are we talking low single digits as a buffer, and then are there potentially plans for another increase as you go into next year? What are you looking at to determine that? Also, high level, you talked about demand being mostly pent-up related outside of new housing starts on the residential side. Leading indicators on the non-residential side still look pretty good. How are you reconciling that at a high level? How do you see this playing out in terms of construction cycle and what variables could be tailwinds or impediments?

Jake, that will depend. We have price increases that were announced between September 1 and October 1 depending on the region, and realization of those will determine carryover. We have had three sets of price increases, so there is carryover into next year. Our goal is always to be positive on the price-cost piece. We'll continue to monitor and over the next three months we'll decide what the January price increases look like. Right now, we are slated for January price increases.

Jake, residential new construction and repair and replacement have been strong. Repair and replacement on the commercial side has also been very strong. For commercial new construction, many projects that started before the pandemic were delayed and are now coming online; those projects are taking longer than expected, but we've seen stronger backlog than we thought. Construction in difficult markets like office buildings, stores, malls and lodging is still significantly below 2019 levels for new construction. The strong repair and replacement and previously started projects have absorbed some of the air pocket. Looking into next year, the background looks strong with GDP, but there are headwinds such as unexpected events like freezes and supply chain constraints. Many are building stock and supply chain capabilities and passing price increases through, so we may see some channel destocking as we head into next year. We are reconciling all of that now and will provide more detail on our next earnings call.

Great. Thank you. I’ll jump back in queue.

Thank you.

Your next question comes from Jeff Hammond of KeyBanc.

Hey, this is David Tarantino on for Jeff. So you touched on it just then, but could you give a little more overview on the channel dynamics given all the supply chain and logistics constraints and how much destocking has happened, if any?

We're not seeing broad destocking. Channels are stocking right now for two reasons: they're trying to beat price increases from inflation, and they're trying to secure inventory before future jobs happen. We're seeing some contractors starting to have warehouses to hold inventory for upcoming projects. There's inventory, but not always the right mix. You might have most of what you need for a job but be missing critical components. Lead times have generally doubled. We're watching this closely and will take advantage of opportunities with our supply chain.

Great. And then just on M&A, following the acquisition of Sentinel, what are your thoughts on more incremental M&A going forward?

You can never precisely time M&A. We remain disciplined; deals must make strategic and financial sense. Multiples are high right now, but we'll look at opportunities as they arise. Our pipeline remains full, and with a healthy balance sheet, we'll act where it makes financial sense.

Great. Thank you.

Thank you.

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

Thanks for taking the follow-up. As lead times extend, we're hearing more about double ordering and bullwhip effects in the economy. Have you seen evidence of that that could affect your backlog? Also, regarding the connected strategy, those products have more technology content and may face component issues. How has this impacted the rollout and penetration of the connected strategy? Has it pushed timelines out, and how will you reaccelerate when things normalize?

We are seeing some double ordering behavior; it's not material. Some customers place orders and may cancel if not delivered, but overall we've been shipping more than we've been losing. Our vertically integrated supply chain strategy is helping in this environment. Regarding the connected strategy, we've had to reallocate some engineers to existing products because of chip shortages; when you change chips you also have to change circuit boards, which requires reengineering. That has impacted some new product development. However, we still have a goal to get 25% of sales from connected products by 2023 and remain focused on that target. The chip shortage has had an impact we didn't plan for, but we're still in the mid-teens percentage of sales for smart and connected products and have come a long way over the last several years.

Thanks again for your time.

Thank you.

Thank you.

At this time, we have no further questions. I will now turn the floor back over to Bob Pagano for any additional or closing remarks.

Thank you 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 2021 results. Enjoy the upcoming holidays and please stay safe. Take care.

Ladies and gentlemen, thank you for your participation in today's event. This does conclude today's call. You may now disconnect.