Watts Water Technologies Inc Q4 FY2021 Earnings Call

Good morning, and my name is Savannah, and I will be your conference call operator today. At this time, I'd like to welcome everyone to the Watts Water Technologies Fourth Quarter 2021 Earnings Call. All lines have been placed on mute to prevent any background noise, and after the speakers' remarks there will be a question-and-answer session. Operator instructions. Thank you. And Tim MacPhee, you may begin your conference. Please stand by for some technical difficulties. Please go ahead.

Good morning, everyone. Welcome to our fourth quarter and full year 2021 earnings conference call. Joining me today are Bob Pagano, President and CEO; our CFO, Shashank Patel; and Diane McClintock, VP of Financial Planning and Analysis. Bob will provide an overview of this past year, review Watts' 2022 priorities as well as update you on our market expectations for this year. Shashank will provide a detailed analysis of our fourth quarter and full year financial results and discuss our outlook for Q1 and the full year 2022. Following our 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 in relevant GAAP measures in the appendix to the presentation. I'd like to remind everyone that during 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, please refer to 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. On a personal note, this will be my last earnings call. I have decided to retire effective March 31. While I have worked with so many great people at Watts over the last 18 years, I'm excited and looking forward to the next chapter. I am also excited to inform you that Diane McClintock, our VP of Financial Planning and Analysis, will be assuming my Investor Relations duties. Diane has over 10 years of increasing financial responsibilities within Watts as well as experience in financial roles with other companies. You will find Diane to be very knowledgeable, energetic and personable. I fully expect you will enjoy working with Diane as much as I have. I've also enjoyed working with you, the investor and analyst community, over the last 9 years. I've appreciated your continued interest in our company, and I wish you all the best, both personally and professionally. With that, I will turn the call over to Bob.

Thank you, Tim, and good morning, everyone. Before beginning the presentation, I'd like to comment on Tim's personal announcement. Tim has been a respected member of the Watts team for 18 years. As Corporate Controller, Chief Accounting Officer, Treasurer and our Investor Relations lead, he has been involved in all aspects of finance. Tim has worked closely with several CEOs and CFOs during his tenure at Watts and all have appreciated his work and counsel. I want to thank Tim for all his services to Watts and wish him all the best in his retirement. Now please turn to Slide 3 in the earnings presentation, and I'll provide a recap of our 2021 efforts and some initial thoughts regarding 2022. Entering 2021, general expectations were that the pandemic's negative global impacts would wane as the year progressed. Instead, new virus variants emerged, supply chain disruptions became more frequent, across-the-board inflation became more prevalent and our personal lives continued to be affected. As the economy recovered, we saw strong market demand. Also, earlier in the year, severe winter weather in the Southeastern United States drove additional unexpected demand. Throughout another challenging year, the entire Watts global team worked tirelessly to meet customer demands despite all the adversities. I must thank everyone for their outstanding performance. The team remained close to our customers, dealt with many complex supply chain disruptions, enhanced our digital platforms to promote remote work collaboration and continued to drive a safety-first mindset. We diligently addressed inflationary pressures through market-leading pricing programs and with productivity initiatives. In addition, we expanded our product offering in leak detection systems and solutions with the purchase of Sentinel Hydrosolutions. We have advanced our efforts to further embed environmental, social and governance, or ESG, tenets into our culture. In 2021, our General Counsel also became the Chief Sustainability Officer and is providing quarterly updates on our ESG efforts to the Board. We performed a materiality assessment to help guide us in determining the ESG touch points most critical to our future success in our ESG journey. We participated in the Water Council's Water Stewardship Accelerator program, which allowed us to better understand how we affect water resources, both upstream and downstream, at eight of our worldwide facilities. We continue to encourage the expansion of our employee resource groups and now have six groups focusing on various constituencies within our company. Our partnership with Planet Water continues to be successful. This past year, we sponsored six additional water towers, providing clean drinking water to almost 11,000 people in five countries. Our three key macro themes are safety and regulation, energy efficiency and water conservation. These product themes embody the handprint of our ESG framework. We have many products that touch upon one or more of these themes, like the Powers IntelliStation, the OneFlow anti-scale system, our full line of condensing boilers and water heaters and our commercial rainwater harvesting systems. These products either keep people and property safe, promote energy efficiency, conserve natural resources or reduce greenhouse gas emissions. Several leading rating agencies have validated our efforts with improved 2021 ESG scores, and we've been recognized by Newsweek as one of the most responsible companies in America concerning our ESG initiatives for the third consecutive year. ESG is ingrained into our culture and product development more than ever. We'll continue to make strides as we move forward on this important journey. Now regarding our 2021 performance. The team's collective efforts delivered record full year sales, operating margin and earnings per share. Organically, sales increased by 17%; adjusted operating margin increased by 140 basis points; and adjusted EPS increased by 42%. We delivered record operating margin while still investing $19 million for the future, including incremental spending on our smart and connected product portfolio and while dealing with rapid cost inflation. Full year free cash flow came in slightly below our targeted goal of 100% of net income, mainly due to a proactive decision to maintain additional inventory levels to meet higher demand from our customers and to provide a partial buffer from logistics and supply chain disruption. We announced the closure of one of our French facilities to optimize our manufacturing footprint and provide incremental productivity. Finally, we strengthened our balance sheet by paying down debt during the year through operating cash flow and renegotiated our financing agreement, extending the debt through early 2026 at more favorable market rates. 2021 was a record year, driven by exceptional collaboration and teamwork across Watts, an intense level of customer focus and a consistently high level of execution. Next, let's review our 2022 priorities. In many respects, our key priorities remain consistent. Employee safety is our number one priority. We'll continue to monitor and adhere to CDC guidelines and other governmental mandates as we hopefully shift to a post-pandemic world this year. Customer focus remains a crucial cornerstone. Our commitment to new product development, especially in smart and connected products, will continue to be a focal point. Voice of customer feedback, as always, will be the cornerstone of our development process. We've received a lot of feedback even with COVID restrictions through our virtual launch and learn programs. We increased those virtual sessions by 70% in 2021 to over 18,000 and plan to continue double-digit growth in 2022. As a market leader, we expect to continue to drive revenue growth and to expand our operating margins through price and productivity, employing our One Watts performance system while still funding long-term investments. Let's talk briefly about how we see the market shaping up for 2022. From a macro perspective, GDP forecasts in all our major regions are expected to grow, albeit at levels below those seen in 2021. In the Americas, our market expectations for new construction in both the residential and commercial markets are mixed. After a banner 2021, new residential housing starts and permits are forecasted to be in the low single digits for 2022. In new nonresidential construction, we anticipate mid-single-digit growth in 2022. The latest industry indicators, including the ABI and Dodge Momentum Index, are portending growth. The AIA recently released its semiannual consensus construction outlook, which predicts overall nonresidential construction spend in the U.S. will increase low to mid-single digits. Repair and replacement activity was extremely strong in 2021, partly as a result of pent-up demand due to the impacts of the lockdowns in 2020. Overall, we expect repair and replacement will grow in the mid-single digits for the year with the first half slightly stronger than the second half as we anticipate tougher compares. In Europe, we are cautiously optimistic about the markets. In general, there are various government subsidies and economic packages that could help local economies. We expect government-sponsored energy subsidies to continue to provide support in Germany and Italy, and the marine market is starting to show signs of coming back. But certainly, growth will not be as robust as 2021. And like the Americas, we expect headwinds with labor constraints, material shortages and inflation. In Asia Pacific, regional GDP growth is expected to be more subdued. China's economy is forecast to grow at about 5% in 2022, a slowdown from 8% in 2021. The country will continue to be subject to potential COVID lockdowns and housing pressures from the Evergrande fallout. New Zealand and Australia should see economic growth, but again, at lower levels. Australia is expected to grow with continued help from government subsidies for new homebuyers. These areas are more susceptible to COVID lockdowns as we've seen this past year and something we'll need to monitor in 2022. On a positive note, the economy in the Middle East region is expected to grow incrementally in 2022. With respect to the impact of our outlook from COVID variants, we have assumed that the Omicron variant subsides in the first quarter of 2022 and that there are no significant impacts from any future variants to either our productivity or end market demands in 2022. Now I'd like to provide an update on our smart and connected product initiatives. Please turn to Slide 4. We want to continue to lead the industry in digitally connected product offerings. We invested $9 million incrementally in support of our smart and connected initiatives in 2021 with more than half of our total R&D spend linked to smart and connected products. We ended 2021 at roughly 16% of total sales, essentially flat from the prior year. This is partially explained by the mix of valve sales resulting from the winter freeze last year in the Southwest U.S. There was an immediate need for product replacement with most of that demand skewed toward traditional unconnected valves. In addition to the freeze, the entire global electronics market has been impacted by extreme levels of component shortages. With this, we had seen volatility in component pricing, extended lead times and earlier-than-planned component obsolescence. In response to these issues, we had to divert approximately 30% of our global electronics development team's efforts in the second half of 2021 to respond to these shortages by approving alternative components and reengineering and validating products for production to meet customer delivery needs. Without these embedded capabilities, our ability to respond immediately to customers would have been compromised. However, that effort hampered our ability to advance the smart and connected portfolio further in 2021. Our stated goal is to have 25% of our worldwide sales be smart and connected by 2023. We're still driving the team towards that 25% goal. However, given the softness created by supply chain, chip shortages and COVID issues, we may achieve 25% smart and connected sales by 2024. Let me now highlight two smart and connected product solutions. The recently launched tekmar Smart Boiler Control System consolidates several preexisting tekmar solutions into a new connected system for boilers. Retrofittable to existing boiler installations, the system helps reduce operating costs by improving boiler-to-boiler sequencing, outdoor temperature resets and indoor feedback. The remote experience is simple and intuitive, providing the building owner or operator with actionable insights to make their jobs easier. IntelliFlow is our proven system for prevention of home flooding due to washing machine leaks. This system not only shuts off water when a leak is detected, it also shuts water off when not in use to prevent over-pressurization of the washing machine. We've updated the IntelliFlow to provide text and e-mail alerts to the homeowner when a leak is detected. At the bottom of Slide 4, you'll notice some of the key metrics regarding our programs and the resources we've invested to-date around smart and connected products. The team remains fully focused and aligned toward the continued execution of our strategy. We remain excited about the future of smart and connected systems and we want to continue to lead the industry in connecting our products to the world. Before turning the call over to Shashank, I want to comment on the news that Munish Nanda, our President of Americas and Europe, has decided that it is time for him to retire. Munish informed me that he made this decision in order to have more time to focus on his family and other personal pursuits. Munish has been very generous in keeping the best interest of the company in mind and has agreed to continue in his current role until his successor is in place and then to remain employed by the company until May 2023 to assist with the transition and be a resource for his successor. I want to personally thank Munish for all his valuable contributions and for his willingness to make this transition as smooth and as seamless as possible. Now Shashank will review our results for the fourth quarter and full year and offer our outlook for Q1 and the full year 2022. Shashank?

Thank you, Bob, and good morning, everyone. Before beginning, I also want to thank Tim for his meaningful contributions to the company. He has been very helpful to me in understanding Watts' long history, what is top of mind with our investor base and how we address those concerns in a concise, timely and transparent manner. Tim has been a great sounding board for me and I've always appreciated his thoughtful input on a variety of subjects. Thank you, Tim, for your efforts and wish you a long and healthy retirement. I look forward to working with Diane in her new role and introducing her to our shareholders and analysts. Please now turn to Slide 5, which highlights our fourth quarter results. Reported sales of $474 million were up 18% year-over-year. Organic sales were up 18% as well with the impacts of acquisitions and foreign exchange movements mostly offsetting one another. Sales were stronger than we had anticipated with double-digit growth in all regions. I will review regional performance momentarily. Adjusted operating profit of $64 million, a 16% increase, translated into an adjusted operating margin of 13.4%, down 20 basis points versus last year. Benefits from volume, price and productivity savings were more than offset by inflation, incentives, cost normalization and incremental investments of $7 million. Adjusted earnings per share of $1.42 increased 23% versus last year. Earnings per share growth was driven primarily from operations up $0.22 and, to a lesser extent, by $0.05 from a combination of lower interest expense and a lower adjusted effective tax rate, partially offset by unfavorable foreign exchange movements. The adjusted effective tax rate in the quarter was 22.8%. The rate declined as compared to last year due to the benefits from higher R&D credits. For GAAP purposes, we took a $1.1 million charge for restructuring in the quarter, mostly related to Europe for the continuing rightsizing of the Mery, France facility that we initiated earlier in 2021 and the initial cost of an asset decommissioning in the Americas. We also took a $7 million tax charge for GAAP purposes related to our restructured Mexican supply chain operations. In summary, better-than-expected global top-line growth drove operating profit and earnings per share higher with margins moderating primarily due to cost normalization, incentives, investments and continued inflationary pressures. Moving to the regional results. Please turn to Slide 6. We saw strong growth in reported and organic sales in all regions during the quarter, prominently from the continued economic recovery and price. Foreign exchange was a headwind of 4% in Europe and a 2% tailwind in APMEA. Acquired sales in the Americas approximated $2 million during the quarter. In the Americas, sales of $380 million increased organically by approximately 19%. We saw growth in all major product categories, driven by strong repair and replacement market, new residential construction and price. Together, the TDG and Sentinel acquisitions and positive foreign exchange movements in the Canadian dollar added 1% to sales year-over-year. Price was also a tailwind. Americas adjusted operating profit for the quarter increased 13% to $52 million. Adjusted operating margin declined 110 basis points to 16.3% as expansion from volume, price and productivity was more than offset by inflation, incentives, incremental investments and business normalization costs. We made approximately $6 million of incremental investments versus the previous year in the Americas. Europe sales of $134 million were up 15% organically with continued growth in both the Fluid Solutions and Drains platforms. Revenues were up in all major regions with Germany and Italy continuing to benefit from government subsidies for energy-efficient heating products. Price was up mainly due to a large electronic demand. Scandinavia was also up from high distributed demand for end-of-year safety stocks of Drains solution products. Like the Americas, price was also positive for Europe during the quarter. Adjusted operating profit in Europe was approximately $21 million, a 25% improvement over last year. Adjusted operating margin of 15.7% increased 170 basis points, partly due to price, volume and productivity, including restructuring savings, which more than offset inflation, incentives, business normalization costs and investments. APMEA delivered sales of approximately $22 million, up 13% organically. We saw double-digit organic growth in most locations during the quarter. Adjusted operating profit of approximately $4 million was up 9% versus last year, with adjusted operating margin down 70 basis points as increased third-party volume, price, productivity and higher intercompany volume were more than offset by inflation, incentives, normalized costs and investments. On Slide 7, let me speak to the full year results. As Bob mentioned, we delivered record operating results for 2021. Reported sales were $1.8 billion, up 20%, primarily driven by a 17% organic increase attributable to the economic recovery and price. Foreign exchange and acquisitions had a positive effect on year-over-year sales of 2% and 1%, respectively. Adjusted operating margin increased 140 basis points to 14.3% in 2021. The margin expansion was driven by price, volume and productivity, which more than offset inflation, normalized cost, incentives and incremental investments. We funded approximately $19 million of incremental investments versus last year. Adjusted full year earnings per share of $5.52 increased $1.64 or 42% versus the prior year. Operating results drove approximately $1.28 of the increase. Lower interest costs and a lower adjusted effective tax rate accounted for $0.23 and favorable foreign currency translation and acquisitions approximated $0.13 for the year. Free cash flow for the full year was $159 million, a 15% reduction compared to last year, driven by a proactive decision to carry additional inventory to meet customer demand and to mitigate potential supply chain disruption. Free cash flow conversion was 96%. We invested approximately $27 million in capital spending, including investments in new product development, capacity expansion and factory productivity. Our 2021 reinvestment ratio was 85%. In 2021, we returned $50 million to shareholders in the form of dividends and share repurchases. We increased our annual dividend return by 13%. During 2021, we also paid down debt by $55 million using cash from operations. Our net debt to capitalization ratio at year-end is negative 9% as compared to negative 2% in the prior year. Our balance sheet continues to be in excellent shape and provides substantial flexibility to address our capital allocation priorities. So despite the many operating challenges, logistics and supply chain disruption, as well as significant inflationary pressures we faced in 2021, our team's ability to proactively drive growth, price, expand our margins and strengthen our balance sheet was notable. I commend the team for delivering these outstanding results. Now on Slide 8, let's discuss the general framework we considered in preparing our 2022 outlook. Firstly, let's look at expected headwinds. We continue to deal with supply chain disruptions. Presently, we believe the issue will persist throughout the year, but should incrementally improve as the year progresses. We think the second half will be less problematic than the first half of the year. Labor shortages will continue to be a major growth impediment. With the current Omicron variant, we do see more acute labor issues in the first quarter driving inefficiencies in our operations. We expect incremental investments and higher normalized costs, as well as inflation, to be a headwind in 2022. Also in the first half, we'll have a tough comp due to U.S. weather freeze last year. As Bob mentioned, we do anticipate a tough comp due to the strength of repair and replacement activity in 2021, coupled with ongoing material and labor shortages. Interest rates are expected to rise during the year as the Fed reacts to inflation. This could also reduce and/or delay funding for construction projects. Foreign exchange rates may fluctuate this year, given the dynamic interest rate environment. We currently anticipate FX translation to be a headwind in 2022. In the middle column are themes that we'll continue to monitor. We've been able to maintain a positive price and productivity over cost dynamic for most of 2021. However, across-the-board inflationary pressures in commodities, logistics, labor and services continue to persist and impact overall customer project costs. We'll also be monitoring the evolution of the pandemic as new variants, if any, could impact the economy, our customers, the supply chain and our operations. As Bob mentioned, we currently assume Omicron's impact should subside during the first quarter with minimal impact from it or other variants as the year progresses. Now looking at anticipated tailwinds. Global and regional GDP are expected to grow but at levels below 2021. We see new home construction up marginally in 2022 with moderate growth foreseen in new nonresidential spending and repair and replacement activity. We should have a positive carryover effect into 2022 of last year's price increase and this year's price increase. We expect to continue to expand revenue through our smart and connected product offering and other new product introductions. Europe will have incremental cost savings from the restructuring exercise begun in 2021. As discussed, our balance sheet is exceptionally strong coming into 2022. We have the flexibility to pursue inorganic growth opportunities to augment the business, assuming a transaction meets our strategic and financial criteria. With that backdrop, let's review our outlook for the full year 2022 and our expectations for the first quarter of 2022. On Slide 9, we have provided our major assumptions. Starting with the full year assumptions, consolidated organic revenue growth is estimated to range from 3% to 8% with regional growth as follows: Americas from 4% to 8%; Europe from 2% to 6%; and APMEA from 4% to 8%. Acquisitions add another $5 million of growth for the Americas and Watts consolidated. We expect consolidated adjusted operating margin for the full year to range from between 14.3% and 14.7%, with both the Americas and Europe flat to up 50 basis points compared to 2021 as price and productivity initiatives offset increased normalized costs, inflation and incremental investments. We anticipate APMEA's adjusted operating margin may decrease due to a reduction in affiliate sales volume. Consolidated margin expansion may range from 0 to 40 basis points. Important to note is that range includes approximately $20 million in incremental investments. As for the other 2022 key inputs, we expect corporate costs to be about $46 million for the year. Interest expense should approximate $6 million. Our adjusted effective tax rate for 2022 should approximate 25%. Capital spending is expected to be in the $45 million range. Depreciation and amortization should also be approximately $45 million for the year. We expect to deliver free cash flow conversion of 90% of net income in 2022 due to incremental CapEx and restructuring payments. We are assuming a 1.13 Euro-U.S. dollar foreign exchange rate for the full year 2022 versus the average rate of 1.18 in 2021. This would imply a 4% reduction year-over-year and equates to an impact of $23 million in sales and $0.08 a share in earnings per share. We expect our share count should approximate 34 million for the year. Finally, a few items to consider for Q1. Organically, we see sales up 5% to 10% with growth anticipated in all regions. Acquired sales in Americas should approximate $2 million in the first quarter. We expect first quarter operating margin to be in the range of 14% to 14.5% or flat to down 50 basis points versus the first quarter of 2021. This is due to the impact of a tougher comp as well as higher investments, normalized costs and labor inefficiencies in the first quarter of 2022 due to the impact of the Omicron variant. We expect incremental investments of approximately $5 million in Q1. We also expect incremental cost normalization of $5 million in the first quarter. Incremental restructuring savings of $0.5 million should be realized in Europe. The adjusted effective tax rate should approximate 21%. We anticipate foreign exchange to be a headwind in the first quarter. We are estimating a 1.13 euro-dollar exchange rate for Q1, which would be a 6% reduction versus the first quarter of 2020 average. This equates to an impact of $8 million in sales and $0.03 a share in earnings per share. With that, I'll turn the call back over to Bob to summarize our discussion before moving to Q&A. Bob?

Thanks, Shashank. Please turn to Slide 10 and let me summarize our discussion. The team delivered record results in 2021 while navigating many challenges throughout the year. We continued our ESG journey, embracing more of its concepts and educating our workforce to make it part of how we do business. Our smart and connected product portfolio and pipeline continue to grow. The original 2023 target remains our goal, but COVID and supply chain issues may delay those ambitions. Markets are expected to grow with growth moderating when compared to 2021 levels. In 2022, we expect moderate revenue and margin expansion, and we'll continue investing for the future. As always, we remain disciplined in our capital deployment, prioritizing reinvestment in acquisitions that strengthen our core, further expand our geographic reach and add technology to build scale. We'll be closely monitoring how future virus variants materialize and how they may impact customer sentiment in the construction markets. I want to again thank the entire team for delivering an exceptionally strong year in 2021. I'm very confident our experienced team will continue to work through the many virus-related supply chain and labor issues and execute again in 2022, while still focusing on our long-term growth strategy. With that, operator, please open the lines for questions.

Operator instructions. We will take our first question from Nathan Jones with Stifel. Please go ahead.

Yes, good morning. This is Adam Farley on for Nathan. In your presentation, you called out price as being a favorable tailwind in your 2022 planning framework. Could you give a little more granular detail on what you expect price versus cost to be in 2022? Do you expect it to be price-cost neutral or positive?

Yes. So just to — going back to 2021, overall price was, on average, about 5% price realization and price and productivity more than offset cost inflation. And in 2022, we see the same dynamic where price and productivity will more than offset cost inflation. Clearly, there's a carryover from the price increases we did in '21. And then we have price increases in the first quarter of 2022. So with that dynamic, again, price and productivity will exceed inflation.

Okay. Thanks for that. And then shifting over to the supply chain more broadly. Is having your own foundries reducing the impact to Watts versus your competitors? Do you think this is resulting in any share gains? And do you think these share gains will likely be permanent or transitory? Thanks.

Well, the way we look at it, our foundry and our overall strategy of manufacturing where we sell our products is, I believe, a strong strategy, and that has benefited us greatly in 2021 because we've been able to control our own destiny. So we believe it's a competitive advantage, and our goal is to keep all the share we've gained this year and then gain some more. So that's our focus and that's our team's efforts on that.

Thanks for taking my questions.

Our next question will come from Jeffrey Hammond with KeyBanc Capital. Please go ahead.

Hey, good morning. This is David Tarantino on for Jeff. Just starting out, given all the puts and takes we've seen with supply chain broadly, could you give us some color on what you're seeing get better or worse in terms of input availability and pricing in Q4?

Listen, I would say, in general, we saw some of our supply chain get better, but it's like whack-a-mole, right? Some things get better and some things get worse. I think the Omicron variant, which happened late in the fourth quarter and carried over into the first quarter, really impacted not only us but our suppliers' labor force. And some of the shutdowns in China obviously impacted our China facility. So in general, I think things are starting to get better, but Omicron was an issue that caused more problems, and our teams are working hard. As we said in our prepared remarks, we believe it's going to continuously get better. But like I said, one step forward, two steps back, and we keep on going. So the team is holding their own, but we still think it's going to be difficult, especially in the first quarter. And as we go into the latter part of the year, we believe it will get better.

And then just as a follow-up to clear up on price. Was the 5% what was realized in Q4? And also, what do you expect price contribution to the 2022 sales guidance to be?

Yes, that 5% number was for the full year 2021. Obviously, we announced almost three increases globally. So the price realization ramped up as we went through the year. Some of that is a tailwind into 2022, along with the first quarter of 2022 price increases. At this point, it's hard to estimate what the price realization will be for 2022. We'll be reporting on it when we do the next earnings call as we get to the realization of Q1 price increases.

Great. Thank you.

Our next question will come from Ryan Connors with Boenning and Scattergood. Please go ahead.

Great. Thanks for taking my question. And congratulations to Tim and Munish, both been very helpful to us over the years. I wanted to talk about price from a different angle. It's amazing how things have evolved in the last year. Now we're obviously at the hinge point where the Fed is going to be raising rates and their goal, I guess, is to tamp down inflation. So theoretically, by the end of the year, some of the raw material cost challenges will start to cool off. What are your thoughts on the ability and strategy around trying to hold price, looking past the next quarter or two out into the tail end of '22 into '23? Any thoughts on that side of things?

Ryan, when you look at the inflationary economy right now, I don't think it's going to abate anytime soon. We'll have to watch that. The more commoditized you are, the more susceptible you're going to be towards potential future margin pressures. We pruned a lot of commoditized products several years ago and are spending a lot of time and effort to focus on value provided to our customers with our smart and connected products. Wage inflation is not going to go away. Costs like insurance are not going to go away. Whether raw materials move, that will be an area we'll focus on, but we're going to continue to build products that differentiate and add value, and we're going to keep as much price as we can. The more commoditized you are, the more difficult it will be to keep price.

Got it. Okay. That's clear and helpful. The other one I wanted to chat about was the channel inventory situation and where you think that stands. Obviously, when you've got so many different pricing actions going out, presumably your channel partners are trying to navigate around that to their own benefit. Where does that stand? And is there any volatility we can expect related to that the next few quarters?

We watch that very closely. We don't have full visibility. Interestingly, channels, including contractors, are starting to store inventory where they haven't in the past. We're seeing general increases as people try to get in front of price increases, but repair and replacement volume has been robust and is driving demand for inventory. We're a book-and-ship business, and that's why we're careful as we watch, especially into the second half of this year. If the supply chain gets better and lead times come down, the tendency will be for the channels to reduce inventory. So we watch that very closely.

Okay, great. Thanks for your time this morning.

And our next question will come from Walt Liptak from Seaport Research. Please go ahead.

Hi, thanks. Good morning everyone. And Tim, it's been great working with you, too. So good luck with everything in the future.

Thanks, Walt.

I wanted to ask a follow-on to that last question about the channel. Could you talk about the timing of the 2022 price increases and if you think there's maybe a fourth quarter pre-buy ahead of that price increase?

Our price increases varied through the first quarter based on our notice and timing. Did a bunch of orders come in to beat the price increase? Yes. Some of them we shipped in the fourth quarter. It's difficult to gauge exactly, but we saw more stocking in Europe, particularly in the Drains business, where wholesalers stocked up. Maybe one or two points of impact, but it's hard to quantify precisely.

You commented that the first quarter is going to be impacted by some Omicron-related absenteeism and supply chain issues more so than the rest of the year. That seems to be peaking and coming back. Can you give any insight into are things getting better now or do we have to wait until Q2 for pandemic-related issues to start dissipating?

We saw a peak in January with absenteeism being the highest. In the last couple of weeks we've seen that trend down. It's still higher than normal absenteeism, but about half the rate it was in January, which is much better. Teams are working hard and we're taking safety protocols seriously. We're working overtime to make up for what we missed in the first month of the year.

And maybe a last one. You mentioned government programs benefiting you in Europe last year. Are some of those programs still in place? And similarly, you mentioned there will be more restructuring savings. Does that accelerate from last year or is it about the same?

I'll turn the productivity and details over to Shashank to answer on the Mery, France restructuring and the government programs.

On the productivity side, the facility in Mery, France will complete the restructuring this year. There will be incremental savings, roughly an additional $2 million that we'll get in 2022. Regarding the government incentive programs in Germany and Italy that we benefited from in 2021, those programs will continue into 2022, but the subsidies are at a lower rate. Those subsidies will continue, however at lower levels.

Okay, great. Thank you.

And our next question will come from Brian Lee with Goldman Sachs. Please go ahead.

Hi, everyone. This is Miguel on for Brian. I think most of my questions have been answered, but I just wanted to touch back on the supply chain real quick. We're hearing more and more about electronic shortages, especially chips. Could you just level set us on your supply of electronic components? Is there a certain kind of chip or component that's become more constrained recently? Or in general, are you seeing more constraints on specific components? And then also, is there a region that might be most impacted by those shortages either because of a higher mix of smart and connected sales? Thanks.

In general, we are seeing chip shortages. It's beneficial to have an internal electronics team who monitors obsolescence and availability. We evaluate what we can reengineer and requalify from a customer standpoint, moving to alternative chips as needed. It's global, but the Americas is most impacted since we have the highest mix of smart and connected products there, and Europe is second. We get daily and weekly reports on where shortages are and what we're doing to correct them. The team is doing a great job mitigating these issues.

Great, thank you very much. I'll pass it on.

Our next question will come from Michael Anasagio with Cowen. Please go ahead.

Hey, good morning, guys. How you doing? I'm sorry, I joined late here. Previously, you mentioned there was a 25% target for the connected products for 2023 and it looks like we might be pushing out to 2024. Can you provide any color if this is more due to chip shortages or other COVID headwinds?

As I mentioned in my prepared remarks, the team's goal is still to get to 25% by 2023. But given the chip shortages and other supply chain issues, we've been shifting internal resources to upgrade chips for current products and to reengineer solutions, which has diverted about 30% of key engineering resources in the second half of the year. That work allowed us to continue shipping existing products but may delay the 25% goal. Internally we're still targeting 25%, but it depends on how fast chip shortages and broader supply chain constraints resolve.

Great. Thanks for the color. And just a follow-up. Can you provide a little more framework around your procurement strategy for these inputs?

We have two electronics operations: one in Canada, one in France, and a low-cost manufacturing presence in Tunisia. That gives us more scale than many traditional companies in our space. We monitor supply closely, maintain long-term agreements where appropriate, and proactively address obsolescence by upgrading to current chips that are more available. The team is actively working on these issues.

Great. Thank you for the color.

Our next question will come from Mike Halloran with Baird. Please go ahead.

Good morning, everyone. Congrats, Tim, on your retirement, Munish as well, and congrats, Diane, on the new responsibilities. Two questions. First, from a competitive standpoint, with the supply chain shortages, how do you think you're faring relative to peers? Are you seeing share shifts across product lines? How much is your scale and broader manufacturing base helping right now?

Our product lines are broad and competitive, but our results speak for themselves—strong growth in the quarter and year. We've been doing a good job getting product to customers, and as a result, I believe we've gained share. Our manufacturing strategy of producing products regionally to serve local customers is an advantage for us right now.

I know you touched on this, but could you share the seasonal cadence you're assuming for revenue and margins in your guidance? How does that compare to a typical seasonal curve?

Historically, pre-pandemic, Q2 and Q3 were typically higher than Q1 and Q4 because of new construction in spring and summer. Post-pandemic, seasonality depends on activity by quarter and on prior year comps. We grew significantly over the last nine months of 2021, and Q1 last year was easier to compare. Pricing impacts have altered some seasonality. Q1 this year benefits from easier comps and pricing carryover. As we go into the out quarters, we'd expect a more normal seasonal pattern, assuming no greater supply chain disruptions or new variants.

Historically, seasonality had second and third quarters a bit higher because of new construction. Post-pandemic, the pattern depends on quarter-to-quarter activity and prior year comparisons. Q1 will reflect the points Bob mentioned, and as we progress through the year it should normalize seasonally provided supply chain and variant risks do not re-emerge.

Thank you. That makes a lot of sense. Appreciated.

We do have a follow-up from Nathan Jones with Stifel. Please go ahead.

Good morning, everyone. Following up on reopening, do you think the repair and replace activity driven by reopening has passed through now, or is there continuing benefit in 2022?

Given project delays from labor shortages and supply chain constraints, not all deferred work has come through yet. We expect much of that activity to come through in the first and second quarters as supply chain stabilizes and job sites reopen. After that, we anticipate a return to more normal growth patterns.

A question on interest rates: new construction could slow if the Fed raises rates. Have you modeled potential impacts for 2022 and beyond, or do you expect minimal impact this year?

It depends on inflation as well. Even if rates rise, they're still historically low. If inflation moderates, that could balance some of the rate impact. Higher rates generally impact single-family housing more than commercial. It's something we are monitoring, but we haven't assumed a material negative impact in 2022 in our base case.

One last question: you mentioned incremental growth investments of about $20 million in 2022. What kind of ROI are you seeing from these investments currently and what do you expect long-term ROI to be?

Our portfolio is moving toward smart and connected products, which we expect to drive higher value and margins long term. We've continued to improve our ROIC year-over-year, and it has increased significantly. We evaluate every project for return, and the intent of these investments is to create differentiated products that allow better pricing and margin performance. You can monitor our overall ROIC to see how these investments are translating to returns.

Great. Thanks for taking my questions and congrats to Tim.

Thank you.

That will conclude our question-and-answer session for today. I would like to turn the call back to Bob Pagano for any closing remarks.

In closing, thank you again for taking the time to join us today for our fourth quarter earnings call. We appreciate your continued interest in Watts and look forward to speaking with you during our first quarter earnings call in May. Have a great day, and stay safe.

This will conclude today’s conference. Thank you for your participation and you may now disconnect.