Watts Water Technologies Inc Q1 FY2022 Earnings Call

Ladies and gentlemen, thank you for standing by. My name is Brent, and I will be your conference operator today. At this time, I'd like to welcome everyone to the Watts Water Technologies First Quarter 2022 Earnings Conference Call. All lines have been placed on mute to prevent any background noise, and after the speakers' remarks, there’ll be a question-and-answer session. Thank you. It is now my pleasure to turn today's call over to Diane McClintock, Senior Vice President of Investor Relations. Please go ahead.

Thank you and good morning, everyone. Welcome to our first quarter earnings conference call. Joining me today are Bob Pagano, President and CEO; and Shashank Patel, our CFO. During today's call, Bob will provide an overview of the first quarter and discuss the current state of the markets and our operations. Shashank will discuss the details of our first quarter performance and provide our outlook for the second quarter and for the full year. 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 this presentation. Before we begin, 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, see what's publicly available in 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. With that, I will now turn the call over to Bob.

Thank you, Diane, and good morning, everyone. As many of you know, Tim MacPhee retired last month, and Diane McClintock has assumed his responsibilities within Investor Relations. Diane has been with Watts for over 10 years, has been an integral part of our finance team and a key contributor to earnings and investor communications. We are confident the transition will be seamless. Please turn to slide three, and I'll provide an overview of the quarter. We have a strong start to the year, with our first quarter results better-than-expected with record operating margins. I want to thank the entire team for their contributions as they manage through supply chain disruptions, labor shortages and unprecedented inflation. Demand remained strong, and our Americas teams delivered double-digit growth despite the difficult prior year comparisons due to the freeze in the South Central U.S. in the first half of last year. The underlying markets in Europe held up during the quarter despite the impact of the war in Ukraine. In APMEA, lockdowns impacted several of our key markets, including New Zealand and China. However, the teams still delivered double-digit top line growth in the quarter. Adjusted operating margin exceeded expectations, supported by price, volume and productivity, which more than offset inflation, incremental investments and cost normalization. As a result of our strong earnings and expected cash flows, we announced a 15% dividend increase starting in June. Our balance sheet remained strong. We have ample capacity, which affords us flexibility in our capital allocation strategy. Operationally, commodity costs increases, especially in copper, steel and energy, together with increases in logistic costs, have driven us to announce additional price increases globally. Those will go into effect during the second quarter, and we should start to see the benefit of those price increases at the end of the second quarter. Our supply chain and sourcing teams have worked diligently to facilitate component availability and to manage cost increases. We have proactively built higher inventory levels, which enabled us to better meet customer demand. During the quarter, we continued to invest for the future. We incrementally spent approximately $4 million, of which over half was invested in our smart and connected initiatives. We plan to spend an incremental $20 million during 2022 to support additional growth, smart and connected products, and automation projects. Now, I'd like to provide an update on our end markets. For now, the North America repair and replacement market is holding up well. Through the first quarter, new residential single-family construction has been up low single digits, and multifamily residential starts have continued to grow with strong demand. In new non-residential construction, the industry indicators, including the ABI and Dodge Momentum Index, have been positive for several months. This would suggest improvement in commercial new constructions starting in late 2022, as the ABI is an indicator of future new construction starts. However, we are monitoring the impact of rising interest rates, inflation, and material and labor shortages on the new construction markets. In Europe, the war has triggered both a reduction in GDP forecast and higher inflation driven by rising energy costs. We have stopped our direct shipments to Russia, the impact of which we estimate to be approximately $10 million for the rest of 2022. As a result of all these factors and our best estimate of indirect shipments to Russia, we anticipate that the second half of 2022 could be slower than we previously thought. Government-sponsored home energy subsidies in Germany and Italy should continue to provide support at least in the near-term. However, the impact of the war in Ukraine and reduced GDP expectations could be a headwind. In the Asia-Pacific region, our China markets were resilient in the first quarter. However, we anticipate the lockdowns in various cities in China could have an unfavorable impact in the second quarter, particularly on the heating business. On a positive note, the Middle East is recovering nicely, with a higher price of oil fueling construction spending in the region. Now an update on our outlook for the second quarter and the remainder of the year. We expect a solid year-over-year performance in the second quarter, despite the headwinds from the freeze in 2021. Price and productivity should more than offset the impact of the war in Ukraine, inflation, and incremental investments. Due to our anticipated strong first half, we are increasing our full-year outlook for operating margin expansion. Our full-year organic sales growth outlook is consistent with our guidance in February. The strong first quarter performance and additional price increases should be able to offset headwinds in the second half, particularly around the war in Ukraine and its potential impact on the economy in Europe. Before turning the call over to Shashank, I want to mention we will be issuing our Annual Sustainability Report this summer. The enhanced report will discuss our latest accomplishments and some important ESG initiatives. So, stay tuned. With that, let me turn the call over to Shashank who will address our first quarter results and our second quarter and revised full-year outlook.

Thanks, Bob, and good morning, everyone. Please turn to slide four, and I will review the first quarter's consolidated results. Sales of $463 million were up 12% on a reported basis and up 14% organically. We saw strong demand in all regions and were able to drive solid price realization. We saw double-digit growth despite the tough first quarter 2021 comps that included a 3% benefit from the freeze in the South Central United States. Foreign exchange primarily driven by a weaker euro, reduced year-over-year sales by roughly $10 million or 2%. Acquisitions accounted for $2 million of incremental sales year-over-year. Adjusted operating profit was $73 million, up 21% compared to last year, and adjusted EPS was up 31% to $1.63. Adjusted operating margin of 15.7% was up 120 basis points as volume, price, and productivity more than offset inflation and incremental investments. The adjusted effective tax rate was 22%, 590 basis points lower than the first quarter of 2021. The decrease relates primarily to a higher tax benefit resulting from the vesting of stock compensation awards, geographical earnings mix resulting from the restructuring of our Mexican manufacturing supply chain operations, and the favorable impact of tax contingencies. Our free cash for the quarter was negative $8 million as compared to positive cash flow of $32 million in the first quarter of last year. The cash flow decrease was due to our proactive decision to invest in inventory, higher employee and customer incentives, restructuring payments, and higher capital spend, which more than offset higher net income. We expect sequential improvement in our free cash flow, and our full-year goal is to drive free cash flow conversion at 90% or more of net income as previously communicated. During the quarter, we repurchased approximately 293,000 shares of our common stock for $43 million. And as Bob mentioned, announced a double-digit increase in our dividend. Please turn to slide five, and let me provide a few comments on the regional results. The Americas had a strong quarter, with organic sales up approximately 14%, despite a volume headwind of approximately 4% resulting from the freeze impact in the South Central region of the U.S. in the first quarter of 2021. The net growth was primarily driven by strong price execution. We saw growth in all platforms and all channels, except for DIY, which had a tough compare due to the freeze. Acquisitions added approximately $2 million or 1% to reported sales. Adjusted operating profit increased by 20%, and adjusted operating margin increased by 70 basis points. The margin expansion was driven by price and productivity, which more than offset inflation, incremental investments, and the return of normalized business costs. Europe also delivered a strong quarter, with organic sales up approximately 14%. Reported sales growth was impacted by 8% due to unfavorable foreign exchange movements. From a platform perspective, plumbing, HVAC, electronics, and drains were all up double-digits. We saw strong growth in Germany and Italy driven by our OEM business and government heating subsidies. Scandinavia also saw strong growth as the marine market showed some recovery and food and beverage end markets continued to be robust. The impact from the war in Ukraine in the first quarter was not significant. Operating margins expanded 120 basis points from price, volume, and productivity more than offsetting inflation. APMEA also had a strong quarter, delivering 13% organic growth. Reported sales growth was impacted by 3% due to unfavorable foreign exchange movements. China's organic sales grew high single digits from commercial valves and underfloor heating. Organic sales outside China were up by double-digits, with growth in Australia, New Zealand, and the Middle East. Adjusted operating margins increased 30 basis points due to higher third-party sales, volume price, and productivity, which more than offset the reduction in affiliate volume, inflation, and investments. China intercompany volume was down 13% due primarily to a tough compare from the U.S. freeze demand in the first quarter of 2021. Slide six provides our assumptions about our second quarter and full year operating outlook. First, let's cover the second quarter outlook. We expect a solid year-over-year comparison despite the headwinds related to the freeze benefit in the second quarter of 2021 in the U.S. As Bob mentioned, we have announced an additional price increase globally to offset incremental commodity and supply chain inflation. These are scheduled to become effective later in the second quarter, and so will have a minimal impact on results. In total, we estimate consolidated sales may grow organically between 5% and 10%. In addition, we expect approximately $2 million of sales from prior acquisitions. We estimate our adjusted operating margin could range from 15.1% to 15.5% for the second quarter, driven by price and productivity and offset partially by incremental investment spending of $5 million and incremental costs of $3 million related to the return of normalized business costs. All-in, we estimate the incremental volume drop-through between 25% and 30%. Corporate costs should approximate $13 million. We expect that interest expense should be approximately $2 million in the second quarter of 2022, an increase versus the first quarter due to an increase in outstanding debt and rising interest rates. The adjusted effective tax rate should be approximately 26%. We are now assuming a 1.10 average euro/US dollar FX rate for the second quarter versus the average rate of 1.20 in the second quarter of 2021 and versus the euro 1.13 we provided with our guidance in February. This implies a reduction of 8% year-over-year in the second quarter, which equates to a reduction of $13 million in sales and $0.05 a share in EPS versus prior year, and a $3 million reduction in sales and $0.01 a share in EPS versus our previous guidance. Now let's cover the full year outlook. For the full year 2022, we are maintaining our prior outlook of 3% to 8% consolidated organic growth. We believe that our stronger-than-expected start in the first quarter and the incremental price increases will be able to offset expected weakness in Europe in the second half due to the war in Ukraine. While we are maintaining our organic sales growth outlook, we are increasing our full year adjusted operating margin expansion to a range of 20 to 60 basis points compared to our previous outlook of flat to 40 basis points. We now expect our operating margins to be between 14.5% and 14.9%. We expect the increase in inflation will be more than offset by price and productivity. Our free cash flow expectations are anticipated to be in line with our previous outlook in February and should approximate 90% of net income. As a reminder, we expect incremental CapEx and restructuring payments in 2022. We are now assuming a 1.10 average euro/US dollar FX rate for the full year versus the average rate of 1.18 in 2021 and versus the euro 1.13 we provided with our guidance in February. This would imply a reduction of 7% in sales year-over-year, and equates to a reduction of $39 million in sales and $0.14 a share in EPS for the full year versus prior year, and a reduction of $13 million in sales and $0.05 a share in EPS versus our previous guidance. And regarding other key inputs for the full year, we expect corporate costs could approximate $48 million for the year. Interest expense should be roughly $7 million for the year. Our estimated adjusted effective tax rate for 2022 should be approximately 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 our share count to be approximately 34 million for the year. Now, let me turn the call back over to Bob before we begin Q&A.

Thanks, Shashank. On slide seven, I'd like to summarize our discussion before we address your questions. The first quarter was stronger than we anticipated, with double-digit organic growth in all regions that was supported by price and stronger underlying demand. Inflation continues to accelerate, and we've announced additional price increases to offset cost increases. We are working hard to stay on top of the price/cost dynamic and monitor the situation daily. Strong North America repair and replacement demand in both residential and non-residential should support a good first half. As a result, we expect a solid second quarter with strong demand and favorable prices. We are increasing our full year operating margin expansion outlook, and are maintaining our full year organic growth expectations with our strong start and incremental price increases able to offset second half headwinds from the war in Ukraine. We plan to continue to make incremental investments in new product development to drive our smart and connected strategy and in automation to drive productivity. We are well-positioned financially, operationally, and commercially to take advantage of market opportunities as they arise. And I'm confident in our team's ability to execute in this uncertain environment. With that operator, please open the lines for questions.

Your first question from Jake Jarnigo with Baird. Your line is open.

Good morning, everyone. This is Jake Jarnigo filling in for Mike Halloran. First question will focus on Europe. I’m not suggesting that expectations are being lowered, but I have a two-part question. Are you noticing any signs of weakness materializing there? Additionally, while we have viewed this business as correlating with GDP, do you have any specifics on how this might impact demand for your products? Are you primarily concerned about possible weakness in the non-discretionary segment?

Good morning, Jake. Currently, the main change we're observing is the absence of orders and shipments to Russia, which we've exited. At this moment, we're cautiously optimistic, but our teams on the ground are indicating that things are starting to slow. Therefore, we are exercising caution. The situation largely depends on the developments of the war and potential actions, such as Russia shutting off gas, which could have significant repercussions. We are remaining cautious until we gain clearer insight into the situation in Russia. It's still early.

Yeah. Totally understand. And then, somewhat related to that. Looking at the implied guidance here, it looks like in the back half of the year, margins are expected to sequentially decline relative to the first half. Is this primarily isolated to Europe? I think typically, Americas, as we see margins expand in the back half of the year, just making sure that that logic thinks with how you guys are thinking about it.

Yes. That's likely due to the fact that in the first half, we experience some increased volume leverage that diminishes a bit in the second half. Additionally, we face more investment spending and higher normalized costs in the second half compared to the first half. That's the reason for the margin profile you mentioned.

Got it. All right. Great. I'll jump back in the queue for now.

Thank you.

Your next question is from the line of Nathan Jones with Stifel. Your line is open.

Yeah. Good morning. This is Adam Farley on for Nathan. Following up on the revenue guide, understand the potential impacts from the war in Ukraine on European growth. Are you expecting any slowdown in APAC, given COVID lockdowns in China?

We are closely monitoring the situation. The lockdowns in China have certainly created some uncertainty. Our team in Shanghai has been confined to their homes for five weeks, which will particularly affect our heating business since construction is halted in that region. We are watching this closely as it represents one of the significant uncertainties we face, and we are approaching our outlook for China with caution.

Okay. And then, Watts is much larger and more sophisticated than the majority of its competitors. Do you believe that you have better product availability that's leading to some market share gains in this environment, and which products and markets do you think that's occurring in?

Well, certainly, we've invested a lot of money into inventory to make sure we have available products. We have a vertically integrated strategy, as you know, where we manufacture and where we sell, both in North America and Europe. So, we believe that in this environment with the uncertainty and spikes in demand has certainly helped. So, I think we're certainly holding our own and in various places taking market share. So, we don't believe we're losing any market share, for sure.

Thanks for taking my questions.

Thank you.

Your next question is from the line of Joe Giordano with Cowan. Your line is open.

Good morning. This is Michael in for Joe.

Good morning, Michael.

Good morning.

Yeah. As we look towards the housing market, specifically multifamily, how should we be thinking about that going forward? What's your outlook there?

Multifamily has been very positive. And we like multifamily homes because they're more code-driven and have more larger products than single-family homes. So, although we might be peaking in the single-family home market, that being more than offset by multifamily, so watching that closely, but we're very cautiously optimistic in that market.

Great. Thank you.

Your next question comes from the line of Jeff Hammond with KeyBanc Capital Markets. Your line is open.

Hey, guys. It's Jeff live and in person.

Hey, Jeff. How are you?

Hey, Jeff.

Good. Good. Just wanted to get a better sense of what price was in the quarter. It looks like it was most of North America growth. And just kind of what you've been seeing or what you've been putting out in terms of follow-on pricing.

In the first quarter, our growth was approximately 10% from price realization, with a slightly higher percentage in the Americas and a bit lower in APMEA, while Europe was in between. As we move forward, we expect the comparisons to become more challenging in the second half of this year due to price increases announced throughout 2021. We typically wait until the end of the quarter to provide future forecasts because while we can announce prices, realizing them is another matter. The teams have performed well so far, but in Q1, the realization was around 10%.

Okay. Great. I noticed that you increased your buyback during the quarter. Is this a result of being opportunistic since the stock has declined, or does it reflect what you are or aren’t seeing in the M&A pipeline?

Sure, I'll address that. I'll let Bob discuss the mergers and acquisitions. Regarding the stock purchases, it was indeed an opportunistic buyback. Historically, we have mentioned that our stock buybacks are primarily aimed at offsetting dilution from issuing equity. However, if there’s a favorable opportunity in the market, as we found in the first quarter, we took action and repurchased stock in Q1.

And Jeff, on the M&A front, look, as you know, we're very disciplined from that regard. So, we're watching. We have a solid pipeline. But we're going to be disciplined. So, we've not done any major acquisitions. We've done some small bolt-ons. And right now, we felt that was the best allocation of cash in the quarter.

Okay. Great. And then, seems like commercial HVAC, or I'm sorry, commercial construction in North America still seems quite robust. And I think most people are saying, 'Hey, we're still building backlog.' And we're kind of being held back more by labor. But just give us a sense of what you're seeing in the commercial landscape.

We agree with that. We're experiencing similar trends. We saw growth across all segments except for retail, which we anticipated due to the impact of the freeze. In commercial construction, there's a significant backlog of projects, and spending is ongoing. Leading indicators suggest potential for further expansion. However, as you mentioned, the labor shortage is a current constraint. Our conversations with contractors reveal that while there is plenty of work available, they require more labor, and material shortages are causing project delays and cost overruns.

Okay. And then, just last one. Maybe just talk about inventory in the channel. I think you've said maybe over the past couple quarters, inventory's gotten better for your product, but there's still maybe competitive or other items that are light.

I would say the situation is similar. We're noticing that inventory is increasing in the channels, but it's inconsistent. Wholesalers, in particular, may not have all the inventory they require from all suppliers to assist builders in completing their jobs. However, we believe we are providing them with the products they need when they need them. We maintain a solid backlog in that regard and have clear visibility into their needs. We will continue to monitor this situation closely.

Okay. Thanks so much, guys.

Thanks, Jeff.

Your next question comes from Brian Lee with Goldman Sachs. Your line is open.

Hi team, thank you for taking the question. This is Grace standing in for Brian. My first question is about margins, following up on previous inquiries. Your suggested margin for the full year indicates that the second half will be lower. Should we anticipate Q3 to be the lowest point of the year, with a recovery in Q4, or do you predict Q4 to be the lowest? Additionally, can you discuss margins by segments? Last quarter, you mentioned that margins in America and Europe would be flat to up, while APMEA would see a decline. Do you still expect those trends, considering the Russia/Ukraine conflict and potential lockdowns in APMEA? Thank you.

Yes. Regarding your first question, currently the second half is expected to have lower margins for the reasons I mentioned. Looking at Q3 and Q4, we will provide an update as we approach the end of the second quarter and assess the third quarter. I would estimate that the margin decline is fairly equal between Q3 and Q4 at this moment, but we will reevaluate. As for the margin profile by region, as Bob pointed out, the impact of the Ukraine war is felt more strongly in Europe. With the decrease in volume and our fixed cost structure, the margin decline will be more significant in Europe, slightly less in APMEA, and in North America, given the strength in the markets, particularly in commercial and multifamily, we should see good margin growth there.

Okay. Understood. And the margin decline in Europe, are you talking about like sequential declines or year-over-year decline? Thanks.

Well, it'd be first half, second half, right? That's what we're talking about. So, it'll be from first half to second half.

Okay. Got it. And then, one last question for me. And then on revenue growth, I think last quarter you talked about, like the organic growth by segments. Just given the Russia/Ukraine conflict and the lockdowns in Asia, can you give us an updated view on organic growth by segments? Thanks.

We received the Q1 numbers and the guidance for the second quarter. Your question seems to focus on the second half. For that period, we anticipate the effects of the Ukraine war to be significant, particularly in Europe. We project low to mid single-digit growth in the Americas, while Europe may see a mid to high single-digit decline. In APMEA, we expect growth to remain relatively flat in the second half.

Thank you. I will pass it on.

Thanks.

There are no further questions at this time. I will now turn the call back over to Mr. Bob Pagano.

Thank you for taking the time to join us today. We appreciate your continued interest in Watts. And look forward to speaking with you again in our second quarter earnings call in early August. Have a good day and stay safe.

Ladies and gentlemen, thank you for your participation. This concludes today's conference call. You may now disconnect.