Earnings Call Transcript - WTS Q1 2025

Operator, Operator

Hello, and thank you for joining us. I would like to welcome you to the Watts Water Technologies First Quarter 2025 Earnings Call. All lines are muted to minimize background noise. Following the presentations, we will have a question-and-answer session. I will now hand it over to Diane McClintock, Senior Vice President of Investor Relations. Please proceed.

Diane McClintock, Senior Vice President of Investor Relations

Thank you, and good morning, everyone. Welcome to our first quarter 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, an operational update and an update on our outlook for 2025. 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 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, see Watts' publicly available filings with the SEC. The company undertakes no obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. With that, I'll turn the call over to Bob.

Bob Pagano, President and CEO

Thank you, Diane, and good morning, everyone. Please turn to Slide 3, and I'll provide an overview of the first quarter. We began 2025 with better-than-expected first quarter results, including record adjusted operating income, adjusted operating margin and adjusted earnings per share. I'd like to thank the entire Watts team for their significant contributions during the quarter. Organic sales declined 2% in the quarter due to fewer shipping days, which we noted on our last earnings call and continuing weakness in Europe. We benefited from incremental sales from our I-CON acquisition. However, the benefit was more than offset by unfavorable foreign exchange. Adjusted operating margin of 19% exceeded expectations due to better-than-expected volume, productivity and cost controls. As a result of our solid start to 2025 and expected cash flows for the remainder of the year, we announced a 21% dividend increase beginning in June. Our balance sheet remains strong and provides ample capacity to support flexibility in our capital allocation strategy. From an operations perspective, we are proactively working to mitigate the impact of tariffs. We expect that our vertical integration strategy with the manufacturing close to our customers here in the U.S. will benefit us. We have a proven track record of successfully navigating inflation and supply chain challenges and are confident in our ability to execute through the current environment. I'll talk more about tariffs in a minute. We continue to drive productivity savings through automation, lean initiatives, both inside and outside the factory walls, leveraging our One Watts performance system and selective restructuring actions, including the previously announced exit from a manufacturing facility in France. The exit is progressing as expected and will be complete by year-end. We're pleased with the progress of the integration efforts with our recent I-CON acquisition, and our teams are working together to capitalize on synergies. We expect I-CON to be accretive to adjusted EBITDA margins and adjusted EPS in 2025. Now an update on our outlook for the remainder of the year. Despite the uncertainty around the trade environment and resulting demand impacts, we are maintaining our full year organic sales and adjusted operating margin outlook. We anticipate that price increases, our global sourcing actions and accelerated onshoring of production should offset incremental tariff costs and any potential demand reduction in the second half of 2025. There are a few positives to note. Our solid first quarter and outlook for the second quarter are supportive of our full year outlook. Mega project activity, including data centers remains strong. We also expect to see a benefit from foreign exchange movements relative to the outlook we provided in February. Recently, global GDP forecasts have been revised downward, including a first quarter contraction in the U.S. Given the uncertain impact of tariffs on inflation, we expect interest rates to remain higher for longer. This may unfavorably impact residential and non-residential new construction in the second half of the year. We expect continued weakness in Europe due to a slowdown in new construction amid continued economic weakness. We saw ongoing heat pump destocking in the first quarter and anticipate this to continue in the second quarter, but current market feedback suggests potential recovery in the second half of the year. Please turn to Slide 4, and I'll provide an overview of the cost impact of the current tariffs and the actions we're taking. The table on the left illustrates the estimated impact of currently enacted tariffs on our 2025 cost base. We source globally and expect there will be some impact on most countries we import from with the biggest impact on raw material and components sourced from China. We have been proactively working on a number of actions to offset the cost impact, including implementing price increases, relocating our supply chain by leveraging our dual source supply base and increasing capacity across our U.S. manufacturing footprint. We have invested in our North American footprint and supply chain diversification over many years and believe we're well positioned to mitigate the impact of tariffs on our cost base and stakeholders. One last item I'd like to mention is that our search for a new CFO is ongoing, and we're making good progress. We'll inform you as soon as we have identified a candidate. In the meantime, Shashank will stay on as CFO to ensure a smooth transition. With that, let me turn the call over to Shashank, who will address our first quarter results and our second quarter and full year outlook.

Shashank Patel, CFO

Thank you, Bob, and good morning, everyone. Please now turn to Slide 5, which highlights our first quarter results. Sales of $558 million were down 2% on a reported and organic basis. As previously discussed, we had fewer shipping days in the first quarter, which unfavorably impacted our sales by approximately 3% across all regions. Americas organic sales were down 1% and reported sales were flat. This was better than expected, particularly with the reduced shipping days. Sales from our I-CON acquisition added $5 million. Europe organic sales were down 9% and reported sales were down 12% with declines across all geographies due to fewer shipping days, heat pump destocking and weakness in new construction markets driving destocking in the wholesale channel. APMEA sales increased 9% on a reported basis and 13% on an organic basis. Growth in China, the Middle East and Australia were partly offset by a decline in New Zealand, primarily driven by fewer shipping days. Compared to the prior year, adjusted EBITDA of $119 million increased 1% and adjusted EBITDA margin of 21.4% increased 80 basis points. Adjusted operating income of $106 million increased 2% and adjusted operating margins of 19% were also up by 80 basis points and is a Q1 record for Watts. Adjusted EBITDA and operating income benefited from price, productivity, favorable mix and cost controls, which more than offset inflation, volume deleverage and investments. Americas segment margin increased 130 basis points to 23.4%. Europe segment margin decreased by 180 basis points to 13.9% and APMEA segment margins decreased 70 basis points to 17.5%. Adjusted earnings per share of $2.37 increased 2% versus last year with operational contribution and reduced interest expense more than offsetting incremental tax expense and foreign exchange headwinds. The adjusted effective tax rate in the quarter was 24.5%, up 70 basis points compared to the first quarter of 2024, primarily due to a lower tax benefit from the vesting of stock compensation awards that occur in the first quarter of each year. For GAAP purposes, we incurred $1 million of pretax acquisition costs and $17 million of pretax restructuring charges, primarily related to the exit of our site in France. These charges were partially offset by a nonrecurring tax benefit related to the reversal of a prior year tax liability. Our free cash flow for the quarter was $46 million compared to $37 million in the first quarter of last year. The cash flow increase was primarily due to the timing of income tax payments compared to last year. We expect sequential improvement in our free cash flow and are on track to achieve our full year goal of free cash flow conversion greater than or equal to 100% of net income as previously communicated. During the quarter, we repurchased approximately 19,000 shares of our Class A common stock for $4 million. Additionally, as Bob mentioned, we announced a 21% increase in our dividends that will begin in June. The balance sheet remains strong and provides us with ample flexibility. Our net debt to capitalization ratio at quarter end was negative 9% compared to positive 3% in the prior year, and our net leverage is negative 0.3. Our solid cash flow and healthy balance sheet continue to give us capital allocation optionality. Now on Slide 6, let's review our assumptions about our second quarter and full year outlook. We are reaffirming our 2025 outlook, which reflects the market factors previously discussed by Bob and assumes that the current tariff structure remains in place for the remainder of the year. As previously mentioned, we anticipate that price increases, our global sourcing actions and accelerated onshoring of production should offset incremental tariff costs and any potential demand reduction in the second half of 2025. For full year 2025, we are maintaining our consolidated organic sales growth outlook at a range of minus 3% to plus 2%. Our reported sales growth is increasing to a range of minus 2% to plus 3% due to favorable foreign exchange movements, which are listed by region in the appendix. Regionally, we expect the Americas to be slightly better, but offset by Europe, which we expect to be down 1 point compared to our original outlook. We are also maintaining our full year adjusted EBITDA and adjusted operating margin outlook consistent with our guidance in February. Our free cash flow expectation remains in line with our previous outlook as we expect to deliver free cash flow conversion of greater than or equal to 100% of net income in 2025. Next, a few items to consider for the second quarter. On an organic basis, we expect organic sales growth to be flat to up 3%. Regionally, we expect low to mid-single-digit growth in the Americas and low single-digit growth in APMEA, partly offset by a high single to low double-digit decline in Europe. We expect approximately $7 million of incremental sales in the Americas from acquisitions. We estimate that foreign exchange in the quarter will be neutral in total. Our assumptions by region are listed in the appendix. We expect we will begin to see the impact from our 80/20 actions in the second quarter with an estimated $2 million of product exits, primarily within the Americas. Second quarter EBITDA margin is expected to be in the range of 21.6% to 22.2% or up 50 to 110 basis points. Operating margins should be in the range of 19.1% to 19.7% or up 30 to 90 basis points. We expect that price and volume leverage in the Americas and APMEA will more than offset continued volume deleverage in Europe. Other key inputs for the second quarter and the full year can be found in the appendix. With that, I'll turn the call back over to Bob before moving to Q&A.

Bob Pagano, President and CEO

Thanks, Shashank. On Slide 7, I'd like to summarize our discussion before we address your questions. Our first quarter performance was better than we anticipated with record first quarter sales, adjusted operating income, adjusted operating margin and adjusted earnings per share due to a strong performance in the Americas and APMEA. We are actively working to manage the current trade environment and expect that our U.S. footprint, global supply chain and price increases will enable us to navigate it successfully. We are maintaining our full year organic sales and adjusted operating margin outlook despite the macro uncertainty and expectation of softer market conditions as the year progresses. Nonetheless, we've proven our business is resilient over the long term. Our portfolio is agnostic to end markets, and our teams are pivoting to growing subverticals. Additionally, our business model includes a large repair and replacement component that provides a durable base and drives steady revenue and cash flow. Our balance sheet remains strong and provides ample flexibility to support our capital allocation priorities, including M&A and continued investment in new product development and our digital strategy. In addition, we are increasing our dividend by 21% starting in June. We believe our highly experienced team is well positioned to proactively navigate current market conditions as we have done in the past. We're confident in our ability to control costs through our One Watts Performance System while capturing our fair share of demand and positioning us to capitalize on long-term secular trends. With that, operator, please open the line for questions.

Operator, Operator

Our first question comes from Nathan Jones from Stifel.

Nathan Jones, Analyst

I wanted to start off right on that last thing that you said, Bob, there about winning your fair share. And I wanted to talk about winning more than your fair share. I recall in 2022 when supply chains were messed up and your competitors couldn't get product in from China that you guys won some additional share. It was at very good margins because you didn't have to give the typical project discounts. It would seem that the same conditions have been created again here, not necessarily because competitors can't get products, but because it's so much more expensive. So maybe just talk a little bit about where you see opportunities to gain share, to gain margin because of that advantaged manufacturing footprint that you guys have.

Bob Pagano, President and CEO

Thanks, Nathan. As you know, our main strategy has been to manufacture products locally for the specific regions. However, we still source some products from low-cost countries like China to maintain competitiveness in the market. We don’t usually discuss our competitors, but having products close to customers is advantageous, especially in the current tariff climate where our cost structure is more favorable. In the past, we've mentioned our U.S.-made gas connectors where our biggest competition is from China. We have successfully gained market share during that period. As I previously mentioned, we plan to capture our fair share of the market despite the dynamic tariff environment. Stay tuned as we navigate through this year.

Nathan Jones, Analyst

Fair enough. I guess maybe if you can just talk a little bit about the pacing of the price increases that you've put through. And then if these are all price increases rather than surcharges, obviously, there's talk about the tariffs being reduced on China. If those do get reduced, what happens to your pricing structure? Do you need to give some of that back? Or would you hold on to it? And then I'll pass it on.

Shashank Patel, CFO

Regarding the price increase, Nathan, we implemented our annual price increase in January, which we discussed during the last earnings call. Since then, we have seen one tariff-related price increase at the end of March, with another taking effect on May 12. That is the latest update. We will discuss the impact of these price increases during the second quarter earnings call.

Bob Pagano, President and CEO

Yes. Regarding pricing in the future, look, these are big tariff amounts and adjustments. So we’re going to be competitive in the marketplace and with a focus on taking care of our customers. So again, stay tuned. We’re watching this very carefully, and we’ll be competitive.

Operator, Operator

Our next question comes from Mike Halloran from RW Baird.

Mike Halloran, Analyst

Can you clarify your comments about the margin and revenue trends in the first half versus the second half of the year? Is it correct to say that the price increases you're implementing are being counterbalanced by expectations of reduced volume? I'm trying to understand if there was already some anticipated softness in your forecasts for the latter half of the year. Has that expectation intensified? If so, is it based on observed trends, or is it a precautionary measure due to broader economic indicators suggesting potential challenges in the second half? It seems like the business has remained stable so far, and your performance this quarter and expectations for next quarter look strong. Are these adjustments reflective of anything you’ve experienced, or are they more of a cautious response to current economic signals?

Bob Pagano, President and CEO

Yes. I think it's the latter, Mike. It's just the uncertainty that's around there with all the tariffs. We've had a solid first quarter as well as April has been very good. So we're watching that. Some of that is just people beating price increases, et cetera, in the marketplace. So we're just watching demand, wanted to make sure it's not being pulled forward too much, and then we'll watch what happens. If these big price increases like the China 145% stay in place, I believe that will certainly impact demand in the second half. Again, it's a fluid motion. And when you look at all the leading indicators and the market indicators, they've not really changed, right? So it didn't make sense for us to increase the second half of the year at this point in time. So we'll watch. It's only the first quarter. We'll watch and see how things flow through.

Mike Halloran, Analyst

Yes. Agreed. No incentive to do that. And then just another question on the margins front half versus back half. Back half is down versus front half, probably a little more than normal. I'm sure some of that's the conservatism you just referenced. Is some of that just associated with the math behind putting in incremental pricing that is kind of more one-for-one on EBITDA dollars based on what you know today? Or are there anything else I should be thinking about going into the back half on the margin line?

Shashank Patel, CFO

Yes. Mike, primarily, first half margins are usually higher than second half margins, based on historical data. Additionally, there will be some volume deleverage that will affect the second half, but we will need to observe how that unfolds as the quarter progresses.

Mike Halloran, Analyst

But implicitly, Shashank, are you saying that the pricing is not margin dilutive in the second half?

Shashank Patel, CFO

The pricing is maintaining our margins despite the cost impact from tariffs in the second half.

Bob Pagano, President and CEO

Yes. And it’s not only price, Mike. It’s price. It’s our global supply chain and our footprint adjustments. So all those together are maintaining our margin outlook.

Operator, Operator

Our next question comes from Jeff Hammond from KeyBanc.

Jeff Hammond, Analyst

Bob, you mentioned kind of controlling prebuying, but what have you seen from a prebuy ahead of these May 12 increases? And are you doing anything to kind of limit the impact of that?

Bob Pagano, President and CEO

Yes. We noticed some prebuy activity in the first quarter during the last week of the month, which resulted in about $5 million in flow through. April has been strong as customers continue to prebuy. We are managing order input to avoid having everyone purchase a full year's supply. Our approach is based on historical data to ensure we're monitoring the situation properly. April's performance was solid, and we are observing how things develop. It's challenging to gauge actual demand compared to the influence of price increases. Returning to the fundamentals, the market conditions have not significantly changed; there's just more uncertainty as people try to anticipate future developments. Currently, we have about three months of inventory available. We are implementing the price increases that Shashank mentioned, and those are gradually taking effect.

Jeff Hammond, Analyst

Okay. And then what's informing the weaker Europe guide? It seems like we're hearing at least better news on the heat pump side. Just more color there.

Bob Pagano, President and CEO

Yes. I think it's really the heat pump side, just like you, we think it's going to come back in the second half of the year. It's just new construction. We saw more destocking than we thought was going to happen inside of this. And there's just some uncertainty, in particular, in new construction. So we just believe that it's prudent at this point based on order trends and what we're seeing to be cautious with...

Jeff Hammond, Analyst

Okay. If I could just sneak one more in. Just maybe update us on how things are going with Bradley, Josam, I-CON in terms of integration, cost revenue synergies, underlying demand trends?

Bob Pagano, President and CEO

Yes. All 3 of the businesses are doing really well. And I would say all our synergy tracking is ahead of schedule, which is exciting. The integration with the teams is going well, and we’re seeing the benefit clearly. And Josam, if you remember, also has a benefit because it has U.S. manufacturing capabilities. And again, in this marketplace, that’s a good thing.

Operator, Operator

Our next question comes from Ryan Connors from Northcoast Research.

Ryan Connors, Analyst

I wanted to discuss the price cost issue from a different perspective. I've noticed that some competitors in the brass and bronze industry have mentioned that certain raw materials, like bismuth, which is essential for some brass products, are in limited supply. This situation has contributed significantly to price increases. Is this something you're experiencing as well, or is the primary challenge you're facing related solely to tariffs?

Bob Pagano, President and CEO

I think it's a little bit of the raw materials, but it's mainly the tariffs and some of the more smaller of our products that we have that we get from China to be competitive in the current marketplace. So our team has done a nice job of securing our fair share of the allocations going forward of the components of our raw material, but it's something we continue to watch daily to make sure we know where we're at. But we have a good 3 months of inventory as well as supply chain availability for an additional 3 months related to our copper and some of our ingots that we use in our foundries.

Shashank Patel, CFO

Yes, Ryan, most of the raw material restrictions have been on rare earth metals, and we hardly use any of that in our processes.

Ryan Connors, Analyst

Okay. Regarding the pricing issue, we have competitors who source directly from China and have faced significant price increases, some exceeding 60%. How do you view this as an opportunity? Are there situations where you might consider raising prices by more than 5% or 10%, perhaps even by 20% or 30%, given that competitors are dealing with these drastic increases? Is the market flexible enough to accommodate that type of pricing strategy, or will it primarily be about passing on actual tariff costs?

Bob Pagano, President and CEO

Ryan, we always look at valuing and pricing to value we’re providing to our customers. So we look at what competitors price. We try to be competitive in the regions and the markets. And again, with some of these tariffs that are going in place, we don’t believe they’re sustainable and that they will change in the long run. So I think it’s – you got to be careful to whipsawing. A lot of these price increases are at list price levels, and it varies. There’s big ranges of products where some of the products are low single-digit increases and some are in high double-digit increases. But again, it depends on the component of the product, and we look at the customer region by region and making sure we’re taking care of customers. So we’ll be looking at that and certainly looking at getting our fair share of price in the marketplace.

Operator, Operator

Our next question comes from Andrew Krill from Deutsche Bank.

Andrew Krill, Analyst

I want to just go back to, I guess, your more U.S.-centric manufacturing, especially relative to some peers. Just could you comment on like your utilization of your facilities there and trying to get a sense of how much more capacity you have to quickly ramp up those as you shift away from other areas like China? And are you planning any further CapEx to build these out this year? Or is it a bit too early to expand further?

Bob Pagano, President and CEO

Yes. The good thing is we're not fully utilized on our manufacturing footprint in North America. So we do have second shifts, but we can improve our second shifts and very few of our facilities are running a third shift. So we don't have to put significant capital expenditures, and we believe we have adequate footprint. We're just going to expand shifts and capabilities as needed.

Andrew Krill, Analyst

That is helpful. Regarding Europe, the margins were quite impressive in the first quarter at around 14%. However, for the second quarter guidance, you anticipate a slight decrease to about 10%. Could you elaborate on the factors that contributed to the strong performance in the first quarter and explain why there is a significant drop for the second quarter? It seems like the forecast for the rest of the year may not show much improvement.

Shashank Patel, CFO

Yes. In Q1, the margin expansion quarter-over-quarter and year-over-year was very strong. This was partly due to increased volume; we shipped about $10 million more than expected, with about half of that being a result of pre-price increase pull-ins. The other half came from significant growth in our data center business. When comparing Q1 to Q2, we are still seeing margin expansion of approximately 40 to 50 basis points. Additionally, when looking at Q2 year-over-year, margins are up about 60 basis points on average. So, we are continuing to see margin growth, although Q1 did benefit from added volume and effective cost management as we anticipated the impact of tariffs. No, that was in total. For Europe specifically, we typically see Q1 and Q2 as the strongest quarters. However, due to the heat pump destocking, the year-over-year comparisons have become more challenging because the heat pump destocking began in the second quarter of last year. We expect that trend to continue in the second quarter of this year.

Operator, Operator

Our next question comes from Joe Giordano from TD Cowen.

Joe Giordano, Analyst

So on the Americas guide for revenue, you started off the year a bit better than I think you were thinking. 2Q guide is coming in plus 2%, plus 5%. I'm just trying to think of how to square that with like the full year guide seems very conservative in light of what you expect first half performance to be on easier comps in the back half.

Shashank Patel, CFO

So part of that is the demand destruction we talked about, right? So with the incremental tariff prices, we do expect demand might be impacted in the second half. Obviously, we're a short book in ship business. We have visibility into the second quarter. but we're cautious about the second half. So we've kind of baked that into the second half guide for now, and we'll see how things progress over the second quarter.

Bob Pagano, President and CEO

Yes. Many people are trying to manage the price increases, and we are monitoring that closely. We want to ensure that they are not pulling demand from the second half of the year into the second quarter. There are too many variables in the economy right now. It seems prudent to wait until the second half of this year to better understand the actual demand once the situation stabilizes.

Joe Giordano, Analyst

That's a valid point. Regarding the margins for the Americas, your current levels are significantly higher than where they were in the past, and your guidance for the second quarter is approaching the 25% range. What are your thoughts on the potential growth in margins as you integrate the additional portfolio from the recent deals?

Bob Pagano, President and CEO

You're asking about margins, and our goal is to achieve a year-over-year increase of 30 to 50 basis points. We continue to invest in the business to support this goal. We are working actively on this throughout the organization. It's not just about the value of our new products; they are also providing added benefits to our customers, which influences our pricing strategy.

Operator, Operator

There are no further questions at this time. I'll turn the call back over to Bob Pagano, Watts Water Technologies CEO.

Bob Pagano, President and CEO

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 during our second quarter earnings call in early August. Have a good day and stay safe.