Watts Water Technologies, Inc.
Q1 2021 Earnings Call Transcript

Published: 8 May 2021

[Operator:]

Good day, and thank you for standing by. Welcome to the Watts Water Technologies' First Quarter 2021 Earnings Conference Call. I'd now like to hand the conference over to your presenter today, Timothy M. MacPhee, Treasurer and Vice President, Investor Relations of Watts Water Technologies, Inc. Please go ahead.

[Timothy MacPhee:]

Thank you, and good morning, everyone. Welcome to our first quarter earnings conference call. Joining me today are Bob Pagano, CEO and President, and Shashank Patel, our CFO. During today's call, Bob will provide an overview of the 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 our revised outlook for the full year 2021. Following our remarks, we will address questions related to the information covered during the call.

[Bob Pagano:]

Thank you, Tim, and good morning, everyone. Please turn to Slide 3 and I'll provide an overview of the quarter. I must first thank our global organization for executing under very trying circumstances. I'd especially like to applaud our manufacturing, supply chain and logistics teams. During the first quarter, the teams dealt with numerous issues around component availability, transportation bottlenecks, customer fulfillment needs and the ongoing pandemic. I'm proud of how they worked together to serve our global customers' demand.We had a solid start to the year. The severe winter freeze experienced in the South Central U.S. in mid-February caused widespread plumbing infrastructure problems and was an unexpected benefit that we estimate positively affected consolidated sales by about 3%. The underlying market conditions in Europe and APMEA were stronger than we had anticipated. Lastly, part of the year-over-year upside was driven by an easier comp in APMEA, which was heavily impacted by COVID in Q1 of 2020.Adjusted operating margin exceeded expectations supported by continued cost actions and incremental sales. We also delivered strong cash flow in the quarter, and shortly after the quarter ended, we completed the renegotiation of our credit agreement extending the facility through March 2026 and amending terms to mirror current market conditions. We have ample capacity, which affords us a lot of flexibility. Finally, we announced a double-digit dividend increase starting in June. Shashank will review the financials in more detail momentarily.Operationally, commodity increases, especially in copper, steel and packaging supplies coupled with the increases in logistics costs have driven us to announce additional price increases globally. These will go into effect later in the quarter. We won't see the real benefit of that price increase until the second half of 2021.

[Shashank Patel:]

Thanks, Bob, and good morning, everyone. Please turn to Slide 4, and I will review the first quarter's consolidated results. Sales of $413 million were up 8% on a reported basis and up 4% organically. As discussed, we had an easier compare in APMEA during the quarter and we estimate sales increase by approximately 3% because of the freeze in the South Central United States. Price was favorable in both the Americas and Europe, and Europe's organic volume was stronger than expected. Foreign exchange, primarily driven by a strong euro, increased the year-over-year sales by roughly $13 million or 3%. Acquisitions net of divestitures accounted for $4 million of incremental sales year-over-year. Adjusted operating profit was $60 million, up 24% compared to last year, and adjusted earnings per share were up 31% to $1.24. Adjusted operating margin of 14.5% was up 190 basis points as volume, price, productivity and cost actions more than offset inflation and incremental investments. The adjusted effective tax rate was 28% comparable to the first quarter of 2020. Our free cash flow for the quarter was $32 million as compared to negative $8 million in the first quarter of 2020. The cash flow improvement was due to better working capital management, higher net income, and less net capital spending. Our goal is to drive free cash flow conversion at 100% or more of net income for the year. During the quarter, we repurchased approximately 31,000 shares of our common stock for $3.8 million, and as Bob mentioned, announced a double-digit increase in our dividend. Please turn to Slide 5, and let me provide a few comments on the regional results. The Americas posted a solid quarter where organic sales up approximately 3%. This was primarily driven by the tailwind from the freeze in the South Central Region of the U.S., which we estimate provided almost 4% of incremental growth. Absent the freeze impact, sales would have been in line with our first quarter expectations. We saw growth in plumbing and electronics, which is partially offset by lower heating and hot water and water quality sales. Adjusted operating profit increased by 11%, and adjusted operating margin increased by 110 basis points. The margin expansion was driven by volume, price, cost actions and productivity being only partially offset by inflation and incremental investments. Europe delivered a solid quarter with organic sales up approximately 2%, and adjusted operating margin expanded by 350 basis points. Reported sales also increased by 10% from favorable foreign exchange movements. Organic sales were better than we anticipated as we saw growth in France in the wholesale plumbing channel, driven by higher residential demand and in OEM electronic products with customers pre-buying due to supply chain and inflationary concerns. In Italy, growth was driven by government heating subsidies.

[Bob Pagano:]

Thanks, Shashank. On Slide 8, I'd like to summarize our discussion before we address your questions. The first quarter was better than we anticipated with growth in all regions that was aided by an unexpected freeze tailwind in the U.S. and an easier compare in APMEA. We expect to benefit from the freeze impact in the second quarter as well. Supply chain issues were minimal in our operations in the first quarter, but we see potential issues in Q2 and beyond that our team is managing on a daily basis. Inflation is also accelerating and we've announced a second price increase to help offset the cost increases. We are on top of both matters and monitoring closely. We are increasing our investments for growth for 2021 while continuing to focus on cost controls. Market expectations in residential end markets are consistent with our February outlook. Near term, the non-residential outlook is better, fueled by the freeze, channel inventory restocking, and stronger repair and replacement demand, which is overshadowing the weak new commercial construction market. We are still cautious about the second half because of supply chain constraints, the air pocket impact due to lower non-residential construction starts, and vaccine rollout progress outside the U.S. The leading indicators are suggesting we'll see growth in non-residential new construction in 2022. Watts is well capitalized. We have ample liquidity to drive our capital deployment strategy. The second quarter should be strong given the easier compare due to COVID last year and freeze benefits this year. We have increased our full year outlook given the strong start to the year while remaining prudent concerning the second half. Finally, we continue to execute on a day-to-day basis to meet our customer needs while managing through the ongoing pandemic and supply chain challenges. The company is well positioned both financially, operationally and commercially to take advantage of market opportunities. With that, operator, please open the line for questions.

[Operator:]

And our first question comes from the line of Nathan Jones with Stifel.

[Adam Farley:]

This is Adam Farley on for Nathan. Related to be the deep freeze in the Southern U.S. you called out inventory restocking in 2Q, do you expect that to be the final quarter of that impact or should it carry through the rest of the year at all?

[Bob Pagano:]

Right now we believe it's going to happen in the second quarter. Could some of it fall into the third quarter? Maybe. It just depends on how quickly they can get up and running and right now there's a shortage of plumbers in the area. So all the bigger things are being done quickly but our assumption is it will be pretty much complete in the second quarter.

[Adam Farley:]

Okay. And then on the margin side related to that, is it concentrated in specific parts of the portfolio, and were sales of higher-margin products related to the deep freeze?

[Bob Pagano:]

Yes. We had favorability in our testable black -- back flows. It was heavy into irrigation, backflow kits, regulators and fittings et cetera. So on average, I would say it was slightly below our average margins but again the volume from the factory point of view drove absorption. So net-net it was favorable.

[Operator:]

Our next question is from the line of Jake Jarnigo with Baird.

[Jake Jarnigo:]

Yes. This is Jake on from Mike Halloran's team. Question on kind of the near-term or kind of structural versus temporary cost actions that we kind of talked about last quarter. I just want to make sure that, that is still largely the same with the results came in as of today. So last I recall, it was basically about $15 million of temporary coming back this year with that largely being offset by incremental savings from 2020 structural actions. I guess where does that stand today?

[Shashank Patel:]

Yes, Jake, so it was $15 million and out of the $15 million we had talked about $5 million in the second quarter and about $10 million in the second half. So that is still our latest outlook. Now the $5 million in the second quarter was -- part of that was travel markout. Obviously with COVID lockdowns, it might be less than that as we go through the second quarter, and then being offset by the incremental restructuring savings we get that number of roughly $14 million of restructuring savings offsets that.

[Jake Jarnigo:]

Got it. Perfect. Thank you. And then another margin question here, so in terms of a price cost then for the year, so it seems like the first quarter was pretty good, second quarter is where it seems like the timing impact was what kind of hit you most and then some catch-up in third quarter, fourth quarter. So on a full year basis, are we thinking net neutral or is there potential to get kind of in that positive there too?

[Shashank Patel:]

Yes, slightly net positive and the reason for that is we do try to get ahead of the price cost curve and that's why we announced in January increases. And also we do lock in some of our commodities like brass in Europe, and in Europe we can lock in for longer periods. But even in the U.S. we've kind of locked in for a certain -- for a few months and stuff. So we've kind of gotten out of it and obviously now we've announced a second price increase because obviously, commodities have inflated more than we had anticipated in the February time period. But overall on a full year basis are slightly positive.

[Jake Jarnigo:]

Great. Thank you. And then one more quick one here again on margins and kind of the mixed impact, and this is kind of more around the commercial water heater and boiler business in North America. It seems like that is still kind of coming off the bottom, I would assume we're going to be starting to hit easier comps here for the rest of the year. I guess one kind of what's your outlook for that business and then secondarily, from a mix perspective, how does that relate relative to the other pieces of the Americas segment?

[Bob Pagano:]

No. So yes, you're right. They were down overall mid-single digits in the first quarter. We expect that will have easier compares for the rest of the year. So I think overall, though we still believe that will be down for the year, slightly down. When you look at the margin from an EBITDA point of view, it's right on so I think in line with our -- all our expectations.

[Operator:]

Our next question comes from the line of Ryan Connors with Boenning and Scattergood.

[Ryan Connors:]

Great. First off, I just wanted to clarify something you said there, Shashank. Did I hear you say that basically the impact of Southeast freeze on mix was negative not really material there was a first question there, was that -- did I get that basic idea right?

[Bob Pagano:]

No. This is Bob. It was -- the question was regarding the mix and how did it impact margins, and from a standard margin it's probably slightly lower given the mix. However, given the overall P&L hit because of the absorption it was favorable to our overall margins.

[Ryan Connors:]

Okay. Okay. Okay. And then my other question, I'm not sure if this is the right way to look at it, but if we look at pricing and price capture and sort of the delta between your resi and your non-resi commercial markets it seems like this environment would be pretty conducive to getting price in resi, I mean if someone is putting up a housing development in this kind of environment for red hot housing that's going to sail right through any price increase, but a lot tougher in commercial I mean can you talk about that and how that affects price capture and what you -- how you manage that the two very different markets set?

[Bob Pagano:]

Yes. Yes. So we're trying to drive price in all the markets, no matter what. Now in some of the, let's call it retail segments, we have longer-term contracts that we adjust and some of our OEM contracts we have inflationary quarterly adjustments based on materials. So all of that said, we're driving price in every one of the markets given the supply chain issues, and most importantly, given the commodity increases we're seeing in the marketplace, so we're full speed ahead on that.

[Ryan Connors:]

Okay. Okay. And then my last one just real big picture, Bob. I mean and it sort of goes in line with Jake's question about the sort of cost-cutting initiatives and so forth. I mean, a year ago we're sitting here talking about cost-cutting and headcount reductions and then 12 months later we've got a record first quarter sales, positive outlook and the temptation is just sort of all systems go, but COVID was not the last black swan the world is going to ever see, and how do you strategically manage the company keep from getting back to normal too quickly where you leave yourself at risk if there is -- things turn South, the Fed or whatever happens. I mean just how do you -- walk us through your thinking on how to manage an organization at this point in the cycle?

[Bob Pagano:]

Well, look as you know, we tend to be conservative in -- from a topline point of view. So we keep our costs under control. We have detailed contingency plans based on what's happening in the marketplace. So we know actions we're going to take right away. So we're very careful about bringing cost back, so -- because we are still uncertain. However, right now, given the volume, given what's happening we can't control the inflation relative to commodity prices. There is labor inflation also. So again, we're balancing all of those things but in the long run right, we're going to continue to focus on costs and growth in our smart and connected overall strategy. So again, we're trying to do -- it's the end, right. We're trying to invest in growth for -- and keep our costs. In particular, you've heard me say many times that we have too much cost in Europe and we're looking at one facility right now in France. So we'll continue to look at that, we'll continue to manage our portfolio and our cost structure as we continue to invest for the future.

[Shashank Patel:]

And, Ryan, so this is -- we're a book and ship business, so we not only look at the leading indicators that you're aware of but we're daily tracking our order input. So back to that $15 million of cost coming back, and yes, that is the plan but we meter that depending on how the orders come in. So we're on top of this like on a daily basis because we have to be.

[Operator:]

Our next question comes from the line of Joe Giordano with Cowen and Company.

[Joe Giordano:]

Just curious kind of how you're triangulating the impact from like 2Q Texas? Is it just from like what you've seen through like today at this point like how are you kind of getting your head around what that kind of impact is?

[Bob Pagano:]

Is this the freeze you're talking about?

[Joe Giordano:]

Yes. Yes, exactly like how are you coming up with the 400 basis point kind of benefit into 2Q from the freeze, is it just kind of extrapolating out what you've seen in that kind of region through so far in this quarter?

[Bob Pagano:]

It's a combination of all the above, right, where we looked at what we did in April, we've talked to our customers, we're looking at channel inventory and our sales teams best estimate of what's happening in the marketplace there. So again, it's a best estimate at this point in time and that's where we're at this -- right now.

[Joe Giordano:]

Are you hearing anything about like -- I know you mentioned specifically the inventory channel there is now low because of this but excluding that like let's talk about inventories elsewhere, are you seeing like customers stocking up ahead of -- I'm guessing for these types of products maybe there is not as much risk of supplies. I'm curious to see what the mindset of your customers are as we're seeing people like kind of overstocking in other parts of the world?

[Bob Pagano:]

Yes, I think you raise a good point. So the freeze in this South Central really brought inventory through all the channels in almost every region because availability of products to ship was being pulled from all regions. So we watched some of that happen. The other thing is given the concerns of the supply chain, especially chips and other products, we're seeing customers pulling in and placing orders early to get in line because they're worried about their future projects in case there is number one, incremental pricing and number two, just availability. So we're seeing both of those at this point in time. That's why Q2 is going to be interesting and that's why we're a little concerned in the second half of this year because we don't know how much has been pulled forward into Q2 based on our latest projections, but there are supply chain concerns just like us. We're concerned and we're ordering more right now to make sure we're ahead of the game.

[Joe Giordano:]

So just the last from me on that point. You mentioned concern on the second half a couple of times, I definitely understand what you mean on how much is being pulled forward into now but on the logistics side, are you kind of worried that this gets worse from here? I mean, I know you're -- I mean everyone's already experiencing pretty tough logistics world over right now like are you thinking that this actually gets incrementally worse from here into second half?

[Bob Pagano:]

I think we started with a strong inventory position at the beginning of the year that we've been drawing down, and I think we're trying to rebuild back quickly. And like everybody, we're getting allocated products in some of our chemical-related products, plastics, et cetera. So we're concerned about that. And our supply chain is very aggressive and feel good about Q2 but again, it's uncertain and God forbid, another thing happens in the marketplace like a tornado or something that takes out something. So again, we're cautious because everything is real tight right now and we don't need another potential disaster in the supply chain at this point in time.

[Operator:]

Our next question comes from the line of Jeffrey Hammond with KeyBanc.

[David Tarantino:]

This is David Tarantino on for Jeff. So could you dig a little bit more into the cadence of the full year guide, maybe what dynamics are you seeing kind of given what seems to be better dynamics in Q1?

[Shashank Patel:]

Yes. So if you think about the previous guide, which midpoint was minus 2.5% and now the new midpoint is 4.5, it's about a 7% increase top line from the previous guide. Out of that 7%, the freeze impact is about a couple of points is the freeze impact which all -- as Bob said, most of that happens in the first half and then the balance of it is basically split between the second price increase, which we had not contemplated in February but was inflation induced, so to speak. And then the remaining is basically stronger underlying markets in France and Italy and in Germany because of the government incentives. And then in the United States, the higher GDP expectations versus February that drives our repair and replace activity, and that's basically how we came up with the 7% increase in topline.

[David Tarantino:]

Great. And then just as a follow up, I know you mentioned there was a lot of inventory drawdown from taxes, but was there any pull forward demand ahead of price increases and kind of how far out is that inventory rebuild kind of how far out does that go?

[Bob Pagano:]

So I think a little less in the first quarter but we're expecting probably more in the second quarter of pull forward based on this new price increase as well as the supply chain constraints. Our goal internally, we're modeling. The supply chain will be caught up by the end of the third quarter. So that's our best estimate at this point in time and that's what we're hearing from our channel partners but that all -- that's just our best estimate at this point in time.

[Operator:]

And our next question comes from the line of Nathan Jones with Stifel.

[Adam Farley:]

Yes, thanks for the follow-up. I was wondering if I could just get a little more color on the new construction in the U.S. as it relates to the air pocket. I think you called out leading indicators are a little more favorable for 2022, so what gives you confidence that, that will start to come back in 2022?

[Bob Pagano:]

Well, again, we're starting to -- we see the same leading indicators that you're looking at, right, dodge momentum, ABI has now been positive for the last 2 months in a row. So you're starting to see the signs of some of the new construction coming back. Certainly, there are headwinds and building products are skyrocketing the costs of both lumber, steel and certainly, copper and related, so those costs are going up low interest rates. But as I sit here today, versus 3 months ago, I feel that the tide is starting to turn and people are talking, more and more quotations are happening in that marketplace. But again, it's too soon to predict what '22 is right now. But again, it's nice to see that the leading indicators that we all track are showing a turn now, at least in the biddings part of the new construction. Starts are still down. They're down and we still have that air pocket. We saw it in Q2 our drains are a leading indicator of that. And so it's down. It's just being offset by all the other momentum we've talked about previously on the call here.

[Adam Farley:]

Okay. And then shifting gears towards acquisitions. The balance sheet is in really good shape, you guys renegotiated terms on your financing, so maybe could you describe the prospects for accelerated M&A and have you seen any increase in the willingness for sellers given the potential for the capital gains tax increase?

[Bob Pagano:]

Yes, so look M&A is always hard to predict, the timing is always difficult. Our pipeline is strong. We'll continue to be disciplined because valuations are still high. Yes, some of the smaller acquisitions, ones we've recently -- the TDG that was because of the tax benefit and so that's all part of it. I think on the smaller size companies that's in their mindset, but again it's always difficult to predict and valuations are still high, so we'll continue to be disciplined.

[Operator:]

And there are no further questions in queue at this time. I'd like to turn the call back over to CEO, Bob Pagano for some closing remarks.

[Bob Pagano:]

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

[Operator:]

This concludes today's conference call. You may now disconnect.