Watts Water Technologies, Inc.
Q3 2013 Earnings Call Transcript

Published: 30 Oct 2013

[Operator:]

Good day, ladies and gentlemen, and welcome to the Q3 2012 -- 2013 Watts Water Technologies Earnings Call. My name is Glen, and I will be your operator for today. [Operator Instructions] Please be aware that remarks made during today's call about the company's future expectations, plans and prospects constitute forward-looking statements under the Private Securities Litigation Reform Act of 1995. Actual results may differ materially from those indicated by these forward-looking statements as a result of various factors, including those discussed under the heading Risk Factors in the company's annual report on Form 10-K for the year ended December 31, 2012, and other reports the company files from time to time with the Securities and Exchange Commission. In addition, forward-looking statements represent the company's views only as of today, and should not be relied upon as representing its views as of any future date. While the company may elect to update these forward-looking statements, it disclaims any obligation to do so. During this call, the speakers may refer to non-GAAP financial measures. These measures are not prepared in accordance with Generally Accepted Accounting Principles. A reconciliation of the non-GAAP financial measures to the most directly comparable GAAP measures is available in the press release dated Tuesday, October 29, 2013, relating to the company's third quarter 2013 financial results, a copy of which may be found in the Investor Relations section of the company's website at www.wattswater.com, under the heading Press Releases. I would now like to turn the conference over to your host for today, Mr. David Coghlan. Please proceed.

[David J. Coghlan:]

Thank you, Glenn, and good morning everybody. And thanks for joining our third quarter earnings call. I'll start by providing a brief overview of the financial results for the quarter. Then I'll speak to some highlights for the quarter before handing the call over to Dean Freeman, who will review our performance in more detail. Dean will also provide you with an update of our guidance for the remainder of 2013. After Dean's review, I'll try to summarize, and then we'll open the call up to your questions. Let's start by turning to Slide 3 of the conference call presentation, for a brief overview of our third quarter financial results. From a revenue perspective, we had overall growth of 5.4%, which was driven by solid organic growth in North America and China, and offset by an organic decline in Europe. The strengthening euro was a tailwind in the quarter. Adjusted operating margins declined 110 basis points versus Q3 2012, largely driven by 2 issues in North America

[Dean P. Freeman:]

Thanks, David, and good morning, everybody. So I'll start my comments on Slide 9, and walk you through some of the financial highlights of the quarter and year-to-date. So on a consolidated basis for the quarter, organic revenue was up 3.6% with North America up organically 8.6%, offset with EMEA declines of 4.2%. Asia had another strong quarter with growth, organically of trade sales of 15.1%. Looking at North America, we did see an increase in the wholesale channel of 9.6% organically, very strong. Same with the OEM channel, up 9%, and retail up 4.7% despite headwinds related to pricing. And this is driven primarily by increased sales in our Rescom commercial flow control products, and as David pointed out, we're clearly seeing the momentum and strengthening trends in the North American residential commercial construction and repair, replace end markets. The U.S. lead free initiative continues to dramatically ramp up during the quarter with lead free sales double that of what we saw in the first quarter. With retailers stocking of lead-free products accelerating as expected, and we expect our major retail customers to be completely transitioned by the end of the year. Larger wholesale customers are on a similar path, however, I think as we've talked about in the past, the smaller wholesalers have not yet ramped up their purchases of lead-free products as much as we had anticipated. So we'll still see some lag there, but we do expect an increase in the transition process amongst those wholesalers as the year comes to a close. Looking at EMEA for the quarter, organic sales have declined 4.2%, resulting from OEM sales decline of 9.1%, offset by a slight uptick in the wholesale market of 1%. And again, while markets are still down, we do see continued size of strengthening potential recovery, particularly in large OEM HVAC end markets, and I think David covered it more comprehensively by country. So we remain hopeful of the sustained recovery, however, we'll point out that we remain cautious and continue to be focused on driving our cost per activity initiatives. I'll talk a little bit more about that in a minute. Asia continues its strong performance, 15% organic growth, as it continues to build out its plumbing and HVAC market coverage. Looking at adjusted operating margin for the quarter, was $34.9 million, and as a percentage of sales, decreased to 110 basis points year-over-year to 9.4%. And as mentioned, the decrease is principally driven by 210 basis point reduction in North America to 11.2%, as product liability cost increased $3.5 million year-over-year, and lead-free transition costs added $2.4 million. Notably, when you look at adjusting for lead free and product liability impact, North America would have been nearly 40% operating earnings for the quarter. So structurally still on track. So let me just make a couple of comments regarding the 2 items impacting North America. First, regarding product liability, over the last few actual review periods, we did see an inflection in reported claims, largely related to legacy products that were not consistent with our claims history. Accordingly, the actual rate adjustment is a result to increase claims activity that we reflected in the product liability reserve. We have not referred to these items as one-off or special because frankly, over time, these types of actual adjustments may occur again. Secondly, regarding our lead-free transition cost, as demand volumes of lead-free products had dramatically increased, we saw a greater impact related to foundry disruption, due to furnace shutdowns and as a result, we saw increased logistics cost and other absorption. We now believe that the production issues have been rectified and as a result, we seen our October production rose ramp up toward normal capacity and they sustain that for some time now. As a result to the third quarter issues, however, we have had to push our normal production schedule back, and we now expect additional manufacturing and efficiencies, which we believe should be final, associated with foundry and transition cost of approximately $1 million in the fourth quarter. So overall, we're pleased that the lead free products, the pricing, the cost of margins in the third quarter were consistent with expectations. But candidly, we saw further shutdowns that obviously, impacted our overall number year-to-date. We expect that number to be $4.4 million and now for the full year, expect that number to be $5.4 million. So moving back to the presentation and looking at EMEA adjusted operating margins, we did see an increase of 70 basis points to 11.5%, as production efficiencies and tight cost controls, offset margin loss for the sales volume reduction. Notably EMEA's gross margin improved to 120 basis points versus prior year and sequentially, as a result of these cost improvement actions. So let me just make a couple of comments on the restructuring efforts to date. The team is now executing on the plans we announced in July, we recorded charges of, in Q3, of approximately $3 million related to the various plans, mostly for expected severance that we are legally required to provide. There is a lot of work to be a accomplished, including meeting with various workers council and government agencies to have redundancy plans agreed and approved. Savings to date, as you can expect, has been minimal, as social plans will take some time to execute on. So still a lot of heavy lifting to be done, but we definitely believe that were aligned with our original guidance regarding the timing and cost and savings, as we outlined in last quarter's conference call. Just a quick comment, Asia's margins were largely affected by sales mix and volume. Our adjusted tax rate was 30.7% versus 31.1%, largely driven by earnings mix between North America and EMEA, and reduction in the Danish tax rate. Adjusted EPS of $0.58, which includes less than half a $0.01, benefit from share repurchases in the quarter, decreased $0.04 or 6.5% versus prior year. This includes approximately of $0.10 of impact related to lead free and product liability. Just looking at Slide 10, on a year-to-date consolidated basis, revenue was up 1.3% year-over-year organically, with North America up 4.7%, EMEA down 4.6%, and Asia up nearly 24%. Year-to-date adjusted operating profit of $103.3 million, improved 10 basis points year-over-year to 9.4% of sales, driven largely by improvement in gross margin, while organic SG&A, as a percentage of sales was flat. The year-to-date adjusted tax rate was essentially flat to prior year. Year-to-date adjusted earnings per share, $1.65, or 5% growth versus prior year, including $0.03 of benefit from the share repurchase. You can read the slides on the regional performance, so I'll turn to Slide 17. Primary working capital, as we've talked about in the last couple of quarters, primarily affected by the inventory build. The lead free conversion to about $28 million, receivables are increasing as a result of North American revenues. Free cash was impacted primarily by the higher operating and capital spend on our lead free foundry, so we also spent about $10 million dollars in share repurchases for the quarter, under our authorized 2013 share repurchase program. We expect to purchase some additional $3 million worth of shares in the fourth quarter. Overall, we ended the quarter with $227 million in cash. So looking at Slide 19, just looking at the guidance for 2013, FX, constant, really no significant changes in the balance of the year. We expect full year North American revenue again on track to 4% to 7%, including the lead-free impact. EMEA being down 4% or 5%, and Asia between -- up between 20% to 25%. We do, as I mentioned earlier, I expect additional cost of no more than $1 million for the lead free transition. And lastly, just making a comment on the CapEx, we expect total CapEx to be $32 million for the year. With that, I'll turn it back over to David.

[David J. Coghlan:]

Thank you, Dean. So let me try and summarize the way we look at the quarter. And we saw improved sales momentum in North American wholesale, OEM and DIY markets. We think Europe performed well, and we believe Europe delivered a solid result given the macro issues in play there. As we discussed, North America's results were impacted by 2 developments, lead-free transition costs and the product liability adjustment. We're starting to see more optimism as key markets like North American residential remained solid. As North American commercial move towards a turn. And as European markets appear to be moving in a more positive direction. Also, we expect the EMEA team to continue to execute on its realignment plan and deliver on the benefits we've committed to. So with that, why don't we open up the line for your questions. Glen, can you open the lines please?

[Operator:]

[Operator Instructions] And your first question comes from the line of Jeff Hammond with KeyBanc Capital Markets.

[Jeffrey D. Hammond:]

Just on the 8, 6 core growth in North America, can you talk about what was price? What would have been, maybe just ramp and lead free versus kind of real demand improvement? And then within the real demand improvement, where are you seeing it within the commercial piece?

[Dean P. Freeman:]

Jeff, It's Dean. So, of the 8, 6, we think, as we talked about our lead free, 1 to 2 points for the year, we think we saw similar trend in the third quarter. And when you kind of look at the breakdown of the growth, primarily in 3 areas. We saw very strong growth in regulators, which is as I think we've talked about earlier, sort of a leading indicator of core structural growth in participating in the end markets. Fittings, we saw again, strong growth there and back flow preventers. So, from a product perspective, we are growing in the areas that we would expect as we participate; we're meaningfully in the growth trends in Rescom. And from a lead free perspective, again, 1 to 2 points could be associated with that.

[Jeffrey D. Hammond:]

But, so was there any kind of inflection in your commercial-based products, or your comments about commercial are more perspective?

[Dean P. Freeman:]

Yes, David, you want to?

[David J. Coghlan:]

I think we continue to execute on some programs on the commercial side, that we're pleased with the returns on. But I think if you really look to links to market, we continue to benefit from the growth that we're seeing in residential new construction and from increased investment in existing residential buildings.

[Jeffrey D. Hammond:]

Okay. And then just on the inefficiency. I mean what gives you confidence that those are kind of largely behind us moving into '14? And should we think of this 5, 4, and 3.5 product liability as completely going away in the '14?

[David J. Coghlan:]

Let me try and deal with the lead-free issues, and then maybe Dean will deal with the product liability issues. So if we look at the lead free transition costs, a lot of it was driven by the fact that in our new foundry, we continued during the quarter to work to get used to the behavior or the characteristics of the new alloy. And that new alloy did cause a couple of furnace downs, which cost us money to take them back up, and also cost us money as we tried to expedite product and to ensure, we didn't disappoint customers. And so we're now comfortable that we understand the drivers of the furnace downs, and we put a lot of work into at mitigating the effect of those drivers, and trying to ensure that they won't recur in the future. So can we guarantee that nothing will happen in the future? No, but we have a much more thorough understanding as to how the alloys are behaving in our furnaces and what some of the issues where, and we're much more comfortable with mitigation plans that we've implemented to deal with them.

[Dean P. Freeman:]

Yes, so let me just make some comments about the product liability, I know that it's on everybody's mind. As I mentioned in the comments, certainly not consistent with our historical trends, certainly as a function of what we did see, we were required to true up our reserve. We think we're adequately reserved at this point. And so again, as we mentioned, not consistent with our history and a full true up of our reserves.

[Jeffrey D. Hammond:]

Do you have an ongoing higher warranty run rate as a result? Or is it just a one-time catch-up?

[David J. Coghlan:]

I think the way to think about it is that, first of all, it relates to some legacy products. And so we're not looking at an across the board lift in warranty rates. And we really believe that the driver for these specific products were some both claims that came in from some specific law firms, who reviewed their inventory of claims with their clients. And that was a substantial contribution to the spike in claims. And so again, what we'd say is that the spike and the both reporting isn't really consistent with our past experience or our general practice.

[Operator:]

And your next question comes from the line of Garik Shmois with Longbow Research.

[Garik S. Shmois:]

I have a follow-up question on some of the anecdotes that you're starting to hear on the commercial construction side. Just wondering if you can help us understand a little better, the lag between when commercial project breaks 'round, and when you start to see it? Some of this commercial improvement does than that planned out in 2014? When realistically should we start to benefit?

[David J. Coghlan:]

Well, one of the advantages, I guess, of our product line on the commercial side is that, we see some reasonably quickly and then we see a lot more as the project gets to the finishing stages. So let me try and explain that. And so, once a commercial project physically starts, i.e. construction starts, one of the first things that goes in is the underground drainage systems, and we participate in that. And then the rest of the building gets constructed, the frame goes up, and then they start to put in the systems that will ultimately form behind the walls. And so there's sort of a value period where not a lot of our stuff is going in, while the frame of the building is going up. While they are finishing out the outside of the project. But, when they start to move inside and put in fire protection systems, hot-water systems, plumbing systems, et cetera, then our products start to participate. And so -- its sort of in the early stages of physical construction, and then it's in the later stages, as they fit out and complete the building.

[Garik S. Shmois:]

Okay, thanks for that. And, I guess just a quick follow-up to that. This year, at least the data points have showed a nice actual growth on some commercial categories, like retail. But the institutional piece, education and healthcare has significantly lagged. Do you have a preference as to what commercial category shows growth, meaning are you more preferable to some of the institutional work that hasn't come back this year that maybe, just maybe wind up returning in a year or 2?

[David J. Coghlan:]

Well, there are vertical markets that are important to our industry. Our largely vertical markets that are associated with large numbers of people, who are going to use large volumes of water. So for example, hotels, that vertical is an important one to us. The commercial office market, multi-family. If we think about distribution centers, which is been another area that's been pretty hot

[Garik S. Shmois:]

Okay, and I guess switching to North American retail pricing, you mentioned it continues to be competitive, would you say the competitive landscape has accelerated in Q3? Or is it just a continuation of recent trends?

[David J. Coghlan:]

I don't know that the trends have accelerated. And I think a lot of it is really driven by the number of line reviews, which the DIY chains themselves are holding. And so anyone of you really want to understand the developments in that arena, a good thing to do might be to look at the, at the sort of the earnings calls for the major DIY retailers, and you get a sense for their focus. So it's less driven by proactive competitive behavior and more driven by the rate at which the DIY change call line reviews. Okay, thanks. And then just lastly, on the North American margin, if you strip out the products manufacturing cost inflation and the liability reserve cost, we're getting an incremental margin somewhere around 19% to 20%, I think it's a little bit below your recent run rate, which had impressive incrementals in the first half of the year. Is there anything else going on within the cost side in North America or within the mix that work down the incrementals on a like-for-like basis and how should we be thinking about that going forward?

[Dean P. Freeman:]

Yes. No, the only other thing I think that we mentioned was the growth in the retail, which both has a lower margin mix but also, obviously, the impact of the pricing that we talked about.

[Operator:]

And your next question comes from the line of Todd Vencil with Sterne Agee.

[L. Todd Vencil:]

Just sort of continued beating this mostly dead horse, a little bit, but I'm interested on the commercial side and the fact that you're sort of seeing what you think are early signs that you are going to see a turn next year. I appreciate this sort of high-level color on how you think that plays out, can you talk about what you're actually hearing? I mean, are you tracking new project awards, or you're just hearing just chatter from your customers? I mean, what you are actually hearing at this point?

[David J. Coghlan:]

We think that the ABI Index is a really good indicator, and as we mentioned, that's been positive now for a long, long time. And so the next thing that we're trying to track from a data perspective, is the actual lending that's being provided. So I can put a project in with an architect design a building, start through the permitting process, but if I don't get finance for that project, it's not going to get ahead. And so we're touching base with our customers, architects, engineers and contractors. We're trying to get a sense for what's going on in terms of the lending environment. And construction is a multi-local industry, it's not a national industry. And so conditions vary region by region, locality by locality. And so we are hearing that lending standards are easing a little bit. Our personal beliefs are that as mortgage refinancing opportunities start to go away, the financial institutions are going to start to look elsewhere to improve their loan book. And so, we're starting to feel a little bit more confident that the amount of lending to commercial projects is going to improve. Now, are there any facts that lay that out? No, but that's the sense we're getting as we touch base with the architects, the engineers and the contracting firms around the country.

[L. Todd Vencil:]

Got it, that's exactly what I was looking for. And then just to sort of pivot off of something that you just said, it is a multi-local industry and you mentioned the regionality, are there any pick of the regions where you're seeing more or less of that kind of dynamic developing?

[David J. Coghlan:]

I'm not sure I will get into a laundry list of regions where we're seeing it, I'm sure there's others who'd love to get that list. But you know, you can look across the country and there is data that would suggest that for example, there are parts of California that there is certainly increased activity. Texas has been pretty strong, the Northeast. So there are certain areas that we're starting to see pockets. But there's a lot of people who would love to get their hands on that data.

[L. Todd Vencil:]

Fair enough. Turning to the North American DIY, you mentioned that the greater sort of frequency or number of line reviews, I mean, does that seem to be developing on the parts of these customers as a way of maybe pushback on some price increases they're seeing in a variety of areas? Or is there anything else particularly driving that, that you know about?

[David J. Coghlan:]

Well, I think first of all, over the last couple of years, the DIY -- the major DIY chains have been adjusting their strategies and they have been looking at ways of improving their price points as well as improving their selection. You get some really good insights from that from listening to some of their earnings calls. But the sense we get is that at least for the biggest, they've been moving through that process. So the future tendency is probably going to be less line reviews than the past tendency has been and that's based on what they're saying.

[L. Todd Vencil:]

Got it. That's really helpful. And then final for me, as you look at the sort of high level particularly of wholesale sales, put also on the DIY side too, when you have a sense of where the inventories of the customer stand and what the channel looks like, is it up, down or flat? I think it varies. And it goes back to the comments that Dean made on the lead-free transition. We are seeing our large wholesale customers work hard to transition their inventory and to be prepared for the January 1 transition. And so, they've been putting in lead-free stock and now are they dramatically increasing their inventories? No, it's largely a phase in, phase out process. We also see a very organized approach on the DIY side to phase out and then phase in lead-free and they have done it reasonably early and they're well organized. We do see a reluctance on the part of the smaller wholesalers

[L. Todd Vencil:]

And not a lot of sort of absolute build in that 8-plus percent growth that you guys saw in the quarter?

[David J. Coghlan:]

Yes.

[Operator:]

And your next question comes from the line of Ryan Connors with Janney Montgomery Scott.

[Ryan M. Connors:]

David, I wonder if you could talk about -- a little bit about this issue on the competitive situation on lead-free. Specifically, earlier this year, you talked about the fact that your scale and your R&D prowess would enable you to build a better mousetrap and that some of the smaller players might have a tougher time engineering these products around the new compliance initiatives. So, can you talk about that a little bit and how that's evolved? And what the competitive front is looking like? Is the market starting to coalesce around some standard? Or is it still kind of a wild west where everyone's offering different types of compliant products?

[David J. Coghlan:]

Well, Ryan, I might word your introduction a little bit differently in terms of what we have been saying. We think the larger manufacturers in our industry are high-quality companies and that they've gone through the transition from what we can see in a very professional and very technically skilled way. And so, our position is that the larger players in the industry can stand behind the products associated with this transition and make the customer feel comfortable that they're providing a quality product that meets the requirements of the new law. I think, in terms of alloy selection, in terms of assuring quality in a multi-standard world, it's tougher for smaller companies, for moms and pops and for importers. And so, I wouldn't be so bold as to say that there's a lot of daylight between the standards that Watts can offer and the large professional companies. I would say though, that there's daylight between what the large guys can do and what some of the importers and the moms and pops can do. And so as a customer sits there, and looks at the law and says, he who introduces it into commerce, i.e., sells it to a contractor, installs it in a building, is responsible under the law. I think that is getting customers to look at the quality standards of their providers and how well they can rely on those standards.

[Dean P. Freeman:]

I'll also just add, it's very early in the process, though. And so in terms of any discrete, sort of analytics or behaviors that we can sort of point to, I think, it's still too early in the cycle to call out any specifics.

[Ryan M. Connors:]

Okay. I mean that would seem -- David, to me, that would seem like something where to the extent there was a market share opportunity, it would materialize sooner than later because the initial jump over to lead free for a contractor is sort of the scariest moment. So if they were going to go with a larger player who could give them a better assurance of quality and compliance, that would happen right away and not in a couple of years down the line. So, I guess, Dean, you already answered that, saying that there's no evidence of that but why wouldn't we be seeing evidence of that kind of right off the bat?

[David J. Coghlan:]

Look, there's a whole bunch of variables that wholesalers, retailers and contractors are trying to get used to. We've talked about the fact that for the industry, these new alloys drive cost increases. And so, our customers are looking at double-digit price increases for their products and obviously, if they're on an aggressive job or a competitive job, they're going to look at, well, what are my alternatives? And so they will have to get used to and feel out and get a sense for what are the consequences associated with that, right? So I think, there are so many variables in play that this is going to take some time to play out.

[Ryan M. Connors:]

Okay, and then just an update on the other side which is -- that you've kind of alluded to but the passing the higher cost through and pricing. Can you guys give us an update, any kind of color around where that's tracking and where you see that tracking next year, relative to your expectations and maybe do you expect to be able to get most of the majority of that right away? Or will that be a process that you think takes a little while?

[Dean P. Freeman:]

Okay. So there's a couple of questions in there. I think, as we've said consistently and certainly, as we're pleased by -- we are seeing the pricing profile that we talked about 10% to 20% price increases, and the cost profile that we talked about consistent with holding our margins, percentages constant, we're seeing that play out as expected. Obviously, how that flows through going into next year will be a function of volumes, it will be a function of a number of dynamics. We're not necessarily seeing anything, as I've said in the past, irrational or in any anyway unusual in terms of the competitive dynamics. And so I think, as we've said, it's consistent with our expectations.

[Ryan M. Connors:]

Okay. And then one of the issues, I guess, one of the silver linings of this lead-free is that actually taken copper away as such a prominent topic. I know for years that's a prominent topic but how does copper impact that whole discussion around pricing, because copper is obviously lower than it was a year ago and some of these customers maybe condition to expect, maybe even a price concession, let alone an increase against that. How do you manage? How are your sale teams managing those kind of desperate expectations?

[David J. Coghlan:]

Well, first of all, there's really no change in terms of copper and how it plays through our business. The lead free truly affects the lead content of the alloy, but it doesn't really affect the copper content. And then secondly, I think, the market is struggling to deal with multivariable calculus. And so you've got some changes in the copper markets down and then more recently, back up. And then you've also got the changes associated with products moving from leaded to lead free. And so, one of the things that we believe is occurring with the smaller guys is they're trying to figure out where should pricing be, and they're wondering whether the sort of increases they've seen from all of the companies thus far, will hold up. And the point we're trying to make to them is lead-free, we're trying to hold our margins, percentage-wise. And that's what we and the rest of the industry are doing. And so, I think, it's difficult for people to sort through all the different variables to see what's going on. And so they're looking at the prices they're seeing. They're looking at their other options and so far, as Dean said, we're very comfortable that we're able to achieve what we laid out in terms of holding percentage margins.

[Ryan M. Connors:]

Okay. And then one last one for me kind of a bigger picture question. Lead free has kind of been such a dominant topic this year, but just as we look beyond the lead free and 6 months from now, this will now be -- the deadline will have passed, and get back to sort of focusing on the underlying operating leverage potential in the business, what can you tell us about how you feel about your ability to generate leverage as the volumes improve towards, you mentioned the $1.4 million, $1.5 million start run rate in residential and so forth? I know you probably can't give us a specific quantitative number, but if you kind of characterize your view on the leverage and the model over the next couple of years.

[David J. Coghlan:]

Well, look, I'll try and point to a couple of things and then I'll ask Dean to add in anything that, that I may have missed. I'll point to 3 things

[Dean P. Freeman:]

No, I think that's exactly right. I think we have a strengthening business model, commercially. We have a strengthening business model, operationally, as David pointed out. Many of you have heard me talk about building the muscularity that lead free has provided us, both operationally from an engineering perspective, from a sourcing perspective, and we're going to leverage that moving forward and I think he said it exactly right.

[Operator:]

And your next question comes from the line of Nick Prendergast with BB&T Capital Markets.

[Nicholas V. Prendergast:]

Just a quick question. On the North American margin performance, last quarter you had about 14%, and it looks like it would've been about the same if we kind of strip out those 2 charges. How should I possibly be looking at this going forward? Is that about sustainable?

[Dean P. Freeman:]

Well, look, we talk about that level, roughly as sort of the structural profile, mix, volumes, obviously, will impact that. But yes, I think that's about right. If you look at gross margins, gross margins are on an adjusted basis, you strip out the effect of the lead-free transition would've been about 500 -- 50 basis points better than prior the quarter and to your point, operating income would've been close to 14%. So, yes, I think that's a good place to start and then you can obviously, think about volumes and mix as a function of adjustments from there.

[Nicholas V. Prendergast:]

Got it. All right, and regarding Europe, France and Germany are still looking pretty weak. Do you see that possibly returning to growth anytime soon as the comps get busier?

[Dean P. Freeman:]

So, I think as David pointed out, as I've highlighted, we're encouraged by the signs that we're seeing. We're hearing a lot of good news. We are seeing recovery. I mean, if you recall and look at the presentation materials, many of the countries that we talk about that we operate in are in fact, down. So we're encouraged, but we're being cautious. And eventually, like all things, of course, Europe will eventually come back. But I think, it will -- I would be very hesitant to sort of call a time frame when we see that happening. But clearly, we're optimistic and we're very pleased with what seems like a recovery. We're going to stay focused on continue to realign the business and focus on our commercial strategies to take advantage of areas of growth that we do see, which is emerging markets, our Electronics business, our Drains business. We have a number of platforms that continue to grow despite sort of the broader macroeconomics in the region.

[David J. Coghlan:]

And Nick, I think, it's just worth maybe going back to something that we said earlier in the call. If you take the economy that's been most troubling to us in Europe, it's an important market for us, that's France, we believe the market is down double digits. But our team there has done a phenomenal job for us and we were effectively flat in the quarter. And so that's great performance. We're very excited by the project backlog that our Drains team is building. They had a really tough comp in the quarter because of 2 big jobs that they had in the Middle East and those jobs don't reoccur, we're very excited by that. And to steal a phrase from Dean, we're also very excited by the improving muscularity that we've got around emerging markets capability throughout the EMEA region. So look, we think the market's bottoming in Europe but we're -- we continue to be encouraged by the self-help programs that we've identified in our driving.

[Nicholas V. Prendergast:]

Okay. And if I could just ask one more. On the working capital front, your inventories have been coming up in anticipation of this whole lead-free transition, do you see that coming down as we move into '14?

[David J. Coghlan:]

Yes.

[Operator:]

[Operator Instructions] And your next question comes from the line of Jamie Sullivan with RBC Capital Markets.

[Jamie Sullivan:]

Question on the lead-free transition and the impact to revenues based on full year 1% or 2%, you've been kind of running there you said in the third quarter, so sounds like you're expecting a pretty big jump in the fourth quarter. Have you seen, sort of an acceleration there on the adoption as we go into the fourth quarter? Just wondering how to think about that?

[David J. Coghlan:]

Jamie, first of all, I'll just point out that the biggest players have been transitioning and it's the smaller wholesalers that have yet to transition. And so, we've seen the buildup through the year occur nicely and smoothly. We were a bit surprised by the fact that the smaller guys seem to be transitioning a little bit later. But the big players in the industry, the big wholesalers, the big retailers, they've all been transitioning. And they're finishing up their transition. So we still say that in the aggregate, we're looking at between $200 million to $300 million piece of business being affected by lead free and we've had a nice relatively smooth build through the year, and we're on track to see that sort of revenue convert.

[Jamie Sullivan:]

That's helpful. Then on the DIY front, when you talk about the line reviews and sort of the impact there, you touched on how that was somewhat impacting the incrementals in North America. Does that -- you also reiterated the 30% to 35% overall capacity of the business on the incremental line, does the DIY channel make you a little bit cautious on still hitting that number? Or once we stabilize with the line reviews, it should be able to deliver on that level?

[David J. Coghlan:]

Yes, we had higher levels of growth in DIY earlier in the year that we did in wholesale. That position is now reversed. But we are seeing line reviews that have yet to lap, if you like. And so, I'd point to a couple of different things in terms of why we feel confident 30%, 35% is still relevant. The first one is that we're seeing the sort of growth that we were working towards up here in wholesale. Second, the next couple of quarters, we're coming up to the lapping of some of the most significant number of line reviews. And then the third factor is that if you look at what the big DIY chains are themselves saying, they seem to be coming to the end of a pretty substantial period of line reviews. And so put all of those factors together, and we still feel comfortable with them, in the aggregate 30% to 35%.

[Jamie Sullivan:]

That's helpful. Then just last quick one on commodities, you touched on it a little bit, maybe just the impact in the quarter on price cost?

[Dean P. Freeman:]

Yes. So total supply chain, if you will, we saw about a 100 basis points of total improvement year-over-year in margins, and only about a third of that was commodity driven. So about 30 basis points.

[Operator:]

And your next question comes from the line of William Bremer with Maxim.

[William D. Bremer:]

Question for you, David. You mentioned $200 million, $300 million business will be affected, I guess, that's at the onset. What are you projecting as your underlying capacity? And where are you manufacturing this capacity?

[David J. Coghlan:]

Well, first of all, capacity for lead free is not a concern from our perspective. The biggest piece of capacity that we've got comes from the large investment that we made in our Franklin Hampshire facility, and that's a fully integrated facility where we put a lot of dollars into building a state-of-the-art, lead-free foundry. And that foundry feeds into dedicated machining and assembly sales for lead free. We do also manufacture lead free products in a couple of other facilities in North America and we do also manufacture and source some lead-free products in Asia. But one of the things that we're really pleased about, how do you take lemons and make lemonade, is that we've actually on-shored a lot of capacity for lead free. And so, we're in a position to serve our customers quickly and efficiently, and we're really pleased with what we're seeing in terms of the productivity that we're going to be able to get out of this investment in Hampshire.

[William D. Bremer:]

What has been, David, the inquiry from say, your foreign customers on this?

[David J. Coghlan:]

The inquiry in terms of foreign customers wanting to buy lead free?

[William D. Bremer:]

Yes.

[David J. Coghlan:]

You really can't look at it that way because Europe moved to a lower lead products standard, 10, 15 years ago. And so this is a specific standard for the U.S. and it's not so much customer driven as code and legally -- legal driven. So the way you need to think about it is this requirement is largely U.S. driven. We do have the regulatory and code authorities in Canada looking at it and we do expect that over the next months and years, there'll be a transition in Canada. But many other parts of the world, previously had requirements for products with a lower lead standard than the old requirements in the U.S. And so you look at this as a catch up.

[Operator:]

At this time, we have no further questions. I will now turn the call back over to David Coghlan for closing remarks.

[David J. Coghlan:]

Well, first of all, I'd really like to thank the folks on the call for some very good questions. And hopefully, that gives you all a better sense for what's going on in our business. But we're very grateful for you for taking the time to join us on the call, and we're very grateful for your continued interest in our company, and we look forward very much to talking to you again during our fourth quarter earnings call, which will be sometime early February of next year. So thanks for your time, thanks for your interest.

[Operator:]

Ladies and gentlemen, that concludes today's conference. Thank you for your participation. You may now disconnect, and have a great day.