WTS - NYSE

Ladies and gentlemen, thank you for standing by. My name is Brent and I will be your conference operator today. At this time, I’d like to welcome everyone to the Watts Water Technologies, Inc. First Quarter 2023 Earnings Conference Call. [Operator Instructions] Thank you. Now my pleasure to turn today’s call over to Ms. Diane McClintock, Senior Vice President, FP&A and Investor Relations. Please go ahead.

Thank you and good morning, everyone. Welcome to our first quarter earnings conference call. Joining me today are Bob Pagano, President and CEO; and Shashank Patel, our CFO. During today’s call, Bob will provide an overview of the first quarter and discuss the current state of the markets and our operations. Shashank will discuss the details of our first quarter performance and provide our outlook for the second quarter and for the full year. Following our remarks, we will address questions related to the information covered during the call. Today’s webcast is accompanied by a presentation, which can be found in the Investor Relations section of our website. We will reference this presentation throughout our prepared remarks. Any reference to non-GAAP financial information is reconciled in the appendix to the presentation. Before we begin, I’d like to remind everyone that during this call, we maybe 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 disclaims any intention or obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. With that, I will turn the call over to Bob.

Thank you, Diane and good morning everyone. Please turn to Slide 3 and I will provide an overview of the quarter. I’d like to start by recognizing our team for their continued efforts to serve our customers. Together, we delivered another better-than-expected quarter with record first quarter sales, operating margin and earnings per share. The Americas and Europe teams expanded top line growth at a low single-digit pace, primarily due to price. Both regions continued to drive organic growth despite the tough comparison to double-digit growth in the first quarter of 2022. We also saw high single-digit growth in APMEA despite challenges in China after COVID restrictions were lifted and the impact of unprecedented flooding in New

Thanks, Bob and good morning everyone. Please turn to Slide 4, and I will review the first quarter’s consolidated results. Sales of $472 million were up 2% on a reported basis and up 4% organically. As Bob mentioned, we drove growth in all regions despite the tough comparison to a very strong first quarter in 2022. Foreign exchange, primarily driven by a weaker euro reduced sales by approximately $9 million or 2% versus 2022. Adjusted operating profit was $84 million, up 16% compared to last year and adjusted earnings per share were up 18% to $1.92. Adjusted operating margin of 17.9% was up 220 basis points as price, mix and productivity more than offset inflation, lower volume and incremental investments. The adjusted effective tax rate was 22.5%, 40 basis points higher than the first quarter of 2022. The slight increase relates primarily to the changes in worldwide earnings mix. Our free cash flow for the quarter was $28 million as compared to negative cash flow of $8 million in the first quarter of last year. The cash flow increase was primarily due to higher net income and lower investment in inventory. We expect sequential improvement in our free cash flow, and our full year goal is to achieve free cash flow conversion of 100% or more of net income as previously communicated. During the quarter, we repurchased approximately 22,000 shares of our common stock for $4 million, and as Bob mentioned, announced a 20% increase in our dividend starting in June. Please turn to Slide 5 and let me provide a few comments on the regional results. The Americas had a solid quarter with organic sales up approximately 3% despite a tough prior year comparison. The growth was primarily driven by price realization across the majority of our platforms and channels. As expected, we did see softening in our residential end markets, which mainly impacted our OEM and specialty channels. Adjusted operating profit increased by 25% and adjusted operating margin increased by 400 basis points. The margin expansion was driven by price, mix and productivity, which more than offset volume declines, inflation and incremental investments. Europe demonstrated resiliency with organic sales up approximately 4%. Reported sales were negatively impacted by 5% from unfavorable foreign exchange movements. Growth was primarily due to price with growth in Germany and Italy driven by our OEM business and in France and Benelux through solid wholesale activity. As a reminder, we stopped our direct shipments to Russia in April 2022, and we estimate the impact of that to be approximately $2 million in the first quarter. Operating margin declined by 250 basis points as price and productivity were unable to fully offset inflation and volume deleverage. APMEA also had a solid quarter, delivering 11% organic growth. Reported sales growth of 4% was negatively impacted by 7% from unfavorable foreign exchange movements. China’s organic sales grew double digits, primarily from commercial valves sold into data centers. Organic sales outside China were up by high single digits with growth in Australia and in the Middle East, partially offset by a decline in New

Thanks Shashank. On Slide 7, I would like to summarize our discussion before we address your questions. The first quarter was better than we anticipated with record first quarter sales, operating margin and earnings per share, supported by price and favorable mix. While we expect muted top line growth in the second quarter due to challenging prior year comparisons, we are increasing our full year operating margin expansion outlook and are maintaining our full year organic sales growth expectations. We acquired Enware Australia and are working on integration into the Watts portfolio. We continue to stay on top of the price/cost dynamic and adjust as needed. Despite the weakening macros, we will continue to make incremental investments in new product development and to drive our smart and connected strategy and in automation to drive productivity. We are also increasing our dividends by 20%. We are well positioned financially, operationally and commercially to take advantage of market opportunities as they arise. And I am confident in our team’s ability to execute in this uncertain environment. With that, operator, please open the line for questions.

[Operator Instructions] Your first question is from the line of Mike Halloran with Baird. Your line is open.

Hey. Good morning everyone.

Good morning Mike.

So, a couple of questions here. First, I certainly understand the leading indicator side of things, particularly for some of the multifamily, ABI, everything like that. But when you look at the core business you have today, leaving aside the residential piece, single-family, are you seeing in North America deterioration happening at this point in time, or is this still perspective? And any kind of channel-oriented commentary would be great.

Yes. Mike, I think we are really seeing it in the residential single-family side. That’s where we are down. We are seeing it in the OEMs. We saw more destocking in Q1 and expecting a little more OEM destocking in Q2. So, that’s where we are really seeing it. I would say multifamily is holding up and non-resi is holding up also.

Any nuance on the non-res side worth mentioning? I mean because non-res is an awfully big market with different constituents.

Yes. Again, our product doesn’t really care what market it goes into. So, if office buildings are down and institutional up, it just ships, right. So, with the labor shortages in the construction market right now, the contractors are still busy and these jobs are continuing to happen. But as you said, we are watching the leading indicators because we are a short-cycle business.

And then second one on the margins here. Obviously, the really strong performance in the first quarter, North America in particular, you look back over the last four, five quarters, frankly longer, but last four or five quarters, you have been hovering, well, in the low 20s on all-in here. You look at how the guidance seems to cadence out, you saw on the margins through the year. Could you just talk about the puts-and-takes? It seems like that’s just mostly tied to the volume side of things. Obviously, there is a 2Q year-over-year comp that you mentioned with the $7 million. But anything else you would point to we saw other than just caution about the environment, or is there something else in that margin profile worth mentioning?

Yes. So, there is a couple of things, right. So firstly, we did have some slightly favorable mix in the first quarter. As we sell less in single-family residential, the margins there tend to be lower. So, there is some mix favorability that helped Americas. And then secondly, on the price-cost side, if you recall, we had price increases pretty much consistently every quarter. We start lapping those starting in the second quarter. The first quarter, we still got benefit of most of the four increases we had last year. So, that helped the margin profile. And then finally, on the cost side of the equation, certainly on the inflation, as Bob noted, inflation has moderated. We saw that in Q1 – beyond commodities in things like logistics costs, etcetera, inflation was a lot less.

Thanks Shashank. Thanks Bob. Appreciate it.

Thank you.

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

Hi. Good morning guys.

Good morning.

Can you just speak to what you are seeing in the channel around any destocking maybe beyond residential – just as supply chains get better if you are seeing any of that in the channel?

Yes. I think electronics is still spotty from a supply chain issue point of view. I would say, as I have said earlier, the destocking is more in the OEM residential side. Wholesale, we are watching it. We are seeing – it’s harder for us to see because we don’t have a lot of visibility into all of the wholesale channel, but it seems like it’s stabilized. We are still watching that very closely. But in general, it’s more – the softness is on the residential side.

Okay, and then just back on the margins, it seems like 2Q is always a step-up from 1Q as you get the seasonal volume, but the guide is kind of suggesting margins are kind of flat to down. It seems like the price-cost gap is getting wider, and you are seeing some moderation in inflation, and we have had a lot of companies talk about – just as supply chain friction, expedited freight, euro-spot buys kind of normalized. You see some of that drop to the bottom line. So, just I don’t know if there is something I am missing there.

Yes. A couple of things. So obviously, we had a little bit of more volume leverage in Q1 versus Q2 because Q1, we grew the business at about 4%. And the midpoint of the guide is about a 2% decline. So, there is some volume deleverage in the second quarter. Back to that pricing dynamic, as I have said earlier that we had the benefit of full prices in Q1. That starts fading in the second quarter, so in Q1, our price realization, mid to high-single digits. We will talk about the second quarter when we close out the second quarter, but our expectation is it will be less. So, that impacts the margins.

Okay. And then just back on kind of non-res. Maybe can you just speak to your lead indicator products, remind us what those are and what you are seeing there that would maybe signal or not signal a slowdown in commercial construction?

Yes. In general, things are holding up. We did see a slight decrease in some of our drains, but that was based on some lumpy business, project business in the prior year. So, I think it’s basically holding steady at this point, Mike, I think – Jeff. What we are doing is continuing to talk to our channels, our contractors. They continue to be busy. They have a backlog of work. So, that’s how we are watching this. The leading indicators are longer term, but feet on the street, talking to what’s happening out there is what we are really watching at this point in time. As I have said earlier, labor shortages are prolonging this. So, there is a backlog of jobs. I think as we have said, as we get into the second half, that’s where we are being a little cautious at this point in time to watch that. Again, we are a book and ship business.

Okay. Thanks so much.

Thanks Jeff.

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

Good morning everyone.

Good morning Nathan.

Maybe a question on the Enware acquisition, I mean that adds pretty significantly on a relative basis, I think to the business in Australia. Can you talk about how you leverage that business to grow? Do you need to make more acquisitions there to build scale? What’s the strategic plan with that?

Yes. So, Enware, look at it, it’s in Sydney. It designs and engineers and manufactures specialty plumbing and safety equipment, and it fits nicely. It’s quite honestly a turnaround for us. It’s basically a breakeven business. Team is already at work integrating that, and we like the channel access to bring our other products with it as well as they did a lot of, what I call, sourcing locally, and we will leverage our global sourcing business. But overall, it gives us scale as well as it gives us additional channel access for our existing products.

Do you need to build further scale to really leverage channels into it and things like that? Like is that a strategic priority at this point? I know you have looked to move into developed markets that have strong plumbing codes. Do you need to build more scale in Australia or wherever else you choose to go in order to leverage those businesses probably?

Yes. In general, I would say our whole APMEA region, we want to continue to scale and leverage that. So, we are looking for quality acquisitions that give us channel access. We have been building a nice position, both in Australia and New

You just let me know when you want to take me to see that business.

Shashank is going in a couple of weeks.

I am sure my invite is in the mail. Just on the Europe margins, they were down 200 bps year-over-year, but given the volume leverage and the high fixed cost base there, I thought a pretty good performance out of Europe. Can you maybe provide some more color on the margin profile there, the contributing factors to the pretty decent margin performance there and how we should think about that going forward?

Yes. If you recall last year, Nathan, in the first half, we had very robust margins in Europe, leveraging the volume, and then they dropped off pretty significantly in the second half as the volume came down, and we had a high fixed cost base. As you recall, we took restructuring actions in Europe in Q4 and early on in January, and that’s certainly helping, and that’s helping the margins in Q1 as well as the fact that the volumes came in better than we had anticipated in Europe. So, less volume deleverage than we thought. And that was – obviously, the strength in Italy, Germany, a little bit in France and Benelux, those regions came in better. So, there was less volume deleverage, and that’s why the margin profile was better.

Great. Thanks very much for taking my questions.

Thank you.

Your next question is from the line of Michael Anastasiou with TD Cowen. Your line is open.

Hey. Good morning guys. Thanks for taking my question.

Good morning.

Good morning.

You had mentioned earlier price was about high-single digit in the quarter. Can you just dive into sort of the price impact expected for the remainder of the year?

Yes. So, we had said first quarter was mid to high-single digit price realization. We don’t really comment on price until we close out the quarters because now we are going on to 2 years plus with price increases. But the expectation when we did our call about three months ago, we expect to be in the low-single digits for the full year. So, that does come down as we go through the year just because we comp higher price realizations last year.

Great. Thank you. And then just on the general commercial side and kind of multifamily and stuff like that. Can you just comment on sort of the cadence throughout the quarter? Anything in particular that would be interesting there?

No, I commented earlier that it’s been holding up. Where we are seeing the softness is single-family side of the business, and that’s where most of the issues are at this point in time as well as the OEM destocking that we are seeing.

[Operator Instructions] Your next question is from the line of Walt Liptak with Seaport Global. Your line is open.

Hi. Good morning everyone.

Good morning Walt.

Hi. Good morning. Shashank, I am ready to go visit Enware too, so just let me know. I wanted to ask a follow-on to the Enware question. It sounds like with the turnaround – love to hear the 80-20 being talked about, that’s great. Can you talk about what normal margins would look like for Enware in the future? And then how much – how long does it take to get them there?

Well, we are expecting basically breakeven now. And then we will continue to ramp up over the next 3 years to get it back in line with the overall APMEA type margin. So, that’s our goal. The teams are working aggressively and have already taken aggressive actions already. So, team is on the ground, making good strides.

Okay. Great. And then on just kind of M&A more generally, it’s good to see you guys get one done here. The rising interest rate environment, is it – are you seeing more deals come into the pipeline from private equity or whoever? And are you seeing any changes in valuations?

I would say in general, I mean M&A activity is still out there. It’s hard to comment on it because it takes two people to get their minds around whether they want to sell or not. But our pipeline is full. We look at small, medium and large acquisitions, and we are – I would say it’s about the same. We are continuing to monitor it, but I don’t think the environment has changed that substantially at this point in time.

Okay. Alright. Great. And then I don’t think I have ever asked a question about this of any company before. But the dividend increase, I think you said was 20%. Is that par for you guys, or is there something that we should read through about the cash levels and uses for cash? I wonder if you could just comment on that.

Yes. We tend to drive to a median yield of about 0.9%, which is kind of in line with the median for the water space. Back in the pandemic days of 2020, we didn’t have any increase. So, we fell a little bit behind because of that as well as our EPS has obviously done well and our stock price has done well. So, it’s in order to try to get back to that median level of 0.9%. That’s why we had the 20% increase. So, beyond that, there is no need to read anything else into that.

Okay. Great. Okay. Thank you.

Thanks.

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

Hey everyone. This is Miguel on for Brian.

Hi Miguel.

Hi everyone. Just a follow-up question on Enware again. You said it would take about 3 years to sort of fully get that business up to the overall APMEA margin levels. Could you just maybe talk through specifically what are the levers to get you there? Do you need to grow that business to a certain scale? Is it a combination of that plus integrating the operations, working on cost structure? Just any additional color there would be great. Thanks.

Well, it’s certainly all of the above, but I would tell you the first focus is on profitable growth, which you know, our playbook. So, if anything, volume is going to go down in the short-term, because we are going to rationalize products, again, the 80-20 concept of making sure we are producing and manufacturing products that make money. And then the second thing, it’s about focus, right. And the team is looking – most of their product was sourced locally. We are going to leverage our global sourcing capabilities around the world, including our global plants to optimize some of the production of that material. So, it’s about focus, it’s about rightsizing the business and potentially decreasing the sales volume to get the profitability, again, similar to what we have done at Watts here.

Great. That’s helpful. And then just a quick follow-on. Historically, can you give a sense of maybe how quickly that business had been growing in Australia? And then you are talking about maybe rightsizing in the near-term. So, what does that look like in terms of the near-term growth for that business then?

In general, it’s mid-single digits. But as I always tell, anybody can give away products, right, and get the growth. So, it’s about leveraging overall profitability, but our goal is to get that in the mid-single digit growth.

Okay. Great. Thanks. It’s very clear. I will pass it on.

Thank you.

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

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