Ladies and gentlemen, thank you for standing by and welcome to the Watts Water Technology Third Quarter 2019 Conference Call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. [Operator Instructions] Please be advised that today's conference is being recorded.

[Operator Instructions] I would now like to hand the conference over to your speaker today, Tim MacPhee, Vice President, Investor Relations. Please go ahead..

Thank you and good morning everyone. Welcome to our third quarter 2019 earnings conference call. Joining me are Bob Pagano, President and CEO; and Shashank Patel, our CFO. Bob will provide a business overview of the quarter, and Shashank will address the financial results and offer our latest outlook for the fourth quarter.

Following the prepared remarks, we will address questions related to the information covered during the call. Today's webcast is accompanied by a slide presentation, which can be found in the Investors section of our website. We will reference these slides throughout our prepared remarks.

Any reference to non-GAAP financial information is reconciled in the appendix of the presentation. Let me remind everyone that during the course of this call, to give you a better understanding of our operations, we'll be making certain forward-looking statements.

These statements are subject to numerous risks and uncertainties that could cause actual results to differ materially from such statements. For information concerning these risks and uncertainties, see our 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. Let me now turn the call over to Bob Pagano..

Thanks Tim and good morning, everyone. Please turn to slide three in the presentation where I'll provide an overview of the quarter. We delivered a solid performance in the third quarter. As anticipated, topline organic growth moderated due to tougher comps, and slowing market expansion.

However, we were able to drive record quarterly sales, operating margin, and EPS. Regionally, the Americas' continued broad growth was partially impacted by softer heating and hot water platform sales due to project timing.

Europe continued on a steady pace and APMEA returned to nominal growth while continuing to be challenged by Middle East project delays. Shashank will review the financial details in a few minutes. Now, let me make a few comments about the markets. We expect to see mixed growth in the fourth quarter in the Americas non-residential end market.

More recent indices that we follow, including the PMI and ABI, have recently touched multiyear lows and the Dodge Momentum Index has been trending downwards year-over-year. The institutional end market is also mixed with growth in health care spending being offset by lower educational spend.

On the residential side, year-over-year changes in new housing starts and existing home sales have stabilized recently and have shown a slight uptick in Q3. Lower interest rates may help the residential side to some extent, but that could take time.

So, we see market moderation continuing in the Americas for the remainder of this year and as we head into 2020. Global policy uncertainty, rising protectionism and other geopolitical factors have become prominent backdrops in Europe. In the U.K., economic activity is expected to remain muted in the coming quarters.

The ECB recently revised its GDP expectations for the euro area to 1.1% for 2019 and 1.2% for 2020. So, in general, we remain cautious regarding Europe. And in APMEA, we see a continued mixed bag with the market spotty depending on the region.

Macro issues like China trade, oil refinery, bombings in Saudi Arabia, and the Turkey-Syria conflict only create additional uncertainties in those regions. Now, let me provide some more background on our latest acquisition.

In late August, we purchased the assets of Backflow Direct, a California-based company that designs and manufactures large diameter stainless steel backflows, primarily used in commercial fire protection applications.

Backflow Direct was established about seven years ago and the founder is well-known in the backflow prevention industries and to Watts as well. Strategically, Backflow Direct provides some innovative products in fire protection applications that broaden our offerings to meet customers' requirements.

We are also excited that the former owner, a well-respected professional in backflow prevention, is joining our team to aid in future backflow development opportunities. We are excited to add Backflow Direct to our portfolio. Finally, our outlook for the second half of 2019 has not changed from the guidance we provided in August.

We still expect growth in the second half to be 2% to 3% on a consolidated basis with Americas growing 3% to 4%, Europe 1% to 2% and APMEA in the 5% to 7% range. Now, I'll turn the call over to Shashank to talk about our third quarter operating performance and provide more color on our fourth quarter outlook.

Shashank?.

Thanks Bob and good morning everyone. Please turn to slide four and we'll discuss the third quarter consolidated results. Reported sales of $395 million were up 1% as organic growth of 2% was partially offset by a foreign exchange headwind of approximately $6 million or 1% during the quarter.

Consolidated organic growth was in line with our expectations and I will address our regional performance in a few minutes. Adjusted operating profit was $52 million, an increase of 4%. This translated into an adjusted operating margin of 13.3%, up 40 basis points versus last year and an all-time quarterly record for the company.

Price, productivity, including restructuring savings and higher volume, partially offset by investments in inflation, were the main drivers of the record margin performance. We continue to invest in growth and productivity initiatives.

In fact, in the third quarter, we spent approximately $4 million on investments, about $1 million more than we had anticipated. More than half of the total investment spend was focused on our smart and connected initiatives. Adjusted earnings per share of $1.04 was a 5% increase over last year and a new third quarter record for the company.

Adjusted earnings per share increase was driven by operations. Negative foreign exchange and positive share dilution were each $0.01 and were net neutral. The adjusted effective tax rate in the quarter was 28.5%, consistent with the prior year.

Turning to cash, on a year-to-date basis, free cash flow was $76 million, a 77% increase as compared to the same period last year. The increase was mainly due to higher income, reduced inventory levels, lower tax payments, and reduced capital spending.

Historically, the fourth quarter is a strong cash flow quarter for the company and we expect that trend to continue this year as well. Our goal is to attain 100% free cash flow conversion for the year. During the third quarter, we repatriated approximately $7 million in cash.

Year-to-date, we have repatriated about $37 million, using a majority of debt to pay down debt. In the third quarter, we purchased approximately 48,000 shares of our common stock at a cost of $4.5 million.

Year-to-date, we've returned a total of $38 million to shareholders in dividends and share repurchases as part of our balanced capital deployment strategy. We also incurred some costs at corporate this quarter, which have been classified as special items.

First, we incurred $2.3 million of professional fees including legal and tax costs to optimize and simplify our European legal structure from a pan-European perspective and align with previous restructuring initiatives.

We also incurred other professional fees in order to obtain a much deeper understanding of our product, country and customer profitability, which should help guide our future new product development and other investments. We expect to complete this review in the fourth quarter.

The second special item of $0.9 million related to acquisition costs incurred for the Backflow Direct acquisition and cost of other acquisition efforts that did not come to fruition.

So, to reiterate Bob's comments, a solid third quarter performance, setting new quarterly highs in sales, adjusted operating margin, and adjusted earnings per share while continuing to invest for the future. Now, to the regions on slide five, let's review Americas results for the quarter.

Sales of $270 million were up approximately 3%, both on a reported and organic basis. The organic growth was driven by price realization and volume increases in plumbing valves, drains, and water quality products. Growth was partially offset by softness in heating and hot water products from project timing delays and continued competitive pricing.

As expected, price was a smaller contributor to growth as compared to the first half. Also, the pre-buy during the second quarter ahead of the previously announced July 1 price increases negatively impacted the Americas sales growth by about 2% in the third quarter.

Adjusted operating profit in the Americas was $48.9 million, a 9% increase year-over-year. Adjusted operating margin increased 100 basis points to 18.1%, driven primarily by price and productivity, which more than offset incremental growth investments and inflation. To summarize, a good quarter for the Americas.

Moving to Europe, please turn to slide six. Sales of $108 million were down 3% on a reported basis and up 1% organically. Foreign exchange, mainly the euro, was a headwind of about $5 million or 4% in the quarter.

The organic sales increase was driven by solid growth within our drains platform and, to a lesser extent, growth within core plumbing and HVAC products in the Fluid Solutions platform. Drain sales into Marine applications continued to be strong. By geography, we saw strength in France, Italy and the Nordic regions.

We saw softness in Germany and the U.K. France was driven by increases in core plumbing and drains products. Italy and Scandinavia were both stronger due to growth within our plumbing product lines. Sales in Germany were down as both plumbing and drains products were soft. Finally, the U.K. was down amid Brexit uncertainties in the market.

Adjusted operating profit for Europe in the quarter was approximately $12 million, a 5% decrease as compared to last year. Operating margin of 11.2% decreased 30 basis points versus the third quarter of last year.

The benefits of incremental price and productivity, including restructuring savings, were more than offset by incremental investments and the timing of certain costs. So, for Europe, steady top line growth with a slightly lower operating margin performance. We expect adjusted operating margin should expand in the fourth quarter.

On slide seven, let's review APMEA's results. In the quarter, sales of $16.5 million were down 1% on a reported basis and up 1% organically. The third quarter was a continuation of APMEA's first half performance with strong growth in China offsetting weakness in other regions, especially the Middle East, where projects continue to be delayed.

Sales in China were up double-digits organically, mainly driven by commercial valves. Sales outside China decreased by double-digits due to the Middle East and Korea.

Adjusted operating profit and adjusted operating margin were significantly affected by a decrease in intercompany sales volume, unfavorable country sales mix and additional investments, which are only partially offset by additional productivity savings.

Recall that last year, the Americas purchased additional product from our Chinese sister companies in anticipation of the higher tariffs. In summary, APMEA returned to growth during the quarter with solid growth continuing in China, but profits were negatively affected primarily by unfavorable intercompany volume and Middle East project timing.

Finally, turning to slide eight, I'd like to make a few comments on the fourth quarter. On a consolidated basis, we expect year-over-year fourth quarter organic sales growth of approximately 3%.

Growth rates should increase sequentially from the third quarter in the Americas and APMEA, while Europe's growth should be fairly consistent as compared to the third quarter.

Adjusted operating margin in the fourth quarter should expand versus the prior year, supported by price, volume growth, continued execution of our productivity and restructuring initiatives, partially offset by inflation. We expect incremental growth investments of $2 million to $3 million in the fourth quarter versus last year.

Excluding special items, we anticipate total corporate costs in the quarter to be $10 million to $11 million and expected restructuring savings are $1 million in Europe. We expect full year adjusted operating margin expansion should be at the high end of the 50 to 70 basis point range that we provided during our February outlook.

Our adjusted effective tax rate should approximate 28.5% in the fourth quarter. The FX impact should be negative as compared to the fourth quarter last year. Our average euro exchange rate last year was 1.14, our current expectation is 1.10 for the fourth quarter of this year.

We are expecting strong cash flow generation in the fourth quarter, consistent with our performance over the past several years. We estimate capital spending will approximate $30 million for the year.

Finally, we anticipate incremental costs of $1 million to $2 million in the fourth quarter including additional cost to finalize the European project I discussed earlier. We will highlight these costs as special items. With that, I'll turn the call back over to Bob before we begin Q&A.

Bob?.

Thanks Shashank. To summarize, the quarter played out as we had expected with solid earnings and margin expansion along with tempered top line growth. We acquired the assets of Backflow Direct to extend our product range and meet our customers' needs and we expect our second half sales and margin expectations to be in line with our previous outlook.

So, with that, operator, please open the line for questions..

Certainly. [Operator Instructions] And our first question comes from the line of Nathan Jones, Stifel. Your line is open..

Hi, good morning. This is Adam Farley on for Nathan..

Good morning..

Good morning..

You guys have been very consistent with your strategy of organic investment and driving growth and margin expansion. So, I'm going to focus first on growth. Your comments on the macro were helpful. I was wondering though if you could talk about some of your strategies of penetrating some of your international markets like the Middle East.

What does that look going forward? Are you seeing traction there? And then also, if you could talk about some of your connected solutions? And maybe an update there. .

Yes. Thanks Adam. Certainly, we believe there's opportunity in growth inside the Middle East region. Right now, our quoting activity is very high. We are continuing to invest there. But we're being very cautious from, let's call it, a collection point of view. There's a lot of jobs out there.

We're really tight with our terms because it's really important we remain disciplined and get our cash. So, a lot of activity, and we're seeing some projects being delayed with some of the uncertainty that I talked about previously. So, again, we believe in the long run though, we have low market share there and it's a huge opportunity for us to grow.

So, we'll continue to invest there. On the connected products, they still remain very strong. We're driving -- those are -- continue to grow double the rate that our existing portfolio is growing and we plan on being in the double-digits as a percentage of our overall sales by the end of this year.

So, again, great opportunities, our continued investment is in that area, and we believe that it will be opportunities for growth in the future..

All right, great. And then just switching over to the margin side. Maybe talk about moving into 2020, there's a lot of uncertainty. How you guys are going to balance growth investments and then also margin expansion? So, where are you guys in the lean transformation journey? And then just any other color there would be great..

Yes. So, when we look at margins next year, obviously, dependent on how far the topline grows, that will determine how far we expand. But we -- as you know, we have many opportunities for lean in our organization, both in our factories and in our front end.

And that's really our focus because we believe we need to continue to drive productivity to allow us to invest in the future. So, margin increases, that's our continued goal, as we've always stated. We believe we have the opportunity to do that.

But in the face of that, we've also been looking at our overall corporate investments and where -- on our global investments on where we believe we can drive overall shareholder value by investing in growth opportunities.

So, we haven't done a lot of M&A, and we believe investing in ourselves is the best value for our -- long-term for our shareholders. So, again, we'll be reviewing that as we get closer to 2020, but I still believe we have ample opportunity to grow our margins..

All right, great. Thank you..

Thanks..

And our next question comes from the line of Jeff Hammond, KeyBanc. Your line is open..

Hey, good morning guys..

Good morning..

Good morning Jeff..

Just on the Americas commentary outlook.

Can you just kind of bifurcate what you're seeing in the business specifically in terms of areas that might be weakening versus kind of the high-level macro data, which might be pointed to more caution, but maybe you're not seeing yet in the business?.

Yes. So, our first issue is the comparison against last year. If you recall, in the Americas, and last year, we grew about 10%. So, some of that was related to the tariffs. And -- but overall, we see very good activity, but we look at the leading indicators, as those are something we look at on a forward basis is predicting our future.

So, activity still is strong. We did see in our heating and hot water, some of our business got pushed into the fourth quarter, some delayed funding happened. Lot of quotation activities are still out there.

So, again, we see growth, but just probably slower growth because a lot of growth has been driven by pricing increases, those -- as a result of tariffs. That will slow down as we go into next year. And then again, our leading indicators are saying that, in particular, in the commercial area that they should be slowing in the future.

But our teams are optimistic. We'll get our fair share and more of the market that's out there..

Okay. And then at this time, I guess delays and timing issues.

Does that reverse in Q4? Or is that something that's pushing into 2020?.

I would say both. We are seeing -- we have a strong backlog on the heating and hot water solutions group into the fourth quarter. So, our orders were up double-digits in Q3. It's just the shipping was in Q4. Some educational institutions just delayed the timing of the funding of those projects.

Normally, they seasonally are in Q3 and it moved out into Q4. So again, we should have a solid Q4 in that business..

And just a note on the heating hot water side, our lead-times are longer. So, those projects came in. That's why Bob talked about orders look good, but they'll be shipping in Q4. On the other side of the business, it is book-and-ship business primarily..

Okay, great.

And then can you give us any more on Backflow Direct? What's the annual revenue? Is there a revenue contribution to think about for Q4? And anything around kind of the multiple you paid for the business?.

Yes. So, Jeff, they've been running about $2 million to $2.5 million per quarter. And again, we've -- the owner has asked us to not talk about the details of the transaction, but you obviously could read our cash flow statement. But anyways, we believe it's a great opportunity for us in the long run from an R&D point of view.

It saves us about three years of development. They have a unique product that is smaller and lighter than our existing products. So, it fills the need that we have in our portfolio and I think it's -- in the long run, will aid in our new product development. So, we're really excited about this acquisition..

And then maybe one last one. Shashank, you talked about some professional fees. And looking at your European business strategically and from a tax, any kind of early observations from that? And how maybe you're thinking about the tax structure differently or strategically or any opportunities that are coming out of that? Thanks..

Yes. As you know, we did restructuring in our Amsterdam office last year. And as a result of that as well as the tax law changes within the Eurozone, we decided to do an assessment of our legal entity structure, and we incurred some legal and tax fees.

As we gain further insights from that effort -- from that analysis, we also hired consultants to actually do a deeper dive of our product and customer profitability by country to help guide us in future investments. So, I think we're still in the middle of that.

We're going to complete that in the fourth quarter, but it will certainly help us drive better investment decisions as we go forward. So, more to come on that in the next call..

And Jeff, just to add, we set up a principal company inside of Amsterdam. And again, a lot of billing and centralized activity was going through that. So, we wanted to break that back up because we're really more focused on the countries at this point in time. And we believe it's a better opportunity to do that.

So, that's why we needed to break that up and allocate the right cost to the right places..

Okay. Thanks guys..

Thank you..

Thank you..

Our next question comes from the line of Brian Lee, Goldman Sachs. Your line is open..

Hey how is it going? This is Alex on for Brian..

Good morning Alex..

Good morning Alex..

Just a quick one for me. I appreciate the macro color in the prepared remarks.

So, in light of those trends that you mentioned, have you -- are there any changes to the business model or the markets that you're targeting going into next year? Or is it just a bit of cyclicality that you're seeing?.

I think it's a bit of cyclicality. I mean, we're going to continue on our investments, our new product development, our connected strategy. All of that, we believe, will allow us to have above-market growth opportunity. So, that's really important. And I always remind everybody that 60% to 65% of our business is repair and replace.

That tends to follow GDP. And as we all see, GDP is continuing to be positive, although slightly moderating. But overall, the business model is sound. We'll continue to invest in emerging markets also because we have low market shares there. But right now, there's a little political turmoil in some of those countries that we've been investing in.

But again, we're in it for the long run and we believe there's opportunities in the long run..

Great, appreciate that. And just a follow-up there.

Would you say those trends that you were referring to are occurring in Europe as well?.

Well, yes, certainly, in Europe. I mean, I think with the Brexit, the uncertainty in that whole region in the -- let's call it, the trade impacts that are going on as a result of that. So, there was a report out yesterday that France is coming back. We had a strong growth in France. So, that's an opportunity for us.

So, again, as you followed me, I've always been very conservative in Europe, just to make sure our cost structure are in alignment. But our two other businesses that are growing and they both are drains and electronics, those are global growth businesses and we believe there's opportunities to continue to grow in those markets.

The other areas, I think there'll be more slower growth and we'll make sure our cost structure is aligned to that..

Excellent. Thanks a lot..

Thank you..

And our next question comes from the line of Joseph Giordano of Cowen. Your line is open..

Hey guys, good morning. This is Francisco in for Joe..

Good morning..

Good morning Francisco..

Good morning. So, you guys called out some of the momentum in U.S. institutional building that seems to be weakening. We've seen things like the Dodge Momentum Index slowing down.

Are you guys seeing anything notable that you could be calling out in that part of the business specifically?.

Not really. I mean, again, coatings is up. We've seen some project delays and that's normal, right? In our business, when there's uncertainty, projects just get pushed out and stuff, but we've not seen any cancellations.

And hopefully, some of this uncertainty will go by, but we still see good spending, but some of those indicators are longer leading indicators. And I think that's what we're very cautious on. So, again, we're going to be watching that carefully. We're talking to our sales team.

They still feel bullish, but we're also very cautious in washing around the corner to make sure we're prepared if there's any significant downturn. But right now, steady as it goes. And again -- but remember, our compares and tariffs and all that are also impacting our growth into the future..

Okay, great.

And then in terms of German OEMs, have you guys seen any positive signs on that side?.

Not really. I think it's -- again, we all read about the German economy and potentially, they've been in recession and I think there's just muted spending right now. I mean -- so that's something we're going to watch cautiously. It's not been horrible, but it's -- we've not seen growth there and that's an area we just will remain cautious on..

Okay, great. Thank you..

Thank you..

And there are no further questions at this time. I'll turn it back over to Bob Pagano for closing remarks..

Thank you, everybody for taking the time to join us today for our third quarter earnings call and we appreciate your continued interest in Watts. We look forward to speaking with you again in our fourth quarter call in February. Thanks again..

This concludes today's conference call. You may now disconnect. Have a good day..