Watts Water Technologies, Inc. (NYSE:WTS) Q3 2023 Earnings Call Transcript

Watts Water Technologies, Inc. (NYSE:WTS) Q3 2023 Earnings Call Transcript November 5, 2023

Operator: Good morning. My name is Emma, and I will be your conference operator today. At this time, I would like to welcome everyone to the Watts Water Technologies Third Quarter 2023 Earnings Call. [Operator Instructions] Diane McClintock, Senior Vice President, Investor Relations and Financial Planning and Analysis, you may begin your conference.

Diane McClintock: Thank you and good morning, everyone. Welcome to our third 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 third quarter and discuss the current state of the markets and our operations. He will also update you on our recent acquisition of Bradley Corporation. Shashank will discuss the details of our third quarter performance and provide our outlook for the fourth 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.

Bob Pagano: Thank you, Diane, and good morning, everyone. Please turn to Slide 3, and I’ll provide an overview of the quarter and our markets. We delivered another quarter with better-than-expected results, including record Q3 sales, operating margin, earnings per share and free cash flow. As a result, we’re raising our full year 2023 operating margin outlook. Organic sales were flat to prior year as we expected due to a tough comparison to a strong third quarter in 2022, where organic sales were up 12%. Strong growth in our Americas nonresidential core valve products was offset by double-digit declines in our gas connectors, radiant heating applications and commercial marine instrumentation. Adjusted operating margin of 18% exceeded expectations and was supported by solid price realization, favorable mix and productivity, which more than offset inflation, lower volume and incremental investments.

Year-to-date free cash flow has been strong, and we expect to generate solid free cash flow through year-end. Our balance sheet remains healthy post Bradley acquisition with a net leverage ratio of less than 0.1x, which affords us ongoing flexibility in our disciplined capital allocation strategy. Strategic M&A, high ROI CapEx and competitive dividends remain our top capital allocation priorities. Moving to operations. As previously announced, we closed on our acquisition of Bradley Corporation in October. This acquisition is highly strategic and expands our addressable market. Integration is underway and the teams are working collaboratively to capture synergies and market opportunities. I’ll speak more about the acquisition in a minute.

The integration of our Enware acquisition is going well and continues to be ahead of schedule. With this acquisition, Australia and New Zealand now represent more than half of our APMEA region. Next, I’d like to provide an update on our end markets. GDP continues to be positive in our key markets, and this supports our repair and replacement activity. In Europe, some markets remained solid in the quarter as growth continued in Germany, France and Benelux. However, we do see softening driven by a slowing residential market and nonresidential new construction and the impact of changes to the energy incentive program in Italy. In the Americas, new residential single-family construction appears to have bottomed out. However, multifamily new construction has seen recent declines in starts and permits, which may signal slowing as we head into 2024.

Nonresidential new construction indicators are mixed. The ABI fell back below 50 in August and declined further to 45 in September after several months of expansion. The Dodge Momentum Index sequentially improved in September after 4 months of decline due to an uptick in institutional and industrial activity. The institutional and industrial verticals have remained supportive year-to-date. In the Asia-Pacific region, China data center activity remains solid, but it’s being offset by declines in residential building activity. The Australian market remains healthy despite continued interest rate increases. We saw strengthening markets in the Middle East due to continued higher oil prices. Now an update on our outlook for the fourth quarter and the full year.

Due to challenging comps as a result of a strong fourth quarter in 2022, we expect our fourth quarter organic sales to be lower than prior year. We also anticipate a sequential decline in operating margins due to normal seasonality, incremental investments, volume deleverage and the dilutive impact of our Enware and Bradley acquisitions as a result of customary transaction-related costs, including amortization. While we expect difficult comps in Q4, we are increasing our full year operating margin outlook due to strong year-to-date performance and anticipated higher margins in the fourth quarter due to favorable mix. We expect America’s non-residential business to remain solid, but be offset by continuing softness in certain specialty channel products.

We also anticipate Q4 to be softer in Europe due to weakening macros. Higher interest rates and lending tightening may also have an impact on new construction. Please turn to Slide 4, and I’ll give you an overview of the recently acquired Bradley Corporation. Bradley is a 100-year-old plus business headquartered in Menomonee Falls, Wisconsin, with approximately 500 employees. Annual sales are approximately $200 million, split evenly between hand washing products, which include syncs and faucets, washroom specialties, which includes accessories and privacy solutions and safety products, which include eyewash stations and safety showers. The addition of Bradley to the Watts portfolio is highly complementary, enables us to offer a more comprehensive solution to our customers.

It expands our total addressable market with front-of-the-wall products for commercial washrooms and industrial emergency safety applications and broadens our exposure to North America institutional and industrial markets. The acquisition leverages the combined strength of our sales network and channel relationships to accelerate growth and leverage cross-selling opportunities. It is also expected to create significant value through greater scale and the capture of cost synergies. If you turn to Slide 5, I’ll share how the acquisition aligns with our M&A strategy. On the left side of the slide, you’ll see our previously communicated M&A strategic criteria. The Bradley acquisition fits nicely with our stated priorities. The portfolio is comprised of code and specification-driven products that align with Watt’s key long-term secular growth trends of energy efficiency, water conservation and safety and regulation.

Bradley’s product portfolio expands our offerings with innovative water solutions as it adds front-of-the-wall applications to our differentiated back-of-the-wall portfolio and increases our exposure to attractive institutional and industrial markets. Bradley is a market leader known for innovative, high-quality, high-value products and has tremendous brand equity. The acquisition also builds on our recent acquisition of Enware, which is a leading supplier of specialty plumbing and safety equipment used in Australian institutional, commercial and industrial end markets, with products and solutions that are highly complementary with Bradley’s portfolio. We expect to realize meaningful run rate cost synergies by leveraging our One Watts performance system through commercial and operational initiatives, including global sourcing savings.

We expect to reach approximately $12 million of annualized savings by the end of 2026. The acquisition is expected to be modestly accretive to adjusted EPS in 2024, factoring in incremental interest expense and normal purchase accounting adjustments. We expect adjusted EBITDA margins to be accretive by 2027. We funded the transaction with a combination of cash and borrowings on our line of credit. As previously mentioned, on a pro forma basis, including the transaction, our leverage ratio is less than 0.1x, leaving us ample flexibility to implement our capital allocation strategy. With that, let me turn the call over to Shashank, who will address our third quarter results and our fourth quarter and revised full year outlook. Shashank?

Shashank Patel: Thanks Bob and good morning everyone. Please turn to Slide 6, and I will review the third quarter’s results. Sales of $504 million were up 3% on a reported basis and flat organically. Organic growth of 1% in Americas and APMEA was offset by a 1% organic decline in Europe. Foreign exchange, primarily driven by a stronger euro, increased year-over-year sales by roughly $6 million or 1%. Sales from our Inver acquisition added $9 million or 2 points and are reported within the APMEA region. Adjusted operating profit was $91 million, up 10% compared to last year and adjusted earnings per share increased 14% to $2.04. Adjusted operating margin of 18% was up 120 basis points as price, favorable mix and productivity more than offset inflation, lower volume and incremental investments.

We’re able to deliver 120 basis points of margin expansion despite a tough comparison to the third quarter of 2022 and the dilution of the Enware acquisition in the quarter. Interest income in the quarter exceeded interest expense and contributed an incremental $0.06 per share versus the prior year. The adjusted effective tax rate was 25.4%, 10 basis points favorable to the third quarter of 2022. Our free cash flow year-to-date was $182 million as compared to $67 million in the first 9 months of last year. The cash flow increase was primarily due to higher net income and a lower amount of working capital investment. We expect solid free cash flow in the fourth quarter and reiterate our full year goal of achieving a free cash flow conversion of 100% or more of net income as previously communicated.

The balance sheet remains strong and provides us with ample flexibility. Our net debt to capitalization ratio at quarter end was negative 22%. As Bob mentioned, when adjusted for the Bradley acquisition that closed last week, the pro forma net leverage is still healthy at 0.1. During the quarter, we repurchased approximately 22,000 shares of our Class A common stock for $4 million. And year-to-date, we have repurchased approximately 69,000 shares of Class A common stock for $12 million. There is approximately $16 million remaining under the current stock repurchase program that was authorized in 2019 and $150 million remains available under the stock repurchase program authorized in July 2023. Please turn to Slide 7, and let me provide a few comments on the regional results.

Americas organic sales were up 1%, slightly better than we expected due to a tough prior year comparison. As a reminder, Americas grew 13% in the third quarter of 2022. Solid growth in our nonresidential core valve products was largely offset by declines in gas connectors, rated heating applications and commercial marine instrumentation. In addition to the tough comps, weakness in single-family residential new construction was a contributing factor. Adjusted operating profit increased by 13% and adjusted operating margin increased by 260 basis points. The margin expansion was driven by price, favorable mix and productivity, which more than offset volume declines, inflation and incremental investments. Europe organic sales were down 1% as expected.

Reported sales were positively impacted by 7% from favorable foreign exchange movements. Growth in our German OEM business and our wholesale business in France and Benelux was more than offset by declines in Scandinavia and Italy with a reduction of government subsidies had an unfavorable impact. Operating margin declined by 190 basis points as price and productivity were unable to fully offset inflation, investments and volume deleverage. APMEA delivered 1% organic growth. Reported sales growth of 33% was negatively impacted by 4% from unfavorable foreign exchange movements and favorably impacted by 36% or $9 million of acquired Enwave sales. Double-digit growth in Australia and the Middle East was more than offset by a double-digit decline in China due to weak residential underfloor heating sales and project timing in data centers.

Adjusted operating margin increased 70 basis points due to higher affiliate volume, price and productivity, which more than offset inflation investments and the dilutive effect of the Enware acquisition. Slide 8 provides our assumptions about our fourth quarter and full year outlook. First, let’s cover the fourth quarter outlook. As Bob mentioned, we’ll have a tough comparison to a strong fourth quarter in 2022, where we grew organically by 11%. We estimate consolidated organic sales may be down 1% to down 6%. We expect Americas may be down low single digits and Europe down mid- to high single digits, offset partly by low single-digit growth in APMEA. This reduction in growth rates is due to the anticipated softening of underlying market conditions in Europe.

As previously mentioned in the Americas, we expect continued weakness in gas connectors, radiant heating applications and commercial marine instrumentation. In APMEA, the acquisition of Enware is expected to contribute $9 million of sales. In the Americas, Bradley is expected to contribute approximately $30 million of sales as Bradley is seasonally slower in the fourth quarter. We estimate our adjusted operating margin could range from 15% to 15.6% for the fourth quarter, up 70 basis points to 130 basis points versus the prior year. The increase versus prior year is due to price, favorable mix and productivity that are more than offsetting the reduced volume, incremental investments of approximately $7 million and the approximately 90 basis points of dilution from the Enware and Bradley acquisitions.

The sequential decline in operating margin from Q3 is driven primarily by the impact of volume deleverage, incremental investments, typical seasonality and acquisition dilution Note that Bradley a similar seasonality to Watts and we expect lower operating margin in the fourth quarter. We also expect customary purchase accounting expense, including incremental depreciation and amortization of approximately $2 million to $3 million. Corporate costs should be approximately $14 million. Interest expense net of interest income should be approximately $1.5 million for the quarter, including interest associated with our borrowings to fund the Bradley acquisition. The adjusted effective tax rate should be approximately 25%. We are assuming a 1.06 average euro-U.S. dollar FX rate for the fourth quarter versus the average rate of 1.01 in the fourth quarter of 2022.

This implies a Q4 European increase of 5% year-over-year, which equates to an increase of approximately $6 million in sales and $0.02 a share in EPS versus the prior year. Now let’s cover the updated full year outlook. For the full year 2023, we expect our organic sales growth to be flat, consistent with the midpoint of our previous guidance, which was a range of minus 2% to plus 2%. As previously mentioned, we estimate sales of approximately $30 million from Bradley. In addition, we now expect approximately $26 million of acquired sales from Enware slightly ahead of our previous guidance. We are also increasing our full year adjusted operating margin expansion to a range of 120 basis points to 130 basis points compared to our previous outlook of plus 30 basis points to plus 90 basis points.

This represents an increase of 65 basis points to the midpoint of our previous guidance. We now expect our 2023 operating margins to be between 17.6% and 17.7%. We expect our solid results year-to-date will partially mitigate the lower margins in the fourth quarter due to seasonality, volume deleverage, incremental investments and the approximately 40 basis points of dilution from the Enware and Bradley acquisitions. Our free cash flow expectations are anticipated to be in line with our previous outlook and should meet or exceed 100% of net income. We are assuming a 1.08 average euro-U.S. dollar FX rate for the full year versus the average rate of €1.05 in 2022. This would imply an increase of 3% in Europe sales year-over-year and equates to an increase of $8 million in sales and $0.03 a share in EPS for the full year versus the prior year.

Regarding other key inputs for the full year, we expect corporate cost to be approximately $54 million for the full year. Interest expense net of interest income should now be approximately $2 million for the year, including interest associated with our borrowings to fund the Bradley acquisition. Our estimated adjusted effective tax rate for 2023 should be between 24% and 25%. Capital spending is expected to be approximately $35 million. Depreciation and amortization should be approximately $45 million for the year, including the incremental depreciation and amortization from the Bradley acquisition. We expect our share count to be approximately $33.5 million for the year. Now let me turn the call back over to Bob before we begin Q&A. Bob?

Bob Pagano: Thanks, Shashank. Please turn to Slide 9. I’d like to summarize our discussion before we address your questions. We’re excited about the addition of Bradley to our family of brands. The acquisition expands our addressable market and enables us to offer front-of-the-wall solutions to our customers. Integration is well underway and progressing nicely. The third quarter was better than we anticipated with record sales, operating margins and earnings per share supported by price and favorable mix. Due to our strong year-to-date performance, we are increasing our full year operating margin outlook. We continue to monitor the slowing global economic indicators and are staying close to our customers. We are confident in our ability to execute in this uncertain environment.

Our strong free cash flow generation and balance sheet continues to provide flexibility to execute our disciplined capital allocation strategy. With that, operator, please open the lines for questions.

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Q&A Session

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

Mike Halloran: Good morning everyone.

Bob Pagano: Good morning.

Mike Halloran: So, let’s start on the Bradley acquisition, philosophically, my question is, you look at the product and the content, it’s a little bit more in front of the wall relative to maybe core portfolio. Now, I can certainly see the overlap with a lot of the maintenance room-type work you do and how much content you have in that area. But I would be curious to understand if you are thinking more broadly about the solutions that you are offering today and how you think this complements what the existing business looks like. Basically, are you thinking more in front of the wall and then just a little more detail on how this fits with what you have already?

Bob Pagano: Yes, Mike. So yes, certainly, we really like the acquisition with Bradley. It’s specifiable products in some great markets. And yes, it expands our opportunity in front of the wall and allows us more content inside of a commercial building. So, we are excited about the acquisition. Teams are well on their way, and I am excited to have them part of our portfolio.

Mike Halloran: Just expanding on that a little bit, Bob, does that mean that you are widening the aperture a little bit for what you look at from an acquisition perspective relative to history, or has this been this broadening out has been in the works for a little longer than I realized?

Bob Pagano: No, I think we will continue to look at expanding our portfolio. Again, it’s right in our core markets, right, residential, commercial and light industrial related to safety. So yes, we are opening our apertures to that, but I don’t think you will see us wake up and be in the oil and gas industry, so again, more closer to the core to us.

Mike Halloran: Okay. Thanks for that. And then second one would just be along the non-res side of the business. I am curious to see how you think this is going to play out. Certainly recognize all the comments you made in the prepared remarks, but my question is going to be two-fold. One, where do you sit in the life cycle from a project activity perspective, more early mid-late cycle within the project life? And then secondarily, when you look at that, how are you thinking about the starts and what that backlog for the newer project activity can look like as we head to next year?

Bob Pagano: Yes. Mike, so when I look at our portfolio, we are in every segment of that from the beginning, middle, end, and with Bradley certainly closer to the very end on that stuff. So, we are watching it. Remember, the 60% to 65% of our business is repair and replace. So, that’s a nice steady annuity with our large installed base. But as we are looking at all of this, I mean we watch the same indicators as you have. But the other indicators that we watch are, how busy are contractors, especially in North America. And they seem to be very busy. Our product is agnostic to a particular market. So, if the office is down, we shift to maybe data centers as an example, right. So, wherever there is construction and we watch the construction backlog of our customers and understanding where that is.

So, in North America, that’s healthy. And again, drains, which as you know is a leading indicator. We saw some softness in that, and as we – a little bit in September, but not really bad. So, again, I think we watch just like everyone else, all these leading indicators. But right now, in particular, North America is holding up.

Mike Halloran: Okay. I appreciate it.

Bob Pagano: Thank you.

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

Adam Farley: Yes. Thank you. This is Adam Farley on for Nathan. My first question is on margins. Margin expansion has been much higher than the level in launch of long-term plan. Have we reset the bar on margins to a new level that to a new level outside of a potential recession impact? And do you believe that you can deliver with that long-term 30 basis points to 50 basis point target with maybe 2023 as a rebased starting point?

Shashank Patel: And I think you are looking at the long-term, I know over the last 3 years, certainly, we have had a very good margin expansion over the last 3 years. And that was driven by, obviously, volume leverage. Our volume was up significantly since the 2020 pandemic year. So, we had good volume leverage, and then we have had good price and productivity over cost. We have got good margin expansion from that. As we look to the future, we still make the case that over the next 5 years, we are still going to be driving 30 basis points to 50 basis points of margin expansion. And that’s again, price and productivity and volume leverage over cost inflation. That’s our target.

Adam Farley: Okay. Thank you for that. And then kind of shifting gears, post the acquisition of Bradley, your balance sheet is still very healthy. Is there a period where you need to focus on integration and synergy generation, or could you potentially be right back in the M&A market immediately?

Bob Pagano: Well, listen, we certainly have the balance sheet to do further M&A. But you never can predict the timing of M&A. I am not afraid to do M&A. We have a great team in our side of our organization that’s capable of doing more. So, Bradley is just one acquisition. So, we continue to nurture our pipeline and the pipeline is still full. So, we will continue to watch and monitor. But as you know, you never can predict acquisitions. So, we will keep monitoring that and we will see what happens.

Adam Farley: Thank you for taking my questions.

Bob Pagano: Thank you.

Shashank Patel: Thank you.

Operator: Your next question comes from the line of Ryan Connors with Northcoast Research. Your line is open.

Ryan Connors: Great. Thank you. Good morning.

Bob Pagano: Good morning.