Overview

The following discussion and analysis are provided to increase understanding of, and should be read in conjunction with, the accompanying unaudited consolidated financial statements and notes. In this quarterly report on Form 10-Q, references to "the Company," "Watts," "we," "us" or "our" refer to Watts Water Technologies, Inc. and its consolidated subsidiaries.

We operate on a 52-week fiscal year ending on December 31. Any third quarter ended data contained in this Quarterly Report on Form 10-Q reflects the results of operations for the 13-week period ended on the Sunday nearest September 30 of the respective year.

We are a leading supplier of products for use in the water quality, water safety, water flow control and water conservation markets in both North America and Europe with an emerging presence in China. For over 130 years, we have designed and manufactured products that promote the comfort and safety of people and the quality and conservation of water used in commercial and residential applications. We earn revenue and income almost exclusively from the sale of our products. Our principal product lines include:

† water quality products, including backflow preventers and check valves for preventing reverse flow within water lines and fire protection systems and point-of-use water filtration and reverse osmosis systems for both commercial and residential applications;

† a wide range of water pressure regulators for both commercial and residential applications;

† drainage products for industrial, commercial, marine and residential applications;

† water supply products for commercial and residential applications;

† temperature and pressure relief valves for water heaters, boilers and associated systems;

† thermostatic mixing valves for tempering water in commercial and residential applications;

† systems for under-floor radiant applications and hydraulic pump groups for gas boiler manufacturers and renewable energy applications, including solar and heat pump control packages;

† flexible stainless steel connectors for natural and liquid propane gas in commercial food service and residential applications; and

† large diameter butterfly valves for use in China's water infrastructure.

Our business is reported in three geographic segments: North America, Europe and China. We distribute our products through three primary distribution channels:
wholesale, do-it-yourself (DIY) and original equipment manufacturers (OEMs). Interest rates have an indirect effect on the demand for our products due to the effect such rates have on the number of new residential and commercial construction starts and remodeling projects. All three of these activities have an impact on our levels of sales and earnings. An additional factor that has had an effect on our sales is fluctuation in foreign currencies, as a portion of our sales and certain portions of our costs, assets and liabilities are denominated in currencies other than the U.S. dollar.

Although we continue to see positive sales trends in the European energy conservation marketplace and in Canada in general, our sales in most other markets during the third quarter of 2008 are unchanged or down when compared to the same period one year earlier. The well publicized credit market crisis creates concerns for our performance into 2009. The worldwide reports of an economic slowdown continue to point toward slower growth for the next several quarters. In response to these concerns, we are taking steps to place the Company on a firm fiscal platform from which these turbulent economic times can be managed. We announced that a reduction of the current United States workforce will be undertaken during the fourth quarter of 2008. We are also evaluating our current manufacturing footprint for opportunities to consolidate operations, thereby reducing overhead costs. Finally, we are implementing a nine-month salary freeze in North America and are reviewing discretionary spending in detail to cut back on operating expenses. We believe that our two primary North American sales channels, retail and wholesale, will both be negatively impacted by the economic downturn and by our customers' inability to obtain capital to fund projects. We believe that a disciplined approach towards the use of capital combined with cost reductions to be achieved through the continued implementation of lean manufacturing and six sigma disciplines as well as our ongoing restructuring plan will help to partially offset any negative pressures to operating income. We expect these conditions to continue through the remainder of 2008 and believe they are likely to continue throughout 2009.

We believe that the factors relating to our future growth include the increased demand for clean water around the world, growing regulatory requirements relating to the quality and conservation of water together with continued enforcement of plumbing and building codes, our ability to grow organically in select attractive market segments and to continue to make selective acquisitions, both in our core markets as well as in new complementary markets, and a healthy economic environment. We have completed 32 acquisitions since divesting our industrial and oil and gas business in 1999. Our acquisition strategy focuses on businesses that manufacture preferred brand name products that address our themes of water quality, water conservation, water safety and water flow control and related complementary markets. We target businesses that will provide us with one or more of the following: an entry into new markets, an increase in shelf space with existing customers, a new or improved technology or an expansion of the breadth of our water quality, water conservation, water safety and water flow control products for the residential and commercial markets.

Products representing a majority of our sales are subject to regulatory standards and code enforcement, which typically require that these products meet stringent performance criteria. Together with our commissioned manufacturers' representatives, we have consistently advocated for the development and enforcement of such plumbing codes. We are focused on maintaining stringent quality control and testing procedures at each of our manufacturing facilities in order to manufacture products in compliance with code requirements and take advantage of the resulting demand for compliant products. We believe that the product development, product testing capability and investment in plant and equipment needed to manufacture products in compliance with code requirements, represent a barrier to entry for competitors. We believe there is an increasing demand among consumers for products to ensure water quality, which creates growth opportunities for our products.

We require substantial amounts of raw materials to produce our products, including bronze, brass, cast iron, steel and plastic, and substantially all of the raw materials we require are purchased from outside sources. We have experienced increases in the costs of certain raw materials, particularly copper. Bronze and brass are copper-based alloys. The average price of copper and pig iron for the first nine months of 2008 increased approximately 17.8% and 49.4%, respectively. In October, the price of copper has decreased significantly, with the market price per pound dropping below prior year levels. We typically carry several months of inventory primarily due to the significant extent of our international sourcing.

Historically, a risk we face is our ability to deal effectively with increases in raw material costs. We manage this risk by monitoring related market prices, working with our suppliers to achieve the maximum level of stability in their costs and related pricing, seeking alternative supply sources when necessary, implementing cost reduction programs and passing increases in costs on to our customers. Where our customers desire and request a fixed price, we may enter into swap contracts to fix the price of copper. During the quarter ended September 28, 2008, we entered into a series of copper swaps to fix the price per pound of copper for one customer. These financial instruments are classified as economic hedges, as more fully explained in the Notes to the Consolidated Financial Statements. For the period ended September 28, 2008, we recorded $0.4 million in losses associated with these copper swaps in other expenses. More recently, the commodity markets have experienced tremendous volatility, with the market prices of many commodities dropping in October 2008. We believe that if copper prices continue to decrease that the open copper swap contracts will result in additional losses that may occur in a period different from when that cost is recovered from the customer.

Another risk we face in all areas of our business is competition. We consider brand preference, engineering specifications, code requirements, price, technological expertise, delivery times and breadth of product offerings to be the primary competitive factors. As mentioned previously, we believe that the product development, product testing capability and investment in plant and equipment needed to manufacture products in compliance with code requirements, represent a barrier to entry for competitors. We are committed to maintaining our capital equipment at a level consistent with current technologies, and thus we spent approximately $37.8 million in 2007 and expect to spend approximately $26.0 million to $30.0 million during 2008.

Acquisitions

On May 30, 2008, we purchased all of the outstanding share capital of Blücher Metal A/S (Blücher) located in Vildbjerg, Denmark, for approximately $183.5 million. Blücher is a leading provider of stainless steel drainage systems in Europe to the residential commercial and industrial market places and is a worldwide leader in providing stainless steel drainage products to the marine industry. Blücher's main products include push-fit stainless steel pipes and related fittings, light-duty drains for residential, commercial and marine applications, and drains for heavy-duty industrial applications including brewery and pharmaceutical applications.

During the second quarter of 2008, we completed the acquisition of the remaining 40% ownership of our joint venture in China for $3.3 million in cash. Under the terms of the agreement, we are contingently liable to pay an additional $2.2 million to the sellers only upon the receipt of $2.2 million due to us under a separate agreement with one of the sellers.

On November 9, 2007, we acquired the assets and business of Topway Global Inc. (Topway) located in Brea, California for approximately $18.4 million. Topway sells a wide variety of water softeners, point of entry filter units, and point of use drinking water systems for residential, commercial and industrial applications.

Recent Developments

During the third quarter ended September 28, 2008, we entered into an agreement to sell our equity interests in one of our China entities to a local company (the buyer). This unit serves the domestic Chinese market and also manufactures products for sale in the U.S. marketplace. We evaluated alternatives, including additional restructuring activities, and determined that the disposition by sale of the domestic Chinese business was the best alternative. We will maintain ownership of the assets used to manufacture our water safety and control products to be sold in the U.S. As such, we have determined that this continuing involvement in the business

prohibits the recognition of this transaction and the related results from operations of this business as discontinued operations. The results from operations of the domestic Chinese business will continue to be reported in the results from continuing operations until the sale is complete, which we anticipate will occur before the end of the fourth quarter.

In November 2007, our Board of Directors authorized the repurchase of up to 3.0 million shares of our Class A common stock. As of October 28, 2008, we had repurchased approximately 2.45 million shares at a total cost of approximately $68.1 million. During the third quarter ended September 28, 2008, we decided to temporarily suspend our stock repurchase program.

Results of Operations

Third Quarter Ended September 28, 2008 Compared to Third Quarter Ended September 30, 2007

Net Sales. Our business is reported in three geographic segments: North America, Europe and China. Our net sales in each of these segments for each of the third quarters of 2008 and 2007 were as follows:

                  Third Quarter Ended        Third Quarter Ended                % Change to
                   September 28, 2008         September 30, 2007                Consolidated
                Net Sales      % Sales     Net Sales      % Sales     Change     Net Sales
                                           (dollars in millions)
North America   $    218.5          57.6 % $    215.8          63.4 % $   2.7            0.8 %
Europe               148.0          39.0        110.5          32.4      37.5           11.0
China                 12.8           3.4         14.2           4.2      (1.4 )         (0.4 )
Total           $    379.3           100 % $    340.5           100 % $  38.8           11.4 %

The increase (decrease) in net sales is attributable to the following:

                                                                               Change                                Change
                                                                  As a % of Consolidated Net Sales         As a % of Segment Net Sales
                     North                                      North                                      North
                    America     Europe     China     Total     America      Europe     China    Total     America       Europe     China
                                                                   (dollars in millions)
Organic            $    (1.1 )  $   4.7    $ (2.6 )  $  1.0        (0.3 )%      1.4 %   (0.8 )%   0.3 %       (0.4 )%       4.2 %  (18.3 )%
Foreign exchange         0.1        9.2       1.2      10.5           -         2.7      0.4      3.1            -          8.3      8.4
Acquisitions             3.7       23.6         -      27.3         1.1         6.9        -      8.0          1.7         21.4        -
Total              $     2.7    $  37.5    $ (1.4 )  $ 38.8         0.8 %      11.0 %   (0.4 )%  11.4 %        1.3 %       33.9 %   (9.9 )%

Organic net sales decreased in North America primarily due to decreased sales in the DIY market. Organic sales in our North American wholesale market for the third quarter of 2008 remained relatively flat compared to the third quarter of 2007. Our North American home improvement retail market sales decreased 2.9% for the third quarter of 2008 compared to the third quarter of 2007. This decrease was primarily due to more product rollouts in the third quarter of 2007, product line resets and a softer economy this year, partially offset by realized price increases. We believe that the residential market, which is served by both our wholesale and DIY customers, will continue to be soft through 2008. We believe the commercial market, which is predominantly served by our wholesale customers, is difficult to predict although recent macro economic data indicates that, like the residential market, this market will also slow down. As a result, we believe that our sales into the commercial marketplace will experience minimal growth through the remainder of 2008. Growth in North America due to acquisitions is due to the inclusion of sales from Topway acquired in November 2007.

Organic net sales increased in Europe primarily due to increased sales in the European OEM market. Our sales into the European wholesale market in the third quarter of 2008 decreased 6.0% while our sales into the European OEM market increased 16.3% compared to the third quarter of 2007. Sales in Europe into the OEM market were positively impacted by increased sales in alternative energy and energy conservation devices. We believe that this trend will continue through 2008 and will continue to positively impact sales for our Europe segment. Sales in our wholesale market were negatively impacted by declines in residential construction activity in Italy and Germany. We believe that our broad product offerings, complemented recently by the acquisition of Blücher, will provide the Company an opportunity to take additional market share from smaller competitors. The acquired growth in Europe is due to the inclusion of sales from Blücher.

Organic net sales declined in China due to decreased sales in both the Chinese domestic and export markets. Our sales from China were negatively affected by a reduction in export sales and the pending sale of one of our wholly-owned subsidiaries. This decrease was partially offset by an increase in sales to infrastructure customers in the third quarter of 2008.

The increases in net sales due to foreign exchange in North America, Europe and China were primarily due to the appreciation of the Canadian dollar, euro and yuan, respectively, against the U.S. dollar. We cannot predict whether these currencies will continue to appreciate against the U.S. dollar in future periods or whether future foreign exchange rate fluctuations will have a positive or negative impact on our net sales. Recent fluctuations in foreign currency rates portend a reduction in those currencies against the U.S. dollar.

Gross Profit. Gross profit and gross profit as a percent of net sales (gross margin) for the third quarters of 2008 and 2007 were as follows:

Third Quarter Ended

                September 28,      September 30,    Point
                    2008               2007         Change
                     (dollars in millions)
Gross profit   $         123.9    $         110.5
Gross margin              32.7 %             32.4 %    0.3 %

Gross margin increased slightly in the third quarter of 2008 compared to third quarter of 2007. The North American margin increased 1.7% to 34.5% for the third quarter of 2008 from 32.8% for the third quarter of 2007 due to realized sales price increases and better product mix. Further, 2007 North American gross margins were negatively impacted by approximately $3.6 million, or approximately 170 basis points on the prior year gross margin, for charges associated with product discontinuances. The European margin increased 0.4% to 31.1% from 30.7% for the comparable third quarter primarily due to our ability to leverage additional volume with the rationalization efforts made over the last two years in Italy, and, to a lesser extent, some realized price increases. Our China segment's gross margin decreased for the third quarter of 2008 primarily due to reduced volumes, underutilized capacity in certain locations due to a labor dispute, negative impact from the increase in the value of the Chinese yuan against the U.S. dollar and value added tax increases.

Selling, General and Administrative Expenses. Selling, General and Administrative, or SG&A, expenses for the third quarter of 2008 increased $13.5 million, or 17.1%, compared to the third quarter of 2007. The increase in SG&A expenses was attributable to the following:

                    (in millions)    % Change

Organic            $           4.3        5.5 %
Foreign exchange               2.1        2.6
Acquisitions                   7.1        9.0
Total              $          13.5       17.1 %

The organic increase in SG&A expenses was primarily due to increased compensation costs and product liability costs, increased commissions due to the increased sales volume, and increased bad debt charges, offset partially by a reduction in shipping costs in North America. The increase in SG&A expenses from foreign exchange was primarily due to the appreciation of the euro against the U.S. dollar. The increase in SG&A expenses from acquisitions was due to the inclusion of Blücher and Topway. Total SG&A expenses, as a percentage of sales, were 24.3% in the third quarter of 2008 compared to 23.1% in the third quarter of 2007.

Restructuring and Other Charges. In the third quarter of 2008, we recorded $0.9 million for severance and relocation costs in North America and China. In the third quarter of 2007, we recorded $1.6 million for the write-down of held for sale assets and for accelerated depreciation related to the relocation of one of our Chinese facilities.

Operating Income. Operating income by geographic segment for the third quarters of 2008 and 2007 was as follows: