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WTS > SEC Filings for WTS > Form 10-Q on 8-Nov-2012All Recent SEC Filings

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Quarterly Report

Item 2. Management's Discussion And Analysis Of Financial Condition And Results Of Operations


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" refers to Watts Water Technologies, Inc. and its consolidated subsidiaries.

We operate on a 52-week fiscal year ending on December 31. Any quarterly or nine-month data contained in this Quarterly Report on Form 10-Q generally reflects the results of operations for a 13-week or 39-week period, respectively.

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 EMEA (Europe, Middle East and Africa), with a growing presence in Asia. For over 137 years, we have designed and manufactured products that promote 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 are:

Residential & commercial flow control products - includes products typically sold into plumbing and hot water applications such as backflow preventers, water pressure regulators, temperature and pressure relief valves, and thermostatic mixing valves.

HVAC & gas products - includes hydronic and electric heating systems for under-floor radiant applications, hydronic pump groups for boiler manufacturers and alternative energy control packages, and flexible stainless steel connectors for natural and liquid propane gas in commercial food service and residential applications. HVAC is an acronym for heating, ventilation and air conditioning.

Drains & water re-use products - includes drainage products and engineered rain water harvesting solutions for commercial, industrial, marine and residential applications.

Water quality products - includes point-of-use and point-of-entry water filtration, conditioning and scale prevention systems for both commercial and residential applications.

Our business is reported in three geographic segments: North America, EMEA and Asia. We distribute our products through three primary distribution channels:
wholesale, do-it-yourself (DIY) and original equipment manufacturers (OEMs). Interest rates, the unemployment rate and credit availability 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 of these activities have an impact on our levels of sales and earnings. An additional factor that has had an effect on our sales and operating income is fluctuation in foreign currency exchange rates, as approximately 47% of our sales in the nine months ended September 30, 2012, and certain portions of our costs, assets and liabilities are denominated in currencies other than the U.S. dollar.

During the third quarter of 2012, sales decreased $9.6 million primarily from the depreciation of the euro against the dollar of $18.0 million offset by organic sales increases of $5.8 million and acquired sales of $2.6 million resulting from our acquisition of tekmar. Organic sales increased by 1.6% compared to last year's comparable period, primarily from increased sales in the EMEA OEM and wholesale markets. Organic sales in the third quarter of 2012 increased in EMEA by $5.0 million, or 3.1%, increased in Asia by $1.3 million, or 22.0%, and decreased over the third quarter of 2011 in North America by $0.5 million, or 0.2%. Organic sales growth excludes the impacts of acquisitions, divestitures and foreign exchange from year-over-year comparisons. We believe this provides investors with a more complete understanding of underlying sales trends by providing sales growth on a consistent basis. Gross margins decreased in the third quarter of 2012 as compared to 2011 by 0.5 percentage points, driven principally by higher non-commodity costs and the continued conversion of our U.S. manufacturing facilities to lead-free production, which caused inefficiencies from pre-production costs and product outsourcing. Our transition to lead-free products is in response to the federal Reduction of Lead in Drinking Water Act, which requires the weighted average lead content of the wetted surfaces of pipes, plumbing fittings and plumbing fixtures used in potable water applications to be reduced to no greater than 0.25% by January 2014. Commodity costs trended down during the quarter. Operating income of $33.1 million decreased by 19.7% in the third quarter of 2012 as compared to the third quarter of 2011, driven by increased impairment charges, incremental SG&A costs, and a decrease in gross margin as previously discussed. Foreign exchange movements primarily related to a weakening of the euro against the U.S. dollar negatively affected operating earnings by $1.9 million, when compared to the same period of 2011.

We believe that the factors relating to our future growth include the demand for clean water around the world, regulatory requirements relating to the quality and conservation of water, continued enforcement of plumbing and building codes, our ability to grow organically in select attractive market segments and geographic regions, the successful completion of selective acquisitions, both in our core markets as well as in new complementary markets, and a healthy economic environment, that fosters residential and

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commercial construction. Our acquisition strategy focuses on businesses that manufacture preferred brand name products that address our themes of water quality, water conservation, water safety, water flow control, HVAC 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 and HVAC products for the residential and commercial construction markets.

We have completed 36 acquisitions since divesting our industrial and oil and gas business in 1999. On January 31, 2012, we completed the acquisition of tekmar Control Systems (tekmar) in a share purchase transaction. A designer and manufacturer of control systems used in heating, ventilation, and air conditioning applications, tekmar is expected to enhance our hydronic systems product offerings in the U.S. and Canada. The initial purchase price paid was CAD $18.0 million, with an earn-out based on the achievement of certain future earnings levels. The initial purchase price paid was equal to approximately $17.8 million based on the exchange rate of Canadian dollar to U.S. dollars as of January 31, 2012. The total purchase price will not exceed CAD $26.2 million. Sales for tekmar in 2011 were approximately $11.0 million. On April 29, 2011, we completed the acquisition of Danfoss Socla S.A.S. (Socla) and the related water controls business of certain other entities controlled by Danfoss A/S, in a share and asset purchase transaction. The net purchase price of EUR 116.3 million was financed with cash on hand and euro-based borrowings under our Credit Agreement. The net purchase price was approximately $172.4 million based on the exchange rate of Euro to U.S. dollars as of April 29, 2011. Socla is a manufacturer of water protection valves and flow control solutions for the water market and the heating, ventilation and air conditioning market. Its major product lines include backflow preventers, check valves and pressure reducing valves. Socla is based in France, and its products are distributed worldwide for commercial, residential, municipal and industrial use. Socla's annual revenue for 2010 was approximately $130.0 million. Socla expands our residential and commercial plumbing and flow control product lines in EMEA and also adds to our HVAC product line.

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 competitive advantage for us.

Historically, we have faced a risk relating to our ability to respond to raw material cost fluctuations. 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, purchasing forward commitments for raw materials, when available, implementing cost reduction programs and passing increases in costs to our customers in the form of price increases.

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, quality and breadth of product offerings to be the primary competitive factors. We believe that product development, product testing capability, breadth of product offerings and investment in plant and equipment needed to manufacture products in compliance with code requirements represent a competitive advantage for us. We expect to spend an aggregate of between $27 million and $30 million during 2012 for purchases of capital equipment, depending on the timing of our continuing conversion of our manufacturing facilities to lead free production. We expect to incur a higher level of capital expenditures in 2013 as we complete our lead free production conversion.

Recent Events

Dividend Declared

On October 29, 2012, the Company declared a quarterly dividend of eleven cents ($0.11) per share on each outstanding share of Class A Common Stock and Class B Common Stock payable on November 30, 2012 to stockholders of record at the close of business on November 19, 2012.

Appointment of new Chief Financial Officer

On October 29, 2012, we announced that Dean P. Freeman has been appointed Executive Vice President and Chief Financial Officer, effective as of November 12, 2012.

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Results of Operations

Third Quarter Ended September 30, 2012 Compared to Third Quarter Ended October 2, 2011

Net Sales. Our business is reported in three geographic segments: North America, EMEA and Asia. Our net sales in each of these segments for each of the third quarters of 2012 and 2011 were as follows:

                  Third Quarter Ended        Third Quarter Ended                % Change to
                   September 30, 2012          October 2, 2011                  Consolidated
                Net Sales      % Sales     Net Sales      % Sales     Change     Net Sales
                                           (dollars in millions)
North America   $    207.4          57.4 % $    205.6          55.4 % $   1.8            0.5 %
EMEA                 146.5          40.6        159.3          43.0     (12.8 )         (3.5 )
Asia                   7.3           2.0          5.9           1.6       1.4            0.4
Total           $    361.2         100.0 % $    370.8         100.0 % $  (9.6 )         (2.6 )%

The change in net sales was attributable to the following:

                                                                     Change                                  Change
                                                        As a % of Consolidated Net Sales          As a % of Segment Net Sales
               North                                   North                                      North
              America     EMEA      Asia    Total     America       EMEA       Asia    Total     America        EMEA       Asia
                                                            (dollars in millions)
Organic      $    (0.5 ) $   5.0   $  1.3   $  5.8        (0.1 )%     1.3 %      0.4 %   1.6 %        (0.2 )%      3.1 %    22.0 %
exchange          (0.3 )   (17.8 )    0.1    (18.0 )      (0.1 )     (4.8 )        -    (4.9 )        (0.2 )     (11.1 )     1.7
Acquired           2.6         -        -      2.6         0.7          -          -     0.7           1.3           -         -
Total        $     1.8   $ (12.8 ) $  1.4   $ (9.6 )       0.5 %     (3.5 )%     0.4 %  (2.6 )%        0.9 %      (8.0 )%   23.7 %

Organic net sales in the North America wholesale market decreased by $2.2 million, or 1.3%, in the third quarter of 2012, compared to the third quarter of 2011, mainly from decreased sales in residential and commercial products. Organic sales increased in the North American DIY market by $1.7 million, or 4.4%, in the third quarter of 2012 compared to the third quarter of 2011, as residential and commercial products and water quality product sales increased.

Organic net sales into the EMEA OEM market increased approximately $4.7 million, or 6.3%, as compared to the third quarter of 2011 due to stronger sales in under floor heating and in our drains product lines primarily related to our geographic expansion into the Middle East. Organic net sales in the EMEA wholesale market increased by $1.2 million, or 1.5%, in the third quarter of 2012 as compared to the same period in 2011 primarily due to our increased sales to Eastern Europe offset by lower sales in Italy and France.

The net decrease in sales due to foreign exchange was primarily due to the depreciation of the euro against the U.S. dollar. We cannot predict whether the euro will appreciate or depreciate 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.

Acquired net sales growth in North America was due to the inclusion of tekmar.

Gross Profit. Gross profit and gross profit as a percent of net sales (gross margin) for the third quarters of 2012 and 2011 were as follows:

Third Quarter Ended

                September 30,      October 2,
                    2012              2011
                    (dollars in millions)
Gross profit   $         130.2    $      135.7
Gross margin              36.1 %          36.6 %

Gross margin decreased 0.5 percentage points in the third quarter of 2012 compared to the third quarter of 2011. North America's gross margin declined compared to third quarter of 2011 due to product mix, higher non-commodity costs, and pre-production and outsourcing costs caused by certain plants transitioning production to lead-free products. EMEA's gross margin increased due primarily to the inclusion of $1.8 million of Socla acquisition related costs in the third quarter of 2011. Adjusting for those costs, EMEA's gross margin declined slightly in 2012 due to lower overhead absorption.

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Selling, General and Administrative Expenses. Selling, General and Administrative, or SG&A, expenses for the third quarter of 2012 increased $0.9 million, or 1.0%, compared to the third quarter of 2011. The increase in SG&A expenses was attributable to the following:

                    (in millions)    % Change

Organic            $           3.7        4.0 %
Foreign exchange              (4.1 )     (4.4 )
Acquired                       1.3        1.4
Total              $           0.9        1.0 %

The organic increase in SG&A expenses was primarily due to higher selling costs in Europe of $2.0 million, higher insurance costs of $0.8 million primarily related to product liability insurance, increased IT costs of $0.7 million related primarily to an ERP implementation in Europe, retention costs related to our retiring CFO of $0.8 million, and higher corporate professional service costs of $1.1 million offset by a decrease in pension expense of $1.1 million related to our decision to freeze the defined benefit pension plan in the U.S. effective December 31, 2011. The decrease in SG&A expenses from foreign exchange was primarily due to the depreciation of the euro against the U.S. dollar in 2012. Acquired SG&A costs were related to the tekmar acquisition. Total SG&A expenses, as a percentage of sales, were 25.9% in the third quarter of 2012 and 25.0% in the third quarter of 2011.

Restructuring and Other Charges, Net. In the third quarter of 2012, we incurred a net $1.2 million in expense resulting from a $1.6 million charge related to an adjustment made to the gain on disposal of TWVC. In addition, we incurred involuntary terminations and other costs incurred as part of our Europe and North America restructuring plans, offset by the reduction of the expected BRAE contingent earnout liability of $1.0 million, as compared to $1.9 million of restructuring charges for the third quarter of 2011. For a more detailed description of our current restructuring plans, see Note 5 of Notes to Consolidated Financial Statements.

Goodwill and Other Long-Lived Asset Impairment Charges. In 2012, we recorded asset impairment charges of $2.4 million primarily related to goodwill impairment at BRAE of $1.0 million and $1.4 million of impairment charges related to certain assets held for sale. The goodwill impairment was based on historical results being below our expectations and a resulting reduction in the expected future cash flows to be generated.

Operating Income. Operating income (loss) by geographic segment for the third quarters of 2012 and 2011 were as follows:

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