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WTS > SEC Filings for WTS > Form 10-K on 27-Feb-2014All Recent SEC Filings

Show all filings for WATTS WATER TECHNOLOGIES INC

Form 10-K for WATTS WATER TECHNOLOGIES INC


27-Feb-2014

Annual Report


Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

Overview

We are a leading supplier of products for use in the water quality, water safety, water flow control and water conservation markets in both the Americas and EMEA with a growing presence in Asia Pacific. For over 139 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:


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: Americas, EMEA and Asia Pacific. We distribute our products through three primary distribution channels: wholesale, do-it-yourself (DIY) and original equipment manufacturers (OEMs).

We believe that the factors relating to our future growth include our ability to continue to make selective acquisitions, both in our core markets as well as in new complementary markets; regulatory requirements relating to the quality and conservation of water and the safe use of water; increased demand for clean water; continued enforcement of plumbing and building codes; and a healthy economic environment. We have completed 36 acquisitions since 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 commercial, industrial and residential 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 competitive advantage for us.

Our performance in 2013 varied, driven by different economic and business dynamics within each region in which we participate. In the Americas, we saw sequential growth during 2013 as the U.S. residential new construction marketplace continued to recover and the repair and replace end market remained strong. Although we experienced minimal growth in the new commercial construction market,


there have been recent positive macroeconomic signs that a recovery is forthcoming. In EMEA, a weak pan European economy negatively impacted our sales. Certain parts of Europe, such as Italy France and Germany, remained affected by the general economic downturn. However, we were able to partially mitigate the effect of the sales volume reduction with productivity initiatives and cost reduction initiatives. Our EMEA segment continued to expand its sales into Eastern Europe during the year. In Asia Pacific, we had solid growth as we expanded our sales and marketing efforts.

Overall, sales grew organically by 2.1% as compared to 2012. 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. Compared to 2012, organic sales in Americas and Asia Pacific grew by 5.5% and 20.5%, respectively, but were offset by a reduction in EMEA organic sales of 3.6%.

Operationally, in the U.S. we continued our focus around our transition to lead free production. In 2013 and 2012, we committed an aggregate of approximately $18.3 million in capital spending for a new foundry and machinery in the U.S. to meet expected lead free demand for our products sold in the U.S. Construction of the new foundry was completed during the second quarter of 2013. We incurred $5.8 million in transition costs in 2013 relating to inefficiencies experienced as part of the lead free conversion project, including furnace repairs, excess scrap and consulting costs related to the new foundry. The impact of commodity costs during 2013 was minimal, especially with our most important raw material, copper. We saw copper spot prices in the first quarter trending higher, with prices declining to a consistent level through the remainder of the year. Pricing, in turn, was fairly stable, although we experienced some pricing pressures in certain geographies and in certain product lines in the Americas, especially in the DIY channel. In EMEA, we were able to selectively increase pricing for certain products. However, we believe the economic uncertainty in Europe may continue affecting how we and our competitors are pricing in end markets.

We continually review our business and implement restructuring plans as needed. The restructuring program for EMEA that we announced in July 2013 is proceeding in accordance with our expectations. Please see Note 4 of the Notes to Consolidated Financial Statements for a more detailed explanation of our restructuring activities.

In the fourth quarter of 2013, we began a program that we refer to as the European transformation. This program is designed to refocus our European operations from being country specific to a pan European business unit operating strategy. Under this initiative, we intend to (1) develop better sales capabilities through improved product management and enhanced product cross-selling efforts, (2) drive more efficient European sourcing and logistics, and (3) enhance our focus on emerging market opportunities. We plan to align our legal and tax structure in accordance with our business structure and take advantage of favorable tax rates where possible. We expect this project to be ongoing through 2016. We anticipate total non-recurring external deployment costs of $12.2 million, with approximately $9.0 million anticipated to be spent in 2014. We incurred approximately $1.2 million in the fourth quarter of 2013 in deployment costs. Total annual savings are forecasted at $18.0 million by 2018, with approximately $3.5 million and $10.0 million in annual savings expected in 2014 and 2015, respectively. We expect that we will need to add approximately $4.0 million of infrastructure costs per annum to our current operational base by 2018 to maintain the program, of which approximately $3.5 million will be added in 2014.

Acquisitions and Disposals

On August 1, 2013, the Company completed the sale of all of the outstanding shares of an indirectly wholly-owned subsidiary, Austroflex, receiving net cash proceeds of $7.9 million. Austroflex is an Austrian-based manufacturer of pre-insulated flexible pipe systems for district heating, solar applications and under-floor radiant heating systems. Austroflex did not meet performance expectations since its purchase in 2010. The loss after tax on disposal of the business was approximately $2.2 million. Further, during the year ended December 31, 2011, the Company wrote down Austroflex's long-lived


assets by $14.8 million. The Company will not have a substantial continuing involvement in Austroflex's operations and cash flows, therefore Austroflex's results of operations have been presented as discontinued operations and all comparative periods presented have been adjusted in the consolidated financial statements to reflect Austroflex's results as discontinued operations. Please see Note 3 of the Notes to Consolidated Financial Statements for additional information regarding operating results of Austroflex.

On December 21, 2012, we disposed of the outstanding shares of Flomatic Corporation (Flomatic), to a third party in an all cash transaction. Flomatic was acquired as part of the Danfoss Socla S.A.S. (Socla) acquisition in April 2011. Flomatic specializes in manufacturing various valves for the well water industry, a product line not core to our business. The operating results of Flomatic have been classified in discontinued operations for 2012 and 2011. A net loss on disposal of approximately $3.8 million was charged to discontinued operations in 2012.

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 future earnings levels being achieved. 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. In 2012, a contingent liability of $5.1 million was recognized as the estimate of the acquisition date fair value of the earn-out. A portion of the contingent consideration was paid out during 2013, in the amount of $1.2 million, based on performance metrics achieved in 2012. The contingent liability was increased by $1.0 million during the year ended 2013 based on performance metrics achieved or expected to be achieved. The total purchase price will not exceed CAD $26.2 million.

Recent Developments

On January 9, 2014, David J. Coghlan resigned from his positions as Chief Executive Officer, President and Director of the Company and our Board of Directors appointed Dean P. Freeman, our Executive Vice President and Chief Financial Officer, to serve as interim Chief Executive Officer and President of the Company. The Company's Board of Directors has initiated a search for the Company's next Chief Executive Officer and President

On February 18, 2014, we declared a quarterly dividend of thirteen cents ($0.13) per share on each outstanding share of Class A common stock and Class B common stock.

On February 18, 2014, we entered into a new Credit Agreement (the "New Credit Agreement") among the Company, certain of our subsidiaries who become borrowers under the New Credit Agreement, JPMorgan Chase Bank, N.A., as Administrative Agent, Swing Line Lender and Letter of Credit Issuer, and the other lenders referred to therein. The New Credit Agreement provides for a $500 million, five-year, senior unsecured revolving credit facility which may be increased by an additional $500 million under certain circumstances and subject to the terms of the New Credit Agreement. The New Credit Agreement has a sublimit of up to $100 million in letters of credit. We expect to use any borrowings under the New Credit Agreement for general corporate purposes, acquisitions and the repayment of existing debt.

In connection with the execution and delivery of the New Credit Agreement, all outstanding amounts owing under our prior Credit Agreement (the "Prior Credit Agreement"), dated as of June 18, 2010, among the Company, certain subsidiaries of the Company as borrowers, Bank of America, N.A., as Administrative Agent, Swing Line Lender and Letter of Credit Issuer, and the other lenders referred to therein, were repaid in full and the Prior Credit Agreement was terminated.


Results of Operations

Year Ended December 31, 2013 Compared to Year Ended December 31, 2012

    Net Sales.  Our business is reported in three geographic segments: Americas,
EMEA and Asia Pacific. Our net sales in each of these segments for the years
ended December 31, 2013 and 2012 were as follows:


                         Year Ended               Year Ended
                     December 31, 2013        December 31, 2012                 % Change to
                                                                                Consolidated
                    Net Sales    % Sales     Net Sales    % Sales    Change      Net Sales
                                             (Dollars in millions)
    Americas       $     878.5       59.6 % $     835.0       58.5 % $  43.5              3.0 %
    EMEA                 562.2       38.2         565.6       39.6      (3.4 )           (0.2 )
    Asia Pacific          32.8        2.2          26.8        1.9       6.0              0.4


    Total          $   1,473.5      100.0 % $   1,427.4      100.0 % $  46.1              3.2 %

The change in net sales was attributable to the following:

                                                                              Change as a %                            Change as a %
                                                                        of Consolidated Net Sales                  of Segment Net Sales
                                            Asia                                          Asia                                         Asia
                    Americas     EMEA      Pacific    Total     Americas       EMEA      Pacific    Total     Americas      EMEA      Pacific
                                                                      (Dollars in millions)
Organic             $    45.6   $ (20.5 )  $    5.5   $ 30.6           3.1 %    (1.4 )%       0.4 %    2.1 %         5.4 %   (3.6 )%      20.5 %
Foreign exchange         (2.8 )    17.1         0.5     14.8          (0.2 )     1.2            -      1.0          (0.3 )    3.0          1.9
Acquisitions              0.7         -           -      0.7           0.1         -            -      0.1           0.1        -            -


Total               $    43.5   $  (3.4 )  $    6.0   $ 46.1           3.0 %    (0.2 )%       0.4 %    3.2 %         5.2 %   (0.6 )%      22.4 %

Organic net sales in 2013 in the Americas wholesale market increased by $37.0 million, or 6.3%, compared to 2012 mainly from increased sales in residential and commercial flow product lines and from our customers continuing to transition to lead free products. Organic sales into the Americas DIY market in 2013 increased $4.8 million, or 2.7%, compared to 2012, primarily due to increased product sales of $1.9 million in residential and commercial flow control products and $1.2 million in water quality products. Unit sales increases were substantially offset by competitive pricing in the DIY market.

Organic net sales in the EMEA wholesale market decreased by $10.7 million, or 3.7%, compared to 2012 primarily due to the economic market conditions in France and Germany. Organic net sales into the EMEA OEM market decreased by $6.0 million, or 2.3%, as compared to 2012 primarily due to a slower HVAC market in Germany and fewer large project sales in the drains business, offset by increased sales in the electronics business.

The net increase in sales due to foreign exchange was primarily due to the appreciation of the euro against the U.S. dollar. We cannot predict whether these currencies 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 Americas was due to tekmar.


Gross Profit. Gross profit and gross profit as a percent of net sales (gross margin) for 2013 and 2012 were as follows:

                                             Year Ended
                                            December 31,
                                        2013            2012
                                       (Dollars in millions)
                     Gross profit   $      526.5    $      513.5
                     Gross margin           35.7 %          36.0 %

In Americas, gross margin decreased primarily due to inefficiencies related to our lead free transition program and retail pricing pressure offset partially by product mix and volume growth. EMEA gross margin increased slightly as compared to 2012, primarily due to production efficiencies driven from ongoing restructuring programs offsetting lower overhead absorption related to reduced manufacturing volumes.

Selling, General and Administrative Expenses. Selling, general and administrative expenses, or SG&A expenses, for 2013 increased $24.7 million, or 6.5%, compared to 2012. The increase in SG&A expenses was attributable to the following:

                                       (in millions)    % Change
                   Organic              $        20.8         5.5 %
                   Foreign exchange               3.6         0.9
                   Acquisitions                   0.3         0.1


                   Total                $        24.7         6.5 %

The net organic increase in SG&A is primarily attributable to increased legal costs of $12.5 million, increased product liability cost of $4.5 million, increased freight and commission costs of $4.1 million associated with increased sales, and increased personnel costs of $2.2 million, offset by lower depreciation and amortization of $1.6 million and lower advertising costs of $1.3 million. Incremental legal costs include the impact of an agreement in principle to settle all claims in the Trabakoolas et al., v. Watts Water Technologies, Inc., et al., matter pending in the United States District Court for the Northern District of California. The net settlement charged to operations amounted to $13.6 million in 2013. Refer to Note 14 of the Notes to Consolidated Financial Statements in this Annual Report on Form 10-K for more detail. Increased product liability cost of $4.5 million in the Americas is based on a third-party actuarial analysis that incorporated higher reported claims in 2013 offset to some extent by the impact of the Trabakoolas settlement. Increased personnel costs primarily relate to investments in new positions and increased stock incentive plan costs.

The increase in SG&A expenses from foreign exchange was primarily due to the appreciation of the Euro against the U.S. dollar. Acquired SG&A expenses related to the tekmar acquisition. Total SG&A expense, as a percentage of sales, was 27.5% in 2013 and 26.7% in 2012.

Restructuring and Other Charges. In 2013, we recorded a net charge of $8.7 million primarily for severance and other costs incurred as part of our previously announced restructuring programs, as compared to $4.2 million for 2012. For a more detailed description of our current restructuring plans, see Note 4 of Notes to Consolidated Financial Statements in this Annual Report on Form 10-K.

(Gain On) Adjustment to Disposal of Business. In 2011, we booked a net gain of approximately $7.7 million relating primarily to the recognition of currency translation adjustments resulting from the sale of TWVC. In 2012 and 2013, we recorded adjustments to decrease the gain on disposal by $1.6 million and increase the gain on disposal by $0.6 million, respectively.

Goodwill and Other Long-Lived Asset Impairment Charges. In 2013, we recorded asset impairment charges of $1.2 million, primarily relating to a $0.3 million goodwill impairment charge for BRAE, and


trade name impairment charges of $0.3 million and $0.4 million for the Americas and EMEA, respectively. The goodwill impairment was based on historical results being below our expectations and a reduction in the expected future cash flows to be generated by BRAE. See the results of operations discussion for the year ended December 31, 2012 compared to the year ended December 31, 2011, for details of the 2012 goodwill and other long-lived asset impairment charges. See also Note 2 of Notes to Consolidated Financial Statements in this Annual Report on Form 10-K, for additional information regarding these impairments.

Operating Income. Operating income by geographic segment for 2013 and 2012 was as follows:

                                                                   % Change to
                                 Year Ended                        Consolidated
                        December 31,    December 31,                Operating
                            2013            2012        Change        Income
                                         (Dollars in millions)
         Americas       $        90.4   $        96.5   $  (6.1 )           (4.9 )%
         EMEA                    46.9            52.5      (5.6 )           (4.6 )
         Asia Pacific             9.7             6.5       3.2              2.6
         Corporate              (35.5 )         (32.2 )    (3.3 )           (2.7 )


         Total          $       111.5   $       123.3   $ (11.8 )           (9.6 )%

The change in operating income was attributable to the following:

                                                                                        Change as a % of                                   Change as a % of
                                                                                 Consolidated Operating Income                         Segment Operating Income
                                         Asia                                                   Asia                                                     Asia
                  Americas     EMEA     Pacific    Corp.     Total     Americas      EMEA      Pacific    Corp.     Total      Americas      EMEA       Pacific    Corp.
                                                                                  (Dollars in millions)
Organic           $    (7.3 ) $ (2.4 )  $    0.9   $ (3.3 ) $ (12.1 )       (5.9 )%   (2.0 )%       0.7 %   (2.7 )%   (9.9 )%       (7.5 )%    (4.6 )%      13.9 %   10.2 %
Foreign
exchange               (0.6 )    1.8         0.1        -       1.3         (0.5 )     1.5          0.1        -       1.1          (0.6 )      3.4          1.5        -
Acquisitions            0.1        -           -        -       0.1          0.1         -            -        -       0.1           0.1          -            -        -
Restructuring,
impairment
charges and
other                   1.7     (5.0 )       2.2        -      (1.1 )        1.4      (4.1 )        1.8        -      (0.9 )         1.7       (9.5 )       33.8        -


Total             $    (6.1 ) $ (5.6 )  $    3.2   $ (3.3 ) $ (11.8 )       (4.9 )%   (4.6 )%       2.6 %   (2.7 )%   (9.6 )%       (6.3 )%   (10.7 )%      49.2 %   10.2 %

The decrease in consolidated organic operating income was due primarily to an increase in SG&A expenses, as previously discussed. Acquired operating income relates to the tekmar acquisition.

The increase in restructuring, impairment charges and other from 2013 to 2012 is primarily driven by the EMEA restructuring programs, as previously discussed.

The net increase in operating income from foreign exchange was primarily due to the appreciation 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 operating income.

Interest Expense. Interest expense decreased $3.1 million, or 12.6%, in 2013 compared to 2012, primarily due to the retirement in mid-May 2013 of $75 million in unsecured senior notes and to a lower balance outstanding on our stand-by letters of credit. See Note 10 of Notes to Consolidated Financial Statements in this Annual Report on Form 10-K, for additional information regarding financing arrangements.

Other Expense (Income), Net. Other expense (income), net increased $3.6 million in 2013 compared to 2012, primarily due to a foreign currency transaction losses in the Americas, EMEA and Asia Pacific as a result of the appreciation of the Chinese yuan and the euro against the U.S. dollar and appreciation of the U.S. dollar against the Canadian dollar in 2013. In addition, a favorable customs settlement recorded in 2012 did not repeat in 2013.


Income Taxes. Our effective tax rate for continuing operations increased to 30.6% in 2013 from 29.7% in 2012. The 2013 rate is up slightly due to a change in tax laws in France that limited intercompany interest deductions. In 2012, the rate was favorably impacted by the release of a tax reserve following the completion of a European tax audit.

Net Income From Continuing Operations. Net income from continuing operations for 2013 was $60.9 million, or $1.71 per common share, compared to $70.4 million, or $1.95 per common share, for 2012. Results for 2013 include net after-tax charges of $18.3 million, or $0.51 per common share, including legal settlement charges of $0.26, restructuring and other net charges of $0.17, goodwill and other long-lived asset impairments of $0.04, earnout adjustments of $0.02 and EMEA transformation deployment costs of $0.02.

Results for 2012 include net after-tax charges of $8.1 million, or $0.22 per common share, including restructuring and other net charges of $0.07, goodwill and other long-lived asset impairments of $0.07, a charge to adjust the TWVC gain of $0.04, retention costs for our former Chief Financial Officer of $0.03, net legal/customs settlement charges of $0.02, and other net credits of $0.01, primarily related to a favorable tax adjustment due to a change in 2012 in Italian tax rules.

The appreciation primarily of the euro against the U.S. dollar in 2013 resulted in a positive impact on our operations of $0.03 per common share compared to 2012. We cannot predict whether the euro, Canadian dollar or Chinese yuan 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 income.

Loss From Discontinued Operations. Loss from discontinued operations in 2013 of $2.3 million, or ($0.07) per common share, was related to the operations and loss on disposal of Austroflex. See Note 3 of Notes to Consolidated Financial Statements.

Results of Operations

Year Ended December 31, 2012 Compared to Year Ended December 31, 2011

    Net Sales.  Our business is reported in three geographic segments: Americas,
. . .
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