Q3 2022 Watts Water Technologies Inc Earnings Call
Organic sales growth and margin improvement versus the prior year.
Due to our strong year to date results and our outlook for the fourth quarter, we are increasing our full year outlook in.
In addition, we're accelerating $3 million of investments into 2022, and increasing our full year investments to $23 million from the $20 million previously communicated.
The incremental increase is primarily related to smart and connected projects.
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.
Thanks, Bob and good morning, everyone.
Please turn to slide four and I'll review, the third quarter consolidated results.
Sales of $488 million were up 7% on a reported basis and up 12% organically.
We had a strong quarter in the Americas and EMEA.
Double digit growth in both regions and mid single digit growth in Europe .
When exchange, primarily driven by a weaker euro reduced year over year sales by roughly $21 million or 5%.
Acquisitions accounted for $2 million of incremental sales year over year.
Adjusted operating profit was $82 million up 25% compared to last year and adjusted earnings per share were up 29% to $1 79.
Adjusted operating margin of 16, 8% was up 240 basis points as price and productivity more than offset inflation and incremental investments.
Consistent with the second quarter, our margins continued to benefit from our investment in inventory at lower cost.
We estimate this impact to be approximately $5 million to $7 million in the quarter, which we do not expect to recur.
The adjusted effective tax rate was 25, 5% 140 basis points lower than the third quarter of 2021.
The decrease relates primarily to the restructuring of our Mexican supply chain operations.
Our free cash flow year to date was $67 million as compared to $120 million in the third quarter of last year.
The year over year free cash flow decrease was primarily due to incremental cash outflows to fund an increase in inventory as well as increased payments related to restructuring income taxes and employee and customer incentives.
We expect seasonally strong free cash flow in the fourth quarter and now expect full year free cash flow conversion to be approximately 75% of net income.
The balance sheet remains strong and provides us with ample flexibility.
Gross leverage was 0.5 times and net leverage was negative 0.1 times.
Our net debt to capitalization ratio at quarter end was also negative at 3%.
During the quarter, we purchased approximately 29000 shares of our common stock at an investment of $4 million, primarily to offset dilution.
Year to date, we have repurchased approximately 463000 shares for $65 million.
Please turn to slide five and I'll provide a few comments on the regional results.
The Americas had another strong quarter with organic sales up approximately 13%.
The growth was driven primarily by strong price realization across all platforms and all channels.
Acquisitions added approximately $2 million or 1% to reported sales.
Adjusted operating profit increased by 37% and adjusted operating margins increased by 380 basis points.
The margin expansion was driven by price and productivity, which more than offset inflation and incremental investments.
Our proactive investment in inventory at a lower cost combined with strong price realization also contributed to our margin expansion.
Europe's organic sales growth was approximately 6%.
Reported sales was negatively impacted by 15% from unfavorable foreign exchange movements.
We had organic growth across all platforms with double digit growth in Germany, and Italy, driven by our OEM business due to government energy incentives.
Scandinavia also saw strong growth with continued demand in food and beverage and marine end markets.
As a reminder, we stopped our direct shipments to Russia, and we estimate the impact of that to be approximately $3 million in the third quarter.
However, operating margin declined by 320 basis points.
And productivity were unable to fully offset rising inflation energy cost increases volume deleverage and investments.
<unk> sales grew organically by 22%.
Reported sales growth of 14% was negatively impacted by 8% from unfavorable foreign exchange movements.
China's organic sales growth was in the double digits as both valves and underfloor heating rebounded after the Covid lockdown in the second quarter.
Organic sales outside China were also up double digits due to strong growth in New Zealand.
Adjusted operating margin decreased 260 basis points as price and productivity were unable to offset a reduction in affiliate volume inflation and investments.
Slide six provides our assumptions about our fourth quarter and full year operating outlook.
First let's cover the fourth quarter outlook.
We are estimating consolidated organic sales for the fourth quarter to grow at 5% to 8% over the prior year period.
This moderation in growth rates is due to softening underlying market conditions in Europe .
Exit of direct sales in Russia of approximately $3 million and more challenging comps due to multiple price increases implemented in the first nine months of 2021.
We estimate our adjusted operating margin could range from 13, 7% to 14, 2% for the fourth quarter with the increase versus the prior year, driven by price and productivity and partially offset by incremental investment spending of $8 million.
We estimate the incremental volume to drop through between 25 and 30% versus prior year.
Sequential decline in operating margin from the third quarter is driven primarily by volume deleverage and incremental investments.
In addition, we expect a favorable price cost dynamic to normalize in the fourth quarter as price cost becomes more balanced.
Corporate costs should be approximately $13 million.
Interest expense should be in line with the third quarter at approximately $2 million.
The effective tax rate is expected to be between 23 and 24%.
Currency will continue to be a headwind in the fourth quarter.
We are assuming a 1.0 average euro U S dollar FX rate for the fourth quarter versus the average rate of Euro 115 in the fourth quarter of 2021.
This implies a reduction of 13% year over year, which equates to a reduction of $19 million in sales and <unk> <unk> a share in EPS versus the prior year.
Now, let's cover the full year outlook.
For the full year 2022.
Increasing our organic sales growth outlook to a range of 11% to 12% from our previous outlook of 8% to 11%.
We are also increasing our view for the full year adjusted operating margin expansion to a range of 190 basis points to plus 210 basis points.
To our previous outlook of 110 basis points to plus 160 basis points.
We are now expecting our operating margins to be between $16, two and 16, 4%.
Our revised outlook is supported by a strong performance through the third quarter, plus our expected fourth quarter outlook.
Our free cash flow is now expected to be approximately 75% of net income.
Our free cash flow conversion is lower than the prior year due to incremental capex higher restructuring income tax in incentive payments and inventory investment.
We do plan to reduce our inventory levels as supply chain begins to normalize.
For the full year, we are now assuming a 1.05 average euro U S dollar FX rate versus the average rate of $1 one eight in 2021.
This would imply a reduction of 11% year over year and would equate to a reduction of $63 million in sales and 20 cents a share in EPS for the full year versus prior year.
And regarding other key inputs for the full year.
We expect corporate cost should approximate $49 million for the year.
Interest expense should approximate $7 million for the year.
Our estimated effective tax rate for 2022 should be between 24 and 25%.
Capital spending is expected to be approximately $35 million.
Depreciation and amortization should be approximately $40 million for the year.
We expect our average share count for the year to be approximately $33 6 million.
Now, let me turn the call back over to Bob before we begin Q&A Bob.
Thanks to shrink on slide seven I'd like to summarize our discussion before we address your questions.
Third quarter was stronger than we anticipated with double digit organic growth and strong drop through as price realization and productivity more than offset inflation.
Our teams continue to effectively manage the price cost dynamic.
We are increasing our full year outlook based on our strong start and our expectations for a solid fourth quarter.
We remain focused on innovation by investing for the future and driving our smart and connected strategy.
And we are increasing our investments in the fourth quarter.
We are monitoring economic conditions in our markets by getting real time feedback from our channels and customers. Our experienced team is well positioned to handle these challenging macroeconomic conditions.
With that operator, please open the lines for questions.
At this time I would like to remind everyone in order to ask a question press star followed by the number one on your telephone keypad. Your first question comes from the line of Jeff Hammond with Keybanc. Your line is open.
Hey, good morning, guys.
Gotcha.
So.
Maybe just to start on Europe .
I was surprised by how resilient the organic growth was but the margins seem to get hit so maybe just.
Expand I don't know if thats mix or.
And then just expand on what Youre seeing in the order rates as we see a lot of uncertainty on Europe .
Yes, so Jeff.
Europe grew at approximately 5% the bulk of that was price in fact, when you strip price out volume was actually negative. So we had unit volume negative and because of the high fixed cost nature of our European business that obviously impacted factory efficiencies and that's why we had margins down. We also had slightly unfavorable mix in our <unk>.
<unk> business as well, so there's a little bit of unfavorable mix, but those two contributed for the the margin decline in Europe .
Jeff on the order rate we're seeing.
Our order rate patterns as through October what we've seen so it's holding up a little more resilient than I think a lot of repair replacement going on and a lot of focus on energy efficient products.
Okay, Great and then just.
I think we've had discussions over the past couple of quarters about inventory levels and your inventory levels in the channel and we've seen clearly a lot of destocking in the residential side, but just anything you're seeing real time around.
Supply chain improves.
Stocking around your product set.
Yes.
You hit it right on the head with related to you.
Residential we're seeing some OEM destocking that primarily serves residential and some of the single family and as we said in the past we've seen destocking in the wholesale level inside of Europe , but not.
Difficult and we're watching that very closely and it depends obviously on channels flow through et cetera, but that's an area where we're closely monitoring.
And then I think you've commented about single family versus multifamily can you just remind us your.
Within <unk>, what your mix is between the two.
Yes. It is.
Half and half our resi mix.
<unk>.
Half and half is related to that so if you look at single family will be under pressure given the higher interest rates, but given the housing shortage people have to look somewhere so we believe multifamily maybe it will be positive and its been positive going forward. So again, it's nice that we have the 50 50 split also remember in our.
Single family side of our business, we probably we primarily serve the higher end homes.
And that from a repair replacement point of view, it's been holding up pretty well.
And Jeff So 40% of our business is residential and as Bob said half of that so 20% is <unk>.
<unk> family, but then when you look at the new construction side of that.
Roughly less than 10% of our total business is single family new construction.
Perfect. Thanks for the color guys.
Thank you.
Your next question is from the line of Joseph Giordano with Cowen and company. Your line is open.
Hey, guys. Good morning. This is tristan in for Joe Thanks for taking the questions.
Okay.
You just talked about Europe , and volumes being negative where where volumes positive in any region.
Unit volumes for.
For the most part unit volumes and Anthony of a positive.
And in the Americas slightly positive unit volumes.
Okay.
Thanks for that and then so strong contribution from price obviously.
How should we think about <unk> contribution going forward and like what does it mean for margins once.
Price starts to.
Good price contribution starts to slow down.
So as we had talked about in the second quarter price cost was favorable in the third quarter price cost was favorable and we quantified that as an incremental $5 million to $7 million going forward, obviously, we understand our cost position pricing, it's always the elasticity of the market and.
And as we had talked about earlier, we've tested the elasticity in the European market in the Americas, We're still doing a good job on price.
So it all depends on the fourth quarter, what happens to that elasticity.
And that's something we obviously our teams are working hard on but we don't comment on it until we actually see the results at the end of the quarter.
Got it Okay and you also mentioned some incremental investments.
Smart and connected products can.
Can you remind us where.
How much is that contributing to your sales right now and like how should we think about the trend going forward.
Yes, Martin connected continues to be a larger part of our part of our portfolio and.
It's growing faster than the regular a regular market. So we're continuing to drive for our goal of 15% to 25% smartphone connected so.
Upping, our investments because we're trying to accelerate and get back on track with that.
Thank you guys.
Thank you. Thank you.
Your next question is from the line of Brian Lee with Goldman Sachs. Your line is open.
Hey, guys. Good morning, Thanks for taking the questions.
Good morning.
So first off I wanted to dive into the comments around Europe , a little bit again.
Nice execution, I know you had kind of called out potential.
Potentially more challenging backdrop in the back half here, you navigated that pretty well it looks like in <unk>, but on the margin front and looking into the near term you made the comments just yank that price cost gets more neutral if not positive in <unk> is that across the portfolio across all the regions or is Europe still going to be lagging.
Because it does sound like Europe has some.
Additional challenges that may be or not.
Making all up on price. So I'm wondering if there's any other mitigation efforts specifically in that region for your.
To kind of recover our margins.
Yes, historically Europe , the European region, it's harder to get price and certainly we're lagging a little bit on price, but from a price cost standpoint. So it is the bigger issue in Europe is a stranded cost as unit volumes go down so think about factory inefficiencies and that hurt us in the third quarter and is yes as long as unit.
Volumes are challenged that's going to continue from a price cost standpoint, yes, we do get less price.
But it's a combination of the price cost and the factory inefficiencies that hurt us in Europe .
We continue to review our cost structure in Europe , but as you know.
Have large facilities with high fixed costs, so it's difficult and it takes a while to work on those large fixed costs, but we're working on the smaller ones adjusting accordingly with our teams in Europe .
Okay Fair enough that's helpful color I guess maybe related to that.
You mentioned sort of order rates pretty healthy maybe sim.
Similar to kind of what you've been running at here at <unk>.
In Europe , specifically are you seeing a recovery in volumes should we be anticipating near term that's more sort of steady as she goes or are you actually seeing an uptick after some of the more kind of recent challenges.
I think it's steady as you go over in Q3 compared.
Compared to Q3.
We're watching that closely I wouldn't say, there's any uptick at this point in time.
Okay Fair enough. Thanks, guys I'll pass it on thank.
Thank you.
Your next question comes from Michael Halloran with Baird. Your line is open.
Hey, good morning, everyone.
Good morning so.
First question is a follow up to one of Jeff's earlier.
Earlier questions just singled with multifamily.
The multifamily side are you guys seeing the positive trends on that side.
Already or is that more of a prospective comment on expectations for.
Maybe a little bit more rotation from the single mother to the multifamily home on the construction markets we serve.
No we saw it in Q3, Jeff we definitely saw in Q3.
We believe it will continue.
Okay, and then on the North American margin side, obviously, that's been pretty healthy.
Two quarters and rose.
Really strong performance.
Last quarter I know you had some favorability built in.
For a couple of reasons this quarter still really strong despite lower revenue sequentially.
Guidance seems to have a step downward maybe talk about the trend there and I think more importantly.
The strong performance you are talking about in that segment through the year, how should we think about.
The rate call it margin level for us to start building also for next year. So what's the base exiting the year essentially.
Yes, I would say that we've had a favorable price cost dynamic, especially in the Americas, starting in the second quarter and continued in the third quarter.
As we've said the elasticity we haven't.
I guess, we've tested a little bit, but that's probably more testing on elasticity to go into the fourth quarter and Thats why we don't comment on the way we will end up in the fourth quarter, we have given the guidance, we know our cost base and we will see how the pricing works in the marketplace. Obviously, our teams will try to get as much as they can.
And therefore, I guess it will be able to answer your question as we end the year as far as what is the exit rate clearly we've had between the second quarter in the third quarter, if you add the 6% to $8 million of price.
Cost favorability and then the another five to 7 million third quarter, we've got about $12 million to $13 million of price cost favorability. Most of that is in the Americas. Most of that in fact all of that is one time. So as we exit as we end the year, we will give more color on that but for now that's the stories through the third quarter.
Yes, Mike as you know that helps.
Yes go ahead from Mike we've been benefited from inventory availability and we obviously didn't have to discount at all at that point in time, and we pre purchased inventory at lower cost. So again that really helped our margins both in Q2 and Q3.
Yes.
Numbers help either way to provide perspective on a forward basis.
Great Great performance. Nonetheless, I appreciate it. Thanks. Thank you. Thank you.
Your next question is from the line of Ryan Connors of Northcoast Research. Your line is open.
Great. Thanks for taking my question.
So I wanted to come at the margin question from a bit of a different angle I know theres. So much focus here on sort of the short term elasticity on the price cost in the fourth quarter or even 'twenty three but.
My question is if you look at the margin run rate Youre talking about north of 16%.
Historically been more like 10%, 11%.
And I guess my question is has anything structurally changed over the last couple of years in your markets.
Structurally that would enable you to be confident and you can see.
Sustain that higher level of economic rent and you're extracting from the value chain in other words has there been consolidation has there been smaller companies that have exited.
Anything like that that really gives you confidence that this is a higher structural margin business going forward or is it really just the price cost.
IMAX that are moving things around.
Ryan when you look at the lower margins you talked about that that was in the 2014 2015. Some of that was structural from our cost structure, which we've taken cost out et cetera.
No we've been innovating spending a lot in R&D and really looking at providing value to our customers with our smart <unk> connected initiative and a lot of what we're doing around leak detection et cetera. So.
We believe structurally we have a much better stronger portfolio thats, providing benefits to our customers. So I think that's a big shift from where we were.
In the past and that's where we continue to go out and we also as you know got rid of a lot of commoditized products in our portfolio and we exited about $175 million to $185 million from that point of view.
So price cost has been favorable we've been disciplined and but we're providing value to our customers to justify that price. So that's something we're watching we're driving and that's why innovation is a key part of our strategy.
Okay. So the answer the quick answer is no then I mean, so the specific question was around consolidation or there's been no movement in terms of the competitive scene over the consolidation or anything like that.
So the competitive dynamics are the same you are talking about internal self help you've done which is great but.
A question regarding the market structure.
I Wonder if you can kind of address it from that standpoint, and I guess my read.
Read of what you said is that none of that really has changed.
Not significantly I think theres been small consolidations as you know, but not significant market.
Consolidation.
Got it okay. That's helpful. Thanks for your time.
Thank you.
Again, if you would like to ask a question press.
Followed by the number one on your telephone keypad. Your next question is from the line of Nathan Jones with Stifel. Your line is open.
Good morning, everyone.
Good morning.
We'll try abating, the Americas margin horse again.
Even if we adjust the margins for the last two quarters and an American stood at 5% to 7% and $6 million to $8 million that you called out as benefit.
Margins in those two quarters are still 20 kind of 20% plus in <unk> and <unk> 22 is there any reason why that is not a decent baseline to stop for for for 2023 outside of some of the seasonality that you say with those being stronger revenue quarters.
No I think thats reasonable Nathan I mean, we if you take out the favorable price cost dynamic in Q2 Q3, and we gave the numbers. So you know exactly what those are but I think thats. Obviously, we try to always as you know our long term plan is always to improve margins at once 30% to 50 basis points and in order to continue on that path.
That base that reset baseline for the Americas needs to continue going forward.
And then maybe one for Bob.
I know you've had a high fixed cost base in Europe that has.
It has been an issue either.
Is the decline in demand of the U.
Perhaps the opportunity to take some more strategic actions around the cost base and how the Europe business operates to you in 'twenty three 'twenty four.
Nathan as you know, we're always looking at our footprint and.
We will continue to do that we will have benefits next year from the closure of our plant from Murray falling over into next year and we continue to look at opportunities, but as you know if you do do a plant closure it takes well over a year to begin seeing that benefit. So teams are evaluating that.
We're trying to meet.
All the customer demand out there.
We'll be looking at that and we will update you during our February call.
And Nathan we did a little bit of we did take a little bit of a restructuring charge in the third quarter about $1 7 million. The bulk of that was some more European restructuring we did.
Last one on the balance sheet as you know.
No net debt on the balance sheet at the moment.
Acquisitions have been pretty few and far between.
Is that.
Is there any expectation that you can get some M&A across the line and in the absence of M&A, what's the plan for gain cash off the balance sheet.
Well Nathan you know, we believe in a balanced capital allocation strategy.
We have a healthy pipeline, we're reviewing that but as we've said in the past.
Be disciplined from an M&A point of view and as you know you can never count the timing of M&A because it takes too.
To do a deal here so.
We'll be monitoring and watching that and we will be discussing other options, but at this point.
Pipeline is full we're evaluating it.
We will continue to have that balanced capital allocation strategy.
Fair enough thanks, very much for taking my questions.
Thanks Nathan.
There are no further questions at this time I will now turn the call back over to Mr. Bob Pagano.
Thank you for taking the time to join US today. We appreciate your continued interest in watts and we look forward to speaking with you again in February to discuss our fourth quarter and full year 2022 results enjoy the upcoming holidays and please stay safe take care.
Ladies and gentlemen, thank you for participating. This concludes today's conference call you may now disconnect.
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Okay.
Okay.
Yeah.
Uh huh.
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