Q2 2023 Watts Water Technologies Inc Earnings Call
Ladies and gentlemen, thank you for standing by my name is Brent and I will be your conference operator today.
At this time I would like to welcome everyone to the Watts water technologies second quarter 2023 earnings call.
All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question and answer session.
If you would like to ask a question at that time simply press star followed by the number one on your telephone keypad. If you would like to withdraw your question again press Star one. Thank you I will now turn todays call over to Diane Mclintock Senior Vice President financial planning analysis and Investor Relations. Please go ahead.
Thank you and good morning, everyone welcome to our second quarter earnings Conference call. Joining me today are Bob Pagano, President and CEO and Shashank Patel, our CFO during today's call Bob will provide an overview of the second quarter and discuss the current state of the markets and our operation.
Yes.
He will also update you on our smart and connected product initiatives and our sustainability efforts.
Shashank will discuss the details of our second quarter performance and provide our outlook for the third quarter and for the full year.
Following our remarks, we will address questions related to the information covered during the call.
Today's webcast is accompanied by a presentation, which can be found in the Investor Relations section of our website. We will reference this presentation throughout our prepared remarks.
Any reference to non-GAAP financial information is reconciled in the appendix to the presentation.
Before we begin I'd like to remind everyone that during this call we may be making certain comments that constitute forward looking statements. These statements are subject to numerous risks and uncertainties that could cause actual results to differ materially.
For information concerning these risks see what's publicly available filings with the SEC.
The company disclaims any intention or obligation to update or revise any forward looking statements, whether as a result of new information future events or otherwise.
With that I will turn the call over to Bob.
Thank you Diane and good morning, everyone. Please turn to slide three and I'll provide an overview of the quarter.
First I'd like to thank the entire watch team for their hard work and dedication to diligently serving our customers worldwide together, we delivered another better than expected quarter. Despite tough comparisons to a very strong second quarter in 2022.
We finished the quarter with record sales operating margin and earnings per share leading to the decision to raise our full year 2023 outlook.
Europe and EMEA regions were resilient as organic sales grew at a mid single digit pace, primarily due to price sale.
Sales in the Americas region were down low single digits as we expected due to a tough comparison to a very strong second quarter in 2022, where organic sales were up 22%.
Strong growth in our nonresidential core valve products was more than offset by double digit declines in our gas connectors radiant heating applications and commercial marine instrumentation.
Adjusted operating margin exceeded expectations supported by solid price realization and favorable mix and productivity, which more than offset inflation lower volume and incremental investments.
Year to date free cash flow has been strong and has added to the strength of our balance sheet, we expect to generate strong free cash flow into the second half of 2023, which will afford us ongoing flexibility and our balanced capital allocation strategy.
To that end our board approved a new $150 million share repurchase program. This program will follow on our existing plan is stock repurchases remain an important part of our capital allocation strategy as.
As a reminder, stock buybacks, along with high ROI Capex investments competitive dividends and strategic M&A, such as our recent and where acquisitions remain our top capital allocation priorities.
Moving to operations the integration of our <unk> acquisition is going well and cost actions are ahead of schedule by.
By leveraging our one watts performance system in collaborating with the <unk> team, we have been able to seamlessly integrate and align the organization and efficiently streamline operations. We're excited about the future of N, where as we continue to scale our operations in Australia.
While inflation is moderating it's still above normal historical levels, we continue to assess our price cost relationship and will address price increases as needed.
Automation is a big focus for our capital spending is necessary to offset labor shortages and drive productivity. We expect to continue these investments to enhance productivity in our factories.
Next I'd like to provide an update on our end markets.
In the Americas, New residential single family construction appears to have bottomed out and multifamily new construction is holding up.
Nonresidential, new construction indicators are mixed but have shown recent resilience.
After multiple readings below 50 dating back to the fall of last year. The May and June the Abi index readings bounce back above 50, indicating expansion. The Dodge momentum index is still suggesting that growth in nonresidential projects will continue.
The institutional industrial verticals it remains solid year to date and we expect this to continue through 2023.
In the Asia Pacific region growth in China has decelerated in recent months, we are seeing strengthening markets in the middle East due to continued higher oil prices.
Australia markets remain resilient. Despite continued interest rate increases and our recent <unk> acquisition gives us confidence that we'll continue to grow in Australia.
Now an update on our outlook for the third quarter and the remainder of the year.
Due to challenging comps as a result of a strong third quarter 2022, we expect our third quarter organic sales growth to be lower versus prior year. We also anticipate declining operating margins due to normal seasonality incremental investments and volume deleverage.
While we expect difficult comps in Q3, we are increasing our full year outlook due to a strong first half performance as well as better than expected price and favorable mix.
We expect Americas nonresidential business to remain solid but be offset by weak single family residential and continued softness in certain specialty channel products. We also anticipate the second half to be softer in Europe due to weakening macros.
Inflated interest rates and lending tightening may also have an impact on new construction.
In addition, we are accelerating $3 million of investments into 2023, and increasing our full year investments to $23 million from the $20 million previously communicated to fund new product development, including smart and connected enabled products.
On slide four I'd like to update you on our smart and connected offerings.
Year to date, the percentage of smart and connected enabled product sales to total sales reached 23%.
Our goal has been to achieve 25% of sales from smart and connected enabled products by the end of 2023, and we expect to meet that goal.
I would also like to share with you one of the new smart and connected products that was developed by the team at <unk>.
Smart flow meter risk management system incorporates a smart thermostat mixing valve tap ware and other hardware to provide monitoring and flow management capability.
Smart flow platform serves the healthcare vertical and provides visibility into water system delivery that will enhance asset performance and longevity reduce operating costs and help proactively manage bacterial and scolding risks, while ensuring a more comfortable patient experience.
We are excited about the smart flow and other new products are smart and connected product offerings.
On slide five I'd like to comment on our most recent sustainability report.
In May we published our 2022 sustainability report, which highlights the accomplishments and the progress we've made within our four ESG pillars footprint and print social responsibility and corporate governance.
Our focus on our sustainability Triple play safety and regulation energy efficiency and water conservation.
Has allowed us to deliver tremendous value to our customers as we continue to enhance efficiency and transform traditional products into our smart and connected solutions.
Our focus on social responsibility reflects our people first approach and commitment to making people and communities safer healthier and stronger.
Sustainability is a core commitment at what's that extends into all aspects of our business I am proud of the progress our global team has made and invite you to read more about it in our sustainability report, which can be downloaded from our investor Relations website.
With that let me turn the call over to Shashank, who will address our second quarter results and our third quarter and revised full year outlook Shashank.
Thanks, Bob and good morning, everyone.
Please turn to slide six and I will review the second quarter's consolidated results.
Sales of $518 million were up 1% on a reported basis and flat organically.
Mid single digit organic growth in Europe , and <unk> were offset by a low single digit organic decline in the Americas.
Sales from our <unk> acquisition totaled approximately $8 million and are reported within the apnea region.
Unfavorable foreign exchange movements had an immaterial impact in the quarter.
Adjusted operating profit was $104 million up 7% compared to last year and adjusted EPS was up 11% to $2 34.
Adjusted operating margin of 19, 5% was up 100 basis points as price mix and productivity more than offset inflation lower volume and incremental investments.
We were able to deliver 100 basis points.
2022, which benefited from approximately $7 million of <unk>.
One time price cost favorability and the dilution of the Engler acquisition in the quarter.
The adjusted effective tax rate was 24, 7%.
The decrease relates primarily to the reduction of foreign taxes associated with the repatriation of funds.
Our free cash flow year to date was $89 million as compared to $33 million in the first six months of last year the.
We expect sequential improvement in our free cash flow and our full year goal is to achieve free cash flow conversion of one.
100% or more of net income as previously communicated.
During the quarter, we repurchased approximately 24000 shares of our class a common stock for $4 million and year to date, we have repurchased approximately 47000.
As Bob mentioned, we just announced a new $150 million stock repurchase program.
Will provide us with <unk> as part of our balanced capital allocation strategy.
Furthermore, the 20% dividend increase that we announced in early May demonstrates our continued focus on returning capital to shareholders.
Please turn to slide seven let me provide a few comments on the regional results.
Americas organic sales were down 2% as we expected due to a tough prior year comparison.
As a reminder, our Americas grew 22% in the second quarter of 2022.
Strong growth in our nonresidential core valve products was more than offset by declines in gas connectors radiant heating applications and commercial marine instrumentation.
In addition to the tough comps weakness in single family residential new construction was a contributing factor.
Adjusted operating profit increased by 7% and adjusted operating margins increased by 210 basis points.
Origin expansion was driven by price mix and productivity, which more than offset volume declines inflation and incremental investments.
Europe demonstrated resiliency with organic sales up approximately 5%.
Reported sales were positively impacted by 1% from favorable foreign exchange movements.
Growth was primarily due to price with growth in Germany, driven by our OEM business and in France, and Benelux by solid wholesale activity.
The growth was partly offset by declines in Scandinavia, and Italy with a reduction of government subsidies had an unfavorable impact.
Operating margin declined by 10 basis points as price and productivity were unable to offset.
Inflation investments and volume deleverage.
<unk> also had a solid quarter delivering 6% organic growth.
Reported sales growth of 33% was negatively impacted by 6% from unfavorable foreign exchange movements and favorably impacted by 33% or $8 million.
<unk> acquired <unk> sales.
China's organic sales grew low single digits, while organic sales outside China or up by double digits with growth in Australia and in the middle East, partially offset by a decline in New Zealand due to the after effects of the historic flooding.
Adjusted operating margins increased 250 basis points due to higher third party sales volume affiliated volume price and productivity, which more than offset inflation investments and the dilutive effect of the <unk> acquisition.
As Bob mentioned, we will have a very tough comparison to a strong third quarter in 2022.
We estimate consolidated organic sales, maybe up by 1% to down by 3% with Americas, and Europe being flat to a low single digit decline offset partly by a low single digit growth in apnea.
This moderation in growth rates is.
Due to anticipated softening underlying market conditions in Europe as.
We also anticipate continued weakness in single family residential new construction.
And <unk> the acquisition of <unk> is expected to contribute $8 million of sales.
We estimate our adjusted operating margin could range from 16% to 16, 5% for the third quarter down 30 basis points to 80 basis points versus prior year.
The decline versus prior year is due to the reduced volume incremental investments of approximately $7 million and a one time price cost benefit of $6 million, we spoke about in the third quarter of 2022.
The sequential decline in operating margin from Q2 is driven primarily by the impact of volume deleverage incremental investments and typical seasonality.
In addition, we expect the <unk> acquisition to be dilutive to operating margin as we continue to adjust the cost structure.
Corporate costs should be approximately $14 million and interest expense net of interest income should be approximately half a million dollars in the third quarter.
The adjusted effective tax rate should be approximately 25%.
We are assuming a 110 average euro U S dollar FX rate for Q3 versus the average rate of 1.01 in the third quarter of 2022.
This implies a Q3 increase of 8% year over year, which equates to an increase of approximately $8 million in sales and two cents a share in EPS versus the prior year.
Now, let's cover the updated full year outlook.
For the full year 2023, we are increasing our organic sales growth outlook to a range from minus 2% to plus 2%.
Previous guide was from a range of minus 5% to plus 2%.
And in fact, this raises the bottom of our range by 3% and the midpoint by 2% based on our stronger than expected start in the first half of the year and our expected third quarter outlook.
We now expect approximately $24 million of sales from the acquisition of <unk>.
We now expect our 2023 operating margins to be between $16 seven and 17, 3%.
We expect our solid first half will partially mitigate the lower margins in the second half due to seasonality volume deleverage incremental investments and the dilutive impact of the <unk> acquisition.
As a reminder, we are also increasing our full year investments from 20 million to $23 million.
Our free cash flow expectations are anticipated to be in line with our previous outlook and should meet or exceed 100% of net income.
We are assuming a 1.09 average euro U S dollar FX rate for the full year.
The average rate of Euro 1.05 in 2022.
This would imply an increase of 4% in sales year over year and equates to an increase of $12 million in sales and four cents a share in EPS for the full year versus the prior year.
We expect corporate cost to be approximately $54 million for the full year.
Interest expense net of interest income should now be approximately $3 million for the full year.
Our estimated adjusted effective tax rate for 2023 should be approximately 25%.
Capital spending is expected to be approximately $35 million depressed.
Depreciation and amortization should be approximately $42 million for the year.
We expect our share count to be approximately $33 5 million for the year.
Now, let me turn the call back over to Bob before we begin Q&A Bob.
Bob.
Thanks, Shashank, please turn to slide nine I'd like to summarize our discussion before we address your questions.
The second quarter was better than we anticipated with record sales operating margin and earnings per share supported by price and favorable mix.
We continue to monitor the slowing economic indicators in Europe and are staying close to our customers. We are confident in our ability to execute in this uncertain environment.
We are prioritizing investment in our smart and connected and sustainability initiatives and are increasing our full year investments from 20 million.
$223 million. We believe we are on track to hit 25% of total revenues coming from smart and connected enabled products by the end of 2023.
Our strong free cash flow generation and balance sheet provides us flexibility to execute our balanced capital allocation strategy.
We announced a new $150 million stock repurchase program to ensure we maintain repurchase flexibility over the coming years with that operator. Please open the line 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.
Well pause for just a moment to compile the Q&A roster.
Your first question comes from the line of Ryan Connors with Northcoast Research. Your line is open.
Hi, good morning, Thanks for taking my question.
So I wanted to start on the gross margin obviously gross margins look really really good and I wanted to just kind of step back and look at the big picture on that and can we kind of interpret that one of these big debates about how well with price hold relative to raw materials and would we be able to hold price and lock in.
Some of that margin longer term.
Input costs moderate I mean does that kind of what's happening here on the gross margin line and is that something that's going to be.
Sustainable going forward.
Good morning, Ryan the first part of that first of all it was favorable mix right residential is down commercial is up and our OEM business is down which are lower margin businesses. So thats good.
That's good from a margin point of view from a.
A pricing point of view, we have been able to hold pricing so far and in that backdrop. We've also seen some reductions in our input costs so that altogether.
A favorable mix as well as.
And is there any sign that thats.
That's.
Any early evidence that that's changing or is the price environment.
Is there no real evidence of any major.
Cracking that pricing it looks pretty solid going forward.
Yes, we don't comment on forward looking price, usually but as of now as I said, it's holding up.
Situation that would be helpful as well thanks.
We've seen some destocking with continued residential destocking with Oems in North America, and I think Theres a big.
Focus on inventory in Europe , right now from the wholesalers to which we've been seeing them starting to destock as well as the Oems in Italy. So we're starting to see more destocking in Europe , we've seen it last year, but we're continuing to see it, especially with the order trends in Q2 in Europe .
Good morning. This is Adam Farley on for Nathan Jones.
Repair and replace volume to be modestly positive.
Yes, we expect that.
Repair and replacement has been holding up I think you've seen some.
Talked about it in our prepared comments that the specialty market, which was really around gas connectors radiant heating and then a niche of of commercial.
Instrumentation, which is really related to our ballast water those areas have been declining.
Declining and we expect them to continue in the third quarter that way.
Okay. That's helpful and then bridging that Youre nonresidential.
Businesses.
Provide a little more color on which end markets within non res still showing strength, which ones are still showing weakness and would you expect strengthen institutional to continue into 2024.
Yes, I think similar to the first quarter.
The commercial market has been holding in there strengthen institutional has been there and I think the normal offices.
<unk> hospitality, but hospitality is coming back a little bit, albeit off a really low comps from last year. So in general it's holding up at this point in time and as in my prepared remarks, we talked about the Dodge and Abi Index is also supporting that so.
So far so good and it's holding in there, but as you can imagine we're watching that very carefully and.
And again, we have some tough comps we're comparing against in the second half of this year.
Okay. Thank you for taking my questions.
Thank you.
Your next question comes from the line of Jeff Hammond with Keybanc capital markets. Your line is open.
Hey, good morning, guys.
Good morning.
Hey, just wanted to unpack the Decrementals I guess first half to second half maybe I understand there is some seasonality in there.
But.
And maybe you can quantify the incremental investments and if theres anything else.
Mix or otherwise that that would be impacting that.
Yes, so Jeff part of it is seasonality typically first half second half we see a decline of 100 150 bps first half to second half.
The other part of this year, we got some volume deleverage right. So the volume deleverage effects not only at the standard margin line, but you got some.
Absorption impacts as well there. The third thing is the incremental investments we have about $5 million of incremental investments age two versus H, one and lastly, and where it was dilutive by about 20 bps.
And then the other point, Bob had talked about which is Europe , we've got negative growth in Europe , and with a high fixed cost base, we see some delever.
Deleveraging there.
Okay great.
And I don't know if you mentioned that but one of the competitors had called that out and then can you just clarify what the specialty channel answers that DIY or something else.
Yeah on the.
I think our Hh W heating and hot water platform is.
<unk> et cetera.
So that's being impacted by.
That part of the market, which is residential same with radiant heating and we had some tough comps last year in that area.
Again, the specialty channel. We also have what we call our commercial marine instrumentation, which is our ballast water where there's.
There was a movement over the last several years to have all of the ships with large shifts measure their ballast water and.
There was that requirement all the ship Scott pretty much done by the end of last year, probably a year earlier than we expected and we're seeing that tail off but again all of that our specialty product is less than 10% of our overall business, but some of this we expected obviously with the residential side of this decreasing.
Big part of that gas also goes through Oems.
Okay.
Okay, and then just finally on Europe .
Guess, the moving pieces are you starting to see destocking that showing up in orders.
You mentioned in Italy.
Regulatory change dynamic.
But that's a business I think you've been worried about for some time, but continues to kind of put up.
It surprised us both in the first quarter and second quarter is held up but as expected given the leading economic indicators and some concerns.
Especially in the residential side of that market, we are seeing starting to see that tip over a little bit.
But we were expecting that it just.
It happened a little later than we expected so the team's done a nice job of getting more than our fair share of the market there and I expect them to continue to do that.
Okay.
Okay. Thanks.
Thank you.
Okay.
Your next question comes from the line of Mike Halloran with Baird. Your line is open.
Hey, Thanks, good morning, everyone.
Hi, good morning, good morning.
So a couple of questions first on the non res side of things, maybe Bob could you talk to the project funnel or the funnel to backfill some of the projects out there I know.
In the past we've talked about.
Working off of what was a backlog of activity.
Curious what you guys are seeing as far as <unk>.
Replenishing that that funnel and replenishing that opportunity out there.
Any any level of variance as you look across some of the sub verticals within non res space.
As I've said in the prior quarter institutional is still holding up as well as like data centers and some of that area has been holding up strong.
Our teams are out in the field, it depends on which country like or part of the country like anything but in general I would say, it's still healthy backlog out there and I think some of it continues to be a result of the shortage of labor inside of those markets and there was some backlog out there. So again, we're cautiously optimistic but we're <unk>.
<unk> it closely.
And how should I think about the north American margins from here I mean, it feels like every quarter there is.
The new high that you're reaching certain I understand a lot of sense commentary on mix. Some other headwinds as you look sequentially in the back half.
When we're thinking a little longer horizon.
What's the right things to build ourselves.
For that segment feels.
So I can just establishing right here.
Yes, I would say so so beyond the mix, which was very favorable in the second quarter and obviously the mix suggests over time, but our goal as we've talked about before is long term to continue to expanding that in the 30 to 50 basis point range going forward, including in the Americas, because that's 70% of our business.
Yeah.
Mike do you have any other questions.
Oh I'm good I said, thanks, I might've been on mute apologize for that Oh, okay. Okay. Thank you.
Your next question comes from the line of Joe Giordano with Cowen <unk> Company. Your line is open.
Morning.
Previously you mentioned OEM related sales are roughly a third.
European business. So I was just curious on how this has trended in the first half and what are your thoughts sequentially for Oems on a global basis and then if you have any margin color there would be very helpful. Thank you.
Yes, I mean, OEM business, which is usually is really tied to the residential markets. Both in North America and Europe has continued to be soft and we've continued to see destocking in that area given the residential nature of that business. So we're expecting that to continue through the rest of this year.
And as you can imagine OEM business is our lowest margin business, so with that being down that obviously helps our margins in total.
From a mix point of view, so again, our guidance assumes that that will continue.
In the third quarter.
Alright, thank you.
Thank you.
Again, if you would like to ask a question press star followed by the number one on your telephone keypad.
Your next question comes from the line of Walter Liptak with Seaport Global Your line is open.
Hi, Thank you good morning, guys.
Good morning, everyone.
Wanted to ask about the.
The incremental spend on the new products and.
I wanted to make sure that we're not like under appreciating.
What youre doing with smart products and so I wonder if you could help us maybe with some data points about how many products you have developed.
Categories might be.
That might be a best seller.
The kind of incremental growth that you might be getting from these investments.
Yes, so we talked in 2022 that we develop 20, new product developments and smart and connected and we're continuing on that journey to get the 25% of our products smart and connected so that's a key initiative for US we continue to highlight those product. So it's nice to see and we're also is in that in that.
Overall quest to be smart and connected so we will continue to invest in there we believe that the future of all of our products into the future and we'll continue to invest in those differentiated products for the marketplace.
Okay great.
Channels as Youre doing now.
The commercialization of Hong Kong.
Yes, they definitely require both training from a customer point of view as well as our Rep network and our channels. So we continue that training our walks for our watts works training.
Initiative as you know is very strong we continue to grow that.
And we will continue to do that so what we always say is we have to make sure that we're easy to do business with in regards to smart and connected how it's connected the data it produces et cetera. So those are key areas training is a key part of that.
But it's a shift and I think everybody is realizing the shift is here and I think during the COVID-19 outbreak everybody realizes that.
It's an important part of the future of plumbing.
The obvious progression for your products.
Are you able to measure yet how much I guess I'm sure you do you measure the.
Incremental sales, but at what point do you think it's going to or maybe its showing up already at what point do you think it's quantifiable, what it's adding to your.
So we are taking our existing products and cannibalizing them, right and making them smart and connected so.
I would just say in general I think we're growing faster than the market and I think having new products that are smart and connected gives us.
Our continued differentiation that we're still capitalizing on so.
Yes that is.
How we see it.
Okay. Okay, great. Thank you.
Thank you.
Yeah.
There are no further questions at this time I will now turn the call back over to Bob for Continental.
Yeah.
Okay.
Okay.
Okay.
Yeah.