Watts Water Technologies, Inc. (NYSE:WTS) Q1 2024 Earnings Call Transcript May 9, 2024

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Operator: Ladies and gentlemen, welcome to the Watts Water Technologies Incorporated First Quarter 2024 Earnings Call hosted by Bob Pagano, President and CEO; Shashank Patel, CFO; and Diane McClintock, Senior Vice President, FP&A and Investor Relations. At the end, we will open the line for questions. And I will now turn the call over to Diane McClintock.

Diane McClintock: Thank you, and good morning, everyone. Welcome to our first 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 first quarter and discuss the current state of the markets and our operations. Shashank will discuss the details of our first quarter performance and provide our outlook for the second quarter and 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. 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 Watts' publicly available filings with the SEC. The company undertakes no obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

Bob Pagano: Thank you, Diane, and good morning, everyone. Please turn to Slide 3, and I'll provide an overview for the first quarter. We began 2024 with better-than-expected first quarter results, including record sales, adjusted operating margin and earnings per share. I'd like to express my appreciation to the entire Watts team for their hard work that made this outperformance possible. Organic sales growth of 6% in the quarter was largely driven by extra shipping days as discussed on our last earnings call. We also benefited from incremental sales due to our acquisitions of Enware, Bradley and Josam. We are very pleased with the performance of these new acquisitions and expect them to continue contributing to our long-term success.

Adjusted operating margin exceeded expectations primarily due to incremental volume from the extra shipping days, solid price realization and productivity, which more than offset inflation, lower European volume and incremental investments. As a result of our strong earnings and expected cash flows for the remainder of 2024, we announced a 19% dividend increase with payments beginning in June. Our balance sheet remains strong and provides ample capacity to support flexibility in our capital allocation strategy. From an operations perspective, we are pleased with the progress of the Bradley, Josam and Enware integration efforts. Our teams are working together to capitalize on synergies and capture additional growth opportunities. We expect both acquisitions to be accretive to adjusted EPS in 2024.

Regarding inflation, we continue to see cost increases across labor and overhead, and we're seeing renewed escalation of raw material costs. While the inflation rate has moderated, it is still above normal historical levels. Our teams have done a great job driving productivity, not only in our operations but outside the factory walls, which has helped offset some inflationary pressure. We continue to invest in our digital strategy as we believe providing smart and connected solutions is vital to improving water safety and regulation, water conservation and energy efficiency. We will provide you with an update on our smart water initiative later this year. In addition, enabling our customers to achieve their sustainability goals and meeting our own remain a top priority.

We'll be issuing our annual sustainability report by the end of June. Additionally, we'll be establishing new long-term goals, including an absolute carbon emissions reduction commitment. Our team has made tremendous progress advancing our sustainability strategy and initiatives, and we are looking forward to sharing this with you. So stay tuned. As I discussed during our last call, 2024 is the 150-year anniversary of Watts. We are proud of this milestone and are hosting customer and employee events across the globe to celebrate this tremendous accomplishment. Our new customer training programs introduced in connection with our 150th anniversary have been well-received. Next, I'd like to provide an update on our end markets. Global GDP, which is a proxy for our repair and replacement business is lower than last year but remains positive in our key markets.

Europe's residential and nonresidential and new construction markets remain soft and continue to be impacted by the conflicts in Ukraine and the Middle East. The reductions of the energy incentive programs in Germany and Italy are unfavorably impacting OEM volume, particularly in the heat pump market. In the Americas, single-family new construction is expected to remain flat, at least until interest rates begin to ease. Multifamily new construction indicators, including starts and permits have been down double digits in recent months and indicate a decline in multifamily new construction as 2024 progresses. Nonresidential new construction indicators in the Americas are mixed. The ABI has been below 50 since July 2023, and the Dodge Momentum Index turned negative in March.

However, the most recent ENR Construction Industry Confidence Index rose above 50 for the first time in 2 years. Industrial a mega projects remain resilient and are expected to be supportive in 2024, but will be tempered by challenging subverticals, including retail, office and recreation. In the Asia Pacific region, China end markets are moderating but are still expected to grow. We are seeing improving markets in the Middle East due to continued higher oil prices. Elevated interest rates have impacted new construction in Australia and New Zealand, but GDP is still expected to be positive. We continue to monitor the geopolitical uncertainty in the Middle East and expect to proactively address any direct or indirect impact to our customers and supply chain as they arise.

Now an update on our outlook for the remainder of the year. We are increasing our full year sales and operating margin outlook due to our strong first quarter performance. We expect continued weakening in Europe as new construction slows, including a decline in OEM volume from the reductions in energy incentives. As I mentioned before, the decline in volume will have a more significant impact on earnings for the rest of 2024 due to our higher fixed cost base in Europe. Interest rates are now expected to remain higher for longer. This may unfavorably impact residential and nonresidential new construction in the second half of the year. With that, let me turn the call over to Shashank, who will address our first quarter results and our second quarter and revised full year outlook.

Shashank?

Shashank Patel: Thanks, Bob, and good morning, everyone. Please turn to Slide 4, and I will review the first quarter's consolidated results. Sales of $571 million were up 21% on a reported basis and up 6% organically. As Bob mentioned, we benefited from extra shipping days in the quarter. We estimate the extra days contributed approximately 7% of sales growth in the quarter. The acquisitions of Bradley, Josam and Enware contributed approximately $68 million or 15% in foreign exchange, primarily driven by a stronger euro, increased sales by approximately $1 million versus 2023. Compared to last year, adjusted operating profit of $104 million increased 23% and adjusted operating margin of 18.2% was up 30 basis points. Adjusted EBITDA of $118 million increased 25% and adjusted EBITDA margin of 20.6% was up 60 basis points.

Benefits from price, productivity and volume from extra shipping days more than offset acquisition dilution of approximately 60 basis points inflation and incremental investments of $6 million. Adjusted earnings per share of $2.33 increased 21% versus last year. Earnings per share growth was driven primarily by solid operational performance, including the benefit of the extra shipping days and the strong performance of our acquisitions. The adjusted effective tax rate was 23.8%, up 130 basis points compared to the first quarter of 2023, primarily due to a lower tax benefit from the vesting of stock compensation awards that occurred in the first quarter of 2024. For GAAP purposes, we incurred $7 million of nonrecurring acquisition-related charges.

We also recorded a restructuring charge of $1.2 million related to several cost actions. These charges were partially offset by the nonrecurring gain on the sale of an office building in Europe. Our free cash flow for the quarter was $37 million compared to $28 million in the first quarter of last year. The cash flow increase was primarily due to higher net income and lower working capital investment. We expect sequential improvement in our free cash flow and are on track to achieve our full year goal of free cash flow conversion greater than or equal to 90% of net income as previously communicated. During the quarter we repurchased approximately 20,000 shares of our Class A common stock for $4 million. Additionally, as Bob mentioned, we announced a 19% increase in our dividends that will begin in June.

The balance sheet remains strong and provides us with ample flexibility. Our net debt to capitalization ratio at quarter end was 3% and our net leverage is 0.1. Our solid cash flow and healthy balance sheet continue to give us capital allocation optionality. Please turn to Slide 5, and let me provide a few comments on the regional results. Americas organic sales were up 11% and reported sales were up 30%. Both were ahead of expectations due to slightly better price. Reported sales benefited from better-than-anticipated acquisition performance. The additional shipping days increased sales by high single digits. Solid growth in our core valve products was partly offset by declines in water quality and radiant heating products. The acquisitions of Bradley and Josam added $60 million or 19% to Americas sales in the quarter.

Adjusted operating profit increased by 28%, while adjusted operating margins decreased by 40 basis points. The operating margin decline was primarily driven by acquisition dilution, inflation and incremental investments, which more than offset price, productivity and leverage from the extra shipping days. Europe organic sales were down 5% as we expected. The reported sales were down 4% and included a 1% favorable impact of foreign exchange movements. Additional shipping days increased sales by mid-single digits. Growth in our Drains business was more than offset by declines in wholesale plumbing in France and Benelux as well as our OEM business in Germany and Italy with a reduction of government subsidies and heat pump destocking had an unfavorable impact.

Despite the challenge, top line operating profit increased 3%, and operating margins increased by 110 basis points as price favorable mix, productivity and the extra shipping days more than offset inflation investments and volume deleverage. APMEA organic sales were up 6%. The reported sales growth of 43% was negatively impacted by 3% from unfavorable foreign exchange movements and favorably impacted by 40% or approximately $8 million of acquired Enware sales. The extra shipping days increased sales by mid-single digits. Growth in Australia and Middle East were partially offset by declines in China due to weak residential under floor heating sales and project timing in data centers. Adjusted operating margin decreased 150 basis points as a result of inflation investments and the diluted effect of the Enware acquisition, which more than offset price volume and productivity.

Slide 6 provides our assumptions about our second quarter and full year operating outlook. First, let's cover the second quarter outlook. On a reported basis, we expect sales to increase between 7% and 11%. Organically, we expect sales to decrease between 1% and 5%. Organic sales in the Americas are expected to be flat, while APMEA is expected to be up low single digits, offset by a low double-digit decline in Europe. In addition, we expect approximately $64 million of incremental sales in the Americas from acquisitions. Second quarter adjusted EBITDA margins are expected to be in the range of 20% to 20.6% or down 100 to 160 basis points. Second quarter adjusted operating margin should be in the range of 17.6% to 18.2% or down 130 basis points to down 190 basis points.

This is partially due to a very difficult comparison to the second quarter of 2023 when margins exceeded 19%. Additionally, acquisition dilution of 110 basis points incremental investments and volume deleverage, particularly in Europe, will all have an unfavorable impact. We expect incremental investments of approximately $5 million. Corporate costs should be approximately $15 million. Net interest expense should be approximately $3 million. The adjusted effective tax rate should be approximately 25%. We are estimating a $1.08 euro-U.S. dollar exchange rate versus the average rate of $1.09 in the second quarter of 2023. This would imply a decrease of 1% year-over-year or approximately $1 million in sales, which is less than $0.01 per share in EPS versus the prior year.

Now let's cover the updated full year outlook. For the full year 2024, we are increasing our reported sales growth outlook to a new range of plus 7% to plus 12%. Our previous guidance was plus 6% to plus 12%. Additionally, we are increasing our organic sales growth outlook to a range of minus 4% to plus 1%. Our previous guidance was a range of minus 5% to plus 1%. In effect, this raises the midpoint of our reported and organic growth range by 50 basis points based on our stronger-than-expected start in the first quarter. We are increasing our full-year adjusted EBITDA margin outlook to a range of 19.6% to 20.2% compared to our previous guidance of 19.4% to 20%. Additionally, we are raising our full year adjusted operating margin outlook. We now expect our 2024 adjusted operating margins to be between 17.1% and 17.7% compared to our previous guidance of 16.9% to 17.5%.

The updated outlook for adjusted EBITDA margin and operating margins represents an increase of 20 basis points from our previous guidance and reflects the flow-through of our better-than-expected first quarter, including acquisition performance. Our free cash flow expectation remains in line with our previous outlook from February as we expect to deliver free cash flow conversion of greater than or equal to 90% of net income in 2024. For the full year, we are now assuming a $1.08 euro-U.S. dollar FX rate, which is flat versus 2023 and down versus our previous assumption of $1.09 euro-U.S. dollar FX rate. This change reduces our sales guidance by $5 million in sales and our EPS guidance by $0.02 a share for the full year versus the prior year.

Regarding other key inputs for the full year, which can be found in the appendix, we expect corporate costs to be about $55 million for the year. Net interest expense should be approximately $12 million. Our estimated adjusted effective tax rate is expected to be approximately 25%. We expect our share count to be approximately 33.5 million. CapEx spending is anticipated to be approximately $50 million. Finally, depreciation and amortization should be approximately $55 million for the year. Now let me turn the call back over to Bob before we begin Q&A. Bob?

Bob Pagano: Thanks, Shashank. On Slide 7 I'd like to summarize our discussion before we address your questions. First quarter performance was better than we anticipated with record first quarter sales, adjusted operating margin and earnings per share due to better-than-expected price and acquisition performance. As a result of our solid first quarter, we are increasing our full year sales, operating margin and EBITDA margin outlook. Our 2024 outlook reflects our expectation of softer market conditions as the year progresses, especially in Europe. As we have said, our portfolio is agnostic to end markets, and we expect our teams to pivot to growing subverticals as needed. Our business model includes a large repair and replacement component that provides a durable base and drives steady revenue and cash flow.

Despite the challenging markets, we plan to maintain our incremental investments to support long-term profitable growth, notably in our digital strategy. We continue to focus on the integrations of Bradley, Josam and Enware to ensure a seamless transition and are pleased with the progress to date. Our balance sheet remains strong post acquisitions and provides ample flexibility to support our capital allocation priorities, including the 19% increase in dividends that we recently announced. We are well-positioned financially, operationally and commercially to take advantage of market opportunities as they arise, and I'm confident in our team's ability to execute in this uncertain environment and to continue creating value for our shareholders.

With that, operator, please open the lines for questions.

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