Watts Water Technologies, Inc.

Thank you for standing by and welcome to the Watts Water Technologies second quarter 2021 earnings conference call. At this time, all participants are in a listen-only mode. After the speaker's presentation, there will be a question and answer session. To ask a question during the session, you will need to press star 1 on your telephone. If you require any further assistance, please press star 0. I would now like to hand the conference over to your speaker today. Timothy M. McPhee, Treasurer and Vice President, Investor Relations of Watts Water Technologies, Inc. Thank you. Please go ahead, sir.

Mr. Thank you. Good morning, everyone. Welcome to our second quarter earnings conference call. We're glad that you could join us. With me today are Bob Pagano, CEO and President, and Shashank Patel, our CFO. During today's call, Bob will provide an overview of the second quarter and discuss the current state of our operations and markets. He will also update you on our smart and connected and sustainability efforts. Shashank will discuss the details of our second quarter performance, provide an initial outlook for the third quarter, and offer a revised outlook for the full year, 2021. 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 the call, we will 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 Watt'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. I will now turn the call over to Bob.

Thanks, Tim, and good morning, everyone. I want to start the call by thanking our 4,500 global employees for their continued dedication and hard work during these challenging times. They've been navigating a robust demand environment and at the same time managing through persistent supply chain constraints and the emergence of COVID-19 variants. I'm proud of our team's efforts to support our customers while remaining safe in the workplace. With that, please turn to slide three in the presentation, and I'll provide an overview of our Q2 performance. We anticipated a strong second quarter performance as the economy improved. However, demand was even better than we expected, and our team delivered record results. As we guided last call, the February U.S. weather freeze provided a revenue tailwind in Q2, and we also benefited from our announced price increases. Adjusted operating margin exceeded our estimate, driven by incremental volume and our focus on productivity and cost management. Year-to-date free cash flow is strong, despite additional working capital needed to meet the current demand. In late June, we successfully completed negotiations to exit our manufacturing facility in Marais, France. This action will help to simplify our manufacturing structure and provide incremental productivity We've taken a charge for GAAP reporting in the second quarter. We expect to realize the full savings by 2023. Shashank will provide more financial details in a few minutes. Now, let me provide a view on the markets. In general, the markets continue to move in a positive direction during the second quarter. GDP expectations for 2021 have trended up in many of our key global regions since the first quarter, so we expect that should continue to drive repair and replacement activity. In the Americas, single-family residential new construction remained strong in the second quarter, and both residential and non-residential repair and replacement activity was buoyant. These markets have more than offset weakness in multifamily new construction and certain non-residential new construction, especially in verticals like lodging and office buildings. Forward-looking data offer some hope that non-residential new construction may gain momentum in 2022. Europe markets were solid again in the second quarter, driven by repair and replacement activity. The wholesale market remained strong in France and Italy, while the OEM market held its own, especially in the electronics business. Here we saw high demand from channel anxiety caused by component shortages in the market. We also saw heating OEMs continue to benefit from green initiatives driven by government stimulus. We're introducing our third quarter outlook with sales and margin improvements expected versus the prior year. And we have increased our full year adjusted outlook to account for the stronger second quarter and expected third quarter results. We are more encouraged about the markets in general, but still have concerns about non-residential new construction, supply chain issues, continued inflationary pressures, and virus variants. On slide four, I'd like to update you on our smart and connected journey. We continue to introduce new connected products in the marketplace based on customer feedback. The Techmar snow melt controller has a snow ice sensor interface designed specifically to integrate into building management systems. It was developed to eliminate the need to write custom code, which is a time and cost saver for the contractor. In addition, the challenge of commissioning, testing, and then maintaining the code is made easier. The Tecmar snow-ice interface provides proven snowmelt functionality in a simple-to-integrate device. HF Scientific's Copper Silver Monitor, or CSM, is designed to monitor the level of copper and silver ions in a plumbing system down to the parts-per-billion range. copper-silver ionization has emerged as one of the leading technology used in mitigation of waterborne pathogen growth, specifically Legionella, in the plumbing systems of healthcare and hospitality facilities. By monitoring ion concentrations daily, the CFM allows copper-silver ionization systems to more accurately regulate their disinfection levels. Underdosing reduces the efficacy of the system, while overdosing increases operating costs and risks patient guest health. During the second quarter, the percentage of smart and connected product sales to total sales increased sequentially as compared to the first quarter, as well as to the full year 2020. We continue to make progress towards our goal of 25% smart and connected product sales by 2023. Now on slide five, I'd like to update you on our sustainability efforts. We're focused on and committed to having a positive impact in the world. This commitment is leading us to deploy ongoing initiatives to reduce energy, water, and waste usage within our own organization, as well as developing solutions to support our customers' sustainability goals. We also view our role as an employer as an opportunity to affect positive change and are addressing diversity, equity, and inclusion in our everyday actions. In June, we issued our most comprehensive sustainability report to date, highlighting 2020 accomplishments and establishing some longer-term goals to reduce our environmental impact. In 2020, we reduced our water usage by 33% and our greenhouse gas emissions by 13%. Our product portfolio shift to eco-friendly products and solutions continues. This past year, sales of our condensing boilers and water heaters reduced more than 110,000 metric tons of CO2 for our customers, more than four times what Watts generated as a company. We have maintained our partnership with Planet Water, providing funding and resources to install water purification systems for disadvantaged areas of the world. Today, we have positively impacted over 30,000 people in eight different countries, providing safe drinking water and education on the importance of proper hand sanitization. And later this year, we'll be sponsoring additional sites as part of a global hand-washing day initiative. Concerning diversity, equity, and inclusion, we commenced our first internal DE&I survey to employees. We've revised our recruiting guidelines and training manuals to include new diversity-based standards. We've begun partnerships with several historically Black colleges and universities, supporting programs that we hope will garner future Watts employees, and we've initiated multiple diversity employee resource groups to promote education, awareness, and inclusivity. Let me turn the call over to Shashank, who will discuss our second quarter operating performance and provide more detail on our third quarter and revised full-year outlooks. Shashank?

Thanks, Bob, and good morning, everyone. Please turn to slide six to review our second quarter consolidated comparative results. Sales of $467 million increased 38% on a reported basis and 32% organically, driven primarily by the global economic recovery. Sales benefited from a 5% foreign exchange tailwind and acquisitions added 1%. Adjusted operating profit increased 85%, and adjusted operating margins expanded 380 basis points to 14.9%. Both measures were driven by increased volume from easier compares to last year, price, productivity, and cost actions. This more than offset incremental investment spend, inflation, and the return of expenses related to business normalization. Adjusted earnings per share increased 100% as compared to last year from the better operating result as well as favorable below the line items and a foreign exchange benefit. Our adjusted effective tax rate was 27.1% compared to 26.4% in the prior year period. As a reminder, last year included a benefit from a discrete item related primarily to the foreign exchange impact of repatriations. As Bob mentioned, we have completed negotiations to exit our facility in Marie, France. Total pre-tax exit costs approximate $26 million, which includes approximately $2 million in non-cash charges. Most of the costs are severance related and are expected to be incurred through 2022. For gap purposes, we booked approximately $18 million of those costs in the second quarter and expect approximately $2 million in additional restructuring charges in the second half of 2021. Full-year pre-tax run rate savings should approximate $5 million, which should be fully realized in 2023. We expect about half a million dollars in savings this year, largely in the fourth quarter. Free cash flow was $65 million through June 30th, up 160% from the same period last year. The increase was due to improvements in net income and lower net capital spending. Our goal remains to achieve free cash flow conversion at 100% or more of net income for the year. The balance sheet remains strong. Gross leverage was 0.7 times and net leverage was negative 0.2. Our net debt to capitalization ratio at quarter end was also negative at 4.5%. During the quarter, we repurchased approximately 31,000 shares of our common stock at an investment of $4 million primarily to offset dilution. Turning to slide seven and our regional results. The regions experienced organic sales growth of between 28% and 51% during the second quarter as compared to last year amid a strong economic recovery. Sales also benefited from favorable foreign exchange in Europe and APMIA by 14% and 10% respectively. Acquisitions benefited APMIA sales by 14%. The Americans had an estimated 5% revenue tailwind from the continuing benefit of the February weather freeze in South Central United States. The Americans experienced strong repair and replacement activity and growth in single-family residential markets. Growth was across all major platforms, with plumbing-related products especially strong. America's adjusted operating profit increased 54%, and adjusted operating margin increased 270 basis points to 17.7%, driven by volume, price, cost actions, and productivity, which is partially offset by incremental investments, inflation, and the return of expenses related to business normalization. Europe delivered another solid quarter with sales growth in all major regions and platforms. The wholesale markets in France and Italy remained strong, and we saw good growth in Germany and Italy OEM sales. Electronic sales increased as pre-buying by customers continued from market concerns around component shortages. Europe's adjusted operating margin increased 700 basis points to 17.1%. This was driven by volume, price and cost actions, which more than offset investment inflation, the return of expenses related to business normalization, and the loss of benefits from government employment subsidies. Apnea's second quarter sales increased double digits both inside and outside China. China's sales continued to benefit from commercial valve demand in data centers. Outside China, New Zealand was strong due to the residential demand, and the Middle East is slowly improving as the region benefits from higher oil prices. Apnea's adjusted operating margin increased 460 basis points to 17.9%, driven by trade volume, a 61% increase in affiliate volume, productivity and cost actions, which more than offset inflation. Moving to slide eight and general assumptions about our third quarter operating outlook. We are estimating consolidated organic sales growth for the third quarter to be 8% to 12% over the third quarter of 2020. versus last year, we should see the benefit of additional volume and price increases announced through June. We have announced a third price increase in the Americas, which goes into effect in September, but we anticipate minimal benefit in the third quarter. Acquired sales should approximate $2 million. We anticipate that our adjusted operating margin could range from 13.7% to 14.5% in the third quarter, turned by volume and price, partially offset by investments of $6 million and incremental costs of $7 million related to the return of discretionary spend. Corporate costs should approximate $13 million in the third quarter. Interest expense should be in line with Q2 at about $1.5 million. The adjusted effective tax rate should approximate 27%. Foreign exchange is expected to be neutral to slightly positive to last year should current rates persist throughout the quarter. Now please turn to slide nine and I'll review our revised full year 2021 outlook. From an organic perspective, we expect America's sales growth to be in the range of nine to 13% for 2021. This is higher than anticipated in our May outlook, and is being driven by stronger growth in non-residential repair and replacement due to higher GDP expectations, a stronger North America residential market, and a third price increase recently announced. Sales should increase by about $5 million for the full year from acquisitions. We expect adjusted operating margins in the Americas should be up versus 2020, driven by the drop through benefits of additional volume, including the freeze impact. We also expect that price will more than offset cost inflation for the year. For Europe, we're forecasting organic sales to increase between 10 and 14%. In France, the increase will be driven by continued residential market growth and government energy incentives will drive the growth in Germany and Italy. Adjusted operating margin should be up from incremental drop through on volume, price and cost savings initiatives. In APMIA, we now expect organic sales to grow from 23% to 27% for the year. Sales also increased by approximately $6 million from the ABG acquisition in the first half of 2021. We anticipate adjusted operating margin for the year to be up as compared to 2020 from third-party and affiliate volume drop-through. Consolidated organic sales growth for the full year is expected to range from 10% to 14%. This is approximately 7.5% higher at the midpoint from our previous outlook and is primarily driven by better global end market expectations and a third price increase in the Americas. We anticipate adjusted operating margin will be up by 100 to 150 basis points year over year, driven by the incremental volume drop through price restructuring savings of approximately $12 million, partially offset by $32 million of incremental investments and expenses related to business normalization and general inflation. And now regarding other key inputs, we expect corporate costs will approximate $48 million for the year. Interest expense should be roughly $7 million for the year. Our estimated adjusted effective tax rate for 2021 should approximate 27.5%. Capital spending is expected to be in the $35 million range. Depreciation and amortization should approximate $46 million for the year. We expect to continue to drive free cash flow conversion equal to or greater than 100% of net income. We are now assuming a 1.21 average Euro-US dollar FX rate for the full year, versus the average rate of Euro 1.14 in 2020. Please recall that for every one cent movement up or down in the Euro dollar exchange rate, our European annual sales are impacted by approximately $4 million, and our annual EPS is impacted by one cent. We expect our share count to approximate 34 million for the year. So with that, let me turn the call over to Bob before we begin Q&A. Bob.

Thanks, Shashank. To summarize, let me leave you with a few key themes. Second quarter results were better than expected as activity improved during the quarter, helped by the global economic recovery, a strong repair and replacement market, and the U.S. weather freeze tailwind. We have announced a third price increase in the Americas as inflation and supply chain costs continue to rise. Markets are supportive and the leading indicators for non-residential new construction are positive entering 2022. We continue to invest in long-term growth opportunities, especially in smart and connected solutions and in productivity-enhancing technology in our manufacturing facilities that support our long-term strategy. We have also increased our full-year investment spend. During the second half, we expect to see increased costs on necessary investments, such as in-house training, as business normalizes from pandemic levels. Still, we continue to closely monitor expenses. We expect to see improvement in third quarter results versus last year. Our full year outlook has been raised for both sales and adjusted operating profits, given the stronger than anticipated second quarter results and expectations for Q3 in the second half. With that, operator, please open the lines for questions.

At this time, if you would like to ask a question, please press star 1 on your telephone keypad. And your first question comes from the line of Nathan Jones with Stifel.

Good morning, everyone. Good morning, Nathan. I'd like to start off just focusing on a comment you made during your prepared remarks, Bob, about high demand from channel anxiety. I think that was a specific comment about some European markets. Maybe you could comment more broadly on your feeling about your customers, distributors potentially over-ordering a little bit here, trying to get to the front of the line. Everybody's trying to lock in their own supply chains. Any color you have on what kind of your sell-in versus sell-through is?

Yeah, Nathan, I think we are seeing some of that inside of the channels all over, in particular in North America and Europe. Europe, I commented on that because of our electronics business in Europe. and we actually were pushing our customers to give us their orders so we could understand how much you know they really needed so we could lock in our supply chain from an electronics point of view so again i think there are some buys out there i think people are beating price increases but we are seeing sell through in the channel so you know people want inventory and when we get the inventory it's pushing through right now so Again, there's some pent-up demand. As we saw, GDP and opening up of the economy has been strong. So we're watching it very closely. But we believe, based on our July results so far, that it's all in line with our forecast for the third quarter.

Yeah, it seems like the markets are getting much better as well. But announcing another price increase for September, obviously inflation continues to go up, freight costs continue to go up. Can you talk about where you expect to be on price costs for the full year and what maybe the price carryover into next year would be?

Yeah, so look, in the first half, if you think about price and material costs, net of the two were slightly positive. As we've talked about, we always try to stay ahead of the curve, and that's why we're looking at that you know, third price increase in the Americas. The second one went into place through July 1 between Americas, Europe, and the rest of the world. As we think about how much of that goes into 2022, I mean, it's a little early for that because we still got to get to the realization of the second and third price increase, but we'll give more color on that in the next call. But certainly on a year-over-year basis, because of the timing, there will be incremental benefits in 2022.

You said you were slightly positive on first half. Do you expect to be neutral, slightly positive in the second half or some lag as pricing catches up to inflation?

We always expect to be ahead, Nathan. You know how we run this business, so we're in front of it.

Not surprising. Thanks for taking the questions. Thank you. Thanks, Nathan.

Our next question comes from the line of Jeff Hammond with KeyBank Capital Markets.

Hey, good morning, guys. Hey, so the European results are very impressive, particularly on the margin side, and I know this has been kind of an ongoing effort, but just trying to unpack the margin improvement here over the last couple quarters and how much you think is mixed versus kind of structural improvements.

I think it's a combination of both. Look at the France in particular, I think there was some pent-up demand. We're strong and residential there. So we're seeing some of the same patterns we saw in North America, just delayed a little bit. And people are staying home and doing DIY and various things in their local houses. So in addition, we talked about the energy incentives in Germany and Italy, which has helped some of our OEM business. And the previous comments made around the electronics that we're seeing people put in orders quickly on that and that you know those between the france and the electronics that was favorable mix for us for sure um when we look at um you know our fixed cost structure you know we continue to look at that we announced the mary france um you know closure that's taken us a while to do and we've been taking out costs as you know all along in this platform. But I think we're benefiting, as you know, with higher volume and our strong fixed costs there. So, you know, it's volume-related, and I think it's going to taper off a little bit as we get going, but we're always focused on improving. But I'm really proud of the team's effort to hit that record operating margin and take advantage of the volume opportunities where we could.

Okay, great. And then... Can you quantify price, how much price was in the quarter, and how you think price plays out in the second half?

Yeah, so in the second quarter, on a global basis, our price was about 2%. And then, as we talked about, we got the second price increase that went into effect from, let's say, the end of May to the end of June time period. And that will benefit us in the third quarter. And then the America's price increase, the third one, will benefit us in the fourth quarter. From a quantification of the second and third price increases, the second price increase is in the 5% to 10% range. And obviously, typically, our realization rates are about 50%. And that's the closest one to us. So, you know, 5% to 10% is the price increase, about half of that realization. The third one in the Americas, it's early days on that one.

Okay. And then just last one. Bob, you still seem a little... less certain on kind of new commercial construction recovery. Can you just talk about what you're seeing from an order activity standpoint and what does that tell you about kind of timing for an inflection there?

Yeah, so, again, we have to estimate that based on, you know, because we sell through the wholesale channel. But certainly our, you know, market intelligence, what we're hearing, et cetera, you know, still lodging, stores, office buildings, you know, recreation, et cetera, those have been still slow. to do it. But we look at the same reports that all of you are looking at, the ABI, the Dodge Momentum, et cetera, and they're all pretending more positive growth. So we've seen some pickup in the education markets from the institutional side, some healthcare also. So again, we're starting to see that. There is still labor shortages out there. We're hearing a lot of that discussion. And it's regional, right? Every region's a little bit different. But again, we're still watching that closely. We look at loan data for new construction and And that's starting to move in the right direction. We're looking at big quotes on new projects and stuff. So I think things are starting to move in the right direction. And, you know, our significant bump in repair and replacement has been nice to offset some of that. But it's nice to see the new construction indicators starting to move forward.

Okay. Thanks, guys.

Thank you.

Your next question comes from the line of Ryan Connors with Boning and Scattergood.

Great. Thanks for taking my questions. First off, just a bigger picture one. If we assume that at least part of what's going on in the markets is the impact of just increased money supply, just general inflation on a monetary basis, and that driving not only the raw material costs higher, but but driving demand in the end markets as well. What are your thoughts about the potential unraveling of that in the future as the Fed steps back and contracts money supply? What's the scenario analysis in terms of how that impacts not only the markets, but the margins and the price cost as all that maybe gets walked back in the next 12, 18 months, if in fact that happens? Yeah, well, look, I still think we're in a low interest rate environment going forward here. You know, so although they might raise it a little bit, I still think, you know, it's still going to be lower interest rates, et cetera. I think a lot of this depends on the virus, how fast, you know, some of these variants are, you know, could potentially, if another lockdown happens, et cetera. Let's hope that's not the case. But look, overall, as I said earlier, labor shortages, too. So there's a pent-up demand. There's some projects that are out there. I don't think we're going to see the boom that we've been seeing right now because I think some of this is, you know, tends to be some pen up the man. But look, if you step back 10,000 feet, our repair replace, which is 60% of our business, tends to follow GDP. And then the 40% tends to follow new construction trends. So we've watched that very carefully. And certainly, GDP has gone up significantly. Overall, I think for the world this year, it's 5%. So That makes sense, but I think that's going to taper down a little bit. But look, I think construction will continue to happen as things continue to open up. And if some of these bills pass, you know, there might be some investments, especially in health care and, you know, institutional type areas. So, again, we're watching very closely, but I think that's how we're looking at the world right now. Okay. And I guess, I mean, specifically what I'm trying to drive at there is price-cost. I mean, if some of this liquidity gets sucked out of the economy in general, and that has an obvious effect on commodity prices and things like brass, do you believe you can hold a significant amount of the price you've gotten and realize the benefit of that in the margin? Or do you think in that kind of a scenario, you'd be, you know, just sort of the market would force you to give some of that, most of that back? I think we're going to have to give some of it back. It'll be our goal and our team's goal to keep as much of that as we can in leveraging our differentiated product that offers a solution to our customers versus a commodity product. And that's why our Smart and Connected initiative is really focused on that, right? So we look at what value are we providing to our customer, not necessarily a cost plus. We don't do that. So that's not our focus. But we're watching that. And, again, that's why we continue to provide higher value to our customers. Got it. And then one last one, just to follow up on the prior question there on non-resi. How important is office to Watts longer term? I mean, that does seem like the one market where we've maybe got a structural change. I mean, I'm talking to you from a fully opened office where about five percent of people have elected to actually be here. So it seems like maybe we are in just a new normal in terms of remote work and so forth. how important is that market if it never really does come back? What impact does that have on you longer term in terms of the business? It's not significant, less than 5%. So, again, you know, we'll focus on the markets that are going well. Our product doesn't care what end market it goes into, you know, so we'll take advantage of the markets that are moving and offset some of that. Absolutely.

So, and Ryan, just to qualify that, that 5%, less than 5% is the new construction piece of our office sub-segment.

Okay, yeah, that makes more sense. That's a little low. Okay, great. Thanks for your time. Thank you.

Your next question comes from the line of Brian Blair with Oppenheimer and Company.

Thanks. Good morning, everyone. Good morning. Good morning. You've called out strong momentum across the repair-replace side of your portfolio. All that makes sense at a high level. Drilling down a bit more, can you offer color on break-fix versus retrofit activity and what your team's expecting, you know, differentiating between the two for the back half?

Yeah, I think it's a combination of both. It's hard to, you know, determine what is what at this point in time because we're seeing the demand. I think we talked about break fix is about 40% renovation, 60% somewhere around there. So look, it's across the board and I can't distinguish between the two. So just solid opening up, people are adjusting and renovating. And as we said before, look, there's only so long you can hold off your plumbing repairs before you really have to do it. And I think we saw some of that in Q2 and some of that happening in Q3.

That's fair and good to hear. Just to level set on the revised guide, Shashank, you walked through some of the pricing dynamics. But if we think of the seven to eight points that you've lifted the full year outlook, what's baked in for incremental volume versus price?

It's approximately half and half because some of those price increases, some of them are going to affect July 1 and then the Americas one is really effective October 1. But if I were to break it out, it's roughly about half of that is incremental price, and the other half is some of the incremental volume we've already seen in the second quarter.

Got it. Thanks again.

Thanks, Brian. Thanks, Brian.

Our next question comes from the line of Joe Giordano with Calvin & Company.

Yeah, good morning. Morning, Joe. Morning, Joe. When I just think about the growth guide for the full year, the raise here, was the previous guide more just, you know, maybe a little unwillingness to extrapolate what you saw a couple months ago into the rest of the year, and now we're just like, all right, well, it's three months later and we're still there? Or do you feel like something structurally changed for the better over the last three months?

Well, I think, look, when we gave guidance the last time, you know, there was still a lot of uncertainty how things were growing as, you know, Could there be slowdowns, et cetera? I think we feel more confident now, and that's why we're more aggressive with our third quarter forecast and outlook at this point in time. And remember, the second quarter last year was an easier compare globally for us because the world kind of shut down in the second quarter. So, again, I think our leading indicators, what we're seeing, what we're hearing from customers gives us the confidence to bring some of that forward for the rest of the year. So, Again, it was too early, you know, when we gave guidance before. We're still hearing mixed signals in the market, and we just wanted to clarify what was happening.

Yeah, fair enough. And then on the balance sheet, just thoughts there on capital deployment priorities. I mean, I know you guys want to, you know, you're always looking and you have a pipeline, but if things don't, if prices are not where you need them to be, thoughts on other sorts of usage of balance sheets?

Well, look, our first priority is investing in ourselves, and we continue to do that. You know, that's our first. We believe in a balanced capital deployment strategy, as we always have. And as you said, we'll look at alternatives. We're not willing to give up at this point in time. We think there's opportunities for capital deployment out there, and we just have to be patient, and we're going to be disciplined like we always have. So we'll be watching. We're looking. But you never can predict timing of any M&A. But, you know, our first priority is investing in ourselves, organic growth, as well as in our factories from an automation point of view. We've increased our dividends and, again, the rest from an M&A point of view. But we continue to monitor and look at that.

Thanks, guys.

Thank you.

If you would like to ask a question, please press star 1 on your telephone keypad. Your next question comes from the line of Michael Halloran with RW Baird.

Hey, good morning, guys.

Morning, Mike.

Hey, so could you just go through on how the uptake is going on the innovation and the connected strategy? Obviously, incremental spend is happening on the R&D side, which we always like to see. Just curious if that receptivity is still gaining momentum, what the clients are saying, and any kind of context behind it. yeah mike uh we're getting very positive comments from our our customers on our innovation strategy especially as it relates to smart and connected and really you know smart and collect connected really allows us to offer solutions to our customer and and we look at you know the various things and the pain points and as we talked about it in the past i mean there's a shortage of plumbers and there's a shortage of maintenance personnel and you know for us to have more connected products to allow them to anticipate issues or see issues before their catastrophic failures, everyone is seeing the benefit of that, especially in this labor shortage market right now. So, again, very positive results, as I said in my comments, opening comments, that, you know, look, we're continuing to increase our percentage as a percentage of our total sales, and that's in, you know, actually if you think about it, the freeze had a lot of increases in our, let's call it traditional sales, but our overall percentage keeps on going up, even though we, you know, sold a lot of, let's call it, uh, non-smart and connected products in the second quarter. So we continue to increase our percentage. The pipeline is very full and, uh, you know, our team is excited about that. Thanks for that. And then outside of some of the pre-buy activity you talked about in Europe, how do you think channel inventories are sitting here today? Um, So it's interesting. We continue to have dialogue with our customers, and it's interesting. I would say, believe it or not, the channel inventory from a year ago is probably flattish. However, the channel wants more inventory given the current demand and volume out there, right? So, you know, I think it's a mixed bag. People want more because of the supply chain concerns, and they're demanding more. So overall, they would tell you they want more. And is that a challenge from a capacity perspective for you to meet at this point where supply chains are, where your channel is, and what the capacity looks like? It's been a challenge only because of supply chain issues, but our team has worked tirelessly at looking at alternative sources, and we've stayed in front of this thing as best we could. So they're doing a great job. I think we're doing well. I would say the team is excelling in that area, and I would tell you our strong supply chain is helping us continue to grow. So we'll continue to push. The team's watching very closely. But like everybody, we have labor shortages and supply chain issues, right? So we're continuing to work real hard on that and building capacity where we need it. Great. Appreciate it, Bob. Great quarter. Thanks. Thanks, Mike. Thanks, Mike.

Our next question comes from the line of Walter Lipsick with Seaport Research. Walter Lipsick Hi.

Thanks, guys. You know, just as a follow-on first to the last one, do you think you're getting market share because of supply?

Are your competitors able to meet, you know, their channel partners' inventory needs? David Morgan I think we're holding our own or doing better. You know, that's the best I can say. Walter Lipsick Okay. Fair enough. I think in your commentary you talked about some costs coming back in. I wonder if you could talk a little bit more about what those costs were that are coming back and maybe quantify them.

Yeah, so for the full year we had talked about business normalization costs, and those are things like travel, Marcom, training, all those things that we cut back starting last March, and that was about $15 million of headwind in 2021. In addition to that, you know, obviously last year we got benefit of, you know, government compensation incentives primarily in Europe and a little bit in China. Obviously those are not there this year. And last year also we got the benefit, you know, we had some pay cuts, et cetera. We got the benefit of that last year for a few months. So that all kind of goes away and that's kind of headwinded. And then incremental investment spend. For this year, we got about $17 million of incremental investment spend. About half of that is, you know, smart and connected strategy. And the rest of it is, you know, whether it's product expansion or global market expansion, et cetera. But those are the headwinds this year.

Okay. All right. And I think you mentioned some expenses from travel and so forth. Have you lifted – You know, any kind of travel bans or are you allowing people to travel, you know, to and from your locations? So, you know, there's limited travel out there. You know, travel has begun. I've been out to our sites and, you know, met with our sales team, has gotten together, et cetera. International travel is still not there. I think it's more internally. So we're starting to visit customers. But, again, very limited, but it's starting to ramp up, and these variants will be watching very closely. So, again, we're balancing all of that right now. Okay. Yeah, and I guess the reason I ask is, is it important now, or have you been able to figure out ways of selling to get around that travel, or do you think it's important to – you know, to have your channel partners, you know, coming into your facility for training on new products? Or are you able to get around that through, you know, digital ways? Yeah, so we've been doing digital training, but I got to tell you, the field is really pushing us to start offering our in house training, which is hands on training, where you take apart products, you troubleshoot them, you know, great beginner training. So we're getting a lot of pressure to open that back up and we're looking to do that. And, you know, right now it's scheduled for the fourth quarter and we're being pushed to open it up even sooner. So if we did that, it certainly would have to be vaccinated people before we allow external people to come inside of our facilities. So anyways, there's a pent-up demand. We've been doing great digitally and Zoom, but at some point with our our long list of new product developments and innovation, we need to, you know, get out there and do more training and show everybody what we have. So, you know, it can only last so long, and I'm sure everybody in the industry is, you know, excited to, you know, see that starting to come back. Okay, great. Okay, thanks for the color on that. Thanks, Walt. Thanks, Walt.

And once again, if you would like to ask a question, please press star 1 on your telephone keypad. We have no further questions at this time. I would like to turn the call back over to Bob Pagano for closing remarks.

Thanks, everyone, for taking the time to join us today for our second quarter earnings call. We appreciate your continued interest in Watts and we look forward to speaking with you again on our third quarter earnings call in early November. Stay safe and enjoy the rest of your summer.

Thank you for participating. This concludes today's conference call. You may now disconnect.