Watts Water Technologies, Inc.

The trading margin is also partially due to a very difficult comparison the second quarter of 2023 when margins exceeded 19%. Adjusted earnings per share of $2.46 increased 5% versus last year with growth driven by operational performance and solid contribution from our acquisitions. The adjusted effective tax rate was 25.2% of 50 basis points compared to the prior year period. primarily due to the reduction of foreign taxes associated with the repatriation of funds that occurred in the second quarter of 2023. For gap purposes, we incurred approximately $4 million of restructuring and acquisition-related charges. These charges were partially offset by a $3 million non-recurring gain on the sale of a building in the Americas. Our free cash flow year-to-date was $120 million compared to $89 million in the comparable period last year. The cash flow increase was primarily due to higher net income, lower working capital investment, and the contribution from our acquisitions. We expect sequential improvement in our free cash flow and are on track to achieve a full year free cash flow conversion goal of greater than or equal to 90% of net income as previously communicated. The balance sheet remains robust and provides us with ample flexibility. Our net debt to capitalization ratio at quarter end was negative 1%, and our net leverage was negative 0.1. A strong cash flow, healthy balance sheet, and the recent extension of our credit facility through July 2029 continue to give us capital allocation optionality. Please turn to slide six, and I'll provide a few comments on the regional results. America's organic sales were up 5%, and reported sales were up 22% year over year. Organic sales were ahead of our expectations as a result of higher volume, partly due to project shipping earlier than expected. We saw solid growth in our core valve products and our heating and hot water solutions. The acquisitions of Bradley and Josem added $65 million, or 17%, to America's sales in the quarter. Adjusted operating income increased 19%, while adjusted operating margin decreased 60 basis points. The operating margin decline was primarily driven by acquisition dilution, inflation, and incremental investments, which more than offset price, volume leverage, favorable mix, and productivity. Europe organic sales were down 15%, which was slightly worse than we expected. Reported sales were down 16% and included a 1% unfavorable impact of foreign exchange movements. Growth in Audrey's business was more than offset by declines in wholesale plumbing in France, Benelux in Scandinavia, as well as our OEM businesses in Germany and Italy, where heat pump destocking had a significant impact. Operating income decreased 48%, and operating margins decreased 620 basis points. Price, favorable mix, and productivity did not offset inflation and the significant impact of volume deleverage due to our high fixed cost base in Europe. Apnea organic sales were up 18%, And reported sales growth of 16% was negatively impacted by 2% from unfavorable foreign exchange movements. We saw growth across China, Australia, New Zealand, and the Middle East. Project timing contributed to the growth in China and the Middle East. Adjusted operating margins increased 70 basis points as volume and productivity more than offset inflation, incremental investments, and the dilutive effect of the acquisition. Slide seven provides our assumptions about our third quarter and full year outlook. First, let's cover the third quarter outlook. On a reported basis, we expect sales to increase between five and eight percent. Organically, we expect sales to decrease between four and seven percent. Organic sales are expected to be down low single digits in the Americas and down low double digits in Europe, partially offset by apnea which is expected to be up low single digits. In the Americas, we anticipate weakening in multifamily and non-residential new construction. In addition, our third quarter guidance includes the unfavorable impact of project timing in the Americas at NAPMEA, where we saw projects deliver in the second quarter, which was earlier than anticipated. It also includes a soft start to the quarter resulting from a reduction in safety stocks at some of our channel partners in the Americas, due to our normalized lead times. Gear markets are expected to remain soft, partly due to continued heat pump and related product destocking. We expect incremental sales in the Americas from acquisitions to be between $60 and $62 million. Third quarter adjusted EBITDA margins are expected to be in the range of 18.7 to 19.3%, or down 70 to down 130 basis points. Third quarter adjusted operating margins should be in the range of 16.2 to 16.8% or down 120 basis points to down 180 basis points. Acquisition dilution of 90 basis points, incremental investments of $6 million, and volume deal average, particularly in Europe, will all have an unfavorable impact. A few other items related to the third quarter. Corporate costs should be approximately $14 million and net interest expense should be approximately $2 million. The adjusted effective tax rate should be approximately 25%. We are estimating a 1.09 euro-US dollar exchange rate, which is flat compared to the third quarter of 2023. Now let's cover the full-year outlook. For full-year 2024, we are maintaining our outlook consistent with our previous guidance. Reported sales are expected to increase 70% to 12%, and organic sales are expected to range from down 4% to up 1%. Full-year incremental acquired sales from Bradley and Joe Sam should be between $210 million and $215 million. Our full-year adjusted EBITDA margin should be between 19.6% and 20.2%, or down 30 basis points to up 30 basis points. Our full-year adjusted operating margin should be between 17.1% to 17.7%, or down 70 basis points to down 10 basis points. Our better than expected second quarter, including acquisition performance, is expected to offset second half weakening in Europe, as previously mentioned. As a reminder, the operating and EBITDA margin guidance includes an increase in incremental investments of $2 million and acquisition dilution of 60 basis points. Our free cash flow expectation remains in line with our previous outlook 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 assuming a 1.09 average Euro-US dollar FX rate versus the average rate of 1.08 in 2023. This would imply an increase of 1% year-over-year and would equate to an increase of $5 million in sales and 2 cents per share in EPS for the full year versus the prior year. Other key inputs for the full year can be found in the appendix. Now, let me turn the call back over to Bob before we begin Q&A.

Bob. Thanks, Shashank. On slide 8, I'd like to summarize our discussion before we address your questions. Our second quarter performance was better than we anticipated with record sales, adjusted operating income, and earnings per share due to better than expected performance in our Americas and AFIA regions. We are maintaining our full-year outlook with a solid first-half performance expected to offset second-half weakness, especially in Europe. Our portfolio is agnostic to end markets, and we are well-positioned 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. The integration efforts at Bradley, Josam, and Enware are going well. We are pleased with the progress today and excited about their growth potential. Our balance sheet remains robust and with a proactive extension of our credit facility provides ample flexibility to support our discipline capital allocation priorities. We are well positioned financially, operationally, and commercially, but I'm confident in our team's ability to execute despite the uncertain environment, which will enable us to continue creating value for our shareholders. With that, operator, please open the line for questions.

In order to ask a question, press star, then the number one on your telephone keypad. Your first question comes from the line of Ryan Connors with North Coast Research. Your line is open.

Good morning. Thanks for taking my questions. Good morning, Ryan. Morning. Yeah, so I want to talk about this issue. You mentioned project timing as a driver behind the the strength in the quarter in both Americas and APME. And if I think back, I don't recall project timing being something you've mentioned much in the past, except maybe around data centers a little bit, and generally don't think of Watts as a project-oriented company. So can you just expand on exactly what that is, what types of projects those were that were pulled forward into the second quarter?

Yes, Ryan. So in APMEA, and actually the data center business five, six years ago, it was virtually nothing. And we've been growing from a small base, but we've been growing at double digits. So it's a significant, it's a reasonable part of our business globally, quite significant in the APMEA region. So in the APMEA region, we had data centers in China and those projects were scheduled for third quarter. They got pulled into the second quarter. And in the Americas, it's primarily in the heating hot water solutions business, the commercial water boilers. There's some large projects that customers needed in the second quarter that we shipped in the second quarter. Combination of both of those is about $78 million of sales that were pulled into the second quarter.

Got it. Okay. And in Americas, what types of non-residential construction projects? Those aren't really data center related. Those are more general.

Yeah, we're starting to get into data centers in North America, so we're seeing a little bit of that. But this was mainly in the heating and hot water heat pump section of our business.

Heat pumps, okay. And my other one was just around pricing. It's been a hot topic. Some companies out there talking about some deflation. Any update on pricing in your business there and any discounting going on on some product lines or – And also, you know, any shift to, as price gets more of a discussion, any shift to the online sales platforms you have like Backflow Direct?

Yeah, in general. So pricing was favorable about one point in the quarter. Certainly on large projects, they are very competitive. So we see that. And certainly our online business with Backflow Direct is up. So we continue to drive e-commerce where our customers need it. But, uh, Pricing has been, like I said, up 1% in the quarter.

Good to hear. Thanks for your time. Thank you.

And your next question comes from the line of Jeff Hammond with KeyBank Capital Markets. Your line is open.

Hey, good morning, guys. Morning. Okay, appreciate the color on the pull forward and quantification. I think you talked about a number of headwinds, kind of 2Q to 3Q, some D-Stock, non-res, multifamily, maybe just rank order, you know, those headwinds and maybe a little more color on that D-Stock impact.

Yeah, so Jeff, on the D-Stocking, that's probably basically our, in the wholesale channel, our customer's Because we now have normalized lead times, they've been reducing their safety stock levels. We saw that in the month of July. That's approximately $7 to $8 million. So far, that's happened in the third quarter. The rest of it on the multifamily, this is what we expect with all the double-digit declines we had in new starts. On the construction side of it, because there is a lag, we expect that to downturn in the second half, which we had factored in when we set the guidance early on, and we still expect to see that. And what was the third part of the question again?

I guess just non-res in general.

Yeah, non-res again, and that's the ABI indicators, right? They've been flashing red below 50 for over a year. And on the non-residential side, you know, we've seen weaknesses in, you know, again, office, retail, restaurants, all those sort of, those sub-segments, but strength in the institutional side. So again, we factored that into the guide as well for the second half.

Okay, and then Europe, I guess one, if it sounds like you're going to continue to see weakness, can you hold double-digit margins into the second half? What else is weakening in Europe besides the European heat pump? And then finally, just any signs that we're hitting bottom or stabilizing or ending this D-stock on the heat pump side?

So on the heat pump side, I'll take that first. I don't think you're going to get any clarity to the potentially end of the first quarter of next year related to heat pump. There's our channel check showing a bunch of heat stock or heat pump inventory, you know, in the channels, and they've got to bleed that off. In general, when we look at Europe, just think about new construction is very limited there, given the uncertainties, the economic challenges, the geopolitical challenges. issues etc so that's something i've been concerned about for a while here and we certainly saw it in q3 and we're expecting to see it again in q4 but some of our channel checks and everybody else once this heat pump goes through some of the you know easier comparison to next year you know they believe they're starting to bottom out as we exit this year and just to note there is one area of strength right in our drains business on the commercial marine side

as well as food and beverage drains actually had a, I had a good quarter in the second quarter. So we do see pockets of opportunity, albeit small.

Okay. And then, and then final one, can you just, you mentioned data center and how it's been growing. Can you just size that business as a percentage of sales now? Um, you know, can you speak to how you, it looks, it sounds like most of that's in, in Asia. how you bring that product or how you enter the North America data center market. And then finally, there seems to be this big shift to liquid cooling, you know, which requires, you know, water, et cetera, in a data center versus, you know, traditional air cooling. And I'm wondering if we, as we move there, if there's an incremental content opportunity for you.

Yeah, Jeff. So certainly our initiative of data centers did start in China. several years ago, and we've been bringing that to North America and in even Europe. So these are growing opportunities. I would say in total, it's less than 2% of our overall watt sales, but it went from nothing three years ago to about 2% of our sales. And as you can imagine, it's lumpy business. As you get into liquid cooled versus air cooled, certainly there's more content for our valves and our products. And from our point of view, we're bundling our solutions. It's not just It includes leak detection, backflow, the whole gamut of products. So it's an opportunity to offset some of the softness we're seeing in the traditional markets that we've been in and something we've been flexing towards and growing very quickly on a small base.

And as you said, the market is shifting to liquid cooling. So we are developing the products for liquid cooling. We sell liquid cooling. A little bit of the market in China is already there. So we're into that market.

Okay, thanks for the time. Thank you. Thank you.

And your next question comes from the line of Nathan Jones with Stifle. Your line is open.

Good morning, everyone. Good morning. I want to follow up on the destocking question. I'm just a little surprised to hear that there's still a bunch of inventory in the channel for certain products. At this point in the recovery, I would have thought that your lead times would have already been back to normal. Maybe any more color on what those products are and if there's anything in your portfolio that still has extended lead times that could lead to us seeing some destocking in the future.

Nathan, I think it was just across the board. I think everybody's looking at reducing inventories just like we are. And I think it's just a natural thing. It's quite interesting, though, is we saw it in July and it spiked out. So I think everybody looked at their June 30th balance sheet and said, they need to start reducing inventory. So we're watching it carefully. Our lead times are probably the best they've ever been even pre COVID. So, um, no major things there, but, uh, we're watching this closely and adjusting, uh, accordingly. So, um, just something we wanted to call out because, uh, we had a, a softer than expected July.

Kind of a one-time reset working, working capital optimization.

Um, Follow-up question on the repair and replace side of the business. I think the general expectation from the macro guys is that you're going to see a slowdown in GDP as we get towards the end of the year, the fourth quarter specifically. Can you talk about kind of what you've baked into the guidance from repair and replace? I know your business is correlated to GDP. So just any color you can give us on what you're thinking there.

Yeah, it's a very low single-digit range, right? You're right, Nathan, in that GDP will continue tracking softer is probably the best way to put it. And that's what we factored into our guide is lower numbers on GDP. And remember, it's going from 2.5%, 3% to maybe 1%. It's a lot of small numbers. It's not a big number, right?

Yeah, perfect. Thanks for taking my questions. Thank you. Thank you.

And as a reminder, if you'd like to ask a question, press star then number one on your telephone keypad. Your next question comes from the line of Mike Halloran with Baird. Your line is open.

Good morning, everyone. Good morning. Just a question on how you're thinking about the back half of the year in terms of sequentials and then also where You previously had the guidance. I certainly understand the weakening comments in Europe and the OE and then how projects can swing things either way. If you look at the underlying dynamics, let's focus on Americas here. Has there been a change in your thinking at all as you've moved to the back half of the year? I know you already had some concern embedded in that outlook going into the Second quarter, I'm curious if that's changed. And then if you normalize for everything, are you just thinking kind of normal sequentials as you move to the back half?

So, Mike, I think, you know, for the most part, Europe is a little softer than we were expecting. America's kind of in the same, maybe 1% softer based on this, you know, adjustment and destocking that happened in July. But when you look at overall, I just want to remind everybody, we had a days issue in the first quarter. quarter of the year. Right. And that will negatively impact us in the fourth quarter. So that's six percent, six points of growth in the fourth quarter. So just keep that in mind. But in general, we expected the markets to slow based on the leading indicators. And, you know, we're adjusting accordingly. So it's not a major shift. It's kind of seeing some of the things that we were anticipating all along in our previous guidance.

Yeah, and at this point, Bob, when you think about some of the leading indicators you guys have seen out there that we've all seen that point to some concern, are those at the point where they would even impact this year or those things that are more relevant for next year?

Well, the multifamily, we're seeing some of that, and I think that's some of the wholesale, you know, desocking that's happening. We said we'd probably see that in the second half of this year, and I think that's holding true. I think in the retail, which is a very low percentage of our business, OEMs or retail big boxes are lowering their inventories. So in general, I think it's slowing. And as we anticipated, I think, you know, in this market, in any commercial construction markets, new construction, uncertainty always, you know, leads people to slow down projects, right? And define. So I think Until the elections are over, clarity on interest rates, maybe some of the geopolitical risks. I think some of this stuff is just being held at this point in time. But there's a lot of shovel-ready projects out there to be released at some point in time. But we are hearing projects are on hold and being deferred until next year. So we're starting to hear that and see that. Versus I think the first half of the year, there was a solid backlog with everybody. I think some of this stuff is just starting to catch up.

And last one on my side, thanks for that. What do you see in the M&A outlook? Obviously, your balance sheet's in great shape. How does that pipeline look and how actionable do you think the pipeline is at this point?

Yeah, so we continue to work the pipeline. It's a strong pipeline. As you know, you never can predict timing of acquisitions. And all I can assure you is we'll be disciplined like we always have been. but we're continuing to have discussions in the space.

Thanks. Appreciate it. Thanks, Mike. Thank you.

And your next question comes from the line of Joe Gordano with TD Cohen. Your line is open.

Hey, guys. Good morning. Hey, Joe.

Hey, I mean, it's small change, but I noticed the M&A dilution is being reduced here a little bit. Can you tell us, like, what you're finding on the acquisitions here? Is it just Better execution, you finding incremental synergies that you're able to take advantage of earlier? Just like what's driving that?

Primarily better synergies, right? If you remember for the Bradley acquisition, we had a synergy target of 12 million with about 40% realization in year one. It's running slightly ahead, so we baked that into the guide. And a little bit more on the Joe Sam acquisition as well.

Better execution all around, I would say.

On the institutional side of the US, I mean, I noticed you mentioned like it's holding in pretty well. Like if you look at some of the like the census that at least for construction put in place for institutional, it's definitely positive, but trending down. Are you like incrementally seeing that shift? Like even if we're in positive territory, it's like getting kind of progressively worse. Is that consistent with what you're seeing on the ground?

We haven't seen that yet. We've seen, you know, institutional, uh, business has held up fairly well at this point in time. But we're watching, certainly, with the leading indicators, just like you are. But that's a bright spot for us right now.

Good. Thanks, guys.

Thank you. And as a reminder, if you would like to ask a question, please press the star, then the number one on your telephone keypad. Our next question comes from the line of Walter Liptock with Seaport Research Partners. Your line is open.

Hey, good morning, guys. Good morning. I wanted to ask about the Europe business. You guys have been, you know, and we've been talking about the, you know, Europe, the, you know, heat pump flowing for some time. Was it below your expectations in the quarter, or is the destocking kind of going the way that you have been thinking that it would?

So we had, you're right, right? Early in the year when we gave guidance, we expected the destocking to happen. Quite frankly, it now looks like it's going to be longer. As Bob said, Q1 2025 is the latest view we have. And it is worse than we anticipated. So that's why when you look at Europe, Europe did come in softer in the second quarter than we had anticipated. We recalibrated the third quarter in the balance of the year, but it is worse than we had anticipated.

Okay, great. And can you remind us, you know, the, you know, the, Positives around the European heat pump, I think, was driven by incentives. Are those incentives, is there another round of incentives coming through, or is that it? Are we back to like sort of a normal consumer market for those products?

No, so the incentives, obviously the incentive levels change, right? We had talked earlier, Italy had incentives of 110%, and then last March they dropped them to 60%, but they weren't instant. They were over... five-year tax period, et cetera. So the incentives are there, but they're different and less. Similarly with Germany and France, they've solidified their incentive program. But I think the situation was there was a huge buildup of heat pumps across Europe. And that's why we got into a situation where even today there's about a nine-month inventory of heat pumps in the European market. So that's got to be bled through. And that's where that Q1 2025 number comes in. But the incentives are there. They're less, but they're still there.

Okay, great. Okay, good. Okay, thanks. I'll take it offline from here. Thanks. Okay, thanks. Thank you.

And there are no further questions at this time. Bob Pagano, I turn the call back over to you.

Thank you for taking the time to join us today. We appreciate your continued interest in Watts and look forward to speaking with you again during our third quarter earnings call. Have a good day and stay safe.

And this concludes today's conference call. You may now disconnect.