Coverage Initiated on Watts Water - Analyst Blog

On May 23, 2014, we initiated coverage on Watts Water Technologies, Inc. (WTS), manufacturer and seller of various water safety and flow control products. Watts Water Technologies reported upbeat first-quarter results with earnings up 10% year over year to 55 cents per share. The strength was driven by increased sales in the Americas, expanded gross margins, and cost reductions in Europe, Middle East and Africa (EMEA).

In the Americas segment, strong order patterns in March and April have set the stage for improved top-line growth and healthy margins in the second quarter. Furthermore, shipments that were delayed due to the unfavorable weather in the first quarter are expected to be shipped in the second quarter. Growth in new residential construction, repairing/replacing activity as well as the U.S. non-residential recovery will be conducive.

The segment will also benefit from an announced price increase with effect from June, which will boost second-quarter revenues. In North America, Watts Water executed an organizational realignment plan aimed at reducing headcount, with 2014 net pre-tax savings of approximately $3 million and an annual pre-tax savings run rate of $4 million.

However, last year Watts Water brought on-line a new foundry to produce lead-free products. The foundry had some furnace issues in the second half of 2013 and again in the second quarter of 2014, it experienced a manufacturing issue that disrupted its lead-free production. The issue, which involved a power transformer equipment malfunction, will affect margins in the second quarter.

Orders remained strong in Asia Pacific. Management anticipates incremental sales in the second half as it is working with several new original equipment manufacturer (OEM) customers. Management expects momentum in Chinese markets to increase as the year progresses. Watts Water continues to expect Asia Pacific revenue growth in the 15–20% range in 2014.

With continued decline in activity in Germany and slowing sales in Italy and Northern Europe, EMEA continues to remain a weak market for Watts Water. Any negative geopolitical event in Russia and Ukraine, and the associated persisting ruble devaluation could affect the segment's results.

The company expects sales in the segment to decline 1–3% in 2014. However, savings from Watts Water's European transformation program and the restructuring program should lead to continued margin gains in the EMEA section despite lower volumes.

Under this European transformation program, which is expected to be ongoing through 2016, the company plans to develop better sales capabilities through improved product management, enhanced product cross-selling efforts and drive more efficient European sourcing and logistics. Total annual savings are forecasted at $14 million by 2018, with approximately $3.5 million and $10.0 million in annual savings expected in 2014 and 2015, respectively.

The other restructuring program is intended to reduce its European manufacturing footprint by approximately 10%, improve organizational and operational efficiency and better align costs with expected revenues in response to changing market conditions in EMEA. The program is expected to be completed by the end of the fourth quarter of fiscal 2015.

Watts Water expects to record approximately $7 million in annual cost savings by 2015 from these actions. Cost controls and efficiency gains should continue to result in continued margin gains in the EMEA section despite lower volumes.

Other Stocks to Consider

Watts Water currently carries a Zacks Rank #4 (Sell). Some better-performing stocks in the same sector that warrant a look include Roper Industries Inc. (ROP), Woodward, Inc. (WWD) and EnerSys (ENS). All of these carry a Zacks Rank #2 (Buy).