Watts Water to Benefit from Order Rates, Headwinds Remain - Analyst Blog

On Sept 5, 2014, we issued an updated research report on Watts Water Technologies, Inc. (WTS), manufacturer and seller of various water safety and flow control products.  

Watts Water's second-quarter 2014 adjusted earnings increased 21% year over year to 69 cents per share, driven by cost savings realized in the EMEA as part of its restructuring and transformation efforts as well as reduced foreign currency transaction losses and interest expense.

In the Americas segment, management noted strong order patterns at the end of the second quarter, increasing 9%, compared with a 6% increase at the end of the first quarter. This sets the stage for improved top-line growth as well as margins in the second quarter. Management expects solid growth in the residential construction markets in 2014. Repair/replace activity also continues to be strong and there are signs of strengthening in the commercial markets as well. The Architecture Billings Index, which is considered a leading indicator of U.S. non-residential construction, rose to 55.8 in July, up from 53.5 in June, marking a seven-year high. Management expects revenue growth in the range of 6% to 8% for the North America segment in 2014.

In Asia Pacific, orders increased 56% exiting the quarter. Management expects a positive economic environment in China despite weakness in the real estate market. The company's market strategy remains unchanged – achieving sales growth in heating products by expansion in Tier 1 cities and sales growth in valves driven by focusing on Tier 2/3 cities. Watts Water still expects Asia Pacific revenue growth in the 15–20% range in 2014.

The EMEA order rates were down 3% for the second quarter, signaling lower sales in the segment for the second half of the year. Watts Water expects sales in the segment to decline 1–2% in 2014 due to a nominal market reduction, weak demand, and reduced sales from product rationalization effort. However, savings from Watts Water's European transformation program and restructuring program should lead to margin gains in the EMEA section despite lower volumes.

Under the 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 projected at $18 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 aimed at reducing its European manufacturing footprint by approximately 10%, improving organizational and operational efficiency and better aligning costs with expected revenues in response to changing market conditions in the EMEA. The program is expected to be completed by the end of fourth-quarter fiscal 2015. Watts Water hopes to record approximately $7.7 million in annual cost savings by 2015 from these actions.

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 lead-free production, which  affected margins in the second quarter. In addition, the company experienced slower-than expected ramp-up of production which further impacted profitability of operations in the Americas. This resulted from manufacturing inefficiencies and had an incremental $4 million headwind in the quarter from lower absorption. The company is yet to resolve the issues and plans to ramp-up production rather slowly. Thus, margins in the second half of the year will also be affected by these manufacturing inefficiencies.

Other Stocks to Consider

Watts Water currently carries a Zacks Rank #3 (Hold). Some better-performing stocks in the same sector that warrant a look include Roper Industries Inc. (ROP), Woodward, Inc. (WWD) and Badger Meter Inc. (BMI). All of these carry a Zacks Rank #2 (Buy).

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