Watts Water Technologies Inc

NYSE:WTS

Earnings Call Transcript 2019-Q4

[Operator]

Ladies and gentlemen, thank you for standing by, and welcome to the Watts Water Technologies Fourth Quarter 2019 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. [Operator Instructions]

I would now like to hand the call over to Tim MacPhee, Treasurer and VP, Investor Relations. Please go ahead.

[Tim MacPhee, Treasurer and Vice President-Investor Relations]

Thank you, and good morning, everyone. Welcome to our fourth quarter and full year 2019 earnings conference call. With me today are Bob Pagano, CEO and President; and Shashank Patel, our CFO. Bob will discuss our key accomplishments this past year and touch upon our 2020 priorities in the macro markets. He will also offer insight into the estimated coronavirus impact to Watts and update you about our smart and connected initiatives.

Shashank will offer a detailed analysis of our fourth quarter and full year results and provide our initial outlook for 2020. Following our prepared 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. Let me remind everyone that during the course of this call, to give you a better understanding of our operations, we may be making certain forward-looking statements. These statements are subject to numerous risks and uncertainties that could cause actual results to differ materially from such statements.

For information concerning these risks and uncertainties, see our 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.

Now let me turn the call over to Bob Pagano.

[Bob Pagano, Chief Executive Officer and President]

Thank you, Tim, and good morning, everyone. Please turn to Slide 3 in the earnings presentation, which summarizes our accomplishments for this past year. I will also provide some initial thoughts on 2020. I'm very pleased with our performance in 2019. The team delivered another year of record results as solid organic sales growth, combined with our One Watts performance system, drove record adjusted operating margin and adjusted earnings per share.

Last February, we mentioned we expected to see more tempered organic growth in 2019 as compared to 2018. 2019, pricing tailwinds were expected to abate and moderating end markets were anticipated, especially in the second half of the year, and that is how the year played out.

For the year, we saw solid organic growth of 4% driven by a number of factors, including decent end market demand in the Americas, a positive price/cost dynamic in the first half of the year and benefits from our new product development efforts. We introduced new smart and connected solutions and expanded our traditional mechanical plumbing product offerings this year.

Full year sales also increased due to the late August acquisition of Backflow Direct, which expands our backflow product offering in fire protection applications to help meet our customer needs. The acquisition also brings some respected talent in backflow technology. Another 2019 goal was continued expansion of our adjusted operating margin. This year, we increased consolidated adjusted operating margin by 60 basis points driven by price realization, volume growth and productivity initiatives.

Margin expansion was in line with our original expectations for the year despite an incremental $3 million of investment spend above our original plan as we accelerated funding for growth and productivity. In total, we invested an incremental $50 million in 2019 to benefit the future. We estimate about 80% of the total investment spend this year related to front-end commercial growth projects and 20% to productivity.

One area of reinvestment included the continued enhancement of our industry-leading training capabilities. In 2019, we opened one additional training facility in the UK. We now have nine training sites worldwide, and we delivered approximately 60,000 training sessions, 150% increase over 2018. From an operating perspective, this is the fourth consecutive year we've achieved record adjusted operating margin and adjusted EPS results.

I'd like to thank all my Watts colleagues for making that happen. Shashank will discuss the fourth quarter and full year results in more detail momentarily. Looking back on the entire year, we maintained our strategic focus on growth through commercial excellence and customer intimacy; new product innovations, including smart and connected product introductions; and driving a culture of continuous improvement.

Looking ahead, let's review our key priorities and general market expectations for 2020. We want to continue to drive top line growth through new products and solutions with a focus on our smart and connected portfolio. We'll also drive commercial excellence by staying close to our customers and look for opportunities to expand geographically into new regions either organically or through acquisition.

We want to expand adjusted operating margin through volume and incremental productivity. Productivity will continue to expand through our One Watts performance initiatives. Finally, we expect to continue to reinvest a portion of the productivity savings into R&D, selling and marketing and IT systems to fund future growth and productivity.

Now let's talk briefly about how we see the market shaping up in 2020. The economic data remains mixed as we enter 2020. The potential coronavirus impact only creates more uncertainty and I'll speak to that subject in a moment. From a macro perspective, GDP forecasts in most of our major regions, including the U.S. the Eurozone, Canada and China are all expected to moderate as compared to 2019, with GDP growth decelerating from 10 to 50 basis points depending on the region.

In the Americas, expectations vary by submarkets. New residential construction in general looks to be on an upswing with lower interest rates, full employment and readily available credit driving anticipated mid single-digit growth in housing starts in 2020. However, in multi-family, where we have more plumbing content, starts are expected to grow more modestly in the low single-digits and the LIRA index is anticipating the growth rate of homeowner spend on repair and replacement projects will moderate to 1.5% in 2020 from 5% to 7% in recent years.

We anticipate slower growth in the total non-residential market as compared to 2019. The ABI Index has been fairly flat on a trailing 12 month basis. But in key regions like the Northeast, the index is negative.

Recently, the Dodge Momentum Index has been positive. However, the average index was down for all of 2019, so that could portend slower growth in 2020. And the December AIA Consensus Construction Forecast for 2020 has moderated with total non-residential growth reduced by 90 basis points from their original July consensus expectations.

In Europe, the overall outlook is generally stable with slower GDP growth, as I mentioned previously. Regionally, we expect to see nominal construction growth in our major markets.

In the Asia-Pacific region, the overall economy was expected to remain fairly steady with GDP slightly down. China GDP is now anticipated to be down noticeably due to the impact from the coronavirus.

Middle East GDP is expected to grow in 2020. However, it is also the area most likely to be influenced by adverse geopolitical issues and the potential knock-on effects from the coronavirus due to decreased short-term energy demand. Macro forces, including continued trade complex, Iran-Iraq tensions, 2020 elections in the U.S. and Germany's manufacturing slump, all require close monitoring as the year unfolds.

Now I'd like to provide an update on the coronavirus potential impact on our business. Please turn to Slide 4. We are diligently watching how events unfold concerning the coronavirus. We have curtailed travel into and out of China. Our sourcing team is monitoring the impact to our global supply chain and taking actions where possible to mitigate the risk of significant disruptions.

Our focus is on the safety and well-being of our approximately 300 employees in China and the customers they serve. Today, we are not aware that any of our employees have been infected with the virus for which we are grateful. Currently, the assumption is our manufacturing and distribution facilities, which are over 400 miles away from Wuhan, should be back to normal operations by early March. We expect multiple logistic issues including our supply chain's ability to ramp up their production. Further, ground and shipping transportation bottlenecks may cause additional delays.

We expect that APMEA’s operations will be the most affected in Q1, both from a sales and manufacturing perspective. And we anticipate that Americas and Europe sales and manufacturing may also be affected due to the impact on the supply chain.

Looking at the potential financial impact on consolidated Q1 results, we estimate sales may be reduced by $10 million to $20 million and our operating margin may be flat to down slightly as compared to Q1 last year. In a few minutes, Shashank will be discussing our full year outlook for 2020, which includes the expected impact of the coronavirus. This is a very fluid situation, but we wanted to provide as much transparency on the financial impact, based on what we know now.

Now I'd like to provide an update on our smart and connected products initiatives. Please turn to Slide 5. We continue to drive our connect, control, conserve strategy which aims to deliver 25% of our products with connected capabilities by 2023. Our presence last week at the AHR Trade Show highlighted our recently launched solutions as well as our customer digital experience capabilities.

We're happy to report that in 2019, the pace of growth of our connected products was two times the rate of growth of Watts, as a whole. This helped raise our sales of connected products to low double-digits in 2019.

We have a solid pipeline of projects under development across all our businesses. From a digital experience perspective, we have been successful in expanding the use and adoption of tools, which simplify our customers' access to key information needed for their jobs. The key actions around this have been the standardization and consolidation of digital tools like our websites, building information modeling and product information management data and our spec solution offering.

On Slide 6, let me highlight two more smart and connected product solutions. The Watts Snow Melt System is a great example of integrating products and technologies from multiple disciplines within Watts to create a comprehensive connected solution that solves an industry problem. The Snow Melt System include sensors, controls, valves, manifolds and pipes to deliver hot water to a slab after it senses a drop in temperature that can result in snow or ice precipitation. Typical applications include sidewalks around hotels and hospitals or, as noted on the slide, a helipad at a local New York hospital. This system ensures connectivity, control and conservation, all aligned to our strategy.

On the right side of the slide, you will see a typical valve actuator which electrically opens and closes valves usually in a large commercial facility. Our AXMART Solution allows for remote monitoring and controlling of valves that are normally placed high in a piping system and are not easily accessible. The mobile app receives a multitude of data, including the number of cycles, total operating time and temperature among others and provides the ability to control the valve remotely.

The AXMART is a connected solution that increases visibility, accessibility and control of a plumbing system. We are excited about what the future of smart and connected systems is bringing to our customers, Watts and the industry. We will continue to update you on the progress of this initiative.

Now, Shashank will review our results for the fourth quarter and full year and offer our initial outlook for 2020. Shashank?

[Shashank Patel, Chief Financial Officer]

Thank you, Bob and good morning everyone. Please turn to Slide 7 which highlights our fourth quarter results. Reported sales of $400 million were up 3% with organic sales up 4%, offset partially by 1% foreign exchange headwind. The organic increase was driven by growth in all three regions. Acquired sales approximated $2 million in the quarter. I will review regional performance momentarily.

Adjusted operating profit of $50 million, a 10% increase translated into an adjusted operating margin of 12.5%, up 80 basis points versus last year and a fourth quarter record for Watts. Benefits from price, volume, productivity and restructuring savings, more than offset higher inflation and incremental growth and productivity investments. Investments totaled $4 million in the quarter.

Adjusted earnings per share of $1 increased 14% versus last year and was another fourth quarter record for the company. Earnings per share growth was driven by $0.11 from operations. Net positive below-the-line items were $0.02, mainly lower interest charges and foreign exchange translation was a headwind of $0.01 in the quarter. Adjusted effective tax rate in the quarter was 27.2%, marginally lower than last year.

Free cash flow for the full year was $165 million, an increase of 22% over 2018, driven by higher income, inventory reductions, lower income tax payments and reduced capital spending. Free cash flow conversion was 125%. Over the course of the year, we paid down debt by $45 million. We invested $29 million in capital expenditures, which equates to a 94% reinvestment ratio. During 2019, we also returned $51 million to shareholders in the form of dividends and share repurchases.

Our net debt to capitalization ratio declined to 8.4% at year-end as compared to 14.3% in the prior year due to the debt reduction and cash generated by operations. Our balance sheet continues to be in excellent shape and provides substantial flexibility to address our capital allocation priorities. In summary, a solid finish to another record year.

Moving to the regional results, please turn to Slide 8. In the Americas, reported sales increased by approximately 5% to $268 million. Organically, sales were up approximately 4%, with broad growth in plumbing, drains, electronics and water quality products. We also saw solid growth in heating and hot water solution products as some projects which had been delayed were released as expected.

Acquired sales from the Backflow Direct acquisition approximated $2 million and added about 1% of growth in the Americas during the quarter. As anticipated, price was a smaller contributor to growth as compared to the first half of 2019.

Americas adjusted operating profit for the quarter increased 6% to $46 million. Adjusted operating margin expanded 20 basis points to 17%. The margin increase was driven by price, volume and productivity, which more than offset incremental investments and higher inflation. We made approximately $1 million more in investments than we had expected coming into the quarter, so another quarter of solid growth and strong operating profit performance for the Americas.

Turning to Europe. Sales of $114 million were down 1% on a reported basis. Organically, sales were up 2%. Foreign exchange, mainly the euro, was a headwind of about $4 million or 3% in the quarter. From a platform perspective, growth was driven mainly by strength in drains, which was up low single digits in land-based sales and up mid-single digits in marine-based applications. Fluid solution sales were up nominally mostly driven by strong performance in electronics. Plumbing and HVAC sales were flat during the quarter.

By region, we saw growth in Germany, France and Italy during the quarter. In Germany, growth was driven by drain sales into marine applications as well as increased electronics volume. French growth was driven by stronger demand in the wholesale market and in land-based drain applications. Italy saw strength in the plumbing wholesale and OEM markets. The Nordics were down marginally as growth in drains was offset by a softer OEM channel. And the UK continued to be weak due to the ongoing impact of Brexit.

Adjusted operating profit in Europe was approximately $13 million, a 6% increase over last year. Adjusted operating margin of 11.8% increased 90 basis points primarily due to price, volume and productivity, including restructuring savings, which more than offset investments and inflation. In summary, Europe's moderate top line improvement, along with restructuring benefits, delivered a solid operating performance in the quarter.

Now let's review APMEA's fourth quarter results. Sales approximated $19 million, up 18% on a reported basis, with 20% organic growth being partially offset by a 2% foreign exchange headwind. We saw double-digit growth across the region. Outside China, growth was driven by the Middle East and Korea. The Middle East saw growth in Saudi Arabia and in plumbing applications throughout the region. In Korea, a few large projects were delivered. And within China, commercial valve sales continued to be strong.

Adjusted operating profit of $3 million was up 67% versus last year, with adjusted operating margin up 470 basis points driven by higher third-party volume, better product and regional sales mix, productivity and cost controls, partially offset by lower intercompany volume, investments and inflation. So APMEA delivered a solid top line and operating income expansion.

On Slide 9, let me speak to the full year results. For 2019, reported sales were $1.6 billion, up 2% on a reported basis and an all-time record. The increase was primarily driven by organic growth of 4%, which was offset partially by foreign exchange. Adjusted operating margin was 12.9% in 2019, up 60 basis points and another record for Watts. Price, volume, productivity and restructuring benefits were the driving factors.

Important to note, the margin expansion is net of funding incremental investments of roughly $15 million, $3 million more than we originally budgeted. Adjusted full year earnings per share of $4.07, was up 9% versus the prior year. The increase was driven primarily by improved operating performance and lower interest costs, offset partially by negative foreign exchange translation movements year-over-year.

We have provided the last three years' results to highlight the progress we've been making by consistently executing our strategy. About one-half of the 2018 adjusted earnings per share expansion benefited from tax reform and other below-the-line movements. But overall, the improved operating performance during the last three years has been noteworthy.

Now on Slide 10, let's discuss the general framework we considered in preparing our 2020 outlook. First, let's look at expected headwinds. As Bob has already discussed in detail, we anticipate the coronavirus should negatively impact us. We see GDP moderating in many of the major regions we serve, and the underlying construction markets continue to moderate as well. So that should translate into lower activity this coming year.

Consistent with our ongoing strategy, we are going to incrementally reinvest for the long-term growth of the business, especially in initiatives that are commercially focused, including investments to drive our smart and connected strategy. Skilled labor is impacting the overall building market as well as project timing. We anticipate this will continue into 2020, which could cause some lumpiness in our results.

In the middle column are themes that we'll continue to monitor. There are a number of geopolitical concerns that could impact Asia Pacific and the Middle East as well as Europe, something we'll continue to monitor and action as necessary. Trade issues are still in flux. Phase 1 of the U.S.-China trade agreement has been signed, and we expect the impact to Watts in 2020 will be minimal. We will have to see how Phase 1 rules are going to be enforced and how it may impact trade with other countries. At this point, we have not factored in any tariff changes as they are unknown.

Recall back in 2016, the election process created uncertainty in the U.S., which caused our markets to slow. Projects were being delayed until there was some clarity in the election results. We think that uncertainty could repeat during the upcoming election cycle. The business could be impacted especially in the second half of this year.

Now looking at anticipated tailwinds. We expect to benefit from our new product introductions, including additional smart and connected products. We expect to drive continuous improvement through our One Watts performance efforts, with additional productivity initiatives within our factory walls as well as in the SG&A functions. We expect additional margin expansion as a result of those initiatives.

Except for the impact of the coronavirus, we anticipate there may be less economic uncertainty in 2020 as compared to last year. Brexit has moved forward. The USMCA agreement has been signed, and there has been more constructive activity lately regarding tariffs.

Finally, let's review our outlook for 2020. On Slide 11, we have provided our major assumptions. Our full year outlook includes the expected impact of the coronavirus, which, as Bob mentioned, assumes our activities are back to normal by early March. At this time, it is difficult to ascertain the full impact in 2020. And therefore, we have widened our sales and operating margin outlook ranges, especially in APMEA.

We estimate that Americas should grow organically 2% to 4% with anticipated growth across many of our product lines. We expect adjusted operating margin in the Americas to expand as well from volume leverage and productivity initiatives. From a phasing perspective, we expect stronger quarter-over-quarter revenue growth in the second half of 2020 as compares should be tougher in the first half given the timing of price increases that positively impacted the first half of 2019.

For Europe, we are forecasting organic sales growth of minus 1% to up 2%. Adjusted operating margin should expand from productivity, including the incremental benefits of restructuring. In APMEA, we expect organic sales may range from down 5% to up 5% for the year, and we anticipate adjusted operating margin may decline against our 2019 levels. Both are being affected by the expected first quarter impact of the coronavirus. Margin may be impacted as well by intercompany volume.

Overall, on a consolidated basis, we anticipate Watts organic sales to increase approximately 1% to 3% in 2020. We estimate our consolidated adjusted operating margin should expand between 30 and 50 basis points, which includes approximately $13 million of incremental investments.

Now a few other key inputs to consider for 2020. We expect corporate costs to be in line with 2019, about $43 million for the year. Interest expense should be roughly $12 million. Our estimated adjusted effective tax rate for 2020 should approximate 28%. Capital spending is expected to be in the $40 million range as we continue to reinvest in our manufacturing facilities and systems, which will support future growth and productivity.

Depreciation and amortization should be approximately $48 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 assuming a $1.1 to euro U.S. dollar foreign exchange rate for the full year.

Please recall that for every $0.01 movement up or down in the euro-dollar exchange rate, our European annual sales are impacted by approximately $4 million and our annual earnings per share is impacted by $0.01. We expect our share count should approximate 34.1 million for the year.

Finally, a few housekeeping items to consider for the first quarter. Bob has already provided our latest estimate of the consolidated impact of the coronavirus for the quarter. From a regional perspective, we believe about half of that sales impact will affect APMEA and the other half in Americas and Europe.

A couple of other points to be mindful of regarding the top line. First, sales growth year-to-year will be negatively impacted by one less shipping day in the first quarter this year. That impacts sales by about 1.5%. We will pick that day up in the fourth quarter.

Secondly, as I mentioned before, we have some tough first half compares. So for first quarter, we see Americas organic growth at the low end of its full year range, Europe in line and APMEA likely experiencing negative growth in the quarter as a result of the coronavirus impact.

As Bob discussed, we estimate our operating margin will be flat to down slightly in the first quarter as compared to the first quarter last year due to the coronavirus. Regionally, we anticipate nominal margin improvements in the Americas and Europe should be offset by a margin reduction in APMEA.

Acquired sales should approximate $2 million in the first quarter. We expect incremental investments of about $3 million in the first quarter, $2 million in the Americas, $800,000 in Europe and $200,000 in APMEA. The investments will be partially offset by about $500,000 of incremental restructuring savings in Europe.

The adjusted effective tax rate should approximate 28%, in line with our full year projection. Corporate costs should approximate $11 million in the quarter. We anticipate foreign exchange could be a headwind in the first quarter given current rates as compared to the first quarter of 2019.

With that, I’ll turn the call back over to Bob to summarize our discussion before moving to Q&A. Bob?

[Bob Pagano, Chief Executive Officer and President]

Thanks, Shashank. Please turn to Slide 12, and let me summarize our discussion. We were pleased to deliver record results for the company in 2019. Our outlook for 2020 anticipates moderating growth and continued margin expansion. Smart and connected products are gaining momentum, and we expect they should continue to drive growth in 2020.

Productivity and efficiencies gained through our One Watts performance system should expand operating margins. We plan to deliver strong free cash flow, and as always, we’ll remain disciplined in our capital deployment. We have provided our current assumptions of the expected Q1 impact of the coronavirus. We will be closely reviewing how this development and other potential macro headwinds could affect customer sentiment and the construction markets.

We intend to continue to focus on becoming a leaner, more customer-centric organization. I’m confident our team will work through the near-term issues as we focus on and execute what we can control.

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

[Operator]

[Operator Instructions] Your first question comes from Nathan Jones with Stifel.

[Nathan Jones, Stifel]

Good morning, everyone.

[Bob Pagano, Chief Executive Officer and President]

Good morning.

[Nathan Jones, Stifel]

Bob, I’d like to start with a discussion on some of these investments, $13 million incremental coming up in 2020 on the back of $15 million in 2019 and, I think, a number somewhere in that area in 2018 and maybe 2017 as well. So we’re starting to invest fairly heavily in the business. We’re talking 300, 400 basis points of margin that you’ve increased the investments over the last few years.

So I’m wondering if you could talk about what benefits you’ve seen from that in terms of, I don’t know, a vitality index, kind of new product revenue generation. What are the tangible results that you’re seeing from these investments? And what are the tangible results you expect to see in the future from these investments?

[Bob Pagano, Chief Executive Officer and President]

Yes, thanks, Nathan. I mean, look at – one of the things when I got here a little over five years ago was we reviewed our pipeline of new product development products – projects and they were very low, and a lot of them were me-too-type products. We really needed to reinvigorate our new product development process and look for breakthrough-type products and investments.

So what’s exciting now is we have a bunch of new ideas, both in research and what I call, execution stages in our pipeline. So the exciting thing is, Shashank earlier talked about, 80% of our investments are really related to growth investments and the remaining are driven by productivity and regional expansion. So a lot of our Smart and Connected initiatives, which are really revitalizing our portfolio, is what we’re focused on. We had an older portfolio of products, and now we’re reinvigorating them. We’re looking at solutions versus components and all of that we believe is driving above-market growth.

So we don’t give out vitality, but I’ll tell you, we’ve now started tracking it internally and we’ve been seeing improvements, significant improvements over the last several years. And again, the team is motivated. And we’re also looking at incremental operating margins, as you see, we’re doing both investments and driving incremental operating margins at the same time, which is a great balance.

[Shashank Patel, Chief Financial Officer]

Yes. And so Nate, I’ll just – as you said, over the last three, four years, we’ve invested over $45 million. And when you look at that, the R&D spend has gone up from 1.5% of sales to about 2.5% of sales. But it’s not only NPD but also market expansion because we’ve put feet on the street as well as invested in training centers, et cetera, and also invested in resources to drive the productivity, which is funding a lot of this as well.

[Nathan Jones, Stifel]

Okay. My follow-up question, despite having put these investments in, you guys have continued to deliver kind of this 50 basis points of margin expansion a year, which really means that core operating performance is up more like 100, 150 basis points each year over the last two, three, four years. You were talking about product – getting productivity this year inside the four walls and also out of SG&A. Can you talk a little bit about what those plans are and how far into the future that you think you can continue to deliver this kind of productivity that you guys have produced here over the last four or five years?

[Shashank Patel, Chief Financial Officer]

Yes. As you said, over the last three, four years, it’s been productivity within the factory walls. There’s still more work to do around that in the Americas but more so in Europe and other regions. And over the last year, we’ve now started focusing with the One Watts Performance System and productivity outside the factory walls and also a big focus on indirect material spend, which started, like in the back half of last year.

So we think there’s a lot more legs to go, there is a lot more opportunity over the next three to five years, which is going to drive the op margin improvement as well as continued funding investments we’ll need for, for example, on the smart and connected side.

[Nathan Jones, Stifel]

Do you guys see further incremental investments in growth here? Or have we reached the kind of plateau level? Are you continuing to find good investments to make that – could see that this investment in R&D go from 2.5% to 3%, 3.5%? Where do you think we should end up at?

[Bob Pagano, Chief Executive Officer and President]

Well, we continue to look at our pipeline and the great thing is the pipeline. We have to draw a line in the sand with our team. So we have more ideas that we can fund right now, which is a great problem to have right now. So again, it’s all about balance. We’d certainly like to improve our R&D spending and get it up into the 3%, 3.5% over the long run. But again, it’s going to be focusing on the quality of those type projects. And again, we look at internal rate of return and making sure that these projects will generate the future. So again, the momentum is building and the teams are excited about it.

[Nathan Jones, Stifel]

That’s helpful. I’ll pass it on. Thanks very much.

[Bob Pagano, Chief Executive Officer and President]

Thank you.

[Shashank Patel, Chief Financial Officer]

Thank you.

[Operator]

Next question comes from Ryan Connors with Boenning & Scattergood.

[Ryan Connors, Boenning & Scattergood]

Great, thanks, good morning.

[Bob Pagano, Chief Executive Officer and President]

Good morning.

[Ryan Connors, Boenning & Scattergood]

I actually wanted to – you mentioned the positive momentum in housing, and obviously, we see that in the macro data, it makes sense, given that you’ve got a strong job market, mortgage rates et cetera. But are you seeing anything specifically in your order boards, in your channel inventory situation, anything specifically that tells you that’s beginning to actually play out on the ground in terms of an acceleration in resi?

[Bob Pagano, Chief Executive Officer and President]

Well, I think it’s important that we back up a little bit and talk about like 60% of our business is commercial, 40% of our business is residential. Of that residential, two-thirds of that is multi-family and one-third is residential. And then when you break that, 65% is repair and replace, which tends to follow GDP and 35% new construction. So about 4% or 5% of our business as a company is in new construction residential.

So it’s hard to really see at that granularity, at that level, but the orders, the stocking levels, we believe, stocking levels were sound by our channels at the end of the year. We didn’t think there was any pull-backs on that. And we had a slower start in January, that was due to the holidays and one less workday. And then certainly with the Chinese New Year that impacted that, but we’re seeing some pickups in February here. So overall, I think what we’re seeing in the start of the year is in line with our overall guidance here.

[Ryan Connors, Boenning & Scattergood]

Okay. And then I wanted to talk about pricing. You go back about a year and a half, when the tariffs went in, you had a pretty sizable set of price increases, I recall it was something like upwards of 15% depending on the product line. And obviously that was a bit of a shock to the system for customers. And Shashank, you mentioned how it’s too early to say what this Phase one trade deal does. But in terms of the price cost dynamics and market customer expectations, I mean, how – what’s the pricing outlook and situation in terms of price cost management, now that it looks like we may be in a different chapter in this whole tariff situation?

[Bob Pagano, Chief Executive Officer and President]

Yes. We’ve been maintaining that – our price has been ahead of cost. And we think pricing, as we said earlier, will start moderating in the second half of 2019 and into 2020. So again, we continue to believe we’ll be in front of that. It’s just lower pricing, probably a little less than 1% is in our assumptions for 2020.

[Shashank Patel, Chief Financial Officer]

And Ryan, so – and last year, if you look at the whole of last year, we did have more tariff induced price, so to speak, in Americas and about half of total growth was priced this year, it’s about 1%, so a lot less. And most of that is in the first half, because we lap in the second half. But on the tariff situation, where we got impacted was on list one, two and three was our components and that 25% tariff is still there, nothing has happened with that. It’s only the list 4a that the tariff went down from 15% to 7.5%. But on that list, our impact was minimal.

[Ryan Connors, Boenning & Scattergood]

Okay. And then last one was, I had a kind of a bigger picture question. It’s water quality is not a huge business for you, but it’s material enough that you do mention it in the press release as being a tailwind. And if we think about coronavirus, we think about things like PFAS in the U.S., it seems like with a lot of these health contamination type scares that, that would be a tailwind for kind of residential and commercial level at the tap-type treatment products, which I know your premier product line, for example. Is that something that’s driving that strength in water quality? Or is that something else?

[Bob Pagano, Chief Executive Officer and President]

Really a lot of the growth is in our HF scientific business, which is really being driven based on ballast water testing that is now required in the coast guard. So we’re seeing a lot of strength in that area, and that’s some of our growth. But your comments are actually true and something that we’re watching. Residential, as you know, water quality is not the bigger portion of our business. We’re really focused more on commercial growth with our One Flow and some of our other products. But again we are seeing some growth in each one of our product lines in water quality and your point is well taken and that’s the areas that we’re focused on.

[Ryan Connors, Boenning & Scattergood]

Okay. Thanks for your time.

[Bob Pagano, Chief Executive Officer and President]

Thank you.

[Operator]

Next question comes from Jeff Hammond with KeyBanc.

[Jeff Hammond, KeyBanc]

Hey, good morning, guys.

[Bob Pagano, Chief Executive Officer and President]

Good morning, Jeff.

[Shashank Patel, Chief Financial Officer]

Good morning, Jeff.

[Jeff Hammond, KeyBanc]

Hey, just wanted to – good color on the coronavirus impact. Just wanted to clarify, what did you say on APMEA sales in the first quarter?

[Shashank Patel, Chief Financial Officer]

We said in the – of the $10 million to $20 million range, about half was APMEA in the first quarter.

[Jeff Hammond, KeyBanc]

Okay. Okay, and then just moving over to Europe, I mean that you’ve kind of had this consistently kind of low growth, no-growth market, but this year 2019, I think you had significant margin improvement and just want to see what’s in the pipeline for kind of margin expansion in Europe if you continue in this kind of muted environment.

[Bob Pagano, Chief Executive Officer and President]

Yes. So when you look at Europe, we’ve seen growth in our Blucher drains business and our electronics, and the other businesses have grown just at a more moderate pace. And the two businesses that are growing have a higher margin than the other two businesses, as well as last year, we did substantial amount of restructuring. So we got a little restructuring and I think Shashank mentioned about $0.5 million of incremental restructuring savings we’re seeing. But the big restructure was last year.

So each one of our businesses, we focus on improving margins all the time and that’s our focus with our One Watts Performance System. So I think there is opportunities, but as you said, we had big margin improvements in 2019. I think as you saw in our guidance, that will moderate a little bit.

[Shashank Patel, Chief Financial Officer]

And we did get – the team did a nice job driving price as well in 2019. And obviously we’re going to continue with that. Just on the restructuring though, the incremental savings from restructuring in Europe in 2020 will be approximately $2 million.

[Jeff Hammond, KeyBanc]

Okay. And then do you expect that mix dynamic to continue where Blucher and the controls business continues to outgrow?

[Bob Pagano, Chief Executive Officer and President]

Yes, that’s the plan. What we don’t know, in particular, you’re seeing some negative readings out of Germany right now. And as you know, we do a lot of OEM business in that area and that’s an area of concern, because we have a lot of fixed costs, and that volume impact on us will hit us hard.

So again, we got to balance both of those discussions so – and that’s kind of really what the Europe numbers I’ve been doing over the past several years is we focus on low growth, controlling our costs, driving those two other growth businesses. And the other two businesses, we’re investing slightly to begin looking at growth opportunities, but again we’re cautious of our German OEM business at this time.

[Jeff Hammond, KeyBanc]

Okay. Can you just talk about what your heating and hot water solutions business grew in 2019? What you’re seeing there from a market perspective into 2020?

[Bob Pagano, Chief Executive Officer and President]

Yes. So overall, I think we are in the – about 3%, a little over 3% for that business year-over-year. They had a really strong fourth quarter. We had some project timing issues in the third quarter. So again, we believe there’s opportunities to grow in that business, in that 3% to 4%, 5% range, somewhere in that. That’s our focus in that area. Again, it’s highly competitive, but we’re focused on the niche part of that in the commercial market, one million BTU and above. And we had a lot of new product developments in that and we will have continued new products. At the recent AHR show, that I know you attended, you saw some of those products. And again, that’s a key focus and it really is part of our overall solutions strategy as a company.

[Jeff Hammond, KeyBanc]

Yes, absolutely. The booth showed really well this year, so congrats on that. Just final one, M&A, certainly the balance sheet kind of continues to improve with the cash flow generation. Just maybe update us on pipeline. And just really how much time do you think – how much time do you guys spend considering like a larger type deal that would push up your leverage a little bit? Thanks.

[Bob Pagano, Chief Executive Officer and President]

Yes. I mean, the M&A front, we’re always looking, cultivating relationships. And as I’ve always said, we’re going to be disciplined. And as you know, in the last quarter, we’ve walked away from some deals. So from our point of view, it’s hard to predict. It’s got to tie to our overall strategy. And again, we evaluate small, medium and large deals all the time and we’ll continue to do that. So in total, I can’t predict that, Jeff, as you know, but our pipeline is full and we continue to look for opportunities, where it makes financial sense.

[Jeff Hammond, KeyBanc]

Okay, thanks guys.

[Bob Pagano, Chief Executive Officer and President]

Thanks, Jeff.

[Shashank Patel, Chief Financial Officer]

Thanks.

[Operator]

Next question comes from Joe Giordano with Cowen.

[Joe Giordano, Cowen]

Hey, guys. Good morning.

[Shashank Patel, Chief Financial Officer]

Good morning, Joe.

[Bob Pagano, Chief Executive Officer and President]

Good morning, Joe.

[Joe Giordano, Cowen]

Just curious, I mean, a lot of companies are talking about coronavirus in the first quarter. And I’m just curious, it seems like there is risk of things may be extending longer than people are giving credit for or slower ramp ups. And I’m just curious as to how you thought that process through in like the rest of your – like the nine months after first quarter outlook. Like, what’s kind of built in for the pacing of getting back to normal?

[Bob Pagano, Chief Executive Officer and President]

Yes. So the way we’ve been looking at, we’ve had extensive meetings. I talk to my Head of Asia Pacific daily, as well as our entire organization is focused on this. So this – what’s nice about this is, we can leverage our global footprint from a manufacturing point of view, but we’re looking at key components, where we might have bottlenecks or a large sourcing of that is inside of China.

So we’re looking at it, we’re putting contingency plans, but a lot of our suppliers are beginning to come back to work and that’s why we kind of felt that the beginning of March is where we’re going to see it. And when we looked at the numbers, the range of $10 million to $20 million, half of that, as Shashank said, was really in the APMEA region, the other is the other side based on supply chain slowdowns.

Now we believe, other than APMEA, because right now in China, they’re not doing any construction right now, everything is at a standstill and it’s difficult at this point to assume that that’s going to come back. But the rest of the world, we believe, is just a timing issue, and it’ll come back from that demand. So again, we’re putting all our resources, the teams, as we speak, are looking at all the potential bottlenecks that we’re leveraging our – all our global resources are on this.

[Joe Giordano, Cowen]

Fair enough. And then do you have any kind of – I apologize if you said this initially in your prepared comments, I had to join a couple of minutes late. But can you talk about momentum in the U.S. commercial market, just from a – maybe like an institutional building standpoint, what you’re seeing there?

[Bob Pagano, Chief Executive Officer and President]

Yes. From an institutional market, I think that is the best part of the market that’s still holding up at this point in time. As you know, 65% of our business is repair and replace that tends to follow GDP. The new construction that we talked about, we’re seeing growth, but just at a slower growth. And in particular in the Northeast, we see some slowing and that’s one of our stronger markets and some of that is slowing right now. But overall, we see growth. It’s just at a slower growth with the institutional markets obviously, being the biggest opportunities for us and a key focus area.

[Joe Giordano, Cowen]

Thanks, guys.

[Bob Pagano, Chief Executive Officer and President]

Thank you.

[Shashank Patel, Chief Financial Officer]

Thank you.

[Operator]

[Operator Instructions] We have a question from Bryan Blair with Oppenheimer.

[Bryan Blair, Oppenheimer]

Good morning, everyone. Thanks for taking my questions.

[Bob Pagano, Chief Executive Officer and President]

Good morning, Bryan.

[Shashank Patel, Chief Financial Officer]

Good morning, Bryan.

[Bryan Blair, Oppenheimer]

I was hoping you could offer a little more color on the early days of owning Backflow Direct and how it’s affected your R&D efforts and maybe any initial feedback from customers having those assets in the Watts portfolio.

[Bob Pagano, Chief Executive Officer and President]

Well, the integration has gone really well. We’ve fully integrated that into our facility. So it’s out of their facility and they’re performing as we expected right now. So there is not much comments and the teams are executing, and it’s giving us a new product line. And R&D, that’ll be a longer-term discussion at this point in time, but the teams are working really well together and we’re really excited about this acquisition.

[Bryan Blair, Oppenheimer]

Yes, fair enough. And it looks like the deal was modestly accretive at the outset. How should we think about 2020 EPS contribution?

[Shashank Patel, Chief Financial Officer]

I think, look, it’s – the incremental sales are not significant. So when you look at incremental EPS, it’s minimal in 2020 after amortization.

[Bryan Blair, Oppenheimer]

Got it. And you commented on overall funnel, you clearly have a strong balance sheet, solid cash flow. If the right opportunity or opportunities came along, Shashank, what do you view as near-term dry powder?

[Shashank Patel, Chief Financial Officer]

Sorry, say that again. Near time – near-term what?

[Bryan Blair, Oppenheimer]

Near-term dry powder or overall balance sheet capacity if the right opportunities came along.

[Shashank Patel, Chief Financial Officer]

Sure, sure. So based on where we stand on the balance sheet and leveraging up to a comfortable 2.5, 3 ratio, I think about $800 million of dry powder is what we have.

[Bryan Blair, Oppenheimer]

Got it. Appreciate the color. Thanks.

[Bob Pagano, Chief Executive Officer and President]

Thank you.

[Operator]

[Operator Instructions] And we do not have any telephone questions at this time, I will turn the call over to Mr. Pagano.

[Bob Pagano, Chief Executive Officer and President]

Thank you. And in closing, thank you again for taking the time to join us today for our fourth quarter earnings call. We appreciate your continued interest in Watts and look forward to speaking with you during our first quarter earnings call in May. Have a great day.

[Operator]

Ladies and gentlemen, this concludes today’s conference call. Thank you for participating. You may now disconnect.