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1. Basis of Presentation
The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included in the Watts Water Technologies, Inc. (the Company) Consolidated Balance Sheet as of April 3, 2011, the Consolidated Statements of Operations for the first quarter ended April 3, 2011 and for the first quarter ended April 4, 2010, and the Consolidated Statements of Cash Flows for the first quarter ended April 3, 2011 and the first quarter ended April 4, 2010.
The balance sheet at December 31, 2010 has been derived from the audited consolidated financial statements at that date. The accounting policies followed by the Company are described in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010. The financial statements included in this report should be read in conjunction with the consolidated financial statements and notes included in the Annual Report on Form 10-K for the year ended December 31, 2010. Operating results for the interim periods presented are not necessarily indicative of the results to be expected for the year ending December 31, 2011.
The Company operates on a 52-week fiscal year ending on December 31st. Any quarterly data contained in this Quarterly Report on Form 10-Q generally reflects the results of operations for a 13-week period.
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2. Accounting Policies
Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Impairment of Goodwill and Long-Lived Assets
The changes in the carrying amount of goodwill by geographic segment are as follows:
Goodwill and intangible assets not subject to amortization are tested for impairment at least annually or more frequently if events or circumstances indicate that it is “more likely than not” that goodwill might be impaired, such as a change in business conditions. The Company performs its annual impairment assessment of goodwill and intangible assets not subject to amortization in the fourth quarter of each year.
Intangible assets with estimable lives and other long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset or asset group may not be recoverable. Recoverability of intangible assets with estimable lives and other long-lived assets are measured by a comparison of the carrying amount of an asset or asset group to future net undiscounted pretax cash flows expected to be generated by the asset or asset group. If these comparisons indicate that an asset is not recoverable, the impairment loss recognized is the amount by which the carrying amount of the asset or asset group exceeds the related estimated fair value. Estimated fair value is based on either discounted future pretax operating cash flows or appraised values, depending on the nature of the asset. The Company determines the discount rate for this analysis based on the weighted average cost of capital based on the market and guideline public companies for the related business and does not allocate interest charges to the asset or asset group being measured. Judgment is required to estimate future operating cash flows.
Intangible assets include the following:
Aggregate amortization expense for amortizable intangible assets for the first quarters of 2011 and 2010 was $4.0 million and $3.4 million, respectively. Additionally, future amortization expense for the next five years on amortizable intangible assets approximates $11.5 million for the remainder of 2011, $13.6 million for 2012, $12.4 million for 2013, $12.4 million for 2014 and $12.1 million for 2015. Amortization expense is provided on a straight-line basis over the estimated useful lives of the intangible assets. The weighted-average remaining life of total amortizable intangible assets is 9.2 years. Patents, customer relationships, technology and other amortizable intangibles have weighted-average remaining lives of 7.7 years, 7.1 years, 14.3 years and 23.8 years, respectively. Intangible assets not subject to amortization consist of trademarks and trade names.
Stock-Based Compensation and Chief Executive Officer Separation Costs
The Company maintains three stock incentive plans under which key employees and non-employee members of the Company’s Board of Directors have been granted incentive stock options (ISOs) and nonqualified stock options (NSOs) to purchase the Company’s Class A Common Stock. Only one plan, the 2004 Stock Incentive Plan, is currently available for the grant of new equity awards. Stock options granted under prior plans became exercisable over a five-year period at the rate of 20% per year and expire ten years after the date of grant. Under the 2004 Stock Incentive Plan, options become exercisable over a four-year period at the rate of 25% per year and expire ten years after the grant date. ISOs and NSOs granted under the plans may have exercise prices of not less than 100% and 50% of the fair market value of the Class A Common Stock on the date of grant, respectively. The Company’s current practice is to grant all options at fair market value on the grant date. The Company did not issue any options in the first quarters of 2011 or 2010.
The Company has also granted shares of restricted stock to key employees and non-employee members of the Company’s Board of Directors under the 2004 Stock Incentive Plan, which vest either immediately, over a one-year period, or over a three-year period at the rate of one-third per year. The restricted stock awards are amortized to expense on a straight-line basis over the vesting period. The Company granted 1,400 shares of restricted stock in the first quarter of 2011 and none in first quarter of 2010.
The Company also has a Management Stock Purchase Plan that allows for the granting of restricted stock units (RSUs) to key employees. On an annual basis, key employees may elect to receive a portion of their annual incentive compensation in RSUs instead of cash. Each RSU provides the key employee with the right to purchase a share of Class A Common Stock at 67% of the fair market value on the date of grant. RSUs vest annually over a three-year period from the grant date. An aggregate of 2,000,000 shares of Class A Common Stock may be issued under the Management Stock Purchase Plan. The Company granted 96,454 RSUs and 158,473 RSUs in the first quarters of 2011 and 2010, respectively.
The fair value of each RSU issued under the Management Stock Purchase Plan is estimated on the date of grant, using the Black-Scholes-Merton Model, based on the following weighted average assumptions:
The above assumptions were used to determine the weighted average grant-date fair value of RSUs of $16.25 and $12.81 in 2011 and 2010, respectively.
A more detailed description of each of these stock and stock option plans can be found in Note 13 of Notes to Consolidated Financial Statements in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010.
On January 26, 2011, Patrick S. O’Keefe resigned from his positions of Chief Executive Officer, President and Director. Pursuant to a separation agreement, the Company recorded a charge of $6.3 million consisting of $3.3 million in expected cash severance and a non-cash charge of $3.0 million for the modification of his stock options and restricted stock awards.
Shipping and Handling
The Company’s shipping costs included in selling, general and administrative expenses were $8.8 million and $8.4 million for the first quarters of 2011 and 2010, respectively.
Research and Development
Research and development costs included in selling, general and administrative expenses were $5.0 million and $5.2 million for the first quarters of 2011 and 2010, respectively.
Taxes, Other than Income Taxes
Taxes assessed by governmental authorities on sale transactions are recorded on a net basis and excluded from sales in the Company’s consolidated statements of operations.
Income Taxes
Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carry forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.
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3. Discontinued Operations
Discontinued operating expense for the first quarter ended April 4, 2010 primarily includes an estimated reserve in connection with the Foreign Corrupt Practices Act (FCPA) investigation at Watts Valve (Changsha) Co., Ltd. (CWV) (see Note 10) and legal costs associated with the FCPA investigation. Additionally, there were costs from the loss on sale of CWV. See Note 3 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2010, for a more detailed discussion.
Condensed operating statements for discontinued operations are summarized below:
The carrying amounts of major classes of assets and liabilities associated with discontinued operations are as follows:
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4. Financial Instruments and Derivatives Instruments
The Company measures certain financial assets and liabilities at fair value on a recurring basis, including short-term investment securities, foreign currency derivatives and deferred compensation plan assets and related liability. The fair values of these financial assets and liabilities were determined using the following inputs at April 3, 2011:
(1) Included in short-term investment securities on the Company’s consolidated balance sheet. (2) Included in other, net on the Company’s consolidated balance sheet. (3) Included in other noncurrent liabilities on the Company’s consolidated balance sheet.
Our Level 3 contingent consideration obligation in connection with the Blue Ridge Atlantic Enterprises, Inc. (BRAE) acquisition was $1.9 million as of April 3, 2011 and December 31, 2010. The valuation was based on the net present value of $3.7 million which is derived from the weighted probability of achievement of a performance metric as of the date of the acquisition. Failure to meet the performance metric would reduce this liability to $0, while complete achievement would increase this liability to the full remaining purchase price of $4.8 million. The change in fair value of this obligation for the quarter ended April 3, 2011 was immaterial. See Note 5 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2010, for a detailed description of the acquisitions.
Short-term investment securities as of April 3, 2011 consist of certificates of deposit with remaining maturities of greater than three months at the date of purchase, for which the carrying amount is a reasonable estimate of fair value.
Cash equivalents consist of instruments with remaining maturities of three months or less at the date of purchase and consist primarily of U.S. Treasury bills, money market funds and certificates of deposit, for which the carrying amount is a reasonable estimate of fair value.
The Company uses financial instruments from time to time to enhance its ability to manage risk, including foreign currency and commodity pricing exposures, which exist as part of its ongoing business operations. The use of derivatives exposes the Company to counterparty credit risk for nonperformance and to market risk related to changes in currency exchange rates and commodity prices. The Company manages its exposure to counterparty credit risk through diversification of counterparties. The Company’s counterparties in derivative transactions are substantial commercial banks with significant experience using such derivative instruments. The impact of market risk on the fair value and cash flows of the Company’s derivative instruments is monitored and the Company restricts the use of derivative financial instruments to hedging activities. The Company does not enter into contracts for trading purposes nor does the Company enter into any contracts for speculative purposes. The use of derivative instruments is approved by senior management under written guidelines.
The Company has exposure to a number of foreign currency rates, including the Canadian Dollar, the Euro, the Chinese Yuan and the British Pound. To manage this risk, the Company generally uses a layering methodology whereby at the end of any quarter, the Company has generally entered into forward exchange contracts, which hedge approximately 50% of the projected intercompany purchase transactions for the next twelve months. The Company uses this strategy for purchases between Canada and the U.S., for purchases between the Euro zone and the U.S., and for purchases between the Euro zone and the United Kingdom. The average volume of contracts can vary but generally approximates $9 to $15 million in open contracts at the end of any given quarter. At April 3, 2011, the Company had contracts for purchases between Canada and the U.S. for notional amounts aggregating approximately $9.0 million to buy U.S. dollars. The Company accounts for the forward exchange contracts as an economic hedge and has not elected to use hedge accounting. Realized and unrealized gains and losses on the contracts are recognized in other (income) expense in the consolidated statements of operations. These contracts do not subject the Company to significant market risk from exchange movement because they offset gains and losses on the related foreign currency denominated transactions. The fair value of these contracts as of April 3, 2011 was not material.
Fair Value
The carrying amounts of cash and cash equivalents, short-term investments, trade receivables and trade payables approximate fair value because of the short maturity of these financial instruments.
The fair values of the Company’s 5.47% senior notes due 2013, 5.85% senior notes due 2016 and 5.05% senior notes due 2020, are based on a discounted cash flow model using like industrial companies, the Company’s credit metrics, the Company’s size, as well as current market demand. The fair value of the Company’s variable rate debt approximates its carrying value. The carrying amount and the estimated fair market value of the Company’s long-term debt, including the current portion, are as follows:
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5. Restructuring and Other Charges
The Company’s Board of Directors approves all major restructuring programs that involve the discontinuance of product lines or the shutdown of facilities. From time to time, the Company takes additional restructuring actions, including involuntary terminations that are not part of a major program. The Company accounts for these costs in the period that the individual employees are notified or the liability is incurred. These costs are included in restructuring and other charges in the Company’s consolidated statements of operations. The Company also includes as part of other charges, expenses associated with asset impairments. In the first quarter of 2011, the Board approved a restructuring program with respect to the Company’s operating facilities in Europe. The restructuring program is expected to consolidate two facilities. The program is expected to include pre-tax costs of approximately $2.0 million, including costs for severance and shut down costs. The total net after-tax charge for this restructuring program is $1.4 million with costs being incurred through 2011. See Note 4 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2010, for a detailed description of the 2010 Europe and North America actions.
A summary of the pre- tax cost by restructuring program is as follows:
The Company does not expect to incur additional costs related to the 2009 restructuring plan, as the project is substantially complete.
The Company recorded net pre-tax restructuring and other charges in its business segments as follows:
The first quarter charges for 2010 of $3.8 million consist of approximately $2.0 million related to involuntary termination benefits, $0.7 million for accelerated depreciation for manufacturing operations, which was charged to cost of sales, and $0.2 million for other costs associated with 2010 actions. Additionally, the Company recorded $0.3 million related to involuntary termination benefits and $0.5 million for relocation expenses associated with 2009 actions. The remaining $0.1 million of costs related to involuntary termination benefits which were not part of a previously announced restructuring plan.
In addition, the Company recorded $0.2 million in the first quarter of 2010 for charges associated with asset impairments in restructuring and a tax charge of approximately $1.5 million in connection with the expected sale of TWVC. The Company expects the sale of TWVC to be finalized before the end of the third quarter of 2011, subject to receiving all applicable government approvals. The Company expects to receive net proceeds of approximately $5.9 million from the sale. The Company also expects to record a gain of approximately $7.1 million after-tax to recognize the cumulative currency translation adjustment related to TWVC. Further, the Company will recognize a $3.9 million gain to reverse a tax provision upon completion of the sale.
2011 Actions
Europe Actions
The following table summarizes the total expected, incurred and remaining pre-tax costs for the 2011 Europe restructuring program:
Details of the Company’s 2011 Europe restructuring program for the first three months of 2011 are as follows:
The following table summarizes expected, incurred and remaining costs for 2011 Europe restructuring actions by type:
2010 Actions
Europe Actions
The following table summarizes the total expected, incurred and remaining pre-tax costs for the 2010 Europe footprint consolidation-restructuring program:
Details of the Company’s 2010 Europe footprint consolidation-restructuring program for the first three months of 2011 are as follows:
The following table summarizes expected, incurred and remaining costs for 2010 Europe footprint consolidation- restructuring actions by type:
North America Actions
The following table summarizes the total expected, incurred and remaining pre-tax costs for the 2010 North America footprint consolidation-restructuring program:
Details of the Company’s 2010 North America footprint consolidation-restructuring program for the first three months of 2011 are as follows:
The following table summarizes expected, incurred and remaining costs for the Company’s 2010 North America footprint consolidation-restructuring actions by type:
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7. Segment Information
The Company operates in three geographic segments: North America, Europe, and China. Each of these segments is managed separately and has separate financial results that are reviewed by the Company’s chief operating decision-maker. All intercompany sales transactions have been eliminated. Sales by region are based upon location of the entity recording the sale. The accounting policies for each segment are the same as those described in the summary of significant accounting policies.
The following is a summary of the Company’s significant accounts and balances by segment, reconciled to the consolidated totals:
* Corporate expenses are primarily for compensation expense, internal controls costs, professional fees, including legal and audit expenses, shareholder services and benefit administration costs. These costs are not allocated to the geographic segments as they are viewed as corporate functions that support all activities.
The above operating segments are presented on a basis consistent with the presentation included in the Company’s December 31, 2010 consolidated financial statements included in its Annual Report on Form 10-K.
The North American segment includes U.S. net sales of $182.9 million and $181.1 million for the first quarters of 2011 and 2010, respectively. The North American segment also includes U.S. long-lived assets of $72.7 million and $75.3 million at April 3, 2011 and April 4, 2010, respectively.
The North American segment and the China segment include $3.8 million and $6.2 million, respectively, in assets held for sale at April 3, 2011. The North American segment, China segment and Europe segment include $4.9 million, $5.9 million and $0.4 million, respectively, in assets held for sale at April 4, 2010.
Intersegment sales for the first quarter of 2011 for North America, Europe and China were $0.9 million, $1.9 million and $30.7 million, respectively. Intersegment sales for the first quarter of 2010 for North America, Europe and China were $1.0 million, $2.1 million and $24.5 million, respectively.
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8. Accumulated Other Comprehensive Income (Loss)
Accumulated other comprehensive income (loss) consists of the following:
Accumulated other comprehensive income (loss) in the consolidated balance sheets as of April 3, 2011 and April 4, 2010 consist primarily of cumulative translation adjustments and pension related prior service costs and net actuarial loss. The Company’s total comprehensive income (loss) was as follows:
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9. Debt
The Company’s credit agreement (the Credit Agreement) provides for a multi-currency $300.0 million, five-year, senior unsecured revolving credit facility which may be increased by an additional $150.0 million under certain circumstances and subject to the terms of the Credit Agreement. The Credit Agreement has a sublimit of up to $75.0 million in letters of credit.
Borrowings outstanding under the Credit Agreement bear interest at a fluctuating rate per annum equal to (i) in the case of Eurocurrency rate loans, the British Bankers Association LIBOR rate plus an applicable percentage, ranging from 1.70% to 2.30%, determined by reference to the Company’s consolidated leverage ratio plus, in the case of certain lenders, a mandatory cost calculated in accordance with the terms of the Credit Agreement, or (ii) in the case of base rate loans and swing line loans, the highest of (a) the federal funds rate plus 0.5%, (b) the rate of interest in effect for such day as announced by Bank of America, N.A. as its “prime rate,” and (c) the British Bankers Association LIBOR rate plus 1.0%, plus an applicable percentage, ranging from 0.70% to 1.30%, determined by reference to the Company’s consolidated leverage ratio. In addition to paying interest under the Credit Agreement, the Company is also required to pay certain fees in connection with the credit facility, including, but not limited to, a facility fee and letter of credit fees. Under the Credit Agreement, the Company is required to satisfy and maintain specified financial ratios and other financial condition tests. The Credit Agreement matures on June 18, 2015. The Company may repay loans outstanding under the Credit Agreement from time to time without premium or penalty, other than customary breakage costs, if any, and subject to the terms of the Credit Agreement. As of April 3, 2011, the Company had $92.1 million of borrowings and $34.9 million of stand-by letters of credit outstanding on the Credit Agreement. As of April 3, 2011, the Company was in compliance with all covenants related to the Credit Agreement and had $173.0 million of unused and available credit under the Credit Agreement.
The Company is a party to several note agreements as further detailed in Note 11 of Notes to Consolidated Financial Statements of the Annual Report on Form 10-K for the year ended December 31, 2010. These note agreements require the Company to maintain a fixed charge coverage ratio of consolidated EBITDA plus consolidated rent expense during the period to consolidated fixed charges. Consolidated fixed charges are the sum of consolidated interest expense for the period and consolidated rent expense. As of April 3, 2011, the Company was in compliance with all covenants regarding these note agreements.
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10. Contingencies and Environmental Remediation
As disclosed in Part I, Item 1, “Product Liability, Environmental and Other Litigation Matters” of the Company’s Annual Report on Form 10-K for the year ended December 31, 2010, the Company is a party to certain litigation, has conducted an investigation regarding information that employees of CWV made payments to employees of state-owned agencies and whether such payments may violate FCPA, and the Company is engaged in certain environmental remediation. There have been no material developments with respect to its contingencies and environmental remediation proceedings during the first three months ended April 3, 2011.
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11. Employee Benefit Plans
The Company sponsors funded and unfunded defined benefit pension plans covering substantially all of its domestic employees. Benefits are based primarily on years of service and employees’ compensation. The funding policy of the Company for these plans is to contribute an annual amount that does not exceed the maximum amount that can be deducted for federal income tax purposes.
The components of net periodic benefit cost are as follows:
The information related to the Company’s pension funds cash flow is as follows:
The Company expects to contribute approximately $7.7 million to its pension plans for the remainder of 2011.
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12. Subsequent Events
Dividend Declared
On May 3, 2011, the Company declared a quarterly dividend of eleven cents ($0.11) per share on each outstanding share of Class A Common Stock and Class B Common Stock.
Acquisition
On April 29, 2011, the Company completed the acquisition of Danfoss Socla S.A.S. (Socla) and the related water controls business of certain other entities controlled by Danfoss A/S, in a share and asset purchase transaction. The aggregate consideration paid was EUR 120.0 million, which consisted of EUR 58.0 million in cash and EUR 62.0 million of debt. The aggregate purchase price, which is subject to working capital and related adjustments, is equal to approximately $175.7 million based on the exchange rate of Euro to U.S. dollars as of April 26, 2011. The Company funded the transaction with cash on hand and Euro-based borrowings under its Credit Agreement. The purchase price allocation for Socla has not yet been completed.
Socla is a manufacturer of water protection valves and flow control solutions for the water market and the heating, ventilation and air conditioning market. Its major product lines include backflow preventers, check valves and pressure reducing valves. Socla is based in France, and its products are distributed worldwide for commercial, residential municipal and industrial use. Socla’s annual revenue for 2010 was approximately $130.0 million. Socla strengthens the Company’s European plumbing and flow control platform and also adds to its HVAC platform.
Supplemental pro-forma information
Had the Company completed the acquisition of Socla at the beginning of 2010, the net sales, net income from continuing operations and earnings per share from continuing operations would have been as follows:
Net income from continuing operations for the quarters ended April 3, 2011 and April 4, 2010 was adjusted to include $0.5 million of net interest expense related to the financing and $1.3 million of net amortization expense resulting from the estimated allocation of purchase price to amortizable intangible assets. Net income from continuing operations for the quarter ended April 3, 2011 was also adjusted to exclude $1.1 million of non-recurring acquisition-related costs.
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