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 June 28, 2015, the Consolidated Statements of Operations for the second quarters and six months ended June 28, 2015 and June 29, 2014, the Consolidated Statements of Comprehensive Income (Loss) for the second quarters and six months ended June 28, 2015 and June 29, 2014, and the Consolidated Statements of Cash Flows for the six months ended June 28, 2015 and June 29, 2014.

 

The consolidated balance sheet at December 31, 2014 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, 2014.  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, 2014. Operating results for the interim periods presented are not necessarily indicative of the results to be expected for the year ending December 31, 2015.

 

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 reflect the results of operations for a 13-week period or 26-week period, respectively.

 

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.

 

Goodwill and Long-Lived Assets

 

During the second quarter of 2015, $4.1 million of goodwill in the Americas segment was reclassified to assets held for sale.  Refer to Note 6 Assets Held for Sale for further discussion. Also during the second quarter of 2015, the working capital adjustment relating to the AERCO International, Inc. (“AERCO”) acquisition was finalized resulting in a $0.7 million reduction in the purchase price and   goodwill recorded in the Americas segment.  The final purchase price after the adjustment was $271.5 million.

 

The changes in the carrying amount of goodwill by geographic segment are as follows:

 

 

 

Goodwill and indefinite-lived intangible assets are tested for impairment at least annually or more frequently if events or circumstances indicate that it is “more likely than not” that they might be impaired, such as from a change in business conditions. The Company performs its annual goodwill and indefinite-lived intangible assets impairment assessment 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 second quarters of 2015 and 2014 was $5.2 million and $3.7 million, respectively, and for the first six months of 2015 and 2014 was $10.3 million and $7.4 million, respectively.  Additionally, future amortization expense for the next five years on amortizable intangible assets is expected to be approximately $10.3 million for the remainder of 2015, $19.1 million for 2016, $18.8 million for 2017, $15.6 million for 2018 and $11.8 million for 2019. Amortization expense is recorded 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 12.1 years. Patents, customer relationships, technology, trade names and other amortizable intangibles have weighted-average remaining lives of 4.7 years, 11.8 years, 10.0 years, 14.2 years and 33.0 years, respectively. Indefinite-lived intangible assets primarily include trademarks and trade names.

 

Stock-Based Compensation

 

The Company maintains one stock incentive plan, the Second Amended and Restated 2004 Stock Incentive Plan (the “2004 Stock Incentive Plan”).  Under this plan, key employees have been granted nonqualified stock options to purchase the Company’s Class A common stock. Options typically become exercisable over a four-year period at the rate of 25% per year and expire ten years after the grant date. However, with the introduction in 2014 of performance stock units discussed below, most options granted in 2014 become exercisable over a three-year period at the rate of one-third per year.  Options granted under the plan may have exercise prices of not less than 100% of the fair market value of the Class A common stock on the date of grant. The Company’s practice has been to grant all options at fair market value on the grant date. The Company did not issue any stock options in the first six months of 2015 and issued 4,808 stock options during the first six months of 2014.

 

The Company grants shares of restricted stock and deferred shares to key employees and stock awards to non-employee members of the Company’s Board of Directors under the 2004 Stock Incentive Plan.  Stock awards to non-employee members of the Company’s Board of Directors are fully vested upon grant.  Employees’ restricted stock awards and deferred shares typically vest over a three-year period at the rate of one-third per year. However, with the introduction in 2014 of performance stock units discussed below, most restricted stock awards and deferred shares granted in 2014 vest over a two-year period at the rate of 50% per year. The restricted stock awards and deferred shares are amortized to expense on a straight-line basis over the vesting period. The Company issued 60,278 and 41,885 shares of restricted stock in the first six months of 2015 and 2014, respectively.

 

Beginning in 2014, the Company also granted performance stock units to key employees under the 2004 Stock Incentive Plan.  Performance stock units vest at the end of the performance period set by the Compensation Committee of our Board of Directors at the time of grant.  Upon vesting, the number of shares of the Company’s Class A common stock awarded to each performance stock unit recipient will be determined based on the Company’s performance relative to certain performance goals set at the time the performance stock units were granted.   The recipient of a performance stock unit award may earn from no shares to twice the number of target shares awarded to such recipient.  The performance stock units are amortized to expense over the vesting period, and based on the Company’s performance relative to the performance goals, may be adjusted.  If the performance goals are not met, no awards are earned and previously recognized compensation expense is reversed. The Company awarded 631 performance stock units in the first six months of 2015, and did not award any performance stock units in the first six months of 2014.

 

The Company has a Management Stock Purchase Plan that allows for the purchase of restricted stock units (RSUs) by 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 represents one share of Class A common stock and is purchased by the employee at 67% of the fair market value of the Company’s Class A common stock on the date of grant.  RSUs vest either annually over a three-year period from the grant date or upon the third anniversary of the grant date and receipt of the shares underlying RSUs is deferred for a minimum of three years or such greater number of years as is chosen by the employee.  An aggregate of 2,000,000 shares of Class A common stock may be issued under the Management Stock Purchase Plan. The Company granted 59,995 RSUs and 30,561 RSUs in the first six months of 2015 and 2014, 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 RSUs weighted average grant-date fair value of $19.04 and $22.57 in 2015 and 2014, respectively.

 

A more detailed description of each of these plans can be found in Note 12 of Notes to Consolidated Financial Statements in the Company’s Annual Report on Form 10-K for the year ended December 31, 2014.

 

Shipping and Handling

 

The Company’s shipping and handling costs included in selling, general and administrative expenses were $13.8 million and $15.8 million for the second quarters of 2015 and 2014, respectively, and were $28.2 million and $30.5 million for the first six months of 2015 and 2014, respectively.

 

Research and Development

 

Research and development costs included in selling, general and administrative expenses were $6.3 million and $5.6 million for the second quarters of 2015 and 2014, respectively, and were $12.7 million and $11.9 million for the first six months of 2015 and 2014, 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.

 

New Accounting Standards

 

In April 2015, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2015-03, “Interest — Imputation of Interest: Simplifying the Presentation of Debt Issuance Costs”. Under ASU 2015-03, debt issuance costs related to a recognized debt liability will be presented on the balance sheet as a direct deduction from the debt liability, similar to the presentation of debt discounts.  The cost of issuing debt will no longer be recorded as a separate asset, except when incurred before receipt of the funding from the associated debt liability. ASU 2015-03 is effective in the first quarter of 2016 for public companies with calendar year ends, with early adoption permitted. The ASU requires retrospective application to all prior periods presented in the financial statements. The adoption of this guidance is not expected to have a material impact on the Company’s financial statements.

 

In January 2015, the FASB issued ASU 2015-01, “Income Statement—Extraordinary and Unusual Items: Simplifying Income Statement Presentation by Eliminating the Concept of Extraordinary Items”. ASU 2015-01 eliminates from U.S. GAAP the concept of extraordinary items as part of its initiative to reduce complexity in accounting standards. ASU 2015-01 is effective in the first quarter of 2016 for public companies with calendar year ends, with early adoption permitted provided that the guidance is applied from the beginning of the fiscal year of adoption. The ASU may be applied prospectively or retrospectively to all prior periods presented. The adoption of this guidance is not expected to have a material impact on the Company’s financial statements.

 

3.Acquisitions

 

On December 1, 2014, the Company completed the acquisition of AERCO in a share purchase transaction. The aggregate purchase price was $271.5 million and was financed from a borrowing under the Company’s Credit Agreement. During the second quarter of 2015, the working capital adjustment was finalized resulting in a $0.7 million reduction in the final purchase price.

 

The Company accounted for the transaction as a business combination. The Company completed a purchase price allocation that resulted in the recognition of $173.3 million in goodwill and $102.4 million in intangible assets. The goodwill balance was reduced during the second quarter of 2015 primarily related to the finalization of the working capital adjustment. Intangible assets consist primarily of customer relationships valued at $78.5 million with estimated lives of 16 years, developed technology valued at $15.8 million with estimated lives of 10 years and trade name valued at $7.4 million with a 20 year life. The goodwill is attributable to the workforce of AERCO and the strategic platform adjacency that will allow Watts to extend its product offerings as a result of the acquisition. Approximately $19.4 million of the goodwill is deductible for tax purposes. The following table summarizes the value of the assets and liabilities acquired (in millions):

 

 

The consolidated statement of operations for the second quarter and the six months ended June 28, 2015 includes the results of AERCO.  The second quarter and the six months ended June 28, 2015 results include $32.4 million and $54.6 million of revenues, respectively, and $6.1 million and $7.3 million of operating income, respectively, attributable to AERCO.  The six months ended June 28, 2015 operating income of AERCO includes $0.9 million of purchase accounting charges.

 

Supplemental pro-forma information

 

Had the acquisition of AERCO been completed at the beginning of 2014, the Company’s consolidated 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 second quarter and six months ended June 29, 2014 was adjusted to include $0.9 million and $1.6 million, respectively, of net interest expense related to the financing of the acquisition and $1.1 million and $2.2 million, respectively, of net amortization expense resulting from the estimated allocation of purchase price to amortizable tangible and intangible assets. Net income from continuing operations for the six months ended June 28, 2015 was also adjusted to exclude $0.7 million of net acquisition-related charges.

 

4.Financial Instruments and Derivative Instruments

 

The Company measures certain financial assets and liabilities at fair value on a recurring basis, including deferred compensation plan assets and related liability, and contingent consideration. There were no designated cash flow hedges as of June 28, 2015 and December 31, 2014. The fair values of these certain financial assets and liabilities were determined using the following inputs at June 28, 2015 and December 31, 2014:

 

 

 

 

 

The table below provides a summary of the changes in fair value of all financial assets and liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the period December 31, 2014 to June 28, 2015.

 

 

The $2.5 million contingent consideration liability balance at December 31, 2014 related to the tekmar Control Systems acquisition in 2012. This liability was classified as Level 3 under the fair value hierarchy as it was based on the probability of achievement of a future performance metric as of the date of the acquisition, which was not observable in the market. The final contingent consideration payment of $2.3 million was made in the second quarter of 2015.

 

Fair Value

 

The carrying amounts of cash and cash equivalents, trade receivables and trade payables approximate fair value because of the short maturity of these financial instruments.

 

Cash equivalents consist of instruments with remaining maturities of three months or less at the date of purchase and consist primarily of certificates of deposit and money market funds, for which the carrying amount is a reasonable estimate of fair value.

 

The fair value of the Company’s 5.85% senior notes due 2016 and 5.05% senior notes due 2020 is based on quoted market prices of similar notes (level 2).  The fair value of the Company’s borrowings outstanding under the Credit Agreement and 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:

 

 

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 sterling. 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 presently does not have any open forward exchange contracts.

 

5.Restructuring and Other Charges, Net

 

The Company’s Board of Directors approves all major restructuring programs that may involve the discontinuance of significant product lines or the shutdown of significant 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.

 

A summary of the pre-tax cost by restructuring program is as follows:

 

 

The Company recorded pre-tax restructuring and other charges, net in its business segments as follows:

 

 

2015 Actions

 

On February 17, 2015, the Board of Directors of the Company approved the initial phase of a restructuring program relating to the transformation of the Company’s Americas and Asia-Pacific businesses, which primarily involves product line rationalization efforts relating to non-core products. The Company expects to ultimately eliminate between $175 million to $200 million of the combined Americas and Asia-Pacific net sales primarily within the Company’s do-it-yourself (DIY) distribution channel (the “program”).

 

On July 29, 2015, the Company entered into a definitive agreement with Sioux Chief Mfg. Co., Inc. (“Sioux Chief”) to sell the Company’s fittings, brass & tubular and vinyl tubing product lines and associated assets in the Americas.  The Company estimates that the total pre-tax program cost will approximate the mid-point of the $27 million to $50 million range previously disclosed in the first quarter of 2015. The total non-cash charges for this program are expected to be $17 million to $25 million, and the net after-tax charge is expected to be $22 million to $40 million. As of June 28, 2015, the assets associated with the product lines in the Americas have been classified as ‘Held for Sale’ as all of the required criteria had been met. Refer to Note 6 Assets Held for Sale for further discussion.

 

During the second quarter ended June 28, 2015, the Company recorded a $3.7 million pre-tax restructuring charge and liability relating to severance costs in the Americas and Asia-Pacific, $0.3 million pre-tax restructuring charge relating to accelerated depreciation and amortization of long-lived assets in the Americas and other transformation and deployment costs in SG&A of $1.9 million.

 

During the first quarter ended March 29, 2015, the Company recorded a $1.3 million pre-tax restructuring charge and liability relating to facility site clean-up costs at one of the affected locations in the Americas and other transformation and deployment costs in SG&A of $1.5 million.

 

During the fourth quarter and year ended December 31, 2014, the Company recorded a $15.2 million pre-tax charge relating to the program, consisting of goodwill impairment of $12.9 million, an indefinite-lived intangible asset impairment of $0.5 million, and other transformation and deployment costs of $1.8 million recorded in SG&A. The goodwill impairment charge was based on a quantitative assessment of the Asia-Pacific reporting unit goodwill performed as a result of it being more likely than not that the Asia-Pacific reporting unit’s third party and intersegment net sales would be significantly reduced as a result of the program.

 

The total pre-tax program costs incurred to date are $23.9 million, including restructuring costs of $5.3 million, goodwill and intangible asset impairments of $13.4 million and other transformation and deployment costs of $5.2 million.  The other transformation and deployment costs include consulting fees and other associated costs. The following table summarizes total expected, incurred and remaining pre-tax restructuring costs for the Company’s initial phase of the Americas and Asia-Pacific 2015 transformation program by type:

 

 

The following table summarizes total incurred, incurred to date and expected pre-tax restructuring costs by business segment for the Company’s initial phase of the Americas and Asia-Pacific 2015 transformation program:

 

 

Details of the restructuring reserve activity for the Company’s initial phase of the Americas and Asia-Pacific 2015 transformation program for the six months ended June 28, 2015 are as follows:

 

 

2013 Actions

 

On July 30, 2013, the Board of Directors authorized a restructuring program with respect to the Company’s EMEA segment to reduce its European manufacturing footprint, improve organizational and operational efficiency and better align costs with expected revenues in response to changing market conditions. Total pre-tax costs for the program were $8.4 million and were incurred from the third quarter of 2013 to the first quarter of 2015. The total charges for this program included costs for severance benefits, relocation, site clean-up, professional fees and certain asset write-downs. The total net after-tax charge for the restructuring program was approximately $5.9 million. The net after-tax charges incurred in the first six months of 2015 and 2014 were $0.4 million and $1.7 million, respectively.

 

Other Actions

 

The Company also periodically initiates other actions which are not part of a major program.  In the fourth quarter of 2014, management initiated certain restructuring actions and strategic initiatives with respect to the Company’s EMEA segment in response to the ongoing economic challenges in Europe and additional product rationalization. The restructuring actions primarily include expected severance benefits and limited costs relating to asset write offs, professional fees and relocation.  The total pre-tax charge for these restructuring initiatives is expected to be approximately $9.9 million, of which approximately $7.7 million were incurred as of June 28, 2015 for the program to date. The remaining expected costs relate to severance, asset write-offs and relocation costs and are expected to be completed by the end of the fourth quarter of fiscal 2016.  The restructuring reserve for these actions as of June 28, 2015 relates to the severance recorded in the prior year.

 

The following table summarizes total expected, incurred and remaining pre-tax restructuring costs for the EMEA 2014 restructuring actions:

 

 

Details of the Company’s EMEA 2014 restructuring reserve activity for the six months ended June 28, 2015 are as follows:

 

 

In 2014, the Company initiated restructuring activities in the Americas and Corporate to reduce costs through reductions-in-force.  Total pre-tax restructuring expense of $2.7 million was incurred in the first quarter of 2014 relating to these initiatives and the related restructuring reserves have been fully utilized.

 

6.Assets Held for Sale

 

Sale of Certain Americas Product lines

 

During the second quarter of 2015, the Company classified certain assets related to the Americas product lines being rationalized as part of the 2015 Actions referred to in Note 5, as assets held for sale.   The carrying amounts of the assets presented in the June 28, 2015 Consolidated Balance Sheet as assets held for sale relating to the 2015 Actions were as follows:

 

 

On July 29, 2015, the Company entered into a definitive agreement with Sioux Chief to sell the Company’s brass fittings, brass & tubular and vinyl tubing product lines and the associated held for sale assets in the Americas. The selling price will be approximately $35.5 million, and the transaction is expected to result in a minimal gain on sale.  The sale is expected to close by the end of the third quarter of 2015, and is subject to customary closing conditions.

 

Assets held for sale in the June 28, 2015 Consolidated Balance Sheet of $34.6 million also includes two buildings in EMEA with a combined carrying amount of $2.2 million.

 

7.Earnings per Share

 

The following tables set forth the reconciliation of the calculation of earnings per share:

 

 

Options to purchase 0.3 million shares of Class A common stock were outstanding during the second quarters of 2015 and 2014, respectively, but were not included in the computation of diluted EPS because to do so would be anti-dilutive.

 

 

Options to purchase 0.3 million shares of Class A common stock were outstanding during the first six months of 2015 and 2014, respectively, but were not included in the computation of diluted EPS because to do so would be anti-dilutive.

 

On April 30, 2013, the Company’s Board of Directors authorized the repurchase of up to $90 million of the Company’s Class A common stock from time to time on the open market or in privately negotiated transactions.  In connection with this repurchase program, the Company entered into a Rule 10b5-1 plan, which permits shares to be repurchased when the Company might otherwise be precluded from doing so under insider trading laws.  The repurchase program may be suspended or discontinued at any time, subject to the terms of the Rule 10b5-1 plan with respect to the repurchase program.  During the second quarter ended June 28, 2015, the Company repurchased approximately 185,000 shares of Class A common stock at a cost of approximately $10.1 million.  During the first six months of 2015, the Company repurchased approximately 349,000 shares of Class A common stock at a cost of approximately $19.5 million.  During the second quarter ended June 29, 2014, the Company repurchased approximately 186,000 shares of Class A common stock at a cost of approximately $10.6 million.  During the six months ended June 29, 2014, the Company repurchased approximately 347,000 shares of Class A common stock at a cost of approximately $20.0 million.  As of June 28, 2015, there was approximately $8 million remaining authorized for share repurchase under this program.

 

On July 27, 2015, the Company’s Board of Directors authorized the repurchase of up to $100 million of the Company’s Class A common stock from time to time on the open market or in privately negotiated transactions.  The timing and number of shares repurchased will be determined by the Company’s management based on its evaluation of market conditions and other factors.  Repurchases may also be made under a Rule 10b5-1 plan, which would permit shares to be repurchased when the Company might otherwise be precluded from doing so under insider trading laws.  The repurchase program may be suspended or discontinued at any time, subject to the terms of any Rule 10b5-1 plan the Company may enter into with respect to the repurchase program.  The Company plans to complete repurchases under the previously existing stock repurchase program before initiating any purchases under the new program.