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Good morning. My name is Mariama, and I will be your conference operator today. At this time, I would like to welcome everyone to the Watts Water Technologies First Quarter 2018 Earnings Conference Call. [Operator Instructions] I would now like to turn the call over to Tim MacPhee, Treasurer and VP Investor Relations. You may begin your conference.
Thank you, and good morning, everyone. Welcome to our First Quarter 2018 Earnings Conference Call. With me today is Bob Pagano, CEO and President. Bob will provide his perspective on our first quarter results, offer some color on the markets, discuss tariff implications and update you on the CFO search.
I will provide a detailed review of our first quarter results and revisit our full year outlook. 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 these slides throughout our prepared remarks. For purposes of today's call, all references to key performance metrics will be on an adjusted basis, unless otherwise indicated and non-GAAP financial information and metrics have been reconciled and are included in the appendix section of the presentation.
Before we begin, I'd like to remind everyone that during the course of this call, we will be making certain comments that constitute forward-looking statements. These statements are subject to numerous risks and uncertainties that could cause actual results to differ materially. For information concerning these risks and uncertainties, see Watts' 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.
Let me now turn the call over to Bob Pagano.
Thanks, Tim, and good morning, everyone. Please turn to Slide 3 and let me briefly provide a rundown of the first quarter.
We started 2018 on a strong note, delivering record Q1 sales, operating margin and EPS. Organic sales growth trended favorably with all regions contributing. We expanded adjusted operating margin by 50 basis points, and adjusted EPS increased by 26% in the quarter. Our operating financial performance is the result of executing on our strategy of delivering profitable top line growth and driving productivity and cost discipline in the organization, while continuing to invest for the future.
Regionally, sales growth was mainly in line with our internal expectations. The Americas had broad growth in a number of product lines, aided in part by favorable comps versus Q1 last year, especially in our boiler business. Europe delivered a solid top line, which was slightly above our forecast and was driven by Drains project timing. Asia-Pacific's growth was consistent with our internal forecast given the anticipated product rationalization headwind during the quarter. Tim will review the quarter's results in more detail in a few minutes.
The end-markets are performing in line with our expectations. In the Americas, much of the nonresidential construction data remains positive with anticipated tailwinds in certain key nonresidential verticals. Residential new construction data is a little lumpy, but repair and replacement indicators are healthy, and we believe in total, the residential market should continue to grow at a moderate pace for the year.
Europe continues to show signs of modest growth, although, some recent macrodata is signaling some softness. Asia-Pacific markets are growing at moderate levels. We continue to monitor the potential impact that tariff regulations may have on our input cost. We believe this issue mainly affects U.S. purchases. China-imposed tariffs are not currently impacting our products. In much of our intercompany activity into China is through Europe, which is not affected by the new regulations.
Regarding U.S. tariffs. There are many unknowns that require clarity, including a final resolution to steel and aluminum imports and the potential impact of sanctions on China-sourced products. So the tariff issue is very much in flux, and we will react accordingly to the final import regulations. We have already seen material inflation affect our input cost as a result of the tariff issue. In addition, transportation costs are rising due to oil cost increases and labor shortages. We've addressed these latest inflationary concerns by announcing price increases this week that we expect should cover the anticipated incremental cost. The price increases become effective in July.
Turning to our full year outlook. Given the Strong Americas' first quarter start and the recently announced price increases, we now expect that Americas' organic sales should grow at the higher-end of the range we previously provided. Further, we are reaffirming our original full year outlook for top line growth in Europe and Asia-Pacific, and reaffirming margin expansion in line with the assumptions we provided in February.
Finally, a few words on our CFO's transition. First, I'd like to thank Todd for his efforts over the past 3 years. He was a key member of our global leadership team, helping to drive our initiatives and serving as an important contact with the investment community. So we wish him the best. As noted in the March 30 press release, I have assumed the interim CFO role, while the outside search for Todd's successor is conducted. The search is well underway, and we hope to have a new CFO on board sometime in the third quarter.
Now I'll turn the call over to Tim to talk about our first quarter operating results in more detail. Tim?
Thanks, Bob. I am on Slide 4, which shows the first quarter's comparative results.
Sales of $379 million were up 9% on a reported basis in a first quarter record for Watts. Organically, sales were up 4% with growth in all regions. Foreign exchange, primarily driven by a stronger euro, increased year-over-year sales by roughly $17 million or 5%. Product rationalization, as expected, was approximately $2 million or a 60 basis points headwind in the quarter. Adjusted operating profit increased 14% to $44 million. Adjusted operating margin of 11.6% was up 50 basis points and represents a Q1 record. Volume, price and productivity more than offset $2 million of growth investment and inflationary pressures from commodities and transportation cost. Foreign exchange contributed about $2 million or 5% of the profit increase year-to-year. Adjusted EPS of $0.82 increased 26% over last year and was another first quarter record for Watts. The increase was driven by operational improvements of 11%, a favorable tax rate of 9% and favorable FX movements of 6% as compared to last year. The effective tax rate of 28.2% is about 500 basis points lower than Q1 last year and relates primarily to the benefits of tax reform.
Turning to cash. As you know, historically, Q1 is a slower period for cash flow, and that played out as expected. Our free cash outflow for the quarter was $33 million as compared to a $15 million outflow in Q1 last year. The majority of the incremental outflow relates to timing of working capital outlays, in particular inventory incentive payments. Important to note, while the first quarter is seasonally slow, we fully expect our cash generation to improve as the year progresses, and to achieve greater than 100% cash flow conversion for the year. During the quarter, we repatriated approximately $71 million in cash. The majority of that cash was used to pay down our line of credit. In addition, we purchased approximately 80,000 shares of our common stock at a cost of $6.2 million. In total, we returned approximately $13 million in Q1 to shareholders in the form of dividends and share repurchases as part of our balanced capital deployment strategy.
So overall, a good start to 2018. We delivered record sales, operating margin and EPS, and we continue to see organic sales growth trend positively.
Now turning to the Regions. On Slide 5, let's review the Americas results for the quarter. Sales were $241 million, up 5% on both the reported and organic basis. We saw a strong performance from our core plumbing well products like backflows, regulated and the relief valves. Heating and Hot Water solution sales increased low double digits during the quarter lead by AERCO boiler and aftermarket sales and some favorable comps. Adjusted operating profit was $36.4 million, up 8% over Q1 last year. Operating margin was 15.1%, a 40 basis point increase over last year driven by volume, price and productivity. Margin expansion was partially tempered by higher commodity costs, transportation cost, product mix and continued growth investments. It was a strong start for the Americas with growth in the number of key products and platforms.
Now on to Slide 6. Let's review Europe's results. Sales of $123 million were up 17% on a reported basis and up 2% organically. Foreign exchange positively affected sales by approximately $16 million or 15%. From a platform perspective, we had growth in both Drains and fluid solutions. Drains benefited from strong project sales into the hospital, industrial end-markets as well as stronger marine-based business sold into shipyards. Within Fluid solutions, the sales increase was driven by valve products, including backflows and check valves, offset partially by software electronic sales and known headwinds associated with product rationalization. Recall that we had expected Europe sales in Q1 to be at the low-end of our 1% to 3% full year growth range due to fewer shipping days. Stronger Drains sales driven by project timing helped to overdrive those expectations. Regionally, we saw solid growth in some of our key regions such as Scandinavia and Italy. France and Germany were flattish for the quarter driven by product rationalization plans and Drains project timing in Germany. We saw continued softness in the U.K. which was down double digits due to lower volumes, pricing pressures and a product line exit.
Adjusted operating profit for the quarter was $14.9 million, an increase of 18%, which includes a 15% foreign exchange tailwind. Operating margins of 12.1% increased slightly as compared to Q1 of last year. Margin expansion was driven by higher volume and productivity and was mostly offset by higher commodity cost, unfavorable product mix and incremental investments. We do expect Europe's margin expansion to improve as the year progresses.
Moving to Slide 7, let's review Asia-Pacific's results. Sales were just over $14 million in the quarter, up 6% on a reported basis, and up 3% organically over the same period last year. Excluding product rationalization, organic sales increased 8%. Sales outside of China, which represents over 7% of Asia-Pacific sales in the quarter, increased organically by 11%. The increase was driven by strength in New Zealand, the Middle East and Korea due to higher demand for our plumbing and HVAC products. China sales, excluding product rationalization, were up 1% as continued demand for our commercial valves sold into data centers and semiconductor markets, was mostly offset by softness in underfloor Heating products. Adjusted operating profit was $1.4 million in Q1, which translates to adjusted operating margin of 9.4%. The key drivers of the margin expansion were higher third-party volume, product and country mix and cost-saving, partially offset by commodities, lower affiliate sales and investments. As expected, a little bit of a slow start to the year for Asia-Pacific. We think it is more timing than anything else, as growth should accelerate in the out quarters.
Now just a quick update on our full year outlook. Slide 8 provides the details, and I will highlight a few points. As Bob discussed, our common assumptions are pretty much aligned with the original outlook we provided in February, except that we now expect Americas' organic sales growth should be at the higher-end of 3% to 5% growth range. Sales in the other regions are falling in line with our previous outlook. We expect operating margins should grow between 50 and 70 basis points, which includes incremental investments to support future growth initiatives. I'd like to point out that we are currently maintaining our full year effective tax rate at approximately 28%. However, the rate in Q1 was a little bit higher at 28.2%. We may have to adjust the rate in the future based on further analysis as additional information and guidance on the new regulations become available.
And as I just mentioned, we anticipate free cash flow for the year converting at or above 100% of net income. Before I turn the call back over to Bob, a few items to keep in mind regarding the second quarter. We're expecting consolidated organic growth in the second quarter to be in line with our full year expectation. Product rationalization should approximate $2.5 million in Q2, $1.5 million in Europe and $1 million in Asia-Pacific.
We expect incremental investments of $3 million to $4 million in Q2, approximately $2 million in Americas, $1 million in Europe and approximately $500,000 in Asia-PAC. The investments will be partially offset by approximately $1 million in incremental restructuring savings, about $500,000 each in the Americas and Europe. Consolidated operating margin in Q2 should grow in line with our full year expectations. Finally, foreign exchange may also be a tailwind when compared to Q2 last year given the current euro-dollar exchange rate. So with that, let me turn the call over to Bob before we begin Q&A. Bob?
Thanks, Tim. I'd like to summarize before we address your questions. The year started out on a positive note. We delivered Q1 record results in sales, operating margin and adjusted EPS, and we continued to seed plant for the future. We are also proactively addressing inflationary concerns. Overall, we expect to make sustained progress and look forward to another solid year of profitable growth.
So with that, operator, please open the line for questions.
[Operator Instructions] Your first question comes from Nathan Jones with Stifel.
Bob, I'd just like to start off talking a little bit about price cost, given all of the inflation that's out there in the market at the moment. You said you've announced price increases, implemented it at the start of 3Q. Does that mean that maybe you're a little bit behind on price cost in the first half of the year, you catch up in the second half of the year and margins expanded kind of in line with what you were looking for in the first quarter? Did you make that up somewhere else? Just any color you can give us around that.
Sure, Nathan. We believe we've been ahead of the curve. And as you know, we announced the price increase in fourth quarter of last year. And we've been staying on top of it. As we see the inflationary pressures continuing to mount, we believe we'll continue to be ahead of the game. So net-net, it's been positive for us through Q1. And we expect that to be -- continue to be positive for the rest of the year.
You also had commented in the press release and a little bit in Tim's comments there that you had a negative impact for mix in the quarter. Any color you can give us on that? And expectations of how mix plays out in 2Q and beyond?
Yes, so I think, overall, mix will play out fine as we go through the year. There's a couple of mix issues we had during the quarter. Number one, in Europe. Drains was better than we expected. We had a project we thought was going to ship in Q2. It shipped in Q1. And it was more in, what we call the Marine business, which is -- it's project related and it was lower margin than normal. So that should even itself out in Q2. In the North America side, we talked about mix also, and that was really we had some nice retail growth in North America with some small wins in stocking levels in the first quarter. Again, that should smooth itself out into the second quarter. So again small mix issues, but not a significant impact, probably 10 or 20 basis points plus or minus, so in the quarter. But that should clean itself up as we go into the second and third quarter.
Okay. Then just on cash flow. It was a little worse seasonally than it usually is. It doesn't sound like you guys think that's any more than timing. Can you just talk about when we get that back, and any expectations you have for growth may be inhibiting cash flow a little bit this year or anything like that?
Yes. Well, certainly it was a little less than last year. But as we look at it progressing through the year, we still believe we'll convert at 100% of net income. Certainly, with growth we'll have some working capital concerns here. But again, we believe we'll mitigate that through our operational excellence initiatives. So I think it's a timing issue. Some of it's ramp-up for some growth initiatives that we have, and we want to get in front of the curve on this. And given tariffs and future inflation, we felt it was better to be in front of this with our inventory than behind it. So net-net, it will smooth itself out probably by the third quarter, we should be back in alignment with where we normally are.
Okay. So a little bit of buying ahead of anticipated price increases from you there?
A little bit. It's -- a lot of little pieces here, Nathan. It's not overall one thing, it's between growth initiatives, some maybe pre-buys, some normal timing. You had Good Friday. I mean there's just a lot of moving pieces here, but nothing that we're worried about.
Your next question comes from Ryan Connors with Boenning and Scattergood.
Tim, you might have addressed this. But I apologize if I missed it. But the 4% organic growth. Did you give a breakdown of the proportion of that from volume versus the price increases that you've already achieved there?
We didn't -- this is Bob. We didn't give that detail. But we had about 1 percentage point of price in the quarter. So the rest was normal growth.
Okay. Got it. Okay. That's good. And then my other one. You called out water quality as a tailwind in the Americas. Is that the residential water treatment business, the premier business, or is it that something else? What exactly is that product line?
Yes, I think -- yes, that's exactly what it is. It's on the residential side. We had some nice wins in the quarter, and again that business is lumpy. So -- but a good early start with the team.
Got it. Got it. And then last one from me. Just on the capital deployment side. You mentioned the buyback dividends, it seems like there's a bit of a shift there towards returning cash to shareholders. Is that a -- should we read into that the -- I mean, you don't like what you see in the M&A side, whether it be from valuation or just the stuff that you're seeing, or is that really too much in that. How do you see the M&A pipeline?
Yes, I think it's reading a little bit into that. I mean I think our dividends and share repurchases have been consistent. We believe in a overall balance capital deployment model. Certainly, we continue to look in the M&A pipeline and cultivate potential acquisitions, but as you said, there are some higher multiples out there. We're going to be disciplined and do the right thing for our shareholders.
Your next question comes from Jeff Hammond with KeyBanc Capital Markets.
This is Brad filling in for Jeff. Just in Americas, look like some nice growth there. Could you just provide maybe a bit more detail on the growth investments? And update any impact on the first quarter? And if not, when you expect to see some yield there?
Yes, I mean our growth investments definitely had an impact in the quarter and for the whole company. We continue to invest in new products. Certainly, they do cannibalize existing products in some regards. But between our geographical expansion and our strategic accounts and our new product initiatives, we're seeing the impact on our growth, and you're seeing the impact with our results. This is the largest growth we've had since my tenure here in 4 years, and we're starting to see the impact of many of the initiatives that we started over 4 years ago as we look to continue to upgrade our products and rationalize them and continue to invest for the future.
Okay. Great. And then just on -- back on price cost. Seems like pushing through a mid-year increase. What's your confidence around the market's ability to absorb that based on what you're seeing so far from the increase back in 4Q?
Yes, I think everybody understands inflation, in particular with the transportation cost, everybody is seeing it. And I believe the market is anticipating it. We've read about many companies in our industry and outside of our industry doing the same thing. So we're going to be in front of the curve on this. We're going to be aggressive, and we believe it's the right thing to do given the cost inflation that's out there.
Your next question comes from Brian Lee with Goldman Sachs.
Maybe first off, it could just be rounding or conservatism, but if we assume the Americas division grows at the 5% organic rate through the rest of the year, then it seems like 4% organic in 2018 on a consolidated basis versus the 3% that you're sticking with is pretty achievable, how would you characterize that read?
Well, when you look at it, our full year guidance is 3% to 5%. And I think in my stated comments that we're moving towards the higher-end of that range. So again, I think it's too early in the first quarter to change the range given all the geopolitical things that are going on. But we certainly are cautiously optimistic and believe we'll be at the higher-end of that range. So again, too early to change all the numbers, but we're, like I said, feeling cautiously optimistic.
Okay. Fair enough. Second question from me and then I'll pass it on is, on the Heating and Hot Water side, good growth there in the quarter. I know you mentioned it was easier comps. Can you discern a bit between how much of it was easier comps? And then just the underlying trends improving, maybe if you could speak to what you're seeing there, and also with respect to pricing dynamics which I know have been an issue for that segment in the past?
Yes. So first of all, it's very competitive in that marketplace. But what we are seeing is our backlogs are strong and it was easier comps, but we're also seeing the growth in the market. So even net of that, it was very positive. So again, the AERCO team is doing a good job. Our new products and the things we're doing are -- we feel good about. So overall, very positive, and with the backlog and what we're seeing in the market, we feel good about it.
Your next question comes from Joe Giordano with Cowen.
This is Tristan in for Joe. Can you maybe address what you're currently seeing in the Chinese housing and in commercial markets? And how do you expect this to evolve during the rest of the year?
Yes. So the Chinese housing market, there's been a shift in the marketplace. In the past, consumers would fit out their apartments and put in their underfloor heating, et cetera. And that would -- really was strong in the retail channel. Based on new guidelines and recommendations, that now is moving to more of a project-base and the condominiums are fitted out by the developer. So less of a retail play and more of a, let's call it, a commercial builder play. So that shift is, as you can imagine, is becoming much more competitive. And pricing and is less about the retail side. So we're seeing a shift there, that's going to be probably impact us. But the Chinese market is a big market in many areas. We're doing good on our valve side, and in particular within the data center space as well as the chip manufacturer. So again, it's a shift in the marketplace. We'll be watching it. And we'll look at moving more outside of that space because of the competitive nature of it. We're still playing it, but we're going to continue to grow in another areas.
That's helpful. And then, I believe you mentioned in the past that Drains are a leading indicator for you for commercial growth. Is that what you're seeing in Europe currently?
We are. The -- again, the European market with our specialty Drains, BLÜCHER, which are stainless steel drains, we've seen a nice pick up there. A lot of it is based on our strategic account focus as well as our focus overall. So we do see, that is a leading indicator. I would say it's more for a leading indicator in North America. I believe we're gaining share in Europe.
So and one last quick one, if I can. What percentage of your PVI sales are international at this point?
It's a very low number. It's a very low number, but it's also an opportunity for us. The increased freight cost always is difficult when you look at PVI because you're shipping big components with a lot of air in them, I would say. So the cost of transportation is a key part of that. However, we believe we have one of the best commercial boilers in the marketplace, or in water heaters. So both of those -- you do have some companies that want to pay that extra amount for that. So -- but again, it's a small percentage and growing. We've had some wins in Latin America, which is a little closer to us. But we believe it's an opportunity for continued growth.
There are no further questions at this time. I will now turn the call back over to Bob Pagano for final comments.
Well, thanks everyone for joining us today. We look forward to speaking with you on our Q2 results in early August. Thank you very much.
This concludes today's conference call. You may now disconnect.