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Get Four
|  | APRIL 19, 2005
 FOCUS STOCK By Stewart Scharf At Watts, the Cup Runneth OverStrong demand for purer H2O and the desire to prevent its waste add up to an S&P rating of 5 STARS for Watts Water TechnologiesWith a growing population and limited water supplies, demand for quality water is growing worldwide (see BW Online, 4/18/05, "Now That's a Liquid Investment"). And we at Standard & Poor's Equity Research think Watts Water Technologies (WTS; recent price, $31) is one company poised to benefit from that trend. In light of Watts's focus on developing new products that meet plumbing-code standards and controlling costs via manufacturing overseas, we view the long-term prospects as favorable and have a 5-STARS (strong buy) recommendation on the shares. We base the recommendation on our view of Watts's attractive market fundamentals, low-cost manufacturing strategy, leading brands in growth categories, new product development, diversified business model, and favorable valuation. Our valuation analysis suggests that Watts is trading at a discount to its intrinsic value, as well as to its closest peers. EXPAND AND ACQUIRE. The company, which changed its name from Watts Industries in October, 2003, supplies plumbing, heating, and water products. Its revenue is split evenly between the residential and commercial markets. Sales in North America account for more than 66% of Watts's total, with Europe representing nearly 31%, and Asia about 3%. The company's 10 largest customers represent about 24% of sales, including about 10% from Home Depot (HD ). Watts's long-term growth strategy emphasizes development of new valve products and related products through diversification of its existing business and strategic acquisitions in related business segments, both in the U.S. and abroad. It plans to expand and complement its core plumbing and heating businesses and its water-quality business through niche acquisitions that would add to its earnings in the first year. In our view, Watts may seek larger acquisitions in future years (companies with revenues in the neighborhood of $30 million, rather than those worth $10 million or less). HOT STUFF. The company's objectives include extending its brand preference with contractors and distributors to include more full-line product offerings and further developing products and services for the home-improvement retail market. We expect Watts to benefit from further strength in its retail markets and a recovering wholesale business, as it continues to focus on new water-related filtration products to complement its comprehensive line of plumbing products and heating and water valve products. New products introduced in the North American home-improvement market in 2004 include a hot water recirculating pump, which conserves water by immediately providing hot water at the tap, and a line of pre-soldered copper fittings that reduce installation time on copper piping systems. PURE AND SIMPLE. Watts also manufactures hydronic radiant heating systems, which continue to gain popularity as customers seek more efficient energy sources. Watts believes that, in the U.S., these systems have grown at an annualized rate of more than 15% over the last 10 years. Another line of products, for water purification, range from undersink residential systems to high-volume commercial systems. And because municipalities are continuing to raise water prices due to a limited supply, Watts offers water-pressure regulators to conserve water. We expect that population growth and demand for quality water will largely generate stronger sales of these products. According to industry sources, demand for purified water is increasing at three times the rate of population growth. Additionally, the supply of water is fixed, with less than 1% of surface water available for consumption. Other positive trends, in our opinion, are the increase in requirements for water conservation, an aging U.S. water infrastructure system, and growing concerns about water safety. OVERSEAS SALES. Watts, we believe, will continue to seek acquisitions that fit within its strategy of either adding value through new technology or increasing market share. It seeks a return on investment (ROI) in the mid-teens percentage within two years of the acquisition. We expect Watts to capitalize on industry consolidation, especially of North American wholesale distributors, growth in the do-it-yourself market, and an increase in imports (as it focuses on low-cost manufacturing facilities overseas). Watts has a strong balance sheet, in our view, with net debt-to-capital of 19% at yearend 2004 and $66 million in cash. During 2004, it entered into a five-year, $300 million credit facility with $218 million of capacity available at yearend 2004. However, we believe the company would be comfortable with net debt-to-capital of around 30% should it make significant acquisitions, which may result in Watts seeking external sources of financing. GUSHING DIVIDENDS. Our forecast calls for free cash flow to increase modestly from some $12 million in 2004, as Watts focuses on managing its working capital. Free cash flow fell from $27 million in 2003 due to increased inventories and accounts receivables. The company generated $36 million in free cash in the 2004 fourth quarter, mainly due to improved working capital as well as reduced inventory levels and accounts receivable. The quarterly dividend was boosted by 14% in February, 2005. We project capital expenditures for 2005 to be in line with 2004's $21 million. We expect the purchase price for future acquisitions to be on a par with the company's historical record, ranging from four to five times earnings before interest, taxes, depreciation, and amortization, or EBITDA. This is in line with industry acquisition multiples. PROFIT IN CHINA. Fourth-quarter 2004 sales advanced 18%, year-to-year -- mainly reflecting strength in North America and Europe, as well as in China -- with 10% internal growth, 5% from acquisitions, and 3% from foreign-exchange gains due to the strong euro. Watts intentionally brought volumes down due to inventory concerns, as it dealt with absorption issues. Revenues in Europe were aided primarily by favorable currency exchange rates and an acquisition, as progress in the German wholesale business offset further softness in the wholesale market in Italy and France. The company's plants in China continue to improve manufacturing efficiencies and increase capacity utilization, which led to a profit in the Chinese operations for the third straight quarter. Product-mix issues -- and inventory reduction costs -- negatively affected gross margins, with lower-margin retail volume outpacing growth in wholesale. Per-share earnings came in at $0.38 (one penny below our estimate), before 8 cents of charges, vs. 36 cents one year earlier before a 2-cent charge. We expect Watts to report 2005 first-quarter results in early May.
BW MALL
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