UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

 

FORM 10-Q

 

ý

Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

For the quarterly period ended March 28, 2004

 

or

 

o

Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

For the transition period from                      to                          

 

Commission file number 1-11499

 

WATTS WATER TECHNOLOGIES, INC.

 (Exact name of registrant as specified in its charter)

 

 

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes ý  No o

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes ý  No o

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

 

 

WATTS WATER TECHNOLOGIES, INC. AND SUBSIDIARIES

 

INDEX

 

Part I.  Financial Information
	Item 1.  Financial Statements
		Consolidated Balance Sheets at March 28, 2004 and December 31, 2003 (unaudited)
		Consolidated Statements of Income for the First Quarter Ended March 28, 2004 and March 30, 2003 (unaudited)
		Consolidated Statements of Cash Flows for the First Quarter Ended March 28, 2004 and March 30, 2003 (unaudited)
		Notes to Consolidated Financial Statements
	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations
	Item 3.	Quantitative and Qualitative Disclosures About Market Risk
	Item 4.	Controls and Procedures
Part II.  Other Information
	Item 1.	Legal Proceedings
	Item 6.	Exhibits and Reports on Form 8-K
	Signatures
	Exhibit Index

 

 

PART I. FINANCIAL INFORMATION

 

ITEM 1. FINANCIAL STATEMENTS

 

WATTS WATER TECHNOLOGIES, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(Amounts in thousands, except share information)

(Unaudited)

 

		March 28, 2004			December 31, 2003
ASSETS
CURRENT ASSETS:
Cash and cash equivalents		$	120,552		$	149,361
Trade accounts receivable, less allowance for doubtful accounts of $7,988 at March 28, 2004 and $7,772 at December 31, 2003		153,884			136,064
Inventories, net:
Raw materials		43,595			41,998
Work in process		24,142			24,348
Finished goods		105,469			90,253
Total Inventories		173,206			156,599
Prepaid expenses and other assets		13,818			8,500
Deferred income taxes		23,320			23,552
Assets held for sale		1,872			1,938
Assets of discontinued operations		4,050			4,460
Total Current Assets		490,702			480,474
PROPERTY, PLANT AND EQUIPMENT:
Property, plant and equipment, at cost		289,306			284,250
Accumulated depreciation		(145,694		)	(138,539		)
Property, plant and equipment, net		143,612			145,711
OTHER ASSETS:
Goodwill		188,870			184,901
Other		31,928			27,557
TOTAL ASSETS		$	855,112		$	838,643
LIABILITIES AND STOCKHOLDERS’ EQUITY CURRENT LIABILITIES:
Accounts payable		$	75,914		$	74,068
Accrued expenses and other liabilities		63,210			55,252
Accrued compensation and benefits		16,976			18,466
Current portion of long-term debt		60,640			13,251
Liabilities of discontinued operations		11,771			11,302
Total Current Liabilities		228,511			172,339
LONG-TERM DEBT, NET OF CURRENT PORTION		135,073			179,061
DEFERRED INCOME TAXES		15,384			15,978
OTHER NONCURRENT LIABILITIES		24,720			25,588
MINORITY INTEREST		9,461			9,286
STOCKHOLDERS’ EQUITY:
Preferred Stock, $.10 par value; 5,000,000 shares authorized; no shares issued or outstanding		—			—
Class A Common Stock, $.10 par value; 80,000,000 shares authorized; 1 vote per share; issued and outstanding: 24,789,410 shares at March 28, 2004 and 24,459,121 shares at December 31, 2003		2,479			2,446
Class B Common Stock, $.10 par value; 25,000,000 shares authorized; 10 votes per share; issued and outstanding: 7,471,700 shares at March 28, 2004 and 7,605,224 shares at December 31, 2003		747			761
Additional paid-in capital		135,603			132,983
Retained earnings		295,123			286,396
Accumulated other comprehensive income		8,011			13,805
Total Stockholders’ Equity		441,963			436,391
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY		$	855,112		$	838,643

 

See accompanying notes to consolidated financial statements.

 

3

 

WATTS WATER TECHNOLOGIES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(Amounts in thousands, except per share information)

(Unaudited)

 

		First Quarter Ended
		March 28, 2004			March 30, 2003
Net sales		$	190,646		$	165,692
Cost of goods sold		124,831			109,928
GROSS PROFIT		65,815			55,764
Selling, general & administrative expenses		45,981			39,854
OPERATING INCOME		19,834			15,910
Other (income) expense:
Interest income		(282		)	(115		)
Interest expense		2,569			2,084
Minority interest		223			(21		)
Other		(248		)	(62		)
		2,262			1,886
INCOME FROM CONTINUING OPERATIONS BEFORE INCOME TAXES		17,572			14,024
Provision for income taxes		6,548			5,088
INCOME FROM CONTINUING OPERATIONS		11,024			8,936
Loss from discontinued operations, net of taxes of $14 and $1,455		(23		)	(2,326		)
NET INCOME		$	11,001		$	6,610
BASIC EPS
Income (loss) per share:
Continuing operations		$	.34		$	.33
Discontinued operations		—			(.09		)
NET INCOME		$	.34		$	.24
Weighted average number of shares		32,136			27,065
DILUTED EPS
Income (loss) per share:
Continuing operations		$	.34		$	.33
Discontinued operations		—			(.09		)
NET INCOME		$	.34		$	.24
Weighted average number of shares		32,549			27,264
Dividends per share		$	.07		$	.06

 

See accompanying notes to consolidated financial statements.

 

4

 

WATTS WATER TECHNOLOGIES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Amounts in thousands)

(Unaudited)

 

		First Quarter Ended
		March 28, 2004			March 30, 2003
OPERATING ACTIVITIES
Income from continuing operations		$	11,024		$	8,936
Adjustments to reconcile net income from continuing operations to net cash provided by continuing operating activities:
Depreciation		6,955			5,516
Amortization		139			186
Deferred income taxes		(348		)	(240		)
Other		4			(18		)
Changes in operating assets and liabilities, net of effects from business acquisitions and divestitures:
Accounts receivable		(19,012		)	(10,567		)
Inventories		(16,778		)	(8,259		)
Prepaid expenses and other assets		(5,453		)	(3,400		)
Accounts payable, accrued expenses and other liabilities		9,131			(2,884		)
Net cash used in operating activities		(14,338		)	(10,730		)
INVESTING ACTIVITIES
Additions to property, plant and equipment		(4,946		)	(5,047		)
Proceeds from the sale of property, plant and equipment		1,522			115
Increase in other assets		(155		)	(370		)
Business acquisitions, net of cash acquired		(16,707		)	—
Net cash used in investing activities		(20,286		)	(5,302		)
FINANCING ACTIVITIES
Proceeds from long-term borrowings		10,699			49,002
Payments of long-term debt		(5,613		)	(27,315		)
Proceeds from exercise of stock options		2,639			1,210
Dividends		(2,274		)	(1,648		)
Net cash provided by financing activities		5,451			21,249
Effect of exchange rate changes on cash and cash equivalents		(491		)	324
Net cash provided by (used in) discontinued operations		855			(839		)
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS		(28,809		)	4,702
Cash and cash equivalents at beginning of period		149,361			10,973
CASH AND CASH EQUIVALENTS AT END OF PERIOD		$	120,552		$	15,675
NON CASH INVESTING AND FINANCING ACTIVITIES
Acquisition of businesses:
Fair value of assets acquired		$	17,727		$	—
Cash paid, net of cash acquired		16,707			—
Liabilities assumed		$	1,020		$	—
CASH PAID FOR
Interest		$	712		$	1,174
Taxes		$	1,976		$	1,417

 

See accompanying notes to consolidated financial statements.

 

5

 

WATTS WATER TECHNOLOGIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

 

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, are considered necessary for a fair presentation of Watts Water Technologies, Inc.’s Consolidated Balance Sheet as of March 28, 2004, its Consolidated Statements of Income for the first quarter ended March 28, 2004 and the first quarter ended March 30, 2003, and its Consolidated Statements of Cash Flows for the first quarter ended March 28, 2004 and the first quarter ended March 30, 2003.

 

The balance sheet at December 31, 2003 has been derived from the audited 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 fiscal year ended December 31, 2003. It is suggested that the financial statements included in this report be read in conjunction with the financial statements and notes included in the December 31, 2003 Annual Report on Form 10-K. Operating results for the interim period presented are not necessarily indicative of the results to be expected for the year ending December 31, 2004.

 

The Company operates on a 52-week fiscal year ending on December 31.  Any first quarter ended data contained in this Report on Form 10-Q reflects the results of operations for the 13-week period ended on the Sunday nearest March 31 of the respective year.

 

Certain amounts in fiscal year 2003 have been reclassified to permit comparison with the 2004 presentation. These reclassifications had no effect on reported results of operations or stockholders’ equity.

 

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

 

The changes in the carrying amount of goodwill by geographic segments from December 31, 2003 to March 28, 2004 are as follows:

 

 

6

 

Other intangible assets include the following and are presented in “Other Assets: Other”, in the March 28, 2004 Consolidated Balance Sheet:

 

 

Aggregate amortization expense for amortized other intangible assets for the first quarter of 2004 and 2003 were $139,000 and $186,000, respectively. Additionally, future amortization expense on other intangible assets will be approximately $413,000 for the remainder of 2004, $549,000 for 2005, $511,000 for 2006 and 2007 and $489,000 for 2008.

 

Stock Based Compensation

 

The Company accounts for stock based compensation in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB No. 25), and related interpretations. The Company records stock based compensation expense associated with its Management Stock Purchase Plan due to the discount from market price. Stock-based compensation expense is amortized to expense on a straight-line basis over the vesting period. The following table illustrates the effect on reported net income and earnings per common share if the Company had applied the fair value method to measure stock-based compensation as required under the disclosure provisions of Financial Accounting Standards Board No. 123, “Accounting for Stock-Based Compensation” (FAS 123) as amended by Financial Accounting Standards Board No. 148 “Accounting for Stock-Based Compensation Transition and Disclosure” (FAS 148).

 

 

7

 

Shipping and Handling

 

The Company’s shipping costs included in selling, general and administrative expense were $5,989,000 and $5,060,000 for the first quarter of 2004 and 2003, respectively.

 

Research and Development

 

Research and development costs included in selling, general, and administrative expense were $2,361,000, and $2,720,000 for the first quarter of 2004 and 2003, respectively.

 

New Accounting Standards

 

In December 2003, the Financial Accounting Standards Board (FASB) issued Financial Accounting Standards Board Statement No. 132 revised 2003, “Employers’ Disclosures about Pensions and Other Postretirement Benefits” (FAS 132R). This standard increases the existing disclosure requirements by requiring more details about pension plan assets, benefit obligations, cash flows, benefit costs and related information. Companies will be required to segregate plan assets by category, such as debt, equity and real estate, and to provide certain expected rates of return and other informational disclosures. FAS 132(R) also requires companies to disclose various elements of pension and postretirement benefit costs in interim-period financial statements for quarters beginning after December 15, 2003. The Company adopted the additional interim disclosure provisions of FAS 132(R) effective January 1, 2004.

 

3.                                      Discontinued Operations

 

In September 1996, the Company divested its Municipal Water Group businesses, which included Henry Pratt, James Jones Company and Edward Barber and Company Ltd.  Costs and expenses related to the Municipal Water Group for 2004 and 2003 relate to legal and settlement costs associated with the James Jones Litigation.

 

Condensed operating statements and balance sheets for discontinued operations is summarized below:

 

		First Quarter Ended
		March 28, 2004			March 30, 2003
		(in thousands)
Net sales		$	—		$	—
Cost and expenses
Municipal Water Group		(37		)	(3,781		)
Loss before income taxes		(37		)	(3,781		)
Income tax benefit		14			1,455
Loss from discontinued operations, net of taxes		$	(23	)	$	(2,326	)

 

		March 28, 2004
		(in thousands)
Prepaid expenses and other assets		$	285
Deferred income taxes		3,765
Assets of discontinued operations		$	4,050
Accrued expenses and other liabilities		$	11,771
Liabilities of discontinued operations		$	11,771

 

8

 

4.                                      Derivative Instruments

 

The Company uses foreign currency forward exchange contracts to reduce the impact of currency fluctuations on certain anticipated intercompany purchase transactions that are expected to occur within the year and certain other foreign currency transactions. Related gains and losses are recognized in other income/expense when the contracts expire, which is in the same period as the underlying foreign currency denominated transaction. 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. At March 28, 2004, the Company had no outstanding forward contracts to buy foreign currencies. For the first quarter of 2003, the Company recorded $221,000 in other comprehensive income for the change in the fair value of the contracts.

 

The Company occasionally uses commodity futures contracts to fix the price on a certain portion of certain raw materials used in the manufacturing process. These contracts highly correlate to the actual purchases of the commodity and the contract values are reflected in the cost of the commodity as it is actually purchased. At March 28, 2004 and March 30, 2003 the Company had no commodity contracts.

 

5.                                      Restructuring

 

The Company continues to implement a plan to consolidate several of its manufacturing plants both in North America and Europe. At the same time it is expanding its manufacturing capacity in China and other low cost areas of the world.  In the first quarter of 2004, the Company recorded a pre-tax charge of approximately $1,177,000 compared to $446,000 in the first quarter of 2003. These pre-tax costs were recorded in costs of goods sold in both quarters. The costs incurred for the first quarter of 2004 were for accelerated depreciation for both the expected closure of a U.S. manufacturing plant and a reduction in the estimated useful lives of certain manufacturing equipment.  The Company also essentially completed its severance payments related to the 2003 manufacturing restructuring plan during the first quarter of 2004.

 

6.                                      Earnings per Share

 

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

 

		For the First Quarter Ended March 28, 2004
		Income (Numerator)			Shares (Denominator)		Per Share Amount
		(Amounts in thousands, expect share and per share amounts)
Basic EPS
Income from continuing operations		$	11,024		32,135,544		$	0.34
Loss from discontinued operations		(23		)			—
Net income		$	11,001				$	0.34
Effect of dilutive securities
Common stock equivalents					413,135
Diluted EPS
Income from continuing operations		$	11,024				$	0.34
Loss from discontinued operations		(23		)			—
Net income		$	11,001		32,548,679		$	0.34

 

9

 

		For the First Quarter Ended March 30, 2003
		Income (Numerator)			Shares (Denominator)		Per Share Amount
		(Amounts in thousands, expect share and per share amounts)
Basic EPS
Income from continuing operations		$	8,936		27,065,478		$	0.33
Loss from discontinued operations		(2,326		)			(0.09		)
Net income		$	6,610				$	0.24
Effect of dilutive securities
Common stock equivalents					198,781
Diluted EPS
Income from continuing operations		$	8,936				$	0.33
Loss from discontinued operations		(2,326		)			(0.09		)
Net income		$	6,610		27,264,259		$	0.24

 

Stock options to purchase 941,660 shares of common stock were outstanding at March 30, 2003, but were not included in the computation of diluted earnings per share for the first quarter of 2003 because the options’ exercise price was greater than the average market price of the common shares and therefore, the effect would have been antidilutive.

 

7.                                      Segment Information

 

Under the criteria set forth in Financial Accounting Standards Board No.131 “Disclosure about Segments of an Enterprise and Related 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. 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 our significant accounts and balances by segment, reconciled to our consolidated totals:

 

		North America			Europe			China			Corporate(*)			Consolidated
		(in thousands)
Quarter ended March 28, 2004
Net sales		$	125,620		$	60,033		$	4,993		$	—		$	190,646
Operating income (loss)		16,490			7,445			(458		)	(3,643		)	19,834
Identifiable assets		515,793			271,041			68,278			—			855,112
Long-lived assets		71,917			46,751			24,944			—			143,612
Intangibles		17,513			140			3,000			—			20,653
Capital expenditures		1,793			1,713			1,440			—			4,946
Depreciation and amortization		4,114			2,258			722			—			7,094
Quarter ended March 30, 2003
Net sales		$	112,955		$	48,669		$	4,068		$	—		$	165,692
Operating income (loss)		15,162			4,860			(483		)	(3,629		)	15,910
Identifiable assets		387,870			222,661			56,443			—			666,974
Long-lived assets		77,115			39,988			18,183			—			135,286
Intangibles		13,940			167			3,291			—			17,398
Capital expenditures		1,496			607			2,944			—			5,047
Depreciation and amortization		3,243			2,074			385			—			5,702

 

The above operating segments are presented on a basis consistent with the presentation included in the

 

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Company’s December 31, 2003 financial statements included in the Annual Report on Form 10-K.

 

*Corporate expenses are primarily for compensation expense, professional fees, including legal and audit expenses 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 North American segment consists of U.S. net sales of $117,362,000 and $106,065,000 for the first quarter of 2004 and 2003, respectively. The North American segment also consists of U.S. long-lived assets of $67,152,000 and $72,418,000 at March 28, 2004 and March 30, 2003, respectively.

 

8.                                      Other Comprehensive Income (Loss)

 

Other comprehensive income (loss) consist of the following:

 

		Foreign Currency Translation			Pension Adjustment			Cash Flow Hedges			Accumulated Other Comprehensive Income (Loss)
		(in thousands)
Balance December 31, 2003		$	19,588		$	(5,829	)	$	46		$	13,805
Change in period		(5,585		)	—			(209		)	(5,794		)
Balance March 28, 2004		$	14,003		$	(5,829	)	$	(163	)	$	8,011
Balance December 31, 2002		$	(7,806	)	$	(3,988	)	$	—		$	(11,794	)
Change in period		3,533			—			(221		)	3,312
Balance March 30, 2003		$	(4,273	)	$	(3,988	)	$	(221	)	$	(8,482	)

 

Accumulated other comprehensive income (loss) in the Consolidated Balance Sheets as of March 28, 2004 and March 30, 2003 consists of cumulative translation adjustments and changes in the fair value of certain financial instruments that qualify for hedge accounting as required by FAS 133.  The Company’s total comprehensive income was as follows:

 

 

9.                                      Acquisitions

 

On January 5, 2004, a wholly-owned subsidiary of the Company acquired substantially all of the assets of Flowmatic Systems, Inc. (Flowmatic) located in Dunnellon, Florida, for approximately $16,700,000 in cash.  During the first quarter of 2004, the Company obtained a third-party valuation to allocate the purchase price consistent with the guidelines of Financial Accounting Standards Board Statement No. 141, “Business Combinations” (FAS 141). The preliminary allocation for goodwill was approximately $6,700,000 and approximately $4,000,000 was for intangibles. Flowmatic designs and distributes a complete line of high quality reverse osmosis components and filtration equipment. Their product line includes stainless steel and plastic housings, filter cartridges, storage tanks, control valves, as well as complete reverse osmosis systems for residential and commercial applications.

 

The acquisition above has been accounted for utilizing the purchase method of accounting.  The pro-forma results have not been displayed, as the results are not significant.

 

11

 

10.                               Debt Issuance

 

On February 28, 2002, the Company entered into a revolving credit facility with a syndicate of banks (as amended, the Revolving Credit Facility).  Outstanding indebtedness under the Revolving Credit Facility bears interest at one of three customary rates plus a margin of 100 basis points, depending on the applicable base rate and the Company’s bond rating. The average interest rate for borrowings under the Revolving Credit Facility was approximately 2.8% at March 28, 2004.  The Revolving Credit Facility includes operational and financial covenants customary for facilities of this type, including, among others, restrictions on additional indebtedness, liens and investments and maintenance of certain leverage ratios. As of March 28, 2004, the Company was in compliance with all covenants related to the Revolving Credit Facility.  The total amount outstanding on the facility was $43,812,000 for euro-based borrowings and no amounts were outstanding for U.S. dollar borrowings.

 

On July 1, 2003, the Company entered into an interest rate swap for a notional amount of €25,000,000 outstanding on the Company’s Revolving Credit Facility.  The Company swapped the variable rate from the Revolving Credit Facility, which is three month EURIBOR plus 0.7%, for a fixed rate of 2.3%.  The term of the swap is two years.  The Company has designated the swap as a hedging instrument using the cash flow method. The swap hedges the cash flows associated with interest payments on the first €25,000,000 of the Company’s Revolving Credit Facility. The Company marks to market the changes in value of the swap through other comprehensive income. Any ineffectiveness has been recorded in income.   For the first quarter of 2004, the Company recorded a change of $209,000 in other comprehensive income for the decrease in the fair value of the swap.

 

11.                               Contingencies and Environmental Remediation

 

There have been no material developments with respect to the Company’s contingencies and environmental remediation proceedings during the period covered by this quarterly report on Form 10-Q.

 

12.                               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 Company uses a September 30 measurement date for its plans.

 

The components of net periodic benefit cost are as follows:

 

 

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Cash flows:

 

The information related to the Company’s pension funds cash flow is as follows:

 

		First Quarter Ended
		March 28, 2004			March 30, 2003
		(in thousands)
Employer contributions		$	27		$	21
Benefit payments		$	27		$	21

 

13.                               Subsequent Events

 

On April 29, 2004, the Company received a payment of $11,000,000 from Zurich American Insurance Company (Zurich) as a reimbursement of amounts paid by the Company to settle the claims of the three Phase I cities in the Armenta case, as more fully described in Part I, Item 1 “Business – Product Liability, Environmental and Other Litigation Matters” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003.  Zurich has asserted that all settlement amounts paid by it to the Company, including the $11,000,000 payment referenced above, are not required by its insurance policies and/or are subject to reimbursement under Deductible Agreements between Zurich and the Company.  Although the Company expects that it will ultimately prevail in the dispute with Zurich over reimbursement of paid settlement amounts, if Zurich is successful in its claim for reimbursement of such amounts the Company would be required to repay the above referenced $11,000,000.  Accordingly, consistent with the Company’s prior disclosures, it expects to record the $11,000,000 received from Zurich as a liability on its balance sheet in the second quarter of 2004.  This amount has been expensed to discontinued operations in prior periods.

 

On April 16, 2004, a wholly-owned subsidiary of the Company acquired 90% of the stock of TEAM Precision Pipe Work, Ltd. (TEAM), located in Ammanford, West Wales, United Kingdom for approximately $17,000,000 in cash subject to final adjustments, if any, as stipulated in the purchase and sale agreement.  TEAM custom designs and manufactures manipulated pipe and hose tubing assemblies, which are utilized in the heating, ventilation and air conditioning markets. TEAM is a supplier to major original equipment manufacturers of air conditioning systems and several of the major European automotive air conditioning manufacturers.

 

On March 29, 2004 a wholly-owned subsidiary of the Company acquired the 40% equity interest in Taizhou Shida Plumbing Manufacturing Co., Ltd. (Shida) that had been held by the Company’s former joint venture partner, Yuhuan County Cheng Guan Metal Hose Factory for approximately $3,000,000 in cash, the assumption of approximately $6,000,000 of debt and the payment of $3,500,000 in cash in connection with a know-how transfer and non-compete agreement. The Company now owns 100% of Shida.  This additional investment became effective subsequent to the Company’s fiscal first quarter close and as such its first quarter results reflect a 60% ownership in Shida.

 

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Item 2.           MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Overview

 

The following discussion and analysis are provided to increase understanding of, and should be read in conjunction with, the accompanying unaudited consolidated financial statements and notes.

 

We operate on a 52-week fiscal year ending on December 31.  Any first quarter ended data contained in this Report on Form 10-Q reflects the results of operations for the 13-week period ended on the Sunday nearest March 31 of the respective year.

 

We are a leading supplier of products for use in the water quality, water safety, water flow control and water conservation markets in both North America and Europe. For more than 125 years, we have designed and manufactured products that promote the comfort and safety of people and the quality and conservation for water used in commercial, residential and light industrial applications. We earn revenue and income almost exclusively from the sale of our products. Our principal product lines include:

 

•                                          backflow preventers for preventing contamination of potable water caused by reverse flow within water supply lines and fire protection systems;

 

•                                          a wide range of water pressure regulators for both commercial and residential applications;

 

•                                          water supply and drainage products for commercial and residential applications;

 

•                                          temperature and pressure relief valves for water heaters, boilers and associated systems;

 

•                                          point-of-use water filtration and reverse osmosis systems for both commercial and residential applications;

 

•                                          thermostatic mixing valves for tempering water in commercial and residential applications; and

 

•                                          systems for under-floor radiant applications.

 

Our business is reported in three geographic segments, North America, Europe and China. We distribute our products through three primary distribution channels, wholesale, do-it-yourself (DIY) and Original Equipment Manufacturers (OEMs).  Increases in Gross National Product (GNP) indicate a healthy economic environment which we believe positively impacts our results of operations. The economic factors that we believe have the most significant direct effect on the demand for our products are the number of new housing construction starts and non-residential, or commercial, construction starts.  In the first quarter of 2004, sales into the DIY market were flat compared to the first quarter of 2003, as our prior year’s first quarter had unusually high sales due to significant initial stocking orders of our tubular business. Interest rates have a significant indirect effect on the demand for our products due to the effect such rates have on the number of new residential and commercial construction starts and remodeling projects. An additional factor that has had a significant effect on our sales is fluctuations in foreign currencies, as a significant portion of our sales and certain portions of our costs, assets and liabilities are denominated in currencies other than the U.S. dollar.

 

We believe that the most significant factors relating to our future growth include our ability to continue to make selected acquisitions, both in our core markets as well as new complementary markets, regulatory requirements relating to the quality and conservation of water and increased demand for clean water and continued enforcement of plumbing and building codes. We have completed fourteen acquisitions since divesting our industrial and oil and gas business in 1999. Our acquisition strategy focuses on businesses that manufacture preferred brand name products that address our themes of water quality, water safety, water conservation and water flow control. We target businesses that will provide us with one or more of the following: an entry into new markets, an increase in shelf space with existing customers, a new or improved technology or an expansion of the breadth of our water quality, water conservation, water safety and

 

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water flow control products for the residential and commercial markets.

 

Products representing a majority of our sales are subject to regulatory standards and code enforcement, which typically require that these products meet stringent performance criteria. Together with our commissioned manufacturers’ representatives, we have consistently advocated the development and enforcement of such plumbing codes. We are focused on maintaining stringent quality control and testing procedures at each of our manufacturing facilities in order to manufacture products in compliance with code requirements and take advantage of the resulting demand for compliant products. We believe that significant product development, product testing capability and investment in plant and equipment is needed to manufacture products in compliance with code requirements, which represents a significant barrier to entry for competitors. We believe there is an increasing demand among consumers for products to ensure water quality, which creates growth opportunities for our products.

 

A significant risk we face is our ability to deal effectively with increases in raw material costs. We require substantial amounts of raw materials, including bronze, brass, cast iron, steel and plastic to produce our products and substantially all of the raw materials we require are purchased from outside sources. Recently, we have experienced increases in the costs of bronze, brass, cast iron and steel. If we are not able to reduce or eliminate the effect of these cost increases by reducing production costs or successfully implementing price increases, these increases in raw material costs could reduce our profit margins.

 

Another significant risk we face in all areas of our business is competition. We consider brand preference, engineering specifications, plumbing code requirements, price, technological expertise, delivery times and breadth of product offerings to be the primary competitive factors. As mentioned previously, we believe that significant product development, product testing capability and investment in plant and equipment is needed to manufacture products in compliance with code requirements, which represents a significant barrier to entry for competitors. We are committed to maintaining our capital equipment at a level consistent with current technologies, as we spent approximately $5.0 million in the first quarter of 2004, and expect to invest approximately $18.5 million in 2004. We are also committed to expanding our manufacturing capacity in lower cost countries such as China, Tunisia and Bulgaria. These manufacturing plant relocations and consolidations are an important part of our ongoing commitment to reduce production costs.

 

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Recent Developments

 

On April 29, 2004, we received a payment of $11.0 million from Zurich American Insurance Company (Zurich) as a reimbursement of amounts paid by us to settle the claims of the three Phase I cities in the Armenta case, as more fully described in Part I, Item 1 “Business – Product Liability, Environmental and Other Litigation Matters” in our Annual Report on Form 10-K for the year ended December 31, 2003.  Zurich has asserted that all settlement amounts paid by it to us, including the $11.0 million payment referenced above, are not required by its insurance policies and/or are subject to reimbursement under Deductible Agreements between Zurich and us.  Although we expect that we will ultimately prevail in the dispute with Zurich over reimbursement of paid settlement amounts, if Zurich is successful in its claim for reimbursement of such amounts we would be required to repay the above referenced $11.0 million.  Accordingly, consistent with our prior disclosures, we expect to record the $11.0 million received from Zurich as a liability on our balance sheet in the second quarter of 2004.  This amount has been expensed to discontinued operations in prior periods.

 

On April 16, 2004, we acquired 90% of the stock of TEAM Precision Pipe Work, Ltd. (TEAM), located in Ammanford, West Wales, United Kingdom for approximately $17.0 million subject to final adjustments, if any, as stipulated in the purchase and sale agreement.  TEAM custom designs and manufactures manipulated pipe and hose tubing assemblies, which are utilized in the heating ventilation and air conditioning markets. TEAM is a supplier to major original equipment manufacturers of air conditioning systems and several of the major European automotive air conditioning manufacturers.

 

On March 29, 2004 we acquired the 40% equity interest in Taizhou Shida Plumbing Manufacturing Co., Ltd. (Shida) that had been held by our former joint venture partner, Yuhuan County Cheng Guan Metal Hose Factory for approximately $3.0 million in cash, the assumption of approximately $6.0 million of debt and the payment of $3.5 million in cash in connection with a know-how transfer and non-compete agreement. We now own 100% of Shida.  This additional investment became effective subsequent to our fiscal first quarter close and as such our first quarter results reflect a 60% ownership in Shida.

 

Acquisitions

 

On January 5, 2004, we acquired substantially all of the assets of Flowmatic Systems, Inc. (Flowmatic) located in Dunnellon, Florida, for approximately $16.7 million in cash. Flowmatic designs and distributes a complete line of high quality reverse osmosis components and filtration equipment. Their product line includes stainless steel and plastic housings, filter cartridges, storage tanks, control valves, as well as complete reverse osmosis systems for residential and commercial applications.

 

On July 30, 2003, we acquired Giuliani Anello S.r.l. located in Cento (Ferrara) Bologna, Italy, for approximately $10.6 million in cash net of acquired cash of $1.4 million.  Giuliani Anello manufactures and distributes valves and filters utilized in heating applications including strainer filters, solenoid valves, flow stop valves, stainless steel water filter elements and steam cleaning filters.

 

On April 18, 2003, we acquired Martin Orgee UK Ltd located in Kidderminster, West Midlands, United Kingdom for approximately $1.6 million in cash.  Martin Orgee distributes a line of plumbing and heating products to the wholesale, commercial and OEM markets in the United Kingdom and Southern Ireland.  Martin Orgee also assembles pumping groups for under-floor radiant heat systems.

 

The acquisitions above have been accounted for utilizing the purchase method of accounting.  The pro-forma results have not been displayed, as the combined results of acquired companies are not significant to our consolidated financial position or results of operation.

 

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Results of Operations

 

First Quarter Ended March 28, 2004 Compared to First Quarter Ended March 30, 2003

 

Net Sales.  Our business is reported in three geographic segments: North America, Europe and China. Our net sales in each of these segments for each of the first quarters ended 2004 and 2003 were as follows:

 

		First Quarter Ended March 28, 2004					First Quarter Ended March 30, 2003								% Change to Consolidated Net Sales
		Net Sales			% Sales		Net Sales			% Sales		Change
		(in thousands)
North America		$	125,620		65.9	%	$	112,955		68.2	%	$	12,665		7.6	%
Europe		60,033			31.5	%	48,669			29.4	%	11,364			6.9	%
China		4,993			2.6	%	4,068			2.4	%	925			0.6	%
Total		$	190,646		100	%	$	165,692		100	%	$	24,954		15.1	%

 

The increase in consolidated net sales is attributable to the following:

 

 

The increase in net sales in North America is attributable to the following:

 

 

The internal growth in net sales in North America is primarily due to increased unit sales into the wholesale markets. Our sales into the North American DIY market, excluding Jameco International LLC (Jameco) sales, decreased by 1.1% in the first quarter of 2004 compared to the first quarter of 2003 primarily due to significant initial stocking orders of our tubular business in the first quarter of 2003.  Our wholesale market, excluding Flowmatic sales, grew by 6.3% in first quarter of 2004 compared to the first quarter of 2003 primarily due to increased sales of backflow preventors.

 

The increase in net sales due to foreign exchange in North America is due to the Canadian dollar appreciating against the U.S. dollar. We cannot predict whether the Canadian dollar will continue to appreciate against the U.S. dollar in future periods or whether future foreign exchange rate fluctuations will have a positive or negative impact on our net sales.

 

The acquired growth in net sales in North America is due to the inclusion of net sales of Flowmatic, acquired on January 5, 2004.  We expect this acquisition will have a positive impact on sales for the remainder of the year.

 

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Included in other for North America are sales of $4,637,000 from Jameco. In October 2003, we determined that our 49% minority interest in Jameco qualified as a variable interest in a variable interest entity under Financial Accounting Standards Board Interpretation No. 46 “Consolidation of Variable Interest Entities – Revised” (FIN 46R) and, as we are considered the primary beneficiary, the results of Jameco are consolidated into our North American results.

 

The increase in net sales in Europe is attributable to the following:

 

 

The internal growth in net sales in Europe is primarily due to increased sales into the European OEM market partially offset by decreased sales into the wholesale market.

 

The increase in net sales due to foreign exchange in Europe is primarily due to the appreciation of the euro against the U.S. dollar.  We cannot predict whether the euro will continue to appreciate against the U.S. dollar in future periods or whether future foreign exchange rate fluctuations will have a positive or negative impact on our net sales.

 

The acquired growth in net sales in Europe is due to the inclusion of the net sales of Martin Orgee, acquired on April 18, 2003 and Giuliani Anello, acquired on July 30, 2003. We expect these recent acquisitions will have a positive impact on sales for the next quarter.

 

The increase in net sales in China of $925,000 is attributable to internal growth primarily due to increased domestic shipments at our TWT joint venture located in Tianjin, China, and our Shida joint venture located in Taizhou, China.

 

Gross Profit.  Gross profit for the first quarter of 2004 increased $10,051,000, or 18.0%, compared to the first quarter of 2003. The increase in gross profit is attributable to the following:

 

 

The internal growth is primarily due to the North American segment, which increased internal gross profits by $3,414,000. This increase is primarily due to improved manufacturing efficiencies and an improved sales mix due to increased sales volume in the North American wholesale market, which generally has higher gross margins than the North American retail market.  The European segment increased internal gross profit by $1,188,000 primarily due to sales growth with the European OEM customers.  The increase in gross profit from foreign exchange is primarily due to the appreciation of the euro and Canadian dollar against the U.S. dollar.  The increase in gross profit from acquisitions is primarily due to the inclusion of gross profit from Flowmatic, Martin Orgee and Giuliani Anello.

 

The increase in gross profit was partially offset by increased manufacturing restructuring and other costs.  In the first quarter of 2004 we charged $1,177,000 of accelerated depreciation to cost of sales compared to $446,000 of accelerated depreciation and other costs in the first quarter of 2003.  Excluding the costs of restructuring for both

 

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periods, gross profits for the first quarter of 2004 would have increased $10,782,000, or 19.2% to $66,992,000 compared to $56,210,000 for the first quarter of 2003.

 

Selling, General and Administrative Expenses.  Selling, General and Administrative, or SG&A, for the first quarter of 2004 increased $6,127,000, or 15.4%, compared to the first quarter of 2003.  The increase in SG&A is attributable to the following:

 

 

The internal increase in SG&A expenses is primarily due to increased variable selling expenses due to increased sales volumes, increased product liability expense and costs incurred for compliance with the Sarbanes-Oxley Act partially offset by a reserve reduction due to a favorable ruling in one of our legal cases and decreased research and development expenses.  Although there is an absolute increase in our SG&A expense over 2003, our SG&A expense as a percent of sales for the first quarter of 2004 remained constant at 24.1% compared to the same period in 2003.

 

Operating Income.  Operating income by geographic segment for each of the first quarters ended 2004 and 2003 were as follows:

 

 

The increase in operating income is attributable to the following:

 

 

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The increase in operating income in North America is attributable to the following:

 

 

The internal growth is due to our increased gross profit in the wholesale market partially offset by increased net SG&A expense.  In the first quarter of 2004, we experienced raw material cost increases. To the extent we are unable to recover raw material cost increases from our customers these cost increases would adversely affect our operating income. For the first quarter of 2004, we recorded $1,177,000 compared to $55,000 in the first quarter of 2003 for costs associated with our manufacturing restructuring plan. Excluding these costs, the operating income in North America would have been $17,667,000 for the first quarter of 2004 compared to $15,217,000 for the comparable period in 2003. We expect to record an additional $4,800,000 in 2004 for manufacturing restructuring expenses primarily attributable to accelerated depreciation associated with the anticipated closure of one of our U.S. manufacturing plants and a reduction in estimated useful lives of manufacturing equipment due to the transfer of production to lower cost countries. The acquired growth is due to the inclusion of operating income from Flowmatic.

 

The increase in operating income in Europe is attributable to the following:

 

 

The internal growth is primarily due to increased gross profit from the increased sales volume in the OEM market partially offset by increased SG&A expenses. We did not record any manufacturing restructuring or other costs in the first quarter of 2004 compared to $391,000 for the comparable period in 2003.  Excluding these costs, operating income in Europe would have increased to $5,251,000 for the first quarter of 2003. We do not anticipate recording any additional manufacturing restructuring costs in 2004 for our European operations. The increase in operating income from foreign exchange is primarily due to the appreciation of the euro against the U.S. dollar.   We cannot predict whether the euro will continue to appreciate against the U.S. dollar in future periods or whether future foreign exchange rate fluctuations will have a positive or negative impact on our operating income.

 

The decrease in operating loss in China of $25,000 is attributable to internal growth primarily due to increased sales volumes partially offset by increased SG&A expenses and under absorbed manufacturing costs associated with our wholly-owned manufacturing plant in China.

 

Interest Expense.  Interest expense increased $485,000, or 23.3%, for the first quarter of 2004 compared to the first quarter of 2003, primarily due to the elimination of amortization from our interest rate swap and increased amounts of indebtedness on our senior notes partially offset by decreased indebtedness in the U.S. revolving credit facility.  On September 1, 2001, we entered into an interest rate swap with respect to our $75,000,000 8 3/8% notes due December 2003. The swap converted the interest from fixed to floating.  On August 5, 2002, we sold the swap and received $2,315,000 in cash.  For the first quarter of 2003, we reduced interest expense by $393,000 by amortizing the

 

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adjustment to the fair value of the swap. The amortization of the swap was completed upon repayment of the $75,000,000 8 3/8% notes on December 1, 2003. On May 15, 2003, we refinanced our $75,000,000 8 3/8% notes with proceeds from the issuance of $125,000,000 senior notes. 

 

On July 1, 2003, we entered into an interest rate swap for a notional amount of €25,000,000 outstanding on our Revolving Credit Facility. We swapped the variable rate from the Revolving Credit Facility, which is three month EURIBOR plus 0.7%, for a fixed rate of 2.3%. The impact of swap was immaterial to the overall interest expense.

 

Income Taxes.  Our effective tax rate for continuing operations for the first quarter of 2004 increased to 37.3% from 36.3% for the first quarter of 2003. The increase is primarily due to a shift in the mix of our European earnings to countries with higher effective tax rates, most notably Germany, France and Italy.

 

Income From Continuing Operations.  Income from continuing operations for the first quarter 2004 increased $2,088,000, or 23.4%, to $11,024,000 or $0.34 per common share, from $8,936,000 or $0.33 per common share, for the first quarter of 2003, in each case, on a diluted basis. The appreciation of the euro against the U.S. dollar resulted in a positive impact on income from continuing operations of $0.02 per share for the first quarter of 2004 compared to the comparable period last year. We cannot predict whether the euro will continue to appreciate against the U.S. dollar in future periods or whether future foreign exchange rate fluctuations will have a positive or negative impact on our net income. Excluding the manufacturing restructuring costs incurred in both periods, income from continuing operations would have increased $2,535,000 or 27.5%.

 

Loss From Discontinued Operations.  We recorded a charge net of tax to discontinued operations for the first quarter of 2004 of $23,000, or ($0.00) per common share and $2,326,000, or ($0.09) per common share, for the first quarter of 2003, in each case, on a diluted basis. These charges are attributable to legal fees associated with the James Jones litigation, as described in Part I, Item 1. "Business-Product Liability, Environmental and Other Litigation Matters" in our Annual Report on Form 10-K for the year ended December 31, 2003.

 

Liquidity and Capital Resources

 

We used $14,338,000 of cash to fund continuing operations for the first quarter of 2004. We experienced an increase in accounts receivable in North America, Europe and China. The North America increase is primarily due to increased sales volume and timing of certain cash receipts from certain large customers.  The European and China increase is primarily due to increased sales volume.  Additionally, we experienced an increase in inventories in North America, Europe and China. The North America increase is primarily due to an increased backlog, planned increases in finished goods as we set up additional distribution centers and seasonal increases for early spring sales. The Europe increase is primarily due to increased finished goods to support the delivery requirements of OEM customers in Europe. The China increase is primarily attributable to certain raw material purchases made in anticipation of cost increases. The increases in accounts receivable and inventory were partially offset by a build up of income taxes payable in the first quarter of 2004.

 

We used $20,286,000 of net cash for investing activities for the first quarter of 2004. We invested $4,946,000 in capital equipment.  Capital expenditures were primarily for manufacturing machinery and equipment as part of our ongoing commitment to improve our manufacturing capabilities. We expect to invest approximately $18,500,000 in capital equipment in 2004.  We received $1,522,000 of proceeds primarily from a sale of one of our North American manufacturing facilities in which we have entered in a sale lease back.  On January 5, 2004, we paid approximately $16,700,000 to acquire the assets of Flowmatic.

 

We generated $5,451,000 of net cash from financing activities primarily from net proceeds from indebtedness in Europe on the revolving credit facility.

 

Our revolving credit facility with a syndicate of banks (the Revolving Credit Facility) provides for borrowings of up to $150,000,000 which includes a $75,000,000 tranche for euro-based borrowings and matures in February 2005. The Revolving Credit Facility is being used to support our acquisition program, working capital requirements and for general corporate purposes. As of March 28, 2004, current portion of long-term debt included $43,812,000 outstanding on the Revolving Credit Facility for euro-based borrowings and no amounts were outstanding for U.S. dollar borrowings.

 

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Outstanding indebtedness under the Revolving Credit Facility bears interest at a rate determined by the type (currency) of loan plus an applicable margin determined by the Company’s debt rating, depending on the applicable base rate and our bond rating. The average interest rate for borrowings under the Revolving Credit Facility was approximately 2.8% at March 28, 2004. We have $106,188,000 of unused and available revolving credit at March 28, 2004. The Revolving Credit Facility includes operational and financial covenants customary for facilities of this type, including, among others, restrictions on additional indebtedness, liens and investments and maintenance of certain leverage ratios. At March 28, 2004, we were in compliance with all covenants related to the Revolving Credit Facility.

 

Effective July 1, 2003, we entered into an interest rate swap for a notional amount of €25,000,000 outstanding under our Revolving Credit Facility. We swapped the variable rate from the Revolving Credit Facility that is three month EURIBOR plus 0.7% for a fixed rate of 2.3%. The term of the swap is two years. We have designated the swap as a hedging instrument using the cash flow method. The swap hedges the cash flows associated with interest payments on the first €25,000,000 of our Revolving Credit Facility. We mark to market the changes in value of the swap through other comprehensive income. Any ineffectiveness has been recorded in income. In the first quarter of 2004, we recorded a change of $209,000 other comprehensive income for the decrease in the fair value of the swap.

 

We generated $855,000 of net cash from discontinued operations. During the first quarter of 2004, we received $469,000 in cash as an indemnification payment for settlement costs we incurred in the James Jones case. This cash has been recorded as a liability at March 28, 2004 because of the possibility that we might have to reimburse the insurance company if it is ultimately successful with a future appeal. We also received $874,000 in cash for reimbursement of defense costs related to the James Jones case. During the first quarter of 2004, we paid $285,000 for defense costs and $37,000 for indemnity costs we incurred in the James Jones case.

 

Working capital (defined as current assets less current liabilities) as of March 28, 2004 was $262,191,000 compared to $308,135,000 as of December 31, 2003. This decrease is primarily due to classification of our outstanding indebtedness on our Revolving Credit Facility which matures in February 2005. The ratio of current assets to current liabilities was 2.1 to 1 as of March 28, 2004 compared to 2.8 to 1 as of December 31, 2003. Cash and cash equivalents were $120,552,000 as of March 28, 2004 compared to $149,361,000 as of December 31, 2003.  This decrease in cash is due to increased working capital requirements, capital expenditures, as well as cash paid for acquisitions.

 

We anticipate that available funds from current operations, existing cash and other sources of liquidity will be sufficient to meet current operating requirements and anticipated capital expenditures for at least the next 12 months. However, we may have to consider external sources of financing for any large future acquisitions. Our current Revolving Credit Facility expires in February 2005. We are currently reviewing proposals from various banks with the intention of structuring a new credit facility during 2004.

 

Our long-term contractual obligations as of March 28, 2004 are presented in the following table:

 

		Payments Due by Period
Contractual Obligations		Total			Less than 1 year			1-3 years			3-5 years			More than 5 years
		(in thousands)
Long-term debt obligations, including current maturities		$	195,713		$	60,640		$	8,375		$	1,001		$	125,697
Operating lease obligations		10,969			1,805			4,618			2,820			1,726
Capital lease obligations		1,508			647			730			131			—
Total		$	208,190		$	63,092		$	13,723		$	3,952		$	127,423

 

We maintain letters of credit that guarantee our performance or payment to third parties in accordance with specified terms and conditions. Amounts outstanding were approximately $39,000,000 as of March 28, 2004 and $29,880,000 as of December 31, 2003. Our letters of credit are primarily associated with insurance coverage and to a lesser extent foreign purchases. Our letters of credits generally expire within one year of issuance. The increase is primarily associated with insurance coverage. These instruments may exist or expire without being drawn down. Therefore, they do not necessarily represent future cash flow obligations.

 

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Application of Critical Accounting Policies and Key Estimates

 

The preparation of our consolidated financial statements in accordance with GAAP requires management to make judgments, assumptions and estimates that affect the amounts reported. A critical accounting estimate is an assumption about highly uncertain matters and could have a material effect on the consolidated financial statements if another, also reasonable, amount were used, or, a change in the estimate is reasonably likely from period to period. We base our assumptions on historical experience and on other estimates that we believe are reasonable under the circumstances. Actual results could differ significantly from these estimates. There were no changes in accounting policies or significant changes in accounting estimates during first quarter of 2004.

 

We have discussed the development, selection and disclosure of the estimates with the Audit Committee. Management believes the following critical accounting policies reflect its’ more significant estimates and assumptions.

 

Revenue recognition

 

We recognize revenue when all of the following criteria are met: (1) we have entered into a binding agreement, (2) the product has shipped and title has passed, (3) the sales price to the customer is fixed or is determinable and (4) collectibility is reasonably assured. We recognize revenue based upon a determination that all criteria for revenue recognition have been met, which, based on the majority of our shipping terms, is considered to have occurred upon shipment of the finished product. Some shipping terms require the goods to be received by the customer before title passes. In those instances, revenues are not recognized until the customer has received the goods. We record estimated reductions to revenue for customer returns and allowances and for customer programs. Provisions for returns and allowances are made at the time of sale, derived from historical trends and form a portion of the allowance for doubtful accounts. Customer programs, which are primarily annual volume incentive plans, allow customers to earn credit for attaining agreed upon purchase targets from us. We record customer programs as an adjustment to net sales.

 

Allowance for doubtful accounts

 

The allowance for doubtful accounts is established to represent our best estimate of the net realizable value of the outstanding accounts receivable. The development of our allowance for doubtful accounts varies by region but in general is based on a review of past due amounts, historical write-off experience, as well as aging trends affecting specific accounts and general operational factors affecting all accounts. In North America, management specifically analyzes individual accounts receivable and establishes specific reserves against financially troubled customers. In addition, factors are developed utilizing historical trends in bad debts, returns and allowances. The ratio of these factors to sales on a rolling twelve-month basis is applied to total outstanding receivables (net of accounts specifically identified) to establish a reserve. In Europe, management develops their bad debt allowance through an aging analysis of all their accounts, with analysis on the aging of specific delinquent accounts. In China, where payment terms are generally extended, we reserve all accounts receivable in excess of one year from the invoice date and specifically reserve for identified uncollectible accounts receivable less than one year old.

 

We uniformly consider current economic trends and changes in customer payment terms when evaluating the adequacy of the allowance for doubtful accounts. We also aggressively monitor the credit worthiness of our largest customers, and periodically review customer credit limits to reduce risk. If circumstances relating to specific customers change or unanticipated changes occur in the general business environment, our estimates of the recoverability of receivables could be further adjusted.

 

Inventory valuation

 

Inventories are stated at the lower of cost or market with costs generally determined on a first-in first-out basis. We utilize both specific product identification and historical product demand as the basis for determining our excess or obsolete inventory reserve. We identify all inventories that exceed a range of one to three years in sales. This is determined by comparing the current inventory balance against unit sales for the trailing twelve months. New products added to inventory within the past twelve months are excluded from this analysis. A portion of our products contain recoverable materials, therefore the excess and obsolete reserve is established net of any recoverable amounts. Changes

 

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in market conditions, lower than expected customer demand or changes in technology or features could result in additional obsolete inventory that is not saleable and could require additional inventory reserve provisions.

 

In certain countries, additional inventory reserves are maintained for potential losses experienced in the manufacturing process. The reserve is established based on the prior year’s inventory losses adjusted for any change in the gross inventory balance.

 

Goodwill and other intangibles

 

We adopted Financial Accounting Standards Board Statement No. 142 “Goodwill and Other Intangible Assets” (FAS 142) on January 1, 2002, and as a result we no longer amortize goodwill. Goodwill and intangible assets with indefinite lives are tested annually for impairment in accordance with the provisions of FAS 142. We use judgment in assessing whether assets may have become impaired between annual impairment tests.

 

Intangible assets such as purchased technology are generally recorded in connection with a business acquisition. In our larger, more complex acquisitions, the value assigned to intangible assets is determined by an independent valuation firm based on estimates and judgments regarding expectations of the success and life cycle of products and technology acquired.

 

It has been two years since adoption, and for both years we have had excess economic support for the carrying value of our goodwill and intangibles. While we believe that our estimates of future cash flows are reasonable, different assumptions regarding such factors as future sales volume, selling price changes, material cost changes, cost savings programs and capital expenditures could significantly affect our valuations. Other changes that may affect our valuations include, but are not limited to product acceptances and regulatory approval. If actual product acceptance differs significantly from the estimates, we may be required to record an impairment charge to write down the assets to their realizable value. A severe decline in market value could result in an unexpected impairment charge to goodwill, which could have a material impact on the results of operations and financial position.

 

Product liability and workers compensation costs

 

Because of retention requirements associated with our insurance policies, we are generally self-insured for potential product liability claims and for workers’ compensation costs associated with workplace accidents. For product liability cases in the U.S., management estimates expected settlement costs by utilizing stop loss reports provided by our third party administrators as well as developing internal historical trend factors based on our specific claims experience. Prior to 2003, we used insurance carrier trend factors to determine our product liability reserves. However, we determined circumstances inherent in those trends were not necessarily indicative of our own circumstances regarding our claims. Management believes the internal trend factors will more accurately reflect final expected settlement costs. In other countries, we maintain insurance coverage with relatively high deductible payments, as product liability claims tend to be smaller than those experienced in the U.S. Changes in the nature of claims or the actual settlement amounts could affect the adequacy of this estimate and require changes to the provisions.

 

Workers compensation liabilities in the U.S. are recognized for claims incurred (including claims incurred but not reported) and for changes in the status of individual case reserves. At the time a workers’ compensation claim is filed, a liability is estimated to settle the claim. The liability for workers’ compensation claims is determined based on management’s estimates of the nature and severity of the claims and based on analysis provided by third party administrators and by various state statutes and reserve requirements. We have developed our own trend factors based on our specific claims experience. In other countries where workers compensation costs are applicable, we maintain insurance coverage with limited deductible payments. Because the liability is an estimate, the ultimate liability may be more or less than reported.

 

We maintain excess liability insurance with outside insurance carriers to minimize our risks related to catastrophic claims in excess of all self-insured positions. Any material change in the aforementioned factors could have an adverse impact on our operating results.

 

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Legal contingencies

 

We are a defendant in numerous legal matters including those involving environmental law and product liability as discussed further in Note 15 of Notes to Consolidated Financial Statements in our Annual Report on Form 10-K for the year ended December 31, 2003. As required by Financial Accounting Standards Board Statement No. 5 “Accounting for Contingencies” (FAS 5), we determine whether an estimated loss from a loss contingency should be accrued by assessing whether a loss is deemed probable and the loss amount can be reasonably estimated, net of any applicable insurance proceeds. Estimates of potential outcomes of these contingencies are developed in consultation with outside counsel. While this assessment is based upon all available information, litigation is inherently uncertain and the actual liability to fully resolve this litigation cannot be predicted with any assurance of accuracy. Final settlement of these matters could possibly result in significant effects on our results of operations, cash flows and financial position.

 

Pension benefits

 

We account for our pension plans in accordance with Financial Accounting Standards Board Statement No. 87 “Employers Accounting for Pensions” (FAS 87). In applying FAS 87, assumptions are made regarding the valuation of benefit obligations and the performance of plan assets. The primary assumptions are as follows:

 

•                                          Weighted average discount rate—this rate is used to estimate the current value of future benefits. This rate is adjusted based on movement in long-term interest rates.

 

•                                          Expected long-term rate of return on assets—this rate is used to estimate future growth in investments and investment earnings. The expected return is based upon a combination of historical market performance and anticipated future returns for a portfolio reflecting the mix of equity, debt and other investments indicative of our plan assets.

 

•                                          Rates of increase in compensation levels—this rate is used to estimate projected annual pay increases, which are used to determine the wage base used to project employees’ pension benefits at retirement.

 

We determine these assumptions based on consultation with outside actuaries and investment advisors. Any variance in the above assumptions could have a significant impact on future recognized pension costs, assets and liabilities.

 

Income taxes

 

We estimate and use our expected annual effective income tax rates to accrue income taxes. Effective tax rates are determined based on budgeted earnings before taxes including our best estimate of permanent items that will impact the effective rate for the year. Management periodically reviews these rates with outside tax advisors and changes are made if material discrepancies from expectations are identified.

 

We recognize deferred taxes for the expected future consequences of events that have been reflected in the consolidated financial statements in accordance with the rules of Financial Accounting Standards Board Statement No. 109 “Accounting for Income Taxes” (FAS 109). Under FAS 109, deferred tax assets and liabilities are determined based on differences between the book values and tax bases of particular assets and liabilities, using tax rates in effect for the years in which the differences are expected to reverse. A valuation allowance is provided to offset any net deferred tax assets if, based upon the available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. We consider estimated future taxable income and ongoing prudent tax planning strategies in assessing the need for a valuation allowance.

 

Certain Factors Affecting Future Results

 

This report includes statements which are not historical facts and are considered forward looking within the meaning of the Private Securities Litigation Reform Act of 1995.  These forward-looking statements reflect Watts Water Technologies’ current views about future results of operations and other forward-looking information.  In

 

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some cases you can identify these statements by forward-looking words such as “anticipate,” “believe,” “could,” “estimate,” “expect,” “intend,” “may,” “should,” “will” and “would” or similar words. You should not rely on forward-looking statements because Watts’ actual results may differ materially from those indicated by these forward-looking statements as a result of a number of important factors.  These factors include, but are not limited to, the following:  loss of market share through competition, introduction of competing products by other companies, pressure on prices from competitors, suppliers, and/or customers, failure to expand our markets through acquisitions, failure or delay in developing new products, lack of acceptance of new products, failure to manufacture products that meet required performance and safety standards, foreign exchange rate fluctuations, cyclicality of industries, such as plumbing and heating wholesalers and home improvement retailers, in which the Company markets certain of its products, reductions in the supply of raw materials, increases in the prices of raw materials, economic factors, such as the levels of housing starts and remodeling, impacting the markets where the Company’s products are sold, manufactured, or marketed, environmental compliance costs, product liability risks, the results and timing of the Company’s manufacturing restructuring plan, changes in the status of current litigation, including the James Jones case, and other risks and uncertainties discussed under the heading “Certain Factors Affecting Future Results” in the Watts Water Technologies, Inc. Annual Report on Form 10-K for the year ended December 31, 2003 filed with the Securities Exchange Commission and other reports Watts files from time to time with the Securities and Exchange Commission.

 

Item 3.  Quantitative and Qualitative Disclosures about Market Risk

 

We use derivative financial instruments primarily to reduce exposure to adverse fluctuations in foreign exchange rates, interest rates and costs of certain raw materials used in the manufacturing process. We do not enter into derivative financial instruments for trading purposes. As a matter of policy, all derivative positions are used to reduce risk by hedging underlying economic exposure. The derivatives we use are instruments with liquid markets.

 

Our consolidated earnings, which are reported in United States dollars are subject to translation risks due to changes in foreign currency exchange rates. This risk is concentrated in the exchange rate between the U.S. dollar and the euro; the U.S. dollar and the Canadian dollar; and the U.S. dollar and the Chinese RMB.

 

Our foreign subsidiaries transact most business, including certain intercompany transactions, in foreign currencies. Such transactions are principally purchases or sales of materials and are denominated in European currencies or the U.S. or Canadian dollar. We use foreign currency forward exchange contracts to manage the risk related to intercompany purchases that occur during the course of a year and certain open foreign currency denominated commitments to sell products to third parties. At March 28, 2004, we had no forward contracts to buy foreign currencies and no unrealized gains or losses.

 

We have historically had a very low exposure on the cost of our debt to changes in interest rates. Interest rate swaps are used to mitigate the impact of interest rate fluctuations on certain variable rate debt instruments and reduce interest expense on certain fixed rate instruments. Information about our long-term debt including principal amounts and related interest rates appears in Note 11 of Notes to Consolidated Financial Statements in our Annual Report on Form 10-K for the year ended December 31, 2003.

 

We purchase significant amounts of bronze ingot, brass rod, cast iron, steel and plastic, which are utilized in manufacturing our many product lines. Our operating results can be adversely affected by changes in commodity prices if we are unable to pass on related price increases to our customers. We manage this risk by monitoring related market prices, working with our suppliers to achieve the maximum level of stability in their costs and related pricing, seeking alternative supply sources when necessary and passing increases in commodity costs to our customers, to the maximum extent possible, when they occur. Additionally, on a limited basis, we use commodity futures contracts to manage this risk, but we did not in the first quarter ended March 28, 2004.

 

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Item 4.  Controls and Procedures

 

As required by Rule 13a-15(b) under the Securities Exchange Act of 1934, as of the end of the period covered by this report, we carried out an evaluation under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the disclosure controls and procedures.  In designing and evaluating our disclosure controls and procedures, we recognize that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and our management necessarily was required to apply its judgment in evaluating and implementing possible controls and procedures.  The effectiveness of our disclosure controls and procedures is necessarily limited by the staff and other resources available to us and, although we have designed our disclosure controls and procedures to address the geographic diversity of our operations, this diversity inherently may limit the effectiveness of those controls and procedures.  Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, as of the end of the period covered by this report, our disclosure controls and procedures were effective, in that they provide reasonable assurance that information required to be disclosed by us in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms.   There was no change in our internal control over financial reporting that occurred during the quarter covered by this report that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.  In connection with these rules, we will continue to review and document our disclosure controls and procedures, including our internal controls and procedures for financial reporting, and may from time to time make changes aimed at enhancing their effectiveness and to ensure that our systems evolve with our business.

 

 

Part II

 

Item l.   Legal Proceedings

 

                                                There have been no material developments with respect to our legal proceedings during the period covered by this quarterly report on Form 10-Q.

 

Item 6.   Exhibits and Reports on Form 8-K

 

(a)          The exhibits listed in the Exhibit Index are included elsewhere in this report.

 

(b)         Reports filed on Form 8-K during the quarter ended March 28, 2004.

 

We furnished a Form 8-K on February 11, 2004, under Items 7 and 12, reporting that we issued a press release announcing our financial results for the year and quarter ended December 31, 2004 and furnishing the press release as an exhibit.

 

We filed a Form 8-K on February 13, 2004, under Item 5, reporting that Timothy P. Horne had established pre-arranged plans to sell shares of the Company’s class A common stock for his own account and for the accounts of certain trusts of which Mr. Horne serves as trustee.

 

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SIGNATURES

 

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

 

			WATTS WATER TECHNOLOGIES, INC.
Date:	May 7, 2004			By:	/s/ Patrick S. O’Keefe
					Patrick S. O’Keefe
					Chief Executive Officer
Date:	May 7, 2004			By:	/s/ William C. McCartney
					William C. McCartney
					Chief Financial Officer and Treasurer

 

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EXHIBIT INDEX

 

Listed and indexed below are all Exhibits filed as part of this report.

 

Exhibit No.		Description
10.1		Relocation Management Agreement between the Registrant and Cendant Mobility Services Corporation dated April 6, 2004.
10.2		Amendment dated March 3, 2004 to Letter of Credit issued January 23, 2002 by Fleet National Bank for the benefit of ACE Property and Casualty Insurance Company and Pacific Employers’ Insurance Company.
10.3		Limited Waiver dated as of March 11, 2004 to Revolving Credit Agreement, dated as of February 28, 2002, by and among the Registrant, Watts Regulator Co., Watts Industries Europe B.V., Fleet National Bank and the lenders listed therein.
11		Computation of Earnings per Share (1)
31.1		Certification of Principal Executive Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended.
31.2		Certification of Principal Financial Officer pursuant Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended.
32.1		Certification of Principal Executive Officer pursuant to 18 U.S.C. 1350.
32.2		Certification of Principal Financial Officer pursuant to 18 U.S.C. 1350.

 

(1)

Incorporated by reference to Note 6 to the Notes to Consolidated Financial Statements included in this Report.

 

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