Watts Water Technologies, Inc.

Thank you. Good morning.

On the call with me today, as always, are David Coghlan, our CEO; and Bill McCartney, our CFO.

Please be aware that remarks we may make during today's call about the company's future expectations, plans and prospects constitute forward-looking statements under the Private Securities Litigation Reform Act of 1995. Actual results may differ materially from those indicated by these forward-looking statements as a result of various factors, including those discussed under the heading Risk Factors in our annual report on Form 10-K for the year ended December 31, 2011, and other reports we file from time to time with the Securities and Exchange Commission.

In addition, forward-looking statements represent our views only as of today and should not be relied upon as representing our views as of any future date. While we may elect to update these forward-looking statements, we disclaim any obligation to do so.

During this call, we may refer to non-GAAP financial measures. These measures are not prepared in accordance with Generally Accepted Accounting Principles.

A reconciliation of the non-GAAP financial measures to the most directly comparable GAAP measures is available in the press release dated May 1, 2012, relating to our first quarter 2012 financial results, a copy of which may be found in the Investor Relations section of our website at www.wattswater.com, under the heading Press Releases.

I will now turn the presentation over to David and Bill.

Good morning, everyone, and thank you for joining our first quarter earnings call. As always, we appreciate your interest in our company.

I'd like to start by providing you with a brief overview of the quarter, and I'll give you a latest view on the market conditions in our key regions and a sense for where we see those markets trending as we move further into 2012. After that, I'll hand the call over to Bill to review our financial performance in more detail, and after Bill's discussion, I'll summarize and we'll open up the call to your questions.

Let me start by recapping the quarter. First, let me say that the Watts management team is disappointed with our first quarter results.

While our end markets are creeping along the bottom and while that isn't helping volumes, we had expected to deliver better operating performance, with many of the key issues in the quarter being internal ones. These issues were largely concentrated in North America and can be grouped into 3 categories.

First, we experienced greater-than-expected cost increases in non-copper bearing raw materials, which we did not offset with productivity savings. You will recall that we moved quickly and successfully to increase prices last year to get ahead of copper-driven inflation.

We're now seeing inflation coming through in our non-copper bearing spend.

Second, as we prepared to transition our products and plants over to new brass and bronze alloys, which meet the requirements of the reduction of lead in Drinking Water Act, we allocated a higher-than-expected amount of our production capacity to preproduction runs. Therefore, we did not absorb our fixed overhead in a normal manner, and we also had to outsource a portion of machining production to meet customer demands, thereby, increasing our costs.

This transition is a very significant initiative for the plumbing industry as a whole, and we are pushing very hard to be ready well in advance of the January 1, 2014 implementation date to ensure we sustain our position as a leader in the industry and minimize transition risks. As a result of this push to be early, we expect to incur more transitional costs over the next few quarters.

Third, after a period of declines, our North America business experienced higher product liability costs in the quarter due to an increase in claims volume, which caused us to increase our product liability reserves. In general, pricing was less of an issue during the quarter as our pricing initiatives of last year in the North American wholesale market were sustained.

Indeed, we were able to pick up some pricing in select markets, especially in Europe and in the North American DIY market.

On the copper bearing material front, we saw costs stabilize, and we believe near-term copper costs will not be a significant factor affecting our margins. So what are we doing to address these issues?

First, we're working hard to limit further cost increases in North America and to mitigate those we've taken. Second, we're accelerating other initiatives, including some SG&A cost reduction programs, rate cost coverage programs and some additional manufacturing footprint consolidation programs.

Third, we're reenergizing some recent product launches to potentially accelerate revenue growth, and we're implementing some selective price increases in areas where we had minimal increases last year. We anticipate that the combined effect of these actions will lead to improved earnings over the next several quarters.

On a positive note, our European business delivered organic operating earnings that were on par with the first quarter of 2011. We accomplished this in spite of the general malaise in much of Europe and incremental IT spending as we near the go live days in Germany of our common ERP platform.

We believe we're taking some market share in certain product lines in Europe, and Q1 was the best quarter we've seen for some time in terms of price realization and productivity gains in Europe.

Within Europe, Germany continued to perform well during the quarter, especially for products sold into the under floor heating marketplace. Our BLÜCHER drains product line also performed well in the quarter, both in terms of building backlog and in terms of shipments, and Socla delivered another solid quarter.

Finally, our Asia business delivered 13% organic sales growth albeit off a small base as we start to see the benefits of our refocused efforts on the China market.

Now let's move on to talk about the market conditions we're dealing with in 2012. First, let's look at Europe.

We haven't seen Q1 Eurozone GDP statistics yet, but our expectations are that Europe may have experienced minimal to slightly negative growth in Q1 on top of negative growth in the fourth quarter of 2011. From our view, Germany, France, the Nordic region and Russia are expanding, with many other markets weak or contracting.

The U.K. recently announced they're in a technical recession, as did Spain some weeks ago.

And we see politics playing an important role in how the Eurozone responds to the ongoing issues, as the elections in France and the fall of the Dutch government plays out. Any further austerity measures that may be undertaken by these and other governments could cause further contraction in the near term.

However, overall, our view of Europe and how it affects Watts in 2012 really hasn't changed that much from what we talked about in late February. We remain cautious about the uncertain macroeconomic environment in Europe.

We remain concerned about southern Europe, particularly Italy, where we have substantial operations, what we believe the repair/replace upgrade business should continue, and we're pleased with the Q1 results of our efforts to focus on growth opportunities in under floor heating and drains and in markets such as Germany, eastern Europe and the Middle East.

The major challenge in Europe will continue to be price cost issues for our copper bearing products in an environment where we face fragmented competition. We have responded to some of the recent increases in copper prices by announcing further price increases in a number of our key markets in Europe, and as I mentioned earlier, we made solid headway in Q1 on the price realization front in Europe.

Let's move on to North America. We still believe North America may grow modestly in 2012.

The U.S. economy is likely to continue with steady but slow growth, although U.S.

GDP in Q1 was a little disappointing at 2.2% compared to 3% in the fourth quarter of 2011. However, recent statistics on housing starts and new housing permits have been positive, driven heavily by multifamily construction.

We still see foreclosure overhang, distressed sales and high unemployment levels as a barrier for significant growth in residential construction in 2012. We believe existing home sales should be steady, which is encouraging for our repair/replace upgrade business.

Commercial construction expectation remains somewhat muted. The ABI has provided positive signs with 5 consecutive months of growth through March, but that has yet to show any significant change in projects breaking ground.

So in summary, things are moving in the right direction in North America, but given our place in the construction cycle, we don't see any significant volume gains occurring in the market in 2012.

Finally, let's look at Asia. In Asia, our operations are still small at present.

So significant growth there won't necessarily move the needle in the short term, but we do anticipate that our longer-term growth prospects there are bright. We believe there's a significant opportunity for us to grow in the China marketplace, and we're making some nice progress in laying the foundations for sustained growth there both in the plumbing market and the HVAC market.

China's economy is expected to grow by roughly 8% in 2012, and a significant portion of domestic GDP is accounted for by real estate, including construction. China is developing its code and regulatory infrastructure, and Chinese consumers are increasingly investing in their homes.

We are also starting to work outside of China to create a presence in other markets in Southeast Asia where growth opportunities exist. So we remain excited about the long-term potential for growth in Asia, even though its impact in the short term may not be substantive.

Let me turn it over to Bill now, who will provide you with more insight into our operating performance in Q1.

Okay. Thank you, David.

If we look at the revenue line, we closed at $364 million. That's a 10.4% increase.

Looking at the components of that increase from an organic standpoint, we had $3 million of growth, just about 1%. The change in the foreign exchange rate decreased our revenue by $5 million, so that's a negative 1.5%.

And then the inclusion of the acquisitions, Socla and tekmar, increased our revenue by $36 million, which is 11%.

At the very bottom line, adjusted net income from continuing operations, $16.1 million. That's an increase of 2.5%.

However, if we look at the adjusted EPS from continuing operations, $0.43 per share, which is equal to last year.

In our GAAP numbers, we have some restructuring costs. I know everyone's always interested in that by region.

So if you look at North America, $400,000 pre-tax, $200,000 after-tax; Europe, $1.3 million pre-tax, $800,000 after-tax. So that's $1.7 million in total pre- and $1 million after-tax that has an impact of $0.03 per share in the quarter.

Looking at the segment performance now. North America, we closed our revenue at $210 million.

That's an increase of $8 million of just about 4% growth. The factors there, organically, we grew $3.7 million, 1.8%.

The change in the Canadian exchange rates declined just a little bit, so that will have an adverse impact of $300,000 or 0.1%. And then in North America, the acquisitions accounted for $4.5 million, 2.2%.

And that is a piece of the Socla business and the tekmar business, which we acquired during Q1.

Looking at the wholesale and retail breakout. Wholesale is $165 million in the quarter, which is an increase of $6 million or 4%, and the retail at $45 million, an increase of $2 million or 5%.

If we look at the North American market overall, basically flat from a volume standpoint, with the increase coming predominantly from pricing. Looking at the European segment, $149 million of revenue, an increase of $25 million or 20%.

Again, the factors there, we had a negative situation on organic growth, a decline of $1.1 million, just a little under 1%. And in Europe on the organic standpoint, that's about negative 2.5% or so on volume, with the offset being price.

Foreign exchange, the change in the euro versus last year, we lost $5 million there or negative 4%. And the inclusion of Socla, $31 million or 25% growth, so that's a total of $25 million.

And total for Europe in 20% growth.

And again, as David said earlier, in Europe, we're seeing some solid growth from BLÜCHER, we see the hit rate improving there on their projects, we're seeing more exports from BLÜCHER outside of Europe. Germany continues to be strong in the under floor heating market, and Socla sales, overall good and particularly into Eastern Europe, with the offsets being southern Europe, particularly in Italy, where we have a weak domestic market.

And the exports into North Africa out of Italy are also weak.

China, revenue is $5 million, an increase of 31%. Even though a small base, mostly -- well, I should say it's about -- $500,000 of that is organic, 13%, and the rest is primarily Socla -- the Socla business in China.

And again, as David said earlier, we're doing well in China, small base picking up additional distribution and seeing some nice growth in some of our heating products.

What's the issue for the quarter for Watts is the gross margin. On a consolidated basis, we had a margin of 35.6%, and that's a decline of 110 basis points versus last year's first quarter.

What we see in looking at the segments, Europe did perform well on the margin line at 34.9%. That's an increase of 70 basis points.

That's driven by the improved pricing, the achievement of some of the productivity initiatives, and we had, again, a good mix within Europe because of the performance of BLÜCHER. Now some of this was offset by some of the increased commodity costs but overall, a good margin performance in Europe.

The issue we have again in the quarter though is the North American gross margin. The margin in North America for Q1, 35%.

That's a decline of 230 basis points versus last year's first quarter. When we kind of break that out, the decline is about 1/2.

Half of it is associated with the increased material costs, and the other 1/2 is associated with some of the inefficiencies in lead-free costs that we saw in our manufacturing plants. The material costs driven -- these are non-commodity costs, so the copper was relatively stable when we compare Q1 to Q1 and Q4 to Q1 as well.

So what we're seeing is some of the costs driven primarily by energy, if you will. We saw increased resin costs, increased freight costs, and these are things that we've experienced very recently.

On the overhead side, again, 1/2 of the miss on the margin is the overheads. We can break that out into 2 components.

So the 1/2 of that 1/2 is associated with costs that we incurred because of the lead-free transition. We're dedicating more of our production capacity to the preproduction runs of these lead-free products.

We're also having to outsource some of our production. So again, we're not -- we're incurring additional costs, and we're not getting the traditional level of fixed overhead absorption.

That's the combination of the 2 items. And then the other half of the overhead issue, if you will, is really associated with some of the productivity issues.

We didn't hit our productivity objectives in the quarter, and we believe a lot of that really is due to the fact that we have manufacturing and engineering teams focused on the lead-free transition. So we have identified very specific programs to address these issues.

We have some initiatives around material costs, obtaining some relief from some of our vendors. We're looking at our freight management programs and freight allowances with our customers and so on, as well as addressing or implementing some selective price increases.

We do anticipate the lead-free costs that will continue for the next 2 to 3 quarters, and we are pushing our productivity teams very hard. So we're expecting to see some improvement there.

So we do expect to see improvement in North American margin over the next couple of quarters, but it will be a couple of quarters to see the material costs move back in to implement the price increases and to get lead-free transition behind us.

On the SG&A front, SG&A was $101 million versus $97 million last year, an increase of $4 million. Just to walk through that increase, we had an increase from an organic standpoint of $1.4 million that was entirely associated with the increase in product liability.

We booked about a $2 million number there. The change in foreign exchange rates caused a decline in our SG&A of $1.2 million.

The inclusion of Socla and tekmar increased our SG&A, $10 million, and then we had a reduction of $6 million versus last year's Q1. If you recall, we did book some CEO separation costs last year.

So that -- we're identifying that separately for you. So the combination of those items takes us to the $101 million.

The operating earnings at $28.7 million is a decline of $1.6 million, and again, that's associated with the lower growth margin in North America, which partially offset by the improved margins in Europe and the contribution from our acquired companies.

The tax rate at 28%, that's down from our normal run rate of about 33%. We did have a favorable -- we had a tax audit in Holland, at our Dutch corporate office in Holland, and that was a favorable adjustment, which impacted our tax rate.

And that was a contribution of about $0.02 in the quarter.

So net income at $16.1 million on an adjusted basis, a slight increase from last year of $400,000 and $0.43 on adjusted basis comparable with last year.

With that, I'd like to turn it back to David.

Thanks very much, Bill. Look, we didn't deliver the type of performance we wanted to in Q1, and we're unhappy with that.

Some of the issues were outside our control, but on others, we stubbed our toe. And so our focus for the coming quarters will be to reinforce our commitment to our 3 strategic priorities, and they are growth, operational excellence and One Watts.

We're going to focus on growth initiatives such as reenergizing our new product introductions, increasing our focus on selling more of our existing products to existing customers and on pushing harder on our geographic expansion initiatives.

We're going to focus more on operational excellence by driving an increased number of our productivity projects through the fruition by doing a better job of mitigating the cost increases we've seen recently and keeping costs in line with expected sales volumes and by accelerating some additional footprint consolidations. And we're going to move our One Watts concept forward by taking advantage of some SG&A leverage opportunities, which we've been working on and will accelerate implementation.

By continuing to standardize our processes to our ERP deployment program, we'll go live in Germany this week and by deploying shared services across more of our organization.

So despite the slow start to 2012, we believe that our focus on these efforts will improve our operating performance as the year progresses.

At this time, we'd like to open up the line and address any questions that you might have. Laura, would you mind opening up the line for questions, please?

So you gave us a lot of info on Europe. And perhaps maybe you could just remind us what exactly is your European exposure.

Maybe if you could go from kind of increasing exposure, what nations do you have the most exposure to and then go and decreasing more.

Well, our #1 market is France, then second would be Germany. #3 is Italy, and then once you get past that, we'd looking at the Nordic region, that's 4.

U.K. would be 5.

So we have a presence in every country in Europe from Portugal to Kazakhstan and Tunisia to Norway. We're in every country.

But you can kind of look at the larger populations, but because of the Socla acquisition, we do have France as our #1 market now.

Got it. And actually, this brings me to my next question.

We're seeing organic growth kind of slip in sequential year. It's actually turning negative in Europe.

What is your M&A pipeline looking like?

We continue to work an active pipeline. We continue to hold our acquisition standards so that we do the right deals.

First question is, Bill, you outlined the year-over-year margin decline in North America, so the attributable to the cost inflation inefficiencies that you saw in the quarter. And I was just wondering, if the inference, if you strip out these several issues that you had in the quarter, that gross margins in North America would have been stable.

I was just wondering if you could provide some color, just if possible, on a like-for-like basis what gross margins are like here.

Yes, that will mean that your statement is correct. I mean, we -- if we didn't have these issues, particularly on the overhead side, we would have had stable to up -- maybe slightly up margins.

I mean, that's the trend we have been on for quite a while with the focus that we have on continuous improvements and using the tools and educating the folks and taking that to the next step around footprint consolidation. We've had a long history the last several years of improving gross margins, and we ran into this lead-free situation where we have a tremendous portion of our workforce in the manufacturing plants focused on this.

And because of that, we had to outsource some products. We had to increase our spending on lead-free and dedicate a fair amount of our production capacity to sort of these preproduction runs, which are, by definition of the accounting rules, have to be expensed.

But I think we would have had, at worst, stable margins if we hadn't had this situation.

Okay. And then -- and just looking at the top line growth in North America, did any of these plant disruptions that you incurred during the quarter, did it cause you any sales loss?

No, we don't believe though. We've had 1 or 2 minor hiccups here and there, which were not due to lead-free.

In terms of delivery rates, they were potentially the knock on FX of some consolidation moves we made. But as we look at our overall delivery rates, overall, they've been pretty good.

They're in the -- they're 95% and above. So we don't believe that any of these resulted in any customer loss.

We made sure of that by moving to outsource at some production where we had some bottlenecks because of the preproduction runs. And so while that cost us, it allowed us to retain the customer business.

Okay. And then just the last question is on the 1% growth in North American wholesale.

Just wondering, looking at some of the macro data points around new construction and even repair and remodel in the first quarter and the outlook for the full year, I was just wondering, it came in a little bit below our expectations. What were you seeing in the first quarter specifically?

Was it maybe some de-stocking at wholesale or was it the weather that limited the upside in the quarter? And maybe if you could talk a little bit more about your outlook for flattish demand through 2012.

I'm just trying to understand the disconnect between what you're seeing and maybe some of the other macro indicators on the building side.

That's a great question. I think it's fair to say that our channel teams are probably tired of seeing our -- the numbers coming from us in terms of what's going on in home starts and some of the other macro data that we're seeing, allied with questions around what are we seeing.

What we're hearing from our channel contacts and what we're also hearing from fellow travelers in our space is that our part of the industry is still not showing a whole lot of growth. And so did we see channel contract -- channel inventory contract in the quarter?

No, nothing meaningful that we know about. And so we're looking at it and saying, "Well, we're later in the construction cycle, and so we're keeping our eyes open to see how this moves through."

Just to kind of understand the moving pieces on these costs again. So if we kind of use 1Q as the baseline, and you quantified those pretty well, I mean, does the lead-free number persist through the rest of the year or does that number start to fade as you ramp?

And then how should we think about price offsetting some of this material inflation? And I guess does the product liability number, a one-timer.

So if we put this in round numbers, what Bill talked about is the $6 million issue in the quarter in North America. $4 million of which is on the gross margin, split between the low lead and the material cost issue, and then the final $2 million in the product liability issue.

If we look at lead-free, what we've been doing is trying to accelerate our efforts on lead-free because the last thing we want to be left with is a bunch of leaded inventory as we approach the transition point. And so we're starting to see Canada talk about implementing lead-free, which means that there's no place left for leaded inventory.

And so we decided to accelerate our efforts, get through this transition as quickly as possible well ahead of the implementation date. So a, we could transition safely; and b, we could transition early enough so we could avoid any inventory issues.

And so we have several hundred preproduction runs to do, and we've done a good chunk of them in the first quarter. And we should start to see them finish up as we move into the third -- as we move through the third quarter.

Net-net, the way we had originally thought about this is that we would run our preproduction runs through a 5- or 6-quarter period. And so we're trying to condense them into 3 quarters so that we get this done early and avoid any inventory issues through the transition.

Okay. And then the material cost issue, you're putting through price to cover that and that's just the transition?

We're doing a couple of different things. We moved very quickly last year to put in price increases ahead of material inflation, and we got the benefits of that for a couple of quarters.

We saw a lot of material inflation hit us, non-copper bearing material inflation hit us in the first quarter, and so we're taking 2 actions. The first one is, we're starting to put our fingers in the dike to stop the flow-in of additional material increases, and we'll follow that by trying to push some of the water back through the dike in terms of getting some benefits back from our vendors.

The second action we're taking is, there are a number of products where we did not -- they're non-copper bearing products and we did not implement significant price increases last year. So selectively, we're going through those, and we're looking to implement price increases.

So they may not be a one-for-one coverage, but between the price increase actions and some of the mitigation actions, we're hoping to squeeze that gap down over the next couple of quarters.

Okay. That's helpful.

And then just back in the North America markets, I mean, you said you're later in the construction cycle. So as you try to look and get visibility, talk to your customers about quoting activity, et cetera, I mean, does it feel like as we move through the year, you start to benefit from some of this more favorable kind of news flow on the construction side or is that -- or is visibility still pretty clouded?

Visibility is still pretty clouded as we talk to our channel contacts. They're certainly seeing and enjoying the benefit in terms of sales of products in the industrial arena, but they're still -- they're hopeful of a lift in sales in the residential and commercial arena, but we're not seeing a whole lot of them point to our types of products and say they're seeing significant lifts now.

And so it's pretty cloudy, and we're trying to keep a close eye on it.

Okay. I'm sorry, just on the product liability, is that a one-time hit or you run in at elevated product liability costs going forward?

The product liability issue is -- I guess the best way of explaining it is, it's an actuarial calculation based on incoming claim rates on product liability claims. These could be products that we sold a year ago, 3 years ago, 5 years ago, 7 years ago, even 9 years ago.

And as our actuary looks at the incoming claim rates, he makes a judgment on what we should do with our reserves. And so just to try and put a framework around this, because it's not driven by current product quality issues, the largest area that we have claims in is water connectors, and we sell about -- we sell in excess of 20 million water connectors a year.

And our incoming claims rate on an annualized basis is bouncing around between 1,300 and 1,800 claims. And so it's the actuarial projection of those claim rates that drives the adjustment in the reserve.

So if you do the math on the claims versus the units sold, you certainly don't see a significant quality issue, so it's the actuarial calculation.

Right. I guess what I'm asking is, is it a one-time adjustment to true it up or is it a new higher run rate based on...

It's an actuarial true-up based on some changes in the rates over the last couple of quarters.

I apologize if I missed anything, as I was bouncing around calls. I just wanted to ask you how we can maybe think about what's driving organic revenue in terms of new construction versus repair/replace business.

Well, over the last several years, it's really been repair/replace which is driving our business. And even though we're looking at the leading indicators of construction permits and housing starts, we're not seeing any meaningful change in the business we're seeing from new construction yet.

And so it's still the repair/replace upgrade element of our business that's driving organic growth.

Great. And then just on the pricing environment, is it fair to say that you still expect to cover a North American wholesale and then DIY in Europe continue to be challenging?

Is that...

What we indicated a little earlier was that we have sustained the price increases that we put through last year in North America wholesale. And we have improved our price realization in North America retail, and we had a nice forward momentum in terms of price realization in Europe.

Looking forward, because of some non-copper bearing material increases that have come in, we are looking for selective price increasing on products that we did not put up in any significant degree last year. And so we'll be implementing those over the next couple of months, and it will take a little bit of time for those to read through.

Great. And then just on the incremental costs related to the conversion to lead-free production, just -- can you give me an idea of just kind of what that means?

Is that like retooling machines to the new standards? And just sort of going forward, what can we think about...

Yes, we mentioned that a little bit earlier. What we've been doing is pulling forward and accelerating a series of preproduction runs for each of our product families.

Up until now, lead-free has been a relatively small part of the market, driven by a couple of states. And so our strategy has been to satisfy lead-free requirements by outsourcing those products.

But as we prepare for a January 1, 2014 transition date, and as we see other countries like Canada begin to move towards lead-free, we decided that we needed to accelerate the transition of those lead-free products into our plants, since by January 1, 2014, it will be an excess of 90% of our copper and bronze -- of our brass and bronze volumes. As we bring those products into our plans in order to ensure that we can produce them properly and that we've got our costings right, our processes are set up correctly, we do a preproduction run for each product family, and we've got about 400 of those to do.

And so we've been accelerating those. And as we push them through the plants, those preproduction runs are taking up material labor and overhead, which are not absorbed into salable product.

And so we'll work through that over the next 3 quarters, and then it will dwindle.

A couple of quick questions. Where -- or how are you managing the California and Vermont lead-free product lines through the same plants that you've stepped up production on these preproduction runs?

Well, maybe we ought to just step back and try and educate folks a little bit on lead-free. The lead-free movement started in 2 states, California and Vermont.

And then it moved to Maryland and Louisiana. And then the federal government decided to implement a law, which is slightly different than the existing laws, but it makes it a nationwide requirement by January 1, 2014.

And so as we look at the states that had already gone, of the products that needed to be converted, approximately 10% of their volume were lead-free and 90% were leaded. And so that 10%, we decided to manufacture at third-party locations.

But as it moves from 10% to the 90%, it will be -- after January 1, 2014, we need to pull it into our plants. So David, they're the same products.

The scope of the product covered may be slightly different between state legislation and federal, but the product we make for California that's lead-free will be the same product that we'll make to meet the federal requirement.

Okay. So I guess that's the part I missed.

That was already being outsourced, that 10%?

Correct.

So then, I guess, there are 2 follow-up questions on the lead side. One is, I guess, intuitively, the 10% is relatively small, so that should help your margins over time.

But as you look at this product as, in part, being outsourced and part you're carrying before the federal mandate, you can't get pricing on full pricing on lead if it's not required. So are you pricing the product line the same as your product with lead for right now?

The challenge the industry has -- well, first of all, the 10% that we're supplying today is outsourced. The federal regulations come in.

90% of the volume associated with those products will be lead-free and we're pulling that into our plants. The challenge for the industry is, the cost of lead-free alloys is higher than leaded alloys.

And so the industry has 2 options: it can avoid phasing lead-free product into the market place until January 1, 2014, in which case, a lot of our customers will have a lot of leaded product that they can't sell, and they'll want to return it. And this is an industry issue; or we can transition early, which means that the higher-priced product will have to come in to the market in advance of the transition date.

And so the industry would collectively -- is collectively looking at this. And obviously, each company will make their decision, but my guess is that everybody will move early to avoid the consequences of the inventory issue.

So there's a risk for you as well that you carry this lead-free inventory and you can't push it through at higher prices, right?

The reason we're transitioning early is that we avoid the leaded inventory issue, and we're working closely with our customers because it's an issue for them as well. And so we want to go early, and we believe that's the way the industry is going to go to avoid the issue of leaded inventory.

Got it. Okay.

But there's still a risk that the lead-free could be potentially be an inventory issue for you if the end markets don't move forward quickly enough. Is that fair?

Right. But our customers would be stuck with leaded inventory.

We could be stuck with leaded inventory. And so we believe that it's in everybody's best interest to transition early.

Okay, I understand. And then on the productivity issue, it sounds like -- I mean, you folks have been lean for quite some time.

It sounds like maybe you're a little bit thin on the bench to have this sort of problem where you can't transition one to a new product line, at the same time, execute on your lean initiatives. Were there any changes in personnel?

Did you lose people? And if not, do you have to add to your bench?

And does this imply a tick-up in SG&A?

David, here's the way I try and typify it. By moving earlier and faster on lead-free, we're transitioning an excess of 30,000 SKUs.

And so we're dedicating our existing -- it's not so much that we're thin on the bench, it's that as we try to accelerate this program through our facilities, in order to transition in excess of 30,000 SKUs, you've got to have all hands on deck.

David, this is much more involved than just introducing a new product line.

Yes, I can imagine. Okay.

And then -- that's helpful, actually. And then lastly, can you describe any impact, if at all, that you've seen from some of the aggressive pricing in the marketplace, such as Apollo/Conbraco for MISAB?

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Well, when -- on the plumbing side, when you take the lead in driving through price increases, you do run the risk that you may lose a little bit of share at the margin from holding to your price increases. And we have seen some of that, but some of the areas are job-related.

And so as you push out your price increases, you can look job by job and make individual decisions to try to protect your market share. And so we've pushed out aggressively on price, and we're now looking at the jobs running through the system.

And we're trying to make sure that we maintain our share situation. So it's a couple of moving pieces that you're managing at the same time.

Okay. And you haven't seen any, on a distributor basis or wholesale basis, any impact from United Pipe at all?

I have to say, David, I'm unfamiliar with it.

Okay. No other -- nobody else in the channel is particularly weak, right?

There's a couple of customers that have been weak. We're keeping our eye on it.

The bad debt situation from our perspective right through the recession has been extremely well-managed. Our DSOs are under control, and our percent current were well over 90%.

This is Sid standing in for Jamie. Well, the first question I had was with regards to the increased professional service fees in Europe relating to the pending German ERP implementation.

Was this sort of anticipated? And how do you project this going forward?

Good question. As often happens when you deploy a new ERP system, you run into more complications than you originally envisaged.

And so we did deploy more consulting in the first quarter to try to get ourselves through that so we could get to launch. We do see those ease as we get past the first deployment.

So first deployment is this week in Germany, and then we move on to the U.K. next.

We should see those consulting fees ease.

Okay. So just a bit of an idea of this ERP implementation, is this like the start of the ERP implementation?

And you're going -- is there a plan to like do it in other parts of the business, other territories like North America? And so they can potentially be similar costs related to, say, the U.K.

implementation later or other parts also?

We use an ERP system in North America called QAD. It's a mid-market ERP system.

We are deploying QAD in Europe for the first time, with Germany being our beta. And we will deploy that over the next several years across our other sites in Europe.

Since it is an updated and upgraded enterprise system, we will take that updated and upgraded system back into North America. So this is a multi-year process.

Okay. Coming back to the lead-free question, one of the questions that I had was that -- I mean, first, I wanted to see that I understood it correctly.

So what happened was that this lead-free thing, I see it going into -- in your 10-K, as going back in like 2009 or '10 timeframe. So this was sort of a thing that you already knew you would have to do.

So I suppose what happened this quarter is that you accelerated the preproduction runs because of Canada and you wanted to be ahead of the curve. Am I correct there?

Or...

Yes. The lead-free legislation that you referred to back in 2009 related to some individual states, California and Vermont, who went this route.

And therefore, it was a very small proportion of our output, and we could meet it from third-party suppliers. Last year, the federal government, the EPA decided to introduce legislation, requiring this nationwide by January 1, 2014.

And we're now seeing other countries such as Canada jump on board. And as we looked at this, our original view was that we would run our preproduction runs over a 4- to 6-quarter basis and still be ready and plenty of time for January 14.

However, to mitigate the risk of unneeded leaded inventory, we decided to accelerate. And so we're doing more of the preproduction runs in the first quarter than we had anticipated, and therefore, it affected our absorption rates.

Okay. Continuing on the same issue, so I guess for going to the lead-free situation, you will be transitioning your plants in terms of manufacturing capabilities, and you will be transitioning to a substitute for lead.

So on both these items, like have your plants all transitioned, like you with your preproduction runs, et cetera? Have all your plants transitioned?

And what is the substitute for lead? Like what material are you going -- what material is used?

And how is the pricing dynamics around that material, the supply situation around that material?

Well, first of all, just to make sure again people understand, the old legislation allowed us to use copper-based alloys, which had up to 8% lead. The new legislation allows us to use copper-based alloys with less than 0.5% lead.

And so the substitutes that the industry is looking at are various, and they include using silicon in place of lead or using a material called bismuth in place of lead. And so different products and different companies are adopting different alloys.

And so that has significant implications for the way you cast, machine, et cetera.

Okay. And I guess you have your supply situation for silicon investment, and that is something that already being planned?

And...

Yes. So the issue really is, as we introduce product families into our plants and do preproduction runs, there's a cost to that because you're testing it, you're trialing it, you're making sure you can do it properly and you have to expense those costs.

So not all of our plants are tooling. We are doing approximately 400 preproduction runs, and we will do them in stages.

And when they're complete, our plants would be fully tooled.

Okay. Coming to Socla, what sort of accretion did Socla contribute in the quarter?

Socla contributed $0.05.

Okay. And for China, I think we saw some strong growth in China.

If I remember in the past, a lot of China products used to be, I think, exported to Europe. So how is that dynamic changing?

What is driving that growth in China?

The growth you're seeing in China is coming in 2 buckets: one, there's a 13% organic growth rate, which is predominately sales in the China market; and then you've got the addition of the Socla sales in China. So the growth -- the organic growth we're experiencing are coming from our growth initiatives in the Chinese market.

Okay. So it's not related to exports to Europe or any place else?

It's organic within...

No.

Okay. And in terms of incremental margins, like what sort of incremental margins, and how -- when do we expect to sort of return to the 35% plus incremental margin range?

We will -- that is still our objective. And we believe that as we get through this transition of lead-free and getting some of the material costs reduced with -- and some of the pricing adjusted that David mentioned, that we will definitely be returning back to that 35% incremental margin on incremental revenue.

And I would expect we'll be there by the end of the year.

Okay. And you mentioned about this non-copper material cost.

Which specific material are you referring to which is sort of driving this raw materials?

We're seeing a long tail. We've seen an increase in our resin costs, which are obviously driven by oil.

We're seeing an increase in some of our cast iron. We're seeing an increase in packaging, freight rates, et cetera, et cetera.

Okay. And just one final question on the wholesale North America growth in Drains.

Is that related to BLÜCHER?

We're seeing nice progress in our entire Drains business in North America. We're seeing particularly nice progress with our BLÜCHER product line in North America.

I was just wondering, just dig in a little deeper regarding the lead-free and the real cost and so forth. How does that change the mix and how you planned for volatility in the market, especially with copper, where, generally in the past, you've just taken maybe 5 to 6 months to pass the cost through?

And based on LIFO accounting, is there any change that you're looking at as far as like accounting...

I think what we said in the past, Stewart, you're correct in that those dynamics really don't change because we're moving to this newer material. Typically, what you're referring to there typically is that what you see is a change in the spot copper rate, will hit our P&L anywhere 5 to 6 months later, and that's based on the inventory that we carry, plus the commitments we have with our vendors.

That really will not change with this material. And I think in terms of the pricing power of the company and so on relative to copper-based products, I don't see that, that really changes with this new material.

So it's really -- the new material will cost a bit more, and we will have to adjust our prices at some point when we start putting it into -- out into the field. And we'll address that when the time comes.

But in terms of the dynamics that you are talking about, I don't -- the historical dynamics, I don't see those changing.

And are customers generally accepting the prices that you're letting through now?

Well, the industry has had an opportunity to get used to this because of the fact that 4 states have already had lead-free laws. And so customers in those states and the suppliers that supply those customers have had an opportunity to sort of work through this issue and establish the pricing levels.

And from our perspective, yes, the industry is getting higher prices for the higher cost to alloys.

And regarding your capital allocation, how are you breaking that down? Plus your -- you need to look for acquisitions.

Any share buybacks or anything?

We -- at the end of the quarter, we had about $250 million or so of cash on hand. We're still expecting to have a solid cash flow year like we had the last couple of years -- last 4 years in a row.

As we think about -- we have a very conservative balance sheet. So our #1 focus relative to capital allocation remains the M&A market.

We do believe that, that creates the most value for our shareholders and improves the firm overall. So we remain committed to that.

Historically, 1/2 our growth has come from acquired companies. Acquisitions are opportunistic by nature, even though we have a very well-defined strategy in terms of what we're looking for, but you never know when properties will come -- become available.

But we will -- we do remain committed to that strategy that we've shared with everyone over the years. So M&A is first.

We remain committed to our dividend. We've had a dividend every quarter since we went public in 1986.

We historically issue between 15% to 20% of our earnings in dividend. We remain committed to that.

We're not committed to a buyback at the moment. We did a buyback last year.

We bought 1 million shares, and we have a philosophy of buying back the creep. And we remain committed to that, but we don't -- I don't see any major buybacks in the near term.

Okay. And just on the Socla accretion is that still -- looking at about $0.18 for the year?

And just of ROI, when is your ROI targets for mid-teens? What's the target date for that?

We've -- as everyone will recall, when we acquired Socla last April, we said that we would -- it would be accretive in the range of $0.14 to $0.18. We just did $0.05 in Q1, so we feel very comfortable saying that we will remain at the top of the range, maybe a little better.

So we feel comfortable with that. Our plan for Socla was to hit 12% ROIC in year 3, and we don't see any reason why we won't hit that.

I wanted to ask a question on the lead-free issue, a little more conceptual in nature. Over the years, you've talked about, generally speaking, the code approval nature of your business as a positive, and it's a moat around the business and helps to sustain returns over time, especially for companies like Watts that get out ahead of these types of things.

So it's somewhat an ironic element here that it's actually a negative this time around. So I wondered if you could kind of frame that, how you look at that whole issue of code approval now in light of what's happened on lead-free.

And is this kind of a one-off? Or is that element to the business still there and you still believe it's a competitive differentiator?

And then relatedly, are there any other big changes to code, either state or national, that would cause -- there on the horizon that would cause a similar issue that we're seeing with this issue today?

Let me deal with the second question first, Ryan, if I may. We don't see any significant other issues out there that are either major positives or major negatives in the North American marketplace.

And then let me move on to the lead-free situation. The way I look at this is that we are dealing with a very complex initiative, which we've got to work through our processes and get behind us.

However, if we stand back and look at this in terms of the long-term, I believe that this is a positive for Watts, and I say that for a couple of different reasons. First of all, most companies in our industry will be supplying a mix of leaded and lead-free products.

For example, the legislation refers to products that are potable in nature. So companies will still be supplying products to, for example, irrigation markets where it's not potable water.

And so there will be -- there will continue to be a mix of leaded and lead-free products. The law also provides that he who introduces the product into commerce is responsible for ensuring compliance with the law.

So as we talk to our customers and our channel partners, the point we're making is, you've got to be -- you've got to trust your suppliers a lot through this whole process to ensure that there's no cross contamination, and that you're not being provided a leaded product for a lead-free application. And so as responsible companies such as Watts work on bulletproofing their supply chains, we believe we will have an advantage in being that -- in being our customers' partner, in being the trusted partner.

The second area where we believe we have an advantage is, there is a wide variety of alloys that manufacturers can choose to use in a lead-free environment. And we believe we've got the technical and engineering heft to make sure we make the right choices for the right applications, such that, for example, you don't end up with a product that cracks 3 or 4 years after it's been installed.

And so we see ourselves as going through a difficult transition process faster than we originally thought, but once we get through it, we believe that our position as a trusted partner with our customers and our engineering and technology heft gives us and other reputable companies in the industry an advantage.

I had a couple of follow-up questions. You have emphasized that mergers and acquisitions still remains your #1 priority for cash deployment.

So I was wondering, in terms of Europe, now that you have Socla somewhat behind you and because of this economic situation there, are you seeing some great opportunities in terms of the prices that which businesses might be available there?

We are certainly seeing some cases where our companies are perhaps struggling a little bit in Europe, but I have to confess, we've not seen many cases where the EBITDA multiples have changed substantially.

Okay. And the second question is, in Europe, what is the dynamics around this lead-free situation?

Is that something that might be expected sometime in the future?

We do not see any signs of it coming in the near term.

Okay. Well, thank you.

That was a good call with a lot of great questions. We appreciate your interest, and we appreciate your anxiousness to try to understand what went on in the quarter and what we're doing about it.

And so our focus is going to continue to be to drive for growth operational excellence in One Watts, get quarter 1 behind us and deliver an improved operating performance as the year progresses. So thanks for your time, thanks for your interest and look forward to chatting at the end of the next quarter.

Thank you.