Watts Water Technologies, Inc.

Moat: 2/5

Understandability: 3/5

Balance Sheet Health: 4/5

Watts Water Technologies, Inc. is a global provider of plumbing, heating, and water quality solutions, with a focus on flow control, and is increasingly leaning into sustainable technologies.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Business Overview: Watts Water Technologies operates across three primary segments: Americas, Europe, and Asia-Pacific, Middle East, and Africa (APMEA). Their offerings range from valves and connectors to water filtration, water quality and flow systems to HVAC and gas products, primarily targeting commercial, industrial and residential markets. This has resulted in the company having a diversified product portfolio and an array of different customers. The company reports its earnings through these geographical segments.

Americas generates the largest revenue share for the company, and it includes the U.S, Canada and South America.
Europe segment consists of revenue coming from the European region, including UK.
APMEA segment is the lowest revenue generator, and consists of Asia Pacific, Middle East and African nations.

Industry and Competitive Landscape: The plumbing and water technology industry is characterized by a mix of mature and developing markets. In the developed world, focus is shifting more to higher-efficiency and sustainable products, which Watts has invested to capitalize on. The global infrastructure development also drives a lot of demand for their products. The industry also experiences cyclicality due to its tie to the construction and real estate industry, making it prone to fluctuations based on demand. The competitive landscape is fragmented, as the company has several different competitors for each product they offer, making it difficult to create barriers to entry. Large players like Ferguson and Home Depot also generate revenue from the same space. There also exist smaller players that the company goes against in each region. This means that the market is very competitive and not easy to gain market share without a significant competitive advantage.

Moat Assessment (2 / 5): Watts has a narrow moat, not because of a single dominant factor, but through a combination of factors that limit competition and add some resilience to their profitability. Here’s a breakdown:

Brand Recognition and Distribution (Narrow): Watts has built a reputation for quality and reliability, particularly in the commercial and industrial segments, which is also supported by a long operating history. However, unlike many consumer product companies, their brand awareness doesn’t necessarily translate to customer willingness to pay a higher price than their competitors, even though they might have higher brand awareness. Their distribution networks, while extensive, aren’t as robust as one would imagine in terms of locking out competitors in all segments. Therefore, they don’t possess a wide moat based on their brand and distribution networks.
Switching Costs (Limited): The nature of their products means that customers can switch to different sellers and companies with relatively less hassle, so the switching costs associated with their products aren’t necessarily high and don’t provide significant economic protection.
Technology and Innovation (Limited): A consistent focus on innovative product development and a focus on technology helps maintain the ROIC levels. They have patents for some products which may give a certain amount of competitive protection, but the technological landscape is fast changing and most technology innovations can be replicated quickly. Therefore, their economic moat is narrow.
Cost Advantages (Limited): The company does not have significant scale advantages relative to peers. While some cost improvements from Lean initiatives are helpful, they can easily be replicated by competitors.

While these factors contribute to a relatively stable position, the company is more susceptible to competitive forces. Therefore, the company should not be considered as having a strong moat compared to its peers in other industries.

Legitimate Risks that could harm the moat and business resilience:

Cyclicality: A slowdown in construction and real estate industries may severely hurt the business since it is dependent on the industry. The company has tried to diversify to non-construction sectors and into service and maintenance to combat this factor, however, this factor will continue to affect their business.
Raw material availability and prices: Increasing costs and volatility of the raw materials may have a negative impact on the profit margins, and may threaten long-term contracts.
Changes in technology: The industry in general is changing towards smart technology and this makes the company’s position relatively vulnerable to new players who have more understanding of these changing technologies. The company has been trying to adopt new technology, but it remains to be seen whether the older generation products will generate value in the future.
Competition: The competitive environment is intense, which makes it difficult for the company to increase price, and therefore may lead to shrinking margins in the future.
Currency risk: The company’s sales are distributed geographically and therefore, fluctuations in currency exchange rates can significantly impact revenue and profits.
Regulation: Changes in regulation or international laws can have negative effects on how they sell their products in different regions. The company has also to keep up with new laws and changes in the markets.

Business Financials:

Revenue Distribution: The Americas segment is the major revenue source, contributing a majority of the revenue. Europe and APMEA segments bring in a smaller portion of the revenue.
Growth: The company has seen decent growth in the past few years, with higher than average revenue growth reported in recent times. But this growth is expected to slow down in the coming years. The company has managed to make significant gains in its sales, however, most of it is inorganic and derived from the acquisition of several businesses.
Margins: The gross margins and net profit margins of the business are relatively lower than its competitors. This could be due to the commoditized nature of their products and less brand awareness.
Capital Allocation and Expenses: The company primarily focuses its investment in mergers and acquisitions which are expected to bring new growth. This strategy involves a large portion of the capital expenditure that the company incurs every year. They have also increased R&D expenses, although a large portion of the research seems to be in areas of minor improvements than in true innovation.
Debt: The company’s debt levels are low and within its defined target ratio, therefore providing it with sufficient flexibility.
Profitability: The company is profitable and has shown decent improvement in its bottom line, however, that might change if their costs increase or revenue falls down.
Cash flow: The company generates a high amount of free cash flow and it is also steadily increasing.

Key points from latest earnings calls and recent news:

Q3 2022 Results: The company reported a record sales quarter, with sales growth of 19.7% in the Americas and 15.5% globally. However, its net income declined slightly compared to the previous year. This is due to the increase in SG&A expenses.
Inflation: The company reported that high inflation impacted the margins, as they are facing higher raw material costs. In addition to that the company had higher inventory and transport costs which reduced the margins. Company management is working to mitigate these impacts through price increase and cost saving measures.
Acquisitions: The company recently completed an acquisition of Bradley Corporation which they expect to provide growth synergies and margin improvements.
Supply Chain: The company has stated they are seeing improvements in supply chain issues. However they are actively working on improving operations to mitigate any potential future disruptions.
Guidance: Company management has reaffirmed their full-year 2022 guidance, predicting a high growth despite inflation and operational challenges.
Strategy: The company has been focusing on high growth segments, and making acquisitions to grow further, while managing costs.

Understandability (3 / 5): Watts’ business is moderately complex. While it sells products in the plumbing, heating, and water technology sector, its diverse range of products and markets across multiple geographies introduces some complexity. It is not straightforward to assess its brand strength or moat, as it needs specific industry and product knowledge, it is not a simple and easy to understand business. Furthermore, there are several moving parts that influence their profit, including macroeconomic factors, currency fluctuations, and new acquisitions. Therefore, this business is only moderately easy to understand.

Balance Sheet Health (4 / 5): Watts has a good balance sheet. They have maintained a debt to equity ratio of under 1, with enough liquidity to deal with any contingencies. The company also generates a decent amount of cash from operations, and the positive cash flow contributes to a stable and flexible financial position. There is a minor concern due to debt incurred through acquisitions, which means that the overall company’s long-term debt has increased. Still, they maintain a healthy balance sheet.