Good day, ladies and gentlemen, and welcome to the Watts Water Technologies acquires AERCO International Incorporated conference call. My name is Crystal, and I will be the operator for today. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. If at any time you require operator assistance, please press star followed by zero, and we will be happy to assist you. Please be aware that remarks made 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 the company's Annual Report on Form 10-K for the year ended December 31, 2013, and other reports the company files from time to time with the Securities and Exchange Commission. In addition, forward-looking statements represent the company's views only as of today and should not be relied upon as representing its views as of any future date. While the company may elect to update these forward-looking statements, it disclaims any obligation to do so. I would now like to turn the conference over to Mr. Tim MacPhee, Treasurer and Vice President of Investor Relations. Please proceed, sir.
Crystal, thank you. Good morning, everyone, and welcome. We're having this conference call as a follow-up to yesterday's press release. We'd like to provide you more information about our expected purchase of AERCO International, Inc., or AERCO. We are very excited about this opportunity, which is going to provide a new platform for Watts and expand our product offering for our customers. I will now turn the call over to Bob Pagano, our CEO, to discuss the AERCO acquisition in more detail. Bob?
Thanks, Tim, and good morning, everyone. Please turn to slide 3 and let me summarize why we believe AERCO is an important addition to the Watts business portfolio. In commercial heating and hot water solutions, AERCO is the leading provider of tankless water heaters and commercial high-efficiency boilers between 1 million and 6 million BTUs. AERCO also sells products into the aftermarket. AERCO has developed a differentiated product offering by working with customers on application-specific solutions. Their solutions deliver operating cost savings to customers and solid operating margins for the company. As I mentioned during our Q3 conference call, we want to focus our business on differentiated systems and solution product offerings, so the addition of AERCO furthers our strategy and aspirations. Strategically, we've been looking at complementary product offerings outside our core plumbing and HVAC product families for the last 3 years, with heat source considered a key adjacency.
The purchase of AERCO provides a strong foundation within the heat source arena, with an opportunity to grow the platform over time. Now, if you turn to slide four, let me provide a brief overview of the transaction. We are acquiring all the outstanding shares of AERCO in an all-cash deal for $264.5 million from The Riverside Company, a private equity group. The purchase price is subject to customary working capital adjustments. Sales for the company on a trailing twelve-month basis approximate $100 million, which drives a 24% EBITDA margin. In our models, we have conservatively estimated pre-tax synergies of between $1 million-$2 million in 2015, mostly related to sourcing and other savings. We have further opportunities, we believe, to enhance revenues through this acquisition. Those opportunities will be developed over time.
Presently, we believe that the AERCO acquisition will be accretive to 2015 adjusted EPS by $0.18-$0.23. This range does include the approximately $0.02-$0.03 of synergies I just mentioned and excludes one-time purchase accounting adjustments and any transaction-related fees. We'll finance the acquisition using our existing credit facility. Based on a trailing twelve-month EBITDA results through September and using our September 2014 balance sheet, pro forma leverage would approximate 2.7 times, and net debt to EBITDA would approximate 1.4 times. These ratios are well within our targeted operating parameters. We are currently working through customary requirements prior to closing, and presently, we expect the transaction should close before the end of 2014. Let's turn to slide 5, where we provide a little more color on the AERCO business and product offerings.
As I mentioned, AERCO is a market leader in the high-efficiency commercial boiler and tankless water heater markets in North America. AERCO's key end markets include education, lodging, government, and office buildings and multifamily housing units. AERCO provides a full suite of custom boiler solutions for customers ranging from light commercial to large commercial applications. Again, AERCO is focused on differentiated product design for project-specific customer applications. This collaboration with the customer provides tailored solutions, ongoing performance management, and technical support. AERCO does all its manufacturing, engineering, design, and testing in one leased facility in New York, where they relocated in 2011. It is a 163,000 sq ft facility, which provides significant growth capacity for the company.
As you'll note in the pie chart, the majority of AERCO sales are generated from boilers, with water heaters and aftermarket sales rounding out total revenues. AERCO is led by a talented and experienced management team, averaging over 20 years per person in the high-efficiency boiler and water heater marketplace. The current management team has served an integral role in the evolution of AERCO and has driven its strategic initiatives. It is our intention to maintain the management team. AERCO's boiler offering is anchored by the gas-fired Benchmark model line, which reduces total project and life cycle costs while delivering energy efficiency, quiet acoustics, and easy maintenance. Each stainless steel unit fits through standard 30-inch doorways and occupies an extremely small footprint for easy installation. Removable enclosure panels support easy access to all piping and simplify lifetime maintenance.
Compatible with popular EMS software, these units can be remotely controlled and provide detailed LCD diagnostics. Now, turning to Slide 6, this graphic highlights how AERCO's product offering would enable us to leverage our existing products within the boiler room. As you can see on this illustration, Watts offers a wide variety of boiler-related products in, on, and integral to a typical space heating and domestic commercial hot water system. A single boiler source may be used to supply water for drinking, commercial food preparation and laundry, sanitation, and personal hygiene. It may also provide water for space heating through several applications, including underfloor radiant heat, baseboard heating, hydronic heating units, and duct coils. On the inlet of the equation, Watts offers safety conveyance devices such as backflow, strainers, pressure regulators, and fill valves.
We also offer water conditioning solution, including our anti-scale OneFlow system, which prevents scaling by transforming dissolved hardness minerals into harmless, inactive particles. On the outlet side of the boiler, you'll see a variety of Watts products, including ball valves, temperature and pressure relief valves, air separators, balancing valves, distribution manifolds, and sub-assembled hydronic panels. With our 2012 acquisition of tekmar Control Systems, located in Canada, and leveraging our Watts electronics position within France and Tunisia, we offer a broad suite of advanced instrumentation, including complete heating and cooling system control, zoning, domestic hot water generation, solar thermal, and snow melting.
On the far lower right-hand corner of the slide, you'll see one of our soon-to-be-released products, Powers' IntelliStation, an electronic water tempering system with electronic controls and communication capabilities that convey critical data points to improve system safety, efficiency, and reliability, and thus reduce facility, operational, and liability costs. Finally, on Slide 7, let me briefly summarize our rationale for making the AERCO acquisition. To reiterate, AERCO plays in a space that is very complementary to our existing business. By extending our product offering back to the heat source, we are able to leverage our existing portfolio while simultaneously extending our reach into key common vertical markets. Further, we see an opportunity to grow a very successful North American-focused business into a worldwide player.
Industry forecasts expect strong growth over the next five years for companies involved in the high-efficiency marketplace, both for boilers and for water heaters, due to an aging infrastructure and the need to be more energy efficient. We believe AERCO provides us a strong foundation as a new platform for growth in an attractive market. We mentioned on our Q3 conference call that we want to focus on a portfolio of differentiated products that provide solution and value-added benefits to our customers, and we want to drive innovation that the marketplace is willing to pay for. AERCO is providing those differentiated products and is driving a lean enterprise mentality. Their culture is in lockstep with ours in that respect. Finally, AERCO will enhance our operating margins, drive further strong cash flow, and provide solid EPS accretion starting in year one.
With that, Crystal, can you open the lines for questions?
Ladies and gentlemen, at this time, if you would like to ask a question, please press star one. Questions will be taken in the order received. Please press star one to begin. Our first question will come from the line of Jim Giannakouros from Oppenheimer & Co. Please proceed.
Good morning, guys. Congratulations on the transaction.
Thanks, Jim.
Hi, Jim.
A question, in terms of revenue and EBITDA volatility at AERCO. Can you talk about what peak-to-trough organic revenues were there over the past 10 years, and maybe put some of this into context? Could you talk about what their organic revenue and EBITDA CAGRs, you know, have been over the last 10 years, just to give us an idea of what kind of longer-term secular growth we should be expecting out of this particular product segment for you guys now going forward?
So, Jim, when you look at their past history, they've grown, you know, solidly over the last 10 years. I think they had CAGRs, 7%-8% and did well even during some of the transition, was slightly down over that period. But, you know, they've been growing very quickly over the last 10 years and, you know, solid overall growth.
Yeah, probably, probably in the high single digits, Jim, over the last 10 years, thereabouts.
... Okay. That's helpful. And, can you tell us as far as you know, as far as your respective customer bases, how much overlap do you already have, Watts having an established relationship in the channel, as you know, AERCO as well? I'm thinking specifically in the wholesale channel, I would think. You know, how much overlap do you have? And I guess, can you kind of frame or expand upon your cross-selling potential through the channel?
So there's not much significant overlap. I think there's, you know, 5 different wholesalers that actually have it, reps, I mean. But when you look at it, you know, we believe as we look at the overall platform and as we expand into the marketplace, we believe it's an opportunity to leverage, you know, the products that we had on slide 6. And you know, we also, you know, AERCO is pretty much a North America-focused business. It takes a lot of code work to go and enter the other markets, but we believe there's opportunities over time to, you know, get accepted in the outgoing regions, you know, outside of North America.
So that'll be an area we'll continue to focus on, but we believe we have the ability to, you know, all of AERCO's future products, you know, we'll make sure they have Watts products on it as it goes out the door. So that's one of our biggest synergies right out of the gate.
Great. Thank you.
Thank you.
Our next question will come from the line of Jeff Hammond from KeyBanc. Please proceed.
Hi, guys. This is James filling in for Jeff.
Hi, James.
I guess first off, can you just talk about whether it was an auction or privately negotiated process for you guys?
Yeah, it was an auction process.
Okay. And, you know, I know I could see that, you know, aftermarket makes us 13% of sales. You know, where do you see, you know, that going over the next three years? I mean, what's your intent there?
Yeah, we believe that'll grow faster than the regular business. I think they've just started that area. They've got a strong, focused team, focused on growing the aftermarket, and as the business grows, we'll continue to grow that aftermarket. So I'm impressed with the team and what they've set up and the customer focus and, you know, putting the inventory. So as the installed base grows, which it has significantly, you know, started to grow, we'll reap the benefits of that.
Got it. And just lastly, can you speak to what the early synergies, early cost synergies are, what they look like and-
Yeah.
Yeah.
We're talking about $1 million-$2 million, and, you know, the first one that we call it sourcing, but really, you know, they use a variety of products, and the first synergy of all is just gonna be to make sure that they use the, where they can, when customers don't spec it, our products on their system as they're developing their systems. In addition, leveraging our global supply chain capabilities and, you know, everything from supplies to all of those things, and our global contracts, whether it be professional services or others. So, you know, right out of the gate, those will be the quick synergies, and we'll develop the revenue synergies as we move forward.
Thanks. I'll get back in queue.
Thanks.
Our next question will come from the line of Garrett Schmaltz from Longbow Research. Please proceed.
Hi, thank you. I'm just wondering if you could provide a little bit more color around the synergy guide or the accretion guidance for next year. And maybe speak to what you're assuming on both ends of the $0.18-$0.23 spectrum.
Well, I think first off, we think it's a reasonable number that we're go-- you know, that we feel comfortable with. It includes, obviously, Garrett, some charges for interest and for amortization relating to the acquisition and the write-up of the business, write-up of the assets. And, you know, it's a range that we feel comfortable with at this point in time. And, the, you know, $0.18, we think is something that is doable for us as a, you know, going forward. And, you know, we're hoping that, you know, Bob mentioned the immediate synergies. We're hoping to get, you know, more going forward as, as we learn a bit, little bit more about the business.
Would you say that the variance is really just driven by top-line assumptions, or, you know, is there, you know, some other uncertainty that's within the kind of that $0.05 range?
There's some minor, you know, revenue we've assumed in there, but a lot of it also you know, depending on the short-term interest rates that are used in the calculation, et cetera. So, you know, again, it's early on. We haven't finalized all the intangibles, write-ups. All of those things need to be finalized at this point in time. We've got preliminary numbers on those, but, you know, certainly those have to be audited and finalized once we get in there in full detail.
Okay. No, that's helpful. And I guess just lastly, I don't know if you could speak to maybe their intentions on selling at this point in the cycle, if we're in the early stages of a commercial recovery. You know, just trying to better understand, you know, you mentioned it was an auction process, just what the motivation for the sellers were at this point?
Sure. Well, the fund has owned it for seven years, and as you know, it's at the end of the life cycle of that fund. So, you know, we like the timing from our perspective, because as we talked about in our previous calls, we believe we see an uptick coming in the commercial market. So we like it from that end, and I think, it's a win-win for both entities on this.
... Okay. Thanks so much, and congratulations!
Thank you.
Our next question will come from the line of Kevin Maczka from BB&T Capital Markets. Please proceed.
Thanks. Good morning.
Good morning, Kevin. Hey, Kev.
You touched on this a bit, but I'll ask it a different way. This is a boiler and water heater company, and you currently sell into a large boiler and water heater company in part of your business. So I'm just curious about, does this put you a bit more in competition with an existing customer? Can you just address that a bit more?
Yeah. So certainly we do provide suppliers. It's not a significant amount of our sales, and, you know, this is in a niche portion of it, right? In the, in the sweet spot, and I call it the light commercial and, and the heavy commercial. So you know, we believe this allows us. There's plenty of room in that marketplace for many players. We believe that our technology and our capabilities speak for themselves, and honestly, it allows us to better understand the system, which should help all parties as we provide products to. So, you know, we don't believe it's a significant risk at this point in time.
Okay. And, just in terms of some of your own management turnover that you've had, you, you currently don't have a, a permanent CFO in place. I think you've had some turnover elsewhere in the organization, in your operational folks. It sounds like this is a, a well-run business that's mostly plug-and-play. But can you just address that point?
Yeah, sure. So look, you can never plan acquisitions at any time. This is something, actually, week one I walked into, and I remember reading the CIM my first weekend here, so you never plan the timing. But I would tell you, this is absolutely a plug-and-play. It's a great management team that is well connected. I'll be honest with you, there's a lot of things that we can learn from them. Their new facility was set up in 2011. They developed it lean out of the gate. It's, you know, I think the facility is a benchmark that we can bring our organization through. So we like it because it's not a distraction. We're gonna continue in our transformation efforts with the company, and it's a plug and play, just like you said, and that's what excited me about it.
One site, one location, very simple integration, and right out of the gates, the teams are all excited about getting together and saying how we can leverage technology together and controls and, you know, how do we expand this business even faster?
Okay, great. Thank you.
Thank you.
Our next question will come from the line of David Rose from Wedbush Securities. Please proceed.
Hi, good morning. Kevin actually hit on the key part of my question, but maybe I can follow up a little bit more detail: how do you plan to prioritize your time now, Bob, with the acquisition and everything you have on your plate? I mean, I'm assuming you're still gonna be involved in the acquisition, so kind of walk us through the integration process.
Yeah. So, so again, the integration is very simple. We have a plan. It's detailed. The integration is out there, and again, it's not as significant. The management team has done a heck of a job of growing where it is, and, we're comfortable the management team is gonna stay with us and grow. So certainly I'll spend the time. My time is just to make sure we connect all the dots for all the parties and make sure we integrate our cultures and make sure, you know, everybody knows who each other are and how we leverage, and give them the opportunities to meet our regional people. So a lot of that work will be done on a regional level. So, you know, we'll continue. My focus is gonna be continuing to drive the overall strategy of the company.
That, that'll drive my overall focus and will continue to drive execution, so, on that strategy. So we hope to lay that out to everybody, like we said in our last call in February.
So this'll be under North American operations. It won't be a stand-up platform that'll roll up directly to you?
Well, for now, right out of the gate, I'm gonna have it report directly to me just to connect all the dots for everybody. We'll roll it up through segment inside the North America channel.
Okay, great. And as you hinted, you never know when acquisitions will take place. Does this mean that you're done for a while, or can we be surprised within the next six months as well?
Well, you never know. Like, listen, I think it's always in everyone's best interest to keep the pipeline full. We're gonna be very disciplined in making sure it aligns to our strategy. This clearly aligned to our strategy, something we've been watching for a long time. It's something we've been interested in. So, you know, if it strategically makes sense and we can, you know, allocate the right resources, we'll look at doing it. But we're not gonna just run right out and go for a big turnaround. That's not something I'm looking to do right out of the gate here. So, you know, this will keep us busy for a little bit here, and we're gaining traction in a lot of areas.
We'll determine, you know, what the next acquisition, but, you know, again, like you said, we can't estimate when they are, but we'll always be cultivating and looking out there to further our strategy.
Okay, perfect. Thank you very much.
Thank you.
Our next question will come from the line of Kevin Bennett from Sterne Agee. Please proceed.
Hey, guys. Good morning.
Good morning, Kevin.
Bob, following up on Jim's question from earlier, I assume you guys expect that high single-digit growth number to continue going forward, or is there something in the market that could accelerate that?
Well, you know, look, that there's a trend with high efficiency going on right now. I think, I think the biggest thing we have to wait for is to see how fast this commercial market turnaround is. Right? So that will accelerate if we see it. But we believe just with the high efficiency, the conversion, and the cost of benefit for our customers, we're gonna have, you know, the type of growth that you just talked about. But, what would really accelerate it is if we just start seeing a boom in commercial spending, which I think we're all waiting and looking, you know, and hoping cautiously that it's gonna come very soon.
Sure, that makes sense. Can you talk about how you think about AERCO's positioning in the commercial boiler market? We talked about how there's plenty of players there. I don't know if, you know, either in terms of market share or perception or how you can maybe quantify that.
Yeah, I never wanna talk about, you know, market share, but I would just characterize they're a strong leader in North America in the markets that I talked about, between 1 million and 6 million BTU, you know, in the high efficiency space, and that's where all the trends and everybody's moving to. So we're very positive. That's why there was many players in this auction process, and everybody knew what a quality asset this was. So we believe we're right in the sweet spot, right where we need to be from a market point of view, so we're very excited about it.
Gotcha. And then, Tim, this one's for you. Thanks for giving us the $24 million in EBITDA. I'm curious, can you tell us what part of that is DA? Approximately, $9 million. Got it. So we're looking at a mid-teens operating margin? Yes. Okay. Thank you. Thank you, guys.
Thank you.
Our next question will come from the line of Jim Funk from Gabelli. Please proceed.
Hi, good morning, guys.
Morning, Jim.
Bob, I was wondering if you could just kind of name who the players are in the market that AERCO competes? Who the competitors are?
Sure.
Yeah.
Yeah. Well, Lochinvar would be one, which is-
Lochinvar?
Yeah.
I'm sorry, what?
Yeah. A. O. Smith, how about that?
Okay.
An example. Okay, they're one of the leaders, you know, and then that, you know, there's many players inside the space.
Okay. So you mentioned A. O. Smith, and then, if Lochinvar is that the subsidiary of A. O. Smith? Is that it?
Yes, it is.
Yes, it is.
All right.
Hydrotherm.
Hydrotherm? Okay.
Yep, and Fulton.
And Fulton.
Okay.
Okay, and Fulton. And then, is there any retail sales in AERCO, or is it just commercial sales? Yeah.
No, this is commercial. Yeah, the retail space is not an area that we would wanna play in. It's the light commercial and to heavy commercial, which is, allows us to play in the differentiated marketplace.
Is the sales channel all through wholesale distribution that you currently have, or is it through some other channel outlets? Yeah.
They mainly go direct through their channels, and they have some reps and but, you know, for the most is direct selling and some reps. So, there's not much conflict at all through our channels.
Okay. And then, and there's $100 million of EBITDA that you pointed out in your slide. How should we look at it? Is that kind of a depressed EBITDA because commercial construction is down? And so should we expect that to grow faster than the high single-digit growth rate on top line?
Well, it was $100 million of, of sales.
$24 million, Jim, of EBITDA.
Oh, wait, $24 million EBITDA. Right. I'm sorry. Yeah. How should we look at this? Is that depressed level?
No, 24% EBITDA margin is pretty strong.
Yeah.
I hope that I can get all the rest of my businesses up to that level.
Oh, no, I just wonder if there's plenty more upside as we go out with the commercial construction market improving.
Sure, sure. Volume expands, certainly we'll be able to leverage that incremental volume.
What was the peak EBITDA margin for this company?
I think it's near the peak. I think last year was close to that number, so they've been driving efficiencies, and they've been scaling with volume. They've been growing very nicely with the market and, actually gaining share.
Okay, great. Thank you. Sounds like good acquisition.
Thank you very much.
With no other questions in queue, I would like to turn the call back over to Bob Pagano for closing remarks.
Thanks, Crystal. Well, in closing, I'd like to thank you for taking the time to join us today to discuss this very exciting opportunity. We're confident AERCO will help drive marketplace opportunities within our product portfolio and adds a significant new platform in North America, and we believe expandable on an international scale. So thank you, and have a good day.
Ladies and gentlemen, that concludes today's presentation. You may now disconnect. Have a great day.