Posted By: Brad Martin

Marilyn AlvaWed Nov 15, 7:00 PM ET

In the global economy, there are all kinds of markets -- oil, steel, gold and copper, to name a few.
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Then there's one you don't hear as much about -- the water market.

It's all about products that help move, control and make water safe to use.

Enter Watts Water Technologies (NYSE:WTS - News), which sells products for water conservation, water safety and water flow.

So how's the water business? Not bad, from the looks of Watts' four straight quarters of double-digit profit increases.

Watts is a market leader in plumbing and heating, back flow prevention and hot-water tempering and mixing valves. Only in drains do a couple of other companies, including Zurn Industries, have higher market share.

"As building codes get stricter, more sophisticated products are needed from large manufacturers like Watts," said analyst Ned Armstrong of Friedman, Billings, Ramsey. Most Watts products meet state and municipal regulatory codes in North America and Europe.

The business ebbs and flows. Right now, demand in the commercial construction end of the market is booming while the residential retail side in North America -- weakened by sluggish new-home starts -- is slowing.

Watts has been around since the 1800s, but it was late to the retail side. Over the last 36 months, execs deliberately focused more of their attention on the firm's historic strength in commercial water markets. They acquired small firms with commercial products and developed new technologies for commercial use.

Top executives -- who were unavailable for comment -- told analysts in a Nov. 1 conference call that they want to position the company to take advantage of the up cycle in the commercial market from the get-go. They said the cycle typically lasts five to seven years.

The retail side has lost steam to the commercial side, which seems to be in full swing. In the third quarter, Watts' North American retail sales excluding acquisitions grew just 1.5% to $45 million, most of that due to price increases.

Wholesale Jumps

Wholesale business, on the other hand, jumped 14% to $167 million excluding acquisitions. With acquisitions, the increase was 41%.

Commercial wholesale products accounted for 55% of total sales in the third quarter; residential products slipped about five percentage points to 45% of total sales.

Commercial plumbing and heating supplies -- drainage and waste systems, back flow devices, under-floor radiant heating gear and the like -- flooded out the door. Wholesale products also tend to have higher margins.

Watts' largest retail customer, Home Depot (NYSE:HD - News), blamed the retail slowdown on weaker residential starts. Home Depot makes up 60% of Watts' total retail business.

The housing slowdown isn't all gloom and doom for Watts. "Even on the residential side they still have more higher-end products, which means they don't expect to feel as much negative impact from a downturn in the housing market," said Stewart Scharf, an equity analyst with Standard & Poor's. That's because products like radiant heat gear tend to go into upscale housing, which isn't declining as much as the overall market, he says.

And as home sales slow, remodelling work might increase to provide another cushion.

The residential side of the business probably won't rebound any time soon. "For the next year or two commercial will be the main driver, complemented by continued acquisitions," Armstrong said.

Acquisitions -- nine in 2005 alone -- have long been a core strategy used to expand Watts' product lines and geographic reach. In the last year they included Dormant Manufacturing, which makes flexible stainless-steel connectors, and SPX Corp.'s (NYSE:SPW - News) Core Industries, which sells back flow prevention valves, specialty steam products and polyjet valves.

"If it didn't do acquisitions it would certainly be a smaller, less diversified company," Armstrong said.

Analyst Mark Grzymski of Needham & Co. added: "These guys have a good track record of not overpaying, and that usually leads to better profitability."

Watts has managed its bottom line well by keeping operating costs down. To offset spikes in the cost of raw materials such as copper, it raised prices this year with little customer resistance.

Third-quarter net income rose to $18.2 million, or 55 cents a share, from last year's $13.3 million, or 40 cents a share. Sales grew 40% to $325.1 million.

Of the internal, or organic, worldwide sales growth, about two-thirds was due to pricing, company execs told analysts in the November conference call.

Material Prices

In the same call, Chief Financial Officer William McCartney said that commodity raw material prices now "seem relatively stable" compared with where they were the past four or five quarters.

In a poll by First Call, Wall Street analysts estimate Watts' earnings will grow 39% this year to $2.32 a share and rise an additional 15% next year.

Meanwhile, Watts has a strong growth engine in Europe, especially in eastern Europe. Europe's continued economic expansion helped Watts' sales there grow 55% in the third quarter to $101.4 million.

Europe accounted for 31% of total sales, including about $18 million derived from acquisitions.

Watts' European sales also are getting a boost from government tax breaks and other incentives to homeowners and businesses for making investments in alternative energy products, such as solar and geothermal packages -- materials that Watts sells.

China could provide another revenue jolt, but not immediately, analysts say. Watts sells mostly into China's utility and infrastructure markets. With about $30 million in annual sales coming from China, it's still a relatively small market.

"To get any kind of scale they'd have to make a lot of acquisitions," Armstrong said. "It would take a long time, because many of those Chinese companies are very small."

India is another "area of opportunity," he said.

Copyright 2006 Investor's Business Daily, Inc.

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