Watts Water Technologies Inc. Q2 2008 Earnings Call Transcript

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Watts Water Technologies Inc. ( WTS )
Q2 2008 Earnings Call
July 29, 2008 5:00 pm ET
Executives
Kenneth Lepage - Assistant General Counsel
Pat O'Keefe - CEO and President
Bill McCartney - CFO and Treasurer
Analysts
Mike Schneider - Robert Baird
Kevin Maczka - BB&T Capital Markets
Ned Armstrong - FBR Capital Markets
Christopher Glynn - Oppenheimer
Ryan Connors - Boenning & Scattergood
Todd Vencil - Davenport & Company
Jeff Hammond - KeyBanc Capital Markets
Jim Fung - Gabelli & Company
Presentation
Operator
Good day, ladies and gentlemen, and welcome to the second quarter2008 Watts Water Technologies Earnings Call. My name is Schinel,and I will be your coordinator for today. (Operator Instructions)
I would now like to turn the presentation over to your host fortoday's conference, Mr. Kenneth R. Lepage, Assistant GeneralCounsel. Please proceed.
Kenneth Lepage
Thank you. Before Pat and Bill begin, I want to let you know thatvarious remarks they may make about the company's futureexpectation, plans and prospects constitute forward-lookingstatements under the Safe Harbor provisions of the PrivateSecurities Litigation Reform Act of 1995. Actual results may differmaterially from those indicated by these forward-looking statementsas a result of various factors including those discussed under theheading "risk factors" in our most recent annual reporton Form 10-K for the year ended December 31st, 2007, and otherreports we file from time to time with the Securities and ExchangeCommission.
In addition, any forward-looking statements represent our viewsonly as of today and should not be relied upon as representing ourviews as of any subsequent date. While we may elect to updateforward-looking statements at some point in the future, we disclaimany obligation to do so. Therefore, you should not rely on thesestatements as representing our views as of any date subsequent totoday.
I will now turn the presentation over to Pat and Bill.
Pat O'Keefe
Thank you, Ken, and good afternoon, everyone. Welcome to the secondquarter conference call and thank you for your continued interestin Watts Water Technologies.
Following my remarks, Bill McCartney, our CFO, will provide youwith financial highlights for the company in total, and Bill willalso cover individual sector results. Then, we will answer anyquestions you may have.
Before we get into the quarterly results, I would like to brieflyupdate you on a few important items; first, regarding the progressin our restructuring program. In Q2, we took an additional pre-taxcharge of approximately $1 million related to severance andrelocation cost.
In the quarter, we finalized the move of our Chinese joint ventureoperations whose physical plant was taken over by eminent domain.This move will ultimately reduce headcount and improve ourmanufacturing efficiency. We will speak to China separately in afew minutes when we discuss our outlook.
In general, we are on target regarding the timing andimplementation of various restructuring programs in the U.S. andChina. Our European management team is reconsidering the details ofthis restructuring program which will cause a delay in both thetiming and cost incurred and the expected savings to be realized.We now expect savings in 2008 from the restructuring exercise willapproximately $500,000 pre-tax. This amount is $400,000 lower thandiscussed previously, again with most of the savings being realizedin the second half of 2008.
With regard to the Chinese joint venture purchase, in June, we paidapproximately $3.3 million for our partner's interest. There is aconditional $2.2 million that may be owed to our former jointventure partners, but only upon one partner meeting certain termsand conditions of the purchase agreement. As we have mentionedbefore, having this operation fully under the Watts umbrella willallow us to control this company in the same fashion as we controlother wholly-owned business units.
Now let's provide you with an update on our stock repurchaseprogram. As of yesterday, Monday, June 28th, we had repurchased2.45 million shares on the open market and we have invested $68.1million to repurchase those shares. The accretions on earnings pershare from the repurchase of the shares in Q2 '08 were $0.03. Theexpected effect on our earnings per share from the repurchaseprogram in 2008 will approximate at $0.12.
As mentioned last quarter, we still expect to have capitalflexibility in the form of existing cash and available credit linesfor the opportunistic and acquisition market price.
Next, let me address the acquisition program. As you already know,on May 30th, we announced the closing of the acquisition of theBlücher Metal at a cost of approximately $169 million, plus theassumption of approximately $15 million in debt. The Blücheracquisition is the largest that Watts has ever made. As you know,Blücher is the leading provider of stainless steel drainagesystems in Europe and a worldwide leader in providing stainlesssteel drainage products to the marine industry. Blücher offersWatts a new platform within the European marketplace.
The transition of Blücher into the European operations has gonevery smoothly during the first two months. Blücher, as expected,was dilutive to our earnings in Q2 by $0.01. We expect Blücherwill be dilutive to by approximately $0.04 in Q3 and anticipatethat Blücher will be accretive to earnings by approximately $0.05in Q4.
As mentioned during the first quarter conference call, we continueto explore other potential acquisition candidates in Europe, and wecontinue to see deal volume in the U.S., but at lower level. Wewould hope that the pipeline will pick up as we move forward duringthe remainder of this year and into 2009. In China, however, ourfocus in the near-term continues to be on operational improvement.
Our 2008 initiative to maximize cash flow and promote operationalefficiency and productivity are proceeding well. Regarding cashflow, I am again pleased to inform you that we continue to generatepositive cash flow through the various working capital initiatives.
For year-to-date June 2008, we expect to generate positive cashfrom operating activities of approximately $40 million, whichcompares favorably to the $200,000 net use of cash from operatingactivities in the first half of 2007. Net cash outflows fromworking capital have decreased from approximately $57.7 million inthe first half of 2007 to approximately $7 million in the firsthalf of 2008, so great progress made there.
Regarding operational improvement, Lean and Six Sigma continue tobe a strong area of the government at Watts. To date, 1200 Wattsemployees have attended training programs. The executive leadershipteam has received formal Lean awareness training and processinnovation training during the second quarter. We have recentlyplaced a senior person to head up our Lean and operationalexcellence effort. Each major manufacturing location is working tobuild Lean/Six Sigma black belts and green belts. In addition, theyare establishing steering teams to charter, prioritize and executeevents.
Performance scorecards have been implemented that track the keymetrics such as on-time delivery, inventory turns, cost reductionand quality improvements. We have conducted several high-impactKaizen events and have generated cost and inventory reduction. Wewill expand Lean techniques to our small manufacturing locations asthe year progresses. We are still in the early stages, but are verycommitted to this and therefore are very pleased with our earlysuccesses.
I would like to take a moment now to discuss the most importantresource, our people. As a company, we are committed to findingtalented people who can lead the organization into the next decade.As I just mentioned, we hired a senior level employee to drive ourLean initiative.
In the second quarter, we also hired a new President of NorthAmerica and China, David Coghlan who will make significantcontributions to our business. We also hired a new VP to add moredepth and expertise to our sourcing capabilities, and we expectthat a new general manager for our French operation will be onBoard in the near future.
We anticipate that these leaders will help us drive new businessopportunities, will help make our operations more efficient in thefuture.
As mentioned in our last conference call, in a changing economicenvironment, we believe that new product development and productexpansion into new markets will be important driver of growth. Asan example, we believe our results for Q2 were enhanced by packageswe sell into the European solar and energy conservationmarketplace. These packages were first introduced in 2006, and oursales have expanded as a reaction to higher oil and gas costs.
Finally, I would like to make the following observation regardingthe just ended quarter and our outlook for the balance of 2008.Bill will provide you with financial details in a moment. Overall,our financial results for Q2 were stronger than we anticipated,given the macroeconomic environment in which we are dealing. We hadorganic growth in sales for the first time since Q3 '07.
Europe contributed to a solid quarter as we were able to leverageadditional volume with some rationalization efforts we had madeover the past several years in Italy. Some of the big customers inEurope are larger boiler OEMs. They have increased theirinventories in anticipation of new orders for alternative energyand energy conservation devices.
We believe they are anticipating that the higher oil and gas pricesare going to increase demand for such products, and in turn, thepackages and products we sell to these OEMs for solar and otherapplications were very strong in Q2. Although, we have minimuminsight into the future demand for these large European customers,given the recent order intake, we expect that trend will continueinto the third quarter, and we still believe that our broad productoffering that we can deliver on a Pan-European basis will allow usto continue to gain market share versus smaller competitors.
Turning our attention to the European macro environment, we seesigns of an economic downturn with increased inflation and higherunemployment. Higher energy costs are causing wildcats strikes insome countries such as Spain, U.K. and France. A recent article ona Wall Street Journal on July 25th indicated that the risk ofrecession in 15-year-old zone country is higher than given some ofthe more recent negative trend. All in all, this informationprovides a concerning outlook for Europe.
So, near term, we are somewhat bullish, given the reaction to thehigher oil and gas prices and the slug of alternative energyproducts we are selling. We are not sure of the impact the economywill have on our result as we move forward into 2009.
In North America, our growth in Q2 was positive due to higher U.S.retail sales and a Canadian economy that is still performing veryrelatively well. In general, we experienced and are continuing tosee a lot of variability in customer demand.
For the first month-and-a-half of the Q2, our run rates were in parwith those that we experienced in Q1. Orders came in much strongerlater in the quarter. It appears that the retailers and wholesalerswere restocking in Q2 after having run their inventories down in Q1and the first part of Q2. We also saw sales increases in the bigmembership stores such as Costco, likely an indication thatconsumers are trying to save money in a tight economy.
Our Canadian business continues to perform well in most areas ofthe country. Our burden is an especially active area, given thegrowing oil-sand production due to the higher oil prices, but alsonew cold regulations for backflow devices in Canada, which ishelping our backflow sales there.
Wholesale sales in North America were down 1% in Q2 which isprimarily due to the softness in the residential market. The U.S.commercial markets are tough to gauge. We see larger markets arefairly strong, but some of the smaller commercial markets arestruggling. (inaudible) for commercial area is not very positiveand mentioned in the past.
We look at both the Dodge reports and the architectural billingindex as data point in evaluating macroeconomic trends. The Dodgereport of expectations for commercial square footage as of Marchshowed a reduction of 12.8 for 2008 compared to 2007. Thisreduction has increased from 7.4 as predicated in the Decembertimeframe.
The June ABI index stood at 46.1, which is up from May, but stillbelow 50 for the fifth consecutive month, meaning business levelsat the architectural firms have deteriorated and continue todeteriorate. Both these trends are obviously concerning. At thispoint, I would hold to my previous statement that the commercialspace will have minimum growth for the remainder of 2008.
Taking a look at the domestic residential channels, the headlinenews is fairly gloomed. Single-home inventory levels stand at 11.1months in June. Single-family construction starts were downsequentially 5% from May of '08, which is the lowest space sinceJanuary of 1991. Home prices keep on falling and potential buyersare squeezed by banks through tighter lending standard.
In short, I still do not believe that we will see any upside in theresidential market place until approximately mid-2009. Regardingthe pricing in U.S., we are expecting selected price increases totake effect in September. These are mostly to cover cost increasesin products made of cast iron where we are seeing escalating costs.However, the effect will be minimal on Q3, but has a positiveeffect on the margins in Q4.
As far as the U.S. replacement market is concerned, from what I cangather, the market remains fairly steady and will remain that wayfor the remainder of 2008.
In summary our view on North America is that we can expect Canadato continue its solid performance. We see near-term opportunitiesin the U.S. running at rates that are somewhat between what we sawin the first and second quarter of 2008. We are not sure we willreceive any restocking just like we saw from retailers andwholesalers at the end of quarter two.
Margins maybe slightly constrained in Q3 until we see the benefitsfrom selective price increases which will help margins in the Q4.
Now, let's talk a little bit about China for a moment. The Q2results for China were disappointing and exasperated by the move ofour plant in Tianjin TWT and our labor dispute at a South Chinaplant WPT, which we discussed during our Q1 conference call. Bothof these issues continue to negatively affect our results in Q2.
As mentioned during the Q1 conference call, much of the Chineseoperations served as a (inaudible) plant for products sold into theNorth American and to a lesser extent into Europe. As North Americahas trimmed the inventory levels as part of the company's overallworking capital initiatives, production levels at our Chineselocations have dropped significantly, which has caused overheadunder-absorption issues. Commodity prices, value-added tax and acurrency swing have also affected our Chinese results.
The main Chinese domestic sales company, Changsha, which makeslarge diameter hydraulic butterfly valves, is experiencing shippingdelays due to the earthquake in Central China a few months ago.Although order rates remain strong, we expect shipping delays topersist into 2009.
Our senior operational management is keenly focused on addressingthe production and potential operating opportunities that exist inour Chinese manufacturing. We expect further plans will beinitiated over the next several quarters. In short, we expect Chinawill continue to under-perform with capacity issues and shipmentdelays through the reminder of 2008.
Now, I would like to turn the call over to Bill McCartney who willtake you through the financial highlights. Then we will take anyquestions. Bill?
Bill McCartney
Okay. Thank you, Pat. First of all, just to note that the figuresthat we released today on our press release are consistent with thepre-release that we had a week ago, Friday. As I go through theresults here, I would like to comment both on a comparison basis toQ2 2007 as well as to Q1 of 2008 just to give you a feel for wherewe experienced some of the improvements.
So, here we go. Revenue, $389 million, was up 11% versus Q2 lastyear, and we picked up $45 million of revenue versus Q1. As we gothrough the segments, I will point out in each area the reasons forthe improved revenue.
When you look at the overall revenue, though, organically, we grew$5.7 million or 1.6% from foreign exchange, primarily the euro. Wepicked up $20 million or just about 6%. From acquisitions, wepicked up $12 million, 3.5%. Those are the acquisitions of TGI andBlücher. So, that totals $39 million.
What I would like to do now is just to take a look at our overall,we call, reconciliation to our earnings per share, both to lastyear and to Q1. When we look at last year's second quarter, we had$0.46 EPS, which excludes our restructuring charges. As we rowforward into Q2 this year, we pick up $0.03 because of our buyback.We picked up $0.05 because of the foreign exchange rates, the eurostrengthening relative to the dollar.
In Q2 of this year, we had some favorable result in our tax linedue to a change in some of the Italian tax law and a favorableresult on a state tax audit here in the United States. So, that is$0.03 there. Then we lost $0.01 from Blücher. We thought we wouldhave about $0.02 of dilution. We actually had $0.01 of dilution,Blücher's margins came in a little bit better than we areexpecting due to a good mix and some good savings on some materialprojects. However, we still had dilution of $0.01.
If you look it below the line, we lost $0.04 versus last year, andthat is primarily due to lower interest earnings because of havingless cash on board as a result of our stock buyback and acquiringBlücher and lower interest rates versus the last year.
We look at all those adjustments and that tells you we would havehad a $0.52 quarter. So, from an operating standpoint, we believethat in the second quarter of this year, we had $0.04 improvementin our operations. I will go into detail now as we go through thesegments, but that is primarily driven by improved pricing in NorthAmerica, a little bit of a favorable mix in Europe. We have volumeand leverage occurring and then some offsets from China as a resultof the issues that Pat mentioned a moment ago, some of the increasein cost was seeing associated with foreign exchange, VAT and lowervolumes in the plants.
Now, the same analysis, if you take a look at that, comparingourselves to Q1 of 2008, you will recall we had $0.39 earnings pershare from operations, excluding restructuring. So, we would havepicked up about $0.01 from Q1 on foreign exchange rates. We wouldhave picked about $0.03 because of the tax rate issue. We wouldhave lost $0.01 on because of dilution of Blücher. We would havelost $0.01 below the line, not because of the change in interest,but because of the minority interest changing, because we broughtout the 40% of our Chinese joint venture. So, we loose thatminority interest.
So that tells you that we would have $0.41 quarter on a comparablebasis. We had $0.56 quarter. So, we had $0.15 improvement inoperations from Q1 into Q2. We look at that, it is really driven byimproved volumes and gross margins in North America, improvedvolumes in operating leverage in Europe and again offset by some ofthe operating issues in China around plant moves and increasedcosts.
What we would like to do now is just go into the typical analysisthat we provide you regarding our segments. Look at North Americain total, $235 million of revenue. That is an increase of 4.5%versus last year and that is 2% organic growth, about 1% fromforeign exchange that is the Canadian dollar, and acquisitions of2% which both come to 4.5% or $10 million.
Now, looking at the wholesale side, in North America, if youexclude the acquisitions, we were at $181 million, and thatcompares to $163 million in Q1, and was down about 1% versus lastyear. When we look at Q2 over Q1 in North American wholesale,really what we are seeing is that we had a pretty good irrigationseason and the commercial construction came in pretty good. As Patmentioned, some markets are weak and some markets are strong, butoverall, the commercial came in good versus Q1.
Compared to Q2 last year, obviously we are continuing to see thesoftness in the residential side, but the commercial side is upsomewhat. We believe that we would have had an overall volumeincrease on the commercial side, very low single digits, and on theresidential side, a decrease in unit volume of about 10%. Thenthose items are offset by some favorable pricing.
Looking at the retail side, $48 million in Q2 compared to $43million last year and $43 million in Q1 of '08. Versus last year,we are seeing some rollouts and some of the large changes on somenew products that we are doing, and we are seeing some pricing. Webelieve that we have a decrease in unit volume of about 5% becauseof the slowness on the residential side.
Now, we compare that to Q1, and we saw about 11% reduction becauseof the slowness in residential which we also believe was due tosome destocking. So, we had a pick-up of about 5 points because ofthe change in destocking in Q1 to some improved stocking levels inQ2.
In Europe, $139 million in the quarter, that is a growth rate of29% versus last year. Compared to Q1, Europe was $122 million.Looking at the components there, we had organic growth of $4.8million, which is 4.4%. The FX was $18 million versus last year,about 17%, and in the acquisitions, $8 million or 7.6%, whichtotals $31 million or 29%.
Again, we compare that activity to Q1, organically we had negativegrowth in Q1 in Europe of 7 points. So, we saw quite a differencein our order entry rate really due to the fact, as that Patmentioned, where late in the quarter, we saw a surge in ordersaround energy efficient products, once we will hit about $140 abarrel. We expect those trends to continue into the next couple ofquarters, as Pat mentioned.
In China, $15 million of revenue, that is a decrease of 14% versuslast year, and it is a pick up of about $5 million versus Q1. So,when you look at China, first of all, you recall in last year'ssecond quarter, we had four months of activity for couple of oursmaller business units, and this year, we are only having threemonths of activity, because if you recall, last year, as weexplained to you that we were bringing all of our accounting andreporting up to a current basis. So, we had a four-month quarter.So, that actually had an impact of about $2.5 million pick-up onthe revenue.
So, if you had a three-month quarter to a three-month quarter, thetotal revenue in China would be flat year-over-year, and it stillis up $5 million versus the first quarter. However, I think Patmentioned a lot of the issues that we are having there. The orderentry rate for our infrastructure business remains good, eventhough we are having some issues around the late shipments becauseof the earthquake, and we had fewer sales because some of thedisruptions in the other plants.
On the gross margin side, 34% on a consolidated basis, that is up1.5 points versus last year and versus 33.2% in Q1. Now, we willtalk about the margin in each of the segments. North America'sgross margin was 35.4%. That is up 4.1% versus last year and upabout 1 point versus Q1.
Looking at the margin in North America, we have much more favorablepricing versus last year in North America. We also had a much morefavorable product mix and some of our products on the commercialside. Then versus Q1, it is really associated primarily with thesales volume that I mentioned earlier to you.
In Europe, gross margin is 33%. That is one of the best margins wehave seen in Europe for many years, and that is an increase of1point versus last year and 1.5 points versus the first quarter.So, we are seeing in Europe relative to the margin, it is afunction of the increased volume, but as you recall, about ayear-and-a-half ago, we did some restructuring in Europe where weconsolidated a couple of plants in Italy into one plant that werestarting to see the impact of that plant consolidation with thisincreased volume.
We are also in the process of the coming year restructuring inEurope where we are bringing additional work into those plants.Then a combination of the restructuring, bringing the work in housefrom another plant that we are downsizing and increased volume fromthe energy orders, that really created some nice operating leveragein our giant factories. That is what, in combination with thevolume, gave us a nice improvement in the gross margin in Europe.
Again, looking at China, the margin is 7%. That is down from 15%last year, and it is down 1 point from Q1. Again, it is the sameissues that we have been mentioning, lower production levels andsome of the higher costs that we are dealing with around foreignexchange rates, change in taxes, some local inflation and theinefficiencies that we are dealing with surrounding plantrelocations and some of the labor issues that we have in SouthernChina.
The SG&A at $96 million is up $12 million versus last year. Webreak that out into the factors. From an organic standpoint, wewere up $4.7 million. The foreign exchange was $4.2 million. Thenthe inclusion of the SG&A from acquired companies is $3.5million, and that brings you to the $12.4 million in total.
So, operating earnings, $35 million at 9%, that is up from lastyear at 8.6% and up from first quarter which was 7.6%. That reallyis a result of the improved gross margins and the operatingleverage from the volumes that we discussed. When you look at theoverall operating earnings, we are up about $5 million versus lastyear. That is primarily due to two factors. One is the volume andimproved margins and then contribution from foreign exchange.
Below the line, we had an increase in expense for the line of about$4 million. That is entirely due to changes in interest income as aresult of the lower cash we have on hand, because again purchasingBlücher, the stock buyback and some of the lower interest rates.
The tax rate 31.2% this quarter, down about 1 point versus lastyear and down about 2.5 points versus Q1, and that is the result ofthe tax law change in Italy and the state tax audit that we had inthe U.S. Overall net income from continuing operations at $20million is up from last year's $17.7 million.
So, I think with that, we can now open it up for any questions thatyou might have.
Question-and- Answer Session
Operator
(Operator Instructions)
Your first question comes from line of Mike Schneider of RobertBaird. Please proceed.
Mike Schneider - Robert Baird
Good afternoon.
Pat O'Keefe
Hi, Michael, how are you doing?
Mike Schneider - Robert Baird
Good. Pat, maybe first just on your opening comments about some ofthe European restructuring being rethought. I think you use yourword. Could you explain what is changed there and again run throughthe math as to the savings delay, or push-out?
Pat O'Keefe
We are rethinking some of the restructuring mostly in terms of thetiming of it. It is mostly delayed because of the fact that Imentioned later in my comment that we were hiring a new manager forone of our operations, the French operation. They want to make surethat he or she whoever comes on Board is completely behind thatprogram and is brought into it. So, that is really what it is, moreof a delay, Mike, than a change in the program.
Mike Schneider - Robert Baird
You had done modeling, 4,000 of the savings gets pushed from '08 to'09?
Bill McCartney
That is right.
Pat O'Keefe
That is correct.
Mike Schneider - Robert Baird
Okay. Then just in the domestic wholesale channel, if I recall lastquarter, the volumes in U.S. wholesale were down about 10% in Q1.In Q2, it looks they were probably down mid single digits. Anychange in distributor tone or restocking, destocking or just inproduct mix or strength that occurred during Q2 to explain the lessnegative results?
Pat O'Keefe
Yes, it is quite clear, Mike, what was going on. In Q1 and for thefirst half of Q2, we still had destocking going on. They wereselling off their inventory and bringing their inventory levelsdown. Apparently, they went too far, because we saw both on theretail side and on the wholesale side, the last 45 days of thequarter are very strong import that continued right through the endof the quarter.
Now, I think that is a reflection of the fact that activity was notas low as they anticipated it, going into the summer months. So,the question that we are struggling with now is where we see thatcontinue into the third quarter. We do not really know at thispoint. We also do not know what they are going to do as they gettoward the end of that quarter.
Whether there is a restocking in anticipation of a strong fall, itdepends I think a little bit on what the basic activity is at thecontractor level. The one thing I would say, Mike, this is a reallyunusual year. The main patterns defy history and now they are muchmore erratic.
Mike Schneider - Robert Baird
Sure.
Pat O'Keefe
That is what you saw. I think our internal forecasts for the firsthalf of the year were accurate, but they were inaccurate dependingupon if you measure them by quarter or measure them by month.
Mike Schneider - Robert Baird
Sure. Then just in Europe, the strength in the solar and geothermaltype products led to growth. Are you able to discern what Europedid, or what the trend was in Europe through the quarter if youback out those types of products?
Bill McCartney
Well, we were on a path, Mike. If you look at Q1, okay, before wehad the surge in oil, we were down 7%. Going into the first half ofQ2, we were thinking we were flat on that a trend. We wound upbeing positive by 5 points in the whole quarter and that surge oforders really started occurring in the second half of the quarter.
Mike Schneider - Robert Baird
Okay. So⬦
Pat O'Keefe
They are continuing into the third quarter as well, Mike.
Mike Schneider - Robert Baird
Can you describe these type of products, what are the typicalapplications, what type of systems, who are the customers, andspecifically, is this a channel fill going on or an inventory buildby some of these OEMs and just really what the sustainability ofthis trend is if we assume crude stays where it is?
Pat O'Keefe
Yes, these are sub-component systems that go into basically solarapplication and condensing boilers. Condensing boiler is a moreefficient boiler, Mike, and a solar is an alternative energypackage. We also make a number of units that measure the thermalheat usage by individual apartment, apartment by apartment. So, youmight have centralized heating system for a large multi-storeyapartment building, but you want a factor reported cash register onevery individual apartment to measure the energy use in thatapartment. So, those are the type of products that these are.
Mike Schneider - Robert Baird
In terms of like a channel fill or inventory stocking by the OEMs,can you detect where they are in this process?
Pat O'Keefe
Well, I think, Mike, they are anticipating a strong fall sellingseason, because I think they expect their people to upgrade theirexisting heating system to put in a more energy efficient oralternative energy system. This is anticipated demand that will besold primarily in the third and fourth quarter.
Mike Schneider - Robert Baird
This has cannibalized other products you have got?
Pat O'Keefe
Not really, no.
Mike Schneider - Robert Baird
Okay. Thank you.
Operator
Your next question comes from the line of Kevin Maczka of[BB&T] Capital Markets.
Kevin Maczka - BB&T Capital Markets
Hi, Pat and Bill.
Pat O'Keefe
Hi, there.
Bill McCartney
Hi. How you are doing?
Kevin Maczka - BB&T Capital Markets
Just a question on the raw material side. I think we said lastquarter that you were expecting a little bit bigger hit in Q3 thenwhat you thought you would see in Q2. Is that still yourexpectation? You always get the question about the whole price costrelationship. Can you just give a little bit more color on whereyou stand there?
Pat O'Keefe
Yes, that statement we still hold by that. What we are seeing isincreases in plastic resins because of the oil, and we are seeingincreases in cast iron, a little bit on the copper side as well,but mostly driven by cast iron and plastics. We are going out witha price increase which will be effective for our major businessunits towards the middle of September. So, we will see a little bitof unfavorable hit on the margin in Q3 because of material. Then,if we are successful with the price increase, we expect to offsetthat for Q4.
Kevin Maczka - BB&T Capital Markets
Okay. Pat, just going back to your comments on the outlook inEurope, I was a little bit confused. I think you were talking aboutthe surge in oil potentially benefiting some of these energyconservation products that you are rolling out, but you had, ofcourse, the slowing economy in general as a negative. So, how do wereconcile that again?
Pat O'Keefe
I am pretty bullish on the second half of the year in Europe. I amconcerned as we go into 2009, okay? I think the demand that we areseeing here in the second quarter is going to continue at leastthrough the third quarter and probably into the fourth quarter.Where I am concerned is, is what happens as we go into 2009,because there are a lot of issues in Europe similar to what we areseeing in North America in terms of the economic slowdown.
Kevin Maczka - BB&T Capital Markets
Okay. Finally, one more quick one if I could. The energy products,can you talk about what percent of your mix in Europe thoserepresent today?
Bill McCartney
About half our business in Europe, Kevin, is heating. Okay? I willsay half of it is OEM, okay? These are selling heating productsinto the large pressure vessels, boiler and water heatermanufacturers. They have been going through a transition over thelast couple of years, transitioning from gas side appliances tosolar and what not, these alternative energy technologies.
Their base businesses on gas side has been declining anywhere from25% to 30% per year for the last two years or so. However, what wesaw in this quarter was when oil really hitting an all time high, Ithink like $140 a barrel, what we call the point of pain, wherepeople really got up and took notice. Like $4 a gallon in gas isvery painful for the people in the U.S. so they started changingtheir behavior. What feels like $140 a barrel is the point of painin Europe for these heating products? So, it is a major part of ourbusiness and it is being going through quite a transition over thelast couple of years.
Kevin Maczka - BB&T Capital Markets
Okay, great. Thank you.
Operator
Your next question comes from the line of Ned Armstrong of FBRCapital Markets.
Ned Armstrong - FBR Capital Markets
Thank you. Good afternoon.
Pat O'Keefe
Hi, Ned, how are you?
Ned Armstrong - FBR Capital Market s
Good, good. To the degree that you can, can you talk about thecommercial markets in the U.S. by type of structure, be it office,hotel, retail? Are you able to differentiate any patterns there asto whether one is any worse and the other are not?
Pat O'Keefe
Let me just make some general comments, and then you can look atthe Dodge reports, and this will help you. However, Watts isgenerally beneficial when there is a high occupancy rate in afacility and particularly high occupancy with high sanitaryconcentration of sanitary processes. So, if you were to look at theDodge reports, Watts' best is something like a doctor's office or anursing home or a hospital with a lot of beds and a lot of sanitaryfunction in them.
You think of hotels being the same way. We hate warehouse space andthose things. So, if you look at the Dodge report, I do not havethem available at the moment, but you want to look at those areaswhere healthcare is a good one, hospitality industry is a good one,office space is a good one for us, prisons are good ones for us.When you get to manufacturing and industrial space, very muchdiscounted.
Ned Armstrong - FBR Capital Market s
Okay. Bill, on the tax benefits that you alluded to, do you knowwhat the impact of each one separately? Is that possible to breakout?
Bill McCartney
I can tell you if you like. The one in Italy was 330,000 euros. Inthe United States, it was $430,000.
Ned Armstrong - FBR Capital Market s
Okay. Then, what was share count at the end of the quarter?
Bill McCartney
Hold on. I will give it to you. One second. It should have been onthe press release, Ned. Let me just see it. I think I have it here.36.8 million.
Ned Armstrong - FBR Capital Market s
That was at the end of the quarter?
Bill McCartney
Yes.
Ned Armstrong - FBR Capital Market s
Okay, good. Thank you.
Bill McCartney
Okay.
Operator
Your next question comes from the line of Christopher Glynn ofOppenheimer.
Christopher Glynn - Oppenheimer
Hi. Thank you.
Pat O'Keefe
Hi, Chris.
Christopher Glynn - Oppenheimer
Hi. So, Around the solar geothermal in Europe, you gave a breakdownof the segment in terms of the half heating, half OEM. Myimpression is that the solar geothermal energy related things crustover both of those pieces. Can you resize that to your current mix?
Bill McCartney
Well, I think what we were saying is that approximately half ourbusiness in Europe is OEM. It has a about 45% wholesale and about5% do-it-yourself. This OEM business is the large boilermanufacturers that are incorporating all these products into theirunits in their systems. Okay? So, the OEM is primarily aheating-oriented business, i.e., heat water.
The wholesale side is both plumbing and the replacement businessfor heating as well. We do not see that geothermal solar on thewholesale side, because it is still relatively new in thereplacement business, really has not built up in there yet.
Christopher Glynn - Oppenheimer
Okay. On the OEM side, it is the majority now?
Bill McCartney
It is a significant portion of the OEM business. I do not want tosay it is the majority.
Christopher Glynn - Oppenheimer
Okay. In North America, it really bifurcates through the first halfof the quarter and the second half of the quarter. In terms ofsell-through, do you think that averages out to what theappropriate sell-through is, just going from destocking toover-compensating?
Pat O'Keefe
I would say that is a fair representation of what we saw overall.
Christopher Glynn - Oppenheimer
Okay. So, although it is difficult, unit volumes just saw in thequarter would be the best shot at earmarking a run rate?
Pat O'Keefe
The best way to look at it and I think is that if you look at thefirst six months of the year, we had destocking probably for, letme think, four out of the six months. Then we had restocking fortwo out of the six months. The best estimate at this point in timeis, if we look at the economic environment, probably that averageis good.
Christopher Glynn - Oppenheimer
Okay. Then on the restocking, do you think a pre-buy ahead of theprice increases had any benefit in the quarter and who would bemore likely, the OEM side or the wholesale side, to engage inpre-buy activity?
Pat O'Keefe
We did not see any pre-buy, and it is based on the pricing. I thinkwe saw that earlier in the economic cycle, but now at this latestage in the economic, there has been so much inflation in rawmaterial that wholesalers are not reacting that way at this point.
Christopher Glynn - Oppenheimer
Okay. Then lastly, could we just get an overall picture on what theconsolidated unit volumes were year-over-year in the Europe andNorth American segments?
Bill McCartney
Well, I think I gave the unit volumes earlier on repeated NorthAmerica, which is the estimates we have here internally. Theresidential would be down somewhere around 10% per unit volumes.Commercial would be up around 4%, and then pricing offsets there.Then when it comes to unit volumes in Europe, we do not reallytrack that here, because there is so many business units andmarkets and what not that it is something that we really do.
If you look at our overall organic growth in Europe, we were up$4.8 million, which is 4.4%. That would have some pricing in it aswell as unit volume. That is a significant change from Q1 where wehad negative organic growth of 7% in Q1.
Christopher Glynn - Oppenheimer
Okay, great. Thanks a lot.
Bill McCartney
Okay.
Pat O'Keefe
Thank you.
Operator
Your next question comes from the line of Ryan Connors of Boenning& Scattergood.
Ryan Connors - Boenning & Scattergood
Good evening.
Pat O'Keefe
Yes.
Ryan Connors - Boenning & Scattergood
I want to spend a couple of minutes, if you could, on actually onthe balance sheet. I think we have gone through pretty good depthon the end markets and so forth. One of the things that wereinteresting, for a period of time during the second quarter, thestock actually did trade meaningfully below book value for anextended period. Obviously, we can interpret that in number ofways. One of them would be that the market was saying it thoughtthat the value of goodwill and/or the inventory and the balancesheet would have to be written down.
So, I wondered if you would take a few a minutes to address how youassess those assets for impairment and what sorts of triggeringevents might need you to take a look at that, especially on theintangible asset side and what the likelihood would be in your viewthat you would have to take that action? If so, whether or not youwould have to raise capital in that a scenario?
Bill McCartney
Right. Well, first of all, I do not envision any type of impairmenton inventory at all. I mean we have a very conservatively valuedinventory. A lot of it is material cost that is in there. So, thatis really not an issue at all.
When it comes to the goodwill and the intangibles, I mean under therules, we are required to do a full impairment analysis every year,which we do on October 29 at the closing of our October. If youlook at what we did last year, we had a pretty wide gap between thecarrying value and the economic value of our intangibles.
The only place that even I think has a potential concerning aroundthe impairment where it maybe have a goodwill in China, which we donot carry a few million dollars of goodwill in China. So, as wehave some of those business units that are struggling, you arealways subject to that, I would have said that is a very smallpercentage of our intangible assets.
Ryan Connors - Boenning & Scattergood
Okay, that is helpful. Thanks, Bill. I do not know if youmentioned. I do not think you did. Obviously, there has been a lotof noise on the tax line. Can you just update us what you full-yearguesstimate is for the run rate.
Bill McCartney
Without any favorable or unfavorable adjustments, the tax ratewould be about 34%.
Ryan Connors - Boenning & Scattergood
Okay, great. Well, then that is been very comprehensive here. So,that is it for me. Thanks.
Pat O'Keefe
Thank you.
Operator
Your next question comes from the line of Todd Vencil of Davenport& Company.
Todd Vencil - Davenport & Company
Thanks. Good evening.
Pat O'Keefe
Good evening, Todd.
Todd Vencil - Davenport & Company
Most of my questions have been gone over, but you mentioned thatmost of larger market in commercial construction are hanging intheir, some of the smaller markets may be hits off and can you maybe highlight some of those that have softened?
Pat O'Keefe
You are talking like Southern California and Florida are the softermarkets for us right now.
Todd Vencil - Davenport & Company
Okay. Concerning Blücher into the (inaudible) some dilution in thequarter. Do you have any update on what the accretion wouldultimately look like? Are you looking for the same amount?
Bill McCartney
We had a $0.01 dilution in the quarter, I think when we firsttalked about Blücher to the Wall Street we were thinking that itwould have $0.02, but their operating results were little bitbetter. We are expecting $0.04 of dilution in Q3.
Todd Vencil - Davenport & Company
Right.
Bill McCartney
Then once we get into Q4 we will then have the inventory and thecustomer backlog and all those issues amortized. We should have apickup or accretion of $0.05 in Q4.
Todd Vencil - Davenport & Company
I think you said it was going to be about $0.05 a quarter next yearis that still good?
Bill McCartney
Yes.
Todd Vencil - Davenport & Company
Okay. That is all I have got. Thanks a lot.
Bill McCartney
Thank you.
Operator
Your next question comes from the line of Jeff Hammond of KeyBancCapital Markets.
Jeff Hammond - KeyBanc Capital Markets
Hi. Good afternoon.
Pat O'Keefe
Hi, Jeff.
Jeff Hammond - KeyBanc Capital Markets
Just in terms of some of the issues in China can you give us asense of, is that still a drag on profitability into the secondhalf of the year, are you loosing money there or is there a pointwere we get back to favorable profitability?
Pat O'Keefe
No I would say it is a drag on us for the remainder of this year.
Jeff Hammond - KeyBanc Capital Markets
Okay. Then just shifting gears, you mentioned how you thought thealternative energy systems projects or orders you thought weresustainable into the third quarter. I mean are you getting somedirect feedback from these OEMs suggesting that and there is morebehind it or what gives you the confidence that those are not onetime in nature?
Pat O'Keefe
I think the OEMs are pretty bullish on these products at themoment, so we are basing that, we are making that statement basedon our in coming order rates.
Jeff Hammond - KeyBanc Capital Markets
Okay. So there has been some follow-on orders that would suggestthat that persists in the third quarter?
Pat O'Keefe
You had a strong order rate and that strong order rate continues.
Jeff Hammond - KeyBanc Capital Markets
Okay. Then as you look at the other floor distributor business thatis may be more consumer oriented in Europe, how would youcharacterize trends there?
Pat O'Keefe
I think, if you look at big markets like the UK its slow, you lookat big markets like Italy and Southern part of Europe it is slow,and it is pretty decent in France and it is pretty decent inGermany and Northern Europe.
Jeff Hammond - KeyBanc Capital Markets
Okay. Finally, it seems like the big aberration or one of the majoraberrations between 1Q, which seem to present 2Q which was prettygood as this destocking versus restocking, is there a way toquantify the magnitude of the contribution there on a op profit orearnings basis in the second quarter that might may be is notsustainable?
Bill McCartney
If you look at the differences, Jeff, in Q1, the wholesale revenuewas $163 million. In Q2, it was excluding acquisitions onapples-to-apples basis, would have been about a $181 million. So wehad about $18 million, $19 million pick up in wholesale revenuequarter-over-quarter. Those are very meaningful, I do not have theexact EPS on that, but I mean it is a very meaningful part of theimprovement.
Jeff Hammond - KeyBanc Capital Markets
Okay. You feel the same about the sequential improvement in retail?
Bill McCartney
Yes, I mean, on retail we had $5 million pick up versus Q1. When wedid the analysis, we identified specifically the new productrollouts in some of the pricing and when you net that out of thechanges that we saw in the quarter, it tells you that we had adecrease in revenue of about 5% versus last year.
Now, if we do that same analysis and you look at Q, compareyourself to Q1, our same analysis has been done for Q1. It says wehad a decrease in revenue of about 11% because of destocking in theeconomy. We had a basically the run rate was cut in half versuslast year from Q1 to Q2.
Jeff Hammond - KeyBanc Capital Markets
It sounds like underlying fundamentals would suggest that the 1Qtrend was maybe a little more normal than the 2Q trend?
Bill McCartney
On retail, I think if you look at the last numbers I have seen outof (inaudible) low that the same-store sales is down around 7%, 8%,if I recall. That is in the middle of those two numbers between 5and 11. As Pat discussed a moment ago, we are thinking that anormal trend for all this North American business is somewhere Q2and Q1.
Jeff Hammond - KeyBanc Capital Markets
Okay. That is helpful. Just final question on Blücher. Can youremind us how big the marine component of that business is?
Bill McCartney
It is 20% of their total business.
Jeff Hammond - KeyBanc Capital Markets
Okay. Then can you just remind me that some of the other bigbuckets in terms of end markets?
Bill McCartney
Yes, residential is about 25, commercial is 25. We have foodprocessing of about 30 and then Marine is 20.
Jeff Hammond - KeyBanc Capital Markets
Okay. Thanks.
Bill McCartney
Okay.
Operator
Your next question comes from the line of Jim Fung of Gabelli &Company. Please proceed.
Jim Fung - Gabelli & Company
Hi, gentleman. Actually most of my questions have been answered,but I just have one thing could you just list a little more, whatyour product lines are in Europe for this geothermal market thatyou are selling to the OEM's?
Bill McCartney
What the product lines are into the OEM?
Jim Fung - Gabelli & Company
Yes
Bill McCartney
Well, we sell things like electronic controls, manifolds systems,pump groups, control valves, safety relief valves, and as Patmentioned we sell a unit that measures energy usage by measuringthe flow and heat of water into an individual apartments in energymonitoring product line.
Jim Fung - Gabelli & Company
Okay. These are the products that you saw very strong sales in thequarter there⬦
Bill McCartney
Yes.
Jim Fung - Gabelli & Company
⬦and going into the third quarter. Okay, alright. Thanks verymuch.
Pat O'Keefe
Thanks Jimmy.
Bill McCartney
Okay.
Operator
(Operator Instructions)
Your next question comes from the line of Christopher Glynn ofOppenheimer.
Christopher Glynn - Oppenheimer
Yes, just a quick one on any impact in '09 on the tax rate mix, thebase of sales with Blücher and also maybe with the European growthgiven the energy efficiency turn outside and are we seeing a littledownward pressure on the tax rate?
Bill McCartney
I think what would happen versus that any downward pressure fromthose sources do have a little a bit lower tax rate might be aoffset by some non-deductible loses out of China. So I would notchange a tax rate.
Christopher Glynn - Oppenheimer
Okay. Thanks again.
Bill McCartney
Thank you.
Operator
There no further questions. I would now like to turn the call backover to Mr. Pat O'Keefe.
Pat O ' Keefe
Well, I want to thank everyone for joining us today and yourinterest in Watts. We look forward to talking to you in the thirdquarter conference call, which will be probably at the end ofOctober, the beginning of November. So thank you very much.
Operator
Ladies and gentlemen, that concludes the presentation. Thank youfor your participation. You may now disconnect. Have an excellentweek.
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