Pentair (PNR), based in Minneapolis, MN, is a diversified manufacturer comprising two operating segments: Water Technologies and Enclosures. The company makes its products from 50 locations in North America, Europe, and Asia. Pentair dramatically repositioned itself with two moves in 2004: the divestment of its Tools division (sold to Black & Decker for $800 million) and the subsequent $900 million acquisition of WICOR water and pool products. Growth in the water segment is a primary focus of management.
Market Cap: $3.1B
Enterprise Value: $3.9B
P/07 FCF: 13.2x
Water Technologies (70% of Revenue). Pentair’s Water Technologies division makes products for the movement, treatment, storage and enjoyment of water. Operating margins should be 11% in 2006 and are projected to expand to nearly 15% by 2008 through cost synergies, organic growth, and integration of the WICOR acquisition. The division is focused on three water markets: pumps (approx. 40% of water sales), pool & spa (30%), and filtration (30%).
o Pumps – This area has been growing 2%-4% and is positioned for the following uses: residential and municipal wells, water treatment, wastewater solids handling, pressure boosting, engine cooling, fluid delivery, circulation and transfer.
o Pool & Spa – This area has been disappointing with expected declines of 3-8% in 2007 from residential exposure, but is poised for good long term growth of 5-8% thereafter. This segment provides a complete line of pool/spa equipment, including: pumps, filters, heaters, lights, controls, cleaners, and other equipment. Approximately 40% of pool & spa revenues are generated from Pool Corp (ticker: POOL).
o Filtration – The filtration segment is growing low to mid single digits. This market is addressed with control valves, filtration components, tanks, pressure valves and other items used for filtration, deionization, and desalination systems, and industrial and residential water filtration applications.
Enclosures Business (30% of Revenue). The Enclosures group manufactures enclosures (essentially specialized boxes) that protect sensitive controls, components, and accessories. Operating margins are 15%, with room for modest expansion thereafter. This group focuses its business on four primary industries: Commercial & Industrial (35% of segment), Telecom and Datacom (35%), Electronics (25%), and Networking (5%). Products include metallic and composite enclosures, cabinets, cases, subracks, backplanes, and thermal management systems. This division was augmented by the $120 million acquisition of APW in 2005.
- Opportunity for Continued Cost Synergies, Margin Expansion. One of the company’s strengths is its ability to apply lean efficiency methods to its manufacturing processes. The company is in the early stages of this process for its water business. PNR also incurred a variety of expenses in 2006 which will not recur in 2007, including plant moves/closures (roughly $15m), pump JV losses ($4m), spa division losses ($5m), and overseas start up costs ($10m+).
- Acquisition Target. Pentair’s valuation and position with several leading brands in the water industry could make it a potential sale candidate. Several larger players that would be interested in Pentair, include Danaher, ITT Industries, Siemens, Cooper or a private equity firm. Eight of ten Board members are independent so I believe management is on a short leash to improve recent weak execution. Management does have a dilutive poison pill that makes a hostile offer less likely. Recent comps of private equity interest in the water space include Jacuzzi bought by Apollo and Water Pik bought by Carlyle Group. Both were done in the 9-10x Ebitda range for lower quality assets.
- New management. Pentair recently appointed Mike Schrock - a noted cost-cutter/efficiency guy - as COO. Schrock previously ran the enclosures business, which saw EBIT margins increase from 2% to 15% over the last 3-4 years. The company also announced corporate/field headcount reduction and removed other layers of management to clearly create more accountability in the organization. I believe this focus will be key for raising water margins to 15% in two years.
- Cheap valuation and good risk/reward. PNR trades at 14.1x 2007 earnings, 13.1x 2007 FCF, and 11.9x 07 FCF ex-growth capex (8.5% yield). Other industry participants such as Mueller, ITT, Flowserve and Pall trade at an average of 18.4x forward EPS. Pentair announced its largest buyback ever at $100m, and bought roughly $45m in the third quarter alone. I think the stock is worth $44 in a year, based on 16.5x 08 EPS of $2.67, which assumes 15% margins for the water business. That’s 42% of upside, while I think downside is limited to $28 (-9%) based on a 15x multiple of 07 EPS of $2.00 which assumes only 100 bps of margin expansion in the water business in 2007.
- Good Long-term Growth Outlook of Water Industry. The growth outlook for the water industry is solid, with projected annual increases of 2%-5% for pumps, 5%-8% for pool & spa, and 8%-plus for more-proprietary filtration systems. Pentair is widely recognized as the leader in pumps and pool/spa products, and is focused on bolstering its position in filtration. Moreover, the company is focused on expanding its presence in the higher-growth international markets.
- Recent performance. Operational consistency has been lacking since the Company purchased WICOR. Basically, this purchase has been more difficult than anticipated, resulting in higher costs and some lost revenue. As a result, the stock is clearly cheap and should move more to a peer valuation once execution improves and investors regain confidence.
- Ties to Real Estate Cycle. Pentair’s product lines have some exposure to the housing cycle, which is at peak levels. Pool/spa has the greatest exposure at close to 50% new pools, while filtration/pumps are 80-90% commercial or replacement. With the recent Q3 pre-announcement, management lowered the bar with pool/spa sales declining by double digit percentages in Q4 as channel inventory levels get worked down. The Company has set pool/spa targets at -3% to -8% in 2007, while its biggest customer (Pool Corp) is looking for 3-5% growth.
- Acquisition Integration. The company will use some free cash flow to pursue acquisition targets, such that there is risk that management will overpay or face difficulties with integration efforts. Difficulties at WICOR have made the company reassess its acquisition plans, hence the higher share repurchases lately. Most of WICOR integration challenges should be complete by year end.
*Note: (I'm on vacation next week, but will be happy to respond to questions after the new year).
Earnings growth via cost rationalization
Sense of a housing bottom in 2007
Sale of the company
Continued share repurchases