Pentair plc (PNR) — Q1 2015 Earnings Call Transcript

Thanks, Jody. And welcome to Pentair's first quarter 2015 earnings call. We're glad you could join us. I'm Jim Lucas, Vice President of Investor Relations. With me today is Randy Hogan, our Chairman and CEO; and John Stauch, our Chief Financial Officer. On today's call, we will provide details on our first quarter 2015 performance, as well as our second quarter and full year 2015 outlook as outlined in this morning's release. Before we begin, let me remind you that any statements made about the company's anticipated financial results are forward-looking statements subject to future risks and uncertainties, such as the risks outlined in Pentair's most recent 10-K and today's release. Forward-looking statements included herein are made as of today and the company undertakes no obligation to update publicly such statements to reflect subsequent events or circumstances. Actual results could differ materially from anticipated results. Today's webcast is accompanied by a presentation, which can be found in the Investors section of Pentair's website. We will reference these slides throughout our prepared remarks. Any references to non-GAAP financials are reconciled in the appendix of the presentation. We will be sure to reserve time for questions and answers after our prepared remarks. I would like to request that you limit your questions to one and a follow-up and get back in the queue for further questions in order to ensure everyone an opportunity to ask their questions. I will now turn the call over to Randy.

Thanks, Jim, and good morning, everyone. Let me just begin on Slide 4 with a summary of how 2015 has started and how we see Pentair positioned for the remainder of 2015. As we announced two weeks ago, this year has started off significantly below our initial forecast. We expected most of our energy-related businesses to be challenged this year given the dramatic decline in oil prices in the second half of 2014. But a global capital spending freeze and its impact on industrial businesses was not foreseen. We do not see this to be a Pentair-specific issue as this broad-based decline was across virtually every business, every geography, and every market. In fact, the only geography of growth we saw was North America. We believe there is broad economic uncertainty that is contributing to delays in our customers' spending habits, and we have felt this in both large projects and some MRO business. As a result of the dramatic impact of FX translation and a significantly slower start to the year, we are now taking a cautious position on any expected recovery this year. So we have gone back to our cost paybook and are working aggressively to adjust our cost structures accordingly. Our balance sheet remains healthy and we expect 2015 to still be a strong free cash flow year. We will continue to invest in M&A where appropriate while executing on costs. Given the uncertainty, we have rebuilt the plan to drive performance in 2015 to equal 2014. As a result, we are adjusting our 2015 adjusted EPS guidance to approximately $3.80 per share, making 2015 a pause year. We believe that Pentair is in attractive markets for the long term. We have detailed plans in place to work through the anticipated near-term challenges and we are executing them. Now let us turn to Slide 5 for a quick look at our key 2015 forecast assumptions. Given the significantly slower start to 2015 as a result of the global capital strike we are experiencing, we are now expecting our core sales for the year to decline 2 to 3 percentage points instead of growing 2% to 3%. Given the first quarter top line shortfall and its negative operating leverage, we could not adjust our cost structure quickly enough in Q1. But we still expect operating margins to expand roughly 50 basis points for the full year. We completed $200 million of share repurchases in January, and we're still focused on our active M&A list in our most attractive businesses. John will outline in detail the cost actions being taken both variable and fixed as we adjust to the start of 2015. As a result of these actions, we are expecting roughly 40 million of repositioning benefits this year, an accumulative 100 million plus in 2016. Our balance sheet capacity is over 800 million. Although the external headwinds have worsened, we are focusing on the elements within our control. This includes getting more aggressive on cost actions, continuing to invest in differentiated growth, and as I mentioned, select M&A where appropriate. Now let us turn to Slide 6 for a discussion of our first-quarter results. This first quarter saw our core sales decline 4% as all verticals declined except Food & Beverage. The one geography that performed well was North America, but we saw weakness in all other key geographies, particularly in fast growth regions. As previously mentioned, FX was a significant headwind in the quarter. Given the sharper than anticipated volume declines, productivity and price were not enough to compensate and we saw adjusted operating income decline and margins contract in the quarter. Cash flow was a typical seasonal usage where we expect another strong free cash flow year and expect significant improvements in sequential cash flow improvement.

Thank you, Randy. Please turn to Slide number 15 titled '2015-2016 cost actions.' As Randy mentioned, we faced increasing headwinds in the first quarter and we are working to align our cost structure appropriately. To start, we saw a strengthening dollar create both top-line and bottom-line headwinds. With euro at $1.07, we anticipate a $65 million operating income headwind for 2015. If the Euro were to move to parity against the dollar, it would create another $10 million impact on operating income. We’re not planning for the dollar to weaken; in fact, we are assuming that this will be the new norm for the year and are now implementing cost-out actions to mitigate the translation impact on a go-forward basis. If the dollar weakens, we would expect to benefit, but we’re not counting on it. The cost actions will primarily be in Valves & Controls and Flow and Filtration Solutions, the two segments hit the hardest by the global capital spending pause. We expect these actions will yield $40 million in savings in 2015, an accumulative $100 million plus in 2016. We plan to continue to focus on G&A and variable labor, but we are also expanding our cost actions through our fixed cost structure.

Thank you. Good morning everyone.

Good morning.

Hi Deane.

Maybe we could start with the comments about the global CapEx spending freeze, and maybe take us through the cadence of the months and I am particularly interested in the comments regarding how it may have spilled into some of the MRO spending, and maybe this was part of the destocking comment in your negative announcement, so could we start there please?

Yeah, thanks Deane. Basically, if you take the industrial market that we follow most closely is of course our equipment protection business, and actually industrial and that business, industrial showed some increasing weakness in Valves & Controls as the quarter went. But really we saw a pronounced decline in March in the other industrial businesses, the sell-through distribution, which we believe is some destocking and uncertainty as the knock-on effect, which we can see in valves as we saw the knock-on from oil and gas into some slowdowns in other projects and delays in other projects. So we think there is a bit of a knock-on effect and uncertainty that has caused this and we do believe this destocking, we even saw some destocking in the residential and commercial side in flow. So we do believe that distribution has taken a cautious turn in their re-ordering in industrial and in some places in residential and commercial.

And then could you expand on that comment on energy regarding seeing the softness starting to work its way into your midstream and downstream businesses, I mean, clearly everyone has been set up for an upstream headwind, and that seems to be playing out a little bit earlier, but could you expand on the comments and any specifics regarding the midstream and downstream activities?

Well, particularly the downstream is bigger for us than upstream. So to see the oil and gas decline that we did and when we look at the projects we see a slowing in the orders rate across the board really. Our hit rate seems to be okay. But with the exceptions we pointed out, process, which we count as industrial, in North America was pretty good, but we saw a slowdown in process. In the fast growth markets, we saw a slowdown in refining in the fast growth markets and now a lot of that is in specific countries like Brazil, which shouldn’t be much of a surprise. But we do think there is a knock-on effect and I think you can see it in oil and gas companies, who are basically constraining capital and constraining capital it is a blunter instrument than just precisely focused on projects. We also saw MRO decline, you know, single digits, but MRO sales in Valves & Controls generally has been up every quarter, and we actually saw a decline, which to us feels like a – obviously you have to maintain things. So, it feels like a slowdown in general capital spending to us in the downstream. We will see how this – if they see it too.

And just last one from me related to the energy side, Randy you made some comments about delays versus cancellations in some of the orders and maybe just expand there by your major energy businesses, you know, how much are delays?

Yes, it was a comment about Valves & Controls, primarily our Valves & Controls ship later in project cycles. And so, you know, every quarter we see projects get pushed out some because they don’t want the valves onsite until they are ready for them. But also usually there is some that get pulled in because projects speed up and slow down. So we always see a mix of delays and expedites in a quarter. We basically saw no expedites in the quarter. I would say delays were probably 20% higher than normal, but there were no expedites to offset it and that to me – that feels like to us just a general slowing on project execution. We have had some specifics, which I won’t get into, people exploring, we have had a few cancellations, but I can’t say that that is any – that is abnormal. You know, orders that we thought were going to go the projects we cancelled. But we are very cautious as to that was my comment about customers reviewing project pipelines. I think mergers in the industry affect that and the customers industry affects that and as they look at adjusting the capital obviously they’re going to take some projects off the list.

Thank you and good morning Randy, John and Jim. So, my first question clearly oil and gas is weaker you’ve got this contingent effect it’s still over into industrial Randy you mentioned in your prepared comments that the delays accelerated in March. And so, I’m just trying to get, I’m trying to understand I guess, when I think about your organic growth guidance for the year of down 2 to down 3, your complicated puffer organic growth is down 4 in the first quarter and just trying to get the sense for what gives you the confidence that you’ll get some improvement as the year progresses?

Joe, just to clarify, it’s John. I think some of the Valves and Controls as we call Q3 and Q4 were not great quarters for us, so we started to see some of the slowdown from the order shortfalls in last Q1 and Q2, start to work its way in Q3 and Q4. So, some of those comps and Valves and Controls get a little bit better, same thing in industrial (indiscernible) business solid backlog that we feel comfortable is going to continue to shift throughout the year. And then, residential commercial has been strong as Randy said in Water Quality Systems and we also start to anniversary some of the tougher headwinds in our flow and filtration solutions. I think we’ve looked at the organic growth and although we don’t see if we took a 90-day rolling average of historical sales we don’t see that improving throughout the year. We do think that gives us a little bit easier comparison to the back half of the year.

Do you guys have any clarity at this point on the destocking and when you would anticipate some of the headwinds associated with destock to subside?

We think it continues in the Q2 for us, I mean, we look at some of the same bellwethers that you guys do in the industrial distribution side, I think they saw the slowdown a little later then we did and they started to correct as Randy mentioned and that started to work its way through our March shipments, we expect that to continue through April and May.

Okay. And then, I guess one last question on – I’ll pass it up. On the restructuring side I applaud your efforts to take cost out just given the economic backdrop, can you just maybe provide some more clarity on the run rate that 100 million plus in 2016 just given the restructuring actions that you have 60 million this year, does that bake into some of the restructuring actions that you took last year as well because the magnitude of that number just seems like a big number and the payback seems quick?

Yes. These are new actions incremental to the things we’re working already in synergies and in fact as Randy and I met with the business precedence we’re still hopeful and our sales people are still hopeful that things are going to improve throughout the year, we’re trying to be hopeful as we were trained, hope it’s not a plan and we think our view now is react to this new economic uncertainty and take the cost out. So which you’re seeing in G&A and then some entry into footprint actions finally in our Valves and Controls and other businesses where we can get after some product line moves and get ourselves right sized and competitive. As Randy mentioned in his remarks and I followed up, I mean, we now expect pricing to be the new norm in Valves and Controls and so even the projects that we’re anticipating winning we’re expecting to come at lower margins and so we’ve to accelerate our competitiveness to continue to bring those projects in at the same drop through that we anticipated for.

Hi guys, good morning.

Good morning, Steve.

So, just on the pricing dynamics, I guess this is just happening in Valves and the orders, just happening a little bit faster than expected in Valves and Controls, I mean, is pricing, are these orders going to impact ’16 now or is this kind of reshuffling in the backlog such as becoming more, it was longer cycle on the way up and it’s now shorter cycle on the way down I guess. And then, from that perspective prices already kind of stating here in that business in revenues, so I mean, how we think about pricing in the back half of the year does that actually go negative in the back half of the year in Valves?

Let me talk about 2000 – we think, we were very cautious on orders through the year which we think will affect Valves and Control sales in 2016. So, we don’t see a change really in sort of things going faster or slower, I think it’s going to be a tough year on order and we’re going to do everything we can do to win in a discipline way which will put switching the price. We already see pricing and you already heard about what customers are asking in terms of pricing. It might not just be in Valves and Controls, I mean, one of the things that affects does is if you’re the example I used in – which was a surprise, it won’t be a surprise next time in terms of the transactional impact of effects that was an impact in our technical solutions business. Technical solutions really did pretty well in the quarter but we had a few surprises that being one that was a Canadian dollar transaction in the U.S. dollar cost and that hits prices. And as competitors as foreign, as non-U.S. competitors start using their change in cost advantage, price advantage we expect the challenging price environment in more than just Valves and Controls.

So when you think about kind of this total price of Pentair going negative in the second half of this year?

Yes. We do think it goes slightly negative still in some of our distribution business; we still expect to gain normal price increase and we have those through and they’ve been accepted but we would expect any project and certainly areas where we got a bid on a cost to the price negative to the back half of the year.

We’ve good material productivity that’s hung up on the balance sheet so that will get more productivity as we go through the year too which will help offset some of that price. But, we think it’s a more cautious plan to assume we’re going to see tougher pricing environment.

The way we look at it is we benchmark against the best and you can look at our businesses and you can see two of our GBUs that do not have margins close to the best of the peers and that would be on filtration solutions GBU in our Valves and Controls GBU. So these are not plans that we invent in the moment. These are long-range plans that we accelerate. We have talked in Valves and Controls I mean I don’t want people to think I am hallucinating given the first quarter we just had you know valves and controls was well above 15% margin we got it to 45 with lots of more opportunities. So we have talked about a number of well north of 15 but I don’t want to give that again because I think it might lack credibility right now.

Okay. One last quick question on free cash, what’s kind of the key lever to ramp that cash flow throughout the year, what’s kind of the one or two things that you’re looking at to play out because it’s little bit weaker than expected in the first quarter?

Yes. It’s right sizing the inventory in our working capital levels to the new one.

Yes. Basically, we’re relying on working capital inventories to support the higher sales level and needs to be corrected and we know how.

Thanks and good morning. Just I want to stick on pricing and margin for a minute, we are entering this environment you had significant material deflation I think as a tailwind as well as pricing up until now has been helpful. Now those are both going against you and my question is given that you don't know how long this will last the restructuring that you have already taken and that is going to be fairly aggressive here how much more can you do there because there seems to be some risk to the margin opportunity going forward?

Yes Steve, I do want to be – I want to clarify something. I think we expect we have done really well in material productivity we expect material productivity to do even better going forward. We can see that and what we call the deferred productivity as Randy said what’s done in Q1, but its hung up in the balance sheet and we work its way in a positive way throughout the rest of the year. We’re continuing to partner with our suppliers to anticipate these potential pricing headwinds and the pricing is an anticipated pricing. It’s not realized so we are expecting that environment is going to be tougher and we are managing it appropriately as when I want you to take away.

On the comment about – concerned about cost cut getting into growth we are very cautious about touching our growth resources but what we are doing is, I am personally redoubling my efforts with our platform, we’re using our precedence to make sure that those investments we made are paying off. I didn't see enough read out of some of them in the first quarter.

One thing to note is that during challenging and uncertain times, new opportunities can arise that weren't previously available, so it's actually a good time to explore options. In response to your question about our readiness, one reason I mentioned the small acquisition in my prepared remarks is that it serves as a good example. Our thermal building solutions business is growing, and we've made significant innovations there, resulting in impressive growth last year. We anticipate another strong growth year this year. This business, built on our existing offerings, enhances our distribution channel. It aligns well with our strategy to drive profitable growth.

And is Australia process on track the divestitures?

Yes.

Hey. Good morning. I am sorry to beat the old dead horse here but if we can just go to slide 13 where we have the forecast for organic by vertical. The energy number has only really been taken down 1 point versus two months ago and we are talking about more concerns about pricing and moving into mid stream and downstream which I think many of us did expect that but nevertheless I am just wondering why we are only down 1 point incrementally from the two months ago guidance particularly given the order scenario that was laid out on an earlier slide?

Yeah, it’s a fair question. Thanks for asking it. I think a couple of things and a couple of factors in here, Valves and Controls is experiencing more challenging entering into environment, we are also experiencing some key wins in technical solutions primarily around industrial e-trace so these are down streams and later projects there are productivity-related and we are starting to see a pickup in that area. So, we do have a mix of where the projects are coming through our typical businesses but all in we have backlogs and those backlogs give us confidence that this is not only appropriate number that we will ship this year.

Yeah, we also don't think that the – we think - -we don't think the MRO declines on the first quarter this sounds like one orbit plan, is going to be as acute as it was in the third quarter, as it was in the first quarter.

Alright. Thank you. And the other – my follow-up would essentially be on the share repurchase so I know we are kind of back into the M&A hunt mode and all that which is great I think I am wondering though is that why would we wait on share repurchases given this environment. Do we, you say if we don't find anything then you are kind of – you buy shares sort of a guess that was implied for the second half of the year you have a ton of balance sheet capacity why would we wait for that?

We feel optimistic. We have been working for fair amount of time as Randy said we have what we call platforms or businesses underneath the four segments that are high performing both in revenue and also on the operating side and we want to continue to feed the core and we have enough in the pipeline that would give us the feeling that we are going to execute on some of those throughout the year if in fact we don't feel that those are going to come through we are not going to execute clearly we would take a look again at share repurchases.

Right, I mean we can only use the part or one so if we can't use our M&A then we will have through that but if we use that when we won’t have M&A.

Good morning guys.

Hi Shannon.

Hey. Can you give a little more color on the geographic difference in Valves and Controls, I mean, you mentioned that the fast growth regions were getting hit the worst maybe a little more kind of specific countries or types of projects just being on there and then in terms of North America being the only piece up was that basically just L&G being the area strength that was there a more positive in North America beyond that?

Starting with that North America was strong in process in industrial as well stronger and L&G was a nice pickup. We had a particular focus on North America and we have actually invested in coverage there and I think that actually helped in Valves & Controls when – few years ago when we first got into it, it looked like our coverage and our share in North America was weaker than it was in other so that's an investment that I think is actually has paid off a little bit. It’s obviously – somewhat by the overall trends. But on the fast growth side both China and Brazil we’re down significant double-digits in the quarter. And Brazil I guess isn’t that surprising, but China was more surprising than we expected and that was in chemicals as well as in oil and gas in industrial.

Okay. And then just maybe a follow-up on this global capital strike point, I mean, as you kind of made sense over the first quarter and talked to your customers what are the most cautious about or uncertain about that sort of driving the decision making is there one sort of macro concerns that's particularly weighing on people one or two things you tend here?

Well, I think the oil and gas industry is one of the biggest drivers in capital spending in the world and I think it’s the uncertain here on the knock-on effect and there is a lot of cuts and there is a high degree of caution and uncertainty about – well, there are projects that are getting delayed and won’t get done but just concern about what all that mean we believe that is the fact and that's why we think destocking. When we see in industrial space where we kind of exclusively distributors we were pretty confident that there is destocking effect going on. But we also – we have seen delays in not just oil and gas we have seen continued delays in deferrals and power. And I think that has more to do with the general need for electricity and the fact that the economy generally is just buttering along in the world and electricity needs grow with the economy so we have had a lot of power projects that are just delayed, delayed, delayed and the fact that percent delays in the first quarter in power were in the projects that we tracked whereas the percent delays was high in oil and gas.

Hey good morning. There is one more left I guess. You talked about the 100 million in cost cuts and the timing of that and that we are going to see it I guess more likely in Valves and Controls infiltration but I am just having I don't know how much color you can give on it having trouble figuring out where do you find that much in cost cuttings when you are so successful in developing cost synergies and attacking that after the merger if there is any more detail around the types of moves you can make that will be helpful?