Pentair plc (PNR) — Q3 2016 Earnings Call Transcript

Thanks, Scott, and welcome to Pentair's Third Quarter 2016 Earnings Conference Call. We're glad you can join us. I'm Jim Lucas, Vice President of Investor Relations and Strategic Planning. With me today is Randy Hogan, our Chairman and Chief Executive Officer; and John Stauch, our Chief Financial Officer. On today's call, we will provide details on our third quarter 2016 performance as well as our fourth quarter and full-year 2016 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 in order to ensure everyone an opportunity to ask their questions. I will now turn the call over to Randy.

Thanks, Jim, and thank you all for joining us today. I'll be starting on slide 4. We delivered third quarter results that operationally met the high end of our forecast and were slightly above our guidance as a result of anticipated separation costs that did not materialize. While two of our three segments did not deliver core sales growth as a result of continued slow industrial spending, the margin performance overall is a testament to our strong discipline around cost management. We announced in August that we reached an agreement to sell our Valves & Controls business to Emerson. This transaction is on track to close at the end of this year or early next year, subject to regulatory approvals. We're not expecting any recovery in industrial capital or maintenance spending at the end of the year in contrast to the typical year-end lift. Given this muted top line outlook predominantly on industrial-facing businesses, we're lowering our fourth quarter outlook. We do not believe the fourth quarter is indicative of a trend, and we expect at some point maintenance spending will return in a more meaningful way. Longer cycle projects, particularly in food and beverage and infrastructure, are also likely to break loose. As we look ahead to 2017, we believe we are positioned to deliver strong EPS expansion despite this ongoing slower growth environment. I'll discuss this in more detail later in the call. Now let's turn to slide five for discussion of our Q3 2016 results. Third quarter core sales declined 2% as we saw further slowdown in capital spending throughout the quarter and ongoing deferrals in maintenance spending. Water Quality Systems was our only segment to deliver core growth as the pool business once again finished the season in a strong position. We reached the one-year anniversary of the ERICO acquisition and the performance has met all of our expectations. Segment income grew 15% and return on sales expanded 110 basis points to 17.9%. Water Quality Systems delivered over 300 basis points of margin expansion. And despite the core sales decline in Flow & Filtration Solutions, income and margins were down only modestly as the segment delivered on better internal execution. Adjusted EPS grew 11% to $0.78 per share and exceeded our forecast of $0.70 to $0.75 per share as our core operating results met our income forecast while we did not incur the one-time separation costs we were expecting below the segment income line. Free cash flow continued to be a bright spot, up over $150 million year-to-date compared to last year, and our conversion to adjusted net income remains just north of 100%. Now, let's turn to slide six for more detail on Pentair's Q3 2016 performance. Once again the residential and commercial vertical was a bright spot, driven in large part by our strong North American pool performance. While ERICO's performance was not captured in the core, its commercial sales also remain strong. After a good second quarter, we did see overall infrastructure sales decline modestly in the third quarter. We continue to see strength in engineered pump orders and backlog but our process filtration business faces difficult second-half comparisons. Food and beverage declined with delays in a number of larger beverage projects being the largest factor this quarter. While we've greatly reduced our exposure in energy, our remaining sales for this vertical remain under pressure. Industrial was down in the quarter due in part to ongoing deferrals in short cycle MRO spending and a global capital spending freeze that shows no sign of thawing. The right-hand side of the page shows that price and productivity continue to more than offset inflation as we continue to control costs across the enterprise. ERICO's contribution also helped drive the strong margin performance in the quarter. Now let's turn to slide seven for a look at Water Quality Systems performance in Q3. Water Quality Systems delivered core growth of 2%. These results were below our expectations as within our water filtration business we saw foodservice and commercial market softness in North America and Western Europe, as well as shifts in timing of key account program installation. We also experienced a moderation in growth rates in the fast growth regions as our distributors closely managed inventory levels due to slower growth in China. The North American pool market ended its season on a strong note. We continue to view this market favorably longer-term. We also believe our water filtration business has good long-term prospects and expect growth to return in 2017 as new product rollouts and key account program installations, particularly in foodservice, return to growth at a normal level. Segment income grew an impressive 15% and return on sales expanded 240 basis points to 21.2%. Robust operating leverage was once again the largest contributor to this strong margin performance, with the strong growth in the pool business contributing positively in the quarter. Now let's move to slide eight for a look at Flow & Filtration Solutions performance in Q3. Flow & Filtration Solutions saw core sales decline 6%. While we anticipated sales to contract in the quarter, water technologies and fluid solutions were down more than expected, as we saw softening demand in short cycle pump sales and weaker capital spending in beverage. Water technologies core sales declined 3% as distributors managed inventory levels tightly and we saw continued declines in irrigation sales, albeit at a moderated pace. We experienced a dramatic slowdown in fast growth regions, particularly in the Middle East and Latin America as sell-through was soft in the quarter and, as a result, distributors are not restocking. In contrast, Western Europe was a bright spot, up double digits in the quarter with good momentum. We continue to see an improvement in infrastructure bid activity, which points to a stronger 2017. Fluid solutions core sales declined 1%, which is slightly better than the 3% decline we saw last quarter. Sales in agriculture grew modestly in the quarter, and importantly, we expect this momentum to continue. Our biogas and beer membrane filtration businesses remain strong, offset partially by our beverage business seeing a number of large project delays globally and softer component sell-through. Core sales in process filtration declined 22%, largely in line with expectations, with the key drivers being project timing within infrastructure as well as declines in oil and gas and industrial filtration. Segment income and return on sales declined modestly as the impact of lower volumes were not fully offset by the continued strong productivity and pricing seen for the past several quarters. We remain vigilant on improving the cost structure to offset the impact of lower volumes. Looking ahead, we expect food and beverage to rebound with agriculture turning positive, along with growth in biogas and beer membrane filtration. As we continue to reduce the complexity in the business and drive better execution in projects, we believe we have a long runway for margin improvement. Now let's turn to slide nine to discuss how Technical Solutions performed in the third quarter. Technical Solutions reported 26% sales growth for the quarter, consisting of a 1% core sales decline and a 27% positive contributions from ERICO. Core sales in enclosures declined 1% as industrial sales continue to bounce along the bottom, diminishing chances of any order rate growth acceleration for the remainder of 2016. Thermal management core sales declined 5% as downstream energy MRO product sales are not showing any signs of recovery. Our industrial heat tracing business continues to win small projects, but our project growth was challenged as large Canadian projects are nearing completion. While the results of ERICO are captured as acquisition contribution, the business performed in line with our expectations at the completion of the one-year deal anniversary. The majority of ERICO's sales are into the commercial vertical, which continued to deliver growth in the quarter, although the rate of growth is moderating. Segment income grew 18% as return on sales contracted 140 basis points to 22%. Margin contraction was isolated to our thermal management business, as the sales of projects versus higher-margin MRO product sales negatively impacted mix and we face productivity issues at the end of the large Canadian projects. ERICO has performed as we had anticipated, and enclosures continue to stabilize. The performance of these two businesses was not enough in the quarter to offset the margin impact from thermal management. We're not expecting downstream MRO spending to rebound for the remainder of the year. We also expect the Canadian project margins to pressure thermal margins in Q4, as we substantially complete them before the end of the year. This will undoubtedly have an impact on fourth quarter margins for Technical Solutions. With ERICO and enclosures performing as expected and thermal completing the large Canadian projects, we still believe Technical Solutions remains well positioned longer-term.

Thank you, Randy. Please turn to slide number 10, titled Q4 2016 Pentair outlook. For the fourth quarter, ERICO is now captured in the core results, so core sales and total sales are currently equal to each other. For the fourth quarter, we expect overall sales to decline approximately 6%, as we expect MRO trends in energy and customer capital spending in all verticals to worsen as we head into the end of the year. Motivation for customers to push our projects and commitments shows no signs of stopping by the end of the year. On a core basis, we expect Water Quality Systems to grow approximately 2%, while we expect Flow & Filtration Solutions to decline approximately 9%, primarily related to project spending in the food and beverage vertical. Technical Solutions is expected to decline approximately 10%, due in large part to the completion of previously mentioned large Canadian projects and mid-teens declines in year-over-year MRO spending within energy. We expect segment income to be down approximately 10%, and return on sales to decline roughly 70 basis points to 17%. Below the operating line, we continue to expect the tax rate to remain around 21.5%, net interest and other to approximate $35 million, and shares outstanding to be around 184 million, about flat with Q3 ending levels. We expect free cash flow to end the year on a strong note, greater than continuing operations net income of $550 million and nearly $780 million inclusive of Valves & Controls. Please turn to slide 11, labeled full year 2016 Pentair outlook. As Randy mentioned at the beginning of the call, we've taken our full-year adjusted EPS outlook for continuing operations down to approximately $3 for 2016. For the full year, we expect core sales to decline 1%. Water Quality Systems full-year core sales are anticipated to be up approximately 4%. We now expect Flow & Filtration Solutions core sales to decline by 4% and Technical Solutions core sales to be down 2% for the full year. We expect segment income to grow roughly 11%, and return on sales to expand approximately 70 basis points to 17.1%. Our revised forecast factors in slightly better operating performance from Water Quality Systems, while Technical Solutions and Flow & Filtration Solutions are expected to have margins impacted by negative mix related to unfavorable market conditions. The pressure on higher-margin short cycle sales has been felt most acutely within Technical Solutions. We anticipate full-year corporate cost to be just under $110 million, net interest and other roughly $141 million, and the share count to be roughly 183 million. Adjusted EPS is expected to grow approximately 6%. Finally, we remain on track to generate free cash flow in excess of adjusted net income for the full year. Please turn to slide 12, labeled balance sheet and cash flow. We ended the third quarter with $4.4 billion net debt inclusive of cash on hand. This continues to improve as we used our strong cash flows in the quarter to reduce our debt levels. On a year-to-date basis, free cash flow has increased over $150 million versus the first nine months last year. We continue to expect to deliver free cash flow greater than adjusted net income for the full year. Our ROIC ended the quarter at 10.6%. When the sale of Valves & Controls closes, we expect our balance sheet will look dramatically different for the better, with lower debt levels and balance sheet capacity available for tuck-ins or incremental buybacks. I'll now turn the call back over to Randy for some closing comments and preliminary thoughts around 2017.

I'll wrap up beginning on slide 13. As I mentioned at the beginning of the call, the sale of Valves & Controls remains on track to close at the end of this year or early next year, subject to the regulatory approvals. With the closing and the Valves & Controls separation, we expect the infusion of cash to alter our balance sheet dramatically for the better. As we discussed in August, we know what debt we will retire, mostly within our bank line. We're also exploring other options to restructure our debt, substantially reduce interest expenses on our higher cost fixed-rate long-term debt. We also continue to build our bolt-on acquisition funnel for businesses that have earned the right to grow, primarily within Water Quality Systems. We're doing what we can to control our destiny and while we still see some pockets of growth within residential and commercial and infrastructure, the uncertainty around any type of recovery within industrial gives us pause. So we're taking a closer look at our cost structure and adjusting it accordingly. Now, let's move to slide 14 for a look at segment positioning. Water Quality Systems has been a bright spot within the Pentair portfolio for several years, and while we've seen the growth rate moderate some, we continue to believe in the long-term prospects of this high-performing segment. With strong residential demand, dealer intimacy, and a steady stream of new products, our outlook for the aquatics business remains strong. Within water filtration, we continue to believe we will benefit from increased awareness around water quality globally, and our investments in a more focused sales effort in North America and Europe are already paying early dividends. Foodservice has been a relatively consistent growth business for us longer term. We continue to believe there are many avenues for growth, including traditional restaurant sales as well as edging on into adjacent products and connected solutions. We believe Flow & Filtration Solutions remains the biggest opportunity for improvement within the Pentair portfolio. Our number one priority is reducing the complexity of the business, accelerating cost-out action and focusing on the most attractive growth prospects. We continue to see momentum around biogas and beer membrane filtration. It is encouraging that agriculture seems to have bottomed out. So, we believe we're building some momentum exiting this year after a tough couple of years. As I discussed previously, we are seeing improved orders in backlog and infrastructure, which is a longer cycle part of the business, positioning for a return to growth. Finally, we're placing an increased focus on building our aftermarket service capabilities to leverage our installed base. Flow & Filtration Solutions has a number of opportunities and our principal focus is to prioritize which opportunities drive first and build momentum to restore growth and raise margins. We believe Technical Solutions has an attractive position in profitable areas of the electrical industry. We expect the 2016 headwinds will begin to dissipate as industrial order rates are near trough levels, hints of inflation returning are on the horizon, large projects in Canada are complete, and deferred MRO spending cannot continue forever. While we expect strong growth in commercial to moderate, growth is likely to continue, progressively right-sizing the cost structure with the slower growth environment. This is the piece of our portfolio where we still have energy exposure. And while oil prices appear to have stabilized, we'll watch closely for signs of improving thermal MRO spending. While we still expect some near-term headwinds in parts of our portfolio, we still believe there are many avenues for growth longer-term. Now let's move to slide 15 for a look at the framework for 2017. Given the portfolio change and attendant P&L and balance sheet improvements we're undergoing, we think it's important to provide some framework for thinking about our prospects for next year. As we discussed throughout the call, we expect the slow growth world we are all facing today to continue, and we do not expect a meaningful recovery in 2017. Therefore, it's prudent to focus on having our cost structure aligned with this reality, the result of which should be margin expansion from all three segments next year. Upon the closing of the Valves & Controls sale, we expect to have an opportunity to restructure our debt, which will reduce interest expenses. Also, we expect to have the financial flexibility to explore other opportunities to allocate capital in a disciplined manner. By focusing on cost, simplifying the business and improving the capital structure, we expect to be able to deliver EPS growth in excess of 15% next year with minimal top-line help while still positioning the company for the longer term. Thanks. And operator, can you please open the line for questions.

Good morning, guys.

Good morning, Shannon.

Good morning, Shannon.

Hey, so, just on kind of the 4Q caution, I mean, is there anything in October that's making you think we've seen yet another decline? Or is it just lack of inflection, concerns around the election? Maybe just a little more color on what keeps you cautious on 4Q? And I know you're more optimistic beyond 4Q.

Yeah, Shannon. It's John here. I think what, if you take a look at Q3, we started out really strong and we ended okay, but we certainly didn't see acceleration towards the end of Q3. And what we're seeing is continued project slippage, where these are projects that we've either won, but the start dates on the projects continue to move to the right. And given where we are right now, with all the uncertainty you mentioned, we just don't think our customers are going to rush to conclude them between now and the end of the year. The other main issue is we've been hoping that MRO would recover throughout this year and that's on the operational side, primarily in energy, and we're not hopeful now at this point that that's going to recover for the end of the year as our customers manage cash to the end of the balance sheets. So, those are the main issues.

Yeah. We almost always see an uptick in industrial spending in the fourth quarter. What we're saying is, we're not counting on that this time, with these deferrals.

Okay. And then just, in terms of all segments improving margins next year, the one that's been a little bit tougher has been Flow & Filtration, maybe just an update on how you think they're progressing operationally? I know volumes were a little tougher this quarter, but what – do you have confidence that segment can improve margins next year?

Yeah. If we had hit the forecast of down 2% instead of down 6%, we would have expanded margin. I think we're making a lot of progress on simplifying the product line and on driving productivity. It's a business that frankly didn't get as much attention as we focused on Valves & Controls, and now we're getting back to it. So I think there's lots of opportunities, and things like agriculture coming back, the crop spray business and some of the other businesses that are more profitable, those stabilizing and even getting a little bit of growth is going to help in the mix.

Okay. Great. Thanks, guys.

Thanks. Good morning, all.

Morning, Steve.

Just first a quick question on ERICO. So I know it's not in core growth. What would that have contributed to core growth? What was just the ERICO core growth for that business?

1% to 2%, Steve.

Okay. And just on Water Quality Systems, this was one of your strongest businesses that could do no wrong historically, and clearly you had a forecast for 8% at least in terms of guidance, came in at just 2%. You talked about a couple of those dynamics, but maybe also for John, I mean, where was the forecasting error here in terms of that business that's supposed to be so much more stable?

I'll hit your last part first and then I'll have Randy. We had three key businesses in Water Quality. We have our aquatic and environmental systems, which is primarily the pool business. The pool business continues to be very strong, and we continue to hit all of our forecasts relative to that business. Where the softness came in the quarter, which also relates to the way we're thinking about Q4 was in the foodservice business, which has been up, high single-digits throughout the year and had moderated back to flat in Q3. And then also we had the water purification business, which also was strong most of the year and took a little bit of pause in Q3. So that's where the misses came, Steve.

Yeah. I'd just add, on the foodservice side, we've been growing at high teens rate in Asia. And while we're still growing there, that took a step down to high single-digit growth rate, which was one change. And then we've seen some, I would call, variability in some of the deployments in some of the chains as restaurant growth has slowed down. So we expect those deployments to continue or get positive again as we launch a new range of products, which I referenced in my comments, but that won't happen in the quarter.

Okay. And Randy, in terms of how you're thinking about M&A. You early on talked about those businesses that have – I guess, have earned the right to capital deployment soon – shortly after Valves & Controls closes. Maybe a little more guidance on how you're thinking about bolt-on, just any kind of size range or just a little bit of sense for investors of what we might expect early next year?

Well, we're going to be disciplined. I mean, we're getting out from under the overhang of a lot of the debt and we take our lessons from that, okay. But the place that we have the most opportunity. We are one of the leading players in water. We expanded that with the Tyco merger into the broader flow space, and I think we want to get narrowly focused again in what I'll call the water side of the flow space. So that's why I mentioned Water Quality. There are some that are sort of in between Water Quality and FFS, which is really, I mean, both of them together are our water business. And so, we want to continue to build that leading position and, so around water quality and availability. We like the food and beverage business, although we want to be careful about the heavy capital side of that versus things with annuity, which is why we like the membrane, the beer filtration, and also biogas, which is I think a nice growth business. So, it will be in areas that expand our reach and deepen our expertise in water – way to think about it.

Okay. Great. Thanks a lot.

Hey. Morning, guys.

Morning, Mike.

So, first on 2017 thought process, obviously, no meaningful improvement embedded in those numbers. Yet I got the sense from some of your commentary more specifically on the divisions that there was some expectation that fourth quarter doesn't represent the right run rate. So, maybe help kind of reconcile those two right there and then what areas should start getting maybe a slightly better in the next year and which ones you're more worried about?

Let me start with Technical Solutions. We mentioned thermal. As the thermal business saw the decline in the energy business, we got aggressive in going after projects to replace the product. Those have proven to be more challenging from a profitability standpoint and those are coming to an end. And so, we'll immediately mix up, if you will, on the profit side. On the growth side, we expect more normalized. We're assuming in the fourth quarter this muted impact on the usual bump in sales we would see in industrial. We don't think – we're hopeful that after the fourth quarter, we'll return to a more normal level, which won't be the negative impact we see in the industrial market for the fourth quarter. John, if you want to add anything?

No. I agree with that.

So, you're basically saying beyond that, though, it's a pretty steady run rate from the fourth quarter other than the maintenance side reverting back to normal?

Yeah. If you take a look at the full year, core growth was down 1% for full year, that had a lot of choppiness in it. We started the year with almost double-digit declines in industrial. We've worked a way back to flattish numbers as we close out the year. So sequentially things have stabilized. What we're really saying is these larger projects that were out there for the Q4 cycle are going to be pushed or deferred into next year or may be deferred permanently. And we don't see any environment that's reflected in Q4 in the pause and concern of our overall customer base being the same cause of concern that we see as we enter 2017. Now, we said negative 2% to plus 2% next year, so that's clearly not robust growth, but it's flattish and then we have the operating income cost structure changes that we're driving as an organization to drive margin improvement.

And I would add, and that's the framework. We're planning on a minus 2% to plus 2% top line, which means to drive the performance that we know we can drive, we need to focus on simplifying. We're already working on simplifying the cost structure with the removal of Valves & Controls. We're going to do more than that, as a result of that outlook. If we get more upside, we will be in a position to serve on the volume side.

Just follow on to Randy's point, real quickly. I mean, we had a focus to integrate and standardize a lot of the Valves & Controls activities, because that's where the biggest opportunities were for improvements. And so we repositioned a lot of our cost structure savings towards Valves & Controls. Now we're going to bring back the focus to reintegrating ourselves, if you will, to our Pentair standards on the rest of the portfolio, and we believe we can accelerate a lot of those cost-out actions in simplifying the company as Randy mentioned.

Thank you, guys. Appreciate it.

Hi, guys. Good morning.

Good morning.

Hey, how do you get so – you got the 5% operating profit increase, I guess 15% EPS growth. Just remind us kind of how you bridge that, I'm not sure if you mentioned early in the call and if you did then I guess I'll take it offline, but just a little more of a precise bridge on how you get there?

Yeah, we didn't, Steve, I mean, but I think the element we're now working to right now is we believe there is opportunity in the debt structure of the company. And we do think for relatively inexpensive investment, we can get a fair amount of interest out by putting our capital position or our debt position more in line with where we want it to be on a permanent basis. And there would clearly be significant interest savings associated with that, Steve.

Okay. So that's a refi or that's, I mean, because your interest rate, I think your average interest rate is pretty low already, right, or is there...

Right. We're carrying gross debt fairly high without taking out fixed debt structure and we think there's an opportunity to take out some of the fixed debt structure in a productive way and therefore it's incrementally better than what we had mentioned before. And we think we then have a capital and a debt structure that mirrors where we think we can be longer term as a growth-oriented company.

I got it. So it's a kind of combination of use of the proceeds effectively and then a little bit of a different structure in the underlying.

Correct.

In what's leftover.

Correct, but no buybacks or.

The 15% plus, think about it as one half on the capital side focused on debt, and one half on the performance side.

Okay. And then in Technical, what's going on in the core enclosures business? And is that decline in the fourth quarter, is that all thermal related? Is that just a tough comp on thermal because it doesn't seem like the enclosures business would have that kind of drop-off from flat given the short cycle nature?

The profit impact is almost 80% thermal and usually in the enclosures business, that's the place where we would see a fourth quarter uptick, and we're assuming we won't.

Okay. So that's within enclosures, though, like the kind of short cycle CapEx, the box business, is that stable down in that negative 10%? What is that kind of trending?

Bumping along the bottom...

It's stable, Steve, from Q3 sequential. The overall...

Okay. So, but down year-over-year, because you may have had a good fourth quarter last year, or something like that?

Slightly down year-over-year, but not 1% to 2% down.

Hey, guys. Good morning.

Good morning.

So the talk about the large beverage projects being pushed out. Is that beer and is that related to M&A or just maybe a little more color on what's happening there?

It's basically the valving in all beverage, it's dairy, it's beer, but the biggest ones for us in beer.

Yes, and there is a capital pause happening, as you mentioned, that's driving some of that delay.

Related to M&A activity, I know you've talked about that before.

Yes.

And so when you talk about the beverage projects, should we think about that bucket of revenue as about $350 million of sales that's kind of...

No.

$250-ish million.

$250 million. Got you. Okay. And maybe just to put a finer point on some of the earlier questions about the framework for next year. I mean what should we plug into our models for 2017 for interest expense and corporate?

Not there yet. We have to get through and figure out where we end, and then we'll give guidance at the appropriate time. We just wanted to provide the framework so that people can understand how we're thinking about it.

I mean the corporate sounded like maybe it would go back to the 90 (48:47) that it was the pre the V&C sale or maybe even a little lower. Is that kind of ballpark?

I think that would be the low end of the range.

Got you. And then maybe just finally in Tech Solutions, you talked about some of the productivity issues with the big projects. I mean in the quarter and maybe year-to-date how much of a drag on the margin has the thermal project productivity issue been?

300 basis points.

Okay. So when we're looking year-over-year, that's like a 3 point headwind that's just going away?

That's correct.

Thank you.

Thank you very much. I'm sure it will be on replay. Thank you. Bye.