There is an old wedding rhyme that begins with the line “something old, something new”. It brings to mind a dividend champion that is today’s spotlight subject. Pentair plc (PNR) is an industrial stock that has raised its dividend payout to shareholders for each of the past 43 years. Despite such a long track record of success (unsuccessful companies cannot raise a cash expenditure for four decades), Pentair is a completely new entity following its massive spinoff of its electrical businesses. The company that presently trades under the ticker “PNR” is actually a water solutions company today. While the spinoff gave shareholders stock in newly formed nVent Electric plc (NVT), investors new to Pentair should note that we have concerns about Pentair as it now exists. We review those below and determine whether Pentair is set up for success in the years ahead.
Pentair is now a company that designs and builds water technology products and systems for the global market. Essentially, the water-related segments of Pentair of old – now stand alone as a business. The company operates in three segments. These include Aquatic Systems, Filtration Solutions, and Flow Technologies. The segments are split quite evenly in regards to size of revenues. The company generates almost $3 billion in annual revenues.
Source: Pentair 2018 10-K
Because of the spinoff taking place just about a year ago, it’s difficult to glean much from a long-term chart of revenues and earnings. What it does illustrate is just how much smaller Pentair has become following the spinoff. Revenues are a fraction of what they were a few years ago. A smaller company can sometimes grow more easily (the math is in your favor) and “turn more quickly”. It will be interesting to monitor Pentair’s growth in the coming years as the company “finds its legs” as a completely new entity.
To begin to analyze Pentair following its spinoff, we will review a few of its key operating metrics.
We review operating margins to make sure the company is consistently profitable. We also want to invest in companies with strong cash flow streams, so we look at the conversion rate of revenue to free cash flow. Lastly, we want to see that management is effectively deploying Pentair’s financial resources, so we review the cash rate of return on invested capital (CROCI). We will do all of these using three benchmarks:
- Operating Margin – Consistent/expanding margins over time
- FCF Conversion – Convert at least 10% of sales into FCF
- CROCI – Generate at least 11-12% rate of return on invested capital
The spinoff is still fresh, but not much has changed in the first year following the shuffle. The company’s operating margins have remained consistent, and the FCF conversion rate remains in double digits. We would have liked to have seen the “new” Pentair received an operational metric boost from the spinoff, but again – it’s still early. The company’s CROCI has declined some over the past year, although it was never great in the first place. We would like to see a CROCI at double what it has been.
Before moving on, we look at the company’s balance sheet. This can give us some valuable information about Pentair’s new structure. Pentair did benefit some from the spinoff of nVent Electric. Total debt has dropped to $1.37 billion, which puts leverage at 2.75X EBITDA. This isn’t ideal, and it exceeds our “warning sign” threshold of 2.5X EBITDA. The leverage ratio isn’t at a critical point at this time, our threshold benchmark is more meant to make investors aware of a potentially worsening issue, so being slightly over isn’t the end of the world.
What is interesting is that nVent ended up with a lower leverage ratio following the spinoff than Pentair. Considering how Pentair is spending on dividends and buybacks (more on this in a minute), we are a little concerned about the balance sheet getting tight if these actions continue.
Pentair is a long-time dividend champion with a long dividend growth streak of 43 years. The dividend is paid every quarter and totals an annual sum to investors of $0.72 per share. The resulting dividend yield of 1.96% is slightly below what 10-year US treasuries are currently offering, making Pentair a less than ideal instrument of income generation.
Like much of Pentair, we need to see what long-term trends look like following the spinoff. Prior to last year, the dividend had a solid growth track record. Growth hovered in the 7-12% range over the past decade. The first dividend increase following the spinoff was just 2.9%. There is room in the financials for more growth, as the dividend consumes just 52% of free cash flow. Management has spent on buybacks, which likely explains the small raise.
The buybacks and dividend payout over the past year have exceeded free cash flow totals. We expect management to prioritize either one or the other. There is not enough cash to pursue both buybacks and strong dividend growth without further pressuring the balance sheet.
Growth Opportunities & Risks
Pentair’s water businesses have some interesting opportunities for growth in the coming years but also come with risk because of the allocation of revenues. When we dive into the make-up of Pentair’s business, we see that the company has heavy exposure to filtration and pump applications.
Source: Pentair 2018 10-K
This should be an opportunity for growth in the coming years for two reasons. First, the company has solid exposure to emerging markets where basic needs infrastructure is modernizing in societies where running water is being developed. However, the same types of needs are present right here in the US because the existing infrastructure of water and waste water treatment is so poor. The American Society of Civil Engineers recently graded out the US wastewater infrastructure as a D+ and drinking water as a D. As investments into these systems and facilities take place over time, the need for pumps, filtration, etc. should all provide opportunity for Pentair.
The major risk we see in Pentair’s business model is actually in the Aquatic Systems segment. The name of the segment sounds fancy, but in reality, the vast majority of sales are for residential pool equipment within the US market. Pools, specifically in-ground pools, are extremely cost intensive (my neighbor was quoted $50K to have one put in recently), an enormous expense for your average homeowner. Because pools are such a large consumer purchase, demand plummets in a recessionary environment. Fellow Seeking Alpha contributor Ian Bezek outlined this point in further detail here. Because these pool systems are such a large contributor to Pentair’s revenue, we worry that any growth seen in the other segments of Pentair can be negated by a disruption in the Aquatic Systems segment.
Shares of Pentair are trading at just under $37 per share, just a few dollars off of its 52-week low.
Analysts are currently estimating full year earnings per share to come in at around $2.34. This places shares at an earnings multiple of 15.81X. This is roughly in line with the stock’s 10-year median PE ratio of 16.02X. It’s important to remember that the past decade of data was based off of the pre-spinoff Pentair. Prior to the spinoff, Pentair grew revenues at a low single-digit rate, and earnings at a mid single-digit rate.
If you give Pentair a pass for its most recent quarter (core sales were down 4% Y/Y), analysts’ consensus is expecting the company to grow earnings at a mid single-digit rate (approximately 6% per annum) over the upcoming five-year time period. Because this is similar to the company’s historical growth rate, we don’t feel that an adjustment is needed to historical valuation norms.
From an FCF perspective, the company’s free cash flow yield has dropped to near a decade low following the spinoff.
We find shares to be somewhere near “fair value” at best. While the PE ratio is in line, the company’s FCF yield being so low is a disappointment. The company’s story post spinoff is still being written, and for that reason alone, we would want a margin of safety. We would want at least a 15% drop in shares before revisiting Pentair. This would place shares at a discount to historical PE ratios and result in a share price of $31 per share.
At the end of the day, it’s not clear that Pentair is a better business following its spinoff of the electrical portions of the company. The company has solid performance metrics, but Pentair currently has growth questions and a balance sheet with enough debt to make you pause. While shares aren’t terribly expensive, we don’t view Pentair as a stock you really need to own unless it comes at a strong discount.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.