Pentair plc — Q3 2016 Form 10-Q
Business context and reporting period. This unaudited filing covers the three and nine months ended September 30, 2016; comparisons are to the three and nine months ended September 26, 2015. Pentair began reporting calendar quarters in 2016, so period lengths differ from the prior-year 13-week reporting periods. The company reports Water Quality Systems, Flow & Filtration Solutions, and Technical Solutions. Valves & Controls is presented as discontinued operations and held for sale.
Financial performance
| Metric | Q3 2016 | Q3 2015 | Nine months 2016 | Nine months 2015 |
|---|---|---|---|---|
| Net sales from continuing operations | $1,210.7m | $1,112.8m | $3,701.9m | $3,327.4m |
| Operating income | $182.8m | $152.9m | $538.9m | $444.4m |
| Operating margin | 15.1% | 13.7% | 14.6% | 13.4% |
| Continuing-operations net income | $117.5m | $94.7m | $342.0m | $293.1m |
| Total net income, including discontinued operations | $141.0m | $115.2m | $391.2m | $376.9m |
| Diluted EPS, continuing operations | $0.64 | $0.52 | $1.87 | $1.61 |
| Diluted EPS, total | $0.77 | $0.63 | $2.14 | $2.06 |
Gross margin improved to 36.4% from 35.5% in Q3 and to 36.6% from 35.1% year to date. Net interest expense increased to $34.3m from $30.9m in Q3 and to $105.9m from $67.5m year to date. The nine-month effective tax rate was 21.5%, versus 22.5%.
Reported sales rose 8.8% in Q3 and 11.3% year to date, largely reflecting ERICO acquisition sales of $134.2m and $396.2m, respectively. Core sales declined 1.7% in Q3 and increased 1.0% year to date. Segment results were mixed: Water Quality Systems sales rose 2.0% in Q3 and segment margin increased 2.4 percentage points to 21.2%; Flow & Filtration Solutions sales fell 5.5% and segment income fell 7.0%; Technical Solutions sales rose 25.6%, substantially from ERICO, while segment margin declined 1.4 points to 22.0%.
Cash flow, debt and liquidity
- Nine-month cash from continuing operations was $459.7m, up from $354.5m. Continuing-operations free cash flow, as defined by Pentair, was $389.3m versus $291.8m; total free cash flow including discontinued operations was $474.2m versus $320.1m.
- Capital expenditures were $94.5m for continuing operations. Management expected fiscal 2016 capital expenditures of approximately $130m.
- Cash was $170.9m at September 30, 2016. Reported debt was $4,411.3m, down from $4,685.8m at year-end 2015. Commercial paper outstanding was $454.3m.
- Revolver availability was $1,430.2m, but covenant limits reduced usable availability to $733.6m. Pentair reported compliance with its debt covenants. The most restrictive leverage covenant was set to tighten over time, reaching 3.50:1 for periods ending after June 2017; minimum interest coverage was 3.00:1.
- Nine-month dividends paid were $181.6m, or $1.00 per share. The board declared a $0.34 quarterly dividend payable in November 2016.
Material changes, outlook and risks
- Planned divestiture: Pentair agreed to sell Valves & Controls to Emerson for $3.15bn in cash, subject to customary adjustments, regulatory approvals and closing conditions. Closing was expected in late 2016 or early 2017. The business generated $410.9m of Q3 sales and $22.9m of Q3 after-tax income; its assets and liabilities are classified as held for sale. Management cited debt reduction as an objective for sale proceeds.
- Operating environment: Management expected industrial and energy weakness, deferred capital spending, depressed oil prices, and strong-dollar effects to persist through 2016. Developing-market slowdowns and raw-material and labor inflation were additional headwinds. Management said restructuring, lean and supply-management initiatives and selective price increases were intended to support margins.
- Restructuring and acquisition: The company reduced approximately 475 positions during the first nine months of 2016 and recorded $19.9m of restructuring costs. ERICO, acquired in 2015, materially increased Technical Solutions revenue and also raised intangible amortization and interest costs.
- Contingencies: Approximately 4,000 asbestos claims were outstanding, including about 3,500 associated with the held-for-sale Valves & Controls business. Recorded asbestos liabilities were $231.2m and related insurance receivables were $109.3m. Pentair cautioned actual outcomes could differ materially from estimates. Environmental reserves were $18.0m; management did not expect them to have a material adverse effect.
- Other disclosures: Pentair identified foreign exchange, commodity prices, market demand, project orders, restructuring execution, the divestiture closing, litigation and regulatory matters among forward-looking risks. No specific earnings or revenue guidance was provided. Management said disclosure controls were effective and reported no material change in internal control over financial reporting.
Important facts for investors to verify
- Whether the Valves & Controls sale closes on expected terms and timing, and how proceeds are applied to debt and leverage.
- How much reported growth reflects ERICO versus underlying demand, particularly given negative Q3 core growth and weakness in Flow & Filtration Solutions.
- Whether cash generation and covenant headroom remain adequate as leverage limits tighten and debt maturities approach.
- Whether restructuring and productivity savings offset inflation, lower volumes and continued industrial and energy-market weakness.
- Potential changes in asbestos claims, insurance recoveries and other liabilities associated with the divestiture.