Pentair plc — Q2 2016 Form 10-Q
Business context and period: Pentair is a diversified industrial manufacturer operating through Water Quality Systems, Flow & Filtration Solutions, Technical Solutions and Valves & Controls. This report covers the quarter and six months ended June 30, 2016. Pentair moved to calendar-quarter reporting in 2016; the comparative 2015 periods ended June 27 under its former 13-week reporting calendar. Amounts below are in millions of dollars except per-share data.
Financial performance
| Metric | Q2 2016 | Q2 2015 | Six months 2016 | Six months 2015 |
|---|---|---|---|---|
| Net sales | $1,733.3 | $1,661.2 | $3,308.8 | $3,136.2 |
| Gross profit / margin | $599.2 / 34.6% | $566.2 / 34.1% | $1,134.6 / 34.3% | $1,076.4 / 34.3% |
| Operating income / margin | $216.9 / 12.5% | $217.9 / 13.1% | $387.5 / 11.7% | $389.1 / 12.4% |
| Net income | $142.8 | $147.8 | $250.2 | $261.7 |
| Diluted EPS | $0.78 | $0.81 | $1.37 | $1.43 |
| Net interest expense | $35.5 | $18.6 | $71.9 | $36.8 |
First-half cash from continuing operations was $369.5, compared with $195.1 a year earlier; free cash flow, as defined by the company, was $304.4 versus $151.4. Capital expenditures were $74.6. Cash and equivalents were $173.3 at June 30. Long-term debt was $4,551.7, down from $4,685.8 at December 31, 2015; there were no current maturities or short-term borrowings reported on the balance sheet. The company reported $1,278.8 of unused credit-facility availability, limited to $630.1 by the leverage covenant, and stated it was in compliance with its financial covenants.
The first-half effective tax rate was 21.2%, versus 23.0%. Dividends paid were $119.7, or $0.66 per share, in the first half. The board had set a 2016 annual dividend plan of $1.34 per share.
Material changes and segment trends
- Consolidated sales rose 4.3% in Q2 and 5.5% in the first half, but core sales declined 3.1% and 1.1%, respectively. ERICO, acquired in September 2015, contributed $141.9 of Q2 sales and $262.0 for the first half. Currency reduced reported sales growth.
- Q2 gross margin improved 0.5 percentage points, attributed to productivity and selective price increases; operating margin fell 0.6 points as SG&A and R&D rose faster than sales. Net interest expense nearly doubled, reflecting debt issued to fund ERICO and higher rates.
- Technical Solutions sales increased 32.8% in Q2, substantially reflecting ERICO; segment income rose 29.2%, while segment margin declined 0.6 points. Water Quality Systems sales increased 2.4% and segment margin improved 1.9 points.
- Flow & Filtration Solutions sales declined 1.6% in Q2, with segment margin down 0.2 points. Valves & Controls sales declined 12.7% and segment income fell 32.1%; its segment margin contracted 2.9 points amid weak energy, oil-and-gas and industrial demand.
- Segment income is a company-defined measure that excludes intangible amortization, restructuring and certain other items; it is not the same as GAAP operating income.
Outlook, commentary and risks
- No full-year earnings or revenue guidance is stated in the supplied filing text. Pentair estimated 2016 capital expenditures of approximately $150 and said it expected restructuring actions to continue through 2016 and contribute to margin growth.
- Management expected the strong U.S. dollar, weak energy and industrial markets, depressed oil prices and volatility in end-market demand to remain headwinds. It cited productivity, lean and supply-management initiatives, selective pricing and growth investments as responses.
- First-half restructuring costs were $27.5, and approximately 600 employees were reduced during the period. The restructuring accrual ended June at $78.6. Higher amortization following ERICO also weighed on reported results.
- The ERICO purchase-price allocation remained preliminary and was expected to be completed in Q3 2016; final adjustments, primarily tax-related, could be material. The acquisition was funded with debt, increasing interest expense and leverage pressure.
- Asbestos claims remained a material uncertainty: approximately 4,000 claims were outstanding, with a recorded liability of $233.0 and insurance receivable of $109.0. The company cautioned actual liabilities or recoveries could differ materially. Environmental reserves were $19.0; management did not expect those conditions to materially affect financial position, results or cash flows.
- Other stated risks include currency and commodity volatility, customer capital-spending weakness, competition and pricing pressure, execution of restructuring and ERICO integration, litigation, and the ability to generate cash and reduce leverage. Management reported effective disclosure controls; ERICO controls were still being integrated.
Investor verification priorities
- Separate ERICO’s contribution and currency effects from underlying sales and earnings trends, especially in Technical Solutions.
- Track Valves & Controls demand, segment margins and the duration of energy and industrial market weakness.
- Monitor debt reduction, interest expense, covenant headroom and the facility’s leverage-limited availability.
- Verify realization of restructuring savings against costs, and assess whether margin improvement offsets inflation and weak volumes.
- Review final ERICO purchase accounting, including goodwill and intangible-asset assumptions, when completed.
- Assess developments in asbestos claims, insurance recoverability and environmental obligations against recorded reserves.