Pentair plc — Q2 2014 Form 10-Q
Business context and period. Unaudited results cover the 13 weeks and six months ended June 28, 2014, compared with periods ended June 29, 2013. Pentair is a diversified industrial manufacturer with four reporting segments: Valves & Controls, Process Technologies, Flow Technologies, and Technical Solutions. On June 3, 2014, the company completed its redomicile from Switzerland to Ireland; it states that it is centrally managed and tax-resident in the U.K.
Financial performance
- Q2 revenue and earnings: Net sales were $1.911 billion, down 2.7%. Operating income was $227.7 million, up 0.8%, with operating margin of 11.9% versus 11.5%. Net income attributable to Pentair was $161.5 million versus $154.1 million; diluted EPS was $0.82 versus $0.75.
- First-half results: Net sales were $3.636 billion, down 2.7%. Operating income rose to $407.6 million from $300.2 million, and operating margin expanded to 11.2% from 8.0%. Net income attributable to Pentair was $280.1 million versus $205.8 million; diluted EPS was $1.41 versus $0.99. The comparison includes a 2013 gain on sale of a business and merger purchase-accounting costs that did not recur in 2014.
- Margins and expenses: Gross margin was 34.5% in Q2 versus 34.0%, and 34.0% for the first half versus 31.9%. First-half SG&A was 21.1% of sales versus 22.1%; Q2 SG&A was 20.9% versus 20.8%. First-half restructuring costs were $60.6 million, compared with $48.3 million.
- Segment performance: Q2 sales increased 2.3% at Valves & Controls, 4.0% at Process Technologies, and 2.8% at Technical Solutions; Flow Technologies sales fell 20.9%. Flow Technologies’ decline reflected Australian project revenue in the prior-year period that did not recur, divestitures, and currency effects. Process Technologies benefited from pool products and food-and-beverage demand. First-half operating income improved in each segment except Flow Technologies, whose operating income fell to $62.9 million from $90.7 million.
- Cash flow: First-half operating cash flow was $415.0 million, versus $386.1 million. Capital expenditures were $59.6 million; reported free cash flow, a non-GAAP measure defined as operating cash flow less capital expenditures plus asset-sale proceeds, was $358.1 million versus $301.7 million. Management’s long-term goal is free cash flow at least equal to net income.
- Liquidity and debt: Cash was $174.4 million at June 28, down from $265.1 million at year-end. Total debt was $2.745 billion, including $701.2 million of commercial paper; long-term debt was $2.739 billion. Revolver availability was $722.3 million, and the company reported compliance with debt covenants. Current assets were $3.166 billion and current liabilities were $1.777 billion.
- Capital returns: The company repurchased 5.8 million shares for $450.7 million during the first half and paid $99.1 million in dividends. At quarter-end, $699.3 million remained under the 2013 repurchase authorization. The reported dividend was $0.50 per share for the first half.
Changes, outlook, and notable items
- Management attributed first-half margin improvement primarily to lower merger-related purchase-accounting costs, productivity and supply-management savings, and pricing; inflation in materials and labor partly offset these gains. Sales declines reflected missing Australian project revenue, divestitures, and unfavorable currency, partly offset by organic growth in Process Technologies and Technical Solutions.
- Management expected 2014 free cash flow to exceed 100% of net income and anticipated full-year capital expenditures of approximately $160 million. It cited ongoing integration, growth in selected markets, product development, and operating-excellence initiatives as priorities. It did not provide a specific revenue or EPS forecast in the supplied filing text.
- After quarter-end, on July 28, the board approved exiting the Australian Water Transport business, with disposal expected by early to mid-2015. The company expected to classify approximately $500 million of carrying value, including $248 million of goodwill, as held for sale and as a discontinued operation in Q3 2014. A potential sale loss was under evaluation and could not yet be reasonably estimated.
- Other unusual items included $10.3 million of first-half redomicile costs and an $8.0 million loss on a first-quarter business sale. The company acquired the remaining 19.9% interest in Pentair Residential Filtration for $134.3 million in January.
- Key exposures include asbestos litigation (about 2,200 pending lawsuits and 2,300 outstanding claims; recorded liability $252.6 million and insurance receivable $118.6 million), environmental reserves of $37.0 million, and uncertain tax positions of $60.9 million. The filing also describes potentially significant shared legacy tax liabilities connected with Tyco-related tax disputes; the company’s eventual share is uncertain.
- Principal business risks cited include economic and end-market weakness, competition and pricing pressure, inflation, foreign exchange, project/backlog timing, integration execution, regulatory and litigation exposure, and the ability to realize savings and growth. Management reported effective disclosure controls and no material change in internal control over financial reporting during the quarter.
Most important facts for investors to verify
- Whether operating-margin gains persist after restructuring costs and the favorable comparison from merger purchase-accounting items.
- The duration and financial impact of Flow Technologies’ weakness, especially the Australian Water Transport exit, expected sale proceeds, and any impairment or disposal loss.
- Whether free cash flow meets management’s 2014 expectation, given working-capital needs, capital spending, dividends, and share repurchases.
- Debt levels, commercial-paper refinancing capacity, revolver availability, and ongoing compliance with financial covenants.
- Developments in asbestos claims and insurance recoveries, environmental obligations, and the legacy tax disputes and related sharing agreements.
- The financial and tax consequences of the redomicile, including U.K. tax residency and the ability to pay future dividends or repurchase shares under Irish distributable-reserve requirements.