PENTAIR Ltd. — Q3 2012 Form 10-Q
Reporting period: Three and nine months ended September 29, 2012. Amounts below are in U.S. dollars; financial statement amounts are converted to millions unless otherwise noted.
Business context and reporting period
Pentair’s current structure began on September 28, 2012, when Tyco spun off Flow Control and it merged with Pentair, Inc. The transaction was accounted for as a reverse acquisition, with Pentair, Inc. treated as the accounting acquirer. Accordingly, the reported income and cash flow statements primarily reflect Pentair, Inc.’s historical results; Flow Control’s results for September 28–29 were immaterial. The reported quarter is therefore not a full-period combined-company comparison.
The combined company has Water & Fluid Solutions, Valves & Controls, and Technical Solutions segments. Before the merger, the segment results shown were for Water & Fluid Solutions and Technical Solutions; Valves & Controls was not included in reported operating results.
Key financial metrics
| Metric | Q3 2012 | Q3 2011 | Nine months 2012 | Nine months 2011 |
|---|---|---|---|---|
| Net sales | $865.5 | $890.5 | $2,665.2 | $2,591.0 |
| Gross profit / margin | $278.1 / 32.1% | $272.1 / 30.6% | $870.9 / 32.7% | $808.9 / 31.2% |
| Operating income | $53.7 | $92.9 | $256.4 | $288.5 |
| Net income attributable to Pentair | $30.4 | $51.1 | $163.1 | $168.3 |
| Diluted EPS | $0.30 | $0.51 | $1.60 | $1.69 |
| Net cash from operating activities | Not provided for quarter | Not provided for quarter | $247.4 | $240.6 |
| Free cash flow | Not provided for quarter | Not provided for quarter | $202.5 | $187.6 |
Q3 sales declined 2.8%; nine-month sales increased 2.9%. Nine-month diluted EPS decreased 5.3%. The effective tax rate was 11.3% for Q3 and 20.1% for the first nine months, versus 31.6% and 30.7%, respectively, in the prior-year periods. The company attributed the nine-month rate decline mainly to favorable U.S. tax-audit resolutions and the mix of global earnings.
At September 29, cash was $642.6, total debt was $1,996.8 (including $501.4 of current maturities), and shareholders’ equity was $6,966.2. Current assets were $3,740.4 and current liabilities $2,131.9. The balance sheet includes Flow Control acquired assets and liabilities, including substantial acquired cash, goodwill and intangibles; comparisons with pre-merger dates are not like-for-like.
Material changes and management commentary
- Q3 gross margin rose 1.5 percentage points, while operating income fell to $53.7 from $92.9. SG&A rose to $204.7, or 23.6% of sales versus 17.9%, substantially reflecting merger-related costs, integration, restructuring and higher labor costs.
- Q3 sales weakness reflected lower Technical Solutions volume in Western Europe and communications, and unfavorable foreign exchange. Nine-month growth was supported by the CPT acquisition, pool and filtration products, and selective price increases; currency and Technical Solutions weakness offset part of the growth.
- Both legacy segments reported higher operating income and margins: Water & Fluid Solutions operating margin was 11.4% versus 9.7% in Q3 and 12.0% versus 11.4% year to date; Technical Solutions was 20.1% versus 17.6% and 19.2% versus 17.5%. Management cited operational savings and pricing, partly offset by inflation and restructuring.
- Nine-month operating cash flow was $247.4 and capital expenditures $49.9. Management’s 2012 outlook was free cash flow exceeding 100% of net income before noncontrolling interest; its longer-term goal is the same conversion level. No specific revenue or earnings guidance is stated in the supplied filing text.
- The company reported $1,392 of availability under its new $1,450 revolving credit facility and compliance with debt covenants at quarter-end. Covenants include a maximum leverage ratio of 3.50:1 and minimum interest coverage of 3.00:1. Management said it intended to maintain investment-grade ratings and adequate liquidity.
Guidance, unusual items, risks and contingencies
- The merger purchase price was $4.9 billion. The purchase-price allocation was preliminary, including approximately $2.5 billion of acquired goodwill, and was expected to be completed in Q2 2013; final valuation could materially change allocated asset and liability values.
- Merger-related costs materially affected reported expenses, including Q3 transaction advisory fees of $16.5 and change-of-control costs of $21.2. Nine-month amounts included $23.2 of transaction advisory fees, $21.8 of change-of-control costs and $26.2 of other transaction costs. The filing also reports $13.5 of merger-triggered stock-compensation expense for the first nine months.
- After quarter-end, the company redeemed $500 of fixed- and floating-rate notes. The redemption included $65.8 of make-whole premiums, plus $0.5 of deferred financing and other costs; approximately $3.6 of swap losses were expected to be reclassified to earnings. It also repurchased about 2.4 million shares for approximately $105 and acquired the remaining 25% interest in KEF for $100.
- Management cited global economic uncertainty, Western European weakness, subdued housing and pool markets, raw-material and labor inflation, foreign-exchange movements, project delays and the risk of failing to realize merger synergies. Integration remained ongoing; the 2012 annual internal-control report was expected to exclude Flow Control from the internal-control assessment because of the limited post-acquisition evaluation period.
- Tax-sharing arrangements with Tyco and ADT may expose Pentair to shared pre-distribution tax liabilities. Open IRS matters involving Tyco’s 1997–2004 tax years could result in uncertain liabilities. The company also disclosed risks if the distribution or merger were determined taxable, including potential indemnification obligations.
- At quarter-end, asbestos liabilities were estimated at $68.2 with $50.3 of estimated insurance recoveries; approximately 1,900 lawsuits and 2,400 claims were reported. Environmental reserves were $14.1. The filing cautions that actual liabilities and recoveries may differ materially from estimates.
- Tyco’s September 2012 SEC settlement and DOJ non-prosecution agreement addressed alleged improper payments involving Flow Control and other Tyco businesses. Flow Control was subject to annual DOJ compliance reporting for three years.
Important facts for investors to verify
- How the final purchase-price allocation, including goodwill and acquired intangibles, compares with the preliminary $4.9 billion allocation.
- Combined-company results after Flow Control is included for full reporting periods, and progress in realizing integration benefits and synergies.
- The effect of the October debt redemption, make-whole charge, share repurchases and KEF acquisition on subsequent debt, interest expense and liquidity.
- Developments in shared tax liabilities, the tax status of the distribution and merger, and the related Tyco IRS disputes.
- Changes in asbestos claims, insurance recoveries, environmental obligations and DOJ compliance requirements.