Pentair (PNR, Financial) is a lesser known dividend aristocrat that most recently boosted its dividend by 5%, representing its 40th consecutive year of dividend increases.
Weak energy markets, slumping commodity prices and unfavorable foreign currency exchange rates are wreaking havoc on the company, which has seen its stock price plummet by more than 30% over the last year.
However, two of the company’s four segments delivered organic growth last year, and a third is poised to return to growth in 2016. Three of its businesses have also delivered healthy margin expansions, and a well-known activist investor took a 7% stake in the company in mid-2015 (the stock has since sold off by nearly 40%).
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Business overview
Pentair was formed in 1966 and is a diversified industrial manufacturing company that sells a wide range of products including valves, water system products, actuators, switches, pumps, filters, enclosures, heat management systems and more.
By end market, Pentair generated 33% of its 2015 sales in residential and commercial construction, 25% in industrial, 23% in energy, 10% in food & beverage and 9% in infrastructure markets.
By geography, Pentair generated 49% of its 2015 sales in the U.S., 18% in Western Europe, 14% in China/Southeast Asia/India/Middle East, 13% in the Rest of the World and 6% in Canada.
Segments
Technical Solutions (33% of sales, 22% segment margin): Sells products that guard and protect some of the world’s most sensitive electronics and electronic equipment as well as heat management solutions designed to provide thermal protection to temperature sensitive fluid applications.
Valves & Controls (27% of sales, 13% segment margin): Sells valves, fittings, automation and controls and actuators. Pentair acquired most of this segment from Tyco International’s (TYC, Financial) spinoff of its flow control business in 2012. Nearly 60% of this segment is exposed to energy markets, with the remaining 40% selling into industrial markets. Half of the business is aftermarket products and services.
Flow & Filtration Solutions (20% of sales, 13% segment margin): Sells solutions for filtration, separation, flow and fluid management challenges in agriculture, food and beverage processing, water supply and a variety of industrial applications.
Water Quality Systems (20% of sales, 20% segment margin): Sells water system products and solutions to meet filtration and fluid management challenges in food and beverage, water, swimming pools and aquaculture applications.
Business analysis
While Pentair has a number of technologically advanced products, R&D is not a major competitive advantage (the company spends 1.5% to 2.0% of its sales on R&D, which amounted to $117 million in 2014).
Instead, the company’s advantages primarily come from its long-standing customer relationships (Pentair has 50 years of operating history), focus on profitable niches, reputation for quality, wide assortment of products, technical know-how and sizable distribution network.
Pentair also has a large global installed base, which provides meaningful aftermarket revenue. This business generates less volatile cash flow that can be used for acquisitions. Pentair’s markets are highly fragmented so it has plenty of opportunity to continue consolidating the industry.
Like many other industrial companies, Pentair also has its own management system grounded in lean methodologies. Pentair began its initial lean deployments in 2005 and believes lean operations are now part of its DNA, driving productivity throughout the enterprise.
The company expects to significantly rationalize its footprint over the next five years by reducing its number of factories and distribution centers by at least 30%. When global growth is slow, these are the levers that industrial companies have to pull to protect their earnings and position themselves for the next upturn.
Management is doing everything it can to pull costs out of Pentair’s Valves & Controls business, which is experiencing mid-teens sales declines. There is not much more Pentair can do, but management has shown a willingness to shed nonstrategic, lousy businesses in the past if it cannot generate a good return.
Pentair’s key risks
Pentair’s diversification by product, end market and geography help protect the company from being decimated by any single macro factor, but the business will always be sensitive to broader trends in global economic growth.
Pentair’s exposure to energy (23% of sales) and industrial (25%) markets is hurting its results today. Oil & gas customers are spending less and pushing back hard on pricing, which is compressing Pentair’s profits. Unfavorable foreign currency exchange rates are also impacting the company’s growth.
The rest of 2016 will be challenging, but some of Pentair’s other markets are performing better (e.g., food and beverage). Over the long run, we expect the macro environment to revert to the mean.
The greater risk to Pentair’s earnings power would be if its products were increasingly commoditized or the company makes a foolish acquisition that endangers the company’s health. These are unlikely events.
Dividend analysis: Pentair
We analyze 25-plus years of dividend data and 10-plus years of fundamental data to understand the safety and growth prospects of a dividend.
Dividend Safety Score
Our Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends and more. Scores of 50 are average, 75 or higher is good, and 25 or lower is considered weak.
Pentair’s Dividend Safety Score is 41, indicating its safety is close to average. The company’s dividend has consumed 50% of its earnings and 39% of its free cash flow over its last four quarters, which is reasonably healthy for a macro-sensitive business. Pentair’s free cash flow payout ratio has also remained mostly stable around 30% during its last 10 fiscal years, giving us further confidence in the business.
Source: Simply Safe Dividends
Pentair’s business is sensitive to the economy. While the company’s sizable aftermarket sales base reduces some of its volatility, Pentair’s revenue still dropped by 20% in 2009, and its stock fell by 31% in 2008. This isn’t the best business to own in the event of a recession.
Source: Simply Safe Dividends
Compared to other high quality industrial companies such as Illinois Tool Works (ITW, Financial) and Parker-Hannifin (PH, Financial), Pentair’s return on invested capital is relatively disappointing. Illinois Tool Works and Parker-Hannifin generate returns on capital that are roughly twice as high as Pentair’s returns, indicating that they are in more profitable niches and have been superior allocators of capital.
Trian, the activist investor involved with Pentair, probably believes Pentair is underearning and can improve its returns with the right acquisitions and productivity initiatives.
Source: Simply Safe Dividends
While Pentair’s returns on capital are more mediocre than we like to see, its cash flow generation has been excellent. As seen below, Pentair has delivered free cash flow in nine of the last 10 years and has more than doubled its annual free cash flow generation over the last decade. Consistently generating free cash flow gives PNR flexibility to pursue acquisitions and sustainably grow its dividend.
Source: Simply Safe Dividends
Pentair’s balance sheet is the biggest factor weighing on the company’s Dividend Safety Score. As seen below, Pentair has just $126 million of cash on hand compared to $4.7 billion in debt. Its dividend payments last year also exceed the company’s current cash balance, putting pressure on the company to generate enough cash flow to keep funding its dividend and operations. If it weren’t for Pentair’s consistent free cash flow generation and large aftermarket business, this would be a bigger issue.
Source: Simply Safe Dividends
Dividend Growth Score
Our Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is good, and 25 or lower is considered weak.
Pentair plans to raise its dividend by 5% in 2016, marking its 40th consecutive dividend increase. The company is a dividend aristocrat and will also join the dividend kings list in 10 years. Pentair’s Dividend Growth Score is 68, which indicates that the company has above-average long-term dividend growth potential.
While macro headwinds will restrict near-term earnings and dividend growth, we can see that Pentair’s dividend growth rate otherwise accelerated over the last decade. Assuming macro conditions eventually normalize and Pentair returns to a 9% to 11% earnings growth rate, we expect the company’s dividend to resume growth at a high-single digit rate.
Source: Simply Safe Dividends
Valuation
Pentair trades at 11x forward earnings and has a dividend yield of 3.1%, which is significantly higher than its five-year average yield of 1.9%.
Management also believes Pentair can deliver 2% to 4% organic sales growth and 9% to 11% annual earnings per share growth over the long term, which would imply 12% to 14% annual total return potential even if Pentair’s earnings multiple remains depressed. The market must think that Pentair’s business trends are going to get worse before they get better.
The stock is starting to look attractively priced for investors with a time horizon of at least five years. However, the company’s balance sheet and high exposure to energy markets are two factors that could inflict even more damage to the stock over the next six to 12 months. We would prefer to stick with some other blue chip dividend stocks that are also going on sale in today’s market.
Conclusion
With major energy companies calling for even deeper spending cuts by the day, it’s hard to get too excited about Pentair at the moment. There is very little the company can do to combat the slump in commodity prices and the slow growth rates of economies around the world.
While these headwinds will ultimately prove to be transitory, they could persist longer than investors expect. The company’s levered balance sheet adds further risk to an investment in Pentair today. We will remain on the sidelines for now.
Disclosure: The author is long Parker-Hannifin but has no position in Pentair or Illinois Tool Works.
