Pentair plc (PNR) Earnings Call Transcript & Summary

All right. Well, welcome to Pentair. We're very pleased to welcome CEO, John Stauch, and Jerome Pedretti, who is the CEO of the Pool Business. So thank you, guys, very much for joining us. I run a little bit different format here, where I'm going to present 3 bear cases on the stock. John is going to tell me why I'm an idiot. Then I'm going to present 3 bull cases on the stock, and John's going to flip and tell me why I'm a genius.

So starting off with the first one. Everyone who bought a pool or replaced pool equipment during COVID now has a 5- to 7-year period before the next replacement remodel upgrade cycle kicks in. It could be a low growth market over the next several years.

I think you're dumb.

That's a given.

Jerome and I will tag team this one. I think just a couple of things to start with. If you think about the COVID period for pools, we're convinced from work that we did prior to the Analyst Meeting that the point to point of '18 to '23, doesn't show really any outsized growth versus the period before. And I know that there was years in there like '20, 21, '22, but some of that was inventory and some of that was also sell-through. So I'm convinced that the market didn't react any differently than it probably did in other periods. And I also remind you, this 5.4 million in-ground pools, where things don't get replaced at the same time. So if you think of this as a giant pool pad with 4 or 5 key products, unfortunately, for the customer fortunately, for the industry, things do tend to go wrong at different times. So I think there's products, clearly, like if you upgraded lights during this period, they're going to last a longer period of time, maybe if you bought a heater, it's going to be a longer cycle. But I think that's a natural process that we see. Jerome, I don't know if you want to add to it.

What I would add is that also you have something, which are on semi-discretionary like remodeling pool or adding technology to our pool to make that pool easier to maintain kind of effortless pool, which I think on provides some opportunities as well over the coming years, right, so our automation and other products that automation drives.

And Nathan, I would just add to this that when you take a look at the mid- to upper 60,000 pools that we built this year. That's historically very low. So I'd also say that on the flip side of this particular case, we should see an upswing in the pool market in '25 and beyond, as people start to see this new housing correction happen again.

So I think there's also a perception that some of the remodeling got pushed off during COVID because the new pool construction is more profitable for the contractors. So they're focused on that there. And that maybe hasn't come back this year. Is there an expectation from you guys that maybe that starts to kick in, in 2025, 2026 as another leg of growth?

I think that's what I was saying with the semi-discretionary, right? I mean there is something you can push off a little bit, but you can just push trough indefinitely. So at some point in time, I think you need to remodel your pool. You cannot have a pool in your backyard, but you're not using. So you need to -- I think you need to do it, and I think it's coming back 2024 or '25 and '26.

From a pool side, I mean, first of all, the normal purchase server pool is a fairly wealthy individual. The demographic tends to be nice. And I...

That's why I don't have one.

Okay. Well, I think you should have one.

Everybody should have a pool. It's a sense of wellness. Let's all that aside, I really do think that we haven't created the demand in the market through the years where people were just serving the market. And I think now we've got to go increase the automation penetration rate. We've got to convince people again to have a -- an easy-to-use pool, and we've got to get the dealers and sell more again. And I think all of that creates a long-term value opportunity for pool is pretty exciting. If you take the flip side, we're mid-30s margins, despite not having those normalized pool builds, and we're in a down market environment this year. So that would be my bullish case to flip this from bear to bull that I think given the position we are in today and how we're going to weather it, I think that's good years ahead for pool.

So seeing as this is my only topic on the pool business, I was going to ask a question about the automation side. And how Pentair's suite of products play into your ability to capture the automation side, what the penetration is, how you monetize it?

I think on the automation side, you see that about 50% of new pools have automation, but it's about 1/3 of existing pool. So that's why I think you have some really growth opportunities in order to drive automation. What automation does is that it investment makes [indiscernible] the life easier of the pool owner, but also of the channel or the dealer, right? So think about remote monitoring, remote travel shooting. So I think there's -- there's a key, there's a value prop for everyone down channel. What automation does is that opens the door for additional new technology on your pool. So it drives it pores other product that's going to make your life much easier. So think about water quality products, but it's going to make it easier, so we can control faster. So that's why I think automation has got a bright future, and that's really what we need to continue working on.

Can you monetize the automation? Or does the automation allow you to drive more hardware sales? Like if I'm -- if I'm using automation on the 4 products that are -- or 3 products that I have on a pool and then I want to put light in, I go goodbye to lights from Pentair because I -- I'm already automating with your app?

That's the more likely scenario. I think the thing beautiful about the pool equipment industry is our products work with our automation platform. Now it works the same for Hayward's, work with Hayward's and [ FLUI ] just worked with Fluidra just being told to be honest there. So if you get the automation suite, you generally have the pad for a long period of time, where you have a stickiness because those protocols are unique to each company. I'd like to say unlike the HVAC industry, all of our subcomponents within all of our key products are proprietary to ourselves to Pentair, but again, to our competitors as well. Does that make sense? We don't share the same products. So it's hard for the protocols to work uniformly across the industry and the ecosystem. Where the big opportunity is, how do we convince the 50% of new pool builders today that -- or consumers that aren't buying automation to get to an automated platform. And that has to be value proposition there, and we're working hard on that.

Okay. In the interest of time, I'll jump on to the next one. Pentair's stated strategic goal at spin was to be a pure-play residential and commercial water company. The Industrial and Flow Technologies businesses don't fit into that strategy. And are a drag on growth in margins for the portfolio that you go a lower multiple?

Ouch my poor Work Flow segment. First of all, IFT was the old name. We now call it Flow because -- had to change it. $1 billion of pumps, which absolutely fit the core portfolio, okay? We're very proud of the margin expansion that we now have on our pump portfolio, which leaves us $500 million of really filtration. At the core, it was bought to be a desalination and industrial wastewater play. That's the old CPT assets that we purchased. That's the heart and soul of what industrial filtration it is. Those markets weren't as robust 10 years ago, 7 years ago. So we diverted and built a really nice membrane filtration business for beer, which has been a good revenue stream for us. And we also expand into the air. The technology is a common technology that's very usable into residential commercial and will be used in residential commercial. We used in pool pump or pool filtration. And it will also find its way into commercial water filtration. So I think it's a lot more core than people think. And I think over the last year or 2, we've done a really nice job on margins, generate a lot of cash, and I think it's certainly the right to be in the portfolio.

So you mentioned desalination as one of the markets that it plays in, which has, I guess, probably for the last 15 or 20 years, been not very good. But there is a lot of activity in desalination these days and a lot of move as part of the hydrogen economy, right, to use desalinated water as an input for splitting into hydrogen. Are you seeing any improvement in that end market, where -- this could become actually a decent business within that?

We've seen some inquiries. Really, we diverted the business' attention away because I think what's made our profitability to expand as we're more plug-and-play. We're more standard product -- standard modules and all of the attempts to go create a new industry have really been challenged in the early going. I really do believe what we're starting to see is a significant growth rate in industrial wastewater, where companies are recycling their own water and really making a lot of their water usage goals that way. And I think that's a bigger long-term revenue stream than diverting into another area that we don't know a lot about.

Yes. I -- we just interesting when you mentioned desalination. There's absolutely a huge move for industrial companies to recycle reuse water both from an environmental perspective and from a business continuity perspective. So maybe talk a little bit about how that's impacting the business and what opportunities you see there?

Yes. So first of all, we're doing a couple of test runs inside of Pentair facilities to prove out the core technology. And then we're starting to work with some of our key larger customers that are more primarily in the beverage processing area to help us test down how they can build the capabilities around recycling that water within their current plants. They're usually the ones that are most forward thinking because their margins are so thin. And everything that turns into a waste becomes an opportunity to use back through the input streams, so.

I'll go on to the third one.

So stop picking on IFT.

Pentair's businesses have higher exposure to markets that are interest rate sensitive, the longer it takes for the Fed to cut rates, the longer it takes for market recovery.

Yes. I mean, I'll hit this one head on. I don't think this is a wrong statement. I think we've been living in this bearish market scenario for some time. We've expanded our margins year-over-year for 8 straight quarters now despite this environment. I think there's more opportunity for interest rates to start coming down than and probably to expand up. I might regret saying that, but I honestly believe that to be true. And we would love to see a little bit of movement here, which I think would unlock people's desire to stay in their homes or move homes. And generally, we like that. 40% of our exposure is North American residential. So we do want people to begin to live that American dream of moving up and changing their houses and ultimately having more of the water products that we provide value for them, so.

Maybe you could talk a little bit besides pool, obviously, which is the headline one that's interest rate sensitive?

I'd actually say it's not as interest rate sensitive to pool. Because that's a cash buyer in the most of the markets that we serve. That's an individual who demographically is getting ready to retire, who's buying a warm winter state, building a spot for themselves as a pool for the grandchildren. And ultimately, that they're spending the money and they're not going to take it with them. It's more of a cash basis.

And they're -- generally they're wealthier on the non-sell-side research analyst... .

And on the pool side 60% of our business is still brick and fix, right? So -- and I think that, that is not really interest rate sensitive.

So maybe talk about, which -- the businesses that are interest rate sensitive and what you're seeing in terms of challenges and potential opportunities should we say lower rates in those?

So right now, we're on residential pumps, we're struggling. Those are small pumps. They go into wells and you're not seeing rural builds for the large builders that would drive that demand. You're not seeing ag investment at an outsized rate pretty expensive in those areas. I think you're also dealing with the high inflation with the high interest rates. So it's hard for people to make their business model work. We talked about some of the fast-food restaurants now having to had value meals. We think we're better positioned because we're on the cold side, side, which is the high profit margin side. So that's our ICE and our core filtration assets that go to beverage. But ultimately, people's wealth are starting to be affected and interest rates are a big piece of that impact to them, so.

So maybe we could just talk a little bit about the Manitowoc business?

But I don't view this as getting worse. So I just would say we've been living in this. We would love it to change, but we're going to control our destiny with our margin efforts around transformation and then the most recent 80/20 activities that we've taken on.

Well, I was going to ask a question, but you said transformation. So -- we'll go into the first bull case. Transformation benefits and savings are in the early innings of impacting financial performance. Many of the expected benefits over the next few years come from supply chain projects that have already been implemented and executed with the majority of the remaining margin expansion within management's control. The organic EPS CAGR of low double digit is strong on its own and could be conservative with additional margin expansion?

I think your genius with this statement.

I know, right. I know it's long.

I mean you could probably tighten up a little market a little bit better...

And it took 15 minutes for me go to -- for me to be dumb to a genius.

So we kicked off transition a couple of years ago as a company, and it was a margin expansion effort to really drive 4 pillars of work, sourcing, pricing, what we call operational footprint or operational execution, and then spans and layers around G&A and cost to serve. And I think we made amazing progress across those 4 work streams, and we're just in the -- just getting Wave 1 realized, and there's a Wave 2 and Wave 3 yet to follow. In our Analyst Day, we gave 2 margin targets. We gave a 24% commitment by 2026 and a '26 number that we felt, if everything went right, we could achieve. I think when we implemented 80/20, which I'm going to have Jerome share a couple of insights into, it was because we were doing transformation, but weren't putting all of the complexity through the work streams because nobody wanted the complexity. So our new suppliers didn't want to source any of that product. We couldn't implement pricing because it was like one-off products that weren't going to the -- so we reverted back to 80/20. We put 80/20 as an analytical aspect. We chose a firm to help us that had run P&Ls before and implemented them in their own businesses that they had led, which was kind of a requirement for me because I wouldn't have someone like a Jerome accept it unless he could trust that a businessperson had engaged in it. And even in a business-like Jerome and pool where we're in mid-30s on margins, there's so much more opportunity about market. Maybe you want to share couple of thoughts on?

Yes. I think what we're finding out is that, for example, our pool business, about 8,000 SKUs, but we see that 200 of those represent 80% of our business. So imagine...

So you'd say over 8,000 SKUs total?

Yes.

With 200 of them generate 80% of the revenue. It kind of shows you the complexity.

So show the complexity and show how much better we are if we would use on complexity and drive for simplicity on our top SKUs. So -- and really, it's not about just so much cutting about how do we grow with -- was 200 SKUs, right, how do we drive penetration, how do we drive to find the next SKUs that they going to part of those 200. So I think there's a lot of growth opportunities that we have. So let's focus.

So maybe we could use that as an example, right? 8,000 SKUs, 200 of them driving 80% of the revenue. What do you do with the other 7,800. How do you reduce that 8,000 to a more manageable number. So how do you move customers that are buying some of those 7,800 to buying the 200. What opportunities does that enable for strategic pricing, where some of those products that are probably low margin certainly lower than the mid-30s that the whole business is doing. And can either be called out of the portfolio by raising prices or moved into being an A product instead of a B product.

It's migration, driving migration to those top SKUs that we have. And then after -- I think you can do that or you can reduce some of the kind of the SKUs, which are bringing on complexity, which I think the channel is not really looking for because if it's low moving for us, it's going to be low moving for our channel as well. So I don't think like we have in that channel. I think that were hampering the channel of being more efficient as well. So I think we can do a lot of work in order to drive. It's not going to go -- the 7,800 is not going to go to 0, of course. But I think you can reduce a lot of the complexity, the supply chain, the focus, the regulatory work that you have to do on those.

I think it's 80-20 is overused as a term, but the process itself is customer centric. So you have your top customers who are running your top products as Quadrant 1. Quadrant 2 would be your top customers buying products that you've created the complexity over many, many years, and you're asking them to buy. Quadrant 3 is your less-performing customers buying your high products, and Quad 4 are your less performing products to your less-performing customers. So Quad 4 is where you start. That's why you get rid of most amount of complexity, right? Raising prices, changing your terms and conditions, et cetera. You got to be careful in Q3 and Q2. You're the one who put them there. So it's things like lead times change, maybe minimum quantity order wise change. It's how do you treat your customers differently. So in pool, for instance, POOLCORP is our largest customer. They should feel special. I guarantee you they don't always feel special, right? And so we got to go out of our way to make them feel special. Our top dealers need to feel special. The phone should ring differently when they call. And our level of service should improve. And by doing that, you're going to grow more with your top customers, and then ultimately be able to walk away from the complexity in your business. For pool, it will be an investment strategy or some of our other businesses that might be a cost-out strategy.

Maybe we could talk a little bit about the supply chain because it's obviously a big generator of margin expansion over the next few years. So maybe you can just talk about what was done in 2022 that you start seeing the benefits for this year, '23 for '25, '24 to '26?

Yes. We use an outside firm, I'll start there, and I'm not -- we choose our outside firms carefully. But the reason we chose them is because they had a large database of working with suppliers. And we had a group of sourcing professionals and business leaders who are very comfortable with our suppliers that were in our own backyards, right? And so you've got to put the opportunity through a funnel, and then say who are the best suppliers to be able to go quote, and I think the good news is we started out with motors, drives, electronics and we're in a difficult situation where it was even hard to get some of that product, right? And so we got a really big win early from having large suppliers step up and say, no, we want to be Pentair's partner and is more like a partner and we saw some really good savings. Now Wave 1 of time, right, because we had to reengineer all that product, requalify all that product, with all that product to inventory as you can imagine inventories are high. And we're starting to realize that benefit here in 2024. Wave 2 is the next 1/3 of the purchase buy. It tends to be more castings. It tends to be more plastics. We're likely to see more of our incumbents hang around different economic environment, wanting to bid and hold on to the product, and so we'll see some of that benefit a little quicker. And then Wave 3 is a combination of going back into Wave 1 and Wave 2 with things that we didn't bring through. And again, we didn't get all the product because the complexity through it and/or being able to work with more specialty purchases that we hope actually at the end of the day, aren't there because we've done the 80/20 work.

It's fair to say though that on the supply chain, most of the work has actually been done...

Yes.

As benefits are still to be generated?

Yes. Yes. You see them coming through the funnel and you can track them, and you can score-keep them. And pricing is that way, too, right? It's value-based pricing and stacking our products up against competition. Are we selling the value appropriately. What's the right price point? And how does it how do you create those value cases in the early going price was just inflation pull-through. Now we're having to work actually on the strategic side of the pricing.

Yes, I think it's an important point to make for investors that a lot of that margin expansion through the 2026 targets. A lot of that you've kind of already locked in and already done the work for, and it's time and inventory rolling through and things like that, that that you've got a wait for?

And that plays in the confidence of our margin targets.

Okay. Second one. Balance sheet is delevered after the Manitowoc Ice acquisition with just over 2 turns of net leverage coming into a very seasonally strong cash flow quarter, so it will be significantly less than that by the time you report it in a couple of months. Giving you significant flexibility for acquisitions and/or share repurchases?

I think you got it right, just how much to add. I think -- given the interest rate environment we're in and our size is a market cap company, and you want to first make sure you remain investment grade. And I think we feel good about that. I think the good news is Manitowoc was a extremely cash flow-generating acquisitions, so we've been able to pay down the debt. We're now going to probably cross into the high 1s here as we get through our largest cash flow season, which is Q2. And ultimately, I think that gives us flexibility to utilize to create incremental value. I think there'll still be some combination of paying off debt because the debt is higher than its historical been, but I think you'll start to see buybacks come into the equation. And hopefully, there'll be some acquisitions out there, right now, I wouldn't say the pipeline is all the robust. So probably shorter term it might be a little bit more on the buyback side.

Historically, Pentair has been fairly balance on capital allocation with some of the cash flow going to acquisitions and some of the cash flow going to share repurchases. You obviously suspended doing share repurchases after you bought Manitowoc because you've got it up a little bit. It didn't make sense to be doing them then. Can you talk about appetite for restarting share repurchases in a more aggressive way? I know you didn't talk about it that much at the Analyst Day. Because you had this second quarter cash flow coming up, which would make the leverage more appropriate, maybe give yourself a little bit more time to look at acquisitions. So -- but just your appetite going into the back half of this year or early '25 for increasing share repurchase?

Yes. I mean, I'll just say, I think there's a huge appetite. I think you'll see that we -- we will do it. And I'm not going to suggest it's going to be some huge leverage buyback, but I think you'll see us start to divert more, returning cash to share owners, either through dividends and/or acquisitions. I'm sorry, through buybacks versus acquisitions just because of the environment we're in. And I would say that half a turn for us is like $0.5 billion. So we're probably going to be in that sweet spot of 1/5 turns is probably a good space to be a good spend, it's basically.

Maybe you could just talk about the priorities for M&A -- assuming there are targets out there where you would like to be investing? What kind of markets, products, whatever you would like to be investing in?

So there's some technology and pools still that I think we want around water chemistry. And some things that we want to stay ahead of in case -- some of the energy usage for heaters change. So we'll stay active, we're trying to add to the portfolio there. But there's not a lot of things we can do in pool. In Water Solutions, I think we've got a really good portfolio of businesses around Commercial Water Solutions between Manitowoc Ice and what we do with Everpure filtration. And we'd like to add and expand there. And then outside of that, it would be things that play into the automation themes or give us data or analytics associated with what we do that can help our dealers and our third party continue to create value in the industry.

How does -- where interest rates are today, change the algorithm or influence your thinking about doing share repurchases versus paying down debt. If we look back in the recent history of the last 15 years, for most of the time, debt was free, right? So you were not making much of a return from paying down debt. Whereas today, you are making a pretty decent return on paying down through revolver paying down debt. How does that change the thinking between debt payoff and share repurchase?

Well, I think most companies look at when you pay off debt, it's something you can access again. When you buy back shares, you don't get to access it again. I actually think a constrained resource is actually the most optimized resource. So ultimately, I think it's a combination of both, and that's why I think you got to continue to return the cash to share owners, because it takes it off the table and keep your focus where you really need to drive the return for investors. And so I look at it as just a combination of both.

All right. Last one. The majority of Pentair's revenue comes from well-structured oligopolistic markets with rational competitors...

Can you say that legally, oligopolistic?

All the got ballistic.

Okay.

Oligopolistic. Most of the remaining comes from markets with higher growth.

I agree that, that's generally true. I think underneath the 3 segments that we operate in; we look at our business as having a revenue stream called pool, which is our largest, primarily North America and really profitable. There are 2 other equipment competitors there. I think both of them do pretty well. You can decide what pretty well is. [indiscernible] general rational, it was through a really good pro channel, where the channel makes margin, dealers make margin, we make margins. So that would be the pool business. When you get into the Commercial Water Solutions business, where we have Manitowoc Ice and filtration, again, really high margins, because water really matters and the quality of it matters to the customer base. And so again, a dealer channel and an industry that generally does pretty well. When you start dropping through some of the other revenue streams, dirty water makes more money than clean water. That's just a given. So anything in wastewater has significantly high margins and anything that's dealing with waste and filtration has high margins. But these are good markets. And I do think the core growth in the core of those markets are good. I think where we generated a little bit lower growth rate as we chased geographical expansion or got into adjacencies to drive our growth that is hard to continue those growth rates because we're not as big in those spaces as competition, and we don't have the standard position versus our competition. And that's where 80/20 redirect you to where you think you are good because you have data that actually proves it, and then you can ultimately continue to double down in the spaces that you're good at. So I agree with the statement.

So we see the application of 80/20, does that -- has that given you businesses that perhaps don't belong in Pentair's portfolio anything that's material -- are we looking at more at pruning around the edges of -- and you've done some things around the edges today?

I'll tell you what. The partner that we chose said to me, 80-20 is not a portfolio tool. If you use as a portfolio tool, there's other tools for that. So I just think that's why I say it's misused. It really assumes that every business you have has something in it that has high quality in it. It doesn't mean you wouldn't recognize later and maybe walk away from it later, but it's all -- it believes that you can improve the profitability and the growth rate of every business you have. And so we start with that as a lens. Will that require us to drop some product lines as we go forward, maybe, but I wouldn't look at it as a portfolio tool at the moment.

Maybe just talk a little bit about the water quality side of the business, which is maybe a market that fits into the second part of that, that maybe it doesn't have as quite as high a margin, but certainly has higher growth rates attached to it. Your appetite for expanding either into that business or into 2 other kinds of businesses that maybe don't have some of those premier margins, but are offset with higher growth rates?

Yes. I mean, first of all, if your low-margin Pentair portfolio, it probably means you're somewhere around 15%.

Yes. All right.

I mean it's not horrible.

Relatively low.

It does strain the higher 20s gross margin businesses that we have. So I would just leave you with, I think there's an opportunity to change the game. I still believe taking what we do for food service and working in the high-end residential to give you an HVAC like system that gives you high-quality water in your home. Will be a very useful top of the market segmentation of residential play, and I think it's an exciting opportunity to be. And I don't think it has to come with low margins because I think those people would value what they're getting, so.

Awesome.

Thanks for your time today. Really appreciate it. Thanks...

We're up on time. So thanks, everyone, for joining us, and thanks, guys, for joining us.

Awesome.