Pentair plc (PNR) Earnings Call Transcript & Summary

[Audio Gap] everybody. Mike Halloran here with Baird and we're pleased to have the Pentair team with us. Joining us today, John Stauch, CEO. Shelly, IR on stage. And then what we're going to do today is pretty normal. They're going to give some prepared remarks. John is and then the 2 of them are going to help with the Q&A session. [Operator Instructions] So please, John, thank you. Appreciate it. The floor is yours.

Well, first of all, thank you for having us here. I always enjoy coming to this conference, both from a standpoint of sharing what we've got going on, I think the timing is great as we start to think about how we position ourselves for next year. But it's also good to hear what's going on with other companies and use that information as well. So thank you. Pentair, roughly $4 billion of mostly water. We help our customers move, improve and enjoy water, which we still believe is life's most essential resource, not lost on me, some of you need air but you also need water. So we're in water. We're not in air. So we'll say water is the most essential resource. I think we're staying focused on improving our business despite a large chunk of our revenue being exposed to residential and some of the challenges that have happened in the last 8 quarters relative to it. If you haven't looked this in a while, I think when you look at our progress against 2019 in the form of ROS and improving the portfolio, it's really stepping back and acknowledging that we're a series of acquisitions over time. We're organized better to go to market and serve the channels and our customers better within the businesses and revenue streams we have. But we leaned into a transformation journey 2 to 3 years ago and that transformation journey has made a lot of progress about working on pricing, sourcing, operational excellence and organizational effectiveness. And then we took a pause and we added 80/20 to the repertoire, primarily because I didn't feel or believe that the complexity in the portfolio was being dealt with. And so when you add 80/20, combined with the tools that we've built in the toolkit of transformation, we're hitting a pretty good stride on margin improvement and really getting the business focused on value-based revenue versus just revenue as a whole. So that's my opening remarks, Mike and I know you probably have a couple of questions for me.

No, good. We're done. Thanks for joining, everybody. Have a...

Good lunch.

You got to eat what you can. I think the core of what you talked about is where we're going to start here, which is, the environment has been choppy but the execution on the margins has been exceptional. So maybe just start with where we are in the execution journey and what's next. And then we'll pivot off that with a variety of questions.

Yes. So when we started the transformation efforts, I wanted to make sure that it wasn't a reporting and consolidation exercise, where we were high-fiving ourselves on dollar values at the top of the company. What we really wanted to do was have a business model obsession. How do our businesses go to market, who do they compete against? And what do we do to improve them in the form of the customer experience but also delivering value for shareowners. And each of them are in a different part of their journey and each of them has a different opportunity. So it is not about adding up the sourcing benefit as a whole for the company. It's about how do we give pool, which has our biggest buy within material purchases, the tools to effectively source motors and drives and electronics more effectively. And as you can imagine, that's had an outsized performance in our ability to deliver for pool. In other parts of our business, labor and overhead is the biggest challenge and how do we more efficiently drive the labor and overhead out. So I want to, first of all, say I think it's different. But most of all, for me, it's different because I can measure at the point of accountability. We're measuring the P&L impact. We're not driving from the top. We're driving it in the business. And then we can use benchmarks as we learn from your companies that you follow and we can put margin expectations associated with it. So despite some headwinds that we've experienced, things like insurance and property taxes and just the utility costs, all these things have really been up significantly. We have not coming off our transformation goals because the business leaders are focused on what can I do to improve the overall operating results of the company. So I'm pretty proud of where we are in the journey. When you take stock halfway through a program like this, I think it's fair to say, is there more opportunity in front? Or is there more in the rear? And I think there's significantly more in front of us as we go forward.

And part of it is, you hired a firm, started an 80/20 journey. And I think part of it is organizationally, you put yourself in a position to be ready to execute on that culturally, the people, the talent, all of it. Maybe talk to what that journey looks like and maybe just level set people on what an 80/20 enterprise approach does for a firm.

Yes. So I'm embarrassed and saddened to share with you that as a former Chief Financial Officer and CEO of a company, I didn't introduce 80/20 late in the game. I think I won't bore you with the details of why not. I think most of us looked at 80/20 as a cost exercise. But when we were deep in the transformation journey, what we realized is, we weren't getting the complexity out of the company. And the complexity is a challenge. Customers want simplicity, investors want simplicity. Human beings inside businesses hold on to complexity because it's a reason for their being and it's an opportunity then to be heroes. But you're spending a lot of time on non-value-added work. And so what 80/20, at the heart of it, is a very simple tool. It makes you quadrant your revenue. So the upper left for most companies and revenues, so you do it at the point of revenue stream and you do it with a customer-centric mindset. It's not a SKU rationalization effort. So in the upper quadrant, you end up with about 65% of your revenue, 80% times 80 equals 64%. By default, when you get to the lower right, which is what we call Quad 4, which is called CRAP, can't realize a profit. It's also an acronym for something else as you figured out. That ultimately is about 4% of your revenue. And the goal is and the understanding is that, that 4% of your revenue is using a disproportion around your cost structure. So it's taking you as much effort to get product out of the door in Quad 4 at a lot less revenue and a lot less income as it is to take care of Quad 1. Well, through our journey through COVID and supply chain challenges, our best customers aren't getting the best experience. And so we had to recommit to say, how do we get back into Quad 1 and outperform our competitors. And then the goal is to let people loose on the Quad 4 side. 4% revenue exposure doesn't mean we're walking away from 4% of the revenue. Probably half of that would likely go away. And then in reality, you pick up a little bit of offsetting revenue growth elsewhere in the quadrants from moving out of Quad 4. So I'll just give you that as a framework. Big fan, big believer in the process. But the math is one aspect but then you have to have a cultural transformation to actually drive the business better. Salespeople are asking me, as a CEO, are you serious, you don't want me to sell that product? Our customer is going to call and complain, what are we going to do? And so the real journey is in culturally helping the whole entire organization realize that walking away from that complexity is good for everyone. It's good for the core customers. It's good for them and it's good for shareowners.

Yes. Frankly, a little friction with sales from the customers creates a conversation where you can drive better results, right? So let's take where are we then in the segmentation process of identifying what is the loose change on the floor that we need to move away from and what is the [indiscernible] place that's the meat of what drives value for Pentair?

Let's start with our best segment and our best business pool. So we'll leave that over to one side and say that's -- I don't know if it gets better than a Rule of 40 company inside of a public company. So the Rule of 40, as you know, is EBITDA 35% and we're growing mid- to high single digits. So very rare to have a business like that and I'm very proud of the performance of that business through the COVID supply chain challenges. And now to be on the cusp of returning to more steady mid- to high single-digit growth, I'm very excited about what we can continue to do there. The rest of the portfolio is where we made a series of acquisitions. And over time, some of those acquisitions are more valuable than others. And that's where we've really committed to walking away from some revenue streams and understanding that not everything can be disproportionately invested in. And I think that focus around what we really create value for in the industry is where the margin lift has really come from.

So let's start with the Quad 4 then. I think you said 4-ish percent of revenue. How do you attack that and maybe put it in terms that we can understand about what that impact might look like because some of it is pricing it up. Some of it, you might not want to price up because even if you price it up, it's still massive inefficiencies from a manufacturing flow perspective. So any framework for what kind of benefit you can get or how that should work as you move those into 2 and 3 and maybe even to 1 over time?

It sounds like you've been through the training, Mike.

I've done a lot of this, yes, actually.

Yes. So first of all, we did this in waves as well. So transformation was in waves and we did 80/20 in waves. So we put about 1/3 of the revenue through the first wave. So they had an early start on quadranting their revenue and then working through the programs and the processes to free themselves. And then wave 2 went along and did the same math. And so they're kind of in the middle of the range. And then you have on the other end, some of the more project and more configured order businesses that went through the last wave. So you're never going to really have all of the revenue coming out in any one given annual year. And you're going to be phasing some of that revenue decline. So you take something like a pool, they've been through the 80/20 in the beginning. They've worked through a lot of their Quad 4 already. And so when you're looking at the results, you would say it's generally net of most of the revenue walk away that you'll see. And then when you get into more of the water solutions, you're starting to see that this year and some of that is walking away from low-value services revenue that you see in their numbers and starting to mix the portfolio forward. And then our -- my proudest business is C&I, who -- which our commercial industrial pump business, who walked away from 11 different revenue streams before we even started 80/20 because they were realizing that they didn't have real value propositions in those 11. And by focusing on the remaining 11 that they have, they were able to go in and win significantly because of reducing lead times or being more nimble and agile versus the larger pump companies. And because they had seen that early, they were able to even take 80/20 to the next level and compress their cycle times even further and really start to grow quickly. So really proud of all the businesses leaning in. I have to continue to stay focused on it. We have to make sure this isn't the program of the year. I think 80/20 plus the transformation tools are in the toolkit to stay. And now it's about having the right business leaders and the right general manager using those tools to drive value.

Yes. No, that's a good point there. Because, if you think about your margin targets at your Analyst Day, 80/20 was not part of it. You gave some contingencies in place. Those contingencies feel like you're outperforming them, right? So given you a path. What is it about your team that you think can keep this embedded in the culture today and not be kind of a soup d'jour type thought process, right? I mean is it incentivized? Are you putting the right incentive structures in place to keep this durable? Anything else you would point to?

Yes. So we did change the incentives. We use a metric that's -- we don't metric on revenue. We metric on a revenue -- our revenue metric that we call realized standard margins. So standard margin, plus or minus the impact of in-period inflation. And I think by focusing on that, we were able to measure the value of price and inflation real time and make sure that we're making progress against the sourcing and the pricing transformation initiatives. I think secondarily, it's not letting the pressure off of the business model and how that business model is a part of our portfolio, what value it has to our portfolio, what role it plays and then holding them accountable to delivering to those metrics. And I thank the team, my leadership team, for staying true to that. And the hardest thing is saying no in a company but it's the most liberating thing to say no. And so we learned how to say no more, right, and quicker. Maybe is really disruptive, a no can be liberating because you know what, you don't have to do anymore. And I think those tools are really, really important. I know it seems really basic but most of business is basic. I think we add complications to it because we come up with the what ifs, what if we did that or what if we did that. I think most of our customers just rely on us to do the little things really well and they want us to do it better tomorrow than we did today.

It's basic but making hard decisions is not easy, right? And that's what a lot of this comes down to is our decisions. A question here, 2 lower-margin segments have returns north of 22% already. But it sounds like there's a lot of opportunity ahead still. Are these 25% margin businesses? And what's the opportunity set look like over time?

Yes. So I think it's a fair question. I think the majority of the portfolio, when I say majority, let's say, 90%, all have the ability to be north of 25%, 26% EBITDA, 25% the way we measure it, which is EBITDA. And I think that's always important to keep the lens on that. I think if you have a business that can't get there and you're going to damage it by way of forcing it to get there, I think it's better off in somebody else's portfolio than it is yours. I think we're able to see a path north of those margins in every area of the company. And I think it will be coming down to, is the effort worth it? There's some easy things to do. And then there might be some harder things like moving factories or moving the footprint or having to commit to ERP and digital investment. And I think somewhere along that path, you have to make the tougher call on is it better for you to have it or somebody else have it if you get to that level.

Makes sense. And so last question then on this and then we'll move on to some underlying dynamics. Pricing, how are you thinking about pricing as a lever for you on a forward basis versus history? We've always had it in pool, consistency in pool. I think it's probably been a little less consistent than the other 2 segments. What does that look like moving forward, do you think at an enterprise level and maybe more instantly in some of the segments?

Yes. I think it's a important part of anybody's business model, especially on the cusp of what might be supply chain headwinds, could be related to the administration change. And I look at our model being that we go through distributors and we go through dealers and we do that in 75% of our businesses. Most of those industries can handle marginal price increases if everybody is doing it and you can do it in an organized fashion because they can plan for it, they can build their business models around it and you can be successful. The good news for us is the 25%, which is more configured order or project related, won't have impacts from the China supply chain challenges, et cetera, to any level that will put them in a difficult position. So the way we're going to look at it is, are we disproportionately advantaged or disadvantaged by the supply chain changes? Can we price effectively? Which I think we can. We've demonstrated that through the last supply chain challenge that we went through. And I think that's the way we have to focus on it. But I think we're looking at inflation next year being generally equal to what it was this year, not necessarily moderating but not necessarily getting worse. And our goal is to always implement enough price increase across the portfolio to offset inflation. And then growth in transformation benefits is the income contribution to the company.

So then maybe just touch on that then. Do you think you have the right footprint for what's coming? Maybe just thoughts on how your footprint has -- how your footprint is constituted today and how nimble you might be able to be if there are some areas of concern?

Clearly, with roughly 40 factories across the globe, I can definitively tell you, we have too many, right? I think at least 10 too many. And ultimately, now that we will begin to get clarity of where we're going to evolve into long-range planning, I think we'll probably going to move out on tweaking a little bit of that footprint or looking at a supply chain that can be much more nimble and agile. We got a head start on most of this in transformation, where we looked at our supply chain and we wanted to be closer to a regionalized approach, so China for China, Europe for Europe and North America for North America. So I think we're well positioned with a couple of factories in Mexico, a good North American footprint. Our biggest opportunities remain around Europe and we don't have a huge factory footprint in China today at all.

Yes. I did get a question on the pool side, where are the major factories today? And what kind of sourcing is there associated with it? And let me add one then. Your competitors probably don't look that different, right? So I mean, from a pricing perspective, it's not like there's going to be a lot of advantageous stuff for other people relative to you on the pool side.

So 90% of our pool revenue today is U.S. and Latin America or Caribbean. Most of all of that is made in the U.S. in 2 factories, one in North Carolina, one in Southern California. And our supply chain is global. We don't buy direct from China but our European-based partners for motors, for drives will be affected by some subcomponents in China. But to your point, it doesn't look different. We don't feel it looks different than the industry. And I think we have the opportunity to get ahead of it the way we've done before when we've had supply chain challenges.

So on the pool side, demand, I mean, it feels like we're -- we've hit a level of stability at a low level, right? I mean the run rate business, stable. I mean, I don't think if anyone wants 60,000 pools built in 1 year but you're kind of towards trough, not much different on the remodel side. As you look towards next year, how do you think that starts tracking? Or at least what are the catalysts that you're thinking of? We hear interest rates a lot but I'm not sure interest rates are as clean of a catalyst for you given the demographics you serve. It's probably a little bit more about household formation plus getting people to incentivize to get out and put a pool in. So I'd love to hear your thoughts on how that tracks and what those catalysts can look like.

Yes. So our pool business is roughly $1.4 billion of revenue today. We're doing that, like you said, in a new pool build cycle that we haven't seen for a very, very long period, probably the '08, '09 crisis is the last time we saw the pool build level at this stage. We believe it's upside from here. But we also believe that we deal with a good demographic, a fairly wealthy end customer, a fairly profitable dealer channel. And I think the opportunity is really to get back to the basics of adding more content to each pool and convincing people of the value of automation by making it simpler and by making it easier to use and easier to understand. And so I see us coming up from here. And I do believe that the pool industry is more affected probably by equity values than it is interest rates on the high end. And then your mid- to lower pools are definitely affected by interest rates. But when you do make that leap and you decide to build a home in one of the 4 really warm areas of the country, most people do put that pool behind it. And most people view that as a must-have, not a nice to have. And they're likely to want to invest in the equipment to keep that pool running. So...

What are some of those content drivers in your mind that people are transitioning to that help on the mix, help on the transition, help on the average price per -- however you want to put it, new pool per remodel of pool per upgrade of whatever that pad looks like?

Yes. I think one of the things that people talk about -- well, people don't talk about enough is energy flexibility, right? I think people -- most homeowners, especially in the warm weather Western states want the flexibility to use natural gas when it's advantaged and to benefit from flex energy, like alternatives like solar. And we have a whole line of products that we call hybrid that can flip on and off of those 2 elements. So when you need to really quickly raise your pool up, you probably use natural gas. When you want to maintain the pool temperature, you're going to switch to a heat pump or something that's more of a hybrid producer. And we haven't had a lot of opportunity to talk about those products as we've been trying to react to supply chains and rebalance the inventory levels. But then it's also automation and maximizing your pool energy efficiency by only turning a pool over once per day and helping the homeowner and the dealer set that to a precise science that will make that happen to lower your energy usage. And the LED lighting has been a huge investment that the industry has made and some of that's coming out with different color combinations. And so I'm -- I said this earlier, I'm a golfer. So like it or not and needed or not, I buy a new driver every year, right? It's just part of the getting ready for the season. A lot of our pool owners constantly think about what else is out there, what else can I buy and what will add a coolness factor to this gathering area in my backyard. Most pools are going in with 2 bodies of water, meaning a hot tub and a pool. The hot tub generally is for them and the pool is for grandchildren. And that's the way they think about the industry. And so our real goal through 80/20 is how do we get the top-end dealers to go back selling again and creating the value again by making sure they're trained, that they're well equipped with the tools to help it be an easy buy for the end customer and that we make that transition to automation simpler than it has been for other industries. Does that make sense, Mike?

Absolutely. And then a question here, a couple of them actually, I'll just roll them into one. How are you thinking about the early buy season as we sit here today, matching of sell-in and sell-out and then hurricane impact? If you can just wrap that all together.

Yes. So I think early buy felt normal for us. We went out with what a more normal expectation would be, which puts it roughly in 50% shippable in Q4, 50% shippable in Q1 and that would represent about half of those 2 forecasted quarters of revenue. That's what a normal early buy looks like for us. The whole purpose of the early buy when we started, it was to level load the factories. If you left it on its own, you'd be producing everything in Q2 and Q3 and you'd be laying off everybody in Q1 and Q4. So that's the balancing of it. We used 80/20. We only offered the early buy on [indiscernible] parts. So we didn't do the Quad 2, Quad 3 and Quad 4 early buy. And so it felt relatively healthy. Sell-through has been throughout the last 6 months in accordance with our guide, has been more normalized, predictable and definitely everybody is more optimistic about it. And Florida has had a slight tick up for sure on sell-through, especially as it relates to products need to be replaced that were damaged by both hurricanes.

No, makes sense. On the water solutions side, I mean, it feels to me that you're prioritizing the Man Ice, the Everpure business, deprioritizing Ken's a little bit, deprioritizing the maybe resi filtration piece. As part of this journey, right, as part of doing the 80/20, where you want to put your capital, prioritizing capital allocation. Is that a fair thought process?

Yes. I would like to take an opportunity to advertising upcoming product window. But I think to answer your...

What is that product?

I'm going to tell you. To answer your question, I think the traditional water softener pro channel has been challenged. It's benefited and generally benefits from financing and pull-through of water softeners and traditional water softeners has been challenged for some period of time. We don't see consumers running to the -- running to the home service centers and investing in high-end PFAS solutions and et cetera. So the product that we're going to be introducing a couple of years from now but we've got over 20 in testing today, it will be more of a whole home full filtration capability for your house on the higher-end homes that would be PFAS-certified and also give you the appropriate mineralized water. This is a product that we actually do for foodservice today where we pretreat and then we go through an RO process and then we remineralize the water to the individual customer's taste. We put that into a box that would look similar to maybe an HVAC product. And we believe with the right channel behind it that, that product has a lot of traction, especially in the areas that are dismissing salt as a solution, and we're really excited to take a technology from commercial and bring it into high-end.

So this is an Everpure solution that you move.

It's an Everpure solution that we moved into a residential application, yes.

So maybe talk about the -- your transition of the Everpure mix.

Whole home, though, like so your showers, your dishwasher, your hose bibs, things that are necessary in areas that you would either have a scale buildup. So you get these beautiful homes in the desert that are black steel and you wash them off and you got all this white exposure from the scale. So think about making sure you have the same quality of water everywhere in the home. That's kind of value to a lot of high-end customers.

No, that's great. So let's talk the Everpure, the Man Ice piece. Both, all else equal, performing well. Let's take this in 2 tranches. How are you thinking about the durability of revenue as we move into next year? And then how are you thinking about the cross-sell and the overlap and maybe the value proposition you lined out when you announced the deal, how that's playing out today?

I think Manitowoc is off to an awesome start in the portfolio. I mean as we take a look at even a slight step back this year off of peak revenue last year, where the year-over-year comparisons are tough, we're still ahead of our '25 expectations that we shared with you on the revenue side. And we're still ahead -- significantly ahead on the operating income side. So it's been a testament to a really good group of people who came in to drive that value. The synergies have come through the filtration side as expected, where we're cross-selling to the same distribution networks. We're getting people excited about filtered ice and the value of filtered ice. We're making it simpler to change those out and that's been really exciting. And so filtration has had a good year. As I think we head next year, we're excited to be able to return to normalized mid-single-digit growth in an industry to really demonstrate the next wave of those synergies, the next wave of the penetration of filtered ice, which is critical to our customers.

Absolutely. Flow segment. If I think back over the tenure, I've covered that, which is a long time, it feels like over the last year or so, there's been maybe a little bit more optimism about what that flow profile can look like over time here. And I think part of it is you've taken some of that transformation and 80/20 approach and found more niches that you can apply this to or better growth vectors you can apply it to. Is that a fair statement? And maybe what are some of those reasons why you seem a little bit more optimistic there?

Well, first of all, we have a leader of one of our businesses who sat across from me in a quarterly business review and I doubted his ability to move this from a mid-single-digit ROS to anything north of 15%. And today, we're going to end the year in that business closer to 23% and have grown mid-single digits. So this is the commercial and industrial space. What they've done is targeted data centers. They targeted commercial buildings, anything that needs fire. And when you need a UL Listed fire, we're really high in the spec list. And then we were able to compete effectively with wastewater on that side, which is our Aquion product. And then they we were able to get blue pumps again, which is general municipal water as part of a package offering to these groups of people. And that has transcended any belief that I could have in a business being able to refocus itself and be able to reduce lead times, be good at what they're going and selling the value proposition it delivers. So it's restored my faith as to that growth exists when you can focus, not be distracted and do what you're good at. And if you remember, the pump industry, as I know you still do, every brand had its own individual value proposition. These are 100-year-old brands. It's when we go compete against others with our brand and try to diminish the value propositions that we're usually challenged. And so I've been really proud of that opportunity and what they've done. So thank you for the question.

Well, I want you to join me in thanking the Pentair team, John, Shelly for the time today.