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Pentair, Inc. (NYSE:PNR)

Q3 FY08 Earnings Call

October 21, 2008, 12:00 PM ET

Executives

Todd Gleason - VP, IR

Randall J. Hogan - Chairman and CEO

John L. Stauch - EVP and CFO

Analysts

Deane Dray - Goldman Sachs

Michael Cox - Piper Jaffray

Michael Schneider - Robert W. Baird

Curtis Woodworth - JP Morgan

Chip Moore - Canaccord Adams

Chris Glynn - Oppenheimer

Operator

Good afternoon. My name is Meg, and I will be your conference operator today. At this time, I would like to welcome everyone to the Pentair Third Quarter 2008 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question and answer session. [Operator Instructions]. Thank you.

And Mr. Gleason, you may begin your call now.

Todd Gleason - Vice President, Investor Relations

Thanks Meg and welcome to Pentair's third quarter earnings release conference call. We're glad you could join us.

I'm Todd Gleason, Vice President of Investor Relations and Business Analysis and Planning. With me today is Randy Hogan, our Chairman and Chief Executive Officer, and John Stauch, our Chief Financial Officer.

On today's call, we will provide details on our third quarter results, as well as discuss our guidance for the fourth quarter and full year 2008. We will also discuss how we're approaching our outlook for 2009.

Before we begin, let me remind you that any statements made about the company's anticipated financial results, are forward-looking statements subject to future risks and uncertainties, such as the risks outlined in Pentair's 10-K as of December 31st, 2007, and Pentair news releases. Forward-looking statements included herein are made as of today, and the company undertakes no obligation to update publicly such statements to reflect subsequent events or circumstances. Actual results could differ materially from anticipated results.

Today's webcast is accompanied by presentation which can be found in the financial information section of Pentair's website at Pentair... excuse, www.pentair.com. We will reference these slides throughout our prepared remarks. Any references to non-GAAP financials are reconciled in the appendix of the presentation.

We would also like to point out that all financial results and references are year-over-year numbers in today's call and presentation are on a continuing operations basis, unless otherwise noted or highlighted. As is our custom, we will reserve time for questions and answer... answers after our prepared remarks.

I will now hand it over to Randy, who will take you through Pentair's third quarter results and highlights. Then John will discuss our fourth quarter and full year guidance. And finally, Randy will wrap up by outlining our early view on 2009 and actions we are taking to drive results. Randy?

Randall J. Hogan - Chairman and Chief Executive Officer

Thanks Todd and thanks to all of you for joining us today. Let's begin by reviewing our third quarter results shown on slide number 2. The headline is, we had performance in the third quarter.

In the quarter, we delivered reported earnings per share from continuing operations of $0.42 which includes non-recurring items predominantly associated with the restructuring actions we announced in July.

We'll discuss these items later in more detail. If we remove those items, which get us to the basis of our guidance, we delivered $0.55 of EPS on an adjusted basis. The $0.55 is up to 2% versus the $0.54 in the third quarter of 2007. The $0.55 also bested the high end of our 51 to $0.53 EPS guidance by $0.02 per share.

While the economic environment continued to be challenging, sales and operating margins in our Water Group slightly exceeded the expectations we set in July, which enabled us to deliver higher adjusted earnings per share.

It also reminds you that our adjusted earnings per share of $0.55 don't include approximately $6 million of expenses related to the integration of our residential water filtration business with General Electric's residential water filtration business.

Pentair third quarter sales of $864 million were 5% above the $821 million in sales we generated in Q3 2007. Our organic growth was up 3% in the quarter and up 1% in local currencies.

Third quarter sales in our Water segment were up 4% year-over-year. We continue to overcome difficult residential and Pool related end markets with global growth, new products and new vertical market penetrations.

Our Technical Products business grew 8% in the third quarter versus Q3 2007, in line with the guidance we provided in July. As the slide shows, margins contracted 100 basis points for the total company.

The positive 400 basis point benefit from price and productivity could not offset the negative 500 basis points impact from inflation, foreign exchange and product mix. The negative $6 million expense related to the residential water filtration integration is netted in productivity.

Relative to our adjusted EPS, our third quarter effective tax rate was 33%, reflecting the investment we have made to position our global operations more optimally. The 33% rate is the rate we expect for the full year.

In the quarter, we bought back shares worth approximately $15.7 million. We have approximately $12 million remaining on our authorization which we expect to fully utilize in the fourth quarter.

We continue to expect to deliver full year free cash flow above adjusted net income. In the third quarter, we delivered $70 million of free cash flow, excluding the $23 million net settlement for the Horizon litigation. year-to-date, we have generated a positive $128 million. So those are the Pentair's overall highlights for the third quarter.

Now let's turn to slide number 3. Taking back to when we provided third quarter guidance, the world seems like a very different place. Turmoil had yet hit the stock market and the credit markets were still actively humming along.

And over the end markets Pentair has been dealing with have been choppy for sometime, especially residential and commercial markets. So while we did have to navigate some new negative forces in the market and proactively manage more uncertainty, we delivered a very solid quarter.

As this slide highlights, the guidance we suggested in July had sales between $845 million and $855 million, adjusted operating income between $92 million and $96 million and adjusted EPS in the range of $0.51 to $0.53. Actual sales exceeded the guidance range coming at $864 million.

Adjusted operating income also surpassed the range of $99 million, which was nice OI conversion on the additional sales. Adjusted EPS of $0.55 was $0.02 higher than the top end of our range and is a reflection of the additional operating income we just mentioned. It's pretty straightforward.

The diversity of our portfolio has been an asset all year. This quarter proved once again that global balance and end-market diversity pays dividends when environments become less predictable. We certainly look forward to residential markets improving someday. But we have yet to see positive trends beyond some moderating declines in a few of the residential markets.

I think it's also a testament to our organization that we continue to proactively go after our cost structure and internal opportunities rather than just react after markets deteriorate. I'd like to thank all our employees for that commitment.

Now, please turn to slide number 4. And we'll review our third quarter performance in more detail. Starting with Water.

Since we're going to cover a fair amount of information today, this is one of our standard slides. I'll just hit some of the highlights.

On the top of the slide, you can see we provide our standard sales and operating income walks. We'll refer to these as we describe the performance of the Water Group. Overall, Water sales were up $20 million to $566 million, up 4% versus last year sales and flat organically.

As you know, approximately 40% to 45% of our Water Group is exposed to residential markets. Those businesses continue to be down double digits as softness in the U.S. and European residential markets continue to impact our sales.

Most of our other major markets continue to grow nicely as we have invested to grow in emerging regions and non-residential vertical markets.

Our Global Flow Technologies business grew 7% as commercial, municipal and agriculture, each had nice growth. We continue to expand into new international markets which will enable our commercial flow segment to drive strong double-digit growth in spite of the U.S. slowdown. The new products for our agricultural pump markets around spraying and crop protection have positioned this business for a sustainable growth.

Global filtration was up 10% in the third quarter versus last year as the group benefited from the newly created Pentair residential water filtration business venture with GE.

Excluding the sales related to this combination, filtration sales were basically flat year-over-year. Several key vertical markets, such as food service and industrial continue to grow nicely but those verticals cannot overcome declines related to residential filtration market.

Global Pool and Spa was down 10% in the quarter as residential pool permits in the U.S. continue to be down over 30% led by declines in major markets, such as Florida, California, Arizona and Nevada.

While we remain cautious regarding the Pool segment, our sales decline improved from down 22% in the second quarter to the aforementioned down 10% in the third quarter. More importantly, we're beginning to get a sense for the early buy program which occurs each fourth quarter. While it's too early to say definitively how the program will finish, so far we're on track with our expectations.

Internationally, sales in Europe, the Middle East and Africa or EMEA were essentially flat when you remove foreign exchange. We've seen a slowdown on Western European markets which negatively impacted our sales in the region. Sales to the Middle East and Eastern Europe continue to expand to double-digit growth rates.

In Asia, Water sales were up over 20% as we continued to see strong system sales in China which were up over 40%.

Let's shift gears and discuss operating profits and margins for Water Group. On the top right, you can see our year-over-year operating income walk for Water. Adjusted margins were 10.8%, down 130 basis points year-over-year. Inflation impacted Water margins by over 440 basis points that could not be overcome by productivity, price, and product mix.

Our third quarter adjusted margins include the $6 million associated with the pay-as-you-go expenses for our restructuring actions and the integration costs associated with the GE combination. Those are some additional expenses that will no longer be with us as we enter 2009.

The adjusted margins of 10.8% are towards the high end of the guidance we provided in July. We continue to drive solid productivity in the face of ongoing softness in residential construction and residential pool markets.

We're taking significant actions to rationalize our global footprint, reduce structure and drive growth opportunities. We expect these to reverse the margin declines once the actions are all complete. So we continue to take the right steps in a challenging environment.

Now, turn to slide number 5 and I'll review Technical Products. Technical Products results in the third quarter remained solid as we grew sales 8% and delivered adjusted margins of 16.2 % which were down slightly versus the third quarter last year. In last year's third quarter, it was extremely strong as the division produced record sales and margin levels for the period. So essentially matching some pretty good costs.

As you look at our sales results for the third quarter this year, our Global Electrical business grew 9% versus last year. We continue to benefit from a very diverse set of vertical markets.

On last quarter's earnings call, we provided detail on the diversity of our Technical Products vertical markets. And we reinforced that at our September 10th Analyst Day which is available on our website. So I won't repeat that detail here.

Clearly, some key verticals have exhibited weakness, such as automotive and machine tools which remains one of our largest verticals. But others such as networking, energy and continuous flow remains strong, help [ph] to maintain nice sales momentum.

Our Global Electronics business grew 7% led by strong growth internationally. Europe grew single digits, excluding exchange, and Asia grew in the mid-teens in local currencies. In the U.S. electronics sales were down in the high single digits.

Looking at Technical Products margins, growth and productivity together contributed 380 basis points of margin expansion. This could not quite offset the impact of the negative 410 basis points from total inflation which was impacted by higher steel prices.

In the quarter, we paid approximately $200 more for ton of steel than we were paying earlier in the year, an increase of about 25%. So while steel prices have begun to pull back recently, we'll still pay higher steel prices for a few more periods on a year-over-year basis.

We executed well on the 2007 restructuring actions which included the shutdown of facilities outside Chicago and one in the UK. By reducing our Technical Products footprint, we believe, we will get even better operating leverage, even if markets contract. Given increases in metal prices, we initiated several price increases this year which has enabled us to largely offset commodities.

So in sum, Technical Products delivered a good top-line helped by price increases and a great execution to deliver solid bottom-line and results in Q3.

Now I am going to hand it over to John Stauch, who will provide additional detail on the quarter as well as discuss our outlook for the remainder of 2008. John?

John L. Stauch - Executive Vice President and Chief Financial Officer

Thanks, Randy. I am going to start on slide number 6. As we typically do each quarter, we'd like to highlight cash and ROIC, which is shown on the chart with the red box around the figures.

As mentioned earlier, we generated $70 million of free cash flow in the third quarter, excluding a $23 million net payment related to settling the Horizon litigation. We continue to make progress in regard to working capital. But in a period that was the use of cash, as we have built inventory and advanced several important customer programs that are currently in our Water and Technical Products backlog, we have more working capital from the GE transaction.

If we take a look at the components return on invested capital, ROIC, to the right of the slide, you see our fourth quarter trailing adjusted net operating profit after-tax or NOPAT was $277 million. Our average invested capital was $2.90 billion which gives us an after-tax ROIC of 9.3%. This is up 60 basis points versus the same period a year ago. We continue to focus on improving this metric.

Our total debt was just over $1 billion for a debt to total capital ratio of 33.6%. As a reminder, the non-GAAP to GAAP reconciliation of these calculations and numbers are included in appendix to this presentation.

As we just discussed our debt position, let me take a few minutes to discus our balance sheet and debt in more detail.

Please turn to slide number 7. Given the uncertainty in the credit markets, we felt it was important to highlight Pentair's debt and credit position which is a very good position.

Our debt levels are healthy. And we expect to reduce debt to about 930 million by the end of the year. A majority of our debt is fixed with rates of approximately 6%. The only notes we have maturing in the near term is our $134 million October 2009 bonds.

As the slide demonstrates, we have ample coverage in our borrowing capacity and strong banking partners in Bank of America, JP Morgan, Wells Fargo, U.S. Bank and Bank of Tokyo-Mitsubishi supporting our credit facilities. So Pentair's balance sheet and credit facilities are in great shape which allows us to focus on operations, growth and our markets rather than securing debt or other concerns.

Please turn to slide number 8, which reconciles our reported to adjusted EPS. Let me try to summarize a few of the moving pieces. The slide is divided into three sections. The top section provides you with our reported GAAP EPS earnings for the third quarter and year-to-date as well as our outlook for the balance of 2008. We then walk across the adjustments to our year-to-date results as well as expected adjustments in the fourth quarter of the year. This middle section reconciles the GAAP to adjusted EPS, so you can better understand our operating performance.

The third section towards the bottom summarizes the same period in 2007 for GAAP EPS and adjusted EPS results for comparison.

Starting at the top, our third quarter reported GAAP EPS was $0.42. Walking down to adjusted earnings, you would add back the unfavorable restructuring charges, which cost Pentair $0.13 per share in the period. We had forecasted we would take significant restructuring actions in the second half of 2008, and this represents a portion of those actions.

But after adjusting for these items, third quarter EPS is $0.55, up 2%. The next column proceeds down the same path but with notable other items which we described in great detail last quarter.

Our year-to-date reported EPS is $2.34. Excluding the $0.86 gain from GE transaction, along with the legal settlement for Horizon and restructuring charges we took in the first nine months of 2008, our year-to-date earnings on an adjusted basis is $1.76 which is up about 12% versus last year's year-to-date EPS.

For the fourth quarter, we are forecasting the reported results of $0.17 to $0.20 per share which includes an expectation that the negative charges for restructuring other items in the fourth quarter will be about $0.35 per share. We forecasted we would take significant action in the second half of 2008 on the July earnings call. Given the slower economy, we are prepared to move proactively to address our global structure which is what we are doing.

We have a number of headcount and facility actions underway and more being considered and the expected fourth quarter charge represents those items. So, by summing up all the quarters, full year reported EPS would be between $2.51 and $2.54.

By adjusting the full year impact to these restructuring items, we now expect our adjusted full year EPS to be between $2.28 and $2.31, up about 10% versus 2007.

As we stated last quarter, this adjusted EPS does include the incremental pay-as-you-go costs related to the GE transaction and restructuring actions in Water and Technical Products.

Let's review the fourth quarter and full year earnings outlook in more detail on the next two slides.

Please go to slide number 9. Let's review our outlook for Q4. Overall we expect sales to be up 3% to 4% to $840 million to $850 million, adjusted operating income of $96 million to $100 million and adjusted EPS of $0.52 to $0.55.

We expect Water sales to be up slightly. Technical Products sales growth is expected to be similar to the third quarter or up about 8%. Overall we expect Pentair adjusted margins to be about 11.5%. Our margin expectations include the pay-as-you-go restructuring related impacts.

We expect our tax rate to be approximately 32 to 33% and interest expense to be lower than Q4 2007 by about $2 million. Our share count is expected to be close to 99 million shares, down over 1% year-over-year. And we expect to generate over $120 million in free cash flow. So we've maintained steady growth in margins, despite heavy investments for restructuring and also increased investments in our global business unit structure and key growth initiatives. We expect these investments will have nice payback in 2009 and beyond.

Please turn to slide number 10, as we'll update you on our outlook for the full year. To summarize, we are essentially maintaining the view we had previously communicated, but we are tweaking our adjusted EPS guidance range slightly. Previously, we had a range of $2.28 to $2.33. We are updating the range $2.28 to $2.31 as we increase our restructuring investments and also recognize the markets have softened. We have trimmed about 1% off of our sales growth outlook for the full year as a result.

For the year, we expect sales to be up 3% or 4% to approximately $3.5 billion. Adjusted operating income is expected to be at least $410 million and as we've just highlighted, adjusted EPS of $2.28 to $2.31. We expect sales on Water to be up slightly for the year, and we continue to forecast Technical Products revenue growth of low double digits.

Overall, Pentair margins are expected to be up modestly as we continue to overcome difficult residential markets and high commodity costs. Also, in this margin assumption are the expenses associated with the integration of the residential water filtration business and the pay-as-you-go expenses for restructuring actions.

We expect our tax rate to be 33%, as previously mentioned, and interest to be about $60 million. Our diluted share count is expected to be close to 99.4 million, down 1% year-over-year. And we expect free cash flow to be greater than adjusted net income, excluding the negative impact of the Horizon settlement.

Our debt position at the end of the year is expected to be approximately $930 million providing a debt to total capital of about 32%. And we fully intend to conclude our purchase of 50 million of our shares under our authorization.

As the takeaway highlights, 2008 has been and will continue to be a year in which we're proactively navigating challenges.

I'd like to add that we have been navigating these challenges for about 24 months and getting adapted to doing so. We expect our markets will not recover in the near term, which Randy will articulate next. So we're taking prudent actions to ensure we are positioned to endure the challenges that lay ahead.

So with that, Randy.

Randall J. Hogan - Chairman and Chief Executive Officer

Thanks, John. Please turn to slide number 11. Before we review Pentair's early view of 2009 and how we're approaching our plan, let me provide an update on our current environment and year-to-date results.

From a financials results perspective, our execution has been pretty solid. Third quarter results exceeded guidance in a high quality way. We continue to invest in growth and also are aggressively cutting our cost structure.

And John showed our balance sheet is in great shape. So we're committed to execution in delivering on our commitments. As we think about some key accomplishments, I would like to highlight a few of the major actions our company has driven. We are successfully integrating our residential water filtration business with GE's and that remains on track and on budget.

And over the past few years, we have consistently been reducing our factory footprint and moving to best cost regions. These actions are important to drive our profitability in the face of challenging end markets.

Also on September 10th, we had a well attended investor and analyst day which highlighted a number of our key growth and productivity initiatives. It was great to see many of you there and the feedback received was positive. So we thank you for your participation.

The presentation material for that event is available on our website, and I encourage every one to take a look at it.

And finally, we continue to launch a number of exciting new products, many of which were highlighted at the analyst day. Our new energy and environmentally efficient Enviro Reverse Osmosis filtration product, the LT [ph] dry industrial filtration product designed to dramatically improve hydraulic performance like the loop system in wind mills.

We also highlighted our Aqua line [ph] pre-filtration solution that will reduce capital requirements as well as improve the life expectancy for pre-filtration systems in a number of applications, including desalination.

There were many other new products displayed and we will keep you updated on the progress of these leading applications.

Our perspective on the current environment, which is highlighted in the upper right quadrant, is that globally many markets, such as residential and pool remains soft while many other markets, such as commercial and industrial are generally weakening. Clearly we expect markets to slow, and we're prepared for it.

So going forward, let me clearly state we're ramping our cost take-out measures and monitoring our markets through our daily order reports and quotations and bid rates.

We've been navigating through very difficult end markets for over through two years. Residential and pool construction market problems are well known, and in 2007 we had difficult electronic end markets. So we've grown accustomed to operating in difficult environment.

With that as a backdrop, let's discuss how we are approaching our 2009 planning process.

Please turn now to slide number 12. We, like many companies, initiate our next year planning process in late summer and early fall. Since kicking of the planning sessions, the global economy and credit markets have experienced the high level of turbulence. As this line indicates credit markets have tightened, recessionary environments are more real for the U.S. and Western Europe, and many items, such as commodities and foreign exchange have been bouncing around in terms of valuations. These elements introduced tremendous amount of uncertainty and challenges in the planning cycle.

So, while our typical process is to introduce next year's guidance on our third quarter earnings call, we're going to hold off until we have completed our final business reviews and allow for some uncertainty to become clearer. We would say, however, that the focused actions we had always planned to take in 2009 remain the same.

We've consistently viewed 2009 as another difficult year in many end-markets, which is why we initiated the aggressive restructuring actions in July of this year. At the same time, many of our growth investments, such as desalination, food service, industrial filtration, water reuse and others remain attractive and will continue to receive the investment they deserved. So not much need for change inside Pentair from a big picture perspective, and we remain committed to delivering shareholder value during these times.

Please turn to slide number 13, which outlines many of the cost actions and related planning assumptions we're taking for 2009. The top half of the slide summarizes many of the cost actions we have already announced and are implementing, and will have a meaningful impact to 2009. We anticipate the 11 plants we are closing in 2008 and 9, coupled with additional headcount reductions and the formation of our global business units, should deliver about $0.15 of earnings per share in 2009.

Additionally, we expect the actions we're initiating in the fourth quarter to reduce our G&A structure to yield another $0.10 per share, next year. So in the aggregate, we're taking actions in 2008 and we believe will have a $0.25 positive impact to earnings next year.

I will discuss our outlook for growth on the next slide. But it's good for you to know we're taking actions in '08 and will make a meaningful impact to '09.

The lower half of the slide introduces some additional actions we're talking as we formalize our 2009 plans. First, we're having each of our businesses create two six month plans, so we can adjust quickly as we feel it is necessary. This approach will allow us to be more flexible in uncertain economic times and also provides an incentive model to ensure all of our businesses remain active and in the game, delivering the best results throughout the year.

As we will discuss in more detail over the next few slides, we're planning for slow to no global growth markets. Thus, the facility rationalization and other cost take-out measures we're driving are imperative to ensure we deliver the highest level of earnings. We also have an opportunity to improve our net sourcing savings with potentially a period of key material deflation. So we're being proactive and assuming a challenging environment, which we believe is realistic.

Now please go to slide number 14. While we are not giving official guidance, we felt it would be helpful to indicate how we are viewing our end markets at this point. I'm not going to read all the detail, but each one of our major end markets is listed along with their expected market growth or declines. Depending on how they materialize, the swinging global markets could be considerable. This could drive Pentair as slightly negative growth on the low-end to modestly positive sales growth on the high-end.

The detail on the right side of the slide is similar nature to the previous slide. And if there are a number of growth items we have already accomplished in 2008 that we expect to provide a benefit in 2009.

For example, we anticipate the residential water filtration deal with GE will add $40 million of sales to 2009, representing the other half of the year we didn't have that business in 2008.

Additionally, 2008 price increases will recognize a full year of sales benefit. And while U.S. residential will likely be negative again in 2009, we may not see the same 30% decline in new home starts. So moderating decline will be less of the headwind in 2009.

With more new products and opportunities in global resale [ph], global municipal and other vertical markets, we have areas of growth that we expect to be beneficial to 2009 as well.

However, it is much more difficult than normal to predict how the consumer-led recession will impact global markets. And if the dollar continues to increase in value versus the euro, we may see a negative impact to exports which we expect will hurt our Technical Products business and commercial and industrial water businesses.

These important factors reduce our ability to forecast 2009 sales growth at this time. But again, we are being realistic.

Now let's talk about the cost side of the 2009 equation. Please turn to slide number 15. Each planning cycle includes the determination on cost inputs as well. Some key inputs are listed on the slide towards the top. You can see, we have listed some preliminary assumptions that certain items like wages, benefits and investments for growth are likely to be higher. There are few other items such as commodities and other material inputs that are uncertain at this time. Our view is that given lower oil prices, resins and distribution list... logistics costs may be deflationary items next year.

The lower half of the slide puts it all together in several scenarios. When we do provide 2009 guidance later this year, we will refine our full year assumption on what type of environment we most likely expect.

Regardless of the environment, we remain confident we can deliver on the cost take-out actions we outlined earlier, which we expect to offset areas of negative earnings or add to earnings growth with the right brakes.

Depending on the market environment, we will take different actions and plan accordingly. For example, in recessionary environment we would clearly anticipate declining volumes and more difficult pricing environment, we will also see the benefit of material deflation. And in environment like we've been dealing with over the past 18 to 24 months about the mid-case shown here, we would expect the mixed environment with some markets up and some markets struggling.

In this case, volumes would be down slightly but not to the same extent as the full recession. Since Pentair has been dealing with some difficult markets already for the past few years, we have a lot of practice.

And finally, we list the high case where global economy somehow escape recession and instead see slightly below average growth.

While the expected impact to our planned EPS has shown under each set of assumptions, it's far too early to be comfortable with what outlook is most likely yet. We hope these past few slides have been helpful in understanding how we see our company developing in 2009 under various conditions.

Now let's wrap up with slide number 16. To summarize, we had a solid third quarter driven by our business diversity and global mix. While end markets are becoming more unpredictable, we have a lot of experience navigating these types of environments. We have been very proactive regarding cost takeouts.

We have a great balanced sheet. So you don't have to spend time worrying about Pentair during this credit crisis. While some markets are close to turning for the worst, some markets are stabilizing or improving and some cost inputs will also be beneficial in 2009.

While it's too early to forecast 2009, it's not to early to take action and assure we're proactively positioning the company to maximize performance under possible market conditions.

Thanks for your attention. Now we'll turn over to the operator to open it up for questions, Meg?

Question And Answer

Operator

Okay. [Operator Instructions]. The first question comes from the line of Deane Dray with Goldman Sachs. Your line is open.

Deane Dray - Goldman Sachs

Thank you. Good day gentlemen.

John L. Stauch - Executive Vice President and Chief Financial Officer

Hi Deane.

Deane Dray - Goldman Sachs

Just quick... this is for Randy or for John, just to clarify the whole steel dynamic within Technical Products. You suggested that the steel prices benefit might not come through for the next couple of quarters. Is that because you have locked in supplier agreements or are you less open to spot pricing?

Randall J. Hogan - Chairman and Chief Executive Officer

No, we've been... we haven't really locked in. We've been expecting a decline. It just takes a while to work through the... working through the books... with FIFO.

John L. Stauch - Executive Vice President and Chief Financial Officer

We use the capitalized variant system Deane as our accounting methodology. So some of the --

Randall J. Hogan - Chairman and Chief Executive Officer

About a quarter lag.

John L. Stauch - Executive Vice President and Chief Financial Officer

So we sometimes have a month or too lag on the favorable pricing working its way through the system.

Deane Dray - Goldman Sachs

But maybe I just misheard Randy, you said... I thought you said a couple of quarters, what... you mean a couple of months or quarters?

Randall J. Hogan - Chairman and Chief Executive Officer

I think I said a couple of periods. I probably should have said a couple of months.

Deane Dray - Goldman Sachs

Okay, good. That's helpful. What about the... how sticky will the prices be that the price increases you were able to get over the past year, what have you seen in the past about being able to hold price?

Randall J. Hogan - Chairman and Chief Executive Officer

Well one of the things we do is our prices go into our base. We don't do surcharges and the like. So it goes into our base pricing, and 80% of what we sell, we sell through distribution. And prices tend to be pretty sticky for distribution. I think it's evidenced in the fact that we were able to get as much price as we did if you compare that to other business that weren't quite as capable of getting as much price to offset commodities. I don't think that was... that was so much execution differences, that is industry structure differences.

So, our planning would be that a lot of that price will stick, won't stick everywhere. But a lot of it will stick. And so that we will get some good read-out material productivity next year, which frankly we haven't this year because of the inflation.

Deane Dray - Goldman Sachs

That's helpful. And then we fully appreciate the fact that it's going to be hard to nail down a specific guidance range for '09 at this stage. So, you've actually provided some good level of detail here in terms of some of the end-markets. If there was one that it kind of stuck out, that might be a little in need of explanation is in the water markets, municipal/desal are being up 5%, my guess is it's more of the desal dynamic than in municipal but if you split those two what would the dynamics be?

Randall J. Hogan - Chairman and Chief Executive Officer

Yeah, it's really global. Our municipal business covered 100 million bucks. Most of those sales are in the U.S. today on the flow side. We got $100 million of quotes outside of the United States this year. So I mean we are so small. We believe we can grow with a decent hit rate in those and our backlog in CodeLine, the vessels for desal mostly outside the U.S. is really quite strong.

Deane Dray - Goldman Sachs

So when we see municipal, we are taking more U.S. but you're talking just water treatment overall?

Randall J. Hogan - Chairman and Chief Executive Officer

We have been investing enormously and the team has done a great job of getting focused outside and taking the capability we have outside. Now we have had the advantage of fairly favorable dollar. And that's why I referenced in my prepared talk that the dollar strengthening could be a headwind for those businesses. But obviously really good to have that quote backlog going from zero to $100 million in pumps.,. municipal pumps outside the U.S.

Deane Dray - Goldman Sachs

And just last question if I could, on the early buy-program I know that it's always hard to gauge at this stage of the year because it can be... surprise you the upside or the downside. What are your expectations and where do distributor inventories sit today?

Randall J. Hogan - Chairman and Chief Executive Officer

Well, if you take a look at... we were down as I said... full equipment business was down some 22% in the second quarter. It was down... the group of that we used [ph] only down 10% in the third quarter which we think reflects more of the market now.

So we don't think that the inventory came down much, and at least as a way we set our expectations for the fourth quarter that John just went through assuming that we would see kind of a market level decline in the early buy and everything we see is consistent with that.

Deane Dray - Goldman Sachs

Great thank you.

John L. Stauch - Executive Vice President and Chief Financial Officer

Thank you, Deane.

Operator

Your next question comes from the line of Michael Cox with Piper Jaffray. Your line is open.

Michael Cox - Piper Jaffray

Hi, good morning. Thank you very much for taking my question, and thanks for all the details provided this morning.

Randall J. Hogan - Chairman and Chief Executive Officer

You're welcome.

Michael Cox - Piper Jaffray

My first question is on Municipal spending, and domestically I was curious what you're seeing on that front, given what we're seeing on in terms of state level budgets, and just the local budget process as well.

Randall J. Hogan - Chairman and Chief Executive Officer

I'll give you a couple of data points. On the flow side, we still have a good backlog. We haven't seen any cancellation in the order and the order rate has remained pretty good. On Tech Products which also serves the public sector, we have seen a slower growth, it went from being double digits to single digits. So we're seeing it there on that Tech Products side.

Michael Cox - Piper Jaffray

Okay, that's helpful. And on the Water side, with the margins down in the quarter, I understand largely from the GE transaction, but as you look out to 2009 from the first of all, you're looking into do you see the Water segment margins being relatively flat, is that a realistic expectation? And how much of the drag in Water margins is just coming off the Pool segment right now?

John L. Stauch - Executive Vice President and Chief Financial Officer

It's a good question. I mean, we really think we have the ability next year even in a down market to expand our Water margins. We've taken a lot of structure out. We continue to migrate the factories. And so we would expect to increase the margins. Pool equipment, which is a part of the Pool Spa business, is roughly around a 10% margin business today. And we would like to say that we're near the bottom of the trough, right?

So I think it's reflective of the hard work that that team has done. And we've seen those margins continually tick up as the volumes come back. So we kind of like our core cost position. So we would say that we're bullish on the Water margins, because we got aggressive with the actions early in 2008, and we continue to address our cost structure.

Randall J. Hogan - Chairman and Chief Executive Officer

And after two years, flat we feel like up to then.

Michael Cox - Piper Jaffray

Sounds good. Thank you very much.

Operator

Your next question comes from the line of Mike Schneider with Robert W. Baird. Your line is open.

Michael Schneider - Robert W. Baird

Good morning guys.

Randall J. Hogan - Chairman and Chief Executive Officer

Hey Mike.

Michael Schneider - Robert W. Baird

Maybe we can focus on Technical Products, for a minute. Just look back... look through the '01 and '02 challenges, and I'm just curious if you could at least compare the business today to what we saw then. And just as a refresher, I think Technical Products revenue was down 29% peak to trough, earlier this decade and margins basic I cut in half from 12 to 6. As you look at the business now with the acquisitions with the pricing contributions, et cetera, what's kind of... what's your recession expectation for that business and compare to what's going on in the past cycle?

Randall J. Hogan - Chairman and Chief Executive Officer

Yeah. I won't jump the [indiscernible] and tell you, I think it's going to be that bad. Let me tell you what the theme is... the theme is that we will not be immune in Tech Products at this downturn. That we're all expecting to need to plan in. And let me tell you what's different. We actually have a much more variable cost structure. We had a lot more structure. We had about six more plants than we have now. And that cost structure was a heavy load. As you recall we had to shut down a lot effective gone, and we have been through lean to be able to grow the business. We have a more variable cost structure. So I think that's important and will help us manage margins.

The second thing is we are lot more global than we were. We really weren't active in Asia, and I think towards the amount of growth that we have, the insight in Asia even if Asia softens a little bit or slows... grows at a slower rate, we still get a lot of market penetration there, though... albeit that is lower margin than our U.S. business.

But... and the last is that we have a much more diverse vertical market set. We talked a lot of about how we've broadened the business. For instance, we are much more involved with continuous flow. We are much more involved with a deeper and more engaged in energy. And I think energy spending will stay up. And we've already suffered some pretty big slowdowns in automotive in there. So I think the more diverse markets that will help a lot.

The other thing is that I think we have... look at the performance we've delivered with the kind of commodity inflation that we've had, and that's going to go away. I mean if we have a recession, there is no place the commodities will go but down and our business has proven, our Tech Products business has proven that they managed really well in their material costs. So I expect. So I will tell you this. I don't think that the best days are behind Tech Products. I think that our team will manage it well. We've had a lot of discussions about getting prepared for it and they are. So while we'll have a little bit of headwinds, so I think we will... we won't see a repeat of the 2001.

Michael Schneider - Robert W. Baird

And can you just based on your experience in this channel... can you discuss if that... if the price inflation that's occurred over the last three, four years, does that create more risk to margins over the next two years if indeed we go through a recession or is it less of a risk?

John L. Stauch - Executive Vice President and Chief Financial Officer

I will jump in [ph] and I'll let Randy... Mike, it's John Stauch. I think there is two halves. Right, we got to remember electronics. We've been challenged by going out in bidding and wining jobs on pricing. And we've lost on the material inflation on those fixed price jobs. We've been able to price in the distribution side and the electrical side and capture most of the commodity increases that we've seen by. So it actually will reverse right? I mean if we take a look at the distribution side, we may or may not see price decreases but will have the ability to realize that price inflation.

On the electronic side, we won't be caught the way we've been squeezed through this --

Randall J. Hogan - Chairman and Chief Executive Officer

Should get us some relief in productivity.

John L. Stauch - Executive Vice President and Chief Financial Officer

We got to figure it all out Mike, and we are just clearly going through our planning cycle and running a series of scenarios around what that looks like. And we're trying to balance that with the fact that we haven't seen these markets drop significantly yet. And so we're challenging our teams to assume that they will.

Michael Cox - Piper Jaffray

Okay, thank you again guys.

Randall J. Hogan - Chairman and Chief Executive Officer

Okay, thanks Mike.

Operator

Your next question comes from the line of Curt Woodworth with JP Morgan. Your line is open.

Curtis Woodworth - JP Morgan

Hi, good afternoon. Just want to talk a little bit more about some of the cost actions that you outlined on in the presentation. For your fourth quarter slight deck, regarding the new actions you're talking about $50 million of annualized takeout which is about $0.34 a share. And then on your other slide deck, you talked about $0.25 of total cost benefit to be realized in '09 partly from what you are planning to do in 4Q which is sort of $0.10 and partly from the 1Q to 3Q actions of 15.

So is the annualized number that you are throwing out in the fourth quarter slide... is that really kind of the run rate you expect to get to by the end of '09 or how do I think about reconciling some of these numbers?

Randall J. Hogan - Chairman and Chief Executive Officer

Curt, we've been... just to hit it head on, we've been dealing with what we are going to do with Spa Bath all year. And in Q4 some type of action related to Spa Bath. Don't know exactly what that action is yet, but we are forecasting either major restructuring or some type of adjustment. And that's why you are not seeing the same payback that you are seeing from the Q1 to Q3 actions.

Curtis Woodworth - JP Morgan

Okay but that would be embedded in the $0.10 benefit that you outlined for 4Q?

John L. Stauch - Executive Vice President and Chief Financial Officer

The $0.35 cost that you're referring to, correct.

Curtis Woodworth - JP Morgan

Okay, got it.

John L. Stauch - Executive Vice President and Chief Financial Officer

We won't see that benefit until 2009.

Curtis Woodworth - JP Morgan

Okay. And then in terms of the price raw material conversation, if you look at this quarter on Water, it looked like that hurt you by at least $0.05 a share. So I'm wondering would you expect to get some relief on that metric at least in the short run as commodity prices go down and maybe you can get to more of a neutral or even positive position?

John L. Stauch - Executive Vice President and Chief Financial Officer

Yes, clearly we're looking at those commodities, as Randy mentioned in his remarks, they are bouncing around right, but we're waiting for them to settle and we would expect that we see more deflationary environment in Water.

Randall J. Hogan - Chairman and Chief Executive Officer

Yeah Curt, when I look at Water, I look at the details. We have some pretty, pretty good cost reduction actions and supply just didn't read out because the inflation was that much worse. I think that process will deliver in space next year without in fact inflation and then the turbo charged by deflation for Water.

Curtis Woodworth - JP Morgan

Okay, and then I guess a follow to Mike's question on the Technical Products. If you look at... I think Randy, you commented on the call that you think you could see better operating leverage even in a down market. So what would the sensitivity be? I know there is lot of moving pieces, but can you help frame maybe what the margins would look like under a flat unit volume growth scenario or down say 5% or down 10%? What... just in terms of thinking about how bad margins could theoretically get next year if volume was to go down 5 to 10?

Randall J. Hogan - Chairman and Chief Executive Officer

Yeah, I think we'll give when we do give guidance later this year. I think we will go into a little more detail. And we're thinking about that. But in a flat environment, I think margins can stay wherever they are, because between productivity and particularly materials productivity, I think there is still a lot than these that can go better in tech products, particularly on the electronics side.

So I think in a flat environment, they could do better I think in a down environment they... we can build a plan to be flat, but I don't want to jump the gun [ph]. We got meeting schedule of the team over the next week, who work through the scenarios. But I don't Mike said it well, I mean in last in downturn we went from a 12 peak to a 6 and now actual are peak 17. So we are up five points from that peak. And I don't think we necessarily, I don't... there is now way we will drop 30%. I would hopefully it would even drop to 6 points. So that sort of fills my expectations.

Curtis Woodworth - JP Morgan

Great. Okay, thank you.

Operator

The next question comes from the line of John Quealy with Canaccord Adams. Your line is open.

Chip Moore - Canaccord Adams

Thanks. This is actually Chip Moore for John. You talked about slowing conditions in Western Europe. Wondering if you can go through what you're seeing from the commercial, industrial, residential markets, et cetera. And kind of how that... what you saw versus your expectations and what you see going forward?

Randall J. Hogan - Chairman and Chief Executive Officer

Well, we actually expected the decline when we set the third quarter. One reason we beat quarter revenue was, we actually were expecting the decline we can see it coming. We're skewed residential in water, Europe. So residential is down in Spain, Italy, France and UK. All those residential market were down. So we are seeing slowing commercial and industrial as well, which is before, because residential decline stared earlier but the commercial and industrial, we saw that decline. That said, the European team has done a great job on margins and we've implemented a safety system and that they've leveraged nicely. They have been supporting a lot of growth in the Middle East and in Eastern Europe. So, I think we still have a opportunity.

Chip Moore - Canaccord Adams

Great. Thank you.

Randall J. Hogan - Chairman and Chief Executive Officer

I think you agree [ph]. Thanks.

Operator

And the next question comes from the line of Chris Glynn with Oppenheimer. Your line is open.

Chris Glynn - Oppenheimer

Thank you. On the restructuring front, the $0.25 is that all water?

Randall J. Hogan - Chairman and Chief Executive Officer

In which period, for next year?

Chris Glynn - Oppenheimer

Yeah, just the benefits you are looking for in '09, from the restructuring actions?

Randall J. Hogan - Chairman and Chief Executive Officer

We're... we took more aggressive actions in the first part of the year in the water, but we are certainly looking to do something in technical products as well and the technical products business is reviewing those actions, and they'll be presenting us some ideas here in Q4.

Chris Glynn - Oppenheimer

Okay. And just in terms of restructuring beyond what you've laid out, would you expect a couple of factories a year type of thing, or prospects for another significant sort of action strategy? And then specifically, with respect to your China or Eastern European footprint, are those appropriate comfort level with the ground expertise in those areas?

Randall J. Hogan - Chairman and Chief Executive Officer

Yeah, I think we've presented some thoughts on that at the Analyst Meeting, as you recall. We continue to see the need, we have a lot of plans. We need to continue to have a more productive footprint, and particularly get to what we call best cost countries which isn't just surely chasing the low lay birds, it's having the best cost plans to serve the markets we're serving.

So well, we like our position in China. We like the position we're building in India. Our Poland factory in tech products is finally profitable, and in helping us in Europe. It's in fact actually in Europe, we were up in tech products in the third quarter, so we haven't seen the market decline there yet. And I think one of the reasons is that the Polish factory is giving us a more competitive cost position to grow by itself. We like the position... we have a nice position in Brazil as well, with our tech products business, we're leveraging in the Water.

John L. Stauch - Executive Vice President and Chief Financial Officer

And the teams they are solid, Chris and I think what we've planned to do is take this tranche of savings and continue to divest annually and constantly getting after the cost basis on a more continued basis.

Chris Glynn - Oppenheimer

Okay and then just lastly, at Pool, what's the mix of newbuilds versus after-market shaking out at these days?

Randall J. Hogan - Chairman and Chief Executive Officer

It's getting close to a 100.

John L. Stauch - Executive Vice President and Chief Financial Officer

About 75

Randall J. Hogan - Chairman and Chief Executive Officer

Yeah we'd estimate 75-80% right now, as after market.

Chris Glynn - Oppenheimer

Well. Okay, thanks a lot.

Randall J. Hogan - Chairman and Chief Executive Officer

Thank you.

Operator

And you have another question coming from the line of Mike Schneider with Robert W. Baird. Your line is open.

Michael Schneider - Robert W. Baird

I'm just curious on the ballot this fall, the California legislature is going to take up this issue of banning water softeners. Have you... can you give us an update just on your market analysis around that and maybe what your exposure is, if indeed this becomes one of the green phenomenon?

Randall J. Hogan - Chairman and Chief Executive Officer

Senator Larry [ph] took it out and Governor Schwarzenegger vetoed it. That said, water softener is a fairly small part of the salinity problems in the water in California. The big problem in California is it does not enough water. And so you'll see right now the State of Washington is looking at banning personal car washes and lot by checked a... a lot so. I don't think there they lack of water and so wash. But I think there is long-term trend towards there is more restrictions on water use and that's a long-term trend that is favorable for us for water reuse is favorable for us for filtration and it's favorable for us actually fluff. So we're... I think the largest provider of products into water conditioning and water softening. So we pay for a lot of attention to things like what's going on in California. And we view long-term that probably would be a saltless way to de-ionize water. None of those are viable now both economically or technically. But one of the things that we're working on with GE is that technology. That's all we're thinking about.

Michael Schneider - Robert W. Baird

Okay. And as far as the GE deal goes; given that the world has changed just even in the last three weeks, four weeks. Have you gone back to your GE modeling assumptions for the joint venture and made any material adjustments to that?

Randall J. Hogan - Chairman and Chief Executive Officer

No, when we form that venture it was really a shared view that we had with GE that the residential markets would be viable and exciting in the future and why not build now during this weak time, a world beating company to winning it. So that's really what we are. We had a review yesterday actually, our monthly review and status is quite good from a plant restructuring standpoint. The thing I am most excited about is the growth strategy that they are building. So we don't see any need with recent events to change the assumptions are on that venture. If anything I am more confident that we will be, when residential comes back and I'm not picking a date or time, but I will tell you I'm bullish on our prospects when it comes back.

Todd Gleason - Vice President, Investor Relations

Mike this is Todd Gleason. I just want to make sure, we are able to get to everybody in the queue. And I know we have about five minutes left on the scheduled time. But we want to take it over. How many people do we have in the queue?

Operator

Actually Mr. Schneider's call... question was the last question.

Todd Gleason - Vice President, Investor Relations

Okay. Well Mike go ahead. Do you have anything else Mike?

Michael Schneider - Robert W. Baird

No, that's it. Thanks, guys.

Randall J. Hogan - Chairman and Chief Executive Officer

Okay. Thanks Mike.

Todd Gleason - Vice President, Investor Relations

Great thanks.

Todd Gleason - Vice President, Investor Relations

Okay. Well, it sounds like we have no one else left in the queue. And if that's the case, then we will go ahead and wrap up today's conference call. Thank you very much for joining us. And if you have any questions, let us know. Again our presentation material is on our website and hopefully you have access to that.

Thank you very much.

Randall J. Hogan - Chairman and Chief Executive Officer

Thanks.

John L. Stauch - Executive Vice President and Chief Financial Officer

Thank you.

Operator

Today's call has been recorded and will be available for a playback today, two hours after the call has ended, through October 31st. It maybe accessed by dialing 800-642-1687 or for international callers, 706-645-9291. You will be prompted for the conference ID number, which is 6630-4540.

Thank you. And this concludes today's conference call. You may now disconnect. .

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