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Executives

Randy Hogan - Chairman & Chief Executive Officer

John Stauch - Chief Financial Officer

Todd Gleason - Vice President Strategic Planning & Investor Relations

Analysts

Hamzah Mazari - Credit Suisse

Mike Schneider - Robert W. Baird

Christopher Glynn - Oppenheimer & Co.

Michael Cox - Piper Jaffray & Co.

Shannon O’Callaghan - Barclays Capital

Jeff Hammond - KeyBanc Capital Markets

Brian Drab - William Blair & Co.

Scott Graham - Landenburg Thalmann

Chip Moore - Canaccord Adams

Pentair Inc. (PNR) Q3 2009 Earnings Call October 20, 2009 9:00 PM ET

Operator

Good morning. My name is Darla and I will be your conference operator today. At this time, I would like to welcome everyone to the Pentair Q3, 2009 earnings conference call. All lines have been placed on mute to prevent any background noise. After the speaker’s remarks, there will be a question-and-answer session. (Operator Instructions)

I would now like to turn the call over to Todd Gleason, Vice President of Strategic Planning and Investor Relations. Please go ahead sir.

Todd Gleason

Thanks Darla, and welcome to Pentair’s third quarter earnings release conference call; we are glad you could join us. I am Todd Gleason, head of Investor Relations, and with me today is Randy Hogan, our Chairman & 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 update you on Pentair’s 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 31, 2008, and Pentair’s 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 a presentation which can be found in the financial information section of Pentair’s website at 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. I would also like to point out that all financial results and references to 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-answers after our prepared remarks.

I will now hand the call over to Randy who will take you through Pentair’s third quarter 2009 results, provide his perspective on the results of our businesses and the markets they reserve, and provide an overview on how we are driving to deliver results in 2009. Then John will conclude our formal comments with additional information regarding our third quarter financials, and provide more detail on our outlook. Randy.

Randy Hogan

Thanks Todd and welcome everyone. Before we begin I’d like to make a few remarks. First, thanks to the many of you that attended our investor and analyst day in New York City on September 3. It was great to see so many of you in the audience, and to share with you our long-term strategies.

Second, as you obviously know since you’re on the call, today’s conference call is starting a few hours earlier than it has been the case historically. We will solicit feedback on this time slot and we do intend to permanently hold our conference calls in the mornings going forward. Hope you find the earlier time convenient and helpful.

Now let’s begin by reviewing our third quarter results shown on slide number two. Sales of $663 million were down 23% and slightly below the low end of the guidance we provided in July. We have some pluses and minuses with respect to sales, but the headline is water sales were in line with expectations, while technical product sales were lower compared to the guidance we provided in July.

Sales in our water business were down 17%. Our largest market, North American residential remains down year-over-year, but we continue to see modest sequential improvement. We will discuss water in more detail in a few minutes. Technical product sales declined 32%, about five points worse than expectations. Virtually all of our major vertical markets and technical products experienced double digit declines as capital spending remains constrained.

In the quarter, we delivered reported earnings per share from continuing operations of $0.38, which includes a negative $0.04 of non-recurring items associated with restructuring actions. If you remove the restructuring, we delivered $0.42 of adjusted EPS, which was down 25% when compared to adjusted EPS in the third quarter of 2008.

While down year-over-year, adjusted Q3 EPS was up $0.04 sequentially when compared to Q2 2009, despite lower revenue of approximately $30 million. The takeaway is, the results from our cost actions continue to benefit us, as we progress through the year. Total company operating margins on an adjusted basis contracted 60 basis points. The positive benefits from productivity and price did not offset the negative impact from the 23% sales decline.

On a sequential basis, though our margins continue to improve nicely, third quarter operating margins expanded 160 basis points when compared to the second quarter margins, and when you compare Q3 margins against Q1 margins, we’re up 490 basis points, so Pentair is indeed making good margin progress.

Relative to our adjusted EPS, our third quarter effective tax rate was 32%, which is the same as the second quarter and inline with our guidance. We continue to expect our full-year tax rate will be between 32% and 33%. Finally, we produced $103 million of free cash flow in Q3. Year-to-date we have generated over $200 million of free cash flow, approximately $95 million more than the first three quarters of 2008.

Now let’s turn to slide number three, which provides an overview of our Q3 water results. Here are the details: on the top of the slide we provided our standard sales and operating income loss. We will refer to these as we describe the performance of the Water Group. Overall, water sales declined $96 million to $462 million, or down 17% versus the third quarter last year and down 16% in local currency. As I mentioned earlier, this was inline with the sales guidance we provided in July.

Let’s review our business performance in water. Our flow technologies business was down 14% year-over-year. Growth in our municipal business, where we continue to have record backlog and nice order activity did not offset continued declines in US commercial and residential markets. However, we are maintaining our investments in global growth and new products, such as our VFD or Variable Frequency Drive controls to improve energy efficiency. So we expect Q4 to start to show better year-over-year comparables.

Filtration was down 21% as we continued to see declines in commercial, residential and industrial sales globally. However, we are seeing stabilization in U.S. Residential Filtration market, with industry shipments improving sequentially. It was our new product launches and growing systems capabilities that were positioning our filtrations business for growth in 2010.

Pool equipment was down 16% as the prolonged decline in North American residential new pool builds persists. Pentair pool equipment sales are essentially all going to satisfy after market replacement and upgrade demand as pool permits are down close to 80% to 90% versus three years ago.

Now let’s discuss our operating profits and margins for the Water Group. On the top right you can see our year-over-year operating income walk for water. Adjusted margins were 12.1%, up 80 basis points year-over-year. Margins came in essentially in-line with our guidance as productivity actions delivered meaningful results and more than offset the impact volume declines had on margins year-over-year.

Because of continued market weakness we instituted new restructuring actions in the quarter. The charge associated with this action is shown on the walk as the $3 million negative impact to op income, which is how you get to our reported operating income of $53 million. So despite the drop in sales, adjusted margins have increased year-over-year as a result of the aggressive cost actions we’ve taken. We expect to maintain this trend with respect to margins in the coming quarters.

Please turn to slide number four and let’s review Technical Products. Year-over-year, third quarter sales in Technical Products were down 32%. As I mentioned earlier, sales declined about five percentage points worse than we had anticipated. However, it is in-line with most of our major end markets, which are declining at rates at or about 30%. That said, we believe the markets have essentially bottomed out, and are relatively flat sequentially, which is demonstrated in our quarter-over-quarter sales volume.

Looking at the businesses within Technical Products, our Global Electrical markets declined 29%, while our global electronic sales declined 32% in local currencies. Technical Products adjusted margins were 14.4%, a decline of 180 basis points versus Q3 2008. Aggressive cost actions and followed execution on our restructuring efforts did not make up for the dramatic decline in sales year-over-year. That said, margins did improve sequentially over 240 basis points, despite the sales volumes that decreased modestly, so we’re delivering the sequential improvements we expected.

As in water, Technical Products took new restructuring actions in the quarter. The $5 million charge associated with those actions is shown on the walk, and covers the cost of the additional factories that we added to the planned shutdown that we mentioned in the July call. This helps you to reconcile to our reported operating income of $24 million.

Now, please turn to slide number five and let’s review some of the key takeaways from Q3. Starting with some of the pluses or positives we mentioned earlier, that we continue to see sequential improvements in the North American residential market. One highlight was that in August, our pool business had the first year-over-year increase in sell-through for any month in about three years. So while sales continue to decline for residential pools in the quarter, this is an indicator that positive comparisons are in the near term horizon.

We’ve already discussed our Q3 margins for both water and Technical Products, but obviously we believe each were positive in the quarter. In the quarter we announced the largest contract in Pentair’s history; a $65 million municipal pump order with the Army Corps of Engineers, to enhance flood controls for the City of New Orleans. The pump station is expected to be the largest in the world, with the bulk of revenues for us being generated in 2010 and 2011.

With the focus on stimulus spending, and the need for infrastructure investments globally, we expect orders to remain strong in our municipal water business. Another plus coming out of the third quarter was free cash flow, which as mentioned earlier was $95 million higher than our cash generation through three quarters of 2008.

The next few items are essentially neutral for Pentair. We expect the commercial and industrial markets to experience declines and certainly we saw that in the third quarter of 2009, so basically no blood versus our guidance. While Asia and Middle East markets generally have slowed earlier this year, we continue to see solid growth prospects for both water and technical products in those areas.

As for the minuses, it is a volume story. Third quarter sales missed the low end of our guidance, as Technical Products continues to experience more dramatic sales declines than anticipated. While we’re seeing slight sequential sales performance, we expected the business of sales to improve modestly, which is yet to occur. Overall, Q3 produced a balance of positive, neutral and negative items, which is not uncommon of course, but there are more positives than negatives and we remain encouraged that the things in our control remain positive to our results.

Let’s take a look at our total company productivity. Please turn to slide number six. Throughout the year we’ve discussed our major productivity actions. We wanted to provide the details, so you had an update on our expectations for each major action and their impact on our cost productivity. The upper half of the slide details, the $250 million of productivity we expect to generate for the full year by component. We’re on track to deliver these savings and we’ve already generated about $200 million to the first three quarters.

The final component is labeled volume. The total company sales expected to be down about 20% for the full year, or approximately $700 million. The negative $386 million is simply the amount of nonmaterial margin drop through that occurs if we had not taken the actions we did to adjust our cost structure.

The bottom half of the slide details the expected headcount reductions by the end of the year. Hourly headcount is expected to be down 14% by the end of this year, which is in addition to the 7% reduction we had already taken in the second half of last year. Salary headcount is expected to be down 9% and shown on the slides, you can see we had reduced our salary workforce by 5% in the second half of 2008. It’s a large drop since we started our major restructuring activities mid last year. In sum, there’s been significant progress on our cost actions, and the way they were done lays a nice foundation going forward.

Now please turn to slide number seven. This slide is also one of our standard update slides and it’s provided into the four quadrants we talked about before; cost out, driving free cash flow, positioning for growth, and our perspectives going forward. As previously detailed, we continue to execute against our cost actions. We knew 2009 would be a very difficult year and so far it has been. Only through solid execution on the cost side have we delivered on our targeted results.

We’ve completed most of our major facility closures. Furthermore, our cost actions are going to yield the $250 million of productivity we just showed you. Of that, we anticipate about $150 million to be permanent and we have reinforced our lien activities at each facility; all of which are focusing on their key deliverables of safety, quality, delivery, cost productivity, and cash flow.

Speaking of cash flow, moving down the left side of the side, our ability to generate significant free cash flow remains the focus for the company. We still have a tremendous opportunity of working capital, and we’re making progress; since year to-date we’re already $95 million ahead of the game.

Moving to the top right of the slide, it’s important to note that we remain energized about our long-term growth prospects in both water and Technical Products. While sales remain in decline for 2009, we continue to introduce new products, win key orders and position our businesses favorably for significant orders in the future.

Last quarter we highlighted the $65 million municipal pump contract with the corps. This quarter we highlight the fantastic work our pool business has done to gain share through energy efficiency pool pumps, and environmentally sound equipment via our Eco Select line of products. Eco Select products now represent over 30% of our pool sales.

As I mentioned earlier, our pool equipment sell through grew in August. The first month to demonstrate year-over-year sell through growth in three years, which coincidentally happened on the third anniversary of the beginning of the U.S. residential decline. Examples such as these highlight some of the investments we continue to make in innovation, sales, and marketing to position us for growth going forward.

The final section of the chart is labeled going forward. We will continue to execute against our cost actions and we’re implementing additional actions to increase productivity even more. As we drive working capital action, we’re confident we’ll deliver strong free cash flow, which will be used for dividends and to pay down debt.

Finally, we believe that with our innovation and market investments, Pentair’s positions take advantage of market opportunities as they emerge. We look forward to continuing to share that progress with you. By taking out costs today, driving free cash flow to investment tomorrow and developing new technologies and satisfying our customers every day, we will emerge stronger for the long term.

Before I hand it over to John, I’d like to review one final slide. So please turn to slide number eight. We maintained our EPS outlook for much of the year, but as this slide indicates, we’ve seen sales decline worse than we anticipated, particularly in Technical Products. However as we showed you, our execution on cost actions and our margin attainment have been very strong. As a result, we can maintain our guidance, excluding the additional restructuring.

John is going to cover our outlook in more detail, but I wanted to highlight that we continue to deliver on our commitment and that we’ve generally forecasted very well in a difficult environment. While sales have been worse than expected, especially in tech products, we expect to deliver more productivity, which will result in the anticipated margins and EPS results.

Now I’ll hand it over to John, who will provide additional details on our financials and also discuss our full year 2009 outlook in more detail. John.

John Stauch

Thanks Randy. Please turn to slide number nine. This slide is divided into three sections. The top section reflects the GAAP or reported earnings per share for Q3 year-to-date 2009 and our Q4 and full year outlook for EPS. The middle section details the adjustment from GAAP to the adjusted earnings per share for those periods. At the bottom of this slide we provide 2008 reported and adjusted EPS results for comparison purposes.

Starting with the first column labeled Q3 ‘09 actual, our GAAP reported earnings per share were $0.38. Included in this result was $0.04 of EPS for severance costs and other charges, as we took new actions in Q3 2009 to eliminate 275 positions not included in our prior restructurings. The majority of these actions were related to the finalization of our plant moves and our water businesses, the announced closure but additional factory in technical products, and incremental down sizing of technical products related to Western Europe.

When moving the impact of these costs, you get to the $0.42 of adjusted earnings per share for Q3 2009. The $0.42 is down 25% versus the $0.56 earned in the third quarter of 2008. Please shift one column to the right, which provides similar detail regarding our year-to-date results.

Rather than walk through the numbers, I’d simply point out that we now have a $0.12 delta between our reported year-to-date EPS of $0.88 and our adjusted EPS of $1. We mentioned earlier that we were expecting a favorable result from a tax audit, we still are, but we are now expecting that benefit could be early 2010, instead of the previous expectation of Q3 or Q4, 2009.

The following two columns represent our Q4 and full year 2009 outlook, in the same reconciliation format. As you can see, the bulk of our restructuring charges are behind us. While there’ll still be minor work left to do, the cost related to our 18 facilities, combined with our move to six global business units is predominantly done. We are forecasting about $0.03 of restructuring charges in Q4.

The absence of our previously expected tax benefit is shown as a TBD as the timing is still little unpredictable. So our adjusted Q4 EPS guidance is $0.40 to $0.44, which is basically flat to up modestly versus Q4 of last year. For the full year, we expect adjusted EPS to be $1.40 to $1.44, which is down approximately 35% for the year.

Please turn to slide number 10. The upper left section of the slide outlines the major components of cash flow for the third quarter and the year-over-year detail. In the quarter, we generated $103 million in free cash flow. Working capital management delivered almost $31 million of cash flow in the quarter, which was over $19 million more than working capital generated in the third quarter of 2008.

Similar to our execution around cost takeout, we are focused on free cash flow. We continue to make nice progress, leveraging our disciplined lien efforts and feel very good about our year-to-date cash position of $202 million for the first three quarters of 2009. You may notice the large negative other in 2008. I want to remind you that most of that with our litigation settlement for Verizon that occurred in Q3 of last year.

As we discussed all year, our cash usage objective has been to reduce debt. Shown on the bottom left side, you can see we remain on target to lower our debt to around $800 million by year-end. In fact, we are currently at $815 million of debt through the third quarter.

Overall, our average interest rate is 4.3%, only around 10 basis points higher than Q2. This represents a mixture of LIBOR plus 625 variable rate debts, along with fixed rate debt of approximately 5.5%. So we remain very comfortable with our debt position and going forward, we expect to increase our EBITDA, which will provide additional flexibility with respect to cash usage.

Please turn to slide number 11, and let’s discuss full year free cash flow and our securitization program. Similar to other companies, Pentair has historically maintained a practice of entering into a receivables securitization program. For Pentair, this occurred each year in the fourth quarter.

The program was put in place to mitigate risk associated with the concentrated set of specific customer receivables. The cost of this program has varied, but between insurance and discounting, the total cost has been around 1% to 2% of the total receivables sold, sold fairly modest. I’d also mention that management is not incentivise on the securitization of receivables.

As we indicate on the lower left side of the chart, the amount of securitization has varied slightly from year-to-year since 2006. Originally, when we estimated our full year free cash flow of $225 million, we forecasted approximately $50 million of securitization, similar to previous years.

However, our Q4 receivables balance and not the risk, is expected to be less this year and the overall cost to this program is higher. Therefore, at this time we are not expecting the securitized receivables in Q4. Assuming we do not participate, we are maintaining our free cash flow forecast to meet or exceed $225 million, given our year-to-date generation is already $202 million.

The reason for this detail is to highlight that our year-end debt position will likely be $50 million less than originally expected, since many rating agencies include securitizations in their outstanding debt calculation. Additionally, we are maintaining our free cash flow forecast at $225 million with this assumption in mind, which is why we’re not raising our full year number.

Please turn to slide number 12, and let’s review our fourth quarter 2009 outlook. This is an overview of our Q4 2009 market forecast. About 65% of our sales are related to U.S. markets. As we head into Q4, our clearest information is related to sequential indicators, since we can analyze current order trends and compare them versus the last several months. At this time, as we look at market and order trends versus the just completed third quarter, it appears most of our major end markets are improving modestly. The loan exception is commercial, which continues to weaken as the backlog of projects shrinks.

As a reminder for Pentair, North American commercial water revenues around $150 million annually, and commercial revenue and Technical Products related to buildings is approximately $50 million annually. In all other North American markets, things are stabilizing, and improving very modestly, with six week order trends improving at all market segments, including the normal impact of seasonality, which means they are actually improving more than the sequential benefit we’re actually seeing.

For Western Europe, markets appear to parallel the U.S. markets, as we are seeing similar trends. We anticipate orders and sales in December will once again moderate for the holidays. In our faster growth markets like China, we have seen a sharp recovery when compared to the initial decrease caused by the global recession, and our low penetration and new product launches in the Middle East and India continue to give us confidence that we will grow in those markets even if things remain unpredictable.

Please turn to slide number 13 and let’s look at our Q4 forecast. For Q4 we expect revenue to be between $655 million and $670 million, down about 14% year-over-year, and approximately flat with Q3 of 2009. We expect water revenue to be around 10% to 12% down year-over-year, but a sequential improvement from the 17% decline in Q3.

We expect Technical Products to be down around 18% to 20% year-over-year. You may remember that Q4 2008 was the first quarter that turned negative in Technical Products, so definitely some easier comparisons year-over-year in Q4. Additionally, we expect Technical Products revenue to increase versus Q3, which will be the first sequential upturn in revenue since mid 2008. So once again, we believe that the Technical Products markets have bottomed.

Adjusting operating income is expected to be between $72 million and $77 million, which will produce overall Pentair operating margins of around 11%, up around 170 basis points year-over-year. We expect water margins to remain around 12%, up about 180 basis points year-over-year, and Technical Products margins to be about 15%, up 170 to 190 basis points year-over-year. All evidence of our cost out actions, and provides additional optimism, that when the top line begins to grow, that we will see the conversion we have positioned the company to achieve.

Adjusted EPS is previously mentioned as expected to be between $0.40 to $0.44 per share, essentially flat to up modestly year-over-year. We expect our tax rate to be around 32% to 33%, our Q4 interest expense to be around $9 million, and expect our share count to creep up to about 98.9 million shares outstanding. Finally, we expect cash flow to be approximately $25 million for Q4, without any securitization.

Please turn to slide number 14. Here is our expectation for the full year. Our total company, full year sales outlook remains $2.7 billion or down about 20%. Our operating income will be around $255 million and our operating margins around 9.6%. We have proven through three quarters, that our cost actions will yield significant 2009 and 2010 savings. Currently, we are forecasting $250 million in productivity savings in 2009 and we are seeing the benefit from material that we expected.

We are maintaining our adjusted EPS guidance of $1.40 plus and with just one more quarter to go, we have introduced a high end of $1.44. We continue to see signs of stabilization and even some pockets of improvement, but it’s too early to determine meaningful trends for 2010, and we will provide you with a 2010 outlook on the fourth quarter earnings call.

In summary, we executed against our major actions very well again in the third quarter, but markets remain challenging. We took additional actions, which were necessary to provide support to our full year outlook and improve our ROIC going forward. We also feel good about our cash generation, and our ability to expand EBITDA next year will give us the flexibility in our balance sheet we used to enjoy, and that we want to have at our disposal for 2010 and beyond.

We now like to answer any questions you might have. Operator, please open the lines for questions. Thank you.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Hamzah Mazari.

Hamzah Mazari - Credit Suisse

Thank you. Could you give us some color on what you are seeing with the inventory in your distribution channel? On the filtration product side, you commented on some de-stocking and some market softness there, as well as on the technical product side, on the electrical side, could you give us a sense of where we are in the de-stocking process? What you’re seeing in the channel?

Randy Hogan

I mean, I think consistent with what you’re hearing from other companies out there, inventories are low. I mean as a general rule of thumb, where we have been able to see our sell through, where we have very clear visibility between our customers and the end markets, our sell through is generally mirroring or is a little greater than what our sell to the distributors has been.

So, I think that would confirm what you’re hearing from everybody else, that distributor levels are low and the nature of the order is still reflected. A non-stocking order usually is smaller than most skews are, and we are still seeing a lot, a higher portion of those kind of orders. So I don’t think that the restocking, to whatever extent it will happen, has really begun at all.

Hamzah Mazari - Credit Suisse

Just a follow-up, on the technical product side, you talked about sales coming in worse than expected. Is it fair to say that you saw end markets within Technical Products get worse during the quarter, but now we’re running sequentially flat and then is that fair, one; and then could you give some more detail on end markets within Technical Products. For example, last quarter you said datacom was down 50%, has that gotten worse and could you give us some detail on what the industrial side is running and the electrical side as well?

John Stauch

I’ll take the first part and I’ll hand it over to Randy for the color on the vertical marks. Really, what we saw in technical products for Q2 to Q3 was a modest decrease, $207 million down to $202 million. What caused the disappointment was we had assumed that sequentially Q2 was the bottom and that we would see a pickup heading into Q3; that in fact did not happen.

The year-over-year our growth rates for Q2 and Q3 in Technical Products were generally the same, down 32 and down 32. So I think it was more hope that we would see recovery quicker than we have and I think when we look at the way we’re exiting September and heading into early October, we feel comfortable we’ll see sequential growth from Q3 to Q4.

Randy Hogan

In terms of what we’re seeing in the vertical market, addressing specifically datacom. Datacom, we had another rough quarter and sales was down year-over-year about 48%, and part of that was timing when the ordered one of our larger orders that just basically got pushed out. It’s not a loss of a job, just the volume decline and we expect that volume will be better in the fourth quarter on that particular job.

When we look across all the markets, they all look down and that part reinforces the de-stocking, right? I mean because they’re not all down, but the ones that look best right now are not surprisingly the ones that are serving the public sector. Institutions, water actually is one of the brighter spots, and on the electrical side, and then on the electronics side, security, military, medical are the best. Still down for us year-over-year, but down modestly.

Hamzah Mazari - Credit Suisse

Thank you very much. I appreciate it.

Randy Hogan

Your welcome.

Operator

Your next question comes from the line of Mike Schneider.

Mike Schneider - Robert W. Baird

Just thinking of Technical Products for a minute, so the push out of the major project you said from Q3 out, is that why you have confidence now in making the call that indeed volumes will be $10 million better in Q4?

Randy Hogan

Well, it’s really when we looked at second going into third, the business felt good, as we look at third going into fourth, the data looks better. That’s why we feel better.

Mike Schneider - Robert W. Baird

Is the project push out, the large food and beverage order that you spoke to earlier this summer?

Randy Hogan

No, it was Datacom, actually in Asia.

Mike Schneider - Robert W. Baird

Then just switching to water, so filtration is really the only business that seems to have sequentially deteriorated. Can you just drill down into that either by market or by brand, and just give us some insight as to still what’s getting worse within there? Is it all ever pure or is there more going on?

Randy Hogan

If you take a look at the net filtration businesses, it’s a modest decrease. The point I made in my comments Mike is, historically Q2 is our best quarter, and we see a seasonal downturn in Q3 and Q4. The fact that we’re actually staying fairly steady, tells you the markets are improving, but the normal seasonality is working against it.

Then the other insight there would be Europe. I mean Europe, our core filtration was weaker, and part of that is the natural summer months we experience and we had seen some recovery here in September and October. Filtration is our global business in water and to John’s point, Europe. Europe, I think we’re continuing to see de-stocking in the third quarter and the distribution channel.

To your point on Everpure actually, Everpure has a lot of momentum going for it. I think we’re actually going to be seeing growth from them. It may be shared, but we’ve had a number of good wins. What’s interesting is it’s a global business, but if you just take a look at its largest market, which is the U.S, the food service industry, as far back as we can see, 17 years at least, this is the first time that there’s been a decline in the number of restaurants in America in the last 17 years. It has been that drawback, and we think that is over. We think if a restaurant has gotten this far, it’s probably going to make it through, so we’re beginning to see an increase in activity.

So I think it’s interesting, because you think about our water business, only about 13% of our sales are commercial, and it’s really split between new construction, which is the flow side, and then Everpure, the food service side. So, we think actually in that part of commercial, we’re probably bottomed out and we’re beyond the bottom. So I feel pretty good about Everpure.

John Stauch

Mike, just a follow-up, the combined filtration businesses were down $3 million from Q2 to Q3. If you take out the benefit of the acquisition last year, they were down nine sequentially from Q2 to Q3, so just not sure if you had that information. I just wanted to make sure you had it.

Mike Schneider - Robert W. Baird

Okay, and could you give us an update just on the joint venture now with the GE residential products? Kind of where are you in the combination of the businesses? What’s gone better than expected in the first few quarters? What’s not up to your expectations? We just haven’t heard much about it.

Randy Hogan

Well, volume has been the biggest disappointment, right? I mean the fact that the residential market fell even further. Just to backup, when we put these businesses together, it was to get into position to win even bigger when residential the market recovers. This additional step down has complicated things. So we really would like some more volume in there.

I think that the radical combination and the shutdown of the factories have gone about according (Inaudible). We’re done with the major shutdowns. We’re now improving our delivery, improving our touch with customers so that we can grow going forward. The thing that’s gone better frankly is the innovation, and I’m really excited about a number of the things we’re doing, both in terms of what we’re doing with the channels and the distribution, but also in terms of the new products we have coming in point of use and even on the point of entry. So that’s how I assess it right now.

Mike Schneider - Robert W. Baird

Okay and then John, just specific on corporate expense or unallocated expense, if you pick a part of this segment guidance for Q4, then the annual, it looks like you’re anticipating that corporate expense line to go from what was about a $10 million or $11 million run rate, possibly as high as $15 million in Q4, and I realize that’s the plug and there maybe some cushion built in there, but is there anything unusual coming in Q4, in that line item to explain the jump?

John Stauch

The only incremental unusual as we go from Q3, Q4, is we intend to adjust our year-to-date insurance rates and we have some incremental stock option expense based upon wherever the stock is trading at, and then there’s some hope on some potential business mix that we’ve accrued for in the next couple of months.

Mike Schneider - Robert W. Baird

Okay, and final question just slide six, where you go through total company productivity, John you laid out that volume is a $386 million decrement in this stair step on a $700 million decline. Can you just give us, I guess the implications of that 55% decremental impact of volume? Is that what you modeled now on the way up, and is that the type of incremental margins we should be expecting at least early in the recovery before you start adding headcount and fixed overhead?

Randy Hogan

I mean it works easier as you know on the way down than it does on the way up. The way we’re modeling it there, as you see in the impact of sales minus materials and material for us is called roughly 40% of sales, and then what we’ve been able to do on the way down is to take variable labor out at a rate slightly higher than what the volume decline has been. We feel very confident that we won’t have to add the labor in at the same rate of the growth. So there should be some incremental, some will comeback obviously.

John Stauch

Mike, this is John. I’d remind you too; we talked in fair detail about this last quarter, that Q2 versus Q1 sequentially showed growth, and that sequential conversion was around 45%. We said at the time a decent indicator, because we think sequential is important as year-over-year in this environment, is as least a decent indicator of probably a really strong drop through.

Randy Hogan

The difference is basically material, plus sales commissions, plus variable labor is kind of how it gets.

John Stauch

Mike just to follow-up, I mean I think 35% to 40% is a reasonable expectation of the growth and the reason I would hedge a little bit on what we lost on the way down is the question of where the mix will be. So not all our revenue is as profitable as other components and I feel good about 35% to 40% as we look forward in 2010; and then as our investments kick in, it probably begins to compress to more of a 30% conversion going forward.

Mike Schneider - Robert W. Baird

Got it, thanks again.

Randy Hogan

Thank you.

Operator

Your next question comes from the line of Christopher Glynn.

Christopher Glynn - Oppenheimer & Co.

Thanks, good morning.

Randy Hogan

Good morning, Chris.

Christopher Glynn - Oppenheimer & Co.

So just reconciling some of the directional pieces in the water margin. Randy, you had kind of a broader comment that maintained the trend of improvement in coming quarters, I’m initially taking that as a sequential comment, but you have some incremental restructuring here in the second half, maybe raw deflation has a little further to go. How far out do you think we are from getting to the point where it sequentially is just more strictly the volume levers that we think about?

Randy Hogan

I mean we’re going to probably have our highest margin quarter in what tends to be one of our weakest water quarters. So I think that’s where we feel confident that when you get to Q2, which is our best quarter, we’re going to see the benefit of this cost reduction in a significantly larger way; that would be my general outlook on this.

The second quarter is always the peak and if we look, there’s a margin being in the fourth quarter, and it’s going to be nominal, and I think we will see water at its wholesome best in the second quarter.

Christopher Glynn - Oppenheimer & Co.

Okay and John, your comments about seeing the operating margin being the highest in one of your traditional weakest quarters. Were you referring to the quarter you just reported?

John Stauch

Q4 is traditionally for water.

Randy Hogan

Seasonally fourth quarter is generally a lower volumes season and quarter two and three are just seasonality.

Christopher Glynn - Oppenheimer & Co.

Okay, then just wondering if you know anything about the stimulus opportunity that you didn’t know a month or two ago?

John Stauch

It’s really the same thing. I mean the activity is picking up in terms of discussion and we still have a couple of million dollars that we’ve won. Obviously we want to win a lot more than that. We didn’t think a lot was going to be left this year, but we expect a lot more will be left next year and hopefully in the first quarter.

Christopher Glynn - Oppenheimer & Co.

I know you had some tangible comments on the water side, but thought that Tech Products played there, too anything more tangible?

John Stauch

Yes, I mean the thing is and that’s one of the big focuses for our Hoffman line of products and distribution. Enclosures are ubiquitous, they’re used everywhere. If there is a capital dollar spent, there is an enclosure sold, and so the business is all over making sure the distributors are using the same data as we’re using on the water side in terms of chasing down the opportunities that are there.

I saw last week one of our panel builders who is actually the biggest businesses in water and they’re actually seeing growth right now, and they’re 100% Hoffman. So that’s what I meant when I said Technical Products going after (Inaudible)

Christopher Glynn - Oppenheimer & Co.

Great. Thanks for the help.

John Stauch

Thank you.

Operator

The next question comes from the line of Michael Cox.

Michael Cox – Piper Jaffray & Co.

Good morning and congratulations on the quarter again. My first question is, the SG&A in the quarter did increased sequentially despite the drop in sales sequentially and I understand part of that probably is from the restructuring, but I just wondering if you could provide a little more color on the sequential change?

John Stauch

On the reported side you are seeing the restructuring in there. If you take a look at SG&A on an adjusted basis, it was up about $2 million to $3 million and the Delta would be primarily some bad debt expense that we accrued, and we have a pretty standard policy on bad debt and when customers go past 180, past due we accrue, and that’s what are you going to see is the Delta.

Michael Cox – Piper Jaffray & Co.

Okay, that’s helpful. Then on the gross margin side, it is the first time we’ve seen above 30% for a year now, and I guess I would be curious as to whether these structural changes have been made that will allow to you maintain that even in perhaps a seasonally slower quarter here over the next couple of quarters.

John Stauch

The biggest drop in that is finally seeing the material improvement, and when you take a look at Q3, we’re a couple hundred basis points better than we were in materials, as a percentage of sales a year ago, that is the help. I mean we have seen it, but because of the way we have thrown in the standards and leasing not standards, it was about six months in arrears and we’re starting to see the benefit of the materials start to flow through. So yes, we would expect to sustain it into Q4.

Michael Cox – Piper Jaffray & Co.

Okay, and then my last question is just in terms of your sales projections for the fourth quarter, and I guess if you’re looking at early in 2010, what have you imbedded for 4X, perhaps a benefit relative to last year?

John Stauch

It’s interesting, as you pointed out, foreign exchange is actually positive in Q4 for the first time for the year. So for us if you take a look at Q3 year-over-year versus Q4 year-over-year, that’s about a 3% benefit sequentially.

Michael Cox – Piper Jaffray & Co.

Okay great. Thank you very much.

John Stauch

Thank you.

Operator

Your next question comes from the line of Shannon O’Callaghan.

Shannon O’Callaghan – Barclays Capital

Good morning, guys. Just on the Tech Products margins, longer term here, you guys have slowed this slide back at your Investor Day with sort of the errors of Tech Products and the future looked like kind of like 13 to 17, but it looks like you are all going to be at 15 in a horrible market in 4Q. I mean, is that range intended that way or do you see potential upside of that based on what you’ve seen happen here this year?

John Stauch

Yes, I’m very pleased with the margins. I’m disappointed that the sales went down as much, but it’s a business and it’s pretty attractive, even at the bottom of the cycle, which is where we think we are today. Q4 by the way is 15%, for the full year 13%, which is actually the goal we set for the business at the beginning.

So that’s kind consistent with where we thought they would be. The 15% in the fourth quarter, we thought they would be close to that on higher sales. So, the fact that they’re there on a little bit lower sales is better.

I would tell you that at the peak in this business, I wouldn’t say that the margins need to be higher. What I want this business to do is grow more aggressively globally and I would like to invest and continue to invest in that business to do it. I think our global opportunities in this business are enormous, absolutely enormous. So if you think about 13 being the bottom, and 20’ish plus the top, pretty nice business, particularly if we globalize.

Shannon O’Callaghan - Barclays Capital

Okay, and then how do you feel about where you’ve set the cost structure here, in terms of if things come back quicker than you think? I mean, where is that threshold where you do have to bring a significant amount of costs back, do you think? What kind of sales growth would you need to see before you need to bring some costs back into the system?

John Stauch

I’ll take the first half and then I’ll have Randy conclude. I think clearly we have capacity in all of our factories. If you look at our shifts, and if you look at the way we took out labor, we have very little temporary labor, which we intend to have to handle the seasonal up ticks.

So our capacity in our factories is pretty set for a sizable upturn here, where we would be challenged, like other companies would be challenged, is in our material supply, and we’re doing everything we can in the areas that we think we’re going to grow to make sure that our suppliers are prepared and ready, and that we have insights into our channels, and to our customers’ customers, to make sure that we’ve got demand, if it picks up quickly back to our supply base.

Randy Hogan

Yes, I think, I’m not concerned about factories. We have a couple of flexes; first of all, we virtually have nobody on overtime, and if we have overtime, we have temporaries and of course we can add shifts. So inside our factories, I think we’ve got a pretty good idea of what we will do. So the challenge, the real key is to make sure our suppliers are ready to go too. So there’s a lot of discussion and activity around that.

Shannon O’Callaghan - Barclays Capital

Alright, and then just last one is, talking about the EBITDA increasing and getting the debt levels down. I mean what’s the future thought, when you get to some target level? What is that level? What do you start doing with your cash at that point? I mean what’s the M&A world look like and what are you think?

Randy Hogan

Well, it will be to fund growth. I’m particularly pleased that we’ve maintained our dividend increases through this period and we’re paying down debt. We want to fund growth too, and that growth could be M&A or it could be organic in terms of putting capital to work in new product innovation, or to help us globalize.

So in terms of M&A, it’s beginning to pick up a little bit, nothing is happening yet, but on the water side, people still think things are worth more than we might think they are. On the Tech Product side, we haven’t seen anything of real interest.

Shannon O’Callaghan - Barclays Capital

So when do you hit that point? I mean can we think of M&A as sort of off the table for you guys for now and when does that change or…?

Randy Hogan

No, I wouldn’t say it’s off. I mean right now we’re still focused on a couple of things; one is to help us globalize. So we’re looking at that in terms of expansion and capability, and that’s true in both businesses.

Now in the case of Tech Products, we tended to do organically. We just built a new factory that we started this year in India, and we’ve expanded the factory in China, and I still see some possibilities for water in Asia.

So for us, it would be bolt-on's in geography and technology, and if we can’t do that, we’ll maybe turn back some stock again. That’s kind of the way we look at it, what can we do on the organic side, what can we do on the acquisition side and then what do we do with extra cash as well.

Shannon O’Callaghan - Barclays Capital

Okay, thanks guys.

Randy Hogan

We’ll be in a good position to deal with it next year, so that will be a nice position to be in.

Shannon O’Callaghan - Barclays Capital

Sounds good. Thanks guys.

Randy Hogan

Thank you.

Operator

Your next question comes from the line of Jeff Hammond.

Jeff Hammond - KeyBanc Capital Markets

Hi, good morning, guys.

Randy Hogan

Good morning.

Jeff Hammond - KeyBanc Capital Markets

I just want to understand a little bit better the moving pieces within water, because you’re taking down your second half revs by about $15 million, and yet you’re speaking about continuing to see signs of improving North America residential. So can you just tell me what the offsets are and maybe give me a little bit better color on what you’re exactly seeing in the North America revs water that makes you feel better?

Randy Hogan

One is, we are in the residential business in Europe and we are in the residential business in Asia, and both softened from what we thought they would be. So the comment about North America is not inconsistent with the data, because the additional softening wasn’t North America so much, it was Europe being lower than we thought it would be.

Actually as I mentioned, Asia slowed down for us. Now, we see it coming back, but it was slower than we would have liked. So those are the keys there, and we look at the U.S., we think the U.S. residential will continue to modestly improve.

Jeff Hammond - KeyBanc Capital Markets

Where are you exactly seeing improvement, actually in your shipments or in order rates, or is there…?

John Stauch

In order rates …

Randy Hogan

Order rates and sell through at distribution.

John Stauch

Here is where we’re challenged. If you take a look at last year, and you can go back and historically take a look at this, and last year had a little Tech Products correction, but generally we’re down $100 million from Q3 to Q4 in total Pentair revenue, and majority of that is the seasonality of our pool business and the residential businesses, which don’t have a strong winter here in North America, or in those areas that experience winter.

What we’re seeing this year is actually increase from Q3 to Q4 on the residential businesses, and that’s where I was mentioning that the seasonality year-over-year is being offset by the sequential up-ticks in those order rates and those sales.

Jeff Hammond - KeyBanc Capital Markets

Okay, that’s helpful. Then, I know you’re not prepared to give any color really on 2010 guidance, but can you give us a sense of, based on all of the restructuring actions you’ve taken, what you think your incremental cost savings are in 2010, and then as you look at this $100 million of cost savings as temporary, based on the trajectory of your business, how much do you think of that comes back?

John Stauch

Well, I mean we said that we were going after and felt that we were going to get 300 in the aggregate between 2009 and 2010, and all of our analysis confirms that. So 250 realized this year, 50 carry over to the next year. There is some headwinds, things like merit increases and some of the short term things we did, and I would say offsetting that is a little bit better feeling than material right now. So, I still feel comfortable with everything we shared earlier of 300 in total, which is 250 this year, and an incremental 50 next year.

Jeff Hammond - KeyBanc Capital Markets

Any temporary costs comeback, you make up with productivity?

John Stauch

I think we make up with incremental material.

Jeff Hammond - KeyBanc Capital Markets

Okay, and just a clarification on Tech Products. I think you mentioned in an earlier question there was maybe a project that got deferred or pushed. Is there a way to quantify that? Is that really just going from Q3 to Q4?

Randy Hogan

Well and in the next year or two. I don’t know the specific numbers. It was a hole in the third quarter. Basically, it’s a large project that the customer in Asia pushed it out.

Jeff Hammond - KeyBanc Capital Markets

Is it more that some of that comes back in the fourth quarter that gives you confidence; you go from the low twos to 210?

Randy Hogan

Yes, we think their receipts. Our sales to them will be higher in the fourth quarter.

Jeff Hammond - KeyBanc Capital Markets

Okay, and then underlying order activity, September and October is a little bit better to support it as well?

Randy Hogan

Yes.

Jeff Hammond - KeyBanc Capital Markets

Okay, thanks.

Operator

Your next question comes from the line of Brian Drab.

Brian Drab - William Blair & Co.

Good morning. I just have a couple quick questions at this point.

Randy Hogan

Hi, Brian.

Brian Drab - William Blair & Co.

Hi. First of all on the pool market, can you give us a little more color there and some of the key indicators you’re looking at, permits and how you think the 2010 season is going to shape up?

John Stauch

Well, we haven’t really focused on the 2010 season right now, but it can’t be worse, it’s got to be better, and when you basically have no new things being built. Well, early by the signs. The best thing right now is if you go several years back, there were supplier pull aheads and you saw people doing things to shape demand, most of that because of credit and distributor needs have shaken out of the system. So what we’re seeing is generally a normal season now, and a sell through consistent with where our orders and sales are.

So I think we feel like there’s not extra stock in the channel, and as we head into next year, pool permits from this point as Randy said in his notes, 80% to 90% down versus where they were at peak. So pretty strong after market demand and new housing builds will drive a little bit better pool permit sales, so net-net I mean right now if we had to make a call, I think pool feels like it could be slightly up next year, but I mean that could change.

Brian Drab - William Blair & Co.

Okay great, and just one other question; on the Technical Products side, just really strong margin performance, given sales were down over 30%. Can you give us any more resolution in terms of margins between the electrical and electronics business and the trends you’re seeing? Is one sub segment trending better than the other?

Randy Hogan

We’ve always sort of said the electrical and electronics are the tale of two cities. Electrical is highly, highly profitable; electronics is thinner margins. They both benefited though. I mean both margins improved because the big lift in the third quarter was material. We finally were getting materials readout that we knew was coming and arrived fully in the third quarter. So they both benefited from the material productivity.

Brian Drab - William Blair & Co.

More clearly talking about steel when you’re talking about material primarily?

Randy Hogan

Primarily, yes.

John Stauch

They also did a great job of reacting to the demand early and taking out the variable portions of the manufacturing side.

Randy Hogan

Yes.

Brian Drab - William Blair & Co.

Okay. Great. That’s all I’ve got. Thanks.

Randy Hogan

Thank you.

Todd Gleason

Darla, this is Todd. I’m just noting that we’re getting close to the end of our hour. If there is anyone left in the queue we certainly want to get to them, if not we will wrap up.

Operator

Yes, you have a question from the line of Scott Graham.

Scott Graham – Landenburg Thalmann

Hey, good morning.

John Stauch

Hey, Scott.

Randy Hogan

Good morning.

Scott Graham – Landenburg Thalmann

If we can put aside the $30 million, $ 40 million, $50 million worth of raw materials benefits that’s part of your overall $300 plus million plan, and just sort of focus on spot rates of materials right now; John, you indicated that you were actually more optimistic about the ability to capture some raw material benefits next year. Could you tell us why that would be with raw materials sequentially rising now, is that a manufacturing, engineering thing or…?

John Stauch

Because we measure it like any company would measure, the gross pipeline going in and results coming out, and what Randy and I and our Chief Operating Officer Mike Schrock heard for sometime is that the gross going in are better, and quite frankly we’re now finally seeing it.

So when we look at the material percentage of sales and the improvement we’re seeing in that line, that’s all in. That’s price, that’s mix, and that’s the commodity savings, and that’s what we really care about is; what’s the benefit to Pentair and we’re capturing it. That’s why we feel more confident.

Scott Graham – Landenburg Thalmann

So you feel a big part this is like you’re using less.

John Stauch

Well, it is more that the promises of where these savings are coming from are finding their way into the P&L.

Randy Hogan

Essentially we’re FIFO. We’ve seen it on the books, but we haven’t seen it in the P&L. It was in inventory, with better costs and that even if costs go up, we will still have a better cost in inventory for a while. Plus depending on whether we go, how long out we go, on materials or not, we can lock in and right now, I think we’re in pretty good shape.

Scott Graham – Landenburg Thalmann

Okay. So on the materials for the third quarter, the gross margin rose. Was that solely from materials or was there some other restructuring involved there, net of the volume decline? Could you maybe give us a couple of buckets on that?

John Stauch

Sure, I mean material as I mentioned earlier was roughly 200 basis points plus of improvement, and the gross margin has actually improved 150. Now I cautioned you that labor was a sizable benefit as well, and the thing that gets squeezed is the fixed costs as the revenue comes down, so that’s kind of the component.

A really productive job on reducing labor rates, which came down almost 100 basis points as a percentage of sales materials, better than 200 basis points, and the other offset would be the squeeze on the fixed manufacturing costs.

Scott Graham – Landenburg Thalmann

Okay, so because of the way you’re handling materials internally, not to say that the 200 basis points is a sustainable number, but even though materials prices across the board are sequentially higher, you can still derive benefit from materials nevertheless.

John Stauch

Yes.

Scott Graham – Landenburg Thalmann

Okay. Good.

John Stauch

We will know when that time ends. We will be able to talk about it.

Scott Graham – Landenburg Thalmann

So it is not like you need to go out and announce a price increase in weak conditions to offset. Okay very good.

The next question was really just about the municipal business, and obviously I know you guys have high hopes for this business. I was just wondering how you guys are marketing the New Orleans win to municipalities in the state, and even internationally and what kind of traction are you seeing on that?

John Stauch

It is a high visibility job and certainly our sales force is talking to it, about wherever they can and we’re not doing any kind of advertising with it. It’s a highly technical sale and it’s about specification. So you want to make sure that the engineering firms, the CH2M HILLS and the Black & Veatches, and the CDM’s and all are aware of it, and Mitsubishi and DOLSAN and making sure that the high fluxes, that the folks in Asia as know about it. So that is primarily what we’re doing.

Our main focus on that job is execution right now, and we’re off to a good start. There’s still a lot going on, and there’s no shipments, but there’s a lot of engineering going on. There is a lot of testing.

Scott Graham - Landenburg, Thalmann

That’s all I had. Thanks.

Randy Hogan

Thank you.

John Stauch

Anybody else in the queue?

Operator

Yes, we have a question from John Quealy.

Randy Hogan

John?

Chip Moore - Canaccord Adams

Good morning, thanks. This is Chip Moore for John. I’m just wondering if you could give us a little more color on free cash flow moving forward. You made reference to having some more to do on working capital. If you could quantify how much more you think you can get there, and then on CapEx, how we should be thinking about that. If you expect that to hold steady I guess at current levels. Thanks.

John Stauch

Yes, I’ll answer CapEx first. I mean I think we have been pretty active moving factories, and anytime you move a factory, there’s a higher level of capital expenditures than you would like. Especially with moving it to places like China, where you’re not really allowed to import the equipment, but you generally have to buy new. So we think that CapEx let’s say stays flat kind of from Q3 levels into Q4.

On the working capital side, we’ve done a good job taking out working capital as the revenues come down, and what we’ve really benefited for in the drop in revenue, that’s been the working capital benefit. I think we can do better around our improvement in the processes, again primarily around the fact that the plant moves are behind us and now we don’t need the type of safety stock and double counting of inventory that our plants like to have to protect themselves against customers.

So I’ve seen an opportunity in the inventory. We have instituted in a series of payment term increases and payables at the starting to see the benefit up, and I expect that more of that in Q4, and then if we get more global, we’re seeing some leakage in the receivable base. So we’re looking at the inventory and payables offset the globalization of our receivable base. That’s where I see the opportunities.

Chip Moore - Canaccord Adams

Great, thanks.

John Stauch

Thank you. Okay Darla, do we have anyone else in the queue or…?

Operator

There is no one else in queue. You may proceed with closing remarks.

John Stauch

Thank you. Thank you all for listening. We’ll be around for further questions if there are any, and this is the end of the call, could you give directions on the recording?

Operator

Certainly. Thank you for participating in today’s Pentair Q3 2009 earnings conference call. This call will be available for replay beginning at 12:00 pm Eastern Time today, through 11:59 pm Eastern Time, on Friday November 20, 2009.

The conference ID number for the replay is 33555056. Again, the conference ID number for the replay is 33555056. The number to dial-in for the replay is 1800-642-1687 or 1706-645-9291. Once again, 1800-642-1687, or 1706-645-9291. This conclude today’s conference call. You may now disconnect.

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