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Pentair (NYSE:PNR)

Q1 2014 Results Earnings Conference Call

April 22, 2014, 9:00 a.m. ET

Executives

James Lucas - Vice President of Investor Relations

Randall Hogan - Chairman, Chief Executive Officer

John Stauch - Chief Financial Officer

Analysts

Mike Halloran - Robert Baird

Deane Dray - Citi Research

Steven Winoker - Sanford C. Bernstein

Shannon O’Callaghan - Nomura

Steve Tusa - JPMorgan Chase

Joshua Pokrzywinski - MKM Partners

Andrew Obin - Bank of America Merrill Lynch

Scott Graham - Jefferies & Company

Jeffrey Hammond - KeyBanc Capital Markets

Brian Konigsberg - Vertical Research Partners

Nathan Jones - Stifel Nicolaus

Hamzah Mazari - Credit Suisse

Operator

At this time, I would like to welcome everyone to the Pentair Q1 2014 earnings conference call. [Operator Instructions] Thank you. Mr. Lucas, you may begin your conference.

James Lucas

Thanks, operator, and welcome to Pentair's first quarter 2014 earnings conference call. We're glad you could join us. I am Jim Lucas, vice president of investor relations, and 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 first quarter 2014 performance, as well as our second quarter and full year 2014 outlook as outlined in this morning's release. 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 most recent 10-K and today's release.

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 Investors section of Pentair's website. We will reference these slides throughout our prepared remarks. All references today will be on an adjusted basis, unless otherwise indicated, for which the non-GAAP financials are reconciled in the appendix of the presentation.

We will be sure to reserve time for questions and answers after our prepared remarks. We will target to be done in an hour. I would like to request that you limit your questions to one and a follow up, and get back in the queue for further questions so that everyone has an opportunity to ask their questions.

I will now turn the call over to Randy.

Randall Hogan

Thanks, Jim. Good morning everyone. Let me begin with our first quarter performance, on slide four. Before I go through the results in detail, as has been our practice since the Flow Control merger, I want to note that we’re discussing our operating results on an adjusted basis to more clearly show the core operating performance of our businesses.

With that, here are the first quarter numbers. First quarter revenue grew 1% on a core basis, but showed down 3% on a reported basis, which we will explain in more detail in a moment. Adjusted operating income was up 14%, and adjusted operating margin expanded 170 basis points to 11.8%.

Adjusted EPS grew 26%, coming at the high end of our expected range at $0.73. Free cash flow was a small usage, which is normal in our first quarter. This reflects a seasonal working capital build in many of our residential businesses and in this year’s first quarter, the fact that a larger than average portion of revenue was generated in March due to the slow January and February. We believe we are on track to deliver full year free cash flow greater than 105% of net income.

During the quarter, we completed our original $1.2 billion share repurchase authorization and are now into our next $1 billion repurchase authorization. Now let’s turn to slide five, for a more detailed look at the first quarter results.

As I said previously, our reported sales declined 3%. The waterfall on the left-hand side of the page shows that we experienced 2 points of foreign exchange headwinds, principally the Australian dollar and the Canadian dollar, a 1 point headwind from divestitures, and another point of headwind from the nonrepeating Glebe Weir project in our water transport business in Australia. We’ll provide more detail on this business when discussing our flow technologies segment.

We do not believe we were alone in seeing a slow start to the year, with weaker revenue in January and February, but the majority of our business has experienced nice revenue acceleration in March and early April has seen many of those trends continue.

The right half of the page shows first quarter Pentair operating profit and margin. Operating margin expansion of 170 basis points was helped in large part by strong productivity, which includes synergies. As we have discussed in the past, in order to deliver on our targeted margin expansion of 150 basis points per year, we need to deliver on both base productivity and synergies, so we track them together.

We continue to gain momentum on both Lean and sourcing initiatives, and we identified 18 focus factories that we expect to drive additional margin gains in 2014. As we’ve experienced additional top line challenges, we took further repositioning actions in the first quarter to accelerate our productivity results.

Overall, while we are not satisfied with our top line performance in the first quarter, we continue to deliver on productivity and synergies and see strengthening of the top line as we enter the seasonally strong period for our residential and commercial businesses. Our backlog gives us further confidence in our expectation for an accelerating top line growth rate in the second half of the year as well.

Now let’s turn to slide six, for a performance review of our largest segment, valves and controls. Valves and controls organic sales declined 7%, which followed strong double-digit growth in the fourth quarter 2013. This segment has shown a great deal of variability quarter to quarter, and we will continue to seek improvements in our forecast for the top line.

One of the ways we’re doing that is by looking at longer periods for comparisons and evaluations. For instance, if we combine the fourth quarter of 2013 and the first quarter of 2014, and compare that six-month period to its prior year comparable, sales show growth of 5% year over year as compared to the 19% gain in the fourth quarter of 2013 and the 7% decline in the first quarter of this year.

A fair amount of the quarter to quarter swing relates to timing of large project shipments, but we also experienced a fair amount of variability in our shorter cycle business. All four industries served by valves and controls posted a decline, with sharp drops in power and mining.

The declines in oil and gas were principally related to the timing of large project shipments, while the power decline came from weaker nuclear demand. We did see some softness earlier in the quarter on our overall short cycle business, but service showed solid growth in the quarter.

The right half of the page shows fourth quarter valves and controls operating profits and margins. Adjusted operating margins expanded 140 basis points to 11.5%, which included $5 million in costs for the GBU’s operating model transformation, or OMT.

As a reminder, we expect the OMT investment in valves and controls to continue on an annual basis through 2016, and that investment is expected to drive nearly $80 million of annual operating income savings once completed, and an overall tax benefit to Pentair of roughly 3 points due to the optimization of the global valves and controls structure in Switzerland.

Now let’s turn to slide seven for a look at the orders and backlogs for valves and controls. As you can see on slide seven, the valves and controls backlog is broken down into four key industries, three of which fall into our energy vertical, oil and gas, power, and mining, and one in our industrial vertical, which is process industries.

Overall backlog remained near $1.4 billion, which is relatively consistent with where it has been since we acquired the business near the end of 2012. Orders were relatively flat in process, oil and gas, and mining, but power showed a sharp decline in orders.

We’ve experienced a fair amount of quarter to quarter variability in sales and orders within oil and gas, but we still see healthy quoting activity. Industrial process is still expected to benefit from increased capital spending related to anticipated growth in North American chemical capacity. We anticipate this will be more of a second half and 2015 benefit for our valves and controls business.

Power remains a wildcard, but the backlog remains relatively consistent, and despite the quarter to quarter volatility in orders, we expect shipments to pick up later in the year. We remain very cautious on mining, but this is the smallest portion of valves and controls.

Now let’s move to slide eight for a review of process technologies. We indicated on our fourth quarter earnings call that we would begin to report in four segments, as our previous water and fluid solutions segment was split into process technologies and flow technologies. As a reminder, process technologies comprises our filtration and process and aquatic systems GBUs.

Process technologies reported good top line growth of 5%, which included a 1 point FX translation headwind. Both the residential and commercial and food and beverage verticals grew at a double digit rate, building on the momentum we saw in this business last year.

The right half of the page shows first quarter process technologies operating profit and margins. Operating margins expanded a disappointingly modest 10 basis points to 11.7% as a result of two principal factors during the quarter. First, we saw strong shipments of larger system sales in our beverage business, which as we indicated last quarter has a dilutive impact on the overall segment results, as these systems carry lower margins on initial installs, but they’re important to building an installed base to drive higher margin replacement sales in the future.

Second, our residential filtration business experienced a slow January that resulted in poorer operating leverage than normal that month, followed by a strong increase in demand in March, which led to overtime and some expedited freight. We expect more normalized sales trends and greater operating margin expansion in the seasonally strong second quarter.

Now let’s move to slide nine for a look at flow technologies. This is the first quarter that we’ve reported our flow technologies segment, which as a reminder is a combination of the legacy Pentair flow technologies business and the Australian water business that was part of legacy Flow Control.

As expected, we saw a sharp decline in flow technologies, with sales down 7% on a reported basis. There were two main causes of this decline. We saw a 4 point headwind from the Australian dollar and another 4 point headwind from the nonrepeating Glebe Weir project in 2013. We’ll discuss the impact of the Australian water transportation further on the next slide. The legacy flow technologies businesses actually saw modest growth in the quarter.

The right half of the page shows first quarter flow technologies operating profits and margins. Operating margins expanded 50 basis points to 9.9% as the impact of no project activity in Australia and the tough comp it created was nearly a full point of margin headwind in the quarter.

We continue to aggressively rightsize the cost structure of the Australia water transport business to reflect the reality of a much different looking business today than was expected over a year ago. We continue to see strong productivity in the other parts of flow technologies, and the repositioning benefits are helping to partially offset the sharp declines experienced in water transport.

Let’s now turn to slide 10 for additional color on our water transport business. Given the dramatic decline in water transport, we thought it would be helpful to explain how much of an impact the decline in the Australian economy has had on this business.

When the mining industry was strong, in 2012, and there were a number of large projects in Australia, this business generated over $550 million of revenue. This is about the average revenue over the five year period five years prior to 2012, with the peak around $715 million in 2010.

At the time of the Flow Control acquisition, based on projects booked and being bid, this business was anticipated to generate over $800 million in 2015. We knew, based on the backlog and the debooking of two large projects shortly after the acquisition, that we were facing a decline in 2013, but this business has faced a significant lack of projects that has led to further declines in 2014 to historically low levels.

We’ve been aggressively going after restructuring in this business, but there is a fixed cost element that, on these lower sales, is creating earning headwinds in 2014. As shown in the slide, the second quarter is the last expected large headwind, and this is likely to lower our overall EPS in the quarter by $0.08.

It’s not realistic to expect this business to rebound anytime soon, as demand from China on the mining industry remains low and municipal investments just aren’t happening. We’ve taken significant costs out of this business and the tough year over year comps diminish in the second half of the year.

A decline in Australia of this magnitude was not foreseen, but it in no way does it lead us to back off of our commitment of $5 of EPS in 2015. We’ve stepped up the restructuring activities and driving up side performance in other businesses, and we continue to drive productivity and synergies across all of Pentair to help offset this lingering headwind. We’ll keep you posted on our progress.

Let’s now turn to slide 11 for a look at the technical solutions results. Technical solutions sales grew 1% in the quarter, but price and volume contributed 3 points of growth, offset by 1 point of headwinds from FX and another point from divestitures.

As a reminder, we sold our [unintelligible] specialty motors business in the first quarter last year, so this divestiture comparison goes away in the second quarter. This is the second consecutive quarter of growth that technical solutions has delivered following declines in the first nine months of 2013.

We saw growth in the industrial, residential, commercial, and infrastructure verticals while energy declined in the quarter. After a slow start to the year, we saw daily orders rates in our electrical business accelerate in March, and this trend has continued into early April. The cold weather in the U.S. did have some benefits for our thermal business, but Europe experienced unseasonably warm weather, and we saw weakness in Canada offsetting that. At the same time, our electronics business has benefited from improving demand and new products.

The right half of the page shows first quarter technical solutions operating profits and margins. Margins were a great story yet again, as adjusted operating margins expanded 210 basis points to 19.1%, with strong productivity, synergies, and operating leverage all on display during the quarter. While thermal is entering its seasonally slowest quarter, our equipment protection and electronics businesses are seeing improved momentum entering the second quarter.

Let’s now turn to slide 12 for a closer look at the total Pentair growth profile. First quarter saw solid performance in the U.S. and Western Europe, weakness in Canada and Australia, and mixed signals in fast growth regions. In the U.S., we continue to see strength in residential and commercial. In Western Europe, we saw a modest recovery. In the fast growth regions, the Middle East declined due to timing of one large project. We still expect strong growth for the full year. Southeast Asia remains mixed, and we continue to see growth in China and Latin America.

Our residential and commercial and food and beverage verticals remain the bright spots. We still expect growth in all of our verticals except infrastructure, which is weighted down by the weakness in Australia. Energy continued its trends of lumpiness with a first quarter decline, following a 15% gain in the fourth quarter of 2013. First quarter weakness was principally related to the power declines in valves and controls, as we discussed earlier.

We continue to see strength in oil and gas quoting activity, so we expect to see low single digit growth in energy for the year. Industrial was down modestly in the quarter, with the improvement in our electrical daily orders rate and the continued strong quoting around the anticipated North American chemical manufacturing renaissance gives us increased confidence that industrial will grow at a modest pace for the full year.

We’re entering the seasonally strongest period for our North American residential businesses, which follows another strong mid-single digit growth quarter for this vertical. We also saw improvements in both the European and China residential markets and our businesses exposed to commercial construction are also seeing signs of improvement.

Infrastructure remains the weakest vertical, but again, this is due exclusively to Australia. Our North American break and fix business remains steady. We’ve seen a bottoming in desalination, and datacom, telecom, electronics has bounced off the bottom, as evidenced by a second consecutive quarter of strong growth.

Food and beverage is expected to see solid mid-single digit growth this year, which follows strong double-digit growth last year. We expect continued slowness in our U.S. agriculture related businesses, both irrigation pump and crop spray OEM, but the aftermarket piece in cross spray remains solid. Our food service business continues to experience strong international growth, and beverage systems continues to have a healthy backlog.

Please turn to slide 13, labeled Q1 Assessment and Full Year Outlook. Before turn the call over to John to review our outlook for the second quarter and full year 2014, I wanted to offer a summary of why we remain optimistic that we’re on track to deliver on our full year commitment. Our top line came in a little lower than we anticipated, but this was due in large part to a slow January and February after robust growth experienced in the fourth quarter of 2013 to end the year.

We saw strengthening in many of our businesses in March, and that has continued into early April. We will still have the Australian water transport headwind in the second quarter, but we expect this will be partially offset by the seasonal strength of our North American residential businesses.

As we look out to the second half, we’re seeing signs of increased capital spending by industrial customers and a building backlog in our valves and controls business. We continue to drive our productivity and synergies and have put additional action plans in place to drive even more productivity gains. And our OMT investment in valve controls is on track. Of course, we’re committed to investing in growth, which we expect to start reflecting in our results in the second half of 2014.

In addition, our balance sheet remains in great shape, and we’re on track for another record year of free cash flow. Our businesses that have earned the right to grow are building their acquisition pipeline. We continue to focus on the elements where we can control our own destiny, and while we still have to earn the right to talk about growth, we believe the second quarter will represent our last difficult year over year comparison, and of course we have opportunities to drive further margin expansion into 2015 and beyond.

With that, I’ll turn the call over to John.

John Stauch

Thank you, Randy. Please turn to slide number 14, titled Q2 2014 Pentair Outlook. For the second quarter of 2014, we expect sales to be flat to down about 1%, and approximately $1.95 billion. Valves and controls are expected to be flat due to timing of current backlog and an expected ramp of short cycle orders.

Process technologies is anticipated to be up 6% to 8% in its seasonally strongest quarter. Flow technologies is expected to be down approximately 20% due to the last tough comparison in our water transport business that Randy discussed in detail earlier on the call. Excluding this project, sales should be up approximately 3%. Finally, technical solutions is expected to be up 4% to 6%, led by our equipment protection and electronics businesses.

We are expecting adjusted operating income up 6%, and adjusted operating margins to expand approximately 100 basis points to 14.7%. This includes about $7 million more of OMT investments in valves and controls and the impact of the Australian headwinds mentioned earlier. Excluding these, operating income would be up approximately 16% versus Q2 of last year. Our EPS forecast for the second quarter is a range of $1.02 to $1.05, or an increase of roughly 13%..

Please turn to slide 15, titled Balance Sheet and Cash Flow. Quarter end debt was approximately $2.9 billion, or $2.7 billion on a net debt basis, inclusive of global cash on hand. In the first quarter, we returned $300 million to shareholders in the form of dividends and share repurchases.

At the end of the first quarter, we have now completed our initial $1.2 billion share repurchase authorization, and have just under $900 million remaining under our current $1 billion authorization. We are seeking authorization from our shareholders at our May annual general meeting to increase our dividend to $0.30 per share per quarter from $0.25 per share per quarter, which, if approved, will mark our 38th consecutive year of annual dividend increases.

Our ROIC ended the quarter at 10%. We continue to have a lot of opportunities on the working capital front with legacy Flow Control businesses, and we expect to make further progress as the year continues.

Please turn to slide number 16, labeled Full Year 2014 Pentair Outlook. We are reiterating our full year EPS guidance of $3.85 to $4.00 on approximately $7.7 billion in sales. We have moderated our growth rate by a point to a range of 2% to 4%, reflecting the impact of FX and the slower start in January.

Valves and controls is now expected to grow 1% to 3%, as backlogs remain strong and we continue to focus more on the short cycle businesses. Process technologies is expected to grow 8% to 10%, with continued strength in aquatics, beverage systems, food service, and an improving residential and commercial filtration business.

Flow technologies is anticipated to be down 5% to 7%, related to the lack of project activity in Australia, the tough comps we discussed earlier, and [unintelligible] backs. Excluding the water transport business, we expect flow technologies to grow approximately 4% to 5%.

Technical solutions is expected to grow 4% to 6%, as we signs of business improving in the North American electrical distribution channel, strength in our electronics business, and easier comps for our thermal business. We do not expect any megaproject activity in 2014, but as we have stated in the past, we will update accordingly at the appropriate time if any megaprojects enter the backlog.

Adjusted operating income is expected to expand to approximately $1.1 billion, which would represent a record for Pentair. We expect three of the four segments to expand operating margins in excess of 100 basis points, with only flow technologies not achieving that level, as we continue to aggressively rightsize the cost structure with a dramatically reduced demand environment at our water transport business.

Overall corporate costs are expected to be down due to lower corporate integration costs. For the full year, we expect the tax rate to be around 23.5%, net interest expense to be approximately $70 million, and the share count to be around 198.5 million.

We expect EPS to expand around 22% to $3.93, at the midpoint of the guidance range. We are expecting another record year of free cash flow, with at least $850 million, or greater than 105% of net income.

Operator, can you please open the line for questions?

Question-and-Answer Session

Operator

[Operator instructions.] Your first question comes from the line of Mike Halloran from Robert Baird.

Mike Halloran - Robert Baird

Let’s start on the revenue guidance. It sounds like the two main pressure points, a little bit of Canada FX and maybe some volumes there, but the predominant part is the Australia side. Maybe you could just go into a little bit more detail - and by the way, great color on slide 10 on the year over year and some more water transportation information - but maybe if you could just talk about what you’re seeing on the short cycle, kind of everyday business over there, as well as what the outlook on the project activity looks like, and if there are even any projects embedded in the guidance as you look forward in that specific piece today.

Randall Hogan

The volume we get is really all small projects, maintenance. There’s always some of that. That business has always had at least one or two larger projects, and then they’d get big ones on top of that. This year is unprecedented in that it has none of those bigger projects. And we don’t have any bigger projects coming in the forecast. So that’s what’s different. We thought we’d get a couple of those. They went away.

Mike Halloran - Robert Baird

And on the regular way side, how’s that business? Is that a little bit worse than expected as well right now?

John Stauch

No, that’s clipping along at roughly flat or modestly up. As Randy mentioned, primarily a break in fix or reestablishing fixing things that are already installed. That business has always been relatively steady. But it’s the project business, and usually at this particular point in time, we’ve always got two or three, or we at least have meaningful ones at the front [log]. We’re not even seeing front log activity in Australia related to these projects.

Mike Halloran - Robert Baird

If I take out the Australia and some of the Canada pieces and things like that, it looks like the core businesses outside of that are tracking consistent, if not ahead of your expectations, on a full year basis. You obviously have commented on some improving trends as you look through March and April here, but what gives you the confidence on the energy side that you’re going to see some improvement as you work through the year there? And then also, maybe just a little bit more color about some of the end markets you’re starting to see improve a little bit.

Randall Hogan

We’re getting better at seeing the businesses in our current configuration, and as we’re looking at our bidding activity. In energy, bidding activity remains strong. The power surprise, nuclear valves is a nice business, and that was surprising to see the short cycle in that. So, short cycle, which is repair and maintenance, was actually weaker in the nuclear business than we would have anticipated. That was really the only surprise in energy. But the variability quarter to quarter is not that big a surprise. So we feel good about energy because of the bidding activity, and that’s consistent across all of the GBUs that serve energy.

John Stauch

The only thing I would add to it is, I’m sure like a lot of the companies you follow, our January and February slow start, March was very strong. And we’ve anticipated or put in the normalized view of what we think the year’s going to be, so we’re obviously monitoring April, and is April tracking more like March, and how comfortable do we feel. We’ll have a better picture of that, obviously, as we close out Q2.

Operator

Your next question comes from the line of Deane Dray of Citi Research.

Deane Dray - Citi Research

It looked like corporate expense came in lighter than what we were looking for, and right at the end of your prepared remarks, you commented that corporate is coming down with lower integration costs. But maybe just what were the dynamics this quarter on the corporate line that might have made it more favorable?

John Stauch

We’re looking at around 23 to 25 this year, probably closer to 23, each and every quarter. So we’re about $1 million under that. We’re going to have variability in things like stock comp timing, medical timing, and litigation. That’s about the only variability we would have. So it wasn’t a big delta. The year over year is the integration costs. We were obviously very heavy into the corporate integration last year, and you see that number reflected in over $30 million of expenses. That came down throughout last year. So most of our integration activities now are all in the businesses. So we mentioned OMT, that’s being absorbed in the valves and controls business. And most of all, our Lean activities and costs that are being borne to drive the synergies that are all being managed by the businesses now.

Deane Dray - Citi Research

And then on process tech, the margin hit, or just the margin pressure because of the mix, maybe you could just expand on that. When you ship these larger systems, is that also because you have content that’s not Pentair content, and that’s more of a pass-through. If you could just give us some context and color regarding those kinds of shipments, and what that outlook embedded is, for the balance of the year.

Randall Hogan

It’s both. It’s both a lower margin because the systems are direct to the OEMs or part of lower projects, and they’ve always been a little bit tighter. But there’s also, as we build a valves kit, or we build a [cold] block, there is a lot more purchase pass through parts. That’s part of it too.

John Stauch

But as you know, we’re doing it because we’ve got the memory there that within 12 to 18 months, it’s going to be replaced, and we look for those aftermarket sales, and that’s much higher margin. So this is the razor, if you will, and the razor blade is to come.

Deane Dray - Citi Research

Yeah, I’d much rather see you shipping these systems as solutions as opposed to component pieces. And then just a quick clarification on the nuclear business. We’ve seen this elsewhere, from mothballed plants, that just would have ordered these valves that are now just being mothballed, or is it lower utilization, lower maintenance spending?

Randall Hogan

Well, it’s some of both. Germany was down, but Germany is moving away from nuclear, so those are being mothballed. So that’s maintenance that isn’t going to get done unless, for some reason, they open them up. At the same time, France has recommitted to another 50 year life extension for their whole nuclear fleet, and they’re going to be net exporters of electricity to all of Europe. But their maintenance was lighter than we would expect. The U.S. maintenance was lighter than we would have expected.

And then there’s project businesses in China and other countries that are there to ship, and they just don’t ship. But the mothballing factor, we believe that we have that factored in. The surprise was more on the expected maintenance and the shipping of projects that are new installations, in countries that are building them.

Operator

Your next question comes from the line of Steven Winoker of Sanford C. Bernstein.

Steven Winoker - Sanford C. Bernstein

John, question for you. When you sort of now think about how long you’ve had valves and controls, and the difficulty in forecasting this business, when you look within your FP&A process and talent pool, what kind of changes are you putting in place so that - I know there are big projects, I know you’ve gotten certain surprises, but nonetheless, there are a lot of highly diversified companies with similar dynamics who have a maybe more mature FP&A process in businesses like this. How far away from that are you, do you think, in terms of time to get there? Or do you think it’s just going to be a tough business to ever get there?

John Stauch

I think we’ll definitely get there. I mean, we talk about blue chips being top priorities here, and believe me, this is Randy’s top blue chip, which means it’s my top blue chip, which means it’s the business’s top blue chip.

And right now, it’s complicated. These acquisitions were acquired, and we basically have 40 individual businesses that really take sales in 128 different locations, and then those sales are put on the factories. And you could imagine, some of these are in stock, and some of these make the stocks, and some of these configure the order, and some of these are larger projects.

But this is all solvable, and this is where our Lean tools really come in, and we’ve initiated and kicked off that project. So there is a financial element to this, but there’s also a process element that goes all the way through the sci op process. And as I mentioned, it’s Randy’s top priority, which means the business is all over it right now.

I can’t tell you why they reach at the end of the quarter so much, like in Q4, and then you see the slowness this quarter, and then the catch up. I think that’s their lack of confidence in what that shipments needs to be to manage those quarters.

Randall Hogan

We all have experience in those kinds of businesses, in our past life, that with longer cycle, should be more predictable. That’s one of the benefits of a longer cycle business. But as John said, it’s a function of the fact that the businesses have not been integrated, and that’s our big opportunity. That’s what our OMT project is about. And beyond the OMT, to get more granular understanding of the forecasts that come in, it’s not just in FP&A. It’s the sales forecasting. It’s an organizational capability. And we know how to do it, and we’re working on it.

Steve Winoker - Sanford Bernstein

And then on capital deployment, what is your willingness or desire to step up the repurchase part of the deployment over the next year or so?

John Stauch

We definitely have the ability to. I think we will, if we need to. Right now, we’d like to balance that with acquisitions, especially in the platforms that Randy mentioned [unintelligible], they’re growing nicely, organically. They have a great standardized back office. And right now, there’s a big willingness to have discussions around acquisition. There is an agreement on price. But that’s what we’d like to do, is balance this between share buyback and acquisition.

Steve Winoker - Sanford Bernstein

And then this food and beverage has been a fantastic contributor now for some time, and offset a lot of weakness in other segments. As those segments start to come back, do you think food and beverage has got this sort of longer-term secular story, where it’s not like we’re going to see that decrease as the other ones come up?

John Stauch

I don’t think we can sustain 20% growth a year, but the reason we think we’re more in the double digits on a long term basis is we have solved something significant for the large beverage manufacturers, which is a way to filter their product, which has become a standard element. And so as they expand the breweries or rearranged the breweries, we’re a big piece of that.

The other element that’s in the food and beverage is not only our ag offering, but what we believe is, you know, aquaculture and aquaponics, and a lot of other offerings. So we are focused on it. We have a lot of new product introductions there, and we have a global offering, which is really being well accepted.

Operator

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

Shannon O’Callaghan - Nomura

First, I was just wondering, I know you touched on this a little bit, but the fast growth markets have been rather lumpy in the recent quarters. Can you talk a little bit more about the moving parts there, and maybe some detail around your outlook for these regions for the rest of the year?

Randall Hogan

The Middle East is still in a long term growth trend. We just had a really big project that shipped last year in the valves and controls business, in the Middle East. And that [unintelligible] in the Middle East looks weak. The secular trend, if you will, for our Middle East growth, is good. China has come back in residential spending. It’s nice to see that again in China. And it’s slowed down. And for us, that’s in the water business. So we think now that that’s coming back, it should continue for us. Latin America had suffered some setbacks from Brazil, but the rest of Latin America is lifting that.

John Stauch

I’d say any time you get to see a valves number like this, you’re going to see its impact. It’s been our largest fast growth provider product, it’s going to have a general toll on the reporting. But the underlying water businesses right now in the fast growth regions is seeing nice, sustained, consistent growth. We’ve put a lot of investment and effort there, and I think I’m with Randy, I think we feel like these markets continue to be better than they were last year, with the exception of Brazil, and I think we have a long term growth rate here that I call mid-single digits.

Shannon O’Callaghan - Nomura

And then just maybe on acquisitions, what are these main areas of priority? Do you have a range in mind when you think in terms of size, of what you’d be willing to do? Or is that kind of a rolling target?

John Stauch

We look at everything. And as I said earlier, obviously the integration effort, we’d like that to be on something that’s much more lean today, and could accept a larger acquisition.

Operator

Your next question comes from the line of Steve Tusa of JPMorgan.

Steve Tusa - JPMorgan Chase

Just kind of a nitpicky question on the process technologies. You had two businesses that are, I guess, representing about 85% of the segment, residential, commercial, food and beverage, they were up 10%, 17% respectively. But sales were only up 5%. What was down so much in that business? Presumably, it’s forex or anything like that. Am I missing something on the end market dynamics?

Randall Hogan

It’s the water purification, the business that serves desalination and just the pure water side.

Steve Tusa - JPMorgan Chase

How big is that business?

John Stauch

A little over $160 million annually.

Steve Tusa - JPMorgan Chase

So it must have been down a lot.

John Stauch

Yeah, it’s a muni play. It was down around 20% in the quarter there. And we were also slightly down in our energy, which is more of a timing issue, and when those shipments will go out. That was down roughly 10%. That’s about a $100 million a year business.

Steve Tusa - JPMorgan Chase

And then on valves and controls, your profits were up $3 million this quarter on a pretty significant revenue decline. I think the guidance for the next quarter has kind of a similar profit on a flattish revenues. Is that like OMT flowing through? Is there something there? Why wouldn’t that be better? Why wouldn’t the $3 million and increase be better with flattish revenues?

John Stauch

I actually love your question, because we feel the same way. Right now there’s a couple million dollars more of OMT, and we do think that the productivity that we’ve seen in the last several quarters, we believe that that’s going to continue to come through here. So we’re looking for that increased Lean and sourcing savings, and I think whenever you’re flat, I think businesses find it hard to forecast significant operating income on flattish growth.

Steve Tusa - JPMorgan Chase

So the OMT, I think it was $5 million in the first quarter, I think we thought it was going to be more like $7 million. I know this is nitpicking, but what’s the number for the second quarter in OMT?

John Stauch

Roughly $7 million.

Steve Tusa - JPMorgan Chase

So you get back to that kind of run rate. And then just one last question on overall productivity. I know you’ve changed the slide somewhat, but getting to about $45 million in combined productivity and synergies for the quarter, I know you’re not going to give us explicit guidance, but I would assume, are the synergies on track here as far as what you had laid out on an annual basis? Are you still expecting the same amount of synergies from [unintelligible]?

John Stauch

Absolutely. I think the piece that we absolutely know about is the restructuring, and when you take a look at what we’ve done today, we’ve taken roughly $200 million in charges, and that run rate on those savings would be north of $200 million. And that’s the piece that we absolutely have tangible confidence that we’re going to achieve. The piece that’s a little harder to gauge is some Lean savings, and how much is core, and how much is synergies, especially when you need growth leverage to benefit from both, and also, on the sourcing side, how much would you have gotten anyway. But right now, I did the same math you did. We exited at $40 million. I think we picked up some incremental synergies on top of that, probably knocking on the door of close to $45 million to $50 million, from a run rate basis. And we continue to believe that we’re going to escalate through the year, based upon the incremental actions we even [drilled] in Q1.

Steve Tusa - JPMorgan Chase

But I guess the comp gets tougher on synergies year over year, into the second quarter. Is that where the restructuring comes in? You just did some restructuring and that kind of reloads that, if we want to call it a core productivity pipeline. So that does look like, in the second quarter, that that productivity, if you kind of parse those out, and use what you had guided to previously, on synergy, it does look like that steps up in the second quarter on your guidance, because the revenues are obviously weaker, but in the context of those weaker revenues, the profitability still looks pretty decent in the second quarter. So is that kind of the way to think about it, that the restructuring, if we assume that the synergies were what they were, does the restructuring kind of help that productivity number step up in the last nine months of the year?

John Stauch

Yeah, because we’re getting the restructuring, we’re getting the synergies, and when we start to grow on that reduced cost structure, the leverage is very nice. And when we track this year, synergies aren’t the problem. We’re slightly underperforming on the core, and that’s related to the revenue. We’re also utilizing those incremental synergies, as you know now, to cover the water transport impact. And we anniversary that in Q2, so I feel like we’re well positioned on restructuring and when we get the growth, we’re going to see some pretty nice leverage.

Steve Tusa - JPMorgan Chase

Is this it for restructuring for the year? Are you guys done for the year?

John Stauch

We expect to be done by the end of Q2.

Steve Tusa - JPMorgan Chase

Okay, so it will be more than $22 million or $23 million or something like that.

John Stauch

I think they’ll carry over into Q2, correct.

Operator

Your next question comes from the line of Joshua Pokrzywinski with MKM Partners.

Joshua Pokrzywinski - MKM Partners

First question, on slide 10, that’s helpful color, but did any of that come together or become more clear as we worked through Q1. I guess as I look at that, a lot of that seems like it could have been more helpful to point out last quarter. So I’m just wondering how much of that is more of a recent revelation in terms of sizing up some of those things.

Randall Hogan

Well, it’s not recent. As we were doing the restructuring, one of the things we knew was this business was one of the reasons we wanted to consolidate GBUs, is we want to take out cost structure around businesses that just didn’t need the cost structure, and couldn’t afford the cost structure. The new information is the fact that the expected additional one or two projects just aren’t materializing. It was at that point we realized, this is something we should share. It’s not a surprise. What’s a surprise is the fact that none of the projects that would be reasonably expected, and that were actually being talked about, have materialized as real projects.

John Stauch

This isn’t a highly configured business. It’s apparently a standard product that goes into our factories that maintain a fairly high fixed cost structure. So when you get a project, you can usually start shipping it within 30 to 60 days. And so this is the season that we usually see those projects enter at least the front log, if not the back log. And what Randy’s saying is, we don’t even see them in the front log, let alone the back log. So this was the time we felt we needed to share with you guys what we’re absorbing in the rest of the base business.

Joshua Pokrzywinski - MKM Partners

And then just shifting over to valves and controls, it seems like there’s a bit of a gap forming between pretty healthy quoting activity or tone from customers and orders that I think have hit a new low since, on a quarterly basis, since you guys took over the business.

And then I guess the same question on backlog versus shipment. Backlog seems like it’s pretty healthy, and you get these persistent delays. What am I missing? Or what is the gap there? Is it walking away from unprofitable business, like you guys had talked about? Is it a forecasting/timing issue that you’re still getting your arms around? I guess are there any other unintended consequences of this transformation, like sales force attrition or anything else?

John Stauch

Not seeing that. We’re feeling the same optimism in the market that everybody else is talking about. Last Q2, we had a difficult orders quarter. We saw a little bit of recovery in Q4 of last year. And I wouldn’t say we’re at a historical low, but we’re not ecstatic about the Q1 orders. But if you take the March order rate, it was relatively strong.

So I think we’re hearing the same optimism in the market, and we’re expecting that quoting activity to turn orders, and we’re tracking this to a weekly order rate, and looking at the variances and doing our root cause countermeasures. I don’t think there’s any systematic issue to what you’ve asked. I think it’s a matter of getting this capital investment spent, and getting those projects put into place.

Joshua Pokrzywinski - MKM Partners

Is there anything else outside of nuclear, which sounds like it was a bit of a short cycle surprise in Q1, from a short cycle perspective, that was particularly underwhelming in the first quarter. I guess you’ve seen energy bounce around in general. Any other kind of quick lead time…

Randall Hogan

Well, yeah, on the short cycle. We have probably the lowest conversion of, if you will, short cycle orders in quarter four quarter the business has seen in a while. And mining affected that too. If the mine’s open, it’s going to have maintenance. And so that was lower than we would have expected. So I would say it’s both power and mining.

Operator

Your next question comes from the line of Andrew Obin of Bank of America.

Andrew Obin - Bank of America Merrill Lynch

Just a question on markets and how should I look at performance? It seems that nuclear was a little bit weaker. Mining was weaker, Australia was weaker. If we strip that out, and if we look at the forecast, what else has changed? And what are the positives and what are the negatives? Just another level down.

John Stauch

Yes, Europe remains a slight positive. They did have a warm winter, as Randy mentioned. We had a thermal business that obviously was impacted, but the rest of our other businesses we saw a slight benefit from that warm weather.

Randall Hogan

Yeah, it seems to be stable and heading up.

John Stauch

The U.S. continues to do really well in the market. Canada was a little weaker this time. And Southeast Asia and China, as Randy mentioned, as well as the Middle East, from a core basis, are good, solid markets right now.

Andrew Obin - Bank of America Merrill Lynch

You also highlighted the fact that you have some overtime in March. Is there enough time to catch up, given the construction season? Or do you think we now basically have to wait until…

Randall Hogan

That comment was really specifically to the process technologies segment, and particularly the water purification or U.S. residential. It was the U.S. residential and European residential comment. And no problem catching up.

Andrew Obin - Bank of America Merrill Lynch

Are we going to catch up in the second quarter, or do we have to wait until the second half?

Randall Hogan

No, it’s building now. The second quarter and third quarter are the residential quarters.

Operator

Your next question comes from the line of Scott Graham with Jeffries.

Scott Graham - Jefferies & Company

I calculated about $76 million of productivity plus synergies, which would be net of the pricing. I think you indicated that you did about $40 million of synergies in the quarter, which would suggest, if my math is right, about $36 million of productivity, which on the sales base, is over 200 basis points. Is my math about right on that?

John Stauch

Yeah, I think I’d say about $50 million in synergies, but your $26 million is right. And then obviously some of that’s going to offset the inflation. So we always look at two elements. We want price to offset inflation. We want productivity to offset inflation in the core. Sometimes we don’t always get there perfectly, but that’s our targeted actions. And so we’re always looking to offset that inflation rate on the [unintelligible] core productivity.

But yeah, we’re seeing that strength of operating performance, seeing good cost structure, good cost discipline management. And that’s why Randy and I are optimistic when we see the growth, we’re going to get that leverage. And the growth is frustrating, because we have 20 product technology platforms, half of them are growing.

And when we talk about growing, they’re growing high single-digits. And we’ve got a couple of these platforms that are in significant contraction mode. The good news is, most of the ones like water transport aren’t our highest margin, but some of the ones that are growing are higher margin, and so that’s part of that positive mix we expect to see as well.

But I think your math is generally correct, yes.

Scott Graham - Jefferies & Company

I’m actually calculating off that adjustment about 150 basis points of productivity, which is still 50 basis points above what your target is. So I just wanted to confirm that. The next question is really more of a question for you, Randy. And you know, once out of every three or four quarters, there’s some questions surrounding the top line that maybe should have been maybe a couple of points higher. Could you maybe talk about some of the things that you’re doing to maybe address some of the vagaries that you see in sales from time to time across the businesses? Anything that you’re hatching that’s new to start to build on the critical mass that you now have in this company?

Randall Hogan

You know, we’ve gone from seven GBUs to five. And then underneath the five, John mentioned that we’ve identified and defined and staffed 20 platforms, focused platforms, to manage profitable growth, so that we can make sure that we’re flowing the resources to our best opportunities. And we just put that in place at the beginning of this year. And John can say what he just said, which is we really do understand which ones are leveraging us for growth, and which ones are laggards, and what do we do about it.

So we have much more granularity to that. At the same time, we’ve invested in a growth function, and we’re very much targeting that right now to get a better handle on the forecasting ability in valves and controls.

And so really, our focus right now is on growth and our growth processes. We’re building the competencies and capabilities for growth that we have built in Lean. It’s taken us 13 to 14 years to get where we are on Lean, but we are among the companies that are, if I dare say so, great at it. We don’t tend to take that long in growth. We’ve been working on it for a couple of years. We want to see more results, more sustained results. And one of the benefits, on the flipside, of being a narrowly diversified company, is we’re able to still execute and perform to promises, even when stuff happens.

And growth is clearly the number one agenda for me. It’s the number one agenda for the company. And that’s really where I’m putting all my focus right now, to make sure we are funding the right things. We need to get the average growth rate up to the low end of what we believe is possible. The profit potential is amazing. The best driver of productivity is growth, operating leverage. We get that. And so between the organization changes we made, between the way we’re flowing resources and we’ve changed resources, it’s all about to drive a more sustained growth.

Operator

Your next question comes from the line of Jeffrey Hammond from KeyBanc Capital Markets.

Jeffrey Hammond - KeyBanc Capital Markets

Just kind of back on the guidance, and maybe a follow-on to what another caller was asking about, just within your guidance range, you seem like you’re talking about more negatives than positives. And I’m just wondering if I’m not picking up on any kind of positive offsets within the number, whether it be lower corporate expense or some additional restructuring savings that you get later in the year. Or should we just be taking our numbers down a little bit within the range?

John Stauch

I think we’re looking at a couple of things. We were hopeful that water transport would recover, but we didn’t plan on it happening. We never really gave Q2 guidance, so within our plans, I don’t think we’re bringing up anything new today within water transport. We’re just sharing with everybody that we doubt it’s going to recover back to historical levels and be any positive contributor past the $3.85 to $4.00 that we’re giving.

We continue to work all those restructuring actions, which are more than offsetting the water transport headwind, and we feel very confident that we’re building the growth process, as Randy said, that is going to generate the growth that’s going to give us the leverage. So right now we feel like we’re being really balanced.

Obviously, we’re managing the corporate expenses for two reasons. One is we’re keeping the spending lower as a contingency, but the other reason is there’s a lot to absorb in the business right now in integration, and they don’t need more initiatives on top of what they’re already driving.

So those are all the normal things that a business goes through, this cycle. But I think we feel like we’re on plan for the year, and we feel like we’ve got enough positives to offset the negatives. Things have been a little bit more choppy in the external markets. I don’t think anybody anticipated a slower start to January. I think we scrambled, like most companies, to make that all up, absorb those costs within our productivity in Q1 as well. So I think you’re just hearing a balanced view from us, Jeff.

Jeffrey Hammond - KeyBanc Capital Markets

And then just on this bidding activity, when do you think you start to see that acceleration in the order book?

Randall Hogan

[crosstalk] better, and expecting the second half to start seeing some shipments from it.

John Stauch

Randy’s put the business on a weekly pulse cycle. If you want to take a look at orders and you want to look at your front log, which is a manageable process, to have visibility into what’s coming, they you want to have a predictability on the hit rate, you want to turn that into what you expect your daily orders rate would be, and what you want to see is a day to day improvement against that. And clearly, given what we saw in valves in Q1, that’s where Randy’s got the business target in Q2. And we all have visibility into how we’re doing against that.

Operator

Your next question comes from the line of Brian Konigsberg from Vertical Research.

Brian Konigsberg - Vertical Research Partners

Just coming back to valves and controls, it sounds like you are optimistic that you will start to see a better ordering environment, but I guess I don’t know if you’re getting any indications as far as the pricing of the early surge in potential orders coming to market. Typically when we see these types of cycles, it does get pretty price competitive in the beginning, and then [unintelligible] takes place, it gets better. So I guess from what you see today, do you see pricing pressure potential associated with the early projects and how disciplined do you expect to be associated with those dates?

John Stauch

I think oil and gas, as we said before, will always have a price element there that’s the most competition in that space. I think the thing that we’re looking at now is based upon our substantial productivity that we’ve driven, we have to have the confidence to maybe take a little bit lower gross margin knowing that we can drive the productivity in those projects.

I can’t tell you that we’ve lost anything over price, though. But we want to have that type of visibility to know that if we are this confident we can continue to get the productivity, does that open up an increased order book for us? Randy, I don’t know if you want to comment, but I don’t think there’s been any of that element.

I’d also say that a window that we have as well is we have an [unintelligible] and controls business, which serves our competition, the whole industry. And I can assure you that based upon their performance in the quarter, it doesn’t feel like we’ve lost share. So we have an inside view to the rest of the world in the valve space. We are still the world’s leading valves and control player, so we feel we’re involved in every project. And we feel like we’re going to win our fair share here.

Brian Konigsberg - Vertical Research Partners

And then just moving over to working capital. That was a little bit more of a headwind than I thought it would be in the first quarter. Is it just related to the cadence of how activity progressed through the quarter?

Randall Hogan

You know, we had more stuff that would have sold in January that we would have got cash for. But it just wasn’t balanced in terms of the usual mix of sales by month. The quarter always is a cash usage quarter for us, just because of the nature of the business.

Brian Konigsberg - Vertical Research Partners

And I know you’ve made comments before on bringing working capital from Flow Control down to more in line levels with legacy Pentair. Is that a benefit you expect you’ll see in 2014? And I guess how much more typical does that become if the cycle is starting to get going?

John Stauch

No, I think we made great progress in ’13. We still have a long way to go, but I think we expect to make another big jump forward here in 2014. It’s just receivable discipline. It’s inventory disciplines, and it’s tracking it and managing it, and holding people accountable to it. No, we think we’re still going to make progress, even with growth in the business.

Operator

Our next question comes from the line of Nathan Jones with Stifel.

Nathan Jones - Stifel Nicolaus

A couple questions on the short cycle oil and gas business. You talked about in your prepared comments that there’s more variability in that business than you thought there was going to be. I think we all understand the timing issues in the long cycle business, but what’s behind their variability in that business, in your opinion?

John Stauch

What I was saying was, in this quarter, we saw a lower short cycle business. That was a surprise, frankly, that, if you will, book in the quarter, ship in the quarter was the lowest conversion that we’ve seen going back in history since before we owned it. And it just seems like that in our area, in our installed base, that there was a little bit of a slow start. And I don’t know if that was weather related in the U.S. There’s a lot to conjecture, but I can’t give you root cause analysis on it. But we’re certainly focused on it. That’s one of the things that, as John mentioned, we have some new disciplines in terms of weekly reviews on order rates. It’s one of the things I think we’re watching to understand better. So I wouldn’t say that that’s something that was worse in the first quarter than we have seen.

Nathan Jones - Stifel Nicolaus

At this point, are you able to say that you expect that conversion rate to improve?

Randall Hogan

We would expect it to revert to the mean. That short cycle business is largely replacement. You know, as long as the refineries are running, as long as work is being done, products get worn out. So it’s the kind of thing you wouldn’t expect to have a high percent of deviation around the mean.

John Stauch

One of the things that we’ll have a clearer picture as we conclude the year, Randy and I both have a lot of experience in long cycle businesses. And when you get into project and maintenance related businesses, Q1 is usually the lowest quarter and Q4 is usually the highest quarter. So one of the conjectures is, the high rate of book and ship in Q4 of last year impacted the low rate of book and ship in Q1, but they were on a different fiscal year. Really shouldn’t be an element of difference. Quarters should be quarters. And you should be responding to whatever the customer demands are. And so we should probably see a more normalized cycle with Q1 being the lowest shipment quarter, Q4 being the highest shipment quarter. And we’ll see how that plays out this year. But that’s what Randy and I are expecting, and that’s what we’ve forecasted.

Nathan Jones - Stifel Nicolaus

And you also said that you expect the ramp in short cycle oil and gas as the year goes on, I know we’ve heard similar things from other companies. Can you just provide a little bit more color on what you’re seeing out there that gives you that confidence?

Randall Hogan

Well, again, it’s the bidding activity, and it’s the quoting activity that gives us that confidence.

Nathan Jones - Stifel Nicolaus

Are we seeing those turn into orders in a timely fashion?

John Stauch

That’s what we continue to track, which I was talking earlier about. We want to make sure that we’re looking at those hit rates, we’re looking at the time in the cycle, from the time that the bidding goes into the front log to when it converts to an order. And we obviously have a lot more data and much more track record now that Randy and I can push the business to see. We are very optimistic as the market is, and we’re tracking those orders. And our expectation is April is a big step up from March, and right now we’re not off of that expectation.

Operator

Your last question comes from the line of Hamzah Mazari from Credit Suisse.

Hamzah Mazari - Credit Suisse

On valves and controls, can you just remind us what share of sales is aftermarket short cycle sales over there and how much of the growth in that business is driven by share gain? And also, some pretty quick update on if you’re seeing any revenue synergies coming through, or any color on that front?

John Stauch

Roughly we would expect a normal cycle to be somewhere around 50% to 60% into what we call the installed base. And that’s mostly like for like replacement against whatever spec you won, for the most part. And then the rest would be a major expansion and/or some type of greenfield application. Obviously, when you’re on large project types of cycles, it probably shifts to more 40% in the installed and 60% elsewhere.

The second part of your question, on sales synergies, we continue to be able to take these 20 product platforms, now that we have the visibility, and those that are strong in energy, try to pull the rest with them. And we continue to be excited about the pull through opportunities that a leading product provider has to bring the rest of our product technologies through product. So we’re as excited about that opportunity as when we acquired [unintelligible].

Randall Hogan

All right, thank you very much.

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