Is Pentair Worth Adding To Your Portfolio?

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About: Pentair Inc. (PNR)
by: AllStarTrader

Summary

Pentair is a pure play water company.

The company should benefit from the growing global population and need for filtration systems.

The company has been growing its share in the pool industry which is benefiting from consumers investing in their backyards.

The stock currently is trading near its 52-week low despite the market trading near highs.

Photo Source

Summary

Pentair (PNR) is a global water solutions provider with operating segments such as aquatic systems, filtration solutions, and flow technologies. Through each one of these divisions, the company's reach expands from industrial end users to the at-home consumer. The company should benefit in the coming years from continued investment into water infrastructure. As filtration, pumps, sanitation, and other items are heavily needed for replacement and efficiency improvement, the company will continue to grow its market share. Despite the long road of growth ahead, the stock is trading as if there is a fundamental problem with its business. Founded in 1966, the company has a strong history as an operator with many of its own patented designs. This should further entice investors as it has its own technology that cannot be copied by cheap competitive manufacturers.

Source: Investor Fact Sheet

Investors looking for a strongly positioned water play trading at a fair price should consider investing in Pentair.

Performance

Pentair has been performing well, growing sales but furthermore growing net income.

Source: 10-Q

For the second quarter, the company delivered core sales growth of 3 percent and a segment margin expansion of 90 basis points. This is especially important as distributors of its products have been looking to sell whoever offers better pricing. It shows Pentair has quality products that don't demand price cuts all the time and the company can raise prices as input costs rise. The company reported adjusted earnings per share growth of 18 percent after accounting for the spinoff of nVent the electrical division. Pentair reported EPS of $0.71 for Q2 2018 compared to $0.60 in Q2 of 2017. The company also raised its guidance for the year and now expects earnings per share of $2.31. This would put shares currently at a P/E of slightly less than 18x 2018 earnings. What is nice about the above chart is that the company breaks down the percentage of operating costs compared to revenue. This makes it easy to visually see where the company is improving or worsening in its expense control. As we can see, there was a significant rise in selling and administrative costs which could partially be due to the increased investment in sales positions for its products. While this raises costs now, a larger presence in its markets gives it better ability to capture sales in the future. More importantly, the company is aiming to generate 100% cash flow conversion on its operating income with $364 million in free cash flow for the quarter.

Source: Q2 Earnings Presentation

As noted above, core sales were strong in flow technologies and aquatic systems, however, it was weak in filtration systems. This will be important to monitor for continued weakness in future quarters. The more important note is that the operating income from the segment still improved alongside the other two segments.

Additionally, the company has a strong balance sheet with almost 90% of its debt being fixed. The company has a small amount of debt that is variable rate and is due in less than 5 years. Should rates continue to rise, the company could easily pay off this debt.

The company currently has a cash position of $78.7 million, however, with cash flow coming in much stronger, the company could use its stream of cash to relinquish the debt.

The company continues to return cash to shareholders, repurchasing $150 million worth of shares in the quarter, or 2% of outstanding shares. Additionally, the company announced its 42nd annual dividend increase to $0.175 per share.

Valuation

As we have seen the stock decline to 52-week lows, it is important to make sure the stock is trading at a reasonable valuation. Making sure the market is not being fair to Pentair is important before making an investment decision.

Source: Morningstar

The shares currently trade at a lower P/S and P/FCF ratio than in the past, however, it does trade at a higher P/B and PEG ratio than it otherwise normally has. Going forward, the valuation would be dependent upon the ability of the company to grow sales. Should sales not increase at a healthy pace, the company will not deserve such a high P/E and could trade down to a more mature valuation type multiple somewhere between 12-15x earnings. I believe the largest risk could come from a decrease in spending in the next recession by government and industrial projects. This alongside with lower discretionary income stopping consumers from investing in backyard projects like pools and spas could cause quite a downdraft in sales.

Given what we can estimate for the 12 months of 2018 and a fair assumption of growth going forward, we estimate the following DCF valuation. We picked these numbers as the water segment group is slated to grow at a much faster pace. Noted in this article from Water Online, just the spending on infrastructure by utilities is slated for a 47% increase.

Source: Money Chimp

With high single-digit growth for the next 3 years and mid-single digit growth thereafter, the company should receive a current DCF of $51.21. This is about 25% higher than where shares currently trade and should offer a margin of safety for new investors.

While competitors are not necessarily operating in 100% of the areas Pentair does, the closest we could find that operate in the water arena are below.

Chart PNR data by YCharts

As we can see Pentair trades at the lowest forward P/E. This further makes Pentair an attractive alternative as it is the cheapest in the space.

Prospects

What is rather interesting is the endless number of applications that need water for their operations.

Image result for Water filtration market

Source: Hexa Research

As we can see above, every industry from pharmaceuticals to food processing to water treatment requires a growing amount of investment. As the world population is set to continue growing, the needs will be extensive.

Photo Source: Our World

While growth has decelerated, it continues to remind us the needs for pumps to send the water to the facilities, such as the flow technologies division which should see benefit. The filtration needed for wastewater, bottling, pharma, and many other applications. The aquatics division of course helping create systems for mining, irrigation, and much more. The applications of water are often not thought of but are numerous. As the future holds nothing but growth, it is safe to say Pentair should be a significant benefactor of this growth.

As the media has brought light to failing water systems in aging municipalities, the solution to fix them is not handled quickly. Pentair has taken advantage of this by creating at-home filtration solutions for families who prefer to ensure their family is safe and protected from contaminated water. Furthermore, as technology-enabled platforms have allowed for control for equipment by devices, Pentair has introduced modules that allow for mobile control on any branded piece of equipment with a quick install of their device. This should help enable consumers to become familiar with Pentair and allow for further investigation into its offerings the next time equipment replacement is needed. These are just a few ways in which the company is expanding its reach into the end market.

Conclusion

Pentair is a dividend aristocrat trading at 52-week lows. The company operates in a cyclical environment for part of its operating segments but sells solutions that cannot be neglected upon by many industries. As the growth becomes more visible, Pentair could be acquired by a competitor or become the target of a private equity group. A strong stream of cash flow and financial strength makes the company a compelling investment. Should investors be searching for a pure play in the water space, Pentair offers it, and at a much more attractive valuation than many other players in the space. Continuing to watch operational growth is important and any weakness should be a sign of a slowdown in economy as the company serves many industrial customers. Besides an economic slowdown, Pentair does not face a huge amount of operational risk due to the necessity of its products. Fortunately, water filtration and flow is a necessity. The only other metric investors should watch is input costs as rising freight and steel costs may cause margin pressure. Additionally, rising oil prices have caused coating costs to go up since most of the equipment Pentair makes is painted in some fashion, this could also cause margin pressure. Investors looking to start a position, however, should take comfort in the margin of safety we have identified in the DCF valuation.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.