Pentair: Dividend Aristocrat Is Not Attractive

Summary

• PNR is a Dividend Aristocrat with 44 consecutive years of dividend increases.
• Because of low capital intensity, the company has copious annual free cash flow, which more than adequately covers the dividend.
• On a negative side, PNR is richly valued, while the dividend yield is meager.
• For now, I am not a buyer.

Pentair plc (NYSE:PNR) is a London-based company that provides water solutions both to consumer and industrial markets. PNR is considered to be a Dividend Aristocrat, as it has been increasing dividend payout for more than 44 consecutive years. However, I would not say PNR is a screaming 'Buy Immediately' for income-oriented investors even despite its relatively strong organic free cash flow to equity and anticipated mid-to-high-single-digit sales growth in 2021-2023. Let's proceed to the details to figure out why.

The top line

For a reader who is perhaps considering going long PNR, it is essential to understand that in the past, it had undergone complex portfolio recalibration, which is fully reflected in its revenue growth dynamics and equity changes.

A reader can notice similar bumpy revenue and equity changes in the cases of energy companies I cover: Hess (HES), Marathon Oil (MRO), and Murphy Oil (MUR). The steep declines in their revenues were caused by divestments of segments and global portfolio recalibration, as the oil players exited a few jurisdictions they considered no longer attractive.

PNR ended FY 2013 with $6.2 billion in shareholder equity, the amount 4.3x higher than it was in March 2020. Between 2011 and 2020, revenue fluctuated, touching $7 billion in 2014 and then retreating to $2.97 billion (from FY 2017 to FY 2019 sales had barely changed). Debt/Equity also wavered, going from 45.7% in 2013 to around 77% in the most recent quarter. The silver lining here is perhaps a year-long EPS growth trend and positive Free Cash Flow to Equity, which had been always generally in-line with earnings even despite sales volatility, and adequately covered annual dividends.

But what precisely led to such extreme fluctuations in the net worth? First and foremost, it was not a pure water treatment company. In 2016, it announced separation into two standalone public companies nVent Electric plc (NVT), an electrical protection & connection company, and Pentair plc to bolster shareholder value creation. The separation was completed in April 2018. It also has been quite active regarding acquisitions and divestments: in 2017, Valves & Controls was sold to Emerson Electric Co. Last year, PNR exited the aquaculture industry divesting the Vaki business unit. A few additions to the portfolio had also been made: Aquion, a company with products from water filters to ozone and ultraviolet disinfection systems, and Pelican, a residential whole home water treatment systems business.

In the 2019 Form 10-K, PNR made no remarks on its rivals. Thankfully, from Xylem's (XYL) most recent Form 10-K (see pages 7 and 8) we know that PNR, together with Grundfos, Wilo SE, and Franklin Electric Co. (BEN) are the principal competitors of its Applied Water segment.

While PNR had been optimizing business structure, its equity value gyrated with no clear recognizable upward or downward trend. Investors who bought shares in June 2015 have gained almost nothing (except for dividends).

Data by YCharts

As of June 9, nVent shares they received in 2018 are trading at a discount to the issuance price.

Data by YCharts

Modern-day Pentair operates via two segments: Consumer Solutions (pool equipment is responsible for 60% of revenue, 75% of sales are aftermarket) and Industrial & Flow Technologies (pressure vessels, gas recovery solutions, membrane bioreactors, etc.); it is worth noting that business structure was reorganized in 2020 (see page 18 of the Form 10-Q). The divisions that the firm used in the 2019 annual report are no longer relevant. Consumer Solutions was significantly stronger in the first quarter, as it delivered 8.5% sales growth that offset almost 3% contraction in IFT caused by the coronavirus-related delays that have taken a toll on commercial & infrastructure flow, and both core and overall sales were up 3%.

As PNR assured on slide 6, the CS division is a leader in the North American pool equipment business. But pools are not essential infrastructure. Pool installation is optional, it depends on household discretionary income and personal preferences. Even the pool repair is not a priority a family will use its cash flow for if the household is facing income issues. So, exposure to the swimming pool business makes PNR risky and cyclical. Segmental revenue will shine when the economy will rebound but lag behind when the sentiment is murky.

Expectedly, analysts do not believe 2020 will be overall positive for PNR's sales. They are expecting around 7% revenue contraction followed by a 5.4% growth in 2021.

Free cash flow and the dividend coverage

A surge in quarterly accounting profit vs. 1Q19 did not help Pentair to improve cash flows, as funds provided by operating activities were deeply negative and obviously did not cover capital investments of $18.7 million.

However, it should be noted that PNR cash flows have seasonal trends because of the cash collection cycle: Q1 net CFFO was sub-zero in 2018, 2019, and this year. In Q2 both in 2018 and 2019, it turned positive. So, perhaps it is too sophomoric to assess dividend coverage using quarterly data and it would be much better to tap annual or last-twelve-months figures for the sake of consistency.

Thanks to low capital intensity (it reinvests just around 2% of annual sales in property, plant, and equipment), LTM FCFE is well above zero and stands at $386.5 million. That amount is almost equal to its accounting profit; this fact signifies PNR has high earnings quality. In 2017-LTM, free cash flow to equity always covered the dividend more than 2x. That means the stock has a sustainable dividend and, hence, PNR is worth considering for income-oriented investors. The issue here is that the yield is not meaningful, just around 1.8% as of June 9. I would not say that there are a plethora of high-yield opportunities in the market right now, especially after a momentous rebound and rally of the global equities after the March stock market meltdown, but there are still a few attractive high-yielders like Schweitzer-Mauduit International, Inc. (SWM) that I have covered recently. In this sense, PNR does not look like a 'Buy.'

Debt

PNR has 77.4% Debt/Equity and around 2.9x Net debt/Net CFFO. That is not perfect, and I would like to see a lower share of borrowed funds in the capital structure and close to 2x ND/Net CFFO. The silver lining is that the nearest substantial maturity (revolving credit facility and term loan) is only in 2023 (see slide 9).

Pentair actively uses commercial paper and a revolving credit facility from quarter to quarter to finance certain expenses and expenditures. We can observe identical financing patterns in 1Q20 and both 2019 and 2018 when it issued and then repaid a considerable amount of debt due in one year. The reason behind that is clear: cash flow seasonality. I would not say it is a flashing red flag, as reasonable short-term debt financing does not put dividend in jeopardy. Dozens of public companies have been using short-term commercial paper financing without any threat to the robustness of financial position.

Final thoughts

PNR is a stock of choice for those investors who want to benefit from its leading position in the North American pool business. On a negative side, the pool business tends to fluctuate with the consumer sentiment and the economy as a whole. And the 2020 coronavirus pandemic had already inflicted damage.

I would not say the company is attractively valued at the moment given its 'D' Value Grade. The yield is also anything but attractive, even despite adequate dividend coverage. So for now, I am not a buyer.

Analyst’s 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.