With 40 straight years of dividend growth under its belt, Pentair (PNR) is a dividend aristocrat that is just a decade away from joining an even more elite club, the dividend kings.
Let’s take a closer look at this industrial blue chip to see what makes its business model so successful.
More importantly, learn if Pentair and its upcoming spin off are likely to continue generating strong total returns and dividend growth for many years to come.
Business Overview
Founded in 1966 in London, England (with roots going back to 1859), Pentair is the world’s leading liquid pump, valve, and control system manufacturer with 19,000 employees operating in 40 countries across six continents.
Pentair’s diversified product mix is placed in two main business segments, water and electrical.
Source: Annual Report
Source: Investor Presentation
The company derives the majority of its sales from North America, with a strong presence in Western Europe, and faster growing divisions in emerging markets such as China and Brazil.
Business Analysis
In order for any company to be able to consistently grow its dividend for decades, it must have several factors working to its advantage.
Pentair’s advantages primarily come from its long-standing customer relationships (Pentair has over 50 years of operating history), focus on profitable niches, reputation for quality, wide assortment of products, technical know-how, and sizable distribution network.
Pentair also has a large global installed base, which provides meaningful aftermarket revenue. This business generates less volatile cash flow that can be used for acquisitions. Pentair’s markets are highly fragmented, so it has plenty of opportunity to continue consolidating the industry.
Like many other industrial companies, Pentair also has its own management system grounded in lean methodologies. Pentair began its initial lean deployments in 2005 and believes lean operations are now part of its DNA, driving productivity throughout the enterprise.
As a result, the company’s disciplined, long-term focused management team has found ways to grow sales, earnings, and cash flow over time while maintaining enough of a competitive advantage to keep margins and returns on capital stable.
While Pentair’s sales, like all industrial companies, are cyclical, notice that over time it has done a good job of growing its earnings and cash flow much faster, and more consistently.
Similarly, the margins and returns on capital have been making steadily progress in the right direction in recent years.
Source: Simply Safe Dividends
That’s largely thanks to Pentair’s internal cost management system, which it calls the Pentair Integrated Management System, or PIMS.
Specifically, PIMS aims to steadily improve the company’s profitability through a wide variety of methods, including: consolidating its factories (30% in the next five years), optimizing its supply chain sourcing (to minimize costs), and focusing on its fastest growing and most profitable niche businesses.
For example, in August of 2016 the company announced it was selling its valves & control business, which mainly served the oil & gas industry, to Emerson Electric (EMR) for $3.15 billion in cash. This was a major restructuring for Pentair because valves & control was its single largest business unit in 2015, representing 27% of its sales.
The reason for this sale was to help Pentair minimize future sales and earnings volatility by focusing on high margin but more steadily growing units, specifically in the $37 billion and $58 billion global water and electrical industries, respectively.
Pentair’s long history and reputation for high quality also give it an advantage in the form of long-term customer relationships that allow it to customize its product offerings to service specific niches, such as advanced filtration systems for micro breweries.
Better yet, in recent years Pentair has taken a more active approach to obtaining new business by trying to become its customers one-stop shopping need for flow management and filtration services.
This means both creating complete systems for clients, as well as cross shopping its products, for example adding thermal management technology to protect one’s pipes once the customized fluid management system is designed and installed.
In addition, while Pentair doesn’t spend a lot on R&D (2.4% of trailing 12-month sales), it has managed to create some truly category dominating products.
For example, its intelliflow high energy efficient variable speed pool pumps dominate the residential pool market. Meanwhile, the triple offset zero leakage valve Pentair invented is the gold standard for high pressure industrial flow systems.
And once a customer has signed on with Pentair to supply its liquid control needs, the paramount need for reliability is often enough to keep customers from price shopping too aggressively, resulting in high switching costs and more recurring sales.
Furthermore, thanks to 2012’s merger with Tyco International’s flow control systems, Pentair achieved far larger economies of scale, while also leveraging its strong customer relationships into a greater focus on consumables (often replaced components), which make up about 40% of the company’s revenue and result in more stable, recurring sales and cash flows over time.
Overall, management’s capital allocation prowess has resulted in some very impressive profitability, with Pentair boasting solidly above industry average margins and returns on capital.
Sources: Morningstar, Gurufocus
Management also recently made the decision to separate Pentair into two companies, with the water business retaining the Pentair name and ticker, and the electrical business becoming a newly named company, in a tax-free spin off that’s expected to be completed by the second quarter of 2018.
Management’s rationale for the split is that each company will be financially strong enough to use this increased financial flexibility to pursue faster growth initiatives, both organically and through acquisitions, on its own.
And there is plenty of growth potential available to Pentair and its upcoming electric spin off, courtesy of long-term underinvestment in global infrastructure.
For example, Oxford Economics estimates that between 2017 and 2020 the U.S. will need to invest $80 to $100 billion into new infrastructure, while globally that figure is $1 trillion.
And between 2015 and 2045, the Federal Government estimates that an additional $926 billion in currently unplanned transportation infrastructure investment will be needed.
Meanwhile, America’s water infrastructure is also in bad need of upgrading and expansion, with almost $400 billion needed by 2030 to ensure Americans have access to clean, potable, and dependable water.
Source: SJW Investor Presentation
And with Pentair maintaining just 5% to 20% market share in its core vertically-integrated business units, there is certainly strong future growth potential through acquisitions and industry consolidation.
The bottom line is that Pentair appears to have plenty of growth runway ahead of it, and with management having proven itself successful at steady cost reductions over time, the company’s sales, earnings, and cash flow growth potential is solid, which bodes well for its ability to sustain double-digit dividend growth long into the future.
Key Risks
There are four risks that current and prospective Pentair investors need to consider.
First, even after the sale of its valves & control business, Pentair still gets about 10% of its revenue from the oil & gas industry. So while its future sales, earnings, and cash flow will be less cyclical than before, some variability in its business will still remain.
Second, the company’s strong growth track record and promising guidance (9% to 11% earnings and FCF growth) is for the consolidated company. Once the Pentair is split in two, only time will tell whether both businesses are capable of generating similar growth and market-beating total returns.
For example, in the last three years, Pentair’s water business has been far slower growing than the higher margin electric segment. However, Pentair’s strongest moat is in water, where it has the majority of its patents and expertise.
Source: 10-K
In addition, while management remains confident that splitting up the company won’t inhibit its long-term margin expansion plans, we can’t forget that as two smaller companies, Pentair is going to lose some economies of scale.
And then there’s the $100 million to $125 million in expected costs associated with the split, which could result in weaker than expected earnings and dividend growth in 2018.
Furthermore, management seems to be indicating that post split, both companies will become more aggressive in M&A. While Pentair’s historical record of acquisitions is good, we can’t forget that 87% of large acquisitions end up ultimately destroying shareholder value, mostly due to overpaying and poor execution (i.e. failure to achieve expected synergies).
Finally, as Pentair diversifies into faster-growing emerging markets, its revenue, earnings, and free cash flow will become more exposed to currency fluctuations, specifically a strong dollar which can hurt reported growth in both its top and bottom lines.
Pentair’s Dividend Safety
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.
Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.
Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.
We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.
Pentair has a Dividend Safety Score of 93, indicating a very safe and dependable payout, which is what one would expect from a dividend aristocrat.
There are two main factors supporting the high security and remarkable consistency of growth in Pentair’s dividend.
First, management has remained highly disciplined in maintaining a very conservative FCF payout ratio, ensuring that even during strong industry downturns, the company’s free cash is sufficient to allow for investment in the company’s growth, while preserving and growing the dividend as well.
The second protective factor is the company’s strong balance sheet, which allows for opportunistic growth through acquisition without diverting enough free cash flow to put the dividend at risk.
At first glance, Pentair appears to carry a relatively high debt load. However, because this is a highly capital intensive industry, it’s important to keep such metrics in perspective.
Sources; Morningstar, Fast Graphs
When we compare Pentair’s balance sheet against its peers, we see a much lower leverage ratio (Debt/EBITDA), debt/capital ratio, a strong current ratio (short-term assets/short-term liabilities), as well as a very high interest coverage ratio.
This results in an investment-grade credit rating that allows for borrowing cheaply, and management is confident that post split, both companies will continue to enjoy strong access to low cost debt capital.
Pentair Dividend Growth
Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
Pentair has a Dividend Growth Score of 72, indicating strong dividend growth potential in the coming years.
Now that the highly cyclical valve & control business is gone, Pentair’s dividend growth prospects look far brighter compared to its moderate dividend increases in recent years.
And considering that the company’s FCF payout ratio is relatively low, this means that dividend investors can likely expect Pentair’s dividend growth post 2019 (once the spin off costs are completed) to at least grow as quickly as its bottom line, and similar to its 9% to 11% historical growth rate.
Valuation
Over the past year Pentair has underperformed the S&P 500 by about 15%, creating a potentially attractive valuation.
For example, PNR’s forward P/E ratio of 17.3 may not be that much lower than the S&P 500’s 17.4, but it is far lower than both the company’s historical median value of 20.3 and the industry median of 23.1.
Similarly, the 2.3% yield isn’t that much higher than the S&P 500’s 1.9% or its peers’ 1.7%, which means that Pentair may not be the best choice for those looking to live off dividends during retirement.
However, keep in mind that over the past 22 years Pentair’s average dividend yield has been 1.9%. In over the past two decades, shares have only offered a higher yield about 15% of the time.
In other words, Pentair’s valuation looks reasonable compared to its long-term historical valuation levels. Pentair has potential to deliver healthy annual total returns of 11.3% to 13.3% (2.3% yield + 9% to 11% earnings growth) going forward.
Conclusion
When it comes to solid long-term investments, it’s hard to beat a boring but steady industrial name such as Pentair.
While only time will tell if both the water and electrical companies will enjoy the same impressive track record of steady growth, strong balance sheets, and clockwork-like dividend growth, given Pentair’s history and quality management teams, it seems likely that both stocks will continue generating solid long-term total returns and dividend growth.
With Pentair’s shares trading at reasonable levels relative to history and its energy exposure significantly reduced compared to a few years ago, today could be a good time to give this quality dividend growth stock a closer look for a diversified income portfolio.
Investors seeking more yield can review some of the top high dividend stocks here.
Brian Bollinger
Simply Safe Dividends
Simply Safe Dividends provides a monthly newsletter and a comprehensive, easy-to-use suite of online research tools to help dividend investors increase current income, make better investment decisions, and avoid risk. Whether you are looking to find safe dividend stocks for retirement, track your dividend portfolio’s income, or receive guidance on potential stocks to buy, Simply Safe Dividends has you covered. Our service is rooted in integrity and filled with objective analysis. We are your one-stop shop for safe dividend investing. Brian Bollinger, CPA, runs Simply Safe Dividends and previously worked as an equity research analyst at a multibillion-dollar investment firm. Check us out today, with your free 10-day trial (no credit card required).
Source: Simply Safe Dividends