PNR - Pentair: Pool May Stay Cold In 2024 But Overall Story Getting More Attractive

2023-10-26 05:54:39 ET

Summary

• Pentair showed good margin performance in Q3 despite significant volume pressures from its residential markets, Pool in particular.
• I'm not bullish on the outlook for 2024, as I think pool demand will be constrained by higher rates and tighter household budgets and non-residential markets are likely to soften.
• I like the long-term opportunities in IFT segment, including growth opportunities like carbon capture and waste stream reclamation, and the margin improvement plan is a credible one.
• Valuation is getting attractive here; my main issue with recommending PNR stock is that expectations for a double-digit Pool recovery in 2024 (partly on easier comps) may be too optimistic.

It’s been a while since I’ve written about Pentair (PNR), and the last 18 months have seen some of the challenges I mentioned in my last article come to fruition – the business has been challenged by a sharp slowdown in residential spending, non-residential activity has shown some stress (though Pentair has outperformed), and industrial markets like filtration have been pretty good.

The shares declined as much as 30% after that last article (wherein I thought it was too early to buy), and have since regained enough ground to be more or less flat in terms of stock price performance (matching the broader industrial space). That performance largely matches that of Franklin Electric ( FELE ) (a comp in some water treatment/quality and pump markets) and exceeds that of Hayward ( HAYW ) (a rival in pool equipment) and Gorman-Rupp (GRC) (a rival in industrial markets).

Having gone through third quarter earnings and revised my model, I end up more bullish on Pentair than I expected to be. The valuation is good enough for a “buy” now, but I do have some concerns about how the Pool segment will perform in 2024. I worry that expectations are too high given the credit environment and as Pentair’s lead business (the highest margins by a good distance), that could create sentiment challenges.

“Good Enough” In A Tough Market

Relative to the pressures in the residential markets that make up more than 60% of Pentair’s revenue, I think the company did fairly well in the third quarter. There’s no missing the significant impact of lower volumes on the business, but underlying margin performance was still quite good and should build confidence in further margin improvement targets and goals.

Revenue declined a little more than 4% in organic terms, good for a 2% beat. Revenue in the Pool business plunged 21% on a 28% decline in volume as the company saw ongoing impacts from destocking and a weaker residential market.

Water Solutions was basically flat, with a meaningful decline in residential sales (down 14%) offsetting strong commercial growth (up 25%) and good performance from Manitowoc Ice.

Industrial and Flow Technologies was up 1% on a 4% volume decline led by, yep you guessed, it residential – residential sales (irrigation and pumps) declined 7%, undermining better results in commercial (up 8%) and industrial filtration (up 12%).

Gross margin improved 390bp from the prior year and was flat sequentially at 36.9%, as the company benefits from input cost relief, sourcing initiatives and so on. Given what should have been a headwind to capacity utilization from the destocking in Pool and overall volume declines of 12%, I like that performance.

Segment profits rose about 6%, with margin up 230bp to 23.5%, and Pentair outperformed by about $0.06/share here (adjusted overall operating income was up a little less than 3%). Pool profits fell 17%, with margin up 230bp to 23.5%, Water Solutions profits rose 40% (with margin up 510bp to 23%), and IFT profits rose 18% (with margin up 250bp to 19.4%).

Is Double-Digit Pool Growth Too Much To Ask For in 2024?

Looking at 2024, one of the biggest questions about Pentair is just how much the Pool segment will bounce back. Between comments from Pentair and Pool Corporation (POOL), the leading pool equipment distributor, the destocking process is almost finished – Pentair expects volumes down year over year in Q4’23, but Pool Corp is talking about growing inventories in Q4 in anticipation of 2024. With all of that, it looks like Pentair’s Pool volumes will decline somewhere around the mid-20%’s for 2023.

That sets up an easy comp for 2024 … or does it? My concern with Pentair a year ago was that the boom in home spending during the pandemic pulled forward a lot of demand for improvements like pools. I expect 2024 to be fairly lackluster for new home construction and home sales, and I likewise don’t expect a lot of discretionary renovation or improvement, particularly given the high-rate credit environment we’re in now. Consumer used to getting bargain-basement rates on projects are now seeing sticker shock on the financing side, and I think the combination of higher rates and pulled-forward activity could create some downside risk in 2024.

Sluggish Non-Resi And Slowing Industrial Could Be Threats As Well

The Manitowoc deal has already been a good one for Pentair, but I am concerned that the company is burning through the backlog at a rapid pace and that underlying commercial sales are going to be weaker in 2024. There’s growing evidence of slowing non-resi activity, and I expect that to lead to lower demand for new-build capex (fire suppression and flood control) and retrofit projects, as well as weaker capital spending in the foodservice and hospitality markets.

On the industrial side, process markets in general are still doing well, but there’s been more pronounced weakness lately in markets like food/bev and shorter-cycle “general industrial” markets. I do like the long-term leverage to opportunities like waste stream recovery, biogas, and carbon capture, though, as well as increased onshoring (more factory capex in the U.S.), and the company’s ongoing shift away from more volatile project-based business (in favor of a more standardized product array). Likewise, I like the company’s move toward value-based pricing (replacing a cost-plus approach), as I think the company’s membrane and filtration technologies haven’t been best-served by that approach.

The Outlook

While Pentair’s various end-markets sort themselves out over the next couple of years, there is an ongoing self-improvement project underway. Management is targeting 25% adjusted operating margin through a combination of facility consolidation, improved sourcing, and value-based pricing (as well as initiatives like moving away from project-based business), and while I don’t think they’ll get there in the next three years, I like the plan. In fairness and in the interests of trying to give a balanced picture, I do have to note that execution at Pentair has historically been hit-or-miss, so taking all of the improvements as a given may be too bullish.

I’m expecting long-term revenue growth from Pentair around 4% a year over the long term, underpinned by population moves into the Sunbelt (perhaps helped by climate change), further expansion of the water solutions business (including in-home water quality), and better maximization of IFT’s technological capabilities (growth opps like carbon capture and waste stream recovery). My concerns about a slower Pool recovery in 2024 are in my model, and my 2024 revenue estimate is a little below the published low estimate on the Street at this point.

On the margin side, a weaker Pool business could create some short-term margin risk, but the company has executed well through a volume downturn already. I believe mid-20%’s EBITDA margin is attainable in FY’25, with an adjusted operating margin around 23%. With this, I think free cash flow margins will enter the high-teens around 2027 (from an historical average in the low double-digits), but likely climb more slowing thereafter, but still supporting a low-to-mid teens normalized growth rate.

Between discounted cash flow and margin/return-driven EV/EBITDA (with a forward multiple of 13.25x), I get a fair value in the high-$60’s.

The Bottom Line

Pentair isn’t necessarily well-loved at this point, and there is no shortage of neutral ratings (and a couple of “sell”s), and that’s a positive to me. The valuation makes this worth watching closely, as my main hesitation now is whether the Street really does believe in a big rebound for the Pool segment in 2024 and how the stock might act if those expectations have to be revised lower. I’m not willing to take the risk yet, if this pullback continues that may change.

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