PNR - Pentair's Outperformance Can Continue

Summary

• Pentair's revenue in 2023 may be affected by inventory destocking at channel partners, but this impact will be partially offset by pricing actions and the acquisition of Manitowoc Ice.
• The company’s margins should benefit from the transformative initiatives and pricing actions.
• The long-term story is compelling and the valuation is cheap.

Investment Thesis

Pentair's ( PNR ) stock has risen over 40% since our last bullish article , with a big jump coming after the recent earnings release. Although Q4 earnings showed modest revenue growth of 1% YoY and a 6% decline in earnings, investors were excited by the company's plans to improve margins over the next three years through a transformation initiative. This initiative focuses on four key areas: pricing, strategic sourcing, operational excellence, and organizational effectiveness, with the goal of improving margins by 400 basis points by the end of 2025. With good margin and earnings growth prospects and a still attractive valuation, I continue to have a buy rating on the stock.

PNR's Q4 FY22 Earnings

Pentair recently reported Q4 FY22 financial results that exceeded expectations. Revenue increased ~1% YoY to $1 billion, beating the consensus estimate by $6.32 million. The adjusted EPS was down 6% YoY to $0.82, exceeding the consensus estimate of $0.79. The revenue growth was driven by higher price realization and the acquisition of Manitowoc Ice, while volume decline and negative foreign currency translation had a partially offsetting effect. The adjusted operating margin improved by 130 basis points YoY to 18.2%, due to pricing actions but partially offset by volume decline. The adjusted EPS decline was due to higher net interest expense from the debt taken on to acquire Manitowoc Ice in July 2022.

Revenue Analysis and Outlook

In Q4 FY22, the Consumer Solutions segment's sales decreased 1% YoY due to an 11% decline in core sales caused by inventory destocking in residential channels and a negative 2% foreign currency impact, partially offset by the acquisition of Manitowoc Ice. Manitowoc Ice is a leading provider of commercial ice machines and is helping Pentair expand in the Food & Beverages market. The Industrial & Flow Technologies segment's sales increased 5% YoY, largely due to higher price realization (11%), partially offset by headwinds from foreign currency translation and divestiture. Effective January 1, 2023, Pentair divided its Consumer Solutions segment into two segments, Pools and Water Solutions, resulting in three reporting segments.

Looking forward, Management is viewing FY23 as a catch-up year for excess demand the company has witnessed in the last couple of years post-Covid and has guided for a ~1% decline in sales for the full year.

Segmentwise, in the pool business, the company should continue to experience volume declines in 2023 due to inventory destocking at its channel partners. The demand has been declining as customers continue to decrease their discretionary spending. PNR's pool business experienced strong demand over the last three years, especially in 2021, when its sales grew ~40% Y/Y. The volume decline should be partially offset by the pricing actions taken in 2022. Management is expecting sales in the pool business to be down low double digits in 2023. Normally, this business derives ~80% of its sales from repair and remodel market and is expected to be somewhat resilient. However, it faces very difficult comps, especially in the first half of 2023. So the decline is expected to be steeper this time. The good news is that once the reset from extraordinarily high COVID demand is over, this business should return to growth in FY24.

The Water Solutions segment focuses on drinking water filtration and water softening solutions in the residential and commercial markets. The residential market contributes one-third to the segment's revenue, and the commercial market contributes the other two-thirds. Management's guidance assumes a ~10% decline in Water Solutions' residential business, which looks conservative given 90-95% of residential business in this segment comes from the aftermarket. The commercial business is expected to do much better, with hotels and restaurants benefiting from the reopening. The business should also benefit from the Manitowoc Ice acquisition. Management expects sales in the commercial business to be up 40% and the total Water Solutions segment sales to be up in the mid-teens in 2023.

The Industrial & Flow Technologies segment is expected to have flat Y/Y growth in 2023 due to a mix of factors. The segment is comprised of three main businesses: residential and irrigation flow (45% of revenue), commercial and infrastructure flow (25% of revenue), and industrial filtration (30% of revenue). The aging infrastructure of wastewater treatment plants and healthy demand in the irrigation market due to high net farm income are expected to benefit the segment. Additionally, increased demand for sustainable gas solutions after the Russia-Ukraine conflict is also expected to have a positive impact. However, these factors may be offset by the weakening residential end market.

While there is little doubt that 2023 will be a tough year for PNR, the good news is it should mark the bottom of organic revenue decline, and once the destocking in the pool business is complete, the company should return to mid single-digit revenue growth from FY24 onwards.

Margin and EPS Growth Outlook

In Q4 of FY22, the Consumer Solutions segment saw a 150 bps Y/Y increase in adjusted operating margin to 23.1% due to higher pricing and contributions from Manitowoc Ice. The Industrial & Flow Technologies segment's adjusted operating margin rose 240 bps Y/Y to 17.4% due to pricing measures and moderating inflation.

Looking forward, the company is working on its multi-year transformation initiative and is targeting a margin expansion of 400 bps by the end of 2025, considering 2022 as the base year. The initiative has four key themes: Pricing Excellence, Strategic Sourcing, Operations Excellence, and Organizational Effectiveness. A significant portion of this initiative is focused on reducing material costs, which is 40% of the company's sales. The company has been increasing prices to offset inflationary costs, which has benefited the margins over the last three quarters. Under strategic sourcing, the company is working with its suppliers to reduce inefficiencies in its supply chain. In Operations Excellence, the company is focused on reducing complexity and driving lean processes across all its operations. In Organizational Effectiveness, the company is focusing on sales and functional excellence to simplify its organization. This should be done by reducing the complexity of its business portfolio.

The company's margin should expand in 2023 despite volume deleveraging due to its transformation initiatives and the pricing actions taken over the last few quarters.

In the medium to long term, PNR is poised to see meaningful EPS growth thanks to these initiatives. If we do some back-of-the-envelope calculations and assume a ~1% Y/Y decline in revenues for FY23 (as per management guidance) and 4% Y/Y growth in revenues in FY24 and FY25 (mid single-digit long-term revenue growth), we have $4,412 mn in revenues for FY25. [Calculation: FY22 revenue of $4122 mn * (1-1%) * (1+4%) * (1+4%)= $4412 mn in FY25 revenues]

Assuming 400 bps margin improvement vs. FY22's 18.6% EBIT margins, FY25 EBIT margin should be 22.6%. Using $4412 mn in FY25 revenue estimates, we have FY25 EBIT of $997 mn.

The company's net interest expense last quarter was $27.6 mn. Annualizing it we get an annual interest expense of ~$110 mn. The company's adjusted tax rate in FY22 was ~14.5% and its weighted average diluted share count in Q4 FY22 was $165.2 mn. Using similar numbers for FY25 we have net income at ~$758 mn [=($997 mn - $110 mn)*(1-14.5%)] and adjusted diluted EPS at $4.58 per share [=$758 mn/165.2 mn]. These of course are the rough calculations. Interest rates in FY25 may turn out to be lower due to debt repayment and the share count may decline due to buyback activities, leading to further potential upside. Nevertheless, this number implies a meaningful growth versus the current FY23 consensus EPS estimates of $3.58, and I believe the company's transformation initiatives will prove a game changer for investors, meaningfully driving EPS growth for the company.

Valuation & Conclusion

The stock is currently trading at a P/E ratio of 16.37x based on FY23 consensus EPS estimates of $3.56 and 14.67x based on FY24 consensus EPS estimates of $3.97, below its five-year average forward P/E of 17.71x. If the company returns to its five-year average P/E multiple of 17.71x by FY25, it would result in a target price of $81.10 using the FY25 EPS estimate of $4.58, implying a potential 40% increase from current levels over the next three years. With a 1.51% dividend yield, the stock could offer mid-teens annual returns over the next three years. Despite expected short-term headwinds and a 2023 revenue impact from an inventory destocking at channel partners, revenue growth is expected to normalize in H2 2023 and 2024. Combined with the company's margin expansion initiatives, this could result in a good return on investment. Thus, I have a "buy" rating on the stock.

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