Ladies and gentlemen, thank you for standing by, and welcome to the Pentair Third Quarter 2018 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question and answer session. If you would like to ask a question at that time, please press star one on your telephone keypad. Mr. Lucas, please go ahead.
Thanks, Christelle, and welcome to Pentair's Third Quarter 2018 Earnings Conference Call. We're glad you could join us today. I'm Jim Lucas, Senior Vice President of Investor Relations and Treasurer. And with me today is John Stauch, our President and Chief Executive Officer, and Mark Borin, our Chief Financial Officer. On today's call, we will provide details on our third quarter 2018 performance, as well as our fourth quarter and full year 2018 outlook as outlined in this morning's press release. Before we begin, let me remind you that any statements made about the company's anticipated financial results are forward-looking statements subject to future risks and uncertainties, such as the risks outlined in Pentair's most recent 10-Q, Form 10-K, and today's press release. Forward-looking statements included herein are made as of today, and the company undertakes no obligation to update publicly such statements to reflect subsequent events or circumstances.
Actual results could differ materially from anticipated results. Today's webcast is accompanied by a presentation which can be found in the investor relations section of Pentair's website. We will reference these slides throughout our prepared remarks. Any references to non-GAAP financials are reconciled in the appendix of the presentation. We will be sure to reserve time for questions and answers after our prepared remarks. I would like to request that you limit your questions to one and a follow-up in order to ensure everyone an opportunity to ask their questions. I will now turn the call over to John.
Thank you, Jim, and good morning, everyone. Please turn to slide number four, titled Executive Summary. We are pleased with our third quarter, as we were able to deliver results in line or better than our forecast on all of our key metrics, marked by 6% core sales growth, 10% adjusted EPS growth, and over $100 million of free cash flow generated in the quarter, and $265 million year to date. All three segments contributed to the top-line performance, with Aquatic Systems delivering a strong 12% core sales growth in the quarter. We also used our strong balance sheet and cash flow to buy back $100 million of shares in the quarter, and have purchased $400 million through the first three quarters.
For the full year, we have raised our core sales growth expectation by a full point to be 4%-5%, and we are still expecting ROS expansion of approximately 50 basis points to 18%. We are also raising our adjusted EPS guidance to be approximately $2.33, which reflects the third quarter performance, as well as a small benefit from share repurchases in the quarter. This marks the second consecutive quarter that we have raised our expectations, driven in part by continued healthy end markets as well as continued execution across our portfolio. I would now like to turn the call over to Mark to discuss the third quarter results and update you on the details of our full year 2018 outlook before I provide an update on our key strategic growth initiatives.
Thank you, John. Please turn to slide five, labeled Q3 '18 Pentair Performance. As John mentioned, core sales grew 6%. All three segments contributed this quarter, with particular strength in Aquatic Systems. We will provide more color on the performance of all three segments shortly. Segment income increased 1%, while ROS contracted 40 basis points to 17.1%, in line with expectations as price increases implemented to offset inflation took effect late in the quarter. We will expand on the margin performance when discussing the individual segments. Adjusted EPS grew 10% to $0.54 per share, which was $0.02 ahead of our prior guidance. Our adjusted tax rate remained 18%, and our share count came in at 175.7 million shares, benefiting in part from the $150 million in shares we repurchased during the second quarter, and an additional $100 million we repurchased during the third quarter.
Free cash flow was strong in the quarter at $108 million, and we have generated $265 million in free cash flow year to date, which is in line with normal seasonal patterns. Please turn to slide six, labeled Q3 '18 Pentair Segment Performance. This slide lays out the performance of our three segments. Aquatic Systems delivered its strongest performance of the year with 12% core sales growth in the quarter, income growth of 13%, and ROS expansion of 60 basis points. We saw strong demand in the quarter, favorable mix, and continued dealer gains. In addition, we implemented our annual price increase in September while continuing to increase our growth investments in this important segment. We believe the outlook for Aquatic Systems remains very favorable, and we continue to believe in the long-term outlook of our franchise business.
Filtration Solutions returned to growth in the quarter, with core sales increasing 2%. We continue to see pockets of strength in our important North American residential and commercial markets. We saw particular strength in our niche industrial businesses, just as important, our food and beverage business showed signs of stabilizing after first half declines. Segment income decrease and ROS contracted 70 basis points to 16%. We implemented price increases in September to help mitigate increased inflation due in part to tariffs implemented in July, we do not expect to see the full benefits of the price increase until the fourth quarter. Flow Technologies reported its third consecutive quarter of core sales growth, and its 5% core sales growth was its strongest performance of the year. We saw solid performance in our North American residential and irrigation business, and our large pump business showed further signs of stabilization.
We would remind everyone that this is the smallest part of our Flow Technologies segment and tends to be longer cycle and therefore a bit lumpier than our other businesses in Flow. Segment income was down 7% and ROS contracted 150 basis points to 15.4%. The margin performance was similarly impacted as Filtration Solutions due to the timing of inflationary pressures and the corresponding price realization. Please turn to Slide 7, labeled Balance Sheet and Cash Flow. This continues to be one of our favorite slides as free cash flow remains strong, and we have significantly reduced our debt levels during the year. As we pointed out last quarter, our debt is now at a level not seen since 2010.
Given the strength of our balance sheet, we believe we are well-positioned to invest in the business, look at attractive, strategically aligned tuck-in or bolt-on acquisition targets, and continue to return cash to shareholders. We have bought back $400 million in shares year-to-date, and we would remind everyone that we have raised our dividend for 42 consecutive years. Please turn to Slide 8, labeled Q4 '18 Pentair Outlook. We anticipate fourth quarter core sales to grow 4%-5%, with all three segments contributing. We expect Aquatic Systems to be up 10%-12%, Filtration Solutions up 1%-2%, and Flow Technologies to grow 2%-3%. Segment income is anticipated to be up approximately 6%, while ROS is expected to expand roughly 30 basis points.
Below the line, we expect the adjusted tax rate to be around 18%, net interest and other expense to be approximately $7 million, and our share count to be around 176 million. Adjusted EPS is expected to be approximately $0.59 per share, which would be the fourth consecutive quarter of double-digit adjusted EPS growth. Please turn to Slide 9, labeled 2018 Pentair Outlook. This slide is one we first introduced at our Investor Day in February, and we wanted to provide an update as we enter the home stretch of 2018. Given our strong year-to-date performance, the expected overall sales number is slightly higher than our initial forecast for the year. All three of our businesses implemented price increases in September.
Consistent with the second half outlook we discussed in our second quarter earnings call in July, the price implementation is essentially in line with our prior expectations. Our full-year outlook for inflation has not materially changed. The net result is that our full-year Segment income expectations have not changed, and we will continue to expect to drive productivity in addition to price increases we have implemented. Please turn to Slide 10, labeled Full Year 2018 Pentair Outlook. For the full year, we have raised our core sales growth forecast by a point and now expect core sales to increase 4%-5%. We expect Aquatic Systems core sales to grow roughly 10%, Filtration Solutions to be up 1%-2%, and Flow Technologies to increase 2%-3%.
Segment income is expected to be up around 8%, while ROS is expected to end the year around 18%, which would represent an increase of roughly 50 basis points. Below the line, we expect the full-year adjusted tax rate to be around 18%, adjusted net interest and other expense to be roughly $30 million, and shares to be around 178 million. For the full year, we now expect adjusted EPS to be around $2.33 per share, and we continue to target free cash flow to approximate 100% of adjusted net income. I would like to turn the call back to John.
Thank you, Mark. Please turn to Slide Number 11, titled Pentair Strategy Summary. We have used this page consistently in our earnings presentations to remind everyone of our strategy to be the leading residential and commercial water treatment company and to share with you the areas where we are investing in growth. Our focused areas of strategy remain on advancing growth in pool and accelerating residential and commercial water treatment, which requires investment at the business and the enterprise level. Our approach to capital allocation remains disciplined, and we remain committed to maintaining our investment grade rating, reinvesting in our most attractive core businesses, and paying competitive dividend yield. We will also look at a balanced approach between M&A and intelligent buybacks, with our M&A decisions being informed by overall valuations and the quality of assets available, as well as our ability to integrate them successfully.
Please turn to Slide 12, labeled Focus Strategies. As we prioritize our growth priorities, we believe this allows us the best opportunity to drive differentiated growth in what we believe is a very attractive water quality space. I would like to give you a quick update on our progress regarding our two most important focus strategies. The first strategy is advancing pool growth. One of our biggest opportunities around automation and connected pools and products. We continue to increase our new product introductions inclusive of smart technologies and have launched two new automation systems. Our IntelliConnect is an entry-level automation system that connects only a few existing pool products. We have also launched our next generation of our more advanced IntelliConnect platform that provides the highest level of automation for our end consumers and pool dealers.
Less than 10% of the 5 million installed in-ground pools today have some form of automation system, and we believe this represents a continued runway of growth where we will continue to invest. Our second key growth initiative is accelerating residential and commercial water treatment. We've conducted several consumer surveys to better understand the market, but equally important, we are engaging consumers through digital marketing to build brand strength and drive demand through our dealer network. We are in the early innings of moving up the value chain from being a leading component supplier to introducing smart, connected, branded products and solutions. We've made several investments in China and Southeast Asia as we see a lot of opportunities in this large market. Please turn to Slide Number 13. This is a slide that we publicly introduced at the EPG conference in May of this year.
We wanted to remind everyone of our long-term goals. In the current inflationary environment where price has been easier to get, and assuming this continues, we would not be surprised to see core sales growth trending toward the upper end of the range, if not slightly better. We are currently expecting the pricing environment, coupled with productivity, to generally offset inflation, and we'll provide more details on the impact to 2019 guidance when we release our fourth quarter earnings at the end of January. We wanted to remind everyone that our long-term goals have not changed. I would now like to turn the call over to Christelle for Q&A, after which I will have a closing comments. Christelle, please open the line for questions. Thank you.
Thank you. At this time, in order to ask a question, please press star one on your touch-tone phones. Once again, that is star one to ask a question. Please limit your questions to one question and one follow-up. One moment please for your first question. Your first question is from Deane Dray with RBC Capital Markets.
Thank you. Good morning, everyone.
Good morning, Deane.
Hey. Start off with a congratulations on that pricing power in pool. Last quarter, it was controversial at the time that you were one of the few companies to hold off on implementing price increases for this one segment, it certainly came through. Could you give us some color as to what that process was? How much price did you get? How much of it stuck? What you think the underlying growth in pool was in the quarter?
Sure, Deane, thanks for the comments, agree that the pool business certainly has the ability to control their pricing decisions and had a strong result. Pricing was in line with expectations. As we discussed before, the price went in in mid-September, in Q3, only saw a small impact of that for the pool business in the Q3 quarter. We'll see the full benefit of that in Q4. It's in line with our expectations overall, it's part of the price that you see for the full-year expectation on our full-year walk. In terms of their growth split between price and core growth, think of most of the growth in Q3 coming from volume rather than price. Only maybe a point to two points of growth coming from price. That grows about double that in Q4.
Got it. Just could you clarify the outlook for this IntelliConnect product? This seems to us to have the potential to be one of these revolutionary products similar to the variable speed pump that you introduced. Today, what's your expectation for growth in IntelliConnect, do you have to retrofit pools in order to implement the system?
The answer to the last question is no. It is an automation system that obviously works off of Wi-Fi or the internet connects to the products to basically give you an intelligent pool system, Deane. Yes, we do believe that. You're talking about 5 million installed pools, less than 10% of them today run on some type of automation capability. That automation capability provides two opportunities. One is for dealers to remotely monitor pools and manage the proper pool for composites for people. The other one is for the consumer themself to interact with their pool more effectively. Lighting, variable speed pumps, as you mentioned, saltwater pools, the chemistry. We see it as a revolutionary product for sure, this one's an easier one that creates over-the-air software updates and really has a better graphic user interface capability.
It's open architecture, meaning it will work not only with Pentair products, but it'll also work with our competitors' products as well, which we think is also revolutionary.
Good to hear. Thank you.
Thank you, Deane.
Your next question comes from Joe Giordano with Cowen.
Hey, guys. Good morning.
Morning.
Morning.
If we look at the other non-pool businesses, how do you feel like you were with your price increases? Do you think you were forward-thinking enough, or were they large enough to deal with your forward expectations for inflation? How do you see that kind of playing out over the next few quarters?
Yep. Yeah, we do. Again, similar response for the other two businesses. The price kicked in in the back half of September, and the realization is consistent with expectations. We see that reading out as expected in Q4. We had a little bit of pull-in in Q3 ahead of the price increase, which we had anticipated. That reduces a little bit of the price expectation for the full year. Overall, on a run rate basis, it's consistent with our expectations and our views on inflation, which price was put in to offset or, and mitigate, remain unchanged as well. You can see the full year expectation on inflation remains about $80 million.
Then, as it relates to your China strategy, how have your discussions at least changed a little bit to consider what's going on trade-wise and geopolitically there? Is there any alterations that you need to make to how you deploy that strategy?
It's a great question. We do about $160 million in China and Southeast Asia overall from a revenue stream, and most of that in our filtration businesses. We still are committed to our China strategy, primarily because they're advanced in the way that the market is evolving. The rate of pace. They're going to put 3,000 new Starbucks stores in. There's a competitor coffee chain called Luckin doing 1,000 stores this year, 2,000 next year. These are some enormous growth rates. We also have the context of we're working with the internet there and the way that people buy off the internet and looking at two to three-hour delivery windows of the products.
I think it's an area that we're going to continue to participate in because we're learning and growing and establishing a lot of the tools and principles that I think ultimately are going to work themselves back into Europe and North America as well.
Last for me, it's still early days post-split, but maybe John, can you just talk about maybe what are some of the biggest changes you've seen internally so far, and maybe a couple of examples of something that's taking a little bit longer than you'd like to move forward in the direction you see?
I'm very impatient, everything takes longer. I'm very proud of the way the team's leaning in. Obviously, great result in the quarter as evidenced by dealing with a late announcement of a tariff impact and reacting to it the best we could and managing through those expectations. We're getting back to consistency and predictability. What we're most excited about is we're having discussions about winning at the product line level again. We have some 30 major product lines, and that's really where you win. You differentiate your product against the competition in the customer's eyes. We're having good discussions about how to utilize technology and innovation and business model innovation to really differentiate that customer experience. That's going to take longer time, but that's ultimately how we're going to get back to the core organic growth that I know we can achieve.
Thanks, guys.
Your next question comes from the line of Steve Tusa with J.P. Morgan.
Hey, guys. Good morning.
Morning, Steve.
Morning, Steve.
Just on free cash flow. You guys, I think, are running slightly ahead of net income. I don't know which net income you use, whether it's adjusted or GAAP or whatever, year to date. I think fourth quarter is usually relatively strong. Anything different about this year, or am I just not getting the normal seasonality right?
No, you got it right, Steve. We're still targeting adjusted net income. Cash flow to be 100% of adjusted net income. Obviously, we'll work through the normal seasonality patterns, and there's nothing really to update at this time.
Anything unusual about the performance in the third quarter that stands out that's not sustainable on the cash front?
No.
The third quarter was in line with expectations. We don't see anything necessarily unusual in the fourth quarter as well.
Okay. I don't know if anybody asked it yet. Tariffs, just kind of give us an update on how you're thinking about that and maybe just give us an update or some color, remind us about your kind of sourcing structure. I think just anything from China is going to get marked up. How are you guys thinking about it into 2019?
Sure, Steve. The overall story on tariffs and inflation in general is, as I mentioned before, is just the consistency with our previous expectations. As we look at the balance of the year, our inflation expectation remains at about $80 million. That includes all the tariffs that have been announced and implemented. It includes sort of the people talk about lists one, two, and three in the different sections that make that up. That's all reflected in our expectations. Really no change from what we talked about before. As we've already touched on pricing and our expectations there. We certainly are going to continue to evaluate the overall supply chain and look for opportunities to be able to make changes to reduce the impact of tariffs long term. Those things take a little bit longer, obviously. We're certainly looking at that.
We have a factory in Suzhou. We'll evaluate what we do there and how our overall supply chain structure is organized.
Yeah. I guess just more specifically, you're only getting hit by part of this year, and then there's other lists, who knows, three, four, five, six, seven coming through. What do you see as of today, assuming some of these things come through, just using a kind of simplified view of what you're sourcing from China and then sticking some sort of an increase in cost on that, what would you expect that headwind in 2019 to be that you could overcome with productivity or whatever else you do?
Yeah. Steve, just to reiterate, the 2018 reflects everything that we currently get out of China, including direct and indirect sourcing. When we put the pricing forward on September 15th, we assumed that we'd likely see another couple points of inflation heading into 2019. That is probably at least a likely scenario, given the fact that we're going to continue to see inflationary pressures come from all of these lists that happen. I think right now we feel like we've got things well contained, and we can only deal with what we know, Steve. If there's anything else that comes about, we reserve the right to go back with incremental price increases.
Okay. Sorry, one last question. What is that bucket of cost that you talked about, either direct or indirect coming from China?
What do you mean, Steve?
What is the total cost of the stuff you're sourcing from over there so maybe we can just do the math ourselves?
Think of it as roughly $300 million, both direct and indirect.
Great. That's exactly what we're looking for. All right. Thanks a lot. Great call.
Thank you.
Your next question comes from Scott Graham with BMO Capital Markets.
Hi, good morning. I guess I just want to piggyback a little bit on Steve's question here. If we look in the third quarter, the waterfall. The inflation is a $24 million number, I know you guys indicated that it's still in line with your expectations, but the most recent two lists were post your second quarter earnings report, the $24 million does not seem to be yet fully loaded with inflation. Could you give us an idea, is there going to be a need to go out with more pricing, let's say, in pool, and have your price increases in the other two segments contemplated what could be over $100 million number next year?
As John referenced before, our expectations haven't changed, the forecast that we've put forth of approximately $80 million reflects all the tariffs that have been announced and implemented, which there's nothing new that's out there. The list that you're referring to, even though they hadn't been implemented and effective prior to our last quarter's guidance, there was enough information out there that we had some visibility to that. As John said, we frankly don't know what we don't know, we reserve the ability and the right to be able to go back and adjust and go back for more price if necessary. The guidance that we have for the year stands on its own and remains unchanged from what we provided previously.
Just to add to that, Scott, as I said, we put in price increases that not only reflected our 2018 expectations for inflation, but that inflation would continue. We're hopeful that we've got enough in there. If not, we'll adjust accordingly.
Okay, great. Maybe just as a quick follow-up to that. I know that the model has been so far as an independent to sort of do the price plus productivity will offset inflation. I'm just wondering if, given your answers to the above, you're thinking on the price increases, which you've answered affirmatively, that they have contemplated more inflation. Could we get to where we are price cost neutral in the first half of next year, excluding productivity, just pure price cost?
I don't think so, Scott. I think we're counting on prices the majority of it, but we also need productivity. Keep in mind, our sourcing teams are active every single day seeking alternative sourcing. We, even within the inflation number this year, have favorable productivity, and you see that in the column offsetting that. I think we're going to need productivity, and we're also going to need growth contributions, Scott. I think that's just the environment we're in right now.
I got you. If I could just squeeze one more in, if you don't mind, and thank you for that answer. I was very interested in your comments, John, about the surveys, understanding the market, which you and I have discussed before, how you're engaging consumers more, the dealer network, the whole thing. I was just wondering if you can give us maybe a couple of win examples, things that you're really excited about that the team actually was able to monetize over the last quarter.
Yeah. I think, first of all, I'll go across the segments. I think Pool really has a great dealer intimacy. When I mention the dealer, it's the actual dealer talking to the consumer and working with the consumer. What we're learning is that that consumer is becoming more and more educated, and as they become more and more educated, we're able to create more content. As you put your pool in or you think about your retrofits to the pool, you're very excited about all of the other products that you can bring to the table. We are clearly getting more content through to the aftermarket, and I do think that that's a result of learning that the consumer is important in helping to influence that end state.
In Filtration, what we're learning is, as you would expect, it's not a national or global issue, it's more local. Your city and where you live, your water quality varies. Obviously, I've shared this with you, New York City is not a problem for water. As you start to move into other particular regions, you have challenges, and getting more specific around the challenges to each region allows us to have the right products to our dealer channel to solve those issues. Very excited about our growth there. In Flow, I think we're starting to realize that we have major brands that we are very well respected and that we need to continue to work to get those products and make those available to the end customers.
We have to work through various distribution channels to do that, since there isn't a large distributor or a large dealer that covers nationally. In China, Southeast Asia, as I mentioned, people want to buy on the internet. They want ready now products. They want an experience center. I do think all of those things we're doing in China that we've learned from connecting with the consumer will work their way into the North American market as well. Thanks for asking, Scott.
John, thanks a lot for that answer. Appreciate it.
Your next question comes from the line of Michael Halloran with Baird.
Good morning, guys.
Morning.
On the food and beverage side, starting to see some stabilization there. Maybe just dig a little more granularly into what you're seeing in the market, why the stabilization's occurring, and how you're thinking about that as we move into the fourth quarter next year.
Sure. As we've talked before, as that business has experienced challenges and has been shrinking for quite a while, frankly, it's gotten to a point where it's a smaller portion of the portfolio, and it's really not something that's going to drive our overall performance. I feel like it sort of hit the bottom, and we're seeing some signs of life and decent order rates. It's something, frankly, that we hope to not have to continue talking about because it's just a small piece of the overall picture, and we're focused on, more importantly, on our residential commercial side of the business.
Mike, just to remind you, the market's growing, and we're growing with the market, but we have a very high-value membrane, and we have products that are really helpful in the overall food and beverage processing. What we're no longer doing is building the systems and the skids around them and just assembling other people's products to go forward. That's what really drove the decline, and we feel confident that we have a product that other people can buy and assemble and put into the process, and that's really where we think we should be long term. It's also better margins for us and better predictability and consistency as our future revenue streams. It was all conscious, and it was all an effort that we put in this year.
Makes sense. Then, on the capital deployment side, obviously been running the buybacks through pretty aggressively last few quarters. I know balance is what you're thinking about on a forward basis, but it takes time to build the funnel back up. How are you thinking about that M&A funnel, and how are you thinking about balancing the two, M&A versus buybacks? Obviously, dividends are a core part, but that's been pretty consistent.
Yeah. I think our first goal was to get back to predictable and consistent results. I'm pleased that we're making progress on that. I think we've got three quarters now where we're starting to build that consistency. We're starting to also understand strategically where our best businesses are and how those businesses are positioned. We're really aligned, not only as a management team, but with our board of where we'd like to make those acquisitions. They're tuck-ins and cores, like basically bolt-ons. I do think we are starting to build a really robust funnel. I really am hopeful that we'll be able to get some things done over the next year.
Great. Appreciate it. Thank you.
Thank you.
Your next question comes from the line of Steven Winoker with UBS.
Thanks. Good morning, all.
Hey, Steve.
Morning.
Hey. Just on the thoughts around holding, I think you still expect ROS to be about 50 basis points up. Why not more given the additional one point of growth and particularly the concentration in aquatics? I think if you could just talk through the puts and takes there a little bit that explain why there's not more ROS coming in.
I mentioned it earlier. As we were coming through September, we did see some pull-in to beat the price increase. We do have slightly less price benefiting the year than we had previously forecasted. We're continuing to see sort of the ramp in our growth investments as we move through the balance of the year. When you think of those two things on balance, overall, that's where we landed it, at maintaining our guidance on income.
How much do you think that took away from, if you were to quantify the impact that you would have otherwise had?
Well, the price change was about $3 million, $2 million-$3 million. The investment is probably a couple of million dollars.
Okay, great. Just as you guys are thinking about that growth for the fourth quarter also, coming off the six to four to five, I mean, these are exceptional growth rates, just any thoughts on slowing mostly comps, other factors here?
No. Part of it is, as I mentioned, it's the price increase acceleration that we experienced in Q3. Q3 was higher than expected, maybe half of that increase was driven by the pull-in to beat price. We don't see that continuing into the fourth quarter.
John, we're talking about a point of we're going from 6% to 4 to 5 on the Q4. Right now we don't see, as you asked, we don't see markets slowing. We still feel good. To remind you, Steve, you know this, but in our residential commercial businesses, this is primarily an installed base that we serve. It isn't a new housing start really phenomenon or anything. As a matter of fact, we shared this before, but a lot of new housing starts are actually urban, which don't utilize our water systems as much as they do out in the rural areas. We really just believe there's a consumer pull on demand on the aftermarket channel, and we see consistency so far on those outlooks.
Great. John, that's actually leading to my follow-up, which was within that all of this great pool growth, more than three quarters or roughly the business is usually aftermarket, I suppose. Maybe just any chance you can break down your thoughts around how much is coming from new installations versus the existing install base on this growth and the new product introductions like IntelliConnect that you mentioned?
Yeah. This is a general rule of thumb for that business. You take housing starts, which is somewhere around 1.2 million housing starts, and about 10% or 11% of those are generally pulling pool permits. I think it's just the way the demographics generally work out. Think about 120,000-130,000 new pools. Which if you really think about what that's up versus last year, it's not up very much. You'd be talking about single digits. We continually work the dealers and the installed base to convince people that more larger systems and more capability in their pool is the way for them to reduce their energy costs, both in LED lighting and also the efficiencies that they can get on the variable speed pump.
As I mentioned in my comments, giving them easier ways like their iPhone and/or remote monitoring to actually manage their pool. That's what's driving a lot of the content and capability. We're really growing the content on the pad fairly significantly and then taking more share through our dealer channel within that growing content. That's been our priority.
You said converting dealers as well, right?
Correct.
Is there a number around that?
Absolutely. Yep.
Any % or any numbers around that?
No.
Okay. All right. Thanks a lot. Bye.
Thank you.
Your next question comes from the line of Nathan Jones with Stifel.
Good morning, everyone.
Good morning.
Morning.
I'd like to pick up the productivity side of the price cost productivity equation. You guys had $20 million of productivity improvements in the first half, dropped to one in the third quarter, and I think the implication's about five in the fourth quarter. Can you talk about the things that have driven those gains down in the back half? Is it comp issues, timing of projects, whatever color you can shed on that?
Yeah. I'd start with, as Mark mentioned, we're ramping up the growth investments. In the beginning of the year, we were identifying where we should place our bets, working on our strategies, and making sure we're all aligned. As we went through the year, we're starting to see our innovation centers for technology, certainly our digital marketing, our consumer insights, and putting more spending in, first of all. That's really what you're seeing is generally offset in the productivity, Nathan.
Okay. Growth investments count against your productivity number?
Correct. Mm-hmm.
Underlying that, has the productivity number improved, declined, stayed about the same as we've gone through the year if you excluded the growth investments?
It's improving, primarily because we started the year with significant inflationary pressures on the material side, as we mentioned, we have begun to work sourcing alternatives and opportunities, which tend to take time, those have started to ramp up here as we head into the back half of the year.
If you think a little bit longer term, as a percentage of revenue, what kind of number would you expect to be able to get out in terms of productivity every year? Is it a point, two points, if we exclude growth investments from the equation?
It's a question that I don't want to dance around. In a normal environment, we would seek for productivity less in inflation on a gross margin basis to drive 100 to 150 basis points of expansion. Then we would look to offset with somewhere around 50 to 100 basis points of growth investment. That's a normalized model. Obviously, we're not in normal times, I think we're still thinking we can get continued margin expansion and still invest.
Then I just want to follow up on some of these revenue numbers. I think, Mark, you said about half of the organic growth rate in 3Q18 you thought was pulled forward from 4Q18.
No, that's not true.
No, sorry. To clarify that. Half of the beat in the third quarter. We were higher than expected by about $10 million. About half of that came from the pull-in.
Got it. That makes sense.
Yeah.
Okay. Thanks very much.
Clarifying question. Thank you.
Your next question comes from the line of Brian Lee with Goldman Sachs.
Hey, guys. Thanks for taking the questions. Staying on the revenue topic here for a moment. When you think about the pool business, I know this may be tough to quantify, but can you give us some sense of how much of the strength in Aquatic Systems was just broader volume based versus how much was maybe driven by mix of new products and increased share that's specific to you? Trying to get a sense for maybe what the market's underlying growth is versus how much share expansion you guys are seeing right now.
We think we're taking somewhere in the 1%-2% share range, the rest would represent the market growth that we think broadly others are experiencing as well.
When you think about the new product introductions and sort of the vitality index, if you will, as you look into next year, is that still the same range of target share outcomes you'd be hoping for? Does that start to accelerate even further?
If you took kind of where we are, you take double-digit growth, we think about half of that is coming from new content adds. That we're going out and creating more content on what we call the pad. What used to be a pump and a filter gets expanded into the automation, gets expanded to lighting, gets expanded to a chlorinator, saltwater pool, those types of things, and we think that adds about half of the growth. As I mentioned, the rest is share.
Okay, that's helpful. Maybe just last one from me, I'll pass it on. I guess specific to China, some of your industrial peers have alluded to weaker volumes in various end markets in the macro recently. Can you level set us a bit on your China exposure and then how you're comping there versus maybe some of the more cautious commentary that's been starting to pop up as of late?
Yeah. I'll start with the fact that we're not as big as some of those peers. Keep in mind that, as I mentioned, we're $160 million total in the China and Southeast Asia region, so We're not anywhere Some of our competitors are two times our size, and those comps get harder. I also think that we're definitely growing double digit, but we're also working through changing channels over there in China as well and making sure we're controlling our own destiny. As I said, most of the consumers want to deal directly with the Internet, and then they want to connect directly with the experience center and the company themselves.
I think our comps are a little easier from where we're starting from, but I also am very excited about what the team's doing over there, and I really like how we're going about winning and just the innovation and the excitement that we have for our new products and new product introductions.
Okay, fair enough. Thanks, guys.
Thank you.
Your next question comes from the line of Jeffrey Hammond with KeyBanc Capital Markets.
Hey, good morning, guys.
Morning, Jeff.
Morning.
Hey, just on the, it looks like your divestiture number was about 2%. Were there discrete divestitures in there, or is that just runoff of product lines that you're ramping down? How does that look kind of into 4Q and into 2019?
That really, it's no new discrete divestitures there. It's the product line exits that we've talked about previously.
Okay, when are we done seeing those?
Oh, it completes in Q4. We'll have a little bit of that in the first half of the year. It'll lap itself.
Okay, what went on with interest expense? It was a little bit lower. How should we run rate that going forward? Thanks.
Well, we gave you the Q4 number.
Yeah, we're still thinking around $7 million. It's become, frankly, it's a relatively small number given our overall debt levels. It can bounce around a little bit really mainly driven by how much interest income we had. That's why it was a little bit lower in Q3.
Okay, thanks, guys.
Thank you, Jeff.
Your next question comes from the line of Brian Drab with William Blair.
Hey, Brian. Brian?
Brian? Mute button.
There we go. All right.
Welcome back.
Morning.
Yeah. My kids were running around in the background, so I forgot I pressed that button.
It's all right.
I just have one question at this point. The aquaculture and agriculture end markets, I don't believe were mentioned on the call here, at least not significantly. I joined a little bit late. What percentage of revenue, roughly, do those account for today? Are you seeing any growth off the bottom here in ag? Just any update on aquaculture, which I think has been a good growth market for you.
Those two things total somewhere around $150 million of total revenue. Not really a big piece of the overall Pentair and not really worth mentioning, to be honest. I think ultimately those are cyclical markets, and they've been performing well lately.
Okay. I'll follow up more later then. Thank you.
Your next question comes from the line of Walter Liptak with Seaport Global.
Hi. Thanks for taking my question. Good morning, guys.
Hi, Walt.
Morning.
I have a question about weather. We haven't talked about that at all on this call, but there's been a couple of big storms, and I wonder about any third-quarter impact and if you're seeing any pipeline for renovations of pools, especially in the fourth quarter.
I will say, it's just a really thank you to our team. I'm sure a lot of companies had this as well, but our pool business is in Cary, North Carolina, and I can't thank the team enough for how they stepped in. We lost a few days of deliveries due to the hurricane, but they were able to recover all those shipments in Q3 and did a marvelous job just protecting the plant, protecting the assets, protecting the people, and then also getting the product out. Other than that, there's no meaningful amount of revenue one way or the other that we can track to weather.
Okay. In the fourth quarter, do you guys track pools that were damaged by flooding, pumps, filters that need to get replaced?
Not on a real-time basis, no. We usually expect and do see a little uptick in the aftermarket repair business there, and we'll see that in the order rate as it comes through Q4, but not able to track the specific amount.
Okay, great. Staying in aquatics and the price increase, I wonder if you could walk us through the pricing that you guys did and the competitive situation. Do your competitors take up pricing earlier in the year, so you were just playing catch-up? Where is your supply chain, I guess, versus some of your competitors?
We did our price increase on cycle, which was in mid-September. Our competitors did do some targeted price increases earlier for various reasons, but we chose to continue to stick with our standard timeline. We implemented a 5.5% price increase, and that's been consistent with what we've communicated previously, and our expectations have been consistent.
Okay. Are your competitors in the same kind of supply chain situation with you where tariffs impact them, and they have to react?
Some of our competitors have similar supply chains, some of them don't. Everybody looks a little bit different than us. As we've talked about, it's not just the direct impact, it's ultimately, and maybe more importantly, just seeing what the indirect impact ends up being as tariffs start to impact the overall pricing, not just from China suppliers, but others as well.
Okay, great. All right. Thanks for taking my questions.
Thank you.
Your next question comes from the line of Brett Lindsey with Verticals Research.
Hi, good morning, all.
Morning.
Hey, just want to talk about some of the regional growth. Obviously, U.S. was strong, mostly driven by pool. You talked a little bit about China. Could you just maybe walk around some of the major international markets you serve, and then any concern on the pace or tenor within your European business?
Yeah, just generally overall, you've got it. North America has been relatively strong this year. China, as I mentioned, has been a growth area for us. We've selectively chosen to get out of a lot of geographies, which is part of the product line exits that Mark has referenced in our divestiture line. Geographies where it's not so much a geography call, we just didn't have scale or didn't have the appropriate presence in those areas to compete long term. Europe has not been a robust growth environment. It's been relatively muted most of the year, and so we don't see that picking up in the back half of the year, but we also don't see it declining in the back half of the year.
Okay, maybe just back to growth investments. I think you'd previously said this year your incremental investment was around $20 million. What have you spent year to date? How did Q3 look? As we look into 2019, you're broadening out the China and Southeast Asia strategy. Does that incremental number step up 2019 versus 2018?
Yeah, we're certainly not going to give it in detail by quarter, but for the full year, we expect still to be in that range for 2018. I would say as we think about going forward, maybe $5 million-$10 million incremental next year is the way we're thinking about it for primarily digital investment and also our R&D and innovation activities we have identified this year, but not a meaningful step up from where we are currently.
Okay, great. Appreciate the color.
Thank you.
Your last question comes from the line of Julian Mitchell with Barclays.
Hi, guys. This is Jason on for Julian. Just looking at the Aquatic Systems demand and taking into account that the 1%-2% of share gain is roughly consistent with the color given on Q2. Backing out the demand you saw as a result of pre-buy, does this imply, given the tougher year-over-year comp in Q3 versus Q2, that there was sort of an end market demand acceleration here? What was the cadence of that demand acceleration going through the quarter? Was it stronger in September, et cetera?
No, I don't think there was anything unusual about the end market demand in the quarter. It was strong in September, but that's not unusual, and some of that was driven by the price increase timing. When you've seen the guidance for Q4, we don't see a significant slowdown as we look at the Q4 run rate and expectation on growth in pool.
Understood. Just going back to the pricing increases, there was sort of an acknowledgement that if there was further inflation seen in the pipeline, there would have to be pricing increases put in to net that out. Just on the pace of those increases, what would be the lag post the acknowledgement of further inflation, i.e., 30-60 days or maybe a quarter in terms of how long it would take for those pricing increases to be effective?
Sure. Maybe to clarify, we said that we'll continue to use price as a lever. We didn't say that we would have to do that in light of inflation.
Oh, right. Sorry.
It's a lever, and it would take approximately 90 days to get that price fully implemented. That being said, it's also about 90 days for us to see the impact of increases from our suppliers as well. What was unusual about Q3, if you recall, was the timing of the tariff announcement and the increase of that coming pretty quickly and not having the time to react.
Understood. Thank you.
Presenters, did you have any closing remarks?
Yes, I do. Thank you everybody for joining us today, and I hope you agree that we delivered a solid third quarter and that we are demonstrating our ability to use agility and prioritization to meet our commitments. By building up a track record of meeting and exceeding commitments, we hope to earn the trust and right to pursue a compounding strategy that allows us to not only achieve core growth in earnings, but to also utilize our strong cash flow and capital structure to pursue strategic, targeted, and accretive bolt-on and tuck-in acquisitions. Thank you for your continued interest. Christelle, you can conclude the call.
Thank you, sir. This concludes today's conference call. You may now disconnect.