I'll ask you a couple more hard questions. All right, well, welcome to Pentair. We're very pleased to welcome CEO John Stauch and Jerome Pedretti, who is the CEO of the pool business. So thank you guys for, very much for joining us. I run a little bit different format here, where I'm gonna present three bear cases on the stock. John's gonna tell me why I'm an idiot, then I'm gonna present three bull cases on the stock, and John's gonna flip and tell me why I'm a genius. So starting off with the first one, everyone who bought a pool or replaced pool equipment during COVID now has a five to seven year period before the next replacement, remodel, upgrade cycle kicks in. It could be a low growth market over the next several years.
I think you're dumb.
That's a given.
Jerome and I will tag team this one.
Sure.
I think just a couple things to start with. If you think about the COVID period for pools, we're convinced from work that we did prior to the analyst meeting, that the point to point of 2018-2023 doesn't show really any outsized growth versus the period before. And I know that there was years in there like 2020, 2021, 2022, but some of that was inventory, and some of that was also sell-through. So I'm convinced that the market didn't react any differently than it probably did in other periods. And I also remind you, there's 5.4 million in-ground pools, where things don't get replaced at the same time. So if you think of this as a giant pool pad with four or five key products, unfortunately for the customer, fortunately for the industry, things do tend to go wrong at different times.
So I, I think there's products clearly, like if you upgraded lights during this period, they're gonna last a longer period of time. You know, maybe if you bought a heater, it's gonna be a longer cycle. But I, I think that's a natural process that we've seen. I don't know if you want to add to it.
Yeah, well, what I would add is that also you have something which are, you know, semi-discretionary, like you're remodeling a pool or adding, you know, technology to your pool, you know, to make that pool, you know, easier to maintain. You know, a kind of effortless pool, which I think, you know, provides some opportunities as well over the coming years, right? So automation and other products that automation drives.
And Nathan, I would just add to this that, you know, when you take a look at, you know, the mid- to upper 60,000 pools that we built this year, that's historically very low. So I'd also say that on the flip side of this particular case, we should see an upswing in the pool market in 2025 and beyond as people start to see this new housing correction happen again.
I think there's also a perception that some of the remodeling got pushed off during COVID.
Mm-hmm.
'Cause the new pool construction is more profitable for the contractors, so they focused on that there. That maybe hasn't come back this year. Is there a expectation from you guys that maybe that starts to kick in, in 2025, 2026, as another leg of growth in the business?
Yeah, I think that's what I was saying with the semi-discretionary, right? I mean, there are some things you can push off for a little bit, but you cannot just push off, you know, indefinitely. So at some point in time, I think you need to remodel your pool. You cannot have a pool in your backyard that you're not using. So you need to... I think you need to do it, and I think it's coming back in 2024, 2025, and 2026.
You know, from a pool side, I mean, first of all, the normal purchaser of a pool is a fairly wealthy individual, so the demographic tends to be nice, and I-
That's why I don't have one.
Okay, well, I think you should have one.
Everybody should have a pool.
It's a sense of wellness. All that aside, I really do think that we haven't created the demand in the market through the years where people were just serving the market. And I think now we got to go increase the automation penetration rate. We got to convince people again to have an easy-to-use pool, and we've got to get the dealers in sell mode again, and I think all that creates a long-term value proposition for pool. It's pretty exciting. If you take the flip side, we're mid-thirties margins, despite not having those normalized pool builds, and we're in a down market environment this year.
That would be my bullish case to flip this from bear to bull, that I, I think given the position we are in today and how we're going to weather it, I think there's good years ahead for pool.
So seeing as this is my only topic on the pool business, I was going to ask a question about the automation side, and how Pentair's suite of products play into your ability to capture the automation side, what the penetration is, how you monetize it.
I think on the automation side, you see that, you know, about 50% of new pools have automation, but it's about, you know, a third of existing pool. So that's why I think you have some really growth opportunities in order to drive automation. What automation does is that it does make the, you know, the life easier of the pool owner, but also of the channel, of the dealer, right? So think about, you know, remote travel, remote monitoring, remote troubleshooting. So but I think there's a case, there's a value prop for everyone, you know, down channel. What automation does, though, it opens the door for additional new technology on your pool. So it drives, it pulls, you know, other product that's going to make your life much easier.
So think about water quality products, that's going to make it easier, so you can control the faster. So that, that's why I think automation's got a, you know, a bright future, and that's really what we need to continue working on.
Can you monetize the automation, or does the automation allow you to drive more hardware sales? Like, if I'm using automation on the four products that I... or three products-
Mm-hmm
...that I have on a pool, and then I want to put lights in. I go buy lights from Pentair because I’m already automating with your app.
That's the more likely scenario. I think the thing that's beautiful about the pool equipment industry is our products work with our main automation platform. Now, it works the same for Hayward's, work with Hayward's, and Fluidra's works with Fluidra, just being totally honest there. So if you get the automation suite, you generally have the pad for a long period of time, or you have a stickiness because those protocols are unique to each company. You know, I like to say, unlike the HVAC industry, all of our subcomponents within all of our key products are proprietary to ourselves, to Pentair, but again, to our competitors as well. Does that make sense? We don't share the same products, so it's hard for the protocols to work uniformly across the industry and the ecosystem.
Where the big opportunity is, how do we convince the 50% of new pool builders today that are consumers that aren't buying automation to get to an automated platform? There has to be value proposition there, and we're working hard on that.
Absolutely. Okay, in the interest of time, I'll jump onto the next one. Pentair's stated strategic goal at spin was to be a pure play residential and commercial water company. The Industrial and Flow Technologies businesses don't fit into that strategy and are a drag on growth and margins for the portfolio, leading to a lower multiple.
Ouch! My poor flow segment. First of all, IFT was the old name. We now call it Flow, 'cause, you know, had to change it. $1 billion of pumps, which absolutely fit the core portfolio, right? We're very proud of the margin expansion that we've, we now have on our, our pump portfolio, which leaves us $500 million of really filtration. At the core, it was bought to be a desalination and industrial wastewater play. That's the old CPT assets that we purchased. That's the heart and soul of what industrial, filtration is. Those markets weren't as robust 10 years ago, seven years ago, so we diverted and built a really nice, membrane filtration business for, for beer, which is, you know, been a good revenue stream for us, and we also expand into the air.
The technology is a common technology that's very easy, very usable into residential, commercial, and will be used in residential, commercial. It'll be used in pool pump or pool filtration, and it'll also find its way into commercial water filtration. So I think it's a lot more core than people think, and I think over the last year or two, we've done a really nice job on margins, generated a lot of cash, and I think it's earned the right to be in the portfolio.
So you mentioned desalination as one of the markets that it plays in, which has, I guess, probably for the last 15-20 years, been not very good. But there is a lot of activity in desalination these days-
Mm-hmm.
And a lot of a move as part of the hydrogen economy, right? To use desalinated water as an input for splitting into hydrogen. Are you seeing any improvement in that end market, where, you know, this could become actually a decent business within that?
We've seen some, you know, inquiries. Really, we diverted the business's attention away because I think what's made our profitability expand is we're more plug-and-play, we're more standard product, standard modules. And all of the attempts to go create a new industry have really been challenged in the early going. I really do believe what we're starting to see is a significant growth rate in industrial wastewater, where companies are recycling their own water and really making a lot of their water usage goals that way. And I think that's a bigger long-term revenue stream than diverting into another area that we don't know a lot about.
Yeah, it was just interesting when you mentioned desalination. There's absolutely a huge move for industrial companies to recycle, reuse water, both from an environmental perspective and from a business continuity perspective. So maybe talk a little bit about how that's impacting the business and what opportunities you see there.
Yeah. So first of all, we're doing a couple test runs inside of Pentair facilities to prove out the core technology. And then we're starting to work with some of our key larger customers that are more primarily in the beverage processing area to help assist them on how they can build the capabilities around recycling that water within their current plants. They're usually the ones that are more most forward-thinking because their margins are so thin, and everything that's turns into a waste becomes an opportunity to use back through the input streams, so.
Cool. I'll go on to the third one.
Stop picking on IFT.
Pentair's businesses have high exposure to markets that are interest rate sensitive. The longer it takes for the Fed to cut rates, the longer it takes for market recovery.
Yeah, I mean, I'll hit this one head on, and I, I don't think this is a wrong statement. I think we've been living in this bearish market scenario for some time. You know, we've expanded our margins year-over-year for eight straight quarters now, despite this environment. I think there's more opportunity for interest rates to start coming down than probably to expand up. I might regret saying that, but I honestly believe that to be true. And we would love to see a little bit of movement here, which I think would unlock people's desire to stay in their homes or move homes, and generally, we like that.
40% of our exposure is North American residential, so we do want people to begin to live that American dream of moving up and changing their houses and ultimately having more of the water products that we, that we provide value for them, so.
Maybe you could talk a little bit, besides pool, obviously, which is the headline one that's interest rate sensitive,
I'd actually say it's not as interest rate sensitive to pool, 'cause that's a cash buyer in most of the markets that we serve. That's an individual who demographically is getting ready to retire, who's buying in a warm weather state... building a spot for themselves, a pool for the grandchildren. And ultimately, that's, you know, they're spending the money, and they're not gonna take it with them. It's, it's more of a cash business.
They're generally wealthier-
Yes.
non-sell-side research analysts.
On the pool side, 60% of our business is still, you know, break and fix.
Right.
Right? So, I think that is not really interest rate sensitive.
Maybe talk about which the businesses that are interest rate sensitive and what you're seeing in terms of challenges and potential opportunities, should we see lower rates in those?
So right now, we're on residential pumps, you know, we're struggling. Those are small pumps. They go into wells, and you're not seeing rural builds from the large builders that would drive that demand. You're not seeing ag investment at an outsized rate, pretty expensive in those areas. And I think you're also dealing with the high inflation with the high interest rates, so it's hard for people to make their business model work. You know, we talked about some of the fast food restaurants now having to have value meals. We think we're better positioned because we're on the cold side, which is the high profit margin side, so that's our ice and our core filtration assets that go into beverage.
Ultimately, you know, people's wallets are starting to be affected, and interest rates are a big piece of that impact to them, so.
Maybe we could just talk a little bit about the Manitowoc business.
I don't view this as getting worse, so I just would say we've been living in this. We would love it to change, but we're gonna control our own destiny with our margin efforts around Transformation and then the most recent 80/20 activities that we've taken on.
Well, I was gonna ask a question-
Okay.
But you said transformation, so we'll go into the first bullet case. Transformation benefits and savings are in the early innings of impacting financial performance. Many of the expected benefits over the next few years come from supply chain projects that have already been implemented and executed, with the majority of the remaining margin expansion within management's control. The organic EPS CAGR of low double digit is strong on its, on its own, and could be conservative with additional margin expansion.
I think you're a genius with this statement.
I know, right? It only took-
It's long. I mean, you could probably tighten it up a little and market it a little bit better.
Only took 15 minutes for me to go from dumb to a genius.
So we kicked off transformation a couple of years ago as a company, and it was a margin expansion effort to really drive four pillars of work. Sourcing, pricing, what we call operational footprint or operational execution, and then spans and layers around G&A and cost to serve. And I think we made amazing progress across those four work streams, and we're just in the just getting wave one realized, and there's a wave two and wave three yet to follow. In our Analyst Day, we gave two margin targets. We gave a 24% commitment by 2026, and a 26 number that we felt if everything went right, we could achieve.
I think when we implemented 80/20, which I'm gonna have Jerome share a couple insights into, it was because we were doing transformation but weren't putting all of the complexity through the work streams because nobody wanted the complexity. So our new suppliers didn't wanna source any of that product. We couldn't implement pricing 'cause it was, like, one-off products that weren't gonna be there. So we reverted back to 80/20. We put 80/20 as an analytical aspect. We chose a firm to help us that had run P&Ls before and implemented it, them in their own businesses that they had led, which was kind of a requirement for me, because I wouldn't have someone like a Jerome accept it unless he could trust that a business person had engaged in it.
And even in a business like Jerome's in pool, where we're mid-30s in margins, there's so much more opportunity we've unlocked. So maybe you want to share a couple of thoughts on...
Yeah, I think what we are finding out is that, for example, our pool business, about 8,000 SKUs, but we see that, you know, 200 of those represent 80% of our business. So imagine-
Say it one more time. 8,000 SKUs total-
Yeah.
-with 200 of them generating 80% of the revenue. It kinda shows you the complexity.
So, show the complexity and show how much better we are if we reduce the complexity and, you know, drive for, you know, simplicity on our top SKUs. So, you know, really it's not about just so much cutting, but about, you know, how do we grow with, you know, those 200 SKUs, SKUs, right? How do we drive penetration? How do you try to find the next SKUs that they are gonna be part of those 200? So I think it's a lot of, you know, growth opportunity that, that we have, that focus.
So maybe we could use that as an example, right? 8,000 SKUs, 200 of them driving 80% of the revenue. What do you do with the other 7,800? How do you reduce that 8,000 to a more manageable number? So, how do you, you know, move customers that are buying some of those 7,800 to buying the 200?
Yeah.
What opportunities does that enable for strategic pricing, where some of those products that are probably low margin, certainly lower than the mid-thirties that the whole business is doing, and can either be culled out of the portfolio by raising prices or moved into, you know, being an A product instead of a B product?
Yeah, it's migration, right? Migration, you know, to those, you know, to those top SKUs that we have, and then, after... I think you can do that, or you can reduce some of the kind of SKUs which are bringing, you know, complexity, which I think the channel is not really looking for, because if it's low moving for us, it's gonna be low moving for our channel as well. So I don't think that we're helping our channel. I think that, we are hampering that channel of being more efficient as well. So I think we can do a lot of work in order to drive.
It's not gonna go, you know, the 7,800 is not gonna go to zero, of course, but I think you can reduce a lot of the complexity, the supply chain, the focus, the regulatory work that you have to do on those.
... I think it's, you know, 80/20 is overused as a term, but the process itself is customer-centric. So you have your top customers who are buying your top products as quadrant one. Quadrant two would be your top customers buying products that you've created the complexity over many, many years, and you're asking them to buy. Quadrant three is your less performing customers buying your high products, and quad four are your less performing products to your less performing customers. So quad four is where you start. That's where you get rid of the most amount of complexity by raising prices, changing your terms and conditions, et cetera. You've gotta be careful in Q3 and Q2. You're the one who put them there. So it's things like lead times change, maybe minimum quantity order buys change. It's how do you treat your customers differently?
So in Pool, for instance, Pool Corp's our largest customer. They should feel special. I guarantee you they don't always feel special, right? And so we gotta go out of our way to make them feel special. Our top dealers need to feel special. The phone should ring differently when they call, and our level of service should improve. By doing that, you're gonna grow more with your top customers and then ultimately be able to walk away from the complexity in your business. For Pool, it'll be an investment strategy. For some of our other businesses, it might be a cost-out strategy.
Mm-hmm. Maybe we could talk a little bit about the supply chain, 'cause it's obviously a big generator of margin expansion over the next few years. So maybe you can just talk about, you know, what was done in 2022 that you start seeing the benefits for this year, 2023 for 2025, 2024 for 2026.
Yeah. We used an outside firm, I'll start there, and I'm not, you know... We choose our outside firms carefully, but the reason we chose them is because they had a large database of working with suppliers, and we had a group of sourcing professionals and business leaders who were very comfortable with our suppliers that were in our own backyards, right? And so you've gotta put the opportunity through a funnel and then say, "Who are the best suppliers to be able to go quote?" And I think the good news is, we started out with motors, drives, electronics, and we were in a difficult situation where it was even hard to get some of that product, right?
So we got a really big win early from having large suppliers step up and say, "No, we wanna be Pentair's partner, and treat us more like a partner," and we saw some really good savings. Now, wave one took time, right? Because we had to reengineer all that product, requalify all that product, with all that product in the inventory. As you can imagine, inventories were high, and we're starting to realize that benefit here in 2024. Wave two is the next third of the purchase buy. It tends to be more castings, it tends to be more plastics.
Mm-hmm.
We're likely to see more of our incumbents hang around. Different economic environment, wanting to bid and hold on to the product, and so we'll see some of that benefit a little quicker. Then wave three is a combination of going back into wave one and wave two with things that we didn't bring through.
Right.
And again, we didn't get all the product because of the complexity to it, and/or being able to work with more some specialty purchases that we hope actually, in the end of the day, aren't there because we've done the 80/20 work.
Yep. It's fair to say, though, that on the supply chain, most of the work has actually been done-
Yes
... and the benefits are still to be-
Yes, yes
-generated.
Yep. You see them coming through the funnel, you can track them, and you can, you can score keep them. And pricing's that way, too, right? It, it's value-based pricing and stacking our product against, up against competition. Are we selling the value appropriately? What's the right price point, and how does it, how do you create those value cases? In the early going, price was just inflation pull through. Now we're having to work actually on the strategic side of the pricing.
Yeah, I think it's an important point to make for investors, that a lot of the, a lot of that margin expansion through the 2026 targets, a lot of that you've kind of already locked in and already done the work for.
Yes.
And it's time and inventory rolling through and things like that you've gotta wait for.
That plays into the confidence of our margin targets.
Okay, okay, second one. Balance sheet is delivered after the Manitowoc Ice acquisition, with just over two turns of net leverage, coming into a very seasonally strong cash flow quarter, so it'll be significantly less than that, by the time you report in a couple of months. Giving you significant flexibility for acquisitions and/or share repurchases.
I think you got this right, there's not much to add. I think, you know, given the interest rate environment we're in and, you know, our size as a market cap company, you wanna first make sure you remain investment grade, and I think we feel good about that. I think the good news is Manitowoc was an extremely cash flow-generating acquisition, so we've been able to pay down the debt. We're now gonna probably cross into the high ones this year as we get through our largest cash flow season, which is Q2, and ultimately, I think that gives us flexibility to utilize to create incremental value. I think there'll still be some combination of paying off debt, 'cause the debt is higher than it's historically been, but I think you'll start to see buybacks come into the equation.
You know, hopefully, there'll be some acquisitions out there. Right now, I wouldn't say the pipeline's all that robust, so by shorter term, it might be a little bit more on the buyback side.
Historically, Pentair has been a fairly balanced on capital allocation, with some of the cash flow going to acquisitions and some of the cash flow going to share repurchases. You obviously suspended doing share repurchases after you bought Manitowoc Ice because you levered up a little bit. It didn't make sense to be doing them then. Can you talk about appetite for restarting share repurchases in a more aggressive way? I know you didn't talk about it that much at the Analyst Day because you had this second quarter cash flow coming up, which would make the leverage more appropriate, maybe give yourself a little bit more time to look at acquisitions. But just your appetite going into the back half of this year or early 2025 for increasing share repurchases.
Yeah, I mean, I'll just say, I think, I think there's a huge appetite. I think you'll see that we will do it. And I'm not gonna suggest it's gonna be some huge leverage buyback, but I think you'll see us start to divert more, you know, returning cash to shareowners, either through dividends and/or acquisitions. I'm sorry, through buybacks versus acquisitions, just because of the environment we're in. And I would say that half a turn for us is, like, $500 million, so we're probably gonna be in that sweet spot of, you know, 1.5 turns is probably a good space to be in.
Maybe you could just talk about the priorities for M&A. You know, assuming there are targets out there, where you would like to be investing, what kind of markets, products, whatever you would like to be investing in?
Yeah, so there's some technology in pool still that I think we want around water chemistry. And some things that we wanna stay ahead of in case, you know, some of the energy usage for heaters change, so we'll stay active with trying to add to the portfolio there. But there's not a lot of things we could do in pool. In Water Solutions, I think we've got a really good portfolio of businesses around commercial water solutions between Manitowoc Ice and what we do with Everpure Filtration, and we'd like to add and expand there. And then outside of that, it would be things that, you know, play into the automation themes or give us data or analytics associated with what we do that can help our dealers and our third party continue to create value in the industry.
How does where interest rates are today change the algorithm or influence your thinking about doing share repurchases versus paying down debt? If we look back in, you know, the recent history of the last 15 years, for most of the time, debt was free, right? So you were not making much of a return from paying back, paying down debt, whereas today, you are making a pretty decent return on paying down, through revolve, but paying down debt. How does that change the thinking between debt payoff and share repurchase?
Well, I think most companies look at when you pay off debt, it's something you can access again. When you buy back shares, you don't get to access it again.
Mm-hmm.
I actually think a constrained resource is actually the most optimized resource, so ultimately I think it's a combination of both, and that's why I think you've gotta continue to return the cash to shareowners, 'cause it takes it off the table and it keeps your focus where you really need to drive the return for investors, and so I look at it as just a combination of both.
Okay. All right, last one. The majority of Pentair's revenue comes from well-structured, oligopolistic markets with rational competitors.
Can you say that legally? Oligopolistic.
Oligopolistic.
Okay.
Oligopolistic. Most of the remainder comes from markets with higher growth.
I agree that that's generally true. I think, you know, underneath the three segments that we operate in, we look at our business as having, you know, a revenue stream called Pool, which is our largest, primarily North America, and really profitable. There are two other equipment competitors there. I think both of them do pretty well. You can decide what pretty well is. And I-
I think they do very well.
... I think that's generally rational, and it goes through a really good pro channel, where the channel makes margin. Dealers make margin, we make margin, so that would be the pool business. When you get into the commercial Water Solutions business, where we have Manitowoc Ice and Filtration, again, really high margins because water really matters, and the quality of it matters to the customer base. So again, a dealer channel and an industry that generally does pretty well. When you start dropping through some of the other revenue streams, dirty water makes more money than clean water. That's just a given. So anything in wastewater has significantly high margins, and anything that's dealing with waste and filtration has high margins.
But these are good markets, and I do think the core growth in the core of those markets are good. I think where we generated a little bit lower growth rate is we chased geographical expansion or got into adjacencies to drive our growth. That is hard to continue those growth rates because we're not as big in those spaces as competition, and we don't have the standard position versus our competition. And that's where 80/20 redirects you to where you think you are good because you have data that actually proves it, and then you can ultimately continue to double down on the spaces that you're good at. So I agree with the statement.
So with the application of 80/20, does that, has that given you businesses that perhaps don't belong in Pentair's portfolio, anything that's material, or are we looking at more at pruning around the edges of... And you've done some things around the edges-
Yeah
... today.
You know, I'll tell you what the partner that we chose said to me, "80/20 is not a portfolio tool. If you use it as a portfolio tool, there's other tools for that." So I just think that's why I say it's misused. It really assumes that every business you have has something in it that has high quality in it. It doesn't mean you wouldn't recognize later and maybe walk away from it later, but it believes that you can improve the profitability and the growth rate of every business you have, and so we start with that as a lens. Will that require us to drop some product lines as we go forward? Maybe, but I wouldn't look at it as a portfolio tool at the moment.
Maybe just talk a little bit about the water quality side of the business, which is maybe a market that fits into the second part of that, that maybe doesn't have quite as high a margin but certainly has higher growth rates attached to it. Your appetite for expanding either into that business or into other kinds of businesses that maybe don't have some of those premier margins but are offset with higher growth rates.
Yeah, I mean, first of all, if you're low margin in Pentair portfolio, it probably means you're somewhere around 15%.
Yeah, it's terrible.
I mean, it's, it's not, it's not horrible, but I mean-
Relatively low
... it, it does strain the higher twenties growth margin businesses that we have. So I would just leave you with, I think there's an opportunity to change the game. I still believe taking what we do for food service and working in the high-end residential to give you an HVAC-like system that gives you high-quality water in your home, will be a very useful top-of-the-market segmentation in residential play, and I think it's an exciting opportunity to be. And I don't think it has to come with low margins, 'cause I think those people would value what they're getting, so.
Awesome.