濱特爾 (PNR) 2003 Q3 法說會逐字稿

Good afternoon. My name is Latanjy (ph), and I'll be your conference facilitator today. At this time I would like to welcome everyone to the Pentair third quarter earnings release conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question and answer period. If you would like to ask a question during this time, simply press star, then the number one on your telephone keypad. If you would like to withdraw your question, press the pound key. Thank you. Mr. Harrison, you may begin your conference.

Good morning, everyone. Thank you for joining us for this conference call to discuss Pentair's results for the third quarter of 2003. I'm Dave Harrison, Chief Financial Officer and your host for this call. With me this morning is Randy Hogan, our Chairman and Chief Executive Officer. Before we begin this call, I would like to remind each of you that any statements made about the company's anticipated financial results are forward-looking statements subject to future risks and uncertainties. Such as but not limited to economic and market risks. Also, I would like to refer you to the risks outlined in our 10-K as of December 31st of 2002. 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. At this time I'll turn the program over to Randy Hogan.

Hello. Thanks for joining us. The third quarter of 2003 turned out pretty well for Pentair. We're working hard to execute our five key initiatives, improve margins and boost sales wherever possible. In the products of those evidence are evidence in our results. Consider the following. Our enclosures business continued its march to double digit profitability by recording at seventh quarter sequential margin improvement. With ROIC 9.3% in the third quarter of 2003, we would expect near-term breakthrough of the double digit goal that we set last year. Given even a modest volume recovery, our outstanding lien manufacturing progress and tight cost structure are likely to leverage a substantial pickups in margins. The Water Technologies Group has reached the crossover point in its margin improvement efforts recording margins of 13.4% in the third quarter, equivalent to those of the third quarter last year. This third quarter marked Pentair's sixth consecutive quarter of favorable quarter over quarter EPS comparison. We generated almost $90 million of free cash flow in the quarter. That's defined as cash from operations less capital expenditures. This gives us positive year to date free cash flow of more than $148 million. Our 12-month moving ROIC was 13.8% in the third quarter of this year, 130 basis point improvement from the same period a year ago. The third quarter was the fifth consecutive quarter that we've realized a solid income gain in our European markets. Even excluding the effects of currency translation. Borders and backlogs increased in the third quarter against year ago levels, showing the results of our organic growth initiatives and hinting at what we think may be a steadily, albeit slowly, improving economy. Over the last two years, Pentair businesses have made investments in growth opportunities, and they're beginning to pay off. Our cost productivity efforts continue to reinforce our margins, we've continued to add strengths to our leadership ranks, our cash flow remains strong. And now we're encouraged to see our businesses are proceeding signs of improved business activity in several of our core markets.

In short, the performance levers of our business are understood and in hand. We're well positioned to take advantage of the benefits of an economic recovery. Now let's review our operating group's performance in greater detail. Our Water Technologies businesses delivered strong sales of $271 million in the third quarter, a 21% improvement over those of the same period last year. Even if you exclude the form of acquisition the group sales were still up in the double digits. This excellent performance came in part as a result of Plymouth Products. Plymouth has performed very well in the first year of ownership. Not only did it bring a solid portfolio of products for our [water groups], it allows us to diversify our presence in water filtration markets. In the last year we've worked to boost profits through operational improvements, specifically our lien enterprise program, supply management, and product rationalizations, and capture additional growth. For example, we mentioned last quarter the Plymouth Products secured a relationship with Procter & Gamble under which we're now manufacturing filter elements for P&G's pure line of Water filters. Water group sales also benefited from pool equipment sales which shot up as late in arriving pool season extended longer than normal into the third quarter. We also had good success with our early buy program and began to generate sales from our two recent pool equipment product line acquisitions, Letro and hydro attempt. In addition, we continue to capture market share in this business, growing substantially faster than the market itself. Our European water businesses performed very well, setting a three-year growth record in the third quarter and generating the highest margins of any Pentair business. Sales of commercial vials were particularly robust with record shipments in September. Sales in the developing markets of Asia and India also grew substantially in the quarter.

In fact, India's third quarter sales were at an all-time record reflecting the impact of establishing our goal facility as the worldwide manufacturing source for CodeLine and [Inaudible] housings. While total pump sales were flat in third quarter wet weather conditions drove higher pump shipments in both our retail and distributor channels. Our higher margin engineering residential systems sales grew in the low double digits as housing start continued strong. Although municipal pump shipments declined from what compared to last year as we expected. Water treatment sales in North America started the quarter flat. But market activity picked up late in the quarter. Despite a tepid third quarter market, our water treatment business continues to focus on fundamentals. For example, the Brookfield, Wisconsin, operation set new performance records in September for inventory, day sales outstanding sales per employee and return on sales. The group's operating income for the quarter grew 21% over the prior year. With ROS of 13.4% driven by continued execution of Pentair's lien enterprise initiative which we called [Apana] integrated management systems, or [PIMS], applied chain management practices. Benefits from our PIMS initiative were particularly strong in water treatment and pump businesses. As mentioned, we also have aggressively implemented PIMS at the Plymouth product filtration business and its first year of ownership, Plymouth has achieved results fully in line with our expectations. Across the entire water technology group, third quarter cost reductions were nearly $10 million more than those in the same period last year, reflecting improved productivity and cost control. I'd like to reiterate that margin improvement efforts in the Water Technologies Group have moved margins to 13.4%, matching year ago levels and marketing crossover point to higher margins. We believe we can build on this improvement and continue to grow margins in Water Technologies. Looking forward, we have a great deal of confidence in the Water Technologies Group. On a year to day basis, water is now our largest business, it has been the largest contributor of operating income each year since 2000.

This year will be the fourth year the group has held that honor. Water Technologies also has the distinction of delivering the highest ROS and Pentair. I'm pleased with the fact our water businesses are beginning to see growth, they got their margins heading in the right direction and we have aggressive plans to build additional sales in 2004. I look forward to seeing many more performance records broken in the future by water. As you saw in this morning's news release, the tools group third quarter net sales of $268 million increased 1% over those of the same period last year. This was driven primarily by the Oldham Saw acquisition which offset a low single digit decline in the base tool business. It's note worthy that this third quarter decline was less than that experienced in the second quarter of 2003. Third quarter operating income of $21.4 million declined 16% from the same period last year due to lower volume and higher Margin products competitive pricing and promotional pressures, some inflationary cost increases, and expenses related to capacity reductions. Margins of 8% or 160 basis points below those of the same period last year. While margin decline in second quarter of 2003 was 200 basis points lower than the prior year period. Specifically, we face some selling price pressures in our equipment line, which include generators and compressors as we work to replace compressors SKUs lost in the first quarter this year. This difficulty was compounded by hard fought battles for pricing and placement that characterized much of the tool market today. While the pricing pressures are likely to continue, we've already begun to ratchet up our cost reduction and inflation control efforts to counter it. For example, we're accelerating efforts to extract savings from our supply management lien enterprise activities in order to reap greater cost productivity. Specifically, we've identified and begun to execute a series of productivity programs that will reduce costs by $35 million in 2004, up from $20 million this year.

While these actions will not benefit our fourth quarter, we do expect to accelerate savings in the first half of 2004. Meanwhile, we continue to define additional cost reduction actions. New products will also help reinforce our margins. As I mentioned in the last conference call, most of the tools groups new products are being introduced in the second half. Among the newly introduced products is a line of pneumatic construction nailers that was completely redesigned to make them smaller and easier to handle than before. This line will help boost our sales and construction nailers towards the same high levels as our finished nailers, category in which we're now the market leader. As we mentioned in the second quarter conference call as well, shipments to a new 39-location distributor named prime source started in the third quarter. Prime source is distributing quarter cable pneumatic Nailers and select item construction related electric and cordless power tools. This new distributor will help expand porter cable placement in the lumber and building supply channels. Also last string in third quarter was a range of Porter-Cable reciprocating saws to replaced and refreshed the existing line. We've revamped the entire line to reduce costs while introducing new features. Thereby allowing us to build on our strong second place market position. Currently in production are a new series of routers that have become the buzz of the industry. More important, they reinforce our leadership in the router category. These routers, mainly 890 series have a proprietary motor design and packed with unique features and benefits for the discriminating woodworker. For example, when installed in a router table, the model 890 router allows the user to make bit changes and adjustments from the top of the table. This eliminates the biggest annoyance in using a router table the need for the user to get underneath the router table to change bits or adjust bit depth.

The 890 series routers will arrive in stores over the next several weeks, just in time for the Christmas selling season. Meanwhile, delta introduced the industry's only 12 inch mighter saw capable of cutting 9 ¼ inch base board and 4 ¼ inch crown molding. The benefits and capabilities offered by the dual bevel saw are unprecedented. It maximizes sawing capacity and offers an innovative fence system for sawing consistency and greater ease of use. In addition to this unique 12-inch dual bevel mighter saw, delta diversified its mighter saw line with a new 12-inch single bevel mighter saw and a new ten-inch dual bevel mighter saw. Delta's X-5 program we lunched in the first quarter this year continues to perform well. This program includes 16 special edition tools that represent our best industrial quality tools for serious woodworkers and professional woodworkers. We also introduced several new products for delta's industrial channel. Including a new variable speed drill press, a new band saw, and a new belt sander. Equipped with a 12-inch disk sander. On the entry-level consumer side of the market, delta introduced a combo kit of six new 18-volt cordless tools under the shop master sub brand which will be stocked at Lowe's in time for Christmas season.

Developers launched a breakthrough 135 PSI compressor product designed for all around household use in the third quarter. This is a consumer friendly design which incorporates a 1.5 gallon tank enclosed by an attractive shroud. We consider this shroud to be a game changes because there's no equivalent product in the market. It's easy to carry compressors is being launched now at the first form at the home depot under the husky brand. We're working hard to combat the competitor refreshers and improve our margins by leveraging our brand strengths, innovative products, cost reduction programs and building volume. Training the Enclosure group, sales of $146.2 million in the third quarter of 2003 were up a solid 4.5%, compared to last year. The growth was driven by recent upticks spread broadly across all facets of the electronics business combined with share gains in both U.S., commercial and networking markets, offsetting otherwise flat industrial demand. Operating income in the group totaled $13.6 million with ROS of 9.3%, and improvement of 300 basis points over last year's third quarter. I can't praise the enclosures group enough when it comes to the work they've done in strengthening margins in a down market. Consider the progress they've made over the last eight quarters, starting with margins of 2.4% in the fourth quarter of 2001, they moved upward in each quarter to 3.3, 5, 6.3, 6.9, 7.1, 8.1 and now 9.3%. The group's seventh sequential quarterly margin improvement. We're very confidence that double digit margins are just around the corner for the enclosure group even without any big help from the economy. Embracing lead enterprise concepts is one key aspect to led to the performance. In the third quarter the group built on past success with Pentair integrated management system and its manufacturing centers by aggressively bringing lien to non-manufacturing functions.

They organized a cross-functional team and examine non-manufacturing processes across 11 functional areas. From that set, the team selected nine high potential areas for [Inaudible] in 2003. Similar strides in supply chain management have played an equally important role in the group's margins success. Our enclosures group margins are continuing to climb and our growth initiatives are yielding results. Even though Hoffman's traditional markets haven't shown significant growth yet, there are some positive signs. In fact, for the second consecutive month, the [nemo’s] electro industry business confidence index for North America remained well above 50 the threshold indicating conditions are favorable for growth. This index is up from its low in March of 2003 of approximately 30. Likewise, the institute of supply management manufacturing index remained above 50 for the third month in a row, indicating the manufacturing sector is gaining momentum. In the power market we've seen renewed activity as a result of this summer's bridge failure in New York with some 130 generation and transmission projects scheduled for kickoff in 2004. Our Hoffman business is the strongest player among the few companies that stand ready to serve this market with our extensive large enclosure product line and our console and control interface products. The safety security and defense markets we've recently signed general service administration letters of supply with both [Anixter] and Graybar. Through these letters of supply our products will be listed on their GSA contracts which is a more efficient means of gaining access to government business than we have previously enjoyed. Graybar also announced on August 1st that they entered into a national distribution relationship with Hoffman Datacom with a Graybar strategic partner. This designation was in the Datacom networking market is a real feather in the Hoffman’s cap and has a potential to dramatically expand sales in our specialize Datacom product as long with prior distribution additions, this makes Hoffman products readily available through the strongest network of distributors in North America.

We also continue to pursue Iraqi reconstruction projects through Bechtel and other firms. We've captured small projects already and confident that we can drive Pentair specifications to the enclosure opportunities that continue to emerge. In medical markets we delivered the first dozen compact PCI system prototype units to GE medical and ordered with some encouraging feedback. This new program is slated for production in the fourth quarter. At Abbot laboratories, we currently have one program in production, a second in development phase and have been earmarked for a variety of other programs. Overseas third quarter European telecom sales were up compared to same quarter last year this. Increase in activity was broad based and generated by existing customers such as Deutsche telecom, converse and Ericsson. Activity with [Inaudible] UK has also increased as they've successfully completed their financial restructuring. Our enclosures group was a significant player in the European telecom industry, so the positive trend we're seeing in Europe bodes well for sales in that market during 2004. Overall, I'm very encouraged with the activity the top line in our enclosures business. Prepare to be impressed by the Performance of our enclosures business once our volume starts to gather momentum. It will be a fun ride indeed. Let me turn the conference call over to Dave for additional details on our third quarter.

Thank you, Randy. We are pleased in many ways with our third quarter results. We saw gains in many key financial ratios return on sales of 9.9% represents the sixth consecutive increase in quarter over quarter operations margin improvement. The third quarter EPS of 77 cents was at the high end of the range that we gave you earlier in the quarter. Our debt to total capital ratio, which was 39.9% at the beginning of 2003, ended the third quarter at 35.6%. This is well below our target level of 40% while supporting dividends, seasonal fluctuations and working capital and six acquisitions over the last year. Free cash flow for the third quarter was $89.9 million, bringing our year to date free cash flow to $148.6 million or 135% conversion of net income. We again expect to achieve our cash flow goal of $200 million in 2003. As Randy mentioned we are continuing to improve our financial performance in a challenging business environment. Operating income margins through the first nine months were up 20 basis points over the same period of 2002. Our gross profit margin in the third quarter increased 70 basis points from the third quarter of last year. [And is up 100 basis points year to date.] All of our businesses were able to obtain incremental material savings and our realizing cost reductions from productivity improvements related to our lien manufacturing activity. We're redoubling our ongoing efforts in tools cost reduction to offset competitive pressures in the marketplace. In addition, we are driving for greater productivity improvements to help mitigate increases in the areas of rising ocean going freight, pensions, health care and insurance. As I mentioned last quarter, our SG&A and R& D costs were intentionally higher compared to last year. This is due to increased promotional costs in the tools businesses. Expenses for downsizing relating to capacity reductions and product transfer as well as strategic investments for growth and innovation.

You should note that even though our SG&A dollars are up 9.3% compared to last year, if you exclude acquisitions and downsizing costs, our spending is essentially flat. Year to date interest expense was lower by $3 million compared to the first nine months of last year due to more favorable interest rates, offset somewhat by interest expense related to our recent acquisitions. We continue to have a 50% split on fixed versus variable rates in order to take advantage of the continued lower interest rates. The 2003 effective income tax rate of 34% is two points higher than the 32% rate in the first nine months of last year. The higher rate is due to the anticipated mix of our 2003 U.S. and foreign earnings, and the fact that many of our tax savings programs are relatively fixed. The good news is that margins are improving in higher tax rate countries, and as our profitability improves, the effective tax rate trends higher. The point of fact is that this year our European water businesses are returning the highest margins in our portfolio. As usual, we are continuing to pursue rate reduction opportunities which could improve our ongoing effective tax rate. We continue to make progress on working capital productivity. Inventory levels have come down over $25 million since the end of the second quarter. But still remain higher than we would like, primarily in our tools business due to lower than anticipated sales in preparations for new product introductions. We expect continued reductions in inventories throughout the coming months. Total working capital days at the end of the third quarter were 43 compared to 45 days at the end of the second quarter on a 13-month rolling average. Working capital was better by four days compared to a year ago.

Driven by [PIMS] process improvements and receivable management. Receivable days are down five, inventory days are down two, and accounts payable days are down three from the prior year on a 13-month rolling average. The 12-month average return on invested capital, which reflects the combination of productivity from asset management and operational results, has improved from 12.5% at the end of the third quarter of 2002, to 13.8% today. And finally, I would like to come back to Randy's comment about orders and backlog. All three groups saw positive trends for the quarter in orders. Tools are slightly positive. Water was up over 20%. And enclosures was up almost 10%. All three groups like wise left the quarter with backlogs up over 10%. We continue in the third quarter to show a positive book to bill ratio for the total company. Now I'd like to turn the conference call back to Randy.

Thanks, Dave. To summarize, organic growth initiatives are beginning to show tangible results. Our tools business is redoubling efforts to overcome the effects of a highly competitive marketplace. Our Water Technologies Group is hitting its stride. And our enclosures business is performing exceptionally in the midst of a soft market. All of our strategic initiatives are driving results and we are enjoying many improvements in the portions of the markets we serve. Looking forward, with continued gains in our Water Technologies and enclosures businesses and a cautious outlook for tools, we expect fourth quarter 2003 earnings per share in the range of 62 to 70 cents compared to EPS of 56 cents in the same period last year. Keep in mind that we're not just a tool company. We enjoy strong cash flow and rising margins. We're investing to grow our most attractive business, which is water. And we have adjusted our expectations for the fourth quarter only modestly. The average or estimated range is only about 3 to 4 cents below current street consensus for the year. Our goal has been and remains double digit earnings per share growth for this year and next. And even though we haven't seen the benefits of substantial growth yet, we still have a shot at double digits this year. Thank you for your attention. I now ask the operator to come on the line.

Please provide our audience with instructions for the Q&A portion of this call.

At this time I would like to remind everyone, in order to ask a question, please press star-one on your touch keypad. We'll pause for just a moment to compile the Q & A roster. Your first question comes from the line of Jim Lucas of Janney Montgomery Scott.

Thanks. Good afternoon, guys.

Morning, Jim.

Hi, Jim.

Few questions. First off, Randy, can you go over the growth in the water segment again of that 20% growth? You said that the organic was up double digits?

Right. It was 21% in total. When you take the acquisitions away, it was just about double digit, and if you back out -- more than double digit, if you back out, translation, it's a little bit under double digit.

Okay. So still high single digit without FX?

Right.

And water treatment being a big contributor there, but --

It is a big contributor. Water treatment, as I mentioned, was in North America, was about flat. Water treatment in Europe was up.

Okay.

Even without FX.

Okay. And I wanted to start off the questions with that since you're more than a tool company. But now I need to ask a question on the tool segment.

Thank you, Jim.

You're welcome. Two related questions here. One you talked about $35 million of cost savings actions that can generate cost savings next year.

Yep.

How much that will go to the bottom line versus being used to either reinvest in the business or offset continued pricing pressures?

Well, you know, as we set plans and still working on them for next year, we're going to assume that pricing is going to stay in an aggressive mode. And we're going to continue to invest at about the same rate we are in R&D. So I don't see ratcheting that up a lot in R&D, but this year what we had is we have in the second half, we have a price that is a little worse than the second quarter. A little bit over 3% decline. We also had more inflation in materials and particularly steel and ocean going freight. And we've had a little bit of a lull in our materials readout just from the timing. So those combined are the things. So that's why we've already identified these programs that will have a much higher readout.

Okay.

The way I think about it is, I'm expecting a lot of that to go to the bottom line.

Okay.

But not all of it.

And the pricing, you talked about the compressor market, in particular, but as you look at the different pieces of the tool segment, is there any one or two pieces in particular where you're seeing competitors that are just being overly aggressive on prices? Is it just that there's no pricing reasoning out there right now?

Well, the -- for us, the biggest issue isn't equipment. And a lot of it was programmed. You know, we had -- we actually had some of our unbranded products, price decline considerably this year. That would be with Sears and the Husky arena as well as well as in the overall. Part of that was program. In other words, we knew it was going to go down. And part of it was as we tried to rebuild margins, obviously, we were more aggressive. So equipment was worse than portable power and stationary bench top. We still had an impact of the $99 price point rolling through our numbers in the third quarter in Canada that hadn't been quite rolled out in Canada yet. So year over year, we had the $99 price point for delta shop master in our numbers for the third quarter last year, everybody but Canada. But I would tell you, there isn't -- the prices were down in all three, in all three of our segments.

Okay. And final question, as you look at the cash flow which is really become, you know, a hallmark, we're getting a lot more consistency in the last few years, you mentioned dividends, talked about the strategic acquisitions, paying down the debt, given that, you know, days like today where the stock comes under pressure, where do you stand in terms of share repurchase?

I have no formal position on that now, but given what happened this morning, you know, I think maybe I'll think about it.

You'll think about it. Okay. Fair enough. Thanks.

Okay.

Your next question comes from Deane Dray with Goldman Sachs.

Hi, Randy and Dave. Question on tools. And more specifically about the margin year over year. You kind of gave a list of different factors. I'll just run through them. A couple you've already addressed. What I'm trying to get is the extent that you can calibrate what sort of impact each has had. So mix, price, you said, was overall 3% decline. But we had promotions, capacity reductions.

Yeah, we put promotions in price.

Okay.

So that's why we say pricing and promotions.

All right. Good. And then capacity reductions, were there -- did you flow expenses through?

Yeah. You know, we didn't -- we don't take restructuring charges anymore.

I know you don't.

We announced the Tupelo closure. That's costing us over $1 million a quarter until we get it closed.

And when should that end?

Middle of next year.

Okay. And so that's a direct hit to your EBIT?

Yes.

And then freight and material costs.

Freight and material costs --

Change year over year?

Um-hm. In the quarter, it was over a couple million dollars. Of costs, you know, we didn't plan for. What we'll need to do is manage those better and raise -- you know, we really need to start getting the 5 to 6% in materials productivity we were getting a year ago. We're just not getting it right now. We have a lull. We haven't -- we don't have a lull in commitment, but we have a lull in readout.

Okay. So looking at those factors, as you flip through, can you size those? How much is price?

Against the 160 -- I don't have that. Do you have it, Dave? 160 basis point decline?

Yeah. You know, when you look at the overall decline, the biggest piece of that was primarily due to price. And then our cost reduction programs almost made up for the inflation that took -- actually, it was a little more than made up for it so if you really look at this quarter, the biggest issue was the fact that we had about a 3% price decline.

Okay. And then looking ahead fourth quarter, tools, this is your home run quarter in terms of the Christmas selling season. How's that shaping up? How do inventories look? And are there -- what's the contribution of new products expected?

Well, the -- you know, right now we're just in the third quarter. We've got close to 10% of our sales from new products that were launched in the third quarter. Our ongoing basis, it's over 30%. And in the fourth quarter, we expect a lot of the ones we just launched like the Q-1,000 Husky compressor that's at $99 and the delta cordless line at Lowe's and the new router, we expect -- I hate to use the word "hope," but we're hopeful that they'll do well. Obviously, it's the change, and I would call it a slight change given the third quarter doesn't look much different than the second quarter. In fact, it's a little bit better from a sales standpoint than the second quarter was. You know, that doesn't turn around in the fourth quarter because we don't have our costs -- we don't have our improved costs readout from the fourth quarter. That's why we adjusted our look at the fourth quarter.

Last question, on the prime source as a new distributor, is there a channel filled benefit? And when should we expect it?

Well, it's really going on in the third quarter and the fourth quarter. It's already -- it's already coming through our sales. We're already getting reorders. We're quite excited about that because they really reach a set of lumberyards and hardware that we didn't. Before.

Okay. Thank you.

Your next question comes from Dan Wang of Lehman Brothers.

Yes, good morning.

Good morning.

Morning. Just had a couple questions. In terms of the expectation for the fourth quarter, could you just talk about the margin trends for tools, water enclosures, whether you expect either sequential or year over year improvements?

Well, I think -- what I think about the three groups, and as I look at what he expect in the fourth quarter, I expect enclosures will continue their trend in improvement in ROS. And I expect water, as I said in this quarter, the third quarter, this is the crossover quarter. We expect year over year improvement in the fourth quarter. For water. And as for tools, the fourth quarter hasn't been our best quarter in tools the last couple years. And I would expect that it won't be again.

Okay. Great. And in terms of the fourth quarter, the guidance 62 to 70 cents. What's the biggest swing factor there that could, you know, impact the results there? What would it take to reach the high end versus the low end of the guidance range? Just trying to get a better feel for that.

Volume specifically in tools.

Okay. That's it. That's the biggest factor there?

Yep.

Okay. And I don't know if you can make comments about 2004. I mean, I think, you know, last year you made sort of high-level comments about that.

Yeah. Well, as I said in my script and I've said, our goal is to double-digit earnings per share growth. And we believe -- we believe we're still committed to that. That's what we're committed to. And we haven't finalized our plans for next year, but that's what we're going to try for.

Great. Thank you very much.

Your next question comes from Brian Lingenberg of Lingenberg and Company.

Great performance in a tough environment, gentlemen.

Thank you Brian.

Couple questions without being too specific. With the water margins, can we expect, you know, no significant of prices to see similar year over year, not sequential, but year over year increases in profitability and margins? Second of all, you know, without giving -- well, if you give us a specific number on ’04 great but--, and appropriate responses, of course, when you think about free cash flow in ’04 versus ‘03, one of the things that's coming out on calls, I would call it cautious optimism. When you think about cash flow direction and the different components between discretionary spending, working capital, fixed capital if '04 turns out to be marginally somewhat better than you're speaking to hoping, those are the two questions. One is more explicit on the water margin and second may be a little more what we can think about for free cash flow.

I'll let Dave handle free cash flow. First let me -- let me talk about the way I see about water. Water had great organic growth in the third quarter. I really feel great about the momentum we have in water. I think about the growth in the businesses going forward, I think water will see organic growth. Of course, Plymouth becomes organic growth in the fourth quarter.

True.

I don't expect to see a 21% growth. The fact the organic growth might even be a little lower because we had that pool shift from the second to third quarter just in terms of timing.

Right.

In terms that, I think you asked about margins as well, we have a lot of momentum and a lot of improvement.

And in terms of some of the material savings and productivity improvements you've had in '03, how much of that improvement through the course of '03 do you think could carry through into '04 for that overall segment?

I think it virtually all carries over. We don't have the kind of pricing environment we're facing in tools. And actually, I expect it to accelerate.

Okay. Thank you.

Cash flow?

Brian, we're still expecting, as we talked about this year, to have another year in 2004 which will be at least $[20] million. Our long-term goal, obviously, is to continue to achieve conversion of net income above 100%. But we're still getting favorable benefits from working capital. Receivables have done extraordinarily well, you know, coming down from a level of 75 days to what we reported on a 13-month average this quarter at 57. And our inventories, we're just now starting to reap the rewards from our PIMS activity. Changing the processes in our manufacturing environment as well as changing the processes in terms of how we basically go to market and have the product that we need for our customer. And there you saw a number of 64 days, which is down two from the prior year. And our goal there, for the whole company, is to try to get that below 50. So we have still opportunity as we go forward over the next one, two, three years, however long it takes. In terms of changing the processes and really getting to our goals for the inventory. Receivables, we think we're going to get probably below the goal we had at 55 versus 57 where we're at today. So we continue to believe that we can generate obviously more than 100% of free cash -- or of conversion of net income, which next year, with some help from the working capital, we'll get over $200 million.

Now, would that number assume -- because one of the things I think about is, gee, if you sell more stuff on the tool side, there is directionally more receivables, clearly there could be offset to that.

Well, that's true, but by the same token, you would expect by selling more, you're going to get more net income.

Good point.

So as you go over a longer period of time, we would expect that the cash flow is going to be derived from the after-tax income from the company. And as it comes up, and as we get growth, we're going to need a little more working capital, but we'll have more income to support it.

So even with some growth next year, you still think over 200's very doable?

I do. Do believe that.

Thank you very much, gentlemen.

I'd just reinforce, Brian, margin enhancement is the best driver for higher cash flow dollars.

Those are two good words.

That's what we're focused on.

Thank you.

Your next question comes from Anant Moore with Brookside Capital.

Hey, it's Adam (ph) from Brookside. Quick question, Randy or Dave. Just on this margin issue on cools -- tools, the way you've managed the company, Randy, when you picked up a decline in margin, let's just say water in first quarter of '03, you guys rectified it quick, you identified three or four issues and took the actions needed and rectified it pretty quick. Same thing in enclosures. In tools it looks like you picked up the issue up early on with the pricing and mix shift. Yet something's, you know, still not working right. So -- and maybe that's just a read from the outside looking in you know, looking at your numbers. It just seems like, you know, it's just not working. I'm just wondering, you know, what's going on there.

Let me attempt to explain it think we do understand what's going on. What's different is, number one, we're not getting volume growth and the volume we lost was our higher margin volume. Number two, you know, three plus percent price decline is larger than we expected. And number three, the combination of higher material inflation that we didn't control and the lower readout of material, we were getting over 5% of material cost productivity a year ago. The fact that that's fallen off into a much lower range of only about 2% is why that 3% of price is hurting the margins as much as it is. So what do we do? We're managing prices as tightly as we can. And we are ratcheting up, as I mentioned in the conference call we're only getting about $20 million worth of productivity in both labor and materials this year. And we've raised the bar, and we've got $35 million worth of actions to go after it. So that's what we're doing about it.

And, you know, I know you haven't made specific comments on '04 and forward, but your plans for '04, specifically on tools, are assuming no return of pricing power and kind of a still, you know, --

As we put --

Makeshift.

We're not assuming any change in the competitive environment. Or the channel power environment.

Got ya. Thanks.

But I should say, we're also not assuming it's going to continue at a 3% rate. Because some of these price reductions that happen, we know how -- you know, they're programmed. They're multiyear agreements, and we know -- they won't happen and hurt us as much as in next year as it has hurted this year. If we can catch up on the cost reductions, then we'll have some benefit.

Yeah. The two things that should benefit us, as Randy said, will be the lower price reduction rate. And then secondly, we do know where we were off a little bit from the standpoint of our previous year cost reductions. We know where that occurred. And there has been a plan put in place to get back on track with that. So the plan is there. And we're working on executing that plan.

Gotcha. Dave, two quick questions for you. Capex for the year still at about 50 and interest expense at about 42? Is that fair?

Well, we're looking at capex more in the range of 45.

Okay.

For this year. And the interest expense, I believe, is around 40 -- I think it's around the 42 or 43 level.

Great. Thank you.

Your next question comes from Ned Armstrong of FBR and Company.

Good morning, gentlemen.

Hi, Ned.

With regard to the enclosures business, what type of signs, if any, are you seeing that the industrial portion of the business is picking up? And what type of things do you tract in that respect.

Well, I mentioned the measures and supply, the supplier confidence level measures. We look at those two. Enclosures typically lags a recover in capital spending. So we also look at, you know, the DRI type of measures and capital spending. Enclosures come late in the second. Once they commit, they buy things and then buy the enclosures. What will happen -- and those indicators are good. In the third quarter, though, as I mentioned in the script, our sort of classic industrial segments really were flat. But we did get growth because we're a networking and commercial, our market segmentation and focus on other segments is beginning to work and show numbers. What will happen, as capital spending does increase, then the distributors will refill the pipeline. But there's a slight lag to that.

Okay. Thank you.

Um-hm.

Your next comes from James Byrne of Capital International.

Hey, gentlemen.

Hi, Gene.

How are you this morning? Okay. Can you define return on capital for me? That is now at 13.8%? How's that calculated?

It's a before-tax number at the operating or EBIT line. And it's the total assets minus current be liabilities calculated on a 13-month moving average.

Okay. In Water Technologies, the margins are flat. We had a double-digit organic sales increase or close to double digit organic sales increase. And you also had an acquisition which had higher than segment margins, if I recall.

No, lower than segment. With us, our focus is to drive it to segment averages.

Okay. Still, a close to double digit sales increase, I would think you'd get some operating leverage out of that and would have --

As we look at it, Gene, we did. I mean, we've been fighting year over year margin declined in the water business. And so we're pleased to get it to be -- we no longer have a decline in margins. That's why I called it the crossover quarter. We continue to invest, though, in building Asia. And so our SG&A is up. And our pool business ramped up well, and we had a lot of volume. But I wouldn't say our productivity there is what we like to have. We did see improvements, however in the pump business, which is why we got to the 13.4.

Since that organic growth was heavily influenced by the pool catch-up from delays of shipments from the second quarter into the third quarter, I would imagine you're not anticipating the same type of sales going forward?

Not in the fourth quarter. But we do expect organic growth -- we continue to build share in pool. We had such rapid growth there, we're still honing our processes so we -- we had negative productivity in that business with that growth. That was why it wasn't higher than 13.4.

So as you think about, you know, lower organic growth, than what you just saw and you got -- your margin comparisons were flat, why would you expect to be above, you know, prior year given --

One is actually we expect -- we expect margins and pools to be higher in the fourth quarter. Because without the expediting of making all that product, trying to ship all that product, we actually will have better prophecies. Our pump business year over year is going to be a big improvement and water treatment year over year is going to be a big improvement. And Europe is going to continue with their strong improvement. It's somewhat counterintuitive, but the fact that a lot of the growth came -- organic growth came from pool actually dragged the margin down in the third quarter because of over time and expediting and the like.

Over in enclosures, how much of the sales increase was foreign exchange?

About half was foreign exchange and half real.

And so, you know, roughly a 2% sales increase?

Yeah, about 2. I guess a little, you know, a little less than 2. That I smidge less than two. This is the first time we've had organic sales growth in enclosures in ten quarters. We feel good about that.

You should. 2% sales increase drove the type of sequential margin improvement?

It wasn't just volume leverage. Remember, we -- this is probably as a group, this is our most successful company in implementing PIMS and supply management. We still have year over year improvement in Structural cost reductions. You know, as you know, we've shut seven plants in this business. And it just volume leverage Gene.

If you look at the second quarter, you had kind of gotten flat on the volumes, as I recall.

Um-hm.

And you had an 8% margin, you know, and change there. Now you have a little bit of volume and you're at a 9% plus range.

Right. And the two big differences from second and are third quarter are continued great execution and supply management and labor productivity and we got -- we got the benefits of a Scottish plant that wasn't fully shut in the second quarter and it's fully shut in the third quarter. So we got rid of that overhead.

Is that -- I mean, would that be a bigger contributor to the sequential improvement, then than the volume?

I'd say it is bigger than the volume. Wouldn't you? I mean --

Probably at least equal, I guess.

You know, if you go back when the thing kind of blew up a little while ago, you took a whole bunch of typical actions to take out capacity --

Right.

-- and downsize the business for the volume environment, et cetera. And they had pretty much matured except you're saying there was one left, and we're now most of the -- now basically those actions have matured.

Right.

And what's left is what you're doing in respect --

Yes.

How much more absent volume improvement, how much more margin improvement is there than we've just seen in the quarter?

I think the productivity will continue. I mean, now, I wouldn't say -- I would say even without volume margins, they'll get better.

And then --

They're just doing really well on productivity.

Where do you think the incremental margin is on the dollar of sale? Incremental volume?

It's pretty high.

It is very high.

Depending on the mix. When it's real hot, if it's rough, it's pretty high. If it's OEM business, it's a little bit lower. But it's still over 20.

Great. Thanks.

Okay.

Your next question comes from Shrani Iyer (ph) Of [Inaudible].

Hi this is a question for Randy Hogan, Randy I remember you I use to work for you at [Inaudible] but I been following Pentair's business after that Randy. My question to you basically is on the tools business, because I've been associated with that business for many years now. You talked about cost reduction mainly coming from lead manufacturing and supply chain initiatives. But having really considered the effect of offshore outsourcing which is basically one of your strengths of trying to move some of your water-based business into India, and secondly, the tools business also since you are facing tremendous cost pressures, have you considered moving into, like mar -- high managing business in the laser tools, which is kind of picking up where you use a lot of laser tools in the DIY markets, too?

You may not be familiar with our tools business. We have a joint venture in China and we get a substantial amount of our product out of China today. And we continue to move product to China, in fact, we're shutting down a plant in Tupelo. Product is going from China and into our existing factory in Jackson. So low-cost sourcing is a key part of our venture. We have a number of people in Asia who are working in that arena today.

Thank you.

Thanks.

Your next question comes from Jim Lucas of Janney Montgomery Scott.

Randy, follow-up question, big picture, you commented that enclosures has been kind of your poster child for the success of PIMS, and Mike and his team are to be commended. What kind of lessons have you learned from the success there that you can apply to the other parts of the organization?

The -- I think the lessons are number one, strongly issued from the top, as you may know, Mike Schrock is the real disciple of lien, and I think that strong leadership from the top is vital. Two, they've done a great job of discipline on training and broadening the number of people who know lien. Three, they've begun to apply thinking of the supply side very effectively. And I'd say four, they're the farthest along, I would say, of taking lien to the strategy deployment level and really defining some breakthrough goals particularly true of Hoffman. And where they have some real discipline around breakthrough goals. In fact, a lot of our productivity is Hoffman, and they're the ones that haven't seen any growth yet except in their core industrial businesses. I guess I'd sum it up that way.

And in terms of, then, translating that to the other businesses in the organization, where do you stand?

I think, you know, let me talk about tools. I think tools is actually very far along in PIMS as well. They just have the three-plus point price improvement. So we need to ratchet it up. And I think we need to be leaner in our supply management efforts in tools. So that's something that Charlie and Mack and I have been talking about. I'd say in water. Water is just a broader business. And I think we need to deepen or broaden the number of disciples we have inside of water. And we're doing that, too. We've enhanced, for instance, we hired a new leader for operations in our tool business. Who actually is from Toyota. So he's not only lean thinking, he's from the fountainhead.

Right. Okay. Thank you.

Okay.

At this time there are no further questions. Mr. Harrison, do you have any closing remarks?

Yes. Randy will, I think, have a couple remarks.

Thank you all for your attention and your questions. We still feel very good about Pentair's prospects going forward. I think we have a good understanding of the challenges we face in tools. But we remain very excited about enclosures and water. And thank you, and we'll talk to you later. Could you give instructions on the replay, please?

Most certainly. Thank you for participating in today's Pentair third quarter earnings release conference call. This call will be available for replay beginning at 3;00 P.M. eastern time through 11;59 P.M. on Monday, October 20th, 2003. The conference I.D. number for the replay is 292-4363. Again, the replay I.D. is 2924363. The dial-in number for the replay is 1-800-642-1687. Or 706-645-91291. This concludes today's teleconference. You may now disconnect.